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Danaher's Well-Oiled Machine

By Efraim Levy, CFA Danaher (DHR

; recent price, $53), a maker of hand tools and process and environmental controls, is benefiting from steady economic growth, in Standard & Poor's opinion. We believe that Danaher will continue to expand through a combination of organic growth and acquisitions.

In our view, Danaher has done an excellent job integrating its purchases, expanding acquired-companies' margins, and generating free cash flow in excess of net income. These funds, in turn, have helped Danaher make additional acquisitions and, in our view, maintain a healthy balance sheet, with a large cash position that offsets most of its long-term debt.

On both a relative and intrinsic basis, we find the shares attractively valued. Given our view of Danaher's strong operating fundamentals and its compelling valuation metrics, our recommendation is 5 STARS (strong buy).

CORE BUSINESSES. Danaher manufactures and markets industrial and consumer products. It has three reporting segments: professional instrumentation (42% of 2004 sales), industrial technologies (39%), and tools and components (19%).

Businesses in the professional-instrumentation segment offer various products and services to professional and technical customers that are used in connection with the performance of their work. At year-end 2004, professional instrumentation served three lines of business: environmental, electronic test, and medical technology.

The industrial-technologies segment manufactures products and sub-systems that are typically incorporated by original equipment manufacturers (OEMs) into various end products and systems, as well as by customers and systems integrators into production and packaging lines. Many of the businesses also provide services to support these products, including helping customers with integration and installation and ensuring product uptime.

U.S.-EUROPE FOCUS. As of Dec. 31, 2004, the industrial-technologies segment encompassed two strategic lines of business: motion and product identification. It also included three focused niche businesses: power quality, aerospace and defense, and sensors and controls.

The tools-and-components segment is made up of one strategic line of business -- mechanics' hand tools. It also includes four focused niche businesses: Delta Consolidated Industries, Hennessy Industries, Jacobs Chuck Manufacturing, and Jacobs Vehicle Systems.

Sales in 2004 by geographic destination were: United States, 55%; Europe, 29%; Asia, 10%; and other regions, 6%.

LOOMING OVERCAPACITY? We believe that industrial machinery companies should generally fare well in 2005 and 2006, due to anticipated economic growth and a favorable interest rate environment. Longer term, we think that large gluts in global industrial production capacity could hamper earnings growth for certain companies.

We expect continued growth in sales and profits for companies in the S&P Industrial Machinery Index in 2005, albeit at a slower pace than last year. More specifically, as of Sept. 13, S&P estimates operating earnings growth of 18%, vs. 44% in 2004. In addition, so far this year, most manufacturers, with the exception of some of the more commoditized product producers, have demonstrated a modest amount of pricing power via surcharges and select price increases to help cope with rising raw material costs (particularly for steel and copper).

This industry takes in a wide range of industrial concerns that supply the equipment that other companies need to run their manufacturing operations. Longer term, we believe Asia-driven industrial overcapacity could trigger a deflationary cycle. With corporate-profit margins likely to get squeezed in that environment, this could also cause manufacturers to cut back on production, employment levels, and machinery and equipment spending.

TRIMMING COSTS. We think that Danaher, with its diverse product mix and geographic diversification, can continue to grow faster than the industrial machinery industry as a whole.

After a sales gain of 30% in 2004, we expect revenue growth to slow to 18% in 2005 and 14% in 2006. This will be driven by a combination of U.S. and foreign economic growth, acquisitions made in 2004 and 2005, and acquisitions that we anticipate for 2005 and 2006.

We see 2005 and 2006 margins benefiting from employment reductions and other streamlining activities, partly offset by narrower margins at some acquired businesses.

HEALTHY MARGINS. For the longer term, we look for sales increases to be spurred by internal growth (5% to 7% a year), supplemented by acquisitions. We anticipate a steady flow of new and enhanced products, as well as greater sales of traditional tool lines, to aid comparisons. We expect margins to widen over time, as Danaher consolidates acquisitions and benefits from higher capacity utilization, productivity gains, and cost-cutting efforts. Management has demonstrated its ability to acquire and integrate companies while enhancing EPS and cash-flow growth, in our view.

Based on S&P Core Earnings methodology, we believe the quality of Danaher's earnings is high. After a series of adjustments made to its net income from continuing operations and before extraordinary items (based on generally accepted accounting principles) to conform to S&P Core Earnings methodology, Danaher's 2004 net income per share of $2.30 would be reduced to $2.20, a 4% reduction. For 2005, we project S&P Core EPS of $2.75, only a 1.1% reduction from our operating EPS estimate of $2.78.

The reductions reflect option expense of 4 cents, offset by a one cent net pension credit. For 2006, we project S&P Core EPS of $3.14, equal to our operating EPS forecast, as our 2006 model includes option expenses and assumes no other adjustments.

STOCK AT A PREMIUM. The company has been able to consistently expand net income, EPS, and cash flow. Given what we see as Danaher's sound balance sheet (long-term debt is under 30% of capitalization), as well as our expectation for strong cash flow growth in coming years, we think the company could raise its 8 cents per share annual cash dividend in 2006.

Based on several valuation measures, the stock is at a premium to that of some peers. We believe this reflects Danaher's wider net margins and faster growth. The quality of earnings appears high to us, as we expect free cash flow in 2005 to exceed net income. Plus, as noted, S&P Core Earnings adjustments are likely to reduce expected 2005 operating EPS by only about 1%.

Based on peer and historical p-e multiple comparisons, we apply a p-e multiple of 21 times to our 2006 EPS estimate of $3.14 to arrive at a price of $66 for Danaher shares. Our discounted cash-flow model calculates intrinsic value of $67. Based on a combination of our p-e multiple and DCF analyses, our 12-month target price is $66.

HURT BY INFLEXIBILITY? We view the stock as attractively valued at a recent level of 17 times our 2006 EPS estimate, a p-e-to-growth (PEG) ratio of about 1.1, and at about a 20% discount to our target price of $66.

We're concerned about some of Danaher's corporate-governance practices, particularly its classified board of directors with its staggered terms, that may allow certain policies to be entrenched longer, despite shareholders' desire to change them. On a positive note, the board is controlled by a majority of independent outsiders.

Potential risks to our investment recommendation and target price, in our view, include: slowing demand for Danaher's products, and unfavorable changes in foreign-exchange rates. Also, Danaher is dependent upon acquisitions and successful integration of acquisitions for its growth in revenues and earnings. Failure to maintain its growth rate and track record of success could result in a lower equity valuation, in our view.

Analyst Levy follows shares of industrial machinery companies for Standard & Poor's Equity Research Services

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