Veralto Corp

NYSE:VLTO

Earnings Call Analysis

Strong Q2 performance with raised guidance amidst broad-based growth.

The company reported a 2.8% year-over-year growth in net sales to $1.29 billion, with core sales growing 3.8%. Gross profit saw a 7% increase, reaching $774 million, leading to a 230 basis point improvement in gross profit margin. Adjusted EPS grew by 6% to $0.85. The Water Quality segment recorded a 2.8% increase in sales, while PQI saw a 2.7% rise. The company has raised its full-year adjusted EPS guidance to $3.37-$3.45, implying a 7% growth year-over-year, and expects core sales growth in the low to mid-single digits for the second half of 2024. Free cash flow was reported at $240 million.

Company Performance and Market Trends

In the second quarter, the company's net sales grew by 2.8% to $1.29 billion, driven by a balanced mix of volume and price increases. Core sales saw a 3.8% growth despite a 0.8% headwind from currency and a small divestiture. Volume growth marked its first positive milestone since Q2 2022, largely due to increased demand in both the water quality and PQI segments. Recurring revenues, which comprise 62% of total sales, grew mid-single digits, showcasing the stability and reliability of core operations.

Water Quality Segment

The Water Quality segment delivered $777 million in sales, up 2.8% year-over-year. Despite headwinds from currency and strategic exits, core sales in this segment grew by 4%. Price increases contributed 2.4% to this growth, while volume growth added 1.6%. Strong demand for water treatment solutions in industrial markets and UV systems in municipal markets were key drivers. Additionally, sales of laboratory instrumentation and reagents to municipalities showed significant growth. Recurring sales grew in mid-single digits, indicating continued reliance on this revenue stream.

PQI Segment Performance

PQI's segment saw a 2.7% increase in sales, totaling $511 million. Core sales grew by 3.4%, with volume and price increases contributing 2% and 1.4%, respectively. The recurring revenue for PQI rose, representing 63% of the segment’s total sales. Both the packaging and color business and the marking and coding businesses reported growth. Particularly notable was the Videojet's 2380 large character inkjet printer, which was well-received and exceeded sales expectations.

Geographic Sales Insights

Sales performance varied significantly by region. North America's core sales grew over 5%, led by robust demand for water treatment solutions in various industrial verticals. High-growth markets like Latin America and India also showed strong performance, whereas Western Europe's sales remained flat overall. In China, core sales grew slightly, indicating a stabilizing market but no substantial recovery in the immediate term.

Financial Health and Investments

Gross profit increased by 7% to $774 million, with gross profit margins improving by 230 basis points to 60%. This increase was due to successful price executions, operational leverage, and reduced material costs. Adjusted operating profit also rose by 5%, and the operating profit margin expanded by 70 basis points to 24%. As of June 28, the company had a net debt of $1.6 billion, resulting in a net leverage ratio of 1.3x. The robust financial position allows for strategic M&A pursuits aimed at long-term shareholder value creation.

Guidance and Market Outlook

The company has revised its full-year 2024 guidance upwards, expecting core sales growth to trend towards the higher end of low single digits. For the third quarter, core sales growth is anticipated to be in the low to mid-single digits. The adjusted operating profit margin is expected at approximately 23.5% for Q3. For the full year, the adjusted EPS is projected to be between $3.37 to $3.45, reflecting a 7% year-over-year growth. Free cash flow conversion is expected to remain strong, within the range of 100% to 110% of GAAP net income.

Strategic Initiatives and Future Plans

Future investments will focus on sales and marketing efforts and R&D initiatives, tied closely to the company's strategic growth plan. The introduction of new products and solutions continues to be central, such as the Videojet's 2380 printer for sustainable packaging. The company also plans to leverage its robust recurring revenue model and focus on M&A to drive long-term growth. Emphasis will remain on operating within attractive and essential markets like water, food, and essential goods, with a focus on sustainability and innovation.

Earnings Call Transcript 2024-Q2

[Operator]

My name is Leo, and I will be your conference operator this morning. At this time, I would like to welcome everyone to Veralto Corporation's Second Quarter 2024 Conference Call. [Operator Instructions]

I will now turn the call over to Ryan Taylor, Vice President of Investor Relations. Mr. Taylor, you may begin your conference.

[Ryan Taylor, executive]

Good morning, everyone, and thanks for joining us on the call. With me today are Jennifer Honeycutt, our President and Chief Executive Officer; and Sameer Ralhan, 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. A replay of this call will be available until August 9.

Before we begin, I'd like to highlight a few recent disclosures. On July 24, we issued our 2024 sustainability report. That report can be viewed on our main website under Sustainability or on our investor website under Corporate Governance.

Yesterday, we issued our second quarter news release, earnings presentation and supplemental materials, including information required by the SEC relating to adjusted or non-GAAP financial measures. Additionally, our Form 10-Q was filed yesterday. These materials are available in the Investors section of our website 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.

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 forward-looking statements. 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.

With that, I'll turn the call over to Jennifer.

[Jennifer Honeycutt, executive]

Thank you, Ryan, and thank you all for joining our call today. I want to start this call by recognizing the engine behind our strong second quarter results, our more than 16,000 associates around the world. Their strong execution in support of our customers drove our growth and improved profitability during the quarter. Nine months into our journey as an independent company, we are hitting our stride and delivering winning outcomes for our stakeholders. A key catalyst has been increased rigor in deploying the Veralto Enterprise System.

As I've shared before, VES is a key competitive advantage for Veralto. It drives continuous improvement, accelerates innovation and enables us to win in our markets. Every day at all levels of our enterprise, our teams leverage VES to solve problems rapidly and drive sustainable improvements. Our increased rigor in deploying VES has helped drive growth, expand margins and ensure that we deliver on commitments.

Our second quarter results demonstrate the benefit of this increased rigor while also highlighting the durability of our businesses. We delivered core sales growth across both segments, led by better-than-expected positive volume and price increases in line with historical levels. We expanded margins at both segments through strong operating leverage, improved productivity and cost optimization.

Based on our strong execution in the second quarter and an incrementally more positive view of our end markets, we have raised our full year adjusted EPS guidance. From an end market perspective, we are capitalizing on secular growth drivers across our industrial and municipal markets in Water Quality. In water analytics, our commercial initiatives are accelerating volume growth and market penetration, particularly in consumables. And in water treatment, we continue to see strong growth driven by our customers' water conservation, reclaim and reuse initiatives.

On that front, ChemTreat was recently recognized as Industrial Supplies and Services Supplier of the Year by one of the largest global beverage companies. ChemTreat is playing an integral role in helping this customer achieve its sustainability targets through wastewater projects that support the reclamation of hundreds of millions of gallons of water annually.

In PQI, we are encouraged by ongoing recovery in consumer packaged goods markets, and improved sentiment from brand owners and packaging converters. In our marking and coding business, recurring revenue grew mid-single digits for the fourth consecutive quarter.

Notably, sales of marking and coding equipment accelerated during the quarter and grew on a year-over-year basis with good traction on new product launches. One of those new products is Videojet's 2380 large character inkjet printer, which launched in early April and is off to an impressive start. This printer is designed for use on sustainable packaging materials, such as corrugated cardboard and other porous materials.

Second quarter sales of the 2380 printer exceeded our expectations, and we continue to build momentum through a robust sales funnel. In our packaging and color business, second quarter bookings were strong, driven in part by the success of new software launches unveiled at recent trade shows and industry events.

At the drupa trade show, our Esko, Pantone and X-Rite teams jointly showcased their latest innovations and highlighted our seamless packaging workflow software and hardware solutions.

At the event, Esko unveiled its S2 platform, a multi-tenant, cloud-native platform that provides cloud computing, data sharing and artificial intelligence. All Esko applications connect to this platform, giving all key stakeholders in the value chain access to live data and identical information wherever they are in the world. This integrated ecosystem will empower customers to compress workflows, harness cloud technology and artificial intelligence to accelerate speed to market with vital integrated color accuracy.

This new technology helps our customers save time, reduce waste and ensure brand fidelity. These workflow improvements help our customers minimize the environmental impact across their supply chains and achieve their sustainability objectives while providing safe foods and trusted essential goods to their customers. This is a great example of the alignment between our product innovation and our purpose.

Our work at Veralto is inspired by our unifying purpose safeguarding the world's most vital resources. We live in a world with big challenges, and Veralto plays a significant role in solving many of them. Helping customers ensure clean water, safe foods and trust in essential goods for billions of people across the globe motivates all of us at Veralto each and every day.

It inspires our associates who are drawn to Veralto because of the role our products and solutions play in helping preserve the planet, how we care for and invest in our people, and our efforts to minimize the environmental impact of our own operations. And it's easy to be inspired by the work that we do at Veralto.

In 2023, our team helped ensure 3.4 billion people around the world had access to clean water for daily use, treat and recycle 13 trillion gallons of water, saved 81 billion gallons of water and ensure product authenticity and safety by helping customers mark and code over 10 billion products every day.

In addition to these positive and enduring contributions, I want to highlight 2 important commitments featured in this year's sustainability report.

First, in support of our commitment to minimize the environmental impact of our own operations, we disclosed our 2023 Scope 1 and Scope 2 greenhouse gas emissions, and committed to a 54.6% reduction goal by 2033. Second, in support of our commitment to drive a responsible supply chain, we set an initial target to have 40% of our supplier base certified through the EcoVadis program. EcoVadis is one of the leading sustainability rating agencies and will help us measure, assess and improve the impact of our supply chain on the world.

The role our products play in preserving the planet and the targets we have committed to achieve embody the culture and are made possible by our people. Our people are the most important part of our strategy, and we invest heavily to recruit, develop and retain the most talented and diverse team possible.

Our 2024 sustainability report published earlier this week contains more details about our commitment and ability to deliver positive enduring impact and drive sustainable outcomes for the benefit of humanity.

Now turning to our Q2 financial results. Before getting into the details, it's important to highlight a key underlying strength of Veralto, and that is the durability of our businesses. Approximately 85% of our sales are related to water, food and essential goods. These are large attractive markets with steady growth driven by strong secular trends. Our customers in these markets have an essential need for our products and solutions to support critical aspects of their daily operations where the risk of failure is high.

Our durability is further bolstered by our razor-razorblade model, which drives a high level of recurring revenue, further catalyzed by VES. The CEO Kaizen events we kicked off in Q1 are a strong proof point. These events, which focus on value-accretive growth have already had a positive impact on our 2024 performance evident in our second quarter results.

On a consolidated basis, we exceeded our guidance on all fronts with 3.8% core sales growth and 24% adjusted operating profit margin. Adjusted earnings per share was $0.85, up 6% year-over-year and $0.05 above the high end of our guidance range. And we generated $240 million of free cash flow, further strengthening our financial position.

Looking at core sales growth by geography in the second quarter, sales into North America and high-growth markets grew in the mid-single digits, and sales into Western Europe were essentially flat.

In North America, core sales grew over 5%, driven by both segments. In Water Quality, we continue to capitalize on strong demand for our water treatment solutions, which grew high single digits in North America. This growth was broad-based across most industrial verticals, with the strongest growth in food and beverage, mining and power generation. We also continue to see strong growth for UV systems at municipalities in North America.

In Water Treatment, we're partnering with customers to help them achieve their sustainability goals related to water conservation, reclamation and reuse. Our water treatment businesses are also well positioned in North America to support onshoring or reshoring activity, including tech operations such as semiconductor fabs and data centers.

Relative to North America, our PQI segment grew 3.5% in Q2. Packaging and color grew mid-single digits, with marking and coding up low single digits. In high-growth markets, core sales grew by more than 4%. We continue to see strong growth in Latin America and India. And in China, core sales grew low single digits year-over-year.

In Western Europe, core sales were essentially flat year-over-year, including 50 basis point headwind related to the strategic portfolio actions in our Water Quality segment that we mentioned on prior earnings calls. Excluding this headwind, core sales into Western Europe were up modestly.

At this time, I'll turn the call over to Sameer to provide more details on our Q2 performance and our guidance.

[Sameer Ralhan, executive]

Thanks, Jennifer, and good morning, everyone. I'll begin with our consolidated results for the second quarter on Slide 8. Net sales grew 2.8% on a year-over-year basis to about $1.29 billion. Core sales grew 3.8%. Currency was an 80 basis points headwind or approximately $10 million. And the small divestiture of Salsnes was a modest headwind.

Our core growth in this quarter was balanced with both volume and price increases driving our growth. Price contributed 2% growth in this quarter, in line with our expectations and historical levels. Volume grew 1.8% with positive volume growth across both water quality and PQI. This marks the first quarter since the second quarter of 2022, in which volume grew across both segments.

Our recurring revenue grew mid-single digits year-over-year and comprised 62% of our total sales. We expanded margins at both segments through strong operational leverage, improved productivity and cost optimization. Gross profit increased 7% year-over-year to $774 million. Gross profit margin improved 230 basis points year-over-year to 60%, reflecting the benefits of pricing as well as improved productivity and reduced material costs. Adjusted operating profit increased 5% year-over-year, and adjusted operating profit margin expanded 70 basis points to 24%.

We delivered strong margin expansion while investing in our sales and marketing efforts to drive future growth. We also increased our R&D investments with R&D as percent of sales increasing 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 second quarter. Adjusted earnings per share grew 6% year-over-year to $0.85 and free cash flow was $240 million, down from the prior year primarily due to stand-alone public company costs and cash tax payments, which were not incurred in the prior year period.

Moving on, I'll cover the segment highlights, starting with Water Quality on Slide 9. Our Water Quality segment delivered $777 million of sales, up 2.8% on a year-over-year basis. Currency was an 80 basis points headwind and the divestiture of Salsnes had 40 basis points impact versus the prior year period.

In addition to this divestiture, small product lines that were strategically exited in the fourth quarter of 2023 resulted in approximately 80 basis points headwind to core growth for the Water Quality segment in the second quarter.

Despite this headwind, core sales grew 4% year-over-year. Pricing contributed 2.4% and volume growth contributed 1.6% to year-over-year core sales growth. Our volume growth was driven by strong demand for water treatment solutions in our industrial end markets and UV treatment systems in municipal end markets. We also saw growth in sales of lab instrumentation, reagents and chemistries to municipalities.

Recurring sales across the Water Quality segment grew mid-single digits. Adjusted operating profit increased 5.5% year-over-year to $192 million, and adjusted operating profit margin increased 70 basis points to 24.7%. The increase in profitability and margin reflects strong pricing execution, leverage on volume growth and improved productivity.

To a lesser extent, our adjusted operating profit margin also benefited from a favorable sales mix this quarter.

Moving to the next page. Our PQI segment delivered sales of $511 million in the second quarter, up 2.7% year-over-year. Currency was a 70 basis points headwind. Core sales grew 3.4%. Positive volume contributed 2% growth, and price increases contributed 1.4% to the year-over-year core sales growth.

PQI's recurring sales grew mid-single digits year-over-year for the fourth consecutive quarter with growth across the portfolio. Recurring revenue increased to 63% of PQI sales mix in the second quarter of this year.

Breaking this down by business, core sales growth in our marking and coding business was in line with the segment, driven by growth in both consumables and equipment. This growth was driven by both CPG and industrial end markets.

In our packaging and color business, core sales grew about 3% year-over-year led by growth in recurring software and subscription revenue. PQI's adjusted operating profit was $141 million in the second quarter, resulting in adjusted operating profit margin of 27.6%. That represents 100 basis points improvement in adjusted operating profit margin over the prior year period. This was another quarter of margin improvement for PQI, driven by the strong operating leverage, particularly on the recurring revenue growth and productivity improvements.

Turning now to our balance sheet and cash flow. In the second quarter, we generated $251 million of cash from operations and invested $11 million in capital expenditures. Free cash flow was $240 million in the quarter, our 118% conversion of GAAP net income. As of June 28, gross debt was $2.6 billion and cash on hand was just over $1 billion. Net debt was $1.6 billion resulting in net leverage of 1.3x.

In summary, our financial position is strong. We have flexibility in how we deploy capital to create long-term shareholder value with a bias towards M&A.

Turning now to our guidance for 2024, beginning with our updated expectations for the full year. We increased our full year guidance to reflect our strong second quarter execution and incrementally positive view of our end markets. For core sales growth, our target remains low single digits. However, we are trending towards the high end of low single digits.

Through the first half of 2024, core sales growth was 2.8%. For the second half, we are targeting core sales growth in the low- to mid-single digits range, similar to what we achieved in the second quarter.

Looking at adjusted operating profit margin for the full year, we now expect to deliver approximately 75 basis points margin expansion year-over-year, which would put our full year adjusted operating profit margin at about 24%. This implies an incremental margin or fall-through of around 50%.

For adjusted EPS, we raised our full year guidance range to $3.37 to $3.45 per share. At the midpoint, this represents 7% growth year-over-year and is $0.11 or about 3.5% higher than our previous guidance. And our guidance for free cash flow conversion remains in the range of 100% to 110% of GAAP net income.

Looking at our guidance for Q3, we are targeting core sales growth in the low to mid-single digits on a year-over-year basis. At the midpoint of our Q3 guidance, we are modeling a core growth rate similar to second quarter.

We expect adjusted operating profit margin of approximately 23.5% in the third quarter. This represents 100 basis points of improvement in adjusted operating profit margin on a year-over-year basis. And our Q3 2024 guidance for adjusted EPS is $0.82 to $0.86 per share. At the midpoint, that represents double-digit year-over-year growth.

With that, I'll hand the call back to Jennifer for closing remarks.

[Jennifer Honeycutt, executive]

Thanks, Sameer. In summary, we are executing well across the company with greater focus and rigor using VES, and we are capitalizing on the secular growth drivers in our key end markets. We delivered a strong second quarter across the board with core sales growth approaching mid-single digits, continued margin expansion and strong cash generation.

Based on the strength of our execution and positive view of our end markets, we raised our full year 2024 adjusted EPS guidance.

As we look longer term, we remain committed to creating value through steady durable sales growth, continuous improvement and disciplined capital allocation. That concludes our prepared remarks. And at this time, we are happy to take your questions.

[Operator]

[Operator Instructions] We'll take our first question from Scott Davis of Melius Research.

[Scott Davis, analyst]

Jennifer, Sameer and Ryan. I got to ask about gross margins just because they've been so incredibly strong. Is -- a, I guess, is 60% the new normal? Or is that just more of kind of a shorter-term impact?

And second, maybe I heard the word price in the context of pricing power more on this quarter and last one too than we would have thought in the past. And are you finding there's just more pricing power in your markets maybe than you thought you had before and that's driving that 60% gross margin. Is that a fair takeaway?

[Sameer Ralhan, executive]

Yes, Scott, let me just touch on the margin, and then I'll have Jennifer just talk about the price. On the gross margin side, it's really been really in the increased rigor on VES really driving the execution side. Frankly, it's been lots of singles and doubles that are driving the margin here.

And also, as you see, we are benefiting a little bit from the recurring revenue here, right? The mix is more towards consumables to the spares, which is impacting and helping us on the margin, the packaging and color business, as you know, that needs to be on the software side with a little higher margin. So that's helping us.

So those things are helping us. I would say you should expect the gross margins to come in a little bit as the growth rate equilibrates between the equipment and consumables over time. But we feel really good about 60%. But I think once the transition happens, it will be more in the high 50%, 50% or 59% kind of a range.

[Jennifer Honeycutt, executive]

Yes. And I think, Scott, what you're seeing relative to price is our ability to sort of hold the value of our products in terms of commercial excellence related to VES. So the teams commercially are executing well around the world, but we have seen price normalize to historical levels, which we believe fit in the range of 100 to 200 bps.

[Scott Davis, analyst]

Okay. Fair enough. And just -- I feel obligated to ask about M&A. I know these things are lumpy, and it's hard to kind of talk about it, but any update on maybe your pipeline, your enthusiasm about the assets that are out there?

[Jennifer Honeycutt, executive]

Yes. We remain pretty convicted about our M&A approach. We've got really robust funnels for both PQI and Water Quality. We're looking at a lot of assets, and we're actively engaged in our market activity here. But consistent with what we've said on prior calls, we're really going to stay close to our heritage and the disciplined capital allocation around market company and valuation.

So we obviously like businesses that have similar operating models and secular durability, financial profiles that look like us and certainly businesses where we think VES can add value. So we're active here. We're excited about the space. We're working hard quite on both sides of the fence and more to come.

[Scott Davis, analyst]

Congrats on the first 2 quarters here of the year.

[Operator]

We'll take our next question from Deane Dray of RBC Capital Markets.

[Deane Dray, analyst]

I'll echo Scott's comments. That's a clean quarter, kind of hard to find anything to quibble about. So maybe I'll start with product quality. Your primary competitor had some similar results yesterday in terms of strong aftermarket, but it looks like your printer sales are stronger. I know that 2380, it sounds like that was a boost.

But just can you comment on the mix and the go forward, especially with the recovery expected in the consumer packaging goods?

[Jennifer Honeycutt, executive]

Yes. Thanks for the question, Deane. Our PQI businesses in the main are performing well. I think you see that both in terms of our marking and coding businesses. You also see it on our color and packaging side. We're not going to comment really on competitors' activity. But what we can say is our marking and coding businesses are performing well and I think in line with the recovery of the consumer packaged goods market.

So we see this fourth consecutive quarter of mid-single digit recurring revenue growth. And we also see, as you rightly point out, Q2 marking the return of growth in equipment sales. And so this follows the nominal recovery that we see when we're coming out of a down cycle, where consumables and by way of inks in solvents and spare parts and so on, recover before equipment does. We're excited about the funnel that we have for equipment.

And certainly, as we talk to our CPG customers, they are -- their sentiment is more positive in terms of the future outlook. From packaging and color standpoint, we've just finished the drupa trade show, where we got a lot of positive response in terms of the products being launched there, mostly around our S2 native cloud, digital integrated solutions. This really helps reduce time to market for the brands. It also helps mistake proof relative the information that they're passing around between their functional department.

So funnels are healthy on both sides. The market recovery in terms of CPG itself is a little bit lumpy. We do see mixed results across various CPG categories. But certainly, we're encouraged by the market indicators, and I think our teams are executing well with recent product launches and our new product innovations really are gaining momentum.

[Deane Dray, analyst]

That's all very helpful. And just a geographic question. For both businesses, what was the sense of demand in China and the outlook -- the expectation is that you all have a very defensive type of mix there, but will you feel any of the ongoing pressures in the economy over the next couple of quarters?

[Jennifer Honeycutt, executive]

Yes. I think, Deane, our view of China hasn't materially changed from quarter-to-quarter. I think we believe that China has stabilized related to the end markets, but we don't expect to see any meaningful recovery in China this year. I think for state-owned or state-sponsored municipalities, funding is still extraordinarily tight, so we're not seeing much money flow there.

I think long term, China is anticipated to improve. It's got a large and aging population. Those folks are going to require clean water, safe food and trusted medicines. But our China team has stepped up to the challenge here in this slower growth macro, and we continue to ensure that we have a China business that's creating incremental value for Veralto.

[Sameer Ralhan, executive]

And then, Deane, from a guide perspective, effectively, assume China will be sequentially flat, right? So as you know, we were down quite a bit in the Q3 and Q4. So you're going to see a little bit of an uptick on a year-over-year basis as we kind of get into the second half, but sequentially, it's effectively flat.

[Operator]

We'll take our next question from Andy Kaplowitz of Citigroup.

[Andrew Kaplowitz, analyst]

Jennifer, Sameer, you raised your revenue guidance by $100 million for '24, I think, versus last quarter's forecast. So maybe just give us a little more color into what markets are better than you expected?

I know you just talked about Videojet equipment starting to accelerate. What are you baking now being in now for the second half of that improvement? And then in Water Quality, is it more that water treatment is driving continued strong momentum? Or are you seeing more improvement in Water Analytics?

[Jennifer Honeycutt, executive]

Yes. I mean I think we see strength across the board, really. We benefit, I think, from a couple of areas here. One is just the markets that we're in and the quality of the products we bring to market being part of the essential nature of customer operations. I think that the deployment of VES and the increased focus that we have as a stand-alone company continues to help us execute well commercially.

From a macro standpoint on where the demand is occurring, water and municipalities, particularly in U.S. and Europe, continue to execute on project backlog in terms of improvements to their respective plants, and their run rate business is steady.

We do see some nice pockets of growth coming for our water treatment businesses and see some tailwind and some benefits from things like CHIPS Act in terms of build out there, data centers which are acquiring an extensive amount of water in their cooling towers.

And those kind of 2 markets really benefit our ChemTreat and our Trojan businesses, respectively. So we're seeing good sort of solid, steady, robust demand really for both water treatment and Water Quality.

[Andrew Kaplowitz, analyst]

Very helpful. And then, Jennifer, just going back to M&A, like I know timing is always difficult, but would you expect to get something done this year? And then under what conditions would you do a larger deal where you may potentially raise equity?

[Jennifer Honeycutt, executive]

Yes. I think you are right that M&A is clearly episodic. We can't guarantee the intersection of when we will see market company and valuation come together. As we've mentioned in the past, we're going to stay disciplined to that approach. We have to like the market, right? It's got to be adjacent or near adjacent to where we play. The company has got to be a strong company that has secular drivers that we value under the umbrella of safeguarding the world's most vital resources, and we got to be able to get it at the right price.

I think right now, valuations are still a little bit inflated. So we're looking at the intersection here. But we've got to fundamentally get to all 3 of those variables. And all I can say is we're working hard in this area.

[Sameer Ralhan, executive]

And Andy, you're just going to look -- take a look at the equity side. It is just one of the components of how we think about funding any transaction. The main thing is value creation, right? Anything that's -- and ultimately help us create long-term value, we'll look at all forms of funding as we've kind of talked in the past. The main thing for us as we kind of think of any kind of funding is maintaining investment-grade balance sheet. That's [ existing ] thing for us.

[Operator]

We'll take our next question from John McNulty of BMO Capital Markets.

[John McNulty, analyst]

Maybe one on the free cash flow side. Obviously, a really strong quarter for you there and hitting kind of conversion levels that are above what you're certainly looking for, for the year.

I guess can you help us to think about what drove that? And if that -- if we see more things that you can kind of wring out from whether it's a working capital side to kind of keep that level elevated for the next couple of quarters. How should we be thinking about that?

[Sameer Ralhan, executive]

Yes, John. As you're going to look at the free cash flow conversion, quarter-to-quarter, it can vary. As you know, we have the bond payments that come in the first or the third quarter. So that gets -- impacts timing of the cash payments. So I would say when you look at the free cash flow conversion, we really look at it from a full year basis.

Overall, given the strength that we're seeing in the business, the execution, we feel pretty good about delivering 100% to 110% free cash flow conversion that's of GAAP net income.

[John McNulty, analyst]

Got it. Fair enough. And then just a question on SG&A. It took a reasonable jump up somewhere in the 7.5% kind of range. I guess can you help us to think about how much of that is just general labor inflationary type trends versus the corporate side where, look, now you're a public company versus investment for growth. I guess how should we be thinking about the various buckets there?

[Sameer Ralhan, executive]

Yes. I think it's -- let's take it in 2 buckets, right? One is firstly on the business side. As we kind of told you right at the beginning of the year, we will be -- we are investing in the sales and marketing side to really drive the growth of the business. And you've seen that kind of really coming through or flowing through the numbers in the first and second quarter.

John, inflation is there a little bit. I think just like everybody else, there's nothing that outsized, but it's -- these are really heads that are added more on the sales and marketing side to drive the growth, and you started seeing a little bit of the impact and more in the 2025 that you're going to see. So I would say on the business side, we are more or less in a normalized state so to speak, SG&A as a percent of revenues.

On the corporate side, we were very judicious in how we bring the cost in. So what you're going to see is more of a run rate view of the corporate expenses in the second half of the year. So there's going to be a little uptick in the second half versus the first year that you're going to see on the corporate side, but that should normalize in the second half. So nothing extraordinary on that front.

[Operator]

We'll take our next question from Mike Halloran of Baird.

[Michael Halloran, analyst]

So just some thoughts on the product rationalization side of things, some of the initiatives you're doing there. Maybe just how far along do you think you are in that journey in general. Has most of the area has been identified already or do you think that there's more to come on that side of things?

[Jennifer Honeycutt, executive]

Yes. I think, Mike, what you've seen us do here is just pruning around the edges, right? And this is actually part of standard work that we do day in and day out in managing the portfolio of the businesses. It's not something that we look at on an episodic basis. We're looking at this all the time.

So I would say when we see opportunities for continued portfolio evolution to get us a stronger portfolio focused in the higher areas of growth with higher margin and recurring revenue. Anything that falls materially far away from that profile is something that we'll take action on.

So we feel good about the portfolio we have today. We'll continue to prune around the edges as and when we see that it's appropriate to do so.

[Michael Halloran, analyst]

And then just a follow-up on, I think, Andy's question earlier. When you think about the greater confidence going into the back half of the year, has anything actually changed? Or is this just about starting to see momentum into this year, first quarter and is actually having materialized that gives you extra confidence? In other words, has there been really any change in your thinking about how these end markets are going to progress?

[Jennifer Honeycutt, executive]

Well, I think we've come out of a pretty tumultuous several years following the impact of the pandemic, Mike. And we saw a lot of whiplash, right, in terms of price and volume and demand cycles and consumer spending and what they were spending on and so on.

I would say that our confidence is built more as a function of an enduring steady state for our Water Quality businesses, driven by the secular drivers that we've talked about and an incrementally improving macro here for consumer products goods markets. 85% of our revenue goes into water, food and pharmaceuticals, and provided that those markets are steady or improving, we're going to see that benefit.

[Operator]

Our next question is from Brian Lee of Goldman Sachs.

[Brian Lee, analyst]

I guess on the first one. Sameer, or maybe Jennifer, you mentioned during your prepared remarks some favorable mix, I think, in the Water Quality segment that might help margins. Can you elaborate any on that? And is that something that either you can quantify? Or as you think about the next few quarters, is that expected to persist?

[Sameer Ralhan, executive]

Brian, yes, I'll take that one. The mix comment is really around consumables. We've seen a good amount of consumable uptick that's driving it. As you've seen, our recurring revenue is almost at 62% right now, and that is predominantly mix in little bit of spares and some of the SaaS software side, but predominantly consumables.

If you recall and go back into the history, when things are more normalized, that tends to be in the high 50s, right? So that kind of helps you dimensionalize. Now the transition, as the volume comes back on the printer side in PQI, instrumentation side on the water quality side, it's going to be a multi-quarter journey as we're going to move. So you're not going to see a big variation quarter-to-quarter, but that's 62% versus high 50s is the way to dimensionalize the change over time.

[Brian Lee, analyst]

All right. Fair enough. That's helpful. And then I know you're talking about improving end markets kind of across the board. Jennifer made some comments around the strong backlog trends in Water Quality.

Can you maybe talk a bit more specifically around -- I think you had comments in the release about strong bookings in packaging and color. Our understanding is that that's more of a short-cycle business. So where is the visibility? Are those the areas where you're seeing trends improving as well? Just kind of any commentary on the short cycle side of your business?

[Jennifer Honeycutt, executive]

Yes. Relative to Packaging and Color, as we mentioned, we've just concluded our drupa trade show. That's a trade show that runs once every 4 years. And given the pandemic, this is the first time that show has been conducted in 8 years. So there were some really good kind of pent-up demand that we saw there.

But I think our solutions and particularly those around innovation that we're providing and the S2 cloud-native digital integration of the workflow has got the attention of a lot of brand owners because they are under pressure to compress their development cycles and ensure the integrity of the information that they're working with, which gives every user of that system access to the same information.

So we had a great showing there. The teams, all 3 teams in terms of Esko, Pantone and X-Rite really did a great job there. And I think the -- outside of the enthusiasm generated in drupa, the recovery of the CPG markets will lend itself to new product releases and new product innovations from brand owners.

So they are getting ready, they have a number of projects that they're considering in terms of new product releases and so on and so forth. And so this is the front end of that. And I think we're well positioned to be able to help them with their solutions.

[Operator]

We'll move next to Brad Hewitt of Wolfe Research.

[Bradley Hewitt, analyst]

So I guess I wanted to start on the margin side of things. Your guidance implies about a 50 basis points step down in margins in Q3 versus Q2 despite the fact that revenue, I think, should be flat to slightly up sequentially. And then also your trade show expenses should step down quarter-over-quarter. So just curious if you can talk about kind of the drivers of the sequential margin pressure there.

[Sameer Ralhan, executive]

Yes, Brian, this is Sameer. Effectively, really 2 things here. The first one is the mix comment that we've made earlier. Our mix is pretty rich in consumables and recurring revenue right now. We have started seeing some good encouraging signs on the equipment side. We said in the second quarter, we finally see some positive revenue growth on the equipment side. So we've modeled in sort of a decent equipment growth in the Q3 and second half of the year. So mix impact is what's kind of flowing through here.

And the other one I would say is really on the corporate side, as we kind of get into the second half of the year, we are going to be getting more towards the run rate expenses on the corporate expenses. So that's impacting the margin side as well. So it's really those 2 things that are impacting the margin.

[Bradley Hewitt, analyst]

Okay. That's helpful. And then I guess going back to the long-term incremental margin framework of 30% to 35%. I know that includes kind of some reinvestment in the business, but just given the strong execution on VES since the spin as well as the implied 50% incremental margins this year despite volume growth kind of in the 1% to 2% zone.

Does that give you confidence that perhaps something more like 40% plus incrementals going forward over the medium term?

[Sameer Ralhan, executive]

Yes. Look, first of all, really kudos to all our teams, all our 16,000 people that are really helping drive this kind of fall-through that we are seeing, right? Really proud of what we've been able to achieve this year. But as you're going to think about 30% to 35%, it's really over the longer term, right? We do want to incorporate in that long-term value creation algorithm, a healthy investment mix from the sales side, from R&D side.

So I think from a long-term value framework perspective, I think still 30% to 35% is the right way to look at it. But I think -- and in the near term, really good performance and execution of the teams is driving a fall-through close to 50%.

[Operator]

We'll take our next question from Nathan Jones of Stifel.

[Nathan Jones, analyst]

I guess I'll follow up on that last question. You guys have made it pretty clear that you intend to continue to invest in growth here. Can you talk about what you think the growth rates will be in kind of investment in commercial resources, investment sales and investment in R&D kind of over the next several years rather than just any 1 year into the next?

[Sameer Ralhan, executive]

No, I think as you're going to think about long term, Nathan, these investments should be supportive of the mid-single-digit growth framework, right? And that is 4% to 6% kind of a range as we have kind of talked about. So as when we think about that mid-single-digit growth framework, we do reflect the incremental contribution coming from these investments on the sales and marketing side as well as on the R&D side, right? This is a technology-heavy business as you kind of think about in the commercial execution business. So those investments are key as we kind of think about long-term sustainable value creation.

[Nathan Jones, analyst]

So you would be looking at kind of that same mid-single-digit growth in those investments as revenue?

[Sameer Ralhan, executive]

Yes. Yes. Look, it kind of depends, right? Just to make sure, Nathan, right? On average, right, this is a cumulative thing that we're looking at. Of course, the new investment should be incrementally driving higher growth from their side. But some things fall out of the portfolio too.

[Nathan Jones, analyst]

Got it. The other question I wanted to ask was on the recycle, reuse, reclaim market driver. I think that is likely to be a pretty considerable driver of investment from industrial water users. So I'm hoping you could talk a little bit more about where Veralto plays, kind of how much of your revenue that makes up where you think it could go to over the next 5 to 10-year kind of time frame? Long-term growth rate you're expecting out of that just because I think that's going to be a pretty good driver of incremental demand.

[Jennifer Honeycutt, executive]

Yes. Thanks for the question, Nathan. We do see great demand here in recycle, reclaim and reuse. The business is most impacted by that certainly is our Trojan business who is well positioned there to help customers with their sustainability initiatives in the space, ChemTreat also has a play here. And certainly, if you're going to be moving water around, you're going to have to test it as well. So it does create some opportunity for our analytics businesses.

But the primary beneficiary really of this opportunity would be our Trojan business. And frankly, we see this space growing probably mid- to high single digits for the foreseeable future. Lots of industries are under pressure to achieve their sustainability targets and we're well positioned with solutions to help them.

[Operator]

Our next question is from Andrew Krill of Deutsche Bank.

[Andrew Krill, analyst]

I want to sort back on margins again in a little bit more on the medium-term perspective. I know there's been a lot of discussion just that the company has meaningfully more opportunities to improve margins than might be improved appreciated by investors.

Just can you update us on any like the findings you've had since the spin on that and whether you would consider especially quantifying those at any point? And then would you also say, is there more opportunity in one segment versus the other? Or do you think it's kind of similar?

[Sameer Ralhan, executive]

Yes, Andrew. As you're going to look at the opportunities on the margin expansion, right, this is -- so the work that the teams have been doing on the procurement side, really our folks on the front line to the shop floor, on the factory optimization. So these are lots of singles and doubles. As I said earlier on the call, it's not one or 2 factors that are driving this margin expansion.

And that, frankly, really is the beauty of the Kaizen culture, right? That's where you're going to see the margin contribution coming in. Those efforts really that the teams have been doing and execution that is happening is giving us the confidence to really up the bar on the margin expansion for the full year. We -- instead of 50 to 75 basis points, what we've said, raised the guidance to is 75 basis point margin expansion for the full year this year. So that should get the full year pretty much close to 24% on the operating earnings margin.

[Andrew Krill, analyst]

Okay. Great. Very helpful. And then can you give us an update on the situation in Argentina? And maybe just how much contingency, if you will, you have left in your guidance for the full year? And then I guess, depending on how that shakes out the rest of the year, how that could help or hurt PQI margins in the back half?

[Sameer Ralhan, executive]

Yes, very brief, right? And Andrew, as you're going to look at Argentina, as we said in the Q1 call, we did the blue chip swap to really insulate any impact on the historical cash that really drove the impact last year. But as you're going to move into the -- into this year, effectively, our exposure is much smaller, and that's reflected in the guide.

[Operator]

We'll take our next question from Andrew Buscaglia of BNP.

[Andrew Buscaglia, analyst]

Just looking at your guidance and trying to map out the ranges and looking at the high end. I'm wondering kind of what's contemplating or wouldn't form the high end of your guidance because it's difficult to get there. So you either need sales to accelerate for some reason or maybe you have some extra margin expansion in your back pocket. I guess, of those 2, what's behind that high end is my question.

[Sameer Ralhan, executive]

Yes. It really comes down to how you're going to think about the CPG markets, right? CPG markets are evolving, incrementally becoming positive, but it's a pretty fast-changing view that we are seeing. So I think as you're going to look at the guidance range, one of the big drivers is how you kind of think about the CPG markets and the impact they will have on the PQI top line.

I would say if there's one thing I can say that, that's one of the key things. And then on the margin side, right, I mean, there's always raw material price versus raw material contribution we always look at. We believe we have baked in a pretty prudent view here. So any benefit from that will be more inuring towards the high end of the range.

[Andrew Buscaglia, analyst]

Okay. That's helpful. And yes, I wanted to ask any update on the PFAS regulation opportunity in terms of whether anything new around your discussions with customers or I know you guys are talking about product development. Just what's the latest there?

[Jennifer Honeycutt, executive]

Yes, we continue to be interested in the space. But as you know, this is an incredibly difficult and complex problem to solve. We believe that we're well positioned, given our 70-year history at Hach for democratizing test and analytics and our long track record at Trojan for developing treatment solutions. So we continue to invest in this space and stay focused there.

But real fit-for-purpose solutions that are focused on at site or in-line testing and at site real-time destruction of PFAS are going to be remaining difficult problems to solve. But we're focused on creating winning outcomes for our customers that have fit-for-purpose solutions. So still a few years away here, but we are interested in the space as we are with sort of all of the micro contaminants that come into the regulation frame.

[Operator]

We'll take our next question from Joe Giordano of TD Cowen.

[Joseph Giordano, analyst]

I was interested in the industrial growth commentary. It's just -- we're not hearing that in a lot of places, right? Industrial data is pretty bad and most companies were seeing orders declined. So it is interesting and good to see that there. Can you kind of -- what's driving that? Is it new project ramps? Is it like -- is it optimization at existing facilities? Like what's the nature of this kind of growth here that does seem somewhat unique?

[Jennifer Honeycutt, executive]

Yes. I think what you're seeing here is that there's really 3 things that differentiate us from other industrials. We play in the end markets with really attractive and kind of non-optional secular growth drivers, right? So when you've got a business that's 85% of our sales in food, water and pharma, these are not elective areas of testing, right? So these are really durable markets.

And as a consequence, the way our businesses have been built are durable in turn. 60% of our recurring revenue or 60% of our revenue is kind of in this recurring revenue space. It's a razor-razorblade business model with high-margin consumables, and these products and services that are deployed for our customers are essential parts of their operation.

So if they choose not to use our products or they choose not to treat and measure and monitor and so on, the cost of failure to them is high because we're really tied to sort of product quality and public health. So the last thing I would say is VES provides a competitive advantage for us really in terms of differentiating us relative to talent growth and continuous improvement.

[Joseph Giordano, analyst]

And then just last for me on the margins. So we touched on this a bunch, but with gross margins at 60%, it's excellent. If I look at the spread between gross margins and EBITDA, 30% in SG&A seems a little high, you're a newer company, like long term, what's a realistic level that, that should normalize out at?

[Sameer Ralhan, executive]

Yes. Joe, I'll take that one. It's really the sales and marketing, right? Just to take you back, effectively, when you look at a P&L, it really aligns with how we create value in the business. It's more driven by investments in R&D. It's a technology-driven business and then on the commercial side, right?

The secret sauce, what we believe and our competitive strength is a direct business model that effectively does result in the sales and marketing, that impact that you see in the numbers. Overall, we feel really good about our business model that is more direct, and it really drives a competitive advantage in the marketplace.

[Operator]

And this does conclude our question-and-answer session. I'd be happy to return the conference to Ryan Taylor for closing comments.

[Ryan Taylor, executive]

Thank you, Leo, and thanks for everybody that joined us on the call today. We really appreciate your engagement and the discussion. Feel free to reach out to me if you have any more follow-ups. Thanks again for joining us, and we'll talk to you next quarter.

[Operator]

This does conclude today's conference. You may now disconnect your lines, and everyone, have a great day.