Danaher Corporation (NYSE:DHR) has always been an unusual stock in the industrial sector. A heavy exposure to healthcare and environmental solutions used to make it the go-to stock when analysts were concerned about an economic downturn. Furthermore, the more cyclical bits of the business have been bundled together and spun off into a new company called Fortive Corporation (NYSE:FTV), leaving Danaher even more exposed to non-cyclical end markets. Given that analysts expect 2017 to see a bounce back in industrial growth, is Danaher a good stock to buy?
I have two arguments for you:
- The market has already priced in a recovery in U.S. industrial production and a stabilization in oil & gas capital spending, so Danaher will not fall "out of sentiment."
- The split from Fortive will allow Danaher to fully realize the growth potential on its portfolio, and investors should look at the stock differently.
Let's look at them more closely.
The cyclical stocks are already priced in, don't fear defensives
2016 was a year when the market bought up cyclical stocks in anticipation of a pick-up in 2017. Two stocks that are emblematic of this theme are Rockwell Automation Inc. (NYSE:ROK) and Caterpillar Inc. (NYSE:CAT).
Rockwell's automation controls, software, and sensors make it a company largely reliant on capital spending plans of industrials -- the first thing to get hit in a general slowdown. Meanwhile, Caterpillar has heavy exposure to resource industries and energy capital spending. As the year progressed, both companies saw deteriorating end market conditions, and both lowered estimates accordingly.
However, as you can see below, they significantly outperformed a leading industrials ETF, the iShares US Industrials, the S&P 500 index, and our leading defensive ETF Danaher Corporation.
All of this suggests you might not be buying cyclical names (Rockwell Automation and Caterpillar) at a discounted price after all. Similarly, Danaher's underperformance suggests its relative lack of exposure to a recovery in industrial growth is already priced in.
Meet the new Danaher Corporation
The separation of Fortive created two companies with different investing characteristics. Fortive will appeal to investors looking for a cyclical and highly cash-generative industrial company, while, as you can see below, the new Danaher has nearly two-thirds of its revenue coming from diagnostics and life sciences.
However, if you thought the remaining Danaher would be a sleepy, low-growth healthcare business, then you'd be wrong. In fact, the company offers a rare combination of growth and margin potential from a relatively defensive set of end markets. There are three things to focus on:
- The opportunity to increase productivity with recently acquired business such as Pall Corp (life sciences) and Cepheid (diagnostics) through the Danaher Business System, or DBS.
- The new company has an opportunity to engage in more merger & acquisition activity.
- Growth & margin expansion through increasing sales of high-margin recurring consumables sales.
As illustrated below, Danaher has a high portion of its revenue (overall 65%) coming from consumables, granting it relatively stable revenue streams.
Moreover, management believes it can increase consumables sales while expanding margin. In fact, in the recent investor & analyst meeting, they outlined expectations to increase core operating margin by 50 basis points to 75 basis points annually (100 basis points equals 1%). Also, the new businesses tend to have higher shares of consumables shares -- for example, Pall Corp and Cepheid with 75%.
All told, Danaher has secular growth prospects and isn't just an ordinary defensive stock; it has genuine growth prospects. Indeed, management forecasts 7% to 10% adjusted EPS growth for 2017, or 9.5% to 12.2% growth if you exclude the negative impact of currency.
A stock to buy for 2017
A look at valuation suggests Danaher is hardly cheap relative to some of its peers.
However, the arguments outlined above suggest investors should be willing to pay a premium for Danaher's underlying growth potential. In addition, 2017 is not necessarily the year when investors abandon defensive-type stocks in favor of cyclical industrials -- the market may have already done that in 2016.
All told, on a risk/reward basis, Danaher is probably close to fair value, but given any kind of market fall, it's worth picking up for its defensive growth properties.
Lee Samaha has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.