The healthcare sector is kicking off the year on the decline. The recent weakness comes after a period of strength as healthcare was in favor throughout a volatile December thanks to the group being viewed as a defensive play. When investors get concerned about an economic slowdown or supply chain uncertainties, they often turn to healthcare because the sector doesn’t need a fast-growing economy to expand earnings and deliver on its targets. If you have been observing the market as closely as we have, you will notice that for the past ~2 years since the pandemic, the market behaves in rotational cycles with different groups leading at different times. Healthcare leads when there are concerns about economic growth, and lags when the economic outlook brightens. Generally, our portfolio is positioned for continued strength in the economy (48% in consumer discretionary, industrials, financials), but it is prudent to be defensive for unexpected slowdowns (currently only 9% in healthcare and consumer staples). That is why recently we initiated a position in Danaher, a healthcare company in research and diagnostics, and would like to discuss our initiation in today's post.

Breaking down Danaher's businesses

Danaher operates through three main segments: Life Sciences, Diagnostics, and Environmental & Applied Solutions. While Danaher may be considered a multi-industry name, some of the common themes across Danaher’s entire portfolio are a focus on high value and mission-critical applications, consumable revenue streams off an extensive installed base (75% of Danaher’s portfolio is recurring), and exposure to long-term secular growth trends.

By segment, Life Sciences is the largest and makes up about 52% of the company’s estimated total 2021 revenue. Danaher’s Life Sciences platform had a very strong 2021, with core revenue growth expected to exceed 20% with operating margins above 25%. The global growth drivers behind the strong trends within Life Sciences are the shift towards biologics, increased focus on genomic medicine, and vaccine, therapeutics, and research in response to COVID-19.

Danaher’s Life Science business was boosted over the past few years through several acquisitions, most notably Cytiva (which was purchased at a great price from General Electric) and the recently closed Aldevron deal. Cytiva gave Danaherleadership in the fast growing bioprocessing market, and Aldevron is a leading producer of high quality plasmid DNA, mRNA, and proteins with exposure to the fast growing genomic medicine industry.

Next is Diagnostics, which is expected to make up about 32% of Danaher’s 2021 revenues. Danaher’s portfolio has a strong position across the entire diagnostics landscape, whether it be in molecular through Cepheid, “niche” areas from Leica and Radiometer, or a lab presence with Beckman Coulter. Cepheid is the business we want to focus on. It may be best known for its COVID-19 tests (and they will ship 55 million tests in 2021 alone), but the longer-term story here is how COVID-19 has accelerated the decentralization of healthcare to settings closer to the patient at the point of care because it is faster and more accessible. This has created a growth catalyst for the molecular diagnostic industry at large, but Cepheid is best positioned to be the winner because it has the largest installed base and most extensive menu in all of molecular diagnostics.

Lastly is Environmental & Applied Solutions, which is expected to make up about 16% of Danaher’s 2021 revenues. This segment is split between a portfolio that focuses on Water Quality and another that specializes in Product Identification. Both are quality assets that are growing faster than industry peers.

Why we like Danaher

In addition to exposure to secular growing end markets, what makes Danaher such a quality name is management’s track record of execution. Management is constantly delivering operational improvements through the application of the Danaher Business System. This playbook is Danaher’s competitive advantage, and it has become a powerful source of business improvement. Across the portfolio, Danaher is focused on improving the cost structure, reinvesting for growth, and accelerating margins & core growth of its different businesses. It’s continuous improvement, but where it happens best is with M&A, which is Danaher’s bread and butter. Danaher is so good at buying businesses and then accelerating growth while also improving margins. 

Danaher’s durable, recurring revenue streams, exposure to secular growing end markets, M&A execution and constant operational improvements have created an attractive long-term growth model. At Danaher’s September Analyst Day, management provided long-term guidance of mid-single-digit core revenue growth (accelerating from 5-6% pre-2019), 50 to 75 basis point operating margin expansion, strong free cash flow with conversion (FCF divided by net income) greater than 100% plus more acquisitions. Just earlier this week, Danaher provided an update to its fourth-quarter 2021 outlook, and estimates fourth-quarter revenue to increase in the high-teens to low-twenties percent range, with core revenue growth in the high-teens percent range; this on itself is above management's previously-guided growth projection. Despite the announcement, Danaher shares were trading flat at the time. We used that as an opportunity to inititate a small position in this name. After the purchase, DHR is now 1% of our portfolio. We have allocated 3% for this name. 

We are initiating Danaher with a price target of $360, representing roughly 35x the FactSet consensus estimate for 2022 earnings per share. The stock isn’t cheap, but Danaher consistently trades at a premium because of its high-quality business model, management’s M&A track record, and long history of continuous operational improvements through the Danaher Business System. Current 2022 revenue estimate may be conservative because COVID-19 tailwinds (from testing and vaccine & therapeutics) are proving to be more durable than previously thought. Danaher believes it will achieve double-digit earnings per share growth over the long term. Danaher’s continuous operational improvements of a portfolio based on recurring revenue streams have made this company quite the earnings compounder.