Frasier, Better Call Saul, Joanie Loves Chachi: TV spinoffs can be beloved connections to the past or outright duds. Corporate spinoffs, luckily, are more predictable; they have long been a source of outperformance for investors.
In a spinoff, the separation of businesses allows each to focus on what it does best. That focus creates an advantage that -- at least until the recent bull market -- had produced market-beating returns for generations. However, over the past decade, companies that were spun out have trailed the market by almost 3% annually.
Danaher (DHR -0.59%) is no stranger to the practice of spinoffs. The company has long been known as an ever-changing portfolio of businesses with a focus on manufacturing excellence and decentralized operations, and it has a history of buying, selling, and spinning off companies -- but its strategic focus has shifted. In 2015, management announced it would split into two businesses, maintaining the faster-growing, higher-margin science-based companies and spinning off its diversified industrial units. With history offering mixed results on spinoffs, curious investors might wonder whether this transaction has created value for shareholders.
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Change for the better
The company was an early adopter of "kaizen," a Japanese operational approach based on continuous, methodical improvement driven by employees. Incorporating this process into what it dubbed the "Danaher Business System" provided a common approach for running the various businesses regardless of industry. The system worked: In the years between 1990 and 2015, shareholders were rewarded with a 9,900% return.
After the 2015 announcement, the company followed through with a series of moves. In 2016, Danaher spun off its industrial businesses as Fortive (FTV -0.81%). The company followed up by spinning out its dental business into Envista (NVST 0.66%) at the end of 2019.
Those businesses that remained under the Danaher name were less reliant on one-off transactions in favor of recurring revenue. Businesses with predictable, recurring revenue typically command much higher valuations than more traditional ones with sales that may or may not be repeated.
The apple doesn't fall far from the tree
When it was spun out in 2016, Fortive was quickly dubbed "Danaher 2.0" thanks to its rapid acquisitions of ISC, Landauer, Gordian, Accruent, and ASP. These businesses bolstered Fortive's industrial offerings with such products as on-the-job gas and radiation monitoring and software to manage facilities, assets, and construction costs. The company fulfilled its legacy as a miniature version of its former parent in September 2019, announcing it was also splitting itself into two businesses.
For their part, Fortive investors have seen an 11.3% annual return since its July 2016 debut, compared with 12.7% for the S&P 500. While the shares have only produced market-matching returns, Danaher investors who received them as a tax-free dividend have plenty to appreciate. The spinoff is only one part of the equation.
A rolling stone gathers no moss
Danaher's transactions over the past five years have all demonstrated its effort to concentrate around a portfolio of diagnostics, life sciences, and environmental solutions. The core of this portfolio began with the 2011 acquisition of diagnostics business Beckman Coulter for $6.8 billion. The company has continued building this segment through acquisition, completing a series of deals worth $20 billion since 2015.
To understand not only how investors have fared but how they are positioned for the future, it is instructive to look at two of the metrics that drove the spinoff: revenue growth and profit margins.
| Metric | Danaher | Fortive |
|---|---|---|
| Revenue Growth |
2019: 5.1% 2018: 9.9% |
2019: 13.4% 2018: 12.1% |
| Operating Margin |
2019: 20% 2018: 19.3% |
2019: 13.7% 2018: 18.3% |
Source: Company materials.
The results are mixed. While Fortive has been growing faster, Danaher does produce higher profit margins. To make a more apt comparison, we can compare Danaher's overall life sciences business as reported by the company to that same business without acquisitions -- the "core" business. This is a better apples-to-apples comparison.
| Metric | Life Sciences | Life Sciences (Core) | Fortive |
|---|---|---|---|
| Revenue Growth |
2019: 7.5% 2018: 13.5% |
2019: 7% 2018: 7.5% |
2019: 13.4% 2018: 12.1% |
| Operating Margin |
2019: 20.2% 2018: 19% |
The company does not break this out |
2019: 13.7% 2018: 18.3% |
Source: Company materials.
Once again the results are mixed. It's clear that the retained life sciences unit is more profitable, but Fortive, despite being spun off as the slower-growing business, is expanding faster. Based on the numbers above, you might expect Danaher's stock to be doing no better than, or even lagging, Fortive's. You would be wrong. Danaher stock is up 154%, or 25% annually, since the Fortive spinoff.
Recall the effects of recurring revenue? Now let's look at how the market is valuing each company. The price-to-sales (P/S) ratio is a useful valuation measure that compares the market cap of a company to its annual revenues. Typically, this ratio increases along with the predictability of sales.
| Company | 2016 P/S | 2020 P/S |
|---|---|---|
| Fortive | 3.0 | 3.7 |
| Danaher | 2.4 | 8.0 |
Source: Morningstar.
Sealing the deal
Danaher has has bought, sold, and spun off businesses to generate incredible shareholder returns, and it has built a reputation as a home to management gurus. After splitting the business in 2015, management doubled down on faster-growing, more profitable businesses with predictable revenue. Despite mixed financial results, the market has rewarded the moves by significantly increasing the valuation. Management has proven that investing in Danaher is a long-term commitment that pays off; however, given the recent run up, healthcare investors should wait for a better opportunity to acquire shares.
