Danaher: Good Capital Appreciation at a Reasonable Price

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Feb 19, 2015

Two brothers went fishing on the Danaher River in Montana, and came back with a bold new vision for their real estate trust. And, the new vision had nothing to do with real estate. Instead, it called for, in the company’s words, “... a manufacturing company, dedicated to continuous improvement and customer satisfaction.”

We don’t know if Steven and Mitchell Rales caught any fish on that trip in the early 1980s, but the vision certainly didn’t get away from them. They soon went on a buying streak and each new company brought into the fold was transformed using what they called the Danaher Business System. DBS, as it’s also called, combines Kaizen and Lean (the key to Toyota’s manufacturing success), to improve productivity and customer satisfaction. Today, the Danaher Corporation (DHR) is a $61 billion dollar company and a member of the Fortune 500

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We found Danaher on the Buffett Munger screener at GuruFocus. Like the other companies that make it through that value screen, it has to be fairly valued or under valued, and it must have strong predictability of future earnings.

History

1984: The company (non-real estate) incorporates as Danaher Corporation.

1986: Within two years the company acquires 12 companies to make its entry into manufacturing. BloombergBusiness writes (in 2007), “In the early 1980s they [the Rales brothers] took a former real estate investment trust, turned it into a leveraged-buyout vehicle, and swashbuckled through the next few years, tacking assets on to their shell company through hostile bids, greenmail, and junk-bond financing, with Michael R. Milken's Drexel Burnham Lambert and First Boston as their bankers.”

1987: Begin using lean productivity practices.

1989: The brothers bring in George M. Sherman to be President and Chief Executive Officer.

1991: Sears, Roebuck & Co. sole sources Danaher for Sears mechanics' hand tools.

1998: Establishes the test & M\measurement business by acquiring Fluke Corporation; the environmental business by acquiring Dr. Bruno Lange G.m.b.H.; and the motion control business by acquiring Pacific Scientific Company.

2004: Enters what becomes the diagnostics business through the acquisition of Radiometer; and the dental business by buying KaVo and Gendex.

2005: Begins life sciences business with acquisition of Leica Microsystems.

2007: Bloomberg Business magazine writes, “Danaher is probably the best-run conglomerate in America. It's clearly the best performing: Over 20 years, it has returned a remarkable 25% to shareholders annually...”

Unless otherwise noted, the company history is based on information at the company website, Wikipedia, Funding Universe, Reference for Business, and its 10-K for 2013.

Comments on Danaher history: This company set its direction early and has stuck to it for the last 30 years.

The DHR Business Model

Danaher can be distinguished by two key characteristics.

  • First, it has been an aggressive aggregator and aquisitor, buying literally hundreds of companies.
  • Second, it either turned around or strengthened the companies its acquired by imposing what it calls the DANAHER BUSINESS SYSTEM or DBS. Based on the lean production or lean manufacturing processes used by Toyota Motor Company (TM, Financial), DBS seeks to simultaneously improve customer satisfaction and reduce manufacturing costs by eliminating waste.

Danaher segments its operations into five groups:

  • Test & Measurement: Professional test tools and general test instruments; brand names include AMPROBE, FLUKE, FLUKE BIOMEDICAL, KEITHLEY, MAXTEK and TEKTRONIX. Communications products that ensure the reliability and efficiency of network equipment. Brand names: AIRMAGNET, ARBOR NETWORKS, FLUKE NETWORKS, TEKTRONIX COMMUNICATIONS and VSS MONITORING.
  • Environmental: Products and services for water quality analysis and treatment; instrumentation and disinfection systems to help analyze and manage the quality of ultra pure water, potable water, wastewater, groundwater and ocean water in residential, commercial, industrial and natural resource applications. Brands include: CHEMTREAT, HACH, HACH/LANGE and TROJAN TECHNOLOGIES. This division also manufactures and sells products that serve retail and commercial gas stations.
  • Life Sciences & Diagnostics: The Life Sciences side of this segment comprises a microscopy business (professional microscopes) and a mass spectrometry business (high-end mass spectrometers). Diagnostics is made up of three groups: a clinical lab business (biomedical testing instrument systems, tests and supplies), an acute care business (instruments, software and related consumables and services), and a pathology diagnostics business (a comprehensive suite of instrumentation and related consumables).
  • Dental: “... a broad range of dental consumables, equipment and services that are used to diagnose, treat and prevent disease and ailments of the teeth, gums and supporting bone, and to improve the aesthetics of the human smile. The buyers of these products are general dentists, dental specialists, dental hygienists, dental laboratories and other oral health professionals.
  • Industrial Technologies: In its 10-K for 2013, Danaher describes itself as, “...a leading global provider of equipment, consumables and software for various printing, marking, coding, design and color management applications on consumer and industrial products. The segment is also a leading global provider of electromechanical motion control solutions for the industrial automation and packaging markets.”

The following table, excerpted from the 10-K for 2013, shows the the contributions to overall revenue by the five segments:

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For 2013, international operations accounted for 58% of overall revenue. The following table, also excerpted from the 10-K for 2013, shows how much each segment drew from outside the U.S.A.

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No single customer accounted for more than 10% of revenue in 2013.

Competititors

The company describes its competitive environment this way, “Although our businesses generally operate in highly competitive markets, our competitive position cannot be determined accurately in the aggregate or by segment since none of our competitors offer all of the same product and service lines or serve all of the same markets as we do. Because of the range of the products and services we sell and the variety of markets we serve, we encounter a wide variety of competitors, including well-established regional competitors, competitors who are more specialized than we are in particular markets, as well as larger companies or divisions of larger companies with substantial sales, marketing, research, and financial capabilities.”

Yahoo! Finance lists Danaher’s competitors as General Electric (GE, Financial), Siemens Water Technologies Corp. (privately held), and the SPX Corporation (SPW, Financial). As a conglomerate, DHR is unlikely to have any exact matches competitively at the corporate level, but a good deal of head-to-head competition at the product level.

Comments on the Business Model: Danaher is a diversified corporation, distinguished by its well-honed strategy of buying up weak manufacturers (and other companies), then turning them into leading entities through the discipline of the Danaher Business System (lean production, kaizen, and other productivity improvement protocols). It operates in five different segments, and competition needs to be assessed within individual segments and product lines.

Management

President and Chief Executive Officer: Thomas P. Joyce, Jr. , age 53, joined the company in 1989 as a Project Manager. He held a number of senior positions throughout the company before becoming CEO in September 2014.

Executive Vice President and Chief Financial Officer: Daniel L. Comas , age 50, joined DHR in 1991 and became CFO in 2005.

Chairman and co-founder: Steven M. Rales, age 62.

Chairman of the Executive Committee, Director, and co-founder: Mitchell Rales, age 57.

Board of Directors: 10 members, including three related directors (CEO Joyce, Chairman Steven Rales, and Director/co-founder Mitchell Rales), and seven independent directors. Board members have experience or expertise in manufacturing, retail and consumer goods, food manufacturing, finance, law, politics, merchant banking, private equity, technology, and pharmaceuticals.

ISS Governance QuickScore: 5, on a scale in which 1 represents lower governance risk and 10 represents higher governance risk. The company receives red flags for Board Composition, Board Practices, and Pay for Performance. It receives a green star for Other Practices.

Comments on Management: The co-founders (as well as the two senior officers) are relatively young and we might assume one or both will stay with the company for the near-term at least, and continue to influence the culture and practices of the company, a culture and practices that have seen the company grow quickly and profitably.

Ownership

Gurus: 15 of the gurus followed by GuruFocus own shares in Danaher Corporation. The biggest holders are Dodge & Cox: 9,975,933 shares, representing 1.42% of shares outstanding; Larry Robbins (Trades, Portfolio) with 5,000,000 shares; and Jeremy Grantham (Trades, Portfolio) with 3,794,069 shares.

Institutions: The following chart from nasdaq.com shows overall institutional holdings; the largest of these owners is T. Rowe Price, with 76,084,429 shares, valued at $6.6 billion.

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Short Interests: GuruFocus puts short holdings at less than 1%, which is very low.

Insiders: GuruFocus puts insider ownership at 2%, and provides the following table/chart of insider holdings:

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Comments on Ownership: Lots of confidence, with strong holdings among the gurus, institutions, and insiders. In particular, we note that the Rales brothers (company founders) collectively own some 13-million shares, strongly aligning their interests with those of other shareholders.

DHR by the Numbers

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Comments on key statistics: The share price is nearing the 52-week high, the dividend is small, and the company did not buy back shares in 2014. It is also a $61 billion company, which gives it a lot of heft in competitive markets.

Financial Strength

The GuruFocus automated system gives Danaher a 7/10 for Financial Strength and 9/10 for Profitability & Growth. A glance at the summary of Financial Strength lets us know why that number is down in the ordinary range: Cash to Debt is poor compared to to what it has been in the past.

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To calculate the Cash to Debt ratio, we sum up the cash and cash equivalents available, and divide that amount by the debt. If the ratio is greater than 1.0, then the company could clear its debt with the cash and equivalents it has on hand. So, given that DHR’s current Cash to Debt ratio is 1.33, above 1.0, what’s the problem? The 1.33 number refers to the quarter ended September 30, 2014, but at the end of the following quarter, December 31, that ratio had dropped to .87 (which means the company still has access enough cash to pay 97% of its debt). We also note that on this metric, DHR is ranked better than 74% of 2055 firms in the Global Diversified Industrials industry.

Looking down two lines in the Financial Strength table, we see Interest Coverage, which we arrive at by dividing Operating Income (EBIT) by the Interest Expense. Of course we don’t need to do the arithmetic, we can simply look at the number next to Interest Coverage and see it is 22.45. In other words, DHR generates enough EBIT (operating income) to cover its interest expense roughly 22 and a half times.

Turning to the 10-Year Financials at GuruFocus, we see that long-term debt, at the end of the fourth quarter of 2014 was $5.4 billion. Also at the end of that quarter, free cash flow (ttm) amounted to almost $3.2 billion. To help put the fluctuations we noted above in context, here’s a chart showing quarterly cash flow data; observe how cash flow varies from quarter to quarter:

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The automated system also generates one Severe Warning Sign, which refers to the rates of asset growth and revenue growth. When the growth of assets outstrips revenue, there may be concerns about asset allocation and the sources of capital used to finance those assets; at this point, we have none.

Comments on Financial Strength: All things considered, we recognize, but don’t get concerned about the level of debt at Danaher. It debt level is comfortable within the context of the industry and its history, and the company has a strong record of growing its free cash flow.

Valuation

At the close of trading on February 18, 2015, DHR had a PEG ratio of .94, indicating it is under valued (slightly). We get this ratio by dividing the P/E (Price/Earnings) ratio by the average five-year growth of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). A stock with a PEG ratio below 1.0 is considered under valued; a stock between 1.0 and 2.0 is considered fair valued; and a stock with a PEG of more than 2.0 is considered over valued. Thus, we would consider Danaher to be slightly under valued at its current price.

With a low PEG, the stock gets one leg into the Buffett Munger screener at GuruFocus. As we know, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) became investing legends by buying stocks that were under valued; originally they sold them when they became overvalued, but more recently, they’ve mostly bought and held. All else being equal, an under valued stock is less likely to hand you a loss than a stock that is fair valued or over valued. And if you minimize losses, you’ll also likely to increase your positive returns.

Being undervalued isn’t enough by itself for a stock to get into the Buffett Munger screener; it must also have strong and consistent EBITDA growth. Again, stocks with this consistency, or predictability, are less likely to harm your wallet, and more likely to fill it.

Danaher earns a 4.5 out of 5 Star rating for its earnings, or EBITDA (many analysts prefer EBITDA to other earnings measures because it removes discretionary costs, and makes comparisons among different companies more feasible). The following chart shows how EBITDA (blue line) has grown steadily; price, shown with the green line, has also grown, but with more fluctuations:

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Comments on Valuation: As the chart above shows, Danaher has established an enviable record of EBITDA growth, both in terms of size and consistency. Because of the strength of those earnings, DHR is considered under valued at its current price, even though it has a P/E of 22.70.

Opportunities & Risks

In a presentation at the Investor & Analyst Meeting, December 11, 2014, the company summarized its opportunities this way:

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Driving growth by investing in organic opportunities with the highest impact tells us the company will continue to focus on asset allocation, investing and acquiring where it sees strong growth and/or margins, and divesting in areas with less potential.

Optimizing the portfolio suggests DHR will continue on its aggressive acquisition path, buying companies and facilities that allow it to enter high potential markets.

Enhancing competitive advantage with DBS means using Danaher Business System, that combination of Lean, Kaizen, and Leadership/Teamwork, that leads to continually increased productivity.

Risks

Economic conditions: As a company with five different segments operating in numerous countries around the world, DHR faces a range of challenges. Many of its lines of business depend on overall economic growth to drive corporate growth.

At the same time, strong economic growth would be expected to make the cost of acquisitions higher, increasing the height of the profitability hurdle.

At the end of 2013, the company reports it carried net value of goodwill and other intangible assets of some $22.3
billion. Any significant changes in accounting for goodwill could harm the company’s financial and operating results.

As a big, diverse conglomerate, Danaher is exposed to numerous regulators in numerous countries. That makes regulatory risk a significant issue.

Similarly, the company is exposed to multiple reputational and legal risks, everything from breaches of data security to potential manufacturing mistakes that hurt consumers.

And, if American corporate tax policies change, DHR could be hit, as will all large companies with foreign subsidiaries.

For more on risks (and opportunities), see the company’s recent 10-K reports.

Growth

In a chart above, we saw how Danaher has grown its EBITDA through its publicly-traded history.

Can it continue to grow like this? In the Opportunities section we’ve seen the company plans to continue doing what has worked well for it in the past. And the Risks section gives us no indication of at least foreseeable problems; essentially, DHR faces the same risks as every other major, international corporation.

For the current year, 2015, Danaher issued earnings guidance of $4.35-$4.45; the lower end would be a 19.8% increase when compared with an expected $3.63 for 2014. Analysts followed by Yahoo! Finance average expectation for 2015 is $4.37.

The analysts at Yahoo! Finance also expect, on average, earnings of $4.76 (a range of $4.62 to $4.93) for 2016, which would represent a 9.4% increase over 2015.

Altogether, it appears that Danaher will continue to earn high ratings for the consistency and predictability of its earnings. That, in turn, should pull the share price upward over at least the next two years, and likely beyond.

Conclusions

At its current price (February 19, 2015) Danaher Corporation is a value stock, with a five-year EBITDA growth rate that exceeds its P/E ratio.

It’s also a highly predictable stock, able to consistently generate strong, growing earnings from year to year.

What it is not is an income stock; the dividend is fairly new and while it did receive a significant bump last year, we will need to see several more years of increases before it can join the line to become a Dividend Aristocrat.

What it does offer is the prospect of better than average capital appreciation, as we say, at an under valued price, which makes it worth the consideration of value investors.