Now that the dust has settled on yet another momentous earnings report from General Electric (GE 1.30%), it's time to dig into the details behind the headlines. The hike in GE's free cash flow guidance and demonstration of improvement in working capital management is undoubtedly a big plus for GE investors, but the really big winner from the earnings report is Larry Culp's former company Danaher (DHR -1.84%). In short, Danaher's deal to buy GE's biopharma business is starting to look like a very good value for Danaher. Here's why.
Danaher is getting GE Healthcare's growth business
In a nutshell, the healthcare stock is getting the main growth driver of GE's healthcare business, and it's getting it a great price, too. To see why this is the case, we need to dig into how GE Healthcare makes money. The life sciences business comprises a pharmaceutical diagnostics business (the manufacturing of materials used by radiologists in medical imaging) and the biopharma business being sold to Danaher.
The goddess of victory, Nike. Image source: Getty Images.
For reference, the biopharma business manufactures equipment and materials used to help pharmaceutical companies research and develop biopharmaceuticals and vaccines, and it was responsible for around $3 billion of GE Healthcare's overall revenue of $19.8 billion in 2018.
As the chart shows, the growth has been coming from the life sciences businesses, not from healthcare systems. This trend continued in the recent third quarter, when healthcare systems reported that revenue rose just 2%, while life sciences rose 12% -- both figures year over year. Moreover, life sciences' organic orders growth was 10% year over year, while healthcare systems failed to grow organic orders.
Whichever way you look at it, life sciences is the growth business within GE Healthcare, and it's being sold to Danaher. Moreover, the business appears to be growing at a faster rate than the 6% to 7% annual rate at which Danaher anticipates it will grow over the long term.
Data source: Company presentations.
The deal's valuation looks good for Danaher
At the time the deal was announced in February, Danaher estimated that GE biopharma would generate around $3.2 billion in revenue in 2019, representing growth of around 7% in 2019. Given that GE life sciences revenue is up more than 11% in the first nine months of 2019 compared to the same period last year, it's fair to say that Danaher's initial estimate may prove too conservative.
No matter. Even using the initial estimates, the deal looks like a good value. For example, the net $20 billion purchase price was estimated by Danaher to be 17 times 2019 earnings before interest, tax, depreciation, and amortization, or EBITDA. This is a lower multiple than what Danaher's own stock has traded at in recent years, and it includes the company with the now spun-off dental segment -- a serial underperformer.
Moreover, on Danaher's first-quarter earnings call in March, JPMorgan analyst Tycho Peterson asked management, "How much actual free cash flow is this business generating?" Danaher CFO Matthew McGrew replied, "They're generating about $1 billion or so."
Throw in some growth in 2019, and it's clear that Danaher is probably buying GE's biopharma business at a valuation slightly less than 20 times free cash flow -- a significant discount to Danaher's current valuation.
DHR EV to EBITDA (TTM) data by YCharts.
GE biopharma is an attractive business
To cap it all off, note that Danaher's own life sciences business continues to grow at a high single-digit rate -- indicating very good end-market conditions -- and the GE biopharma business gets 75% of its revenue from recurring consumable sources. The last point is important for two reasons.
First, it's a longstanding Danaher aim to increase consumables revenue as it tends to be higher margin, highly cash generative, and more stable in a downturn. Second, even if you assume GE is pulling every bit of sales forward before the business is sold to Danaher, it's likely Danaher will benefit, too, because biopharma has a so-called razor-and-blade business model. In other words, Danaher will get the recurring consumables revenue from any equipment sales GE biopharma is doing right now.
Looking ahead
The latest update confirms that GE biopharma is growing strongly, and it continues to make the deal look a great value for Danaher. The deal comes at an earnings and free-cash-flow discount to the valuation at which Danaher has traded in recent years, and you could argue that GE's need for cash has led management to undersell the strongest part of its healthcare segment.
