Veralto Q1 2024 Earnings Call Transcript

Quartr
Provided by Quartr
April 24, 2024

There are 12 speakers on the call.

Operator

My name is Shelby, and I will be your conference operator this morning. At this time, I would like to welcome everyone to Veralto Corporation's First Quarter 2024 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. I will now turn the call over to Ryan Taylor, Vice President of Investor Relations.

Operator

Mr. Taylor, you may begin your conference.

Speaker 1

Good morning, everyone. Thanks for joining us on the call. With me today are Jennifer Hunnicutt, our President and Chief Executive Officer and Sameer Rawhan, our Senior Vice President and Chief Financial Officer. Today's call is simultaneously being webcast. A replay of the webcast will be available on the Investors section of our website later today under the heading Events and Presentations.

Speaker 1

A replay of this call will be available until May 8, 2024. Before we begin, I'd like to point out that yesterday, we issued our Q1 news release, earnings presentation and supplemental materials, including information required by the SEC relating to any adjusted or non GAAP financial measures. These materials are available in the Investors section of our website, www.varalto.com, under the heading Quarterly Earnings. Reconciliations of all non GAAP measures are provided in the appendix of the webcast slides. Unless otherwise noted, all references to variances are on a year over year basis.

Speaker 1

During the call, we will make forward looking statements within the meaning of the federal securities laws, including statements regarding events or developments that we believe or anticipate will or may occur in the future. These forward looking statements are subject to a number of risks and uncertainties, including those set forth in our SEC filings. Actual results may differ materially from any forward looking statements that we make today. These forward looking statements speak only as of the date that they are made, and we do not assume any obligation to update any forward looking statements except as required by law. And with that, I'll turn the call over to Jennifer.

Speaker 2

Thank you, Ryan, and thank you all for joining our call today. The Q1 of 2024 marks our 2nd consecutive quarter of solid operating execution as a standalone company. We are driving steady, profitable growth and continuous improvement through greater focus and accountability using VES fundamentals, basic blocking and tackling. For Q1, we delivered 8% adjusted earnings growth year over year driven by 2% core sales growth and 90 basis points of adjusted operating profit margin expansion. And we exceeded our guidance across the board.

Speaker 2

Our financial performance reflects our culture of continuous improvement and demonstrates our ability to deliver on commitments. From an end market perspective, we are seeing drivers across industrial markets, particularly in North America, along with steady demand at municipalities. And in our product quality and innovation segment, we are seeing modest signs of recovery in consumer packaged goods markets. Most notably, PQI's recurring revenue grew mid single digits year over year for the 3rd consecutive quarter. Equipment bookings for marking and coding started to show signs of recovery late in the Q1, and we continue to see encouraging trends at some of our large CPG customers led by food and beverage.

Speaker 2

Based on our Q1 results and improving market trends, we continue to expect our core sales growth rate to modestly improve sequentially throughout the year. Looking at our full year guidance, we are on pace to deliver low single digit core sales growth and are trending toward the high end of our adjusted operating margin range of 50 to 75 basis points of improvement over 2023. As a result, we have modestly increased our full year adjusted EPS and free cash flow conversion guidance. Samir will cover that in more detail a bit later in the call. Confidence in our ability to deliver on commitments is, in large part, grounded in the Veralta Enterprise System, our proven system for driving growth, operational improvements, and leadership development.

Speaker 2

A core tenet of VES is continuous improvement or Kaizen. During March, we completed Veralta's 1st CEO Kaizen Week as a standalone company. CEO Kaizen Week is a long standing tradition of our enterprise system and personally one of my favorite weeks of the year. The purpose of this year's CEO Kaizen Week was to drive value accretive growth. For 1 week, we immersed 12 cross functional teams at Kemba, where the real work happens, across 6 businesses in 5 countries.

Speaker 2

The Veroroso executive team worked alongside associates in our operating companies to solve some of the most complex challenges and yield high impact results. For example, this year's event included increasing customer engagement in North America and EMEA to drive incremental sales growth of Hox Consumables, improving the customer buying experience at Videojet to accelerate key growth initiatives, and using lean conversion tools for make to stock products at a Hock distribution facility in North America to optimize efficiency, improve on time delivery, and meet increasing customer demand. The benefits of Anytime Van Week include immediate solutions that are rapidly implemented and yield real time results. Success is proven by sustaining these results, which we track following the Kaizen event. From a big picture perspective, this year's CEO Kaizen Week fortified our ability to deliver on our commitments to key stakeholders and reinforced that at Veralto, we are all practitioners of continuous improvement.

Speaker 2

Turning now to our financial results for the quarter. Core sales grew 1.8% year over year led by price increases across both segments and modest volume growth in our water quality segment led by our industrial water treatment businesses. Notably, both segments delivered recurring sales growth in the mid single digits year over year, increasing our percentage of recurring sales to 61% of total sales in the quarter. As compared to our guidance, we exceeded core sales growth expectations due to strong commercial execution and better than expected volume at both segments, particularly within consumables. On the margin front, we delivered 90 basis points of adjusted operating profit margin expansion, primarily through price execution, productivity improvements and cost optimization.

Speaker 2

Adjusted EPS was $0.84 per share, up 8% year over year and $0.06 above the high end of our guidance range. And we generated over $100,000,000 of free cash flow, further strengthening our financial position. Looking now at core sales growth by geography for the Q1, sales in North America grew over 3% year over year with sales in high growth markets flat and sales in Western Europe down about 1%. In North America, we continue to see strong growth in our water treatment businesses across industrial verticals, including food and beverage, chemical processing, mining and power generation. We also continued to see strong demand from municipal customers for UV treatment systems.

Speaker 2

In Western Europe, core sales were down modestly year over year primarily due to timing of UV system projects and the strategic portfolio actions in our water quality segment that we mentioned in our Q4 earnings call. Apart from these two items, core sales in Western Europe were steady year over year in both segments. In high growth markets, core sales were essentially flat year over year as growth in Latin America and India was offset by low single digit decline in China as anticipated. Despite the year over year headwind in Q1, we believe our end market environment in China has stabilized. That concludes my opening remarks.

Speaker 2

And at this time, I'll turn the call over to Sameer for a detailed review of our Q1 financial performance.

Speaker 3

Thanks, Jennifer, and good morning, everyone. I will begin with our consolidated results for the Q1 on Slide 7. 1st quarter net sales grew 1.8% on year over year basis to about $1,250,000,000 Currency was a modest benefit offset by the divestiture of Saltness product line. Saltness was a small commodity filter product line in our water quality segment that was divested in January. Core sales growth in Q1 was 1.8%.

Speaker 3

Price contributed approximately 2% growth in this quarter, in line with expectations. This aggregate price increase is also in line with historical levels. Volume was down a modest 40 basis points year over year. This was better than we expected primarily due to higher sales volumes of consumables at both segments during the quarter. Gross profit increased 6% year over year to $747,000,000 Gross profit margin increased 220 basis points year over year to 60%, reflecting the benefits of pricing as well as improved productivity and reduced material costs.

Speaker 3

Adjusted operating profit increased 5% year over year and adjusted operating profit margin expanded 90 basis points to 24.5%. We delivered strong margin expansion while investing in our sales and marketing efforts to drive future growth. We also increased our R and D investment to 4.8% of sales, up 20 basis points over the prior year period. These investments are aligned with our strategic growth plans and we expect to continue to fund ongoing growth investments. Looking at EPS for Q1, adjusted earnings per share grew 8% year over year to 0 point 8 4 dollars and free cash flow was $102,000,000 down from the prior year.

Speaker 3

This decline is primarily due to cash interest payments that we did not incur last year prior to our spin off. Moving on, I will cover the segment highlights starting with water quality on Slide 9. Our water quality segment delivered $749,000,000 of sales, up 2.7% on a year over year basis. Currency was neutral and the divestiture of Solvnath had 10 basis point impact on sales this quarter versus the prior year period. In addition to this divestiture, we strategically exited small product lines in our water quality segment in the Q4 of 2023.

Speaker 3

As we previously mentioned on the earnings call in February, exiting these product lines resulted in approximately 60 basis points headwind to core growth for the segment in this quarter. Despite this headwind, core sales grew 2.8% year over year as compared to 11% core sales growth in the prior year period, bringing the 2 year core sales growth stack for water quality segment to about 7%. Pricing contributed 2.6% to core sales growth and volume was up 30 basis points year over year. This is the 1st quarter of volume growth for water quality since Q1 2023. Our volume growth in this year's Q1 was driven by strong demand for our water treatment solutions in industrial end markets and UV treatment systems in municipal end markets.

Speaker 3

Recurring sales across the segment grew mid single digits, highlighted by increased sales of reagents and chemistries used in our analytical instruments at municipalities in North America. Adjusted operating profit increased 9% or $16,000,000 year over year to $186,000,000 Adjusted operating profit margin increased 150 basis points to 24.8%. The increase in profitability reflects solid pricing execution and improved productivity. Moving to the next page, our PQI segment delivered sales of $497,000,000 in the 1st quarter, up modestly versus the prior year period. Core sales were essentially flat on a year over year basis as price increases of 1.5% were largely offset by 1.3% declines in volumes.

Speaker 3

Recurring sales grew mid single digits with growth across the portfolio, increasing the mix of recurring sales for PQI to 63% in Q1. In packaging and color, sales were up low single digits year over year, highlighted by growth in recurring software and subscription revenue. In contrast, marketing and coding sales declined modestly, reflecting lower demand from CPG customers as compared to Q1 2023. This decline, however, was less than what we had anticipated in our guidance. As Jennifer mentioned, we continue to see modest signs of recovery in CPG markets with consumable sales up mid single digits year over year for the 3rd consecutive quarter and equipment bookings showing pockets of improvement.

Speaker 3

We remain cautiously optimistic that CPG volumes will improve sequentially as the year progresses. EQI's adjusted operating profit was $139,000,000 in the 1st quarter, resulting in adjusted operating profit margin of 28%. This was a strong margin performance for PQI and demonstrates the earnings power of these businesses. Turning now to our balance sheet and cash flow. In Q1, we generated $115,000,000 of cash from operations and invested $13,000,000 in capital expenditures.

Speaker 3

Free cash flow was $102,000,000 in the quarter. Note, this included about $57,000,000 of cash interest payments, which we did not incur in Q1 2023 prior to our spin off. At the end of the quarter, gross debt was $2,600,000,000 and cash on hand was 827,000,000 Net debt was $1,800,000,000 resulting in net leverage of 1.5x. In summary, we further strengthened our financial position during the quarter and have ample liquidity. This gives us flexibility in how we deploy capital to create long term shareholder value with a bias towards M and A.

Speaker 3

Turning now to our guidance for 2024, beginning with our updated expectations for the full year. As Jennifer mentioned, we are on track to deliver our target of low single digit core sales growth at the enterprise level and in both segments. We're targeting 100 to 200 basis points of price consistent with historical pre pandemic levels. From a sequential perspective, our guidance assumes that year over year core sales growth increases modestly quarter to quarter through 2024. Looking at adjusted operating profit margin, our target remains 50 to 75 basis points of improvement this year.

Speaker 3

Based on our Q1 performance, we are trending towards the high end of this range. Given our Q1 results and current view on margin improvement for the year, we have increased our full year adjusted EPS guidance to a range of $3.25 to $3.34 per share, up from our prior guidance range of $3.20 to $3.30 per share. In addition, we increased our free cash flow conversion guidance to a range of 100% to 110%. Looking at our guidance for Q2, we are targeting core sales growth in low single digits on a year over year basis with adjusted operating margin of approximately 23%. And our Q2, 2024 guidance for adjusted EPS is 0.75 dollars to $0.80 per share.

Speaker 3

That concludes my prepared remarks. At this time, I'll turn the call back to Jennifer for closing remarks before we open up the call for questions. Thanks, Sameer. In summary,

Speaker 2

as a standalone company, we have increased focus, discipline, and accountability across all levels of the enterprise, which has elevated our level of execution. We are driving continuous improvement and investing in future growth as our end market environment gradually improves. We are off to a positive start in 2024 with solid growth and strong margin expansion in the Q1. Our financial position remains strong and we can continue to take a disciplined approach to capital deployment with our primary focus on strategic acquisitions with attractive returns. Looking ahead, we remain focused on driving commercial excellence, continuous improvement, and disciplined capital allocation to create shareholder value while safeguarding the world's most vital resources.

Speaker 2

That concludes our prepared remarks. I want to thank you all again for joining our call. And at this time, we're happy to take your questions.

Operator

And we'll take our first question from Scott Davis with Melius Research. Your line is open.

Speaker 4

Good morning, guys, Jennifer and Brian. Good morning. The 60% gross margin is a pretty incredible number when you really think about the mix of businesses you have. Should we think about this as kind of high watermark? Or would you think about it as more of a step up into a new level of entitlement?

Speaker 4

How do you guys think about it?

Speaker 3

So maybe I'll take that one, Scott. Overall, if you got to look at our margin perspective, some of it comes down to deliverable mix. I think it's still going to be in the 58% to 60% kind of a zip code. As Jennifer mentioned on the call earlier, we saw good sort of a rebound in the consumables in both sides that really helps us on the margin side, both in the water quality and PQI side. But as kind of equipment kind of starts coming back in the rest of the year, the second half of the year, we should be in that 58% to 60% type of zip code.

Speaker 4

Okay. Fair enough. And just following on a little bit to comment you made, Jennifer, on increasing accountability. Understanding has always been that the DNR business system always drove a pretty high level of accountability. How have you tweaked it to even raise that to a different level?

Speaker 4

And what kind of changes have you made when you think about just tightening things up for the assets that you have here?

Speaker 2

Yes. I mean, I think it's always challenging to provide an equal level of focus across a very, very large enterprise like Danaher has. I think a smaller, more nimble $5,000,000,000 business obviously allows us to focus exclusively on these businesses, whereas there were many more factors, sort of previously with the life sciences and diagnostics side in Banner Her. And so some of the things that we've done here is, you know, we've just we've raised the level of not only expectation, but visibility to how we're operating, the tools that we're using by way of VES, and we're really focusing on the critical few. Every business is a little bit different.

Speaker 2

Their evolutionary maturity is a little bit different, and as a result, we focus on using fit for purpose tools in our VES toolbox to make sure that we're elevating the level of performance of each of those businesses.

Operator

And we'll take our next question from Andy Kaplowitz with Citigroup. Your line is open.

Speaker 5

Good morning, everyone.

Speaker 2

Good morning, Andy.

Speaker 5

Jennifer, Samir, how are you feeling about the PQI recovery at this point? I know you mentioned North America and Western Europe continue to see signs of recovery. You talked about equipment demand coming back late in the quarter. Maybe you could elaborate on that equipment trend. Have you seen follow through in that food and beverage recovery that started, I think, in Q4?

Speaker 5

And how are you factoring in China related growth in that segment for

Speaker 4

the rest of the year?

Speaker 2

Yeah. We're really encouraged by the PQI performance here in Q1, particularly around our consumable revenue stream or recurring revenue. This is the 3rd sequential quarter that we've seen mid single digit growth there. And with regard to sort of how those markets, particularly in food and beverage, recover from a downturn, we will always see the consumable revenue stream ramp first. And that's as a result of CPG customers coming back on lines that were previously mothballed.

Speaker 2

They're getting those lines running. They're refurbishing equipment. And so we always see that leading our equipment growth. Now on the equipment side, we did see some nice pockets of growth relative to orders late in the Q1. And so this is sequentially encouraging and very closely maps to the pattern of what we would have seen with consumables recovery first followed by equipment recovery.

Speaker 3

Yes. And the only other thing I would add from a guide perspective, we're building equipment recovery more in the second half, while the orders, as Jennifer mentioned in the March, were very encouraging. Good discussions with the customers and the business teams are having, but we're still cautious and we are building into anything on the equipment side more in the second half than in the Q2 at this point.

Speaker 5

Very helpful. And then maybe a similar question on the water quality side. Obviously, you've talked about strengthening industrial businesses for a while now. Maybe talk about the resilience of that. Are you seeing North American municipalities on the HOC side spend anymore?

Speaker 5

Is there do you see any risk of higher rates maybe impacting that side of the spend?

Speaker 2

Yeah. So the nice thing about our business, Andy, is it's largely an OpEx focused set of businesses. So interest rates, CapEx approval cycles, we are minimally impacted by. And because we operate at the high end of the value continuum in terms of being integral to operating municipal water plants, we see steady spends there. And following the pandemic when municipalities were kind of in lockdown relative to their execute on that activity, there will be more analytics and testing required for refurbishing plants and getting going on those improvements.

Speaker 2

So we continue to see good demand here that's continuing to recover municipalities, and we also have a variety of opportunities here in water reuse and recycling reclaim activities as well. So we're encouraged by the new markets that are starting to recover and look forward to continued execution there.

Operator

Thank you. And we'll take our next question from Jeff Sprague with Vertical Research Partners. Your line is open.

Speaker 6

Thank you. Good morning, everyone. Hey, Jennifer, just first on just kind of the M and A side of the equation. Obviously, couple of quarters out of the box here, probably kind of a solid year or so to think about it given the timeline of the spin. Just wonder how the pipeline is coming together?

Speaker 6

Do you see things that are actionable? And do they lean towards one segment or the other?

Speaker 2

Thanks for the question, Jeff. Yeah, this is everyone's favorite topic, I think. We are 207 days post spin, I think, today. So it's still early days here. But I have to say, we have a very, very robust process and a strong pipeline of activity, both in the water quality side and the PQI side with a number of opportunities that we're considering.

Speaker 2

We are going to stay disciplined here, consistent with our heritage and focus on making sure that we're going after the right markets, strong companies within those markets, and making sure that they come at the right valuation. We continue to like businesses that have similar operating model, durability and financial profile to those that we have in the portfolio today, businesses that can drive VES or they can utilize VES for continued improvements in gross and margin. And certainly, you know, our bias towards M and A is an important catalyst here going forward, but we will continue to maintain the rigor and the discipline that we have inherited from our history. And as always, M and A is a little bit episodic. We do see more opportunities opening up relative to actionability as the year progresses, and so we are encouraged by that.

Speaker 6

Great. And then maybe unrelated in for Sameer. Given that maybe kind of the consumables versus equipment mix doesn't really shift a whole lot until we get into the second half of the year, why is it that margins would be down sequentially Q1 to Q2 on sequentially higher revenues?

Speaker 3

Yes. Thanks, Jeff, for that. As we go from Q1 to Q2, Jeff, this is really ends up the first thing is the second quarter ends up being a seasonally heavier trade show activity quarter for us. So the operating expenses do go up seasonally just for us in Q2 and Q1. And that's kind of I would say, applies to both the segments.

Speaker 3

The other factor is just some of the corporate spending. As we said at the beginning of the year in February, right, we just want to be very cautious and judicious as you bring in the corporate expenses from a standalone company perspective. So some of that is just how we're kind of pacing in and slowly in Q2, some of that just want to ramp up. And lastly, I would say, as Jennifer mentioned, we are investing on SG and A side. And in Q1, we did make investments.

Speaker 3

We're going to start seeing more run rate impact as we're going to move into the Q2. So it's really a combination of those three things that's driving the sequential decline.

Speaker 6

Does it bias towards one segment or the other?

Speaker 3

No, it's pretty universal across the board.

Operator

Thank you. We'll take our next question from Mike Halloran from Baird. Your line is open.

Speaker 7

Hey, good morning, everyone. Good morning, Mike. Following up. So following up on Jesper's question, as you became a standalone company, did you have to change processes in any way from an organizational perspective with incremental resources, whatever, to essentially build the muscle on the M and A side, obviously, a little bit less prioritized at Danaher. So is there anything that you had to do to kind of build that up more than what you've done than what you have when you came in here and centralization of resources?

Speaker 7

And then I guess the second part is how integrated is that with the R and D functionalities we see here today?

Speaker 2

So clearly standing up a standalone company does require you know, a a corporate organization to support it. You know, previously, tax and treasury and all of those functions were taken care of for us. But with respect to sort of the m and a trajectory, we were very deliberate in bringing in top talent in our sustainability our strategy and sustainability function and our corporate development function. Both of those individuals that sit on my staff have long standing histories within Danaher of building strategy and executing on M and A. Insofar as the muscle building within the operating companies themselves, we have upskilled the capability for our leadership within the operating companies to be able to perform strong due diligence, look at effective ways of integrating, and so on.

Speaker 2

So we spent actually quite a bit of time here in both the ramp up to the spin and following the spin itself. And then

Speaker 7

thanks for that. And the second one is just kind of putting the commentary together on the water quality and PQI side as far as starting to see some green shoots in specific areas or recovery in areas. How much of that is embedded from here from a guidance perspective? Are we talking relatively normal sequentials? Or is there an assumption for an improved backdrop as we get through the year?

Speaker 7

Just to add some context.

Speaker 3

Hey, Mike. Yes, this is me. I'll this one. Essentially, it's going to be kind of a gradual sequentially improving quarter by quarter that you guys kind of built into the guide at this point. As I said earlier, really what we're building at this point for in the near term is really more on the consumable side, still that trend slowly kind of building.

Speaker 3

Equipment side, it's really more in the second half of the year. So there's a little bit of a macro backdrop kind of helping us, some of the equipment side coming back, but it's going to be pretty moderate sequentially kind of going up. But on a year over year basis, as you can imagine from the Q3, Q4, it will be better. That's how the math works.

Operator

Thank you. We'll take our next question from Deane Dray with RBC Capital Markets. Your line is open.

Speaker 4

Thank you. Good morning, everyone.

Speaker 2

Good morning, Deane.

Speaker 4

Hey, appreciate all the color and specifics in the slides in your prepared remarks. I'd like to get a very specific question in water quality, if I could. So the new EPA regulations on PFAS, the 4 parts per trillion is really as that pushes the testing technology limits. And right now, it's still, you have to use a prohibitively expensive mass spec, no utility really can afford a prohibitively expensive mass spec, no utility really can afford that. So is the industry any closer?

Speaker 4

Are you all any closer to what might be a more economical test? Because all this is going to be seeing incredible demand over as of now, as of 2 weeks ago?

Speaker 2

Yeah. Great question, Dean. You know, we knew that the EPA was headed towards a 4 parts per trillion limit of detection here. So that's not fundamentally new news for us. What is new news there is the timeline for compliance with Xelphi's in 2027.

Speaker 2

But you are right that this is a phenomenally difficult and complex problem to solve in a fit for purpose way. Right now, the way to solve for this is water samples sent to centralized lab run through you know, GC Mass Spec, answers come back, you know, a couple weeks later. In the meantime, you know, the municipality has discharged tens, if not hundreds of thousands of gallons of water. We are investing in this area. We do believe we have a right to play here.

Speaker 2

Hach in and of itself has over a 70 year history of innovating in the analytics space. We've got a broad portfolio there. And certainly on the water treatment side, particularly in UV applications, we've got great expertise there as well. But I would say this is a long game here with solutions that are not imminent, but we're probably still a couple years out here in terms of identifying and developing fit for purpose technology that addresses both detection and destruction. We think that winning is going to require both.

Speaker 2

And right now, the analytical test options, as you say, are not fit for purpose in terms of being at plant. And frankly, destruction technology is not readily available either. There are products out there, granular activated carbon being one of them, that can capture PFOS. But what happens when you refresh those resin beds, you're just moving the PFOS to some other place like a landfill. So it's going to be a long journey here, but we are investing in a number of organic activities and are open to inorganic options as well.

Speaker 4

All right. That's really helpful. And I fully appreciate that timeline that you've suggested. That's everything that we've heard as well. There's a question between wanting something and there's a demand industry demand versus the practicality given the complexity of the molecules.

Speaker 4

But I really appreciate the color and I'm so glad to hear you mentioned destruction as well because that's an opportunity. All right. And then just for a follow-up question and I'll echo Scott's comments about that 60% threshold on gross margin and how big a deal that is. And I remember when Danaher hit that level as well. And just one of the ways that you might be able to boost that further, I know your business model is a direct to customer on the overall and especially on the Hach consumables where you just would think there'd be more of a distribution angle to this, which would lower that cost of getting the reagents to the customers.

Speaker 4

Just where does that stand? Is that a nonstarter? Or is that something you've explored? I know in some countries, you will use distributors just because it's not practical to have direct, but just where does that stand?

Speaker 2

Yeah. I mean, I think you're right, Dean. We do and will use distribution for our analytics businesses in certain countries. They tend to be areas where we don't have critical mass in terms of staffing up the full capability of selling direct. We think it's actually a good thing to sell direct, and it's part of what I would consider to be the secret sauce because we have that long standing technological applications knowledge.

Speaker 2

And it's that customer intimacy and the insight to their processes, their process control, their analytics needs, their unmet, you know, the the problems that have yet to be solved that give us great insight and create the flywheel of a feedback loop from our sales and service organization to our new product development organizations that help us continue to innovate and evolve the product portfolio to solve unmet customer needs. So we are not inclined to sort of steer away, if you will, from our direct sales model just from a margin benefit standpoint. We think there's lots of opportunity by virtue of applying VES and working on mix. The teams are doing a great job here in delivering margin as a result of just good operating execution, right, where the factories are running better. Procurement teams are pushing back on inflationary pressures, and we're doing far fewer spot buys.

Speaker 2

So we got a number of other levers that we can pull relative to margin without compromising the secret sauce of customer intimacy.

Operator

Thank you. We'll take our next question from Andrew Krill with Deutsche Bank. Your line is

Speaker 8

open. Hi, thanks. Good morning, everyone. I wanted to ask on going back to price and price cost more specifically. Just can you give us an update on what you're assuming there?

Speaker 8

I think we've heard from companies like transportation, labor, certain raws, all continue to be pretty inflationary. So is the guide assuming you can stay price cost positive like on a margin basis or just dollars? And anything there would be really helpful. And if there's any big difference by segment? Thanks.

Speaker 3

Hey, Andrew. I'll take that one. Essentially, from a price, from a guide perspective and the future look perspective, we're modeling in price in line with historical norms. So it's 100 basis points, 200 basis points. This quarter, of course, as we kind of things are rolling off, we came in a little bit towards the high end of that range.

Speaker 3

But I think from an outlook perspective and the guide perspective 100 basis points to 200 basis points is a good way to model. On the raw materials and the materials side, look, I think it's a pretty broad mix of kind of things that we buy all the way from semiconductors, some of the circuit boards down the stuff in plastics and things of those nature which are kind of tied to commodity. I would say the operating discipline and the VES really helping us kind of manage that I think has been a big differentiator and that's kind of really reflected in Q1 and the question that Scott and Dean had as well on the gross margin side. We saw a big uplift from that side as well. I think really going forward having the operating discipline, making sure we are doing less of a spot buy.

Speaker 3

I would say inflationary pressures are there. We are managing, managing them really well. It's also about the operating discipline to make sure we are minimizing any kind of spot buys, which can really have a big impact on the market side. So I would say pricing, we're doing the value in use pricing and it's showing up in the market side. But the price side, there's a lot of discipline that all starts all the way from operating discipline.

Speaker 8

Okay, great. Very helpful. And then for a follow-up on free cash flow conversion, I think nice to see the conversion boosted for the year from 100% to 100% to 110%. Just any more insight into like what changed to give you confidence in 1 quarter? And looking ahead, should we maybe thinking of like 100 conversion as kind of a floor?

Speaker 8

Just like legacy Danaher was very consistently over 100? Thanks.

Speaker 3

Yes. Andrew, if you look at free cash flow conversion, right, just as a reminder, we do give the conversion on the base of the GAAP metrics, right, not on any competitive metrics. So essentially when you look at that, just add the amortization and the share compensation or the stock based compensation, I think based on all that stuff, we should be a little bit on the 100%, a little over 100%. But really going towards 100% to 110% range this quarter for the full year for us. That guidance is really driven by getting more conviction on the margin side.

Speaker 3

As Jennifer mentioned, our margin will be towards the high end on the 50 to 70 5 basis points that kind of flows down. That gave us a little more conviction. And also there's a non cash charge in there as well, right, this quarter that's flowing to the GAAP net income. It is tied to the Solsys divestiture. So that's kind of from a math perspective and adds up on to the cash flow conversion as well.

Speaker 3

But overall, it's a reason why better operating performance.

Speaker 8

Thank you.

Operator

Thank you. And we'll take our next question from Nathan Jones with Stifel. Your line is open.

Speaker 2

Good morning, everyone. Good morning, Nathan. I'm going

Speaker 9

to follow-up on Deane's question on distribution, but I'm going to come at it from the PQI side. I would have thought there might actually be some more opportunities to leverage a distribution model and maybe reduce the costs to serve on the PQI side than on the water side. Potentially maybe in lasers where there's not the same kind of consumable revenue or some of the smaller customers that maybe don't need that kind of super high level of service from you guys. So is there any commentary you could make on maybe the potential from that side of the business to leverage distribution a bit

Speaker 2

more? Yes. I mean, I think it's probably the same answer as for water. I mean, we do have distribution, and we do consider use of distribution depending upon where we're selling in the world and what types of products are in the portfolio. We, we this is something that we always consider in terms of when we when we decide to make investments and which product lines actually require a more significant level of applications, knowledge, and insight.

Speaker 2

But I will tell you that, like in water, there are pretty significant insights to be gained from understanding customer problems in a direct way for any kind of of customer who's on the packaging and color side or on the marketing and coding side, and it actually spurs a great deal of our innovation. You will recall from our Q4 call that Videojet launched 7 new products last year. They additionally launched another 2 in the Q1, and these are on the back of innovations for direct customer feedback. So I continue to be a little bit biased here towards our direct model because I do think it creates a customer intimacy required to have those untapped insights relative to some of the problems that they face. But we do use distribution and we selectively consider that in the course of every strategic planning cycle.

Speaker 9

Thanks. I wanted to ask a follow-up on recycle and reuse in industrial markets, which is a market I think has significant growth potential over the next 5, 10, 20 years and would certainly be a market that's right in the bull's eye for a lot of your water quality business. So maybe some commentary on trends in industrial recycle and reuse markets, what you're seeing going on there and what the opportunities are for Veralta to play in those markets?

Speaker 2

Yes. This is a great question. And absolutely, we see a great deal of activity, interest, and growth potential in both recycle and reuse. And it's one that is 10 operating company, I would say, across our water quality businesses. So the intersection of ChemTreat, Trojan, and Hach can can all play in that space and, in fact, do have conversations amongst themselves and amongst the sales folks, in the field relative to solving those kinds of applications.

Speaker 2

But increasingly, by virtue of the importance of ESG amongst our customers, we do have them coming to us saying, you know, look. My company has just said I've got to use, you know, 25% less water, and of the water that's, you know, not used in the process, I've got to recycle 50% of it. Right? So can you help me with both reduction and recycling? And those are those are great those are sweet spots for us.

Speaker 2

We've got a great product portfolio that can be deployed to these applications, and so we continue to be excited about the space.

Speaker 9

Sounds like a good opportunity to me. Thanks very much for taking my questions.

Operator

You bet. Thank you. And we'll take our next question from Andrew Buscaglia with BNP Paribas. Your line is open.

Speaker 10

Hey, good morning, everyone.

Speaker 2

Good morning, Andrea.

Speaker 3

So I just wanted

Speaker 10

to check on the water quality side, you're talking about really strong industrial demand in your guide. You did much better than your guidance. I'm wondering what changed, I'd say, from December, January to what transpired throughout the quarter? And then just the sustainability around that, what's driving that really?

Speaker 2

Yes. I mean, I think we still see pretty strong industrial output here, particularly in North America. I think, as we mentioned in our prepared remarks, we do see food and beverage coming back, which across the strong. We do see opportunities around the reshoring activity as well as the world becomes a little bit more fractured relative to its trade relationships. And so that's, you know, providing, you know, great opportunity, particularly with respect to microelectronics and, you know, the CHIPS Act and so on.

Speaker 2

So we do see, a good macro environment here, particularly in North America for our industrial sector.

Speaker 3

Yes. It's a

Speaker 10

lot of little things, it sounds like. Yes, yes. And you got a lot of questions on M and A. Obviously, that's where a lot of interest lies. I'm wondering if you can comment on your margins, especially in water quality are quite high.

Speaker 10

How are you thinking about margins as you add M and A to your portfolio? Is there enough out there where you could see some accretion or generally long term, is this not really should we not expect those margins to stay where they are if you're adding deals?

Speaker 3

Yes, Andreas. It's as you've considered in the past and when it comes down to M and A, it's really we follow a very disciplined and rigorous approach around markets, companies and valuation. With respect to the financial metrics, it really is a combination of multiple factors, right? We look at ROIC, we look at margin, what's the what are the things that we can add to the portfolio that can drive overall core growth and create synergies? How do we apply VES into the acquired businesses to really create the differentiated value.

Speaker 3

So it really comes down to the value creation potential and ultimately that's based on a combination of all these different financial factors that we kind of look at as part of our rigorous process. So I wouldn't really focus on one metric versus the other. It really comes under the combination of all to see how they'll create long term value. Okay. All right.

Speaker 3

Thank you, everyone.

Operator

Thank you. We'll take our next question from Brian Lee with Goldman Sachs. Your line is open.

Speaker 11

Hey, good morning, everyone. Thanks for taking the questions. Lots been covered on the call, so maybe just a few follow ups, I guess, on PQI. Can you remind us how far out does your visibility extend on the equipment back log and then the recent strength you're seeing in bookings? And then also maybe remind us what are the mix implications?

Speaker 11

You kind of alluded to them, but mix implications for margins and PQI as you move through the year. And it does sound like equipment will grow relative to consumables. How should we think about that in the context of margins?

Speaker 2

Yes. I mean, I think what we see here is visibility for equipment in the 60 to 90 day timeframe, right? This is a short cycle business. So a lot of our confidence around equipment here in the second half is a product of history, right? When we see cycles of food and beverage and consumer packaged goods sort of decline in recovery.

Speaker 2

We see typical patterns, which is pretty intuitive of the inks and solvents, spare parts, consumables recovering first as these lines are brought back online and then equipment following when funds are available to do line expansions, equipment upgrades and so on and so forth. You do see in the guide that we've projected a rebalancing of kind of consumables and equipment here in the back half of the year, and so we've accounted for that.

Speaker 11

Okay, great. That's helpful. And then just one on water quality. I think a couple of questions ago, you were talking, Jennifer, about the demand in water reuse, water recycling, somewhat from an ESG footprint, from a growing subset of your customers. I think there's also a growing subset of customers and industries here levered to power gen growth.

Speaker 11

We're seeing load growth on the grid in the U. S. Especially first time in a while really seeing some positive inflection. So can you kind of give us a sense of from your vantage point the different technologies, products that you have into the microelectronics sector? How much of the mix it is?

Speaker 11

And then it seems like there's just incremental volume growth opportunities there. Maybe if you could just speak to that a little bit? Thank you.

Speaker 8

So

Speaker 2

the business that is benefits most from the CHIMPS Act and microelectronics is Trojan, that sells UV treatment systems in for high purity, ultrahigh purity water. That water has to be exceedingly pure given the manufacturing requirements for semiconductor wafer fab. But there are, you know, pockets of other equipment and, analytics and so on that gets sold into that space. But we've really seen some nice growth in our UV treatment business as a result of sort of the on shoring or reshoring of fabs here in North America as well as the ones that continue to be built in China.

Speaker 3

And Brian, the only other thing I would add is to that is as we look at the bid activity that our teams are seeing, we've seen a pretty pretty healthy bid activity that's kind of tied to the reuse point that earlier Nathan had as well on the municipal side and then on the semi side for the UV treatment system. So the bid activity is actually pretty good on both sides that kind of tie back into the Trojan business.

Operator

Thank you. And it appears that we have no further questions at this time. I will now turn the call back over to Ryan Taylor for any additional or closing remarks.

Speaker 1

Thanks, Shelby, and thanks everybody for joining us today. We really appreciate your time and engagement. As normal, I'll be available for follow ups today and throughout the next coming days weeks. Should you want to talk, please reach out to me. And at this time, we'll conclude our call.

Speaker 1

Thank you so much again and we'll join you next time.

Operator

That concludes today's teleconference. Thank you for your participation. You may now disconnect.

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Veralto Q1 2024
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