Danaher’s (DHR) share price has seen a considerable increase recently, doubling within the past two years. Particularly interesting is the performance during the corona pandemic. Following a brief pullback in March, the stock of Danaher has risen well above its level before the corona crash.
The price of the stock is currently about 20 percent higher than its previous high in March – a remarkable increase within such a short time. Reaching a new all-time high during a pandemic is something we rarely see outside of the tech sector. Why the Danaher stock has been performing so well and if it still is a viable purchase right now, you will find out in this analysis.
The business model: This is how Danaher makes its money
Danaher is a conglomerate based in Washington, D.C. A conglomerate is a company that owns subsidiaries in multiple different industries. Important for the status as a conglomerate are the different fields of activity of the subsidiaries. Even if McDonald’s (NYSE:MCD) were to buy up all the fast-food companies in the world, it still would not be considered a conglomerate because all the subsidiaries would be operating in the same industry. Conglomerates are highly diversified due to the large number of industries they operate in and are therefore fairly well-protected against downturns in any one industry. Well-known examples of such companies are General Electric (NYSE:GE) and Siemens (OTCPK:SIEGY).
In 2016, Danaher restructured its subsidiaries into 3 distinct business units: Life Sciences, Diagnostics and Environmental & Applied Solutions. The Dental segment was sold in a spin-off in 2019.
Source: Annual Report
In this segment, Danaher develops instruments for the analysis of organic material, such as genes, proteins and cells. The target group for these products is scientists who use them to examine diseases and research possible therapies.
In addition, Danaher offers filtration, separation and purification technologies for applications in the medical, food & beverage, aerospace and other industries.
The life sciences sector was founded with the purchase of Leica Microsystems in 2005. Enthusiastic photographers know the name Leica as the manufacturer of the popular cameras. However, this is a different company with the name Leica Camera. In 1997, the Leica Group was divided into three companies. Leica Microsystems is one of them and, unlike its brother, develops optical microscopes rather than cameras.
Source: Annual Report
As the name suggests, this segment deals with the diagnosis of diseases. The instruments such as chemicals and software are used in hospitals and laboratories. With USD 6.6 billion in sales, this segment is similar in size to the Life Sciences segment and is also comparably profitable, as you can see from the EBITDA margin. The Diagnostics segment, however, has a decisive advantage. While only 63 percent of the Life Sciences revenues are recurring, that share is 84 percent in the Diagnostics segment. This means that almost all sales in this segment are recurring revenues. Since most of the sales are generated from long-term contracts with recurring payments, the revenues are fairly stable.
Environmental & Applied Solutions
Source: Annual Report
Danaher’s smallest segment in terms of sales is called Environmental & Applied Solutions. This segment offers products that help to protect natural resources. For example, by purifying water using ultraviolet disinfection systems for the water supply of cities.
Revenues of Danaher by geographical region
Danaher’s sales are well-diversified across different regions. North America contributes the largest share but is closely followed by the other industrialized countries. Western Europe also makes an important contribution with 23 percent of total sales. No region accounts for an excessively large share in relation to the others. Through this geographical diversification, Danaher is protected against negative developments within individual regions.
Source: Danaher 10-k
The growth strategy of Danaher
Danaher claims it owes its success to a concept it calls the Danaher Business System (DBS). This strategy originated from the KAIZEN methodology when Danaher adopted this tactic from Toyota in 1988. KAIZEN is all about continuous improvement of processes and products.
Danaher Business System (Source: uk.kaizen.com)
The DBS stands on 4 pillars: People, Plan, Process and Performance. “People” refers to the careful selection of employees who fit the corporate culture. “Plan” refers to the strategic planning for each individual company in Danaher’s portfolio. “Process” refers to the KAIZEN process concepts, on which Danaher managers receive intensive training. The last pillar “Performance” is about monitoring and controlling the implementation of strategies in the company.
The DBS may seem somewhat cryptic to outsiders, but it is the central element in Danaher’s corporate culture and is even referred to as the company’s identity (“DBS is who we are and how we do what we do“). For shareholders, the KAIZEN mentality is certainly helpful. After all, continuously improving the company’s processes also means striving for long-term profit growth, which is reflected in the return on Danaher shares.
How profitable is Danaher?
The Kaizen strategy has paid off for Danaher. Earnings and cash flow per share have risen steadily over the last 20 years.
The setbacks are few in number and are negligibly small. Admittedly, the yearly growth rates are nothing out of the ordinary, but the business model is resilient and mostly crisis-proof. Even in 2009, a year in which many companies suffered painful setbacks as a result of the financial crisis, Danaher’s profit fell by just 13 percent. The effect on cash flow was even less significant.
These declines are a result of the spin-offs. Danaher sells off some of its subsidiaries from time to time. A recent example is the sale of Envista. Under the name Envista, three dental companies from Danaher’s portfolio were bundled and subsequently sold on the stock exchange. The buying and selling of companies is part of Danaher’s business activity. This ensures that the available capital is always allocated in the most efficient manner possible. If a company no longer fits into the overall company profile or no longer achieves the desired profitability, it is sold, and the proceeds are invested elsewhere. Following such spin-offs, Danaher loses the revenues and profits of the sold company. However, the money from the sale can be invested into new assets. This is why the revenue declines are usually of short nature. Historically speaking, revenues always increased in the year after a decline.
The revenue projections for the coming years are particularly interesting. While many companies are suffering quite heavily from the corona pandemic, Danaher is expected to continue growing. Due to its product offerings in the medical space, Danaher actually benefits from the pandemic.
Is the dividend safe?
Danaher pays a quarterly dividend of $0.18 per share which amounts to a total of $0.72 every 12 months. Despite the continuous increases, the dividend yield is only about 0.3 percent. This makes the stock rather unattractive for anyone looking for income from their investment. The yield of the stock has always been low as you can see in the following chart which shows the historical dividend yield over the past 10 years.
Up until 2013, the yield hovered around 0.2 percent. From 2014 to 2016, Danaher considerably increased the payout-ratio which quadrupled the yield to 0.8 percent within two years. However, this large increase did not last long. As a result of the rapid price increase in recent years, the yield has now fallen back to 0.3 percent and is thus only slightly higher in nominal terms than it was 10 years ago.
One reason for the low yield is the high price of the stock. Since the stock price and dividend yield are negatively correlated, the yield decreases as the price goes up. However, the high price is not the only reason why the yield is so low. Danaher only pays out a very small share of its earnings as a dividend. As you can see in the chart below, Danaher’s payout ratio is quite low. In the last 12 months, only 17.5 percent of profits have been paid out to shareholders. Most companies pay out a much higher percentage of their profits. In some industries like tobacco, payout ratios of 90 to 100 percent are not uncommon.
Danaher prefers to invest its profits internally rather than distribute them to shareholders. This approach has paid off so far, as you can see from the long-term success of the company. Over the last 10 years, Danaher has achieved mid-single-digit profit growth over the past 10 years. Instead of a high dividend yield, shareholders were compensated through capital appreciation.
High-quality stocks are seldom cheap, and Danaher is no exception. As a valuation metric I used historical multiples. Ten years ago, the stock was trading below its fair values for both profit and cash flow. The fair value dividend is not very useful in this valuation because Danaher has substantially increased the payout ratio in 2014. Due to the widely differing values, the average is not helpful. Looking at the fair values for profit and cash flow, we see that the stock price has moved alongside those values between 2015 and 2017. Since 2017, however, the price has decoupled itself from the fundamental data and is now trading well above the fair values.
According to this valuation, Danaher shares are significantly overvalued right now. Today, the market is willing to pay a much higher multiple for Danaher’s profit than it did 10 years ago. In 2010, the P/E ratio was just under 12, but today it is over 40.
One could make the argument that this apparent overvaluation is caused by the long time frame over which the averages were calculated. A shorter valuation period better reflects the current status of a company and places a bigger weight on recent profit increases. While this argument might sound plausible, it does not change much in this case. When looking at a shorter time frame, we essentially see the same picture. Although the fair values for a 4-year valuation period are higher than for the 10-year one, there is still a large gap between the share price and fair values. When you think about it, this makes sense. Considering the sizable P/E increase in the last few years, any valuation using historical multiples will result in Danaher looking overvalued right now. In the end it comes down to whether or not you are willing to pay over 40 times earnings for this company.
Conclusion: Danaher is a high-quality company with a rich valuation
Behind the Danaher stock is a high-quality company with a profitable and crisis-proof business model. Unfortunately, in my opinion, the price of the stock is too high and is not justified by the fundamentals. I do not see any development in the last few years that would sufficiently explain the P/E expansion. Despite Danaher’s quality, it does not seem reasonable to me to pay such a high multiple for the earnings. I will consider the stock again if it returns to the multiple it was trading at a few years ago. Until then, I will keep my distance and wait until Mr. Market prices the shares with a little less enthusiasm.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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This is neither an offer nor a recommendation to buy or sell securities. The points presented in this article are estimates and opinions of the author and may or may not correctly indicate the future.I am not a financial advisor and this report is not to be considered financial advice. Please always conduct your own research and consult a financial advisor before making any investment decisions.