On October 26, 2023, Veralto Corporation (NYSE: VLTO, $70.00, Market Capitalization: $17.20 billion) reported 3Q23 results that surpassed consensus expectations. Total sales were $1.3 billion, an increase of 3.0% YoY (core sales +1.0% YoY), beating the consensus by 3.0%. The growth is mainly attributable to the Water Quality segments (+4.2% YoY), slightly offset by the Product Quality and Innovation (PQI, +1.0% YoY) segment due to the weak China market and softer demand in consumer-packed goods. Adjusted Operating profit was flat at $281.0 million (+6.0% above consensus) while the corresponding margin contracted 66 bps to 22.4%, mainly on higher separation cost. Adjusted EBITDA declined slightly by 0.3% YoY to $290.0 million, with a corresponding margin falling by 8 bps to 23.1%. Net Income was $205.0 million, declined 6.0% YoY, while it was above the consensus of $178.0 million. The corresponding margin contracted by 155 bps to 16.3%. Adjusted Diluted EPS came in at $0.75 (3Q22: $0.76) ahead of the consensus of $0.72.
In the near term, softer demand in China are anticipated to continue, coupled with weakness in volume growth in the global consumer packaged goods sector. Despite these short-term difficulties, management is confident in the resilient growth in the long term for both Water Quality and PQI. For FY23, core sales growth is anticipated to be low-single-digit (LSD) YoY, with mid-single-digit growth in Water Quality and a low-single-digit decline in PQI. Adjusted EPS is anticipated to be $3.11 to $3.16 per share, assuming an effective tax rate of 25.0%. Diluted shares outstanding are expected to be 247.0 million.
On September 14, 2022, Danaher announced its intention to spin off the Veralto Corp., an Environmental & Applied Solutions division, into an independent, publicly traded company. On August 3, 2023, Veralto filed Form 10 with the SEC, disclosing the terms and conditions of the separation. Danaher distributed 246,291,242 shares of Veralto to existing Danaher shareholders as of the record date of September 13, 2023, on a pro-rata basis. Specifically, for every three shares of Danaher common stock a Danaher shareholder holds, they received one share of Veralto common stock. The transaction was tax-free for DHR’s shareholders. The distribution date for the spin-off was September 30, 2023. Both the stocks commenced regular way trading on October 2, 2023, on the NYSE. After separation, Veralto joined the S&P 500 Index effective October 2, 2023, and is listed under the symbol VLTO on the NYSE Index.
Veralto continues to grapple with the ongoing issues of weakened demand in the PQI segment and destocking, notably in China. We anticipate a recovery to take hold in late 2024. Concurrently, with inflation easing, the pricing growth in the Water Quality segment is expected to stabilize to a historical level, pressuring the margins. Accordingly, we reduced our target price on Veralto to $86.00 per share (previous: $113.00 per share) with an upside of 22.9% over the closing price as of 10/26. We reiterate our BUY rating on Veralto.
Key highlights of the conference call (3Q23)
• VLTO achieved a strong quarter amidst a challenging macro-environment, marked by significant challenges in China and reduced demand for consumer goods. Although pricing remains favorable, it is gradually returning to historical levels as supply chains stabilize and inflation eases. The management is focusing on cost efficiency initiatives while sustaining investments in research and development and growth initiatives.
• In 3Q23 VLTO achieved sale of $1.25 billion, with 59% being recurring. Core sales grew by 1% YoY. Adjusted operating profit was flat YoY to $281.0 million with corresponding margin was at 22.4% declined on increased separation cost. Adjusted EBITDA reached $290.0 million, equivalent to 23.1% of sales. Adjusted EPS was $0.75 per share. For 3Q23, VLTO generated over $230.0 million in free cash flow, representing 113% of net income.
• On consolidated basis, core sales increased by 3.5% YoY in North America and 2.5% YoY in Western Europe. In North America, growth was primarily driven by the water quality segment, particularly in water treatment businesses, with modest growth in water analytics. However, in high growth regions core sales declined by 5.0% YoY mainly on weakness in China (core sales -15.0% YoY).
• In Water Quality segment sales were $772.0 million, representing a 4.0% YOY increase. Currency exchange provided a 1.0% boost. Core sales grew by 3.0% YoY vs a significant 16.5% growth in the previous year, resulting in a two-year core growth stack of approximately 10%. Pricing was a significant contributor, adding 5.0% to core sales growth during the period and offsetting the impact of lower overall volume.
• In water treatment, ChemTreat and Trojan both saw year-over-year sales volume growth. ChemTreat’s consistent growth across industrial sectors attracted new customers through technical expertise, while Trojan successfully expanded the adoption of UV systems in municipalities and experienced strong growth with the mobile rental program at Aria Filtra (formerly Pall Water).
• PQI segment achieved sales of $483.0 million (+1.0% YoY). Currency exchange provided a 2.5% boost, and acquisitions added 1.0% to the YoY. However, core sales declined by 2.5%, primarily due to reduced demand for consumer packaged goods and challenges in China. Pricing had a positive impact of 2.0% in the quarter, partially mitigating the effects of volume reductions across the PQI product portfolio.
• In the PQI segment, core sales dropped by 2.5% in North America due to reduced sales of packaging hardware and color equipment, despite modest growth in marking and coding. In Western Europe, PQI sales remained steady, but the segment achieved 5.5% core sales growth, primarily driven by the water division. Hach’s analytical instruments and consumables were the key drivers of core sales growth in the water sector, with significant contributions from Germany and France.
• At the end of 3Q23, VLTO had a cash from operations of $243.0 million and incurred capital expenditure of $11.0 million. As of 3Q23, the company has a net debt obligation of $2.2 billion, 1.8x of net leverage.
• The management intend to initiate distributing cash dividend to shareholders from 4Q23 onwards of $0.09 per share subject to approval from board.
• In near term, the challenges in China are anticipated to continue coupled with weakness in volume growth in the global consumer packaged goods sector. Despite these short-term difficulties, management is confident in the resilient growth in the long term for both water quality and PQI. In long run the core sales growth of mid single digit could be achieved.
Guidance:
• In 4Q23, VLTO anticipate flat to slightly lower single-digit YoY decline in core sales on a consolidated basis considering continued weakness in China across both segments. In the water quality segment, core sales to remain flat YoY on difficult comparable.
• In PQI segment, core sales is anticipate to decline in a low-to-mid single-digit YoY. This decline is attributed to the persistent weakness in consumer-packaged goods markets. The adjusted operating profit margin in the range of 23.5% to 24.5% (+100 to 200 bps sequentially). Adj. diluted EPS is anticipated to be in the range of $0.79 to $0.84.
• For FY23, core sales growth is anticipated to be low-single-digit (LSD) YoY with mid-single-digit growth in water quality and low-single-digit decline in PQI. Adjusted EPS is anticipated to be $3.11 to $3.16 per share assuming effective tax rate of 25.0%. Diluted shares outstanding are expected to be 247.0 million.
Overall Results 3Q23
VLTO reported sales of $1.3 billion, an increase of 3.0% YoY (+3.0% consensus) with core sales growing 1.0% YoY mainly on growth in Water Quality segments. Geographically, VLTO witnessed a 6.0% YoY growth in sales within developed markets where Sales in North America rose by 3.5% YoY, and Western Europe saw a notable 12.5% YoY increase. Conversely, high-growth markets declined by 4.5%, mainly due to a significant 20% drop in Chinese sales due to reduced demand.
Water Quality segment revenue was up 4.2% YoY to $772.0 million. The segmental adj. operating profit expanded by 3.2% YoY to $191.0 million whereas, the corresponding margin declined by 23 bps to 24.7%. On the other hand, the headwind from weakness in China and lower demand for consumer packaged goods limited the growth of PQI segment with reported revenue of $483.0 million, +1.0% YoY. The adj. operating profit was $110.0 million (-2.7% YoY) with corresponding margin contracted by 87 bps to 22.8%.
VLTO gross profit was $723.0 million with a corresponding margin of 57.6% (+68 bps YoY). Adjusted operating profit was flat at $281.0 million (+6.0% above consensus) while the corresponding margin contracted 66 bps YoY to 22.4% mainly on higher separation cost. Adjusted EBITDA declined slightly by 0.3% YoY to $290.0 million and corresponding margin fell by 8 bps to 23.1%. Net Income was $205.0 million, declined 6.0% YoY, while it was above the consensus of $178.0 million. The corresponding margin contracted by 155 bps YoY to 16.3%. Adjusted diluted EPS came in at $0.75 (3Q22: $0.76) ahead of the consensus of $0.72.
VLTO free cash flow for 3Q23 declined 7.6% YoY to $232.0 million. Net Debt at the end of 3Q23 was $2.2 billion with net leverage ratio at 1.8x.
Investment Thesis
Veralto Corporation
Surging demand for water treatment solutions amidst global clean water crisis
Veralto strategically focuses on key sectors within the water treatment industry, targeting growth areas to address pressing issues like water scarcity, safety, extreme weather events, and responsible resource management. Upgrading wastewater facilities is crucial due to cost, energy, and capacity challenges, along with stricter compliance demands. Projections indicate that the world’s freshwater supply could run out within 17 years unless water consumption is significantly reduced, underscoring the importance of water purification and efficient water management. Veralto currently seizes opportunities in the clean water sector, encompassing environmental testing and water/wastewater treatment, backed by 2500 patents. This sector offers substantial market potential, estimated at $800.0 billion in 2022. While North America and Europe are well-established markets, emerging regions like China present significant growth prospects. Factors such as limited access to clean drinking water, increasing demand for sewage and drainage water treatment, and expanding regulatory requirements make these markets especially promising.
Product Quality & Innovation to provide consistent revenue stream:
Veralto’s resilient business model centers around its Product Quality and Innovation segment, contributing 41.0% of its revenue. Notably, around 59.0% of this segment’s income is recurring, ensuring stability and predictability. The company’s strategic emphasis on innovative technology in product packaging positions it well for future growth. Anticipated increased adoption of advanced packaging technology is expected to drive revenue growth. This alignment with technology strengthens Veralto’s competitiveness, allowing it to capitalize on evolving market trends and consumer preferences. Veralto’s commitment to product quality, innovation, and technology in this core segment enhances its market position and growth prospects. Additionally, this segment could be a valuable asset, offering favorable returns for Veralto.
Robust ESG attributes resonate well for investors:
The core tenet of Veralto’s business model revolves around water treatment and mitigating its environmental footprint. This strategic emphasis aligns closely with the burgeoning trend among investors who prioritize environmental, social, and governance (ESG) considerations when making investment decisions. Veralto’s commitment to addressing water-related challenges and its sustainable practices positions it as an attractive prospect for ESG-conscious investors and underscores its potential for generating long-term value through eco-friendly and responsible business practices. This alignment with ESG principles can enhance Veralto’s appeal within the investment community and may contribute to securing funding and support from stakeholders who prioritize sustainability and ethical corporate conduct in their portfolios.
A slowdown in demand and weakness in China continue to weigh on sales in the near term:
In the Water Quality segment, Veralto is anticipated to witness significant sales impact due to the weakness in China, affecting both municipal and industrial consumers, particularly in the water analytics subsegment. Conversely, in the Product Quality and Innovation segment, the reduced consumer demand for packaged goods due to lower disposable income of consumers on back of inflation and market weaknesses in China will exert downward pressure on sales in the short term. Furthermore, the Veralto margin will likely encounter challenges from elevated inflation rates and labor costs.
Valuation
We value Veralto Corp. (Spin-Off) on a relative basis (EV/EBITDA and P/E) based on our FY24E EBITDA and Net Earnings.
Veralto Corp. (Spin-Off entity)
Veralto has presence in segments within the water treatment industry which has substantial growth prospects and are well-positioned to tackle pressing issues like water scarcity, water safety, extreme weather events, and responsible management of natural resources. Additionally, its business model is having highly attractive ESG attributes which resonate well for ESG- conscious investors. While we maintain a positive outlook on the company’s long-term growth potential, we do anticipate short-term challenges. These challenges include the current high inflation rates and high-interest rate environment wiping out consumer demand for packaged goods and slower-than-expected demand in China, which are expected to exert downward pressure on the company’s growth. We compare Veralto with Pentair Plc, HORIBA LTD, Xylem, Mettler Toledo, Dover Corp, BADGER METER, ITRON Inc, Sartorius AG. Our EV/EBITDA multiple and P/E multiple are at a premium to peers considering the superior margin and return on equity and invested capital profile. Considering ongoing softness in demand and increased geopolitical risk, we have reduced our valuation multiple for Veralto. We value at EV/EBITDA multiple of 20.0x and arrive at an Enterprise Value of $24.6 billion. Subsequently, we deduct net debt of $2.2 billion (3Q23) to arrive at an implied equity value of $22.4 billion. Using the P/E multiple of 26.0x, we get the implied equity value of $20.0 billion. Consequently, we arrive at average equity value of $21.2 billion. Considering the diluted shares outstanding of ~246.4 million we arrive at a fair value of $86.00 per share (previously: $113.00 per share). We reiterate a BUY rating on Veralto.
Company Description
Veralto Corporation (Spin-Off)
Veralto Corporation operates in two segments: Water Quality and Product Quality and Innovation (PQI). The company portfolio includes water analytics, water treatment, marking and coding, packaging, and color offerings. It has many brands under them like Hach, ChemTreat, Trojan, OTT, and McCrometer and in product identification, it operates through Videojet, X-Rite Pantone, Esko and Linx. The company is headquartered in Waltham, Massachusetts, with ~16,000 employees and has presence in more than 45 countries. Collectively, Veralto and its subsidiaries have ~2500 patents.
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