Investors in Danaher (NYSE:DHR) saw the company deliver a disappointing set of second-quarter results that caused the stock to drop notably. In fact, as of today, it's pretty much flat on a six-month basis. In truth, the results weren't that bad: The midpoint of full-year generally accepted accounting principles earnings per share guidance was actually raised by a couple cents as management narrowed its guidance to $3.67-$3.72 from $3.60-$3.75.
However, the market obviously expected more, and certain elements of the company's performance surprised on the downside. Danaher reports out of five segments: industrial technologies, environmental (mainly water quality), dental, life sciences and diagnostics, and test and measurement. This kind of diversification normally means that the company is broadly exposed to the industrial economy, and management's commentary certainly reflected a moderately growing environment. With that said, here are five things management wants you to know about the quarter.
Weakness limited to two areas, profits and margins hit
First, Danaher's management was keen to point out that the weakness was limited to two specific areas. Communications revenue within its test and measurement segment was down at a "low double-digit" rate, which the company linked to delays in spending by wireless carriers. Indeed, rival Agilent (NYSE:A) also reported a 6% fall in its communications revenue. The other difficult area came in the dental segment, which recorded "weak consumable sales," possibly due to bad weather earlier in the year. Unfortunately, according to Danaher CEO Larry Culp, both products tend to be "high-margin variables", and their underperformance hit operating profits within the test and measurement and dental segments.
Second, the impact of these two weak products hurt margins, but elsewhere Danaher achieved good growth in core margins. The following chart illustrates how segmental operating profit margins (measured in basis points, with 100 points equal to 1%) grew handsomely in three of five segments.
Good cash flow trends, bullish on acquisitions
Danaher has long been noted for its strong cash generation, which is often uses to make earnings-enhancing acquisitions -- a good example being the $6.8 billion acquisition of Beckman Coulter in 2011.
Management would like investors to know two things in this regard. First, while free cash flow was flat compared to the first six months of last year, the quarterly trend is upward. Per CFO Dan Comas on the earnings conference call: "[I]t's trending well and generated almost $850 million of cash in the quarter versus less than $400 million in the first quarter. I expect that positive trend to continue."
In fact, Danaher generated $2.97 billion in free cash flow in the last four quarters, representing nearly 5.7% of its enterprise value. A company's enterprise value (market cap plus debt) equates to what a potential acquirer would actually pay for the company, and free-cash flow is de-facto the return on their investment. A yield of 5.7% is attractive, as it it's significantly above the interest rate that an acquirer could get on its money. .
Second, Culp was keen to outline an intent to pursue acquisitions: "[W]e remain confident in our ability to deploy our more than $8 billion of M&A capacity." So, even though its forecast for core revenue growth is only 2%-4% for the full year, investors can expect management to use its strong cash flow generation to make earnings-enhancing acquisitions. In other words, growth could receive a boost in the future thanks to the company's strong cash flow generation.
The final takeaway from management's commentary is a certain sense of caution. Core revenue grew at 3% in the second quarter, following a 3.5% increase in the previous quarter, but management maintained the 2%-4% full-year target. Moreover, the weakness in the communications branch of the test and measurement segment is expected to continue. Culp's commentary on the issue: " [O]ur network monitoring business was adversely affected by delays in wireless carrier spending, which we now believe will also result in negative growth for the platform for the rest of the year."
Furthermore, management described the overall growth environment as being "modest," with Western Europe growth coming in slightly below expectations in the second quarter. Looking ahead, the third-quarter guidance is for "core growth to be comparable with the growth rate in the first half." In a nutshell, Danaher's CEO is not telling you to expect great things in the coming quarters.
There were a couple weak spots in the earnings report. Dental consumables sales might well come back in future quarters, but communications looks likely to remain weak throughout the year. If you can forgive these two issues, then you could argue that Danaher's management is doing a pretty good job of increasing core margins across its segments while it waits for a better growth environment.
In addition, the guidance is cautious -- possibly creating some possibility for upside surprise -- and management has the free cash flow and will to make growth-enhancing acquisitions in the future. Given its acquisition history, you shouldn't be surprised if it does so.