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Wringing Hands Not Rolling Up Sleeves

(Guest Commentary by Rick Konrad and Ken Freeman – August 27, 2009)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is a regular guest commentator and usually writes for us every third Wednesday of the month.  We highly appreciate your investment insights and general wisdom, Rick!

For this commentary, Rick will begin with his views on the market rally and the banking industry.  Ken Freeman, Rick's friend, associate, and analyst, will then evaluate the prospects of Danaher, a large diversified conglomerate (you can find a biography of Mr. Freeman here).  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Reaching for a Cool One” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


But those who forget the past, neglect the present, and fear for the future have a life that is very brief and troubled; when they have reached the end of it, the poor wretches perceive too late that for such a long while they have been busied in doing nothing...They lose the day in expectation of the night, and the night in fear of the dawn.- Seneca

What an amazing run-up! Though sentiment seems to have gotten somewhat subdued in the last couple of weeks, equity markets seem to be holding their own. Yet, so many of us seem to be wringing our hands, concerned about the “what comes next.”

The quality of the rally has been dismissed by a few bears, yet it seems to me that the rally has been quite “garden variety” as compared to others I have experienced. The dimensions of the rally have been impressive, and it seems that most consensus thinking views this as overdone. In many ways, the market's recovery from its March lows has followed a historical institutional investing playbook. Big-money investors frequently gravitate toward high-beta, volatile and low-priced stocks to capture a turn in the market's fate, so the market's leadership in high tech, basic materials, and consumer discretionary names is not surprising. We recognize the knee-jerk out of the starting blocks institutional playbook leadership of these definitively high beta sectors, but the key here is not to get caught up in linear thinking over time.  There is no guarantee that what has occurred so far will continue ahead.  Moreover, the question looms large as to whether investors are truly discounting the reality of fundamental outcomes that lie ahead, or are simply and blindly following the historical playbook script. 

Absent pricing power, sales growth and the quality of top line revenues, in very large part, the headline corporate earnings gains we are seeing as of late are being driven by cost cutting and lack of meaningful corporate capital expenditures. But isn't that the way most earnings gains are constructed in the early days of a rally. As I said, garden variety rally.

One can easily point to the misdeeds of the banking system that is trying to repair itself. Once again, most recessions result in horrific credit losses through the banking system. What changes is the sector affected. Judging from the decent working capital management at most large firms and a reluctance to borrow (in my opinion more prevalent than an unwillingness for banks to lend,) as well as some surprisingly decent earnings reports, corporate America has been very resilient.

Furthermore, the terrifying experience that banks have gone through in the last two years has taught them some very important lessons:

  1. The Importance of Diversification- Overconcentration will kill you. Banks are being very vigilant to avoid too much exposure to one area whether it is alt-A mortgages, CDO's, or credit derivatives, etc.

  2. Avoiding Business that Doesn't Pay an Adequate Return- Many mortgage assets that seemed to be low risk yet ultimately proved destructive were fairly low return instruments from the onset. As has always been the case, the industry will rescue itself through fee increases to consumers primarily and wider spreads on interest charged versus paid.

  3. Having the Strength of your own Convictions- Not playing “follow the leader” and involving bank assets in businesses that are only barely understood.

  4. Risk Management Technology- Systems depending on historical norms do not provide real-time solutions.

Chastened by this trial by fire, banks are a repentant lot. Regulatory changes will force more prudent use of capital. Like the boy caught with his hand in the cookie jar, better behavior is cultivated, at least for a while!  As to the threat of new regulation, let me reiterate a quote from the last quarterly:

“A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents."

Though I am aware of the historical dangers of September and October, how bad has this actually been? In the last 20 years, the market has been positive in September only 40% of the time…however, the average decline, a not-terribly relevant 1.5%.

As Seneca noted, are we losing the day in expectation of the night, and the night in fear of the dawn? I think it is time to get to work on some analysis rather than fear. Excellent advice comes from the following quote:

“You can't wring your hands and roll up your sleeves at the same time.”

In the spirit of looking at decent companies with some heft to them, we are looking at Danaher, a company which we currently find a little pricey based on conservative assumptions, but with a remarkable history of value creation. Our models for Danaher can be found at this link: http://tinyurl.com/m6q7ex

The commentary has been written by my friend, associate, and analyst, Ken Freeman.

A look at Danaher – 8/26/09

Company

Danaher

Ticker

DHR

Price (8/25/09)

$62.81

52-week high

$83.16

% below high

32.4%

52-week low

$47.20

% above low

33.1%

   

Shares Out

319.738

Market Cap

$20,082.8

   

Total Debt

$2,904.8

Cash

1,258.4

Net Debt

$1,646.4

   

TEV

$21,729.1

   

Dividend yield

0.19%

   

TEV / LTM EBITDA

13.3x

Debt / LTM EBITDA

1.8x

Net Debt / LTM EBITDA

1.0x

Debt to Total Capital

21.5%

LTM PE

16.6x

   

LTM FCF Yield

7.7%

Danaher is a large diversified conglomerate which operates in 4 segments: Professional Instrumentation (products/services include UV disinfectant systems, analytical instruments and industrial water treatment) Medical Technologies (products/services include microscopes, dental products and pathology diagnostics), Industrial Technologies (products/services include motion control equipment, aerospace and defense equipment and sensors & controls), and Tools & Components (mechanics' hand tools including Sears' Craftsman line of hand tools and Matco tools for professional mechanics). 

Revenue Breakdown

2008

2007

2006

2005

2004

Professional Instrumentation

38.0%

32.0%

31.0%

32.0%

33.0%

Medical Technologies

26.0%

27.0%

23.0%

15.0%

10.0%

Industrial Technologies

26.0%

29.0%

32.0%

37.0%

38.0%

Tools & Components

10.0%

12.0%

14.0%

16.0%

19.0%

Total

100.0%

100.0%

100.0%

100.0%

100.0%

The Company's business model is focused on growth through acquisition.  In the Company's own words, their businesses are “characterized by strong brand names, proprietary technology and major market positions”.  The typical target companies that Danaher looks for operate in niche segments and offer opportunities for improved financial and operating performance once integrated into Danaher's portfolio of Companies.  Danaher accomplishes this through the Danaher Business System (“DBS”) which is a “set of tools and processes designed to continuously improve business performance in critical areas of quality, delivery, cost and innovation”. 

As a result of this system of operating and acquiring businesses, Danaher has been able to generate strong growth and double digit returns on capital with 10-year average growth in revenues and free cash flow of 15.6% and 21.1%, respectively and 10-year average ROIC of 10.7%.  While accomplishing this, the Company averaged a level of debt to total capital of 25% for the past 10 years, indicating that these results were not the result of unsafe leverage which would put the cash flows at risk.

 

LTM

2008

3-yr avg

5-yr avg

10-yr avg

ROE

12.0%

14.5%

18.2%

18.8%

18.5%

ROIC

7.5%

8.6%

11.8%

12.1%

10.7%

Debt/Total Capital

21.5%

21.1%

25.7%

23.3%

25.5%

Like most companies, Danaher has been hampered by the economy.  While margins and returns are down year over year, in the Company's 2nd quarter conference call CEO H. Lawrence Culp Jr. said, “In this environment, we continue to focus our efforts on capturing market share.  Sybron, Videojet, Radiometer, Gilbarco Veeder-Root, Matco and ChemTreat are among the Danaher businesses where we believe we have taken notable share from competition.”  Once the business environment normalizes, Danaher will emerge stronger as a result of these market share gains.

Over time, Danaher has produced a steady and growing free cash flow stream of good quality: 

 

2008

2007

2006

2005

2004

OCF

$1,859

$1,646

$1,547

$1,204

$1,033

Capex

($194)

($162)

($136)

($120)

($116)

FCF

$1,665

$1,484

$1,411

$1,084

$917

growth

12.2%

5.2%

30.1%

18.2%

17.4%

           

Revenue

$12,697

$11,026

$9,466

$7,872

$6,889

FCF Conversion (FCF/Revenues)

13.1%

13.5%

14.9%

13.8%

13.3%

           

Net Income

$1,318

$1,214

$1,109

$886

$746

FCF Conversion (FCF/NI)

126.4%

122.2%

127.2%

122.4%

123.0%

Valuation

To value the Company, we look at multiples of Earnings, Sales and Free Cash Flow. 

Danaher

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

 

5-yr avg

10-yr avg

P/E

27.0x

30.7x

30.0x

23.5x

27.3x

24.9x

20.2x

20.8x

23.6x

14.3x

 

20.8x

24.2x

P/S

2.2x

2.6x

2.4x

2.3x

2.8x

2.7x

2.3x

2.5x

2.6x

1.5x

 

2.3x

2.4x

P/FCF

16.8x

19.1x

15.1x

14.7x

17.2x

18.2x

15.2x

15.2x

17.6x

10.2x

 

15.3x

15.9x

                           

Source:  Morningstar

Based on this data, we chose to use the 5-year average multiple being that they are the most conservative.  Even using these conservative assumptions, the Company provides a very good value at current levels. 

Metric

LTM multiple

5-yr avg. multiple

Denominator

Valuation

Shs. Out

Value per share

Price / Earnings

16.6x

20.8x

$3.40

 

319.7

$70.58

Price / Sales

1.7x

2.3x

$10,603

$24,598

319.7

$76.93

Price / FCF

12.9x

15.3x

$1,437

$21,954

319.7

$68.66

The EPS used is the mid-point of the Company's current guidance range of $3.30 to $3.50.  In the 2nd quarter conference call, Danaher's CEO said, “For the full year, we are forecasting core revenues declines approximately in line with the first half of this Year” so, we took the first half revenues and annualized them to determine the sales number.  Going with the same methodology as sales, we annualized FCF based on the first half of the year.  Both of these numbers are lower than the LTM amounts and current consensus estimates so, to reiterate, these are conservative per share values.

With a strong portfolio of businesses and the fact that the Company is selling at a discount, Danaher provides an attractive investment opportunity.

Disclaimer: Neither I, my friends, or clients own a current position in this security.

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