Danaher Corporation's (DHR 0.24%) third-quarter earnings saw the company return to form by generating core margin expansion and 3% core revenue growth. On a reported basis, revenue increased 9.5% and adjusted diluted EPS increased 15% in the quarter. Moreover, Danaher shrugged off the negative impact of hurricanes in reporting its strongest quarter of the year. Let's look at the quarter and what it's changed about the investment thesis for the stock.
Danaher's dental segment is facing a difficult fourth quarter. Image source: Getty Images.
Growth and margin picked up
On the 2017 outlook meeting in December, CEO Tom Joyce had set a full-year 2017 target of 3%-4% core revenue growth, but a growth rate of just 2.5% and 2% in the first and second quarter suggested Danaher would miss the target.
No matter. Danaher promptly hit 3% in the third quarter, in line with Joyce's guidance on the second-quarter earnings call, and now CFO Daniel Comas is expecting 3.5%-4% for the fourth quarter.
Image source: Danaher Corporation presentations. Q4 17 estimate is the midpoint of the indicated range.
The good in the quarter
Digging into the segment performance in the quarter, we find a mix of positives and negatives. Fortunately, the positives come in the two highest revenue-generating segments: life sciences and diagnostics, making up 31% and 32% of revenue year to date, respectively.
Despite the impact of hurricanes, which reduced growth at Danaher's life-sciences segment, the company increased its growth rate overall, and life sciences core revenue growth and margin expansion was impressive. However, the standout performer in the third quarter was diagnostics. Revenue growth and margin bounced back strongly in diagnostics, particularly after a poor showing in the first quarter.
Danaher's first-quarter earnings showed that the key worry was soft growth at Beckman Coulter Life Sciences, but this appears to have been a timing issue. In fact, on the third-quarter earnings call, Joyce pointed out that "[a]t Beckman Life Sciences, core revenue increased at a high single-digit rate on broad-based strength across all major product lines and regions."
Data source: Danaher Corporation presentations.
The bad
On a less positive note, the margin decline in the environmental and applied solutions segment, which provides around 30% of segment profit before eliminations, is a concern -- as is the ongoing struggle in the dental segment. Regarding the former, Joyce spoke of the impact of incremental growth investments, principally in the water-quality businesses, and the modest impact of hurricanes on industrial water treatment company ChemTreat.
Meanwhile, the dental segment saw mixed fortunes. Specialty consumables achieved mid-single-digit core growth, and Nobel Biocare, which specializes in dental implants and CAD/CAM systems, generated mid-single-digit growth, too. However, traditional dental consumables had yet another quarter of "continued weakness," as Joyce put it.
In addition, the outlook for the fourth quarter isn't great for the dental segment. Comas talked about the likelihood that customers will destock dental equipment, hurting sales and margin. Meanwhile, he expects dental to be flat in the second half, and given that dental core revenue growth was 1% in the third quarter, this implies a core revenue decline in the fourth quarter. It's true that he also said that "traditional consumables will start to see some recovery here in Q4," but it's a recovery that's been a long time coming.
Image source: Danaher Corporation presentations; bps is basis points, where 100 bps is equal to 1%.
What does it all mean for the stock?
All told, Danaher raised full-year adjusted diluted EPS guidance to a range of $3.96-$4.00 from $3.90-$3.97 previously, having started the year predicting $3.85 to $3.95. Moreover, there is a strong argument that the separation of Fortive Corporation means that the new Danaher -- which generates around 70% of its profits from medical focused activities such as life sciences, diagnostics, and dental -- should now be benchmarked against medical companies rather than industrials. The latter tend to command a higher rating.
The following chart shows how Danaher stock is cheap relative to other life-sciences and diagnostics companies.
DHR EV to EBITDA (Forward) data by YCharts
However, I would argue that the argument from relative value is the only strong case for buying the stock. On an absolute basis, a forward P/E ratio of 27.5 times earnings is hardly cheap, even for a company of Danaher's quality. Furthermore, the company faces a difficult fourth quarter in its troublesome dental segment. If you believe in relative valuations, then buy the stock. Otherwise, it looks expensive.
