2024-01-11 17:43:47 ET
Summary
- VLTO is down by mid-single digits since it made its debut on the bourses.
- We like the reliability of the topline and the strong FCF generation.
- VLTO carries ample debt, and given its predilection towards strategic M&A, dividend growth prospects could be subdued.
- The financials for 2024 are not resplendent, and valuations look pricey.
- The charts suggest that buying at this juncture may not be too rewarding.
Good Pedigree, But Spin-Offs Have A Dubious Track Record
Veralto Corporation ( VLTO ), which previously was a part of the famed life sciences and diagnostics innovator - Danaher Corporation ( DHR ), came into inception as a standalone entity at the start of Q4 last year when it was spun-off. Note that since it made its debut on the market, VLTO hasn't made any money for its shareholders and is down by mid-single digits over the last three months.
Granted, VLTO comes from a good heritage, and the well-established system and practices of Danaher should hold them in good stead as a standalone play, but studies have shown that spin-offs typically don't add a great deal of value to the parties involved.
For context, a study conducted by HBR entailing 350 large spinoffs over the last two decades showed that average returns post-separation, for the combined market cap of the two entities was only around mid-single-digits even after two years.
Impressive Recurring Revenue Profile and Asset-Light Model Translates To Useful FCF Generation
VLTO essentially comprises Danaher's old environmental and applied solutions ((EAS)) segment. Products here are primarily utilized to analyze, treat, and manage water used in industrial, residential, and commercial applications (60% of the business). The rest of the business comes from the sale of various instruments, software, services, and consumables to the consumer, pharma, and industrial markets.
One of the standout qualities of Veralto is that it has a healthy stream of recurring revenue that accounts for 57% of its revenue base. This recurring revenue facet is a reflection of how pivotal some of VLTO's offerings are to its clients. As an aside, whilst that recurring revenue proportion is impressive in its own right, do note that the erstwhile Environmental & Applied Solutions segment of Danaher (which is what VLTO covers now) still had the lowest share of recurring revenue compared to Danaher's other segments - Biotech (82%), Diagnostics (88%), and Lifesciences (62%).
Besides the steady revenue stream, the relative reliability of the VLTO operating model also comes through by way of the markets it is predominantly exposed to. A massive 80% of its topline comes from steady dependable end markets such as water, food, and pharmaceuticals.
Whilst the underlying texture of VLTO's topline brings a degree of reliability to this story, it also translates to consistently positive operating cash flow (OCF). This is also an asset-light business, with CAPEX accounting for less than 1% of sales, so inevitably the OCF coverage of the CAPEX is quite huge (for the first three quarters of 2023 the OCF covered the CAPEX by 22x) and translates to excellent FCF. Between FY20 and FY22 the company converted over 100% of its net earnings to FCF, but last year that improved even further with the Q3 conversion coming in at 113% !
Don't Expect Generous Distribution Growth In Light of Significant Gearing
Even though VLTO has barely had any time as a public company, we've already seen it take the initiative to distribute quarterly dividends of $0.09 per share, which will be paid at the end of this month. That figure is certainly not Earth-shattering and only translates to a minuscule yield of 0.47%. Given the low base, some dividend-chasing investors might be hoping for some generous distribution growth next year, but we would seek to play down those hopes in light of the elevated levels of debt that exists on VLTO's balance sheet
As per the latest data Veralto had around $2.6bn worth of debt, which as a function of its operating profits translates to a hefty gross leverage level of 2.27x. From another lens, you're also staring at a remarkably high debt-to-equity ratio of 262%! For perspective, the average debt to equity for stocks in the environmental services universe is a lot lower at only 88% .
Thus even though the VLTO operating model continues to generate healthy doses of FCF (on a trailing twelve-month basis, we're looking at roughly $1bn of FCF), a significant chunk of that will be required to manage the debt (which overshadows the FCF by 2.6x) and also fuel VLTO's inorganic ambitions. This is a business with ample appetite for M&A (in the analyst day PPT they've spoken about their desire for strategic acquisitions which will be pricier than your standard bolt-on M&A) and it is reflected in the goodwill on the books which already accounts for a massive 48% of the total asset base.
Financial Outlook And Forward Valuations
Over the last couple of fiscals, VLTO has delivered healthy core sales growth of 8%, but it appears that the pace of growth is now on a declining trend and could stay that way for a while.
In Q3, core sales only grew by 1%, and management implied that Q4 could be worse with either a flattish performance or low-single-digit declines.
As long as the Chinese market continues to be a drag (it was down by the high-teens in Q3), it could be difficult for VLTO to flourish. Besides, the PQI segment (particularly in North America) is also facing its own set of challenges with subdued demand for packaging hardware and color equipment. Separately, weakness in the consumer packaging goods markets could also continue to weigh heavily on marking and coding-related revenue.
All in all, if one looks at consensus revenue estimates for the current year, it's not as though VLTO is set to dazzle with expected growth of only 3%. The expected bottom line growth for FY24 is pretty unremarkable at only 5% . That number is a patch on the average forward EPS growth of 17.5% that other environmental-based stocks are poised to deliver.
In light of such a weak earnings trajectory, we don't think it makes a great deal of sense to buy with a forward P/E of 23.6, as that translates to quite a hefty PEG (Price to earnings growth) ratio of 4.7x.
Closing Thoughts - Technical Considerations
Recent developments on the charts also suggest that VLTO would not make a great buy at this stage.
The chart below measures how VLTO is positioned relative to its peers from the environmental services universe. Over the last three months, we've seen the ratio make a peak and a trough, setting the boundaries for a trading range. As things stand, the ratio is now a lot closer to the mid-point of the trading range and is unlikely to benefit from ample rotational interest (quite unlike the situation in mid-November).
Separately, if we look at VLTO's standalone price imprints on the daily charts, note that after forming a small base in late October/early November, we saw the stock trend up in the shape of an ascending channel. We also witnessed the Golden Cross trigger by mid-November, which would have brought a few bulls to this counter.
From then until 2024 VLTO had trended well within the ascending channel, until we saw a large-bodied red candle breakdown from the channel last week. Since then VLTO has failed to recoup the channel, and we've also seen the death cross with the 10DMA dropping well below the 20DMA which doesn't bode well for someone considering a long position now.
For further details see:
Veralto: Some Useful Qualities, But Not Compelling Enough At These Levels