Thoughts on Veralto - Danaher's spin-off

In February 2023, the American industrial conglomerate Danaher ($DHR) officially announced the spin-off of its Environmental and Applied Solutions (EAS) segment under the name Veralto ($VLTO) during 2023 Q4.

As Danaher shareholder I will receive Veralto stock. In today’s newsletter I will cover which are the activities on the EAS segment the new company will consist of and why I think its moats are narrower than the segments focused in life sciences.

DISCLAIMER: This article is not a recommendation to buy or sell any financial instrument, the content is educational and my personal opinion. Each person has to make his own analysis. Any action or decision you take as a result of viewing this article is your sole responsibility.

Veralto’s business in brief

Danaher's spun off the Environmental and Applied Solutions (EAS) segment which generated a revenue of $4.8 billion in 2022 (55% recurring) and has 16000 employees. It will be led by Jennifer Honeycutt (President and CEO).

Veralto conglomerate comprises the following companies:

1. Water Quality Platform: group of companies providing water quality analytics, testing, and measurement (Hach), chemical metering and pretreatment (ChemTreat), and UV disinfection (Trojan), water quality monitoring solutions (OTT HydroMet) and flow measurement instruments (McCrometer).

2. Product Identification: segment started with the acquisition of Videojet in 2002. Videojet is in the business of coding, marking, and printing systems, application-specific fluids, and digitally enabled solutions. Customers use unique identities by printing date, lot, and barcodes and other information on packagings, applying high-quality alphanumeric codes. Danaher expanded this business line by acquiring Linx in 2005, EskoArtwork in 2011 and X-Rite in 2012. Linx and Esko provide packaging design software solutions used by brands worldwide while X-Rite provides HW/SW solutions for color management.

DHR’s moat. Competitive advantages on which it is sustained

Danaher’s has four competitive advantages:

• Operating in a highly regulated industry where legislation is not only a barrier of entry for new players but also prevents overnight disruption from new technologies and imposes switching costs to customers.

• Know-how: Danaher provides its customers cutting-edge products protected by patents.

• Danaher’s ecosystem: Danaher’s products are state of the art in some industries - for example UNICORN software for chromatographies - imposing switching costs to its customers. For example, in case a customer wants to use a different chromatographic software, retraining of their whole workforce will be needed. Furthermore, when Danaher sells a machine they maintain relations with the customer by selling them the disposables needed to operate it.

• Company’s culture: Danaher has a great culture which is materialized and exerted through Danaher Business System (DBS). DBS was an initiative launched in the 80s to implement lean manufacturing principles on the company and it has been guiding what they do, how do they measure it to determine how well are they executing, and, finally, creating alternatives for improvement.

Does Veralto have a moat?

After reviewing Veralto’s business and establishing Danaher’s moat the question is if Veralto has a moat and if its width is comparable to Danaher’s one.

Veralto will sustain the previously mentioned competitive advantages to a lesser extent because drugs are more regulated than the water or food industry. Even in a pharmaceutical facility, regulatory locks will be lower.

Let’s consider the case where water quality needs to be controlled on a facility where pharmaceutical production of one product takes place. GMP guidelines for pharmaceutical activities establish harder regulatory restrictions for activities which imply product and genetically modified organisms (GMO) manipulation than for other supporting activities like cleanings and utility systems.

Products from Danaher will be used on the most regulated activities, as they are used on critical manufacturing steps while Veralto’s ones will be used on the least regulated, for example the control of highly purified water (HPW) quality on the (utility) piping system. Moreover, the sampling frequency of more critical steps is usually larger than the one of non-critical ones.

A large stake of Danaher’s products are bought by CDMO’s (Contract Development and Manufacturing Organization) which manufacture drugs for 3^rd parties. CDMO’s perform the manufacturing of the drug for a customer which still owns the process. However, customers do not own the CDMO facility. This means for the change of any machine used on the most regulated activities the CDMO will need customer who owns the process to approve it, providing an additional lock to regulation. This is not applicable for the exchange of a flowmeter on the HPW piping system for example.

I also think the ecosystem Veralto can offer is less strong than Danaher’s one based on the larger disruption potential which exists on the water quality and treatment market. Multiples technologies are under development. Some of these novel technologies even question the status quo of using extense piping systems to transport water from a deposit to end users homes. I recommend watching the documentary Brave Blue World if your are interested in having deeper insights on the roll-out and adoption of new technologies for water management.

Finally, there is a risk of cultural change. Veralto will consist of a new company separated from Danaher so despite they can follow a lean manufacturing and continuous improvement system, it will differ from DBS playbook.

Conclusion

Historically, Danaher has spun-off the business segments which showed weaker performance. In 2015, Danaher completed the spin-off of its "Industrial" segment, resulting in the formation of Fortive Corporation (FTV). Then, in 2019, Danaher spun-off its dental segment, creating Envista Holdings (NVST). These companies have significantly underperformed Danaher in the public market.

In the present case, Danaher is spinning-off the segment which despite of “providing critical services for its customers” in words of its CEO, Jennifer Honeywcutt, shows the lower share of recurring revenue among Danaher segments (55% vs >75% on average the rest) and the weaker competitive advantages.

Hence, I am selling the Veralto shares I get and buying more Danaher shares, where I expect higher barriers of entry and switching costs and less uncertainty referring to disruption risk and company culture change.