Heavy Static At Danaher Corporation

"What we've got here is ... failure to communicate," Cool Hand Luke.

As one of the best-loved conglomerates out there (and seldom a cheap stock as a result), Danaher (NYSE: DHR  ) operates to a different set of Wall Street expectations than most companies. In the case of second quarter earnings and forward guidance, disappointing results in the volatile test & measurement business not only sent the stock down but will likely renew calls for management to consider breaking up the company. Perhaps adding a bit of irony to that, analysts also continue to express frustration that Danaher isn't making bigger splashes with its M&A efforts.

Danaher is Danaher, and the company will be fine. The diagnostics business is getting stronger and operations like water quality/treatment have strong growth potential in markets like China and India. Though I can't say that the shares have reached a bargain price yet, this may be a name to add to the watchlist in case the disappointment coming out of this quarter leads to a more pronounced skid.

Barely missing the mark in Q2
It seems as though there is a lot more concern about what went wrong for Danaher in the second quarter than what went right. All told, revenue revenue rose 5% as reported (3% on an organic basis) and just barely missed the average estimate and likewise the 5%-plus growth in operating income was just slightly below expectations.

Test & Measurement was the problem child this quarter, with sales down 2% on an organic basis. Dental grew 2% organically, while Environmental and Industrial Tech were both up 3.5% (which Motion seeing its first positive quarter in about two years). Life Sciences and Diagnostics was the leader, with organic growth of 6% on strong performance at Beckman and good results from the IRIS business.

Segment-level profits rose 4%, with Test & Measurement giving a particularly bad showing (down almost 12%) while LSD was up more than 17%. A bit concerning was that only LSD and Industrial Tech showed segment-level margin improvements.

Flunking the test, for now...
The problems in Test & Measurement come down to weak spending by wireless network operators, and Danaher management expects this to continue into 2015. Volatile spending from carriers is nothing particularly new and it underlines part of the reason Agilent is splitting off its test & measurement operations (Keysight) from the life sciences operations. Danaher's news is not particularly positive for EXFO, Teledyne, or Agilent, but Agilent/Keysight at least as the advantage of a more diverse collection of businesses and end market exposures.

Waiting for deals, while getting deals
It has been a while now since Danaher has launched a major acquisition and the analysts who follow Danaher seem to be getting edgy about it. Satisfying sell-side analysts who are jonesing for some activity is a poor reason to do deals, though, and Danaher has echoed a lament that has been expressed by other conglomerates like Dover and Parker Hannifin – namely, that deal valuations have risen significantly and there aren't a lot of attractively priced assets out there right now.

It's also not as though Danaher has just been sitting still. The company has concluded 10 deals for over $1 billion this year. Most recently, the company agreed to acquire Siemens' Microbiology business for $450 million. Danaher paid about 2.25x sales for a business with good margins and one that should represent a good opportunity for synergies with Beckman and the life sciences operations (particularly with an opportunity to follow Bruker and bioMerieux into MALDI-TOF in clinical microbiology).

Should Danaher play to its strengths in health?
Life sciences and diagnostics now represent more than a third of Danaher's revenue and adding in the Dental operations brings the total health/life sciences exposure closer to 50%. Danaher has done a fine job of turning around Beckman and the sales growth has caught up to Abbott Labs. Prolonged weakness at Siemens and Johnson & Johnson (before the sale) didn't hurt Danaher's efforts and with sales growing nicely again there should be more opportunities to boost margins (which are almost 300bp below the company segment average).

The question I have is whether Danaher wants to do more. Danaher management has generally tried to run a balanced operation, so I would frankly expect acquisitions to be anywhere but health and life sciences. Motion and motion control, industrial sensors/controls, and product ID all seem like places where Danaher could expand – perhaps even going so far as to consider acquiring a company like Rockwell Automation. On the other hand, buying more of Siemens' flagging diagnostics operations could be another turnaround opportunity akin to Beckman and a chance to grow a business serving a market with good long-term growth and margins.

The bottom line
I still expect Danaher to generate long-term free cash flow in the mid single or "mid high" single digits and that sort of growth suggests the shares are close to fair value. I'd much prefer to buy Danaher at a price below fair value, but that opportunity comes very rarely. Given the weakness in test & measuremnt and management's commitment to maintaining value discipline, I could see these shares lagging over the next couple of quarters and that could create an interesting long-term opportunity. With that, I'd definitely keep Danaher on a watch list.

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