Danaher (NYSE: DHR) has a reputation as a go-to industrial stock in times of trouble. In other words, it's the sort of stock that you want to hold in a slowdown. Indeed, its combination of medical-focused businesses and industrial businesses with secular growth prospects (such as water quality and environmental solutions) means it has a defensive quality lacking in many other industrial stocks. That's well known, but is the stock a good value? Let's take a look.
Defensive end markets
Danaher stock isn't cheap, but no one said you can buy high-quality companies at bargain prices. The investment thesis behind the stock is based on the defensive nature of its end markets, which means the stock should command a premium to reflect its ability to generate growth in any business cycle.
Image source: Getty Images.
As you can see below, the company currently generates the overwhelming majority of its earnings from relatively defensive sources such as life sciences, diagnostics, dental, and environmental solutions.
Data source: Danaher Corporation presentations.
The defensive nature of these businesses was further confirmed during the recent fourth-quarter earnings call. Whereas other companies are seeing slowing growth in China, Danaher's CEO Tom Joyce said: " We are not seeing anything specific that we could point to today that is impacting our businesses in China." In fact, Danaher's double-digit revenue growth in China was "the eighth consecutive quarter -- or, better said, the second straight year of double-digit growth for us in China," according to Joyce. He went on to outline that Danaher's exposure to industrial end markets is "probably less than 10% of Danaher wide today."
And finally, Danaher's segment performance in the last recession shows how well its life sciences and diagnostics segments held up under very difficult circumstances.
The near- and mid-term outlook
A quick look at Danaher's core revenue growth trends by segment shows ongoing growth at the three most important segments -- the underperforming dental segment is set to be spun off in 2019 -- and the return to organic growth in the fourth quarter is very welcome.
Data source: Danaher Corporation presentations.
Management's long-term financial outlook, given during the investor-day presentation in December, calls for core revenue growth in mid-single digits and core operating margin to increase by 50 to 75 basis points a year. For reference, 100 basis points equate to 1 percentage point.
Based on analyst estimates for 2019 and 2020 and management's outlook, my calculations imply operating-profit growth of 7% to 9.5% per year for the next decade. In addition, the company's excellent free cash flow (FCF) generation means that its FCF valuation is actually lower than a cyclical industrial like 3M (NYSE: MMM).
3M isn't a defensive stock and, in contrast to Danaher, it's medium-term guidance looks a bit optimistic, not least because the company has started its 2019 by lowering its full-year organic growth and earnings guidance. By way of comparison, Danaher maintained its full-year guidance for 4% organic revenue growth and adjusted diluted EPS of $4.75 to $4.85.
The case against Danaher stock
The strongest bearish argument regarding the stock relates to its valuation. For example, going back to the issue of FCF, it's fair to say that last year was a standout year for FCF conversion from net income. For argument's sake, let's assume that Danaher converted 100% of net income, then its market cap to FCF multiple would be closer to 30 -- that's the kind of valuation you might pay for a growth stock.
Given that the medium-term outlook for Danaher's operating-profit growth is only high single digits, it means that any slip-up in execution or a faulty acquisition, and Danaher's stock price and valuation multiple could come under threat.
What to do with Danaher stock
Both the bullish and bearish cases discussed here have merit, but on balance, the stock is still worth buying for investors concerned by growth prospects in the economy and/or investors looking to balance their portfolios by buying a more defensive stock than they currently hold. However, the stock's appreciation means that the upside from here isn't significant.
One thing is for sure: Danaher is definitely the kind of stock that investors should be monitoring with a view to buy given any major broad market sell-off.
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