2023-10-26 15:24:51 ET
Summary
- Veralto Corporation, a $5 billion water and product quality business, was spun off from parent company Danaher Corporation.
- Shares of Veralto have fallen 20% since the spinoff, but still trades at a small premium.
- The company's growth is underwhelming, and parts of the business are not well positioned, making caution necessary before buying.
When Veralto Corporation ( VLTO ) was spun off from its former parent company Danaher Corporation ( DHR ) at the start of the month, I offered some thoughts on the prospects for the standalone business.
The former environmental & applied solutions business of Danaher was spun off to become a $5 billion water and product quality business. While Danaher spun off the business to focus on its higher growth and higher margin businesses, Veralto commanded a premium valuation itself which left me a bit puzzled.
Over the 2–3 weeks which followed, shares of Veralto have fallen some 20% as the move has reduced high valuations quite a bit, but Veralto still trades at a small premium while current growth is a bit underwhelming and parts of the business are not that well positioned. All this makes me cautious to buy the Veralto Corporation dip yet, as quite frankly I require a larger selloff before getting involved.
About Veralto
Veralto is a $5 billion business which focuses on water and product quality. The water quality segment is responsible for about 60% of sales, with brands and business including Hach, Trojan Technologies, ChemTreat, Aquatic Informatics, among others. Typical applications include addressing and handling water scarcity, water quality, as well as sustainability and regulation of contamination.
The remaining 40% of sales are generated from so-called product quality and innovation businesses which includes the likes of Videojet, X-Rite, Ekso and Pantone. The products and solutions of these businesses are used in marking & coding, as well as packing & color, used in consumer safety, packaging, digitization and sustainability.
While Danaher deemed the business inferior from a growth, positioning and margin perspective, as reasons for the spin-off, the actual 2022 performance was rather impressive. Veralto (still as part of Danaher) posted an 8% increase in 2022 sales to $4.9 billion while EBITDA margins were reported at 24%.
Revenue growth slowed down to 4% in the first half of the year, with sales reported at $2.48 billion, with operating margins posted at 23%. This is supposed to include some overhead costs already, but it is always to be seen how the standalone costs and margins will really develop as standalone business is really separated. Following payments to Danaher, net debt of $2.35 billion worked down to a 2.0 times leverage ratio.
With 246 million shares trading at $87 after the spinoff, the $21.1 billion equity valuation looked rather steep. After all, a 22% margin profile on $5 billion in sales translates into operating profit of $1.1 billion. Assuming a $100 million interest expense and 25% tax rate, earnings of $750 million worked down to $3 per share, for a 29 times multiple.
The investor presentation at the time of the spinoff backed up these numbers with Veralto claiming adjusted earnings of $2.96 per share in 2022, after a $0.84 per share adjustment to factor in costs to be incurred by the standalone entity, as earnings came in at $1.56 per share in the first half of this year. This left me a bit puzzled, as Danaher deemed the business to be of less quality than the core business, at least it decided to no longer keep in its portfolio, but valuations were rather demanding.
That demanding valuation, despite the interesting water positioning, made me cautious to get involved, as I was waiting for more interesting levels and confirmation of the standalone performance.
Coming Down
Since early October, shares of Veralto have sold off some 20%, with shares now down to $70 per share, marking quite a substantial pullback in a rather short period of time.
Third quarter sales rose just 3% to $1.25 billion, with non-GAAP core sales up just a percent in a rather inflationary environment. The company posted GAAP earnings of $0.83 per share, but after accounting for costs related to the standalone operation, adjusted earnings were reported at $0.75 per share, down a penny from the year before.
The company incurred just $5 million in interest costs for the quarter, which of course only ended on September 29 alongside the spinoff. With a $2.3 billion net debt load pro forma for the spinoff, these interest expenses will of course increase going forwards, as the guidance in that light looks comforting (at least on the earnings front).
After all, interest expenses run at around $100 million per annum here, suggesting some $25 million per quarter, and thereby $20 million more than seen in the third quarter. That works down to about an 8 cents headwind (pre-tax) in the coming quarter, so in that light the below-mentioned near term guidance looks comforting.
For the fourth quarter, non-GAAP core sales are flat to down low single digits, due to lower demand in China in the product quality and innovation segment. Adjusted margins are seen around 24%, with adjusted earnings seen between $0.79 and $0.84 per share. This looks solid given the discussion above around additional interest expenses, something I would like to see confirmed in the fourth quarter results.
Investors can furthermore look forward to a dividend, although that an announced dividend of nine cents per quarter translates into a yield of just half a percent.
Promising is that net debt of $2.18 billion was lower than a $2.35 billion number pro forma for the spin-off and with EBITDA close to $1.2 billion, leverage ratios have fallen to 1.8 times already.
And Now?
Right now the situation is more or less as expected, as a 29 times earnings multiple at $87 per share fallen to about 23 times earnings at $70 per share here, a meaningful reduction.
The first quarterly earnings report as a publicly listed business is more or less in line with expectations. Sales growth is softer than expected, in a murky environment, as the business will of course be impacted by the spin-off, in terms of additional costs and distraction.
If Veralto Corporation was a 100% water business, I would be inclined to become a buyer given the long-term growth profile and the fact that leverage is quite reasonable. The issue is that the remaining 40% of the business is less well positioned. Quite frankly, I find it a bit early to buy the dip just yet, and I am awaiting potential further dips to the lower sixties.
For further details see:
Veralto: A Soft Receipt For This Spinoff