Long-term investors in Danaher Corp. (DHR 1.75%) have grown used to watching their stock outperform the index in rising markets, with the stock price gaining around 200% over the past 10 years versus an 81% gain for the S&P 500. However, this year's underperformance of nearly 6% versus the S&P 500 must have them wondering whether the company has lost its touch. Why has Danaher started to underperform, and is it likely to continue?
Why Danaher Corp. has underperformed
In a nutshell, there are three reasons the stock has underperformed this year:
- There are questions about the company's ability or opportunity to make suitable acquisitions -- a key part of its business strategy
- CEO Larry Culp, whose 11-year tenure is partly responsible for the recent outperformance, announced in April that he would be leaving the company.
- Two of the company's higher-margin businesses -- communications (test and measurement) and dental consumables -- have underperformed expectations.
Danaher Corp.'s existential angst
Companies' reputations define how investors look at them. In Danaher's case, the company has long been seen as an excellently run conglomerate that uses its substantive cash flow generation to make earnings-enhancing acquisitions.
The company then applies what management calls its Danaher Business System, or DBS, its own specialized business philosophy and set of management processes, to the acquisitions in order to make them more profitable for investors. In fact, Danaher has acquired more than 400 businesses since 1984 and applied DBS to each and every one of them.
It's a strategy that has worked very well over the years, particularly with acquisitions like the $6.8 billion purchase of life-sciences company Beckman Coulter. Indeed, Fools already know how Danaher continues to generate core margin improvements in its life sciences and diagnostic division.
However, the flip side of following this kind of growth path is that investors have to accept a miserly dividend yield of 0.5%, because much of the cash flow is being earmarked to make acquisitions rather than pay dividends. That's fine when the stock is outperforming, but not so appetizing when it underperforms.
Moreover, until the recent agreement to acquire Swiss dental implant company Nobel Biocare for $2.2 billion, the company hadn't made an acquisition above $500 million since 2012. Throw in the departure of Culp -- a man very closely associated with Danaher's long-term success -- and the market is bound to question whether Danaher can still follow the same acquisition-led model in the future.
Communications testing and dental consumables underperforming
The third reason the stock has underperformed is that two of its higher-variable-margin businesses -- those whose earnings rise and fall more strongly with revenue -- have shown some weakness this year. A quick look at second-quarter operating profits by segment reveals the damage done in its test and measurement and dental segments.
Source: Danaher Corp. presentations.
Readers can get more color on what's going on with these segments from two of my previous articles: From a bullish standpoint, this could present an opportunity for Danaher; from a bearish standpoint, the weakness could be more of a structural concern.
What does it all mean for investors?
There are strong reasons to believe that he market is being a little harsh on Danaher. Other companies, such as Agilent, have reported weakness with wireless carrier spending as well, and extreme bad weather may have caused dental patients to forgo visits earlier this year, bringing bad news for dental companies. These issues may rectify themselves in future quarters. Wireless carrier spending is notoriously lumpy, and dental spending tends to rise with stronger economic growth.
Moreover, rising stock markets, and increasingly active involvement from private equity firms -- witness the $4.2 billion sale of Johnson & Johnson's ortho clinical unit to private equity company The Carlyle Group -- has made deal-making a lot tougher this year.
However, investors should not be overly concerned. The role of management is to generate value for shareholders, not to chase acquisitions just because investment analysts are clamoring for them. Investment history is littered with tales of managements that overreached with their acquisition strategies. Moreover, the new CEO, Thomas Joyce, who stepped into the position this month, is a 20-year Danaher veteran. Indeed, he led the Beckman Coulter acquisition, and according to the company is a major architect of its DBS.
All told, investors should not be too quick to conclude that Danaher needs to change its business strategy just yet.
