Veralto Corporation (VLTO) Earnings Call Transcript & Summary

Thanks for joining us. My name is Mike Halloran. We're pleased to welcome Veralto with us today. Recently publicly traded also, I might add, which I'm sure nobody in this room is familiar with. I think I had mentioned that. But we're going to do a Q&A session following Jennifer's prepared remarks. Joining me today, Jennifer Honeycutt, President and CEO; Sameer Ralhan, CFO; and then Ryan Taylor decided to bear himself in the crowd. [Operator Instructions] Please, Jennifer, floor is yours.

Well, thank you, Mike, and thanks, everyone, for joining us this morning. It's a pleasure to be here and we appreciate the invitation. I want to start here by giving you a little bit of an overview of Veralto. This is a $5 billion enterprise represents sort of the finest industrial assets that have come from Danaher's heritage. It's comprised of 60%, which is water quality in which there are effectively 2 categories: water analytics, which is the larger of the 2 here in water treatment. These businesses play in everything from regulatory compliance and municipalities all the way through process optimization, recycle, reclaim and as well in areas that are focused on ESG parameters for customers. Strong secular growth drivers. We play in the high value chain here within the water workflow where these are OpEx -- typically OpEx-intensive businesses where the cost of failure is high, if customers choose not to test and treat. And therefore, we've got great embedded businesses with our customers with high recurring revenue. 40% of our business is in water is in product quality and innovation, comprised of 2 categories in marketing and coding and packaging and color. The narrative here is very similar to water analytics and that these businesses help secure and safeguard food supply, medicines and other consumer product goods to verify brand authenticity and integrity of the products they serve. So effectively, these are best before date, or on days, date codes, lot codes, et cetera, for consumer packaged goods. Both characterized on both sides of the house in terms of being leaders in water and product quality. The brands that you see here are leaders in their respective industries and are unified in the global purpose of safeguarding the world's most vital resources to strong brands, long track records of innovation and the commercial excellence. Again, we've got highly durable business model in these high-quality businesses. Roughly 80% of our business goes into food, water and pharmaceuticals. These are essential resources for everyday life. Again, we serve the high end of the value continuum where the cost of failure is high. So we are in the integral part of the operation. These are not CapEx-focused purchase cycles. They are really tied into OpEx. And we've got good diversity in sort of our end markets and geographic distribution. They are harmonized by decades of ownership under Danaher with the Danaher Business System. We also have the parameters of the razor/razor-blade model wherein 57% is recurring revenue, which gives us a steady stream and durable, robust growth over the cycle, attractive end markets and high recurring sales here. I think what's most remarkable though is our impact on the world environment. And these are some of the ESG parameters or deliverables, if you will, that these incredible businesses have been a part of. Every day, we ensure that 40% of the world's population, roughly 3.4 billion people have access to safe drinking water. We actually conserved over $80 billion or 80 billion gallons of water for customers in 2022 and recycled roughly 12 trillion gallons of water that get treated by our systems each and every year. We are in the top 20 consumer product goods businesses for customers, including both pharmaceutical and food brands. We have about 80% that use our product quality and innovation technologies with coding over 10 billion codes per day. And in one case, we were able to help one of our customers achieve their reliability and sustainability goals by removing 500,000 annual trucking miles for a single customer with our pallet optimization software. And so we were able to reduce the emissions of 2 million pounds of CO2 for that particular customer in that year. So again, these are plenty of businesses talk about how they cater to sustainability, environmental compliance. We actually do it. We do it each and every day by safeguarding the world's most vital resources. Long-standing heritage. As I mentioned with Danaher and the Danaher Business System. Moving forward, we have converted this to the Veralto Enterprise system anchored in the core values that you see here, fueled by the 4 disciplines in the center ring including fundamentals, operational excellence, growth and leadership. And effectively, the playbook is very much the same at Veralto as it was at Danaher in terms of taking great businesses and making them better through the use of these tools in a continuous improvement environment. So VES obviously underpinned by DBS and grounded in our values going forward. The playbook, if you're familiar with Danaher is going to look pretty similar here at Veralto and it's pretty simple long-term value creation algorithm and modeling framework wherein we drive core growth. Through the cycle, we've seen these businesses deliver mid-single core sales growth by delivering incremental margin. We would expect that incremental volume reads through at 30% to 35% OP, generating strong free cash flow and delivering 100% roughly of free cash flow conversion. You add in strategic acquisitions through the disciplined capital deployment that we are inheriting from Danaher, strong bias towards M&A to deliver compounding EPS growth and returns. So it's this flywheel, if you will, of doing these things and doing them consistently, which we have done with these businesses and the decades of Danaher ownership to actually increase long-term shareholder value. I talked a lot about the business and it's only fitting that a great business deserves a great leadership team. The folks that you see here have been carefully handpicked, curated and the team has been architected over the 12 months prior to the spin. 60% of these folks come from Danaher with 3 decades of Danaher experience in over 100 years combined in total. The remaining 40% come from outside of Danaher, and they bring critical public company experience. Together, we are 70% diverse, comprised of 50% women and 40% people of color. So highly accomplished professionals brought together in a high-functioning leadership team with the best of both Danaher heritage and outside public company experience from similar industries. So with that, I can turn it back over to you, Mike, and we can take some questions.

Absolutely, and thanks for that. So why don't we start with some high-level stuff. The #1 question I get when I leave all these conversations, someone asked the conversation is, what can this team do differently today as a separate company that maybe didn't have the same level of entitlement or capital allocation or whatever it is under the previous Danaher?

It's a great question. We get that question not only from you but from others. And the reality is it's a whole lot different being 100% of a $5 billion enterprise than being 17% of a $30 billion enterprise. I think the attention that these businesses get now in terms of the focus, the acuity and the directiveness of the VES tool set, which we are evolving to meet the needs of the $5 billion enterprise as opposed to sort of the life science and diagnostic focus that Danaher kind of created as a pivot to that tool set. But more importantly, I think while this business will look and feel pretty similar for customers and associates, I think the biggest differentiating factor is that we have full access to our own cash flow and working capital. And the significance of that is that these businesses have tended to be underinvested in from a capital deployment relative to M&A in the last 5 to 8 years. And for all the right reasons, we pushed that cash flow over to Danaher for acquiring these big deals like Cytiva and Pall and Aldevron and so on. But that, in fact, didn't really help fortify or augment the value of the Veralto businesses. And we'll be generating close to $700-plus million of cash a year. The opportunity for us to spend that on value-accretive M&A is going to be incredibly impactful.

So let's touch on that in 2 different ways. As long as you were bringing up the external capital deployment, let's bring up -- let's maybe dig into that first. Another question that I'm sure you get all the time. Are there enough assets in the water space for you to pursue to really leverage that strategy? And how tangential would you feel comfortable moving depending on what you can or can't find in the water space. And by the way, I think people are assuming that the water space is where the capital is going to go, less so the PQI piece. I know you guys probably voice something slightly differently, so probably citing that would be also helpful.

People get really excited about the water space because it is a closer fit to the durable business model narrative. The reality is that the PQI businesses are incredible businesses with just as much regulatory influence in terms of their need for use in critical applications and customers. So we feel very good about our M&A trajectory on both sides of the house for PQI or for water quality. And we wasted no time in building a team that would be fully capable of getting out of the door, ready to go with M&A in the 12 months prior to the spin. We brought some of the best folks in Danaher that are -- have been involved directly in some of the largest deal volume that we've seen on the Danaher side, inclusive of strategy and so on and so forth. Getting to your question, however, relative to water and water assets, we feel pretty good about the funnel for the water side. We don't believe that we lack in our portfolio where we play and where we are strong, which again, is in that OpEx intensive side of the water workflow. But there are some assets out there that would be incremental and additive to the workflows that we are in and/or near adjacent.

And when you think about what that means, one, if I think about Hach, market leader. Maybe there's some technologies that could feed in. Is that the thought process as we work through those 3 pieces, ChemTreat, maybe expanding where you play in the facilities? I mean, maybe just talk through what that could look like?

Yes. I mean I think for both analytics and for treatment, there are plays that we are considering looking at and cultivating. I think Hach has over 70 years of innovating in water analytics. And frankly, there are ever-increasing needs to go after detection of new parameters. You've got PFAS is out there. That's a challenge to be solved right now that can only be solved in a centralized lab with a multimillion-dollar mass spectrometer. So Hach has the earned authority to be able to innovate in the space, which is at point of use or very, very near to that. And I think as long as there are emerging contaminants, there are going to be opportunities for us to continue to innovate in that space. For ChemTreat and Trojan, one of the things we did pre-spin with Trojan as we brought over the Pall Water business, which gives us access and sort of closed loop control over the microfiltration and ultrafiltration needed relative to reuse. And so you've got companion products with both filtration and UV treatment that create a nice bundle there. So there are plays like that, that still exist out there that we're keen to pursue.

That's super helpful. Now let's shift the gears a little bit to the internal side, right? 5% R&D -- near 5% R&D, you don't necessary think underinvested in.

Correct.

Right. So maybe just talk about the opportunities for internal capital allocation, how those shift? Or is that more of an iterative process from here as management team continues to wrap their hands around everything, and you really prioritize as a company.

Yes. I mean I think internally, we don't believe we've been underfunded in sales and marketing or R&D. Our 5% R&D is intentional and deliberate because that's really where the value is created. As innovators in treatment and analytics, in particular, part of that deep domain expertise and customer knowledge that we have 75% of our sales are direct to customer. And frankly, that creates the flywheel for being able to innovate in ways where potentially competitors don't have the acuity that we do because they're not in those plants. They're not side-by-side in the process every single day. So we think we're dialed in about right at 5%. We think that gives us license to be able to innovate in new and different ways that others might not be able to.

So you touched on a few thematics and the water quality to be patent -- water quality piece, of which I've gotten a couple of questions. First, let's just hit PFAS. Twofold question. One, how do you play in the PFAS chain? Because you really have 2 avenues as we sit here to hear at least 2 potential avenues? Maybe we just start there to level set everybody in the thought process.

Yes. I mean, as I had mentioned, we've always had a strong play in analytics, particularly even in emerging analytics and even treatment. The Hach business was directly involved in setting the turbidity standard and the DPD chlorine standard decades ago working with the EPA. When the entire area of Long Island was overcome by one for dioxane, we spent time and energy to understand that problem and we've got 56 skids, Trojan skids that are installed there to actually treat and deal with the 14 dioxane problem so that everyone there on the islands got access to clean drinking water. So I mean, I think given the history, we've got fairly good entitlement in terms of innovating in this space. I do think solving the PFAS problem at point of use is going to take some technology breakthroughs, right? And right now, it's not optimal, right? The U.S. has regulated down to 4 parts per trillion. And the only way that, that can be accomplished is sending a water sample out to a centralized lab. You might get a result in 48 hours at the fastest. We're here in 2 weeks. By that time, you've discharged hundreds of thousands of gallons to your local communities, right? That's not a fit-for-purpose sort of solution. Now we'll see, I'm sure lots of activity around centralized labs and so on and so forth. Our power ally really is in sort of fit-for-purpose, point of use, kinds of analytics. But we equally feel that destruction on site is also part of the equation. So I think the game will be one around not only detection, but also destruction. There's plenty of companies out there that are getting excited about PFAS capture. The problem is, is all of that resin then has to be moved to some sort of landfill where it's going to cleave off of that and get back into the water system, and you're going to be trying to take it out again. That's why they're called forever chemicals. They're really hard to get rid of. And so there's a genuine amount of work to do there.

And let's be realistic. Forever chemicals are involved in almost anything involved in building our infrastructure today. It's not like you can get rid of the use of them. The follow-up question I got was essentially twofold here. One, because there's a couple of questions weaving together. Average utility size, the U.S. is small. How does that pose an opportunity or challenge to adequately address PFAS, which ties in the broader concern, which is how does this really get invigorated from a time perspective because who's the one driving it? Is this a regulatory environment? Is it private companies? Is it lawsuits? How do you see all of this weaving together over time?

Yes, I think it's a little bit of all of those things, right? We got regulatory environments where we've got the U.S. and Europe sort of a materially different levels of limits of detection. U.S. is going after parts per trillion in the single units parts per trillion. Europe is converging closer to sort of 100 parts per trillion as endorsed by the WHO. So there's some regulatory alignment there, I think, that obviously needs to be happened. But equally, lawsuits are creating a pretty significant motivator in terms of the funding envelope that's available to deal with some of this stuff. So I think it's going to be an intersection of a lot of those things. And we're currently working with the EPA to help them understand sort of technologies available, limits of detection, practical use and so on.

So let's take a higher-level look at the water quality piece. You look over the last decade, more like a 4% grower, you tend to think in that 5 to 6-ish percent range. You go prior to the global financial crisis was in that 5% to 6% range. Why do we revert back to that range? I'm in your camp. I think you do have a higher growth profile this cycle. I'd be curious at the drivers of why there might be a slight acceleration in that growth profile?

Yes. I mean I think we see the portfolio in aggregate delivering mid-single digits over the cycle, and it's done so for decades. PQI tends to be a little bit lower at the lower end of mid-single-digit growth. Water, as you mentioned, tends to be in the 5% to 6%. The reality is the secular drivers for both of these businesses remain strong and durable. There's not a situation or a scenario when people are going to stop drinking, eating or needing to be medicated. So I think in light of the fact that we do fit in that OpEx part of the plants, that is to say we're not as subject to sort of lumpy CapEx cycles where you have to wait for funding to become available. These products and these solutions are part and parcel to the standard everyday operating of the plan. And so I think you're going to see the durability of that driver continue to persist well into the future and frankly, accelerate as a function of some of the incredible environmental problems that we have, water scarcity, water contamination, storm surge, hurricane, all of these sort of environmental events are disturbing watersheds at levels that we have never seen before. And so the cleanup of that water, the treatment of that water, the scarcity of it, the need to reuse, recycle, reclaim is ever increasing, and that's just going to continue to be the case.

In terms of demand dynamics, a little bit more mix in the short term, again, sticking to water quality, we'll address PQI in fact. How do you see that playing out? It feels like there's just a slight air pocket get against tougher comps but the underlying momentum and the dynamics are favorable and there's some other catalysts that could emerge next year. Maybe just talk to what you're seeing today.

Yes. I mean we've seen some -- certainly some water hammer, no pun intended. In terms of the comparables year-over-year and quarter-over-quarter as a result of working out sort of post-pandemic sort of realities. The third quarter last year, we posted 16.5% growth. We posted 9.5% fourth quarter last year, right? So we do have some pretty incredible comps for our water business to sort of step up to. But I think in the main, what you see is the long-term drivers of the cycle remain intact. If you look at any 2, 5, 10, 20 year period, you're going to see that water business deliver mid-single digits in the 5% to 6% range. And so do we see some fluctuation here near term a little bit, but we remain confident about sort of the long-term profile as some of this noise levels out between the quarters.

Also does it seem like there's as much, call it, cyclical interest rate sensitivity, however you want to phrase it. Your industrial piece is even higher on the replacement curve as a percentage of revenue relative to some muni pieces, pieces. Maybe you have some regulatory drivers that start hitting as you move into the next year and move through next year. Do you agree with that from a balancing perspective? Or should I be thinking about the cyclicality a little differently?

Yes. I mean on the industrial side, so we have roughly -- it's like 40%, 40% and 20%, right? 40% of the water business is in muni, 40% in industrial, 20% in sort of applied hospitals and other kinds of applications. You're going to see some nuances that are different between how the industrial markets move and how the muni markets move. And between the 2, we've had for the first 3 quarters, our industrial piece has held up really, really well, right? So we're seeing great growth in Trojan and ChemTreat as a function of some of the vertical markets that are growing. You've got oil and gas, you've got some aerospace in there, you've got metals, steel mills running around the clock here in part to keep up with demand of construction. And we've got a couple of -- unfortunately, we've got a couple of wars now sitting abroad that require metal machinery, armory and so on and so forth. So I mean, those are opportunities for us to continue to grow and play in. On the muni side, again, we're going to continue to see sort of that be sort of run rate steady as she goes business. So you're going to see a little bit of sort of some fluctuations and based on what industrial markets are up or down. But in the main, I think if you look over the cycle, it's pretty -- it's pretty consistent relative to sort of that delivering on that mid-single-digit growth.

Maybe I'll just clarify a little bit that, Mike. I mean look at the industrial side of the business, even that is very heavy consumable business right? Actually, when you look at the industrial side that we talk, we put the microelectronics and semi business in it. And there, we are seeing incredible tailwinds, right? So that's where the capital side is [indiscernible] lot of capital available, and you're seeing that in the build-out. So industrial is also very consumables, heavy businesses. It's not that sensitive to interest rate environment.

Because the sensitivity is going to be a little bit more on the PQI side, let's use that as a transfer point. Even there, very heavy consumable business. Correct. Maybe talk about the underlying dynamics there. China seems to be having an outsized impact relative to the percentage of revenue, probably speaks to how bad China is right now as a cumulative thought process. How do you think about the short term there? I mean I know medium term, you're thinking that 3% to 5% range. But how do you think about the short-term dynamics and we can progress back towards normal?

Yes. I mean, the largest part of the marking and coding portfolio sits in continuous inkjet, which is a razor/razor blade kind of business. And ink and solvent volume is consumed based on printing volume or unit of goods that are printed just like your inkjet printer at home, you print a whole ream of paper. You're going to be replacing your cartridges faster than if you're printing one piece of paper every other month. And so with absolute demand in consumer product goods, which is about 50% of that PQI marketing and coding business being down, we see consumer buying behavior shifting as a result of the CPG inflationary environment, right? If you go to your grocery store, everybody is seeing inflated food prices. And customers are electing to buy down or buy less in most cases, by less. So that's created a little bit of a short-term sort of contraction of the ink and solvent volume within our marketing and coding business. Again, it's not something that we expect to be sustained over the cycle or for an incredibly long period of time. We do think as sort of inflation abates and interest rates sort of start to renormalize a little bit that those supply and demand curves are going to come back in line, and we're going to see sort of those kinds of run rates that we would see historically.

And then I did have a question from the audience. Any thoughts on China holistically across both your businesses? How do you think that plays out?

Yes. I mean China, I think China is down for most businesses right now. They continue to have funding challenges with foreign direct investment moving out of the country. And I think we did our earnings call a couple of weeks ago. I think we said that we didn't see any near-term change in China, right? Demand is going to continue to be soft. But we've got a huge global population. It still ends up being an important manufacturing country for much of businesses around the world. And so we would expect that we will not see these rates of decline going forward from a long-term perspective.

Well, please join me in thanking Jennifer and Sameer for the time with us today. Management will be available outside up 1 level to -- for a breakout session immediately following this. Thank you for your time.

Thank you, Mike.