Diversified industrial conglomerate Danaher Corporation (NYSE: DHR ) remains one of the highest quality stocks in the industrial sector, but there are question marks about its prospects going forward. What should investors do with a stock that has rewarded them handsomely over the years but faces some near-term risk? Is it time to buy or sell Danaher Corporation?
Danaher Corporation bear and bull points
Before looking into this question, readers should note that this article is part of a series. We laid out a more detailed bullish case here and a comparable bearish case here. You can find some background on what management would like you to know here.
In a nutshell, bulls will point out the possibility of a bounceback in its underperforming communications and dental consumables product lines, while bears might see weakness in these areas as a structural problem. Bulls are looking for Danaher Corporation to generate growth via acquisitions, while bears will say it hasn't made an acquisition of more than $500 million in two years. Thinking longer term, bulls like Danaher's commitment to adding more digital capability to its products, while bears worry about increasing reliance on emerging markets for growth.
Valuation, and why you buy Danaher Corporation
Essentially, Danaher Corporation is known for being a company that generates high free cash flows and then reinvests them to generate organic and, in particular, acquisition-led growth. With a current 0.5% dividend yield, it's not a stock for dividend chasers. However, it is for those who believe its management can carry on generating good returns on investment.
The following charts explain graphically the issues at hand. The top chart is enterprise value, or EV (market cap plus debt) to earnings before interest, tax, depreciation, and amortization, or EBITDA. EV simply represents a proxy for what a company acquiring Danaher Corporation would pay, and EBITDA can be used a proxy for long-term free cash flow. It's the usual metric used for valuing takeover deals in the investment community.
Meanwhile, return on invested capital, or ROIC, is a measure of how much cash flow a company is generating from the capital it has invested in the business. It's a good measure of management's effectiveness in running a business. However, as the recession periods demonstrate, it varies depending on market conditions.
What the charts mean
Clearly, Danaher's ROIC in the past few years, at around 10%, is somewhat lower than the 12%-17% range the company previously generated in the non-recessionary periods since the late 1990s. Critics will seize upon this as evidence that Danaher is finding it harder to generate ROIC as a consequence of being too large. After all, conglomerates are hardly in fashion in the investment community. Indeed, smaller rival Agilent Technologies (NYSE: A ) is spinning off its electronic measurement company, called Keysight. Furthermore, some analysts, such as Citigroup's Deane Dray, are already discussing the benefits of breaking up Danaher.
However, investors should appreciate that global economic growth since 2008 simply hasn't been as strong as it was in previous recoveries, making it harder to generate ROIC improvements. Moreover, Danaher's EV/EBITDA valuation clearly reflects this. Indeed, the current valuation, despite a strong rise in recent years, is toward the lower end of the 12-15 range that it was between the past two recessions.
With regard the bull-bear argument, it's too early to doubt Danaher's management on its acquisition strategy. The current CEO, Larry Culp, is leaving next March, but his successor has been at Danaher since 1989. Good management doesn't become bad overnight. Moreover, Danaher isn't alone in suffering some lumpiness in communications spending (particularly with wireless carriers), and dental distributors such as Patterson Companies, Inc. (NASDAQ: PDCO ) have also reported weakness in dental consumables because of the poor winter weather. On balance, the weight lies toward the bullish side.
Turning to valuation, Danaher Corporation's stock looks like a good value. It trades at a historical EV/EBITDA discount, but this is justified by the lower ROIC. However, Fools should consider that if it generates around 10% in EBITDA next year (in line with current ROIC, and what analysts expect its EPS growth to be in the next two years), then its EV/EBITDA will be close to a 12 times multiple at this point next year, making the stock look cheap. In other words, given a growing global economy, it's reasonable to expect Danaher's stock to generate returns close to its earnings growth, and at 10% that might suit Fools just fine.
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