Description

On Oct. 2nd, Danaher completed the tax-free spin-off of its Environmental and Applied Solutions business, which began trading on the NYSE under the name Veralto (ticker: VLTO).  Based on approximately 738,185,234 shares of Danaher common stock outstanding as of June 30, 2023, and a distribution ratio of 1/3, approximately 246,061,744 shares of Veralto common stock were distributed to Danaher’s stockholders.

Veralto is a premier technology leader in water and product quality whose mission is to safeguard the world’s most vital resources.  The company offers leading technology and high-value water analytics and treatment solutions along with a strong leadership position in digital workflows.  Their end markets are characterized by strong secular tailwinds, and they operate with strong, global brands in large, attractive end markets, with 80% of their business in the water, food, and pharmaceutical verticals.

Veralto does this with a premier financial profile, with ~60% of sales recurring, and gross margins in the high 50s reflecting the value of their technology, leading to EBITDA margins in the mid-20s.  Limited capex requirements lead to consistent conversion of 100% of net income to free cash flow, and the nature of their durable business model renders them more or less immune to general economic cycles.

These traits constitute a high-quality, predictable business, which, having declined modestly since the spin as DHR shareholders unable to / not interested in holding the VLTO shares have exited, now trades at a significant discount to peers of similar or inferior quality.  At $72.45/share, VLTO represents an opportunity to purchase a high-quality compounder whose present value, in my view, is closer to $95/share.  One might quibble with the simplistic valuation, but given the high-quality nature of the business, time is on your side here.

Basic Overview –

VLTO’s business comprises two segments: Water Quality (60% of sales) and Product Quality & Innovation (40% of sales).

Water Quality ($2.9B sales; 57% recurring)

The water business helps ensure clean drinking water for roughly 40% of the world’s population via various solutions in water analytics and treatment (quality, regulations, compliance, conservation, reuse, etc.).  This segment plays across the entire water value chain, from environmental management of water resources, to municipal drinking water, commercial and industrial use, wastewater, and discharge.  End markets are 70% municipal/industrial and 30% commercial/environmental; 75% developed markets, and 25% developing markets.  Major companies within this segment include Hach, ChemTreat, and Trojan Technologies.

VLTO’s water business is highly attractive because its technologies and solutions operate at the high end of the value continuum.  Their services constitute a small fraction of their customers’ budget, yet serve a mission-critical function for the customer.  This results in extremely strong customer relationships, sticky business, and insulates VLTO from the CAPEX cycles of its customers.  VLTO has a 75-year history with a tremendously large installed base of their popular instruments (colorimeters, fluorimeters, spectrophotometers, etc.) in the market that is 3-4x the size of their nearest competitor.  The consistent reliability of VLTO’s products is of immense value to industrial customers, for whom unplanned downtime of even one hour creates millions of dollars in unexpected costs.

Water availability and cleanliness are significant issues across the globe as both population growth and warming climate concerns continue to pressure the global water supply.  This dynamic makes VLTO’s water business highly dynamic through economic cycles.  Indeed, since DHR’s ownership, the water businesses have never had a single down year.

This business grows organically mid-single-digits with 23% operating profit margins and capex requirements of <1% of sales.  Giving effect to all acquisitions, divestitures, and currency fluctuations, revenues at this business have grown at a 10% CAGR over the past 20 years.

Product Quality & Innovation ($2B sales; 60% recurring)

The PQ&I business itself comprises two primary segments: Marking & Coding and Packaging & Color.  These businesses focus on ensuring product compliance, authenticity, and traceability primarily for food, beverage, and pharmaceutical producers.  PQI solutions are used by 80% of the brands you see in the market today to authentic their products for safety and traceability.  Their VideoJet and Linx brands, as well as their Esko and Pantone brands, represent the leading global players in packaging design solutions, color, and marking/coding.  Nine out of ten of the products you find in any given supermarket have been touched at some point by VLTO’s PQ&I business.  Consumables connected to their printers, service contracts, and software businesses represent recurring revenue streams and account for 60% of total sales.  PQ&I’s worldclass customer list speaks to its reputation, with 80% of the top 20 global CPG brands and 75% of the top 20% global pharmaceutical brands.

This business also benefits from strong secular tailwinds.  Increasing regulations and consumer pressure on brands increases the need for a reliable solution ensuring product safety, authenticity, and traceability.  Increased demand in global brand consistency and agile, shorter time-to-market product development cycles also directly benefit PQ&I.  Finally, PQ&I benefits from a growing focus on minimizing environmental impact of packaging as customers convert to recyclable mono-materials and biodegradable substrates.

The secular trends of consumer safety, omnichannel buying, packaging proliferation, digitization, and sustainability all serve as long-term growth drivers of PQ&I’s business.  The deep domain expertise that comes with PQ&I’s solutions is something not typically found internally at PQ&I’s customers and serves as the foundation of this business’s competitive advantage, along with its innovation capabilities and its existing large installed base.  In sum, PQ&I is a stable business with low cyclicality, high recurring sales and benefits from increasing regulatory requirements and the fact that they represent part of their customers’ OPEX, not CAPEX (and a small part of OPEX at that - <1%). 

Similarly, management expects this business to grow organically at mid-single-digits with adjusted operating profit margins of ~25%.

Capital Allocation –

VLTO management has committed to implementing their own version of the Danaher Business System (which they are calling the Veralto Enterprise System) of continuous improvement, which revolves around improving the cost structure, reinvesting for growth, and compounding EPS with accretive M&A.  As such, shareholders can expect a capital allocation framework that exhibits a bias toward accretive M&A, but one that also maintains flexibility to return capital to shareholders and retains an investment grade rating.  Management is confident the M&A runway is long and with an active pipeline in both segments, and their long history at DHR suggests they are capable of delivering.  If one looks at the timing of historical acquisitions, one sees that the company has been less acquisitive over the past six years than it has been historically.  Now that 100% of the working capital VLTO generates can be reinvested exclusively into their own businesses, management fully expects to return to historically normal levels of M&A activity.

Valuation –

I typically try to avoid engaging in false precision by building highly detailed models going out 10+ years.  On a consolidated basis, VLTO currently trades at ~13x 24Y Ebitda, which strikes me as low considering it is well below the market multiple and yet VLTO is a high-quality business that has significantly outgrown GDP on any timeframe going back 20 years.

Decent comps include EcoLab (ticker: ECL) for the Water business and Zebra Technologies (ticker: ZBRA) for PQ&I.  I note ECL sports similar growth but inferior margins, while ZBRA has both inferior growth and margins.  I arrive at 24Y Ebitda by giving the company credit for management’s guided incremental margins of 30-35% and have the topline growing in each segment at 7.5% - a lower rate than recent growth, although I have no reason to suspect a decline in growth.  I don’t anticipate a breakup of these two businesses any time soon, but a simple SoTP suggests unrealized value with significant upside, all while intrinsic value continues to grow:

VLTO has consistently outperformed GDP on an organic basis (total sales were down only low-single-digits at the depths of the GFC and in 2020).  The durability of the business model reflects a portfolio of assets with common traits: products and services that are driven by regulatory and compliance requirements, dependence on customers’ OPEX instead of CAPEX, and products that are integral to the everyday operations as opposed to capital investment cycles.

In sum, VLTO is strategically positioned in attractive end markets with low cyclicality and durable business models.  The basic needs served by VLTO’s products/services remain steady throughout economic cycles, and VLTO’s solutions are a mission-critical component of their customers’ daily business operations and tend to be a low percentage of their overall spend.  With a razor/razorblade business model, VLTO has a large installed base that drives recurring sales of consumables and services.  This combination of attractive end markets and high consumable, mission-critical solutions will lead to sustained, long-term profitable growth.

Catalyst

- 1st quarter reporting as a standalone company on Oct 25th

- Time