After an underwhelming set of second-quarter results and some cautious management guidance, investors in Danaher Corporation (NYSE:DHR) must have felt the stock was likely to be range-bound for a while. However, a good quality company is rarely without upside potential, and there are three key reasons for optimism over the stock, ranging from the near term to the long term -- suggesting that investors have a significant time frame in which to expect some upside.
Communications and dental consumables to bounce back?
Starting with the near term, Fools already know that Danaher's second-quarter results were adversely affected by the underperformance of two businesses with high variable margin. Communications-based revenue in the test and measurement segment was weak because of spending delays by wireless carriers, and dental consumables in the dental segment were weak, too. You can see the effect on profits and margins in this article.
Danaher's management candidly said that it doesn't expect conditions to get better anytime soon with communications, but the reality is that wireless carrier spending is notoriously lumpy. For example, early last year a number of technology companies disappointed the market when telco service providers cut spending, only to see revenue recover later in the year. As for dental consumables, it's possible that poor weather earlier in the year held back patient visits, which then caused dentists to delay consumable purchases. If that's true, there could be some pent-up demand to be released in the coming quarters.
In other words, it's entirely possible that these two product ranges could see a bounce back in the near future, and since Danaher's management has been cautious, the stock is nicely primed for some upside.
Danaher's acquisition strategy
The company is known and respected for its acquisition strategy -- but less so for its dividends, as the shares currently yield just 0.4% -- and management recently reiterated that it has $8 billion worth of capital for acquisitions. The Beckman Coulter life sciences and diagnostics segment is a good example of what Danaher can do. Danaher acquired the company in 2011 for $6.8 billion and has managed to increase Beckman Coulter's operating margins from around 10% to the "mid-teens" in 2013.
In fact, Danaher has already made 10 acquisitions adding up to more than $1 billion since the start of April. In a sense, investing in Danaher is about making a conscious decision to back management's ability to generate synergies from acquisitions, using its so-called Danaher Business System, or DBS. Indeed, in the last quarter, overall revenue grew 5%, with core revenue up 3% and acquisitions contributing 1.5%, or 30% of the total.
Going forward, investors should expect Danaher to be active with acquisitions, but since it takes time to realize the full benefits of any deals, this has to be viewed as a medium-term driver for the stock.
Danaher's strategic shift
The long-term upside driver relates to a strategic decision the company is making to invest in digital solutions. This move is reflective of shifts in the economy, whereby the intellectual portion of a good's value, such as software, is increasing relative to hardware. Indeed, at its most recent analyst day, Danaher CEO Larry Culp said that a third of the company's engineering headcount is now in the software area, and that 10% of its marketing headcount is in "specific digital activities".
Danaher is trying to increase the software component of its product architecture and embrace cloud-based software-as-a-service technologies, or SaaS. The benefits are that it can stay engaged with its customers, generate more consumables sales, and increase its recurring revenue base. I appreciate that this sounds like management jargon, but consider the long-term advantages:
- More consumables, service, and software sales will reduce the inherent cyclicality in its revenue base
- According to Danaher, recurring revenue already made up more than 40% of its overall revenue in 2013; that number should increase in the future.
- SaaS solutions nicely dovetail with DBS's embrace of the slogan "customers talk, we listen," because they allow for greater active engagement with the client.
If Danaher's management carries on with this strategy. then it's reasonable to expect a reduction in cyclicality in its business, and that would justify a rerating in the stock. In addition, a greater software component arguably leads to margin improvements.
What it means to Danaher investors
All told, the three upside drivers offer something for the near, mid- and long term. Conditions within its communications and dental consumables product lines could get better in 2014, and management is actively seeking earnings-enhancing acquisitions. Meanwhile, the ongoing shift toward increasing the digitization of its products offers an exciting long-term upside driver. There is a lot to like about Danaher Corporation.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.