I knew what Danaher Corporation (DHR) had been around for years, but I never bothered to look under the hood of this Washington DC-based company. This was perhaps one of the biggest mistakes of my investing career that resulted in no capital losses – only missed gains. Now that Danaher has lost almost a fifth of its market capitalization since August, it’s time to explain why dividend growth investors will like this stock – despite its 0.37% dividend yield. What we’re talking about here is a great example of what investors are looking for: a free cash flow growth machine. It beats everything in its path, whether it’s high-yield income or high-growth “technology”. In this article, I’ll explain why I put this stock on my list, despite my goal of buying dividends close to 2%.
So let’s go !
Dividend Growth > High Yield
People invest in dividends for one reason: income. The more people earn, the better, right? Well, that’s the goal. Yet there are many ways to get there. I notice that a lot of young dividend investors like to buy high yield investments. It’s good because everyone has to make their own decisions. Yet young people in particular should look beyond high performance.
The snapshot below shows my long-term dividend growth portfolio. Please note that the size of each investment is based on market capitalization only, not the size of the stocks in my portfolio. This means that Apple (AAPL) is not my biggest holding. What I’m trying to do is strike a balance between high yield and dividend growth. I own a number of high yield stocks. 3 energy actions, 1 health action and a bank. Other actions are primarily aimed at increasing their dividends.
Generally speaking, high yield is not a bad choice as long as it is diversified. The High Yield ETF (VYM) has underperformed Dividend Growth (VIG) by just 20 points over the past 10 years – including dividends.
The biggest mistake young people make is betting on high yield. In some cases a (very) high yield such as certain energy stocks, utilities, mortgage REITs or the like that have long-term negative capital gains.
Below I list three popular high yielding stocks. I’m not saying these are bad investments at all – they aren’t. I’m just showing that buying high yield has a price. This makes it harder to generate total returns that approximate market performance.
Another mistake is to avoid low yielding dividend growth companies. To be honest, there aren’t many of them and it’s very hard to find them.
This is where Danaher comes in.
The Seeking Alpha preview below assigns ratings to Danaher’s dividend “categories.” I think it is absolutely stunning as I will show you in this article. The stock has A+ dividend safety, A- dividend growth and consistency, and a big D- for its yield. Again, that’s a 0.37% return. Investing $10,000 in this stock earns you $37 per year. I don’t know why I spent the time looking for it, but it gets you a seat in the stands and a beer when Arizona takes on the Houston Astros next month.
And of course, few people have the kind of money to invest $10,000 in a single stock.
So why am I talking about it?
There is so much value in Danaher
Looking at Seeking Alpha’s dividend growth ranking, we see that the company has grown its dividends by an average of 29% per year for 10 years. The median for the health care sector is 7.2%. It’s not bad either. Since 2015, Danaher has increased its dividends by an average of 15% per year.
Using the 10-year CAGR of 30%, a return of 0.3% would have turned into a return of 4.1%! That’s 0.3 x 1.3^10 = 4.1%.
Yet the dividend yield is still 0.3%. As the dividend yield is the (annual) dividends divided by the stock price, this means that the stock price must have “absorbed” all the dividend gains. And that’s true.
Over the past 10 years, Danaher has achieved a return (excluding dividends) of almost 580%. This crushes the S&P 500 by a mile and even the popular technology-intensive ETF (QQQ).
What’s remarkable is that Danaher flies under the radar. People promoted all kinds of stocks, mostly FANG+ members, because they are well-known companies that brought a lot of joy (earnings) to investors.
One of the things I always highlight in my articles is free cash flow or FCF. I talk about it so much it annoys me sometimes. But it is important. This is what drives stocks. FCF is essentially net income adjusted for non-cash items and capital expenditures. It is money that a company can distribute in the form of dividends and buybacks, or use to reduce its debt.
Danaher’s FCF amounted to $7.1 billion in 2021. A new all-time high. The company is not capital intensive as capital expenditure has been stable in recent years. The main driver of CapEx growth comes from acquisitions. In 2020, the company acquired Cytiva, the biopharmaceutical business of General Electric (NYSE:GE) for $21.4 billion, which boosted free cash flow.
What makes Danaher unique is its business. The company engages in life sciences through companies such as Beckman Coulter, Sciex, Pall and others. Danaher also has a Diagnostics segment and an Environmental and Applied Solutions segment.
The overview below shows the company’s exposure by segment and region. Note a high international exposure, which means a weaker dollar supports the company’s sales (expressed in US dollars).
Before showing you what M&A (mergers and acquisitions) does to debt, let’s stick with FCF. This year, the company is expected to make $7.6 billion in FCF, followed by an increase to $8.2 billion in 2023. Using the company’s market capitalization of $194 billion, we get an implied return in FCF by 4.2% next year. The company’s dividend yield is close to 0.4%, meaning there is LOTS of room to pursue dividend hikes and aggressive redemptions. However, the company does not make net buybacks because the number of shares outstanding has remained unchanged for years.
That said, the company needs money to reduce the debt accumulated because of mergers and acquisitions. The good news is that most of its acquisitions are small – with the exception of the $21.4 billion Cytiva deal in 2020. It grew net debt from $1.8 billion in 2019 to $19.6 billion at the end of 2021. The net leverage ratio increased from 0.4x EBITDA to 2.0x EBITDA.
Note that 2.0x EBITDA is not high leverage. However, it’s getting better. Since the company pays a small dividend, almost all of its cash is spent on debt reduction. As shown in the table below, net debt is expected to turn into net cash by 2024. This means more cash than gross debt. Sure, the company may engage in new (huge) M&A deals, but that’s okay, as free cash flow can cope with more or less debt load.
The only problem is that quality is almost never cheap.
Valuation of DHR shares
Using the market capitalization of $194 billion and the net debt of $5.5 billion projected for 2023 – to assess the high free cash flow – we obtain an enterprise value of approximately $200 billion. This is 18.5x expected EBITDA for 2022 and 17.7x EBITDA for 2023E.
The graph below shows the company’s historical EV/EBITDA multiple as well as the total volume of disposals/(acquisitions) on a TTM basis. Prior to 2015, the company was trading at nearly 10x EBITDA, which is fair. Then, as M&A volume increased, valuation steadily increased. This helped investors, as the share price was now boosted by higher earnings AND a higher valuation. An 18.5x valuation isn’t cheap, but it’s a far cry from recent highs.
The same goes for DHR’s free cash flow yield. Previously, it was close to 8%, which was well undervalued. Now it’s closer to 4.5% as I calculated in this article. It’s OK, but more underrated.
Additionally, the current 18% decline from the stock’s all-time high is one of the largest in the past 10 years. The COVID panic sell caused a decline of more than 30%. Before that, dips of 8-10% were buying opportunities.
The purpose of this article is not to urge you to invest in low yielding dividend growth companies. My goal is to get investors to invest in a balance between high-yielding companies and low-yielding, higher-growth companies.
Danaher is a company I’ve ignored for too long. The company is a well-diversified, technology-exposed healthcare company bound by a series of growing acquisitions. Still, its debt position is extremely healthy and the company is in a fantastic position to pursue long-term growth in free cash flow, earnings and dividends.
The dividend yield of 0.37% is low and it will take at least a decade before investors will see a satisfactory return on cost. However, if history is any indication, it will come with strong capital gains and outperformance. Eventually, investors can (probably) sell their position with a big gain in the future and transfer money into (higher) yielding investments if they wish.
However, the stock is still not cheap and I doubt it will get cheap. The current sell offers a buying opportunity.
Personally, I want to buy the stock between $240 and $250. I think the stock fits well in my dividend growth portfolio and I think despite the somewhat high valuation there is a fantastic risk/reward ratio over the long term.
(Disagree? Let me know in the comments!