The Importance of Spinoff Investments
It’s no secret that I like looking at Spinoffs for great investment opportunities. Investing in a Spinoff can be fruitful since it gives you access to value that was previously obscured by the parent firm. Spinoffs generally result in improved operational efficiency and development potential since the newly formed division or subsidiary may function with more clarity, speed, and openness. Additionally, there are several market phenomena, such as the forced selling of Spinoffs by institutional investors constrained by specific mandates, that could lead to an initial undervaluation. As a result of the discount, astute investors may find good entry positions. Furthermore, Spinoff’s management may be more motivated to drive performance and shareholder value due to the presence of stock-based pay. Therefore, investors can find hidden jewels that the market may ignore by focusing on Spinoffs. I’ve written about the benefits previously here.
Danaher
(DHR) is a global science and technology company that provides essential solutions to customers in healthcare, diagnostics, environmental and applied solutions, life sciences, and industrial technologies. The company's products and services are used by customers in over 120 countries. The company is a leading innovator in its markets. It has a strong track record of developing new products and services that meet the needs of its customers.
(DHR) has shifted its focus towards becoming a pure healthcare player, which is why the decision to Spinoff its Environmental & Applied Solutions (EAS) division aligns with this vision. Management believes that EAS, as an independent entity, would be strategically advantageous with greater opportunities to pursue high-impact organic and inorganic investment, ultimately maximizing the creation of long-term value.
On September 14, 2022, (DHR) announced the Spinoff of its Environmental & Applied Solutions (EAS) division, to be called (VLTO). The company suggested a distribution ratio of 1:3 and (DHR) has no plans to retain any ownership stake in (VLTO). Each (DHR) stockholder will receive one share of (VLTO) for every three shares of (DHR) held on the record date of Sept 13, 2023. (VLTO) has raised a gross debt of ~$2.6bn and will transfer ~$2.7bn to (DHR), representing a net leverage of ~1.9x. The Spinoff was a tax-free transaction. (VLTO) started trading on Monday 2nd October in a regular way.
History Says Buy
Metrics aside, historically, Spinoffs and Parents in these sectors do well. 23 years of data from The Edge says that Large-cap Parents and Spinoffs within the Healthcare and Industrials sector observe a consistent trend of outperformance. Investors could see a similar trend with (DHR) and (VLTO) post-Spin. The study suggests that overall, US Parent Healthcare initially experiences a negative trend for the first 6-months but then rebounds into positive territory during Year-1 and Year-2, outperforming the overall US Parent average during that timeframe. However, when focusing on the Large-cap space (over $5bn) within the US Parent Healthcare sector, investors have consistently observed positive returns, consistently outperforming all benchmarks,
For the Large-cap space (over $5bn), the Industrials sector has been the best performer out of all eleven sectors from a medium term to a long-term perspective. In this case, US Large-Cap Spinoffs in the Industrials sector returned an average +36% in their first year, outperforming both the overall all-caps Industrials US Spinoffs and the US Spinoff average in general. Two recent additions to the Large-cap Industrials sector that have positively impacted the average are (CARR) and (OTIS), both delivering impressive returns in their first year of trading (+148% and +46%, respectively).
History Of Value Creation
In 1984, (DHR) was co-founded by the billionaire Rales brothers (Steven and Mitchell) with a vision to create a new kind of manufacturing company that would be dedicated to continuous improvement and customer satisfaction. They have been pretty good at becoming rich from Spinoffs too. (DHR) has generated a total return (CAGR) of 18.77% vs S&P’s total return of 11.86%, outperforming the benchmark by 6.91%.
Veralto
(VLTO) is an industry pioneer in providing mission-critical software and services. Customers can take advantage of the products and services offered by the Company's Water Quality, Product Quality and Innovation, and Traceability and Security divisions to better oversee, clean up, and safeguard some of the world's most important resources. Clients in the water and wastewater treatment, food, and beverage, pharmaceutical, and consumer packaged goods sectors all employ solutions developed by (VLTO). The Company will be the global leader in Water Quality (59% of 2022 revenue) and Product Identification (41% of 2022 revenue). Its Water Quality business provides precision instrumentation, advanced purification technology, software, and treatment solutions to help analyze, disinfect, and manage the world’s water across the environment and municipal, commercial, and industrial applications. While its Product Identification business provides color management, packaging design, and marking and coding technologies used to secure and track goods.
The Water Quality division offers a variety of products and services for the purification of potable water and wastewater. The Company's Product Quality and Innovation division offers services to guarantee the reliability and security of the items its clients produce. The Traceability and Security division offers technologies and services to monitor and secure items at every stage of the distribution process.
The mission is to provide its clients with cutting-edge innovations that enable them to successfully navigate complex environments and realize their most important objectives. Sustainability and social responsibility are also priorities for the business. (VLTO) is included in the World Economic Forum's Global Lighthouse Network and the Dow Jones Sustainability Index. Some of the Company's most important clients are:
- Veolia, Suez, RWE, and Thames Water are four water and sewage treatment companies.
- Coca-Cola, PepsiCo, Nestlé, and Unilever for food and beverages Pfizer, Merck, and Johnson & Johnson for pharmaceuticals
- P&G, Unilever, and Nestlé for home products.
The Rales Brothers
The Rales brothers have just completed their sixth break-up and their third Spinoff in the last seven years by Spinning off their Water Quality and Product Identification businesses into (VLTO). As a result, (DHR) has transformed into a pure-play, higher-margin healthcare company, focusing on their Diagnostics, Life Science and Biotechnology divisions.
Of the five transactions by the Rales brothers, if one were to follow the money and only invest where their main wealth is (in DHR), this creates a great opportunity to outperform the market given the value creation through (DHR)’s Spinoff in 2016 and the IPO-exchange offer in 2019,
Likewise, the stocks in which they have no stakes or management roles (AIMC, NVST, and VNT) have not outperformed the market, with (ESAB) and (ENOV) having only been trading for just over 1-year post-Spin but still an outperformance in (ESAB). While in (FTV) , there has been a mixture of performances across the different transactions. Since Steven Rales will hold a 6% stake in (VLTO), and Mitch holds a 3.8% stake in (DHR) (and thus (VLTO), there is a good chance for further wealth generation in both companies.
In FY22, (VLTO) generated revenue of $4.8bn vs. $4.6bn compared to the prior year FY21, a growth of 3.8% on a yearly basis. However, it’s Adj. EBITDA grew from $1.1bn in FY21 to $1.2bn in FY22, a rise of 6.5%. This indicates that the company has substantial operating leverage, thanks to its 59% recurring revenue, which improved margins from 24.9% in FY21 to 25.6% in FY22.
Post-Spin, the Company will be well-positioned to leverage its leadership in high-growth areas in a highly unorganized market with strong earnings visibility due to ~55% of recurring revenue and attractive margins. This enables VLTO to strengthen its position due to its unique product offerings and create synergies as an independent entity. In addition to it, a favorable secular tailwind would further aid the growth supported by new product development, rising concerns on water quality, ESG (Environmental, Social, and Governance) initiatives, and stringent regulatory norms acting as long-term catalysts.
Post Spinoff, Steven M. Rales will hold an approximate 6% stake in (VLTO) representing 14.5 million shares. Mr. Rales’s position includes an indirect holding of DHR shares owned by limited liability companies, mandatory convertible preference shares, charitable foundation, and others where Mr. Rales is either a sole member or director of the foundation. Historically, the Spinoff companies where one of the Rales brothers had a stake have outperformed and sometimes even beat the benchmark (taking cues from the DHR-FTV and ENOV-ESAB transactions). Steven Rales's ownership interest has the potential to boost investor confidence and mirror the strong historical transaction performance of past deals, thereby driving (VLTO) towards success.
(VLTO) is poised to emerge as a premier technological frontrunner within the water and product quality sector. The Company is strategically positioned to capitalize on its robust margins and a sustainable business model, driven by over 50% of its revenue derived from recurring sources. Following the Spinoff, it's worth noting that (VLTO) net leverage stands at approximately 1.9x, which is relatively higher when compared to industry peers. However, you can have reasonable confidence in the manageable nature of this leverage and anticipate it will diminish over time, largely owing to VLTO's impressive cash conversion yield, which surpasses 100%. Additionally, VLTO is well-positioned to harvest the benefits of rising demand driven by heightened regulatory standards and stringent governance practices within the ESG landscape, all while successfully navigating the ongoing consolidation occurring within the industry.
Based on the above factors and technical aspects and applying premiums/discounts compared to its blended peers average on EV/EBITDA FY24E. The Bull Case Target Price for (VLTO) is $100 per share, implying an upside of nearly 30% from today’s close of $77. The investment is a good longer-term bet. For your portfolio.
