Veralto Corp

NYSE:VLTO

My name is Margo, and I'll be your conference operator this morning. At this time, I'd like to welcome everyone to Veralto Corporation Fourth 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.

Good morning, everyone. 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 also be available until February 19.

Yesterday, we issued our fourth quarter and full year 2024 news release, earnings presentation and supplemental materials including information required by the SEC relating to adjusted or non-GAAP financial measures. In addition, we also issued our 2025 full year and first quarter guidance. These materials are available in the Investors section of our website, www.veralto.com, under the heading Quarterly Earnings. Reconciliations of all non-GAAP measures are also 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 our 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. And with that, I'll turn the call over to Jennifer.

Thank you, Ryan, and thank you all for joining our call today. I'll begin with a look back at our 2024 accomplishments followed by a recap of our fourth quarter performance. Sameer will then take you through a detailed analysis of our Q4 results and 2025 guidance. Reflecting on 2024, I'm proud of our team for their strong execution in our first full year as a public company to grow our business, strengthen our portfolio, and deliver attractive value creation for all stakeholders. In doing so, 3 notable accomplishments stand out.

First, we delivered on our financial commitments. Second, we increased our growth investments; and third, we demonstrated a disciplined approach to capital allocation executing strategic actions to improve our portfolio and increase our dividend in conjunction with our earnings growth. Let me expand on each of these. Beginning with our financial performance for the year, we delivered core sales growth, adjusted operating profit margin expansion and adjusted earnings per share growth above our initial guidance.

This outcome demonstrates the durability of our businesses, fortified by the Veralto Enterprise system. Our simplification of VES and focus on leveraging high-impact tools drove sales growth and margin expansion throughout the year. Our results reflect the benefits gained from our team's engagement in focused Kaizen events and leverage of VES growth tools to enhance commercial architecture, improve funnel management and increased lead generation.

Our VES focus, combined with increased investments in sales, marketing and R&D, enabled us to capitalize on strengthening demand as the year progressed. This resulted in steady sequential improvement in volume growth partly attributable to new customer wins and increased market penetration.

Across both segments, we delivered mid-single-digit core sales growth in the second half of 2024. On the strength of this growth and strong underlying margin expansion, we accelerated investments to drive future value creation. Specifically, we expanded our direct sales force augmented our marketing efforts and accelerated innovation in verticals and regions with high return opportunities.

We enhanced our talent through new hires and internal development programs, and we increased our investment in innovation with our full year R&D expense up 40 basis points year-over-year to about 5% of sales. Our focus on innovation led to several new product and technology launches across our businesses throughout 2024. PQI led the way with digital offerings in packaging and color and a steady cadence of next-gen technology launches in marking and coding. Videojet has now launched more than a dozen new products over the past 2 years. Its latest breakthrough, the 7920 UV laser marketing system launched in the fourth quarter.

This laser enhances usability, adaptability and consistency in coding operations and was met with immediate enthusiasm and demand from customers. We shipped our first unit shortly after the product launched in November and continue to see strong demand here in Q1. The UV laser is optimized for high-quality permanent coating on some lighter weight flexible films made for mono-material plastics. These flexible films are among the fastest-growing substrates in the packaging industry due to their high levels of recyclability, further supporting our customers' sustainability goals.

We are excited about this new UV laser technology, along with many other products and solutions we brought to the market last year. In addition to delivering our financial commitments and increasing our growth investments, our third key accomplishment last year was executing disciplined capital allocation.

In 2024, we took steps to improve our portfolio across both segments. This activity ramped in the fourth quarter as we acquired TraceGains, our first acquisition of size invested in minority stake in [indiscernible] Water Technologies and signed an agreement to sell Advanced Vision Technology, or AVT, a print inspection product line in our PQI segment with approximately $40 million in annual sales. As we talked about on our Q3 call, TraceGains was acquired early in the fourth quarter.

It is a leading provider of cloud-based software solutions that enable connected data and digital workflow management for consumer brands. TraceGains digital solutions help customers innovate new recipes faster and significantly reduces time to market for new products. Additionally, it helps increase transparency to ingredient inputs for food and beverage safety.

The acquisition of TraceGains in combination with our ESCO business, strategically expands our digital offering and provides us the opportunity to deliver greater value to consumer brands as they digitize critical workflows with connected data across new product development, compliance and packaging. The integration of TraceGains is going well.

Our integration team is executing on all fronts. The customer response has been very positive and the team at TraceGains has quickly embraced the VES. TraceGains fourth quarter core sales growth exceeded 20% year-over-year. And importantly, we are on track with our growth investments. Late in the fourth quarter, ESCO entered into an agreement to sell its AVT product line. This sale is expected to be completed in the first quarter of 2025.

This divestiture is another example of our stewardship of the portfolio with ESCO's focus on providing source-to-shelf digital workflow solutions for our CPG customers, we believe new ownership of AVT will provide the necessary focus to drive its growth and innovation. In combination, acquiring trade gains and divesting ABT enhances our packaging and color portfolio. Both deals are immediately accretive to PQI's core growth rate, gross margin and recurring revenue.

In water quality, we have also taken actions to improve our portfolio. As previously discussed, since Veralto's spin-off, we have strategically exited 3 product lines that were not aligned with our long-term value creation strategy. In the fourth quarter, we made a minority investment in [indiscernible] a provider of electrochemical oxidation technology used to destroy contaminants in water, including PFOS.

Our water quality team has a long proven track record of developing and commercializing technologies that help customers detect and destroy emerging contaminants. A key part of our growth strategy in water quality is developing fit-for-purpose solutions to help our customers meet complex challenges. We believe [indiscernible] electrochemical oxidation technology provides a promising solution for difficult-to-treat organic contaminants and that our commercial partnership with [ Axione ] will accelerate technology adoption over time.

Overall, we are pleased with the progress we made in curating our portfolio in 2024. Moving forward, we expect acquisition growth to be a key value creation lever. The pipelines for both segments are full and active and we continue to be disciplined in our approach to capital allocation.

Looking now at 2025, we are starting off the year with an improved portfolio positive trends in our end markets and a stronger financial position. Demand across our key end markets has strengthened compared to this time last year, highlighted by strong demand for industrial water treatment in North America and improved demand in consumer packaged goods markets globally.

For the full year 2025, we are targeting low- to mid-single-digit core sales growth with strong incremental margins, solid earnings growth and strong cash generation. And we believe the durability of our business is fortified by the Veralto Enterprise system are competitive advantages that enable us to consistently grow and improve even in dynamic macro environments.

Looking at our financial results for the full year 2024. Total sales grew 3.4% year-over-year to just under $5.2 billion, an all-time high. We delivered 3.7% core sales growth with 80 points of adjusted operating profit margin expansion and adjusted earnings per share grew 11% to $3.54 per share. Notably, we exceeded our initial guidance on all 3 of these metrics. And we generated $820 million of free cash flow, further strengthening our financial position.

We ended the year with $1.1 billion of cash on hand and net leverage at 1.2x. Overall, I'm pleased with the growth and margin expansion we delivered in 2024. Every operating company across both segments contributed core sales growth with positive volume. Our Water Quality team delivered 3.9% core sales growth with 50 basis points of adjusted operating profit margin expansion. They set all-time highs with annual sales of over $3 billion and adjusted operating profit margin of 25% and our PQI team delivered 3.3% core sales growth with 160 basis points of adjusted operating profit margin expansion.

They also reached all-time highs with over $2 million in sales and adjusted operating profit margin of 27%. I'm proud of our teams across the world for their strong commercial and operational execution in support of our customers. We capped off a strong 2024 with solid fourth quarter results.

Core sales grew 4.6%, led by volume growth with both segments growing core sales by more than 4%. Adjusted earnings per share grew 9% year-over-year to $0.95 and free cash flow generation was strong at $263 million in the fourth quarter, further strengthening our financial position. Looking at core sales growth by geography and end markets for the fourth quarter, growth across the enterprise was broad-based across key verticals and regions and our commercial teams executed well, leveraging our VES growth tools and investments made earlier in the year.

North America and Western Europe, which comprise about 70% of our total sales grew nearly 6%, and high-growth markets grew low single digits year-over-year. In North America, core sales grew 5.8% within both segments. In water quality, we continue to capitalize on strong demand for our chemical water treatment solutions, which grew high single digits in North America.

From an industrial end market perspective, this growth was broad-based with the strongest growth in food and beverage, chemical processing and power generation. We also continue to see strong growth for Trojan's UV systems at municipalities in North America, primarily related to water reuse. Veralto continues to benefit from strong secular drivers in water conservation, reclamation and reuse as we help our customers achieve their sustainability goals.

Over the long term, we expect these secular trends to drive continued growth opportunities given the scarcity of water today, coupled with more frequent severe weather events and increasing water usage from industry, such as data centers, which consume large quantities of water for cooling. It also includes traditional industries ranging from power generation to food and beverage processing.

Both our water treatment and analytics businesses are poised to benefit from increased industrial activity in North America. At PQI, core sales in North America also grew 5.8% in Q4 with mid-single-digit growth in both packaging and color and marking and coding. PQI's growth in North America was largely driven by strong growth in equipment sales. This reflects a combination of improving end market demand from CPG customers and market penetration from our strategic initiatives.

Specifically, in North America, Videojet focused on new customer wins differentiated new product launches and VES driven commercial excellence. In Western Europe, we saw continued momentum with core sales growth of 5.8% year-over-year, led by 7.3% growth in water quality sales and 4.4% growth in PQI. The sales growth in Western Europe was largely driven by strong commercial execution by our water analytics team.

Additionally, we drove growth across PQI in both our marking and coding and packaging and color businesses. In high-growth markets, core sales increased 1.5% in the fourth quarter, led by Latin America and India. In China, PQI continued to drive solid year-over-year core sales growth however, similar to our third quarter performance, PQI growth in China was offset by lower sales in water quality.

This is primarily due to ongoing soft demand for water analytics, and a lower level of UV system installations for chip processing, which were exceptionally strong in the fourth quarter of 2023. Total company sales into China in Q4 were in line with our quarterly average for the year. We continue to do demand for our products in China as stable at low levels and do not expect China sales to grow in 2025.

Overall, we delivered solid fourth quarter financial results on the back of strong commercial execution, while continuing to invest in future value creation. At this time, I'll turn the call over to Sameer to provide details on our fourth quarter results and 2025 guidance.

Thanks, Jennifer, and good morning, everyone. I'll begin with our consolidated results for the fourth quarter. Total sales grew 4.4% on a year-over-year basis to over $1.3 billion. Currency was a 50 basis point headwind year-over-year and acquisitions contributed 30 basis points of growth, primarily driven by TraceGains. Core sales grew 4.6%.

Our core sales growth was primarily driven by volume, which grew 3.1% year-over-year. Price contributed 1.5% growth this quarter, in line with historical levels. Our recurring revenue grew mid-single digits year-over-year and comprised 59% of our total sales. The percentage of recurring revenue is in line with 2023 levels.

However, it is down sequentially primarily due to high single-digit sequential growth in nonrecurring revenue, specifically water testing instrumentation and marking and coding equipment. Gross profit increased 7% year-over-year to $801 million. Gross profit margin improved 170 basis points year-over-year to 59.6% and primarily driven by pricing.

Adjusted operating profit increased 5% year-over-year, and adjusted operating profit margin was flat year-over-year at 23.8%. As Jennifer mentioned, in the fourth quarter, we continued to increase investments in our direct sales and marketing efforts on both a year-over-year and sequential basis. On a year-over-year basis, R&D as a percent of sales increased 70 basis points or $12 million to 5.1%. In addition, our cost optimization investments in this quarter increased by about $7 million on a sequential basis.

These investments are aligned with our strategic growth plans. Looking at EPS for Q4, adjusted earnings per share grew 9% year-over-year to $0.95 per share. As compared to our guidance, adjusted EPS came in stronger, primarily due to lower corporate expenses and a lower tax rate. These benefits more than offset a headwind from currency.

As compared to our guidance expectations, strengthening of the U.S. dollar during the quarter resulted in about 2% and or approximately $25 million headwind to sales, primarily due to translation of foreign currencies. This led to a headwind of about $7 million to adjusted operating profit or $0.02 to adjusted earnings per share as compared to our guidance assumptions.

In the fourth quarter, we generated robust free cash flow of $263 million or 116% conversion of GAAP net income. Moving on, I'll cover the segment highlights, starting with water quality. Our Water Quality segment delivered $811 million of sales, up 3.7% on a year-over-year basis. Currency was a 60 basis point headwind. Divestitures reduced total sales by 60 basis points versus the prior year period. Core sales grew 4.9% year-over-year. Water quality's core sales growth was led by volume which grew 3.3%. Pricing contributed 1.6% growth year-over-year.

Water quality's 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 a good volume growth in sales of analytical instruments reagents and chemistries to municipalities. Recurring sales grew mid-single digits and equipment growth was up low single digits year-over-year. Adjusted operating profit increased 2% year-over-year to $207 million, and adjusted operating profit margin was 25.5% and marking Water quality's highest quarterly margin performance this year. Moving to the next page.

Sales in our PQI segment grew year-over-year to $534 million in the fourth quarter. Currency was a 30 basis point headwind and acquisitions contributed 1.6% growth in the quarter. Core sales grew 4.1%, with volume up 2.9%. Price increases contributed 1.3% to the year-over-year growth in core sales. PQI's recurring revenue grew high single digits year-over-year with positive momentum across the portfolio. PQI's equipment sales grew low single digits, primarily driven by marking and [indiscernible] systems. On a sequential basis, equipment sales were up mid-single digits, driven largely by marking and coding equipment.

Breaking this down by business Marking and coding core sales grew mid-single digits, driven by growth in both consumables and equipment. The strongest growth was at food and beverage applications within our CPG customer base. In our packaging and color business, core sales grew mid-single digits year-over-year, led by growth in both recurring software and subscription revenue.

PQI's adjusted operating profit was $133 million in the fourth quarter, up $10 million over the prior year period, resulting in adjusted operating profit margin of 24.9%. That represents a 60 basis point improvement in adjusted operating profit margin over the prior year period. The margin expansion was primarily due to favorable currency benefit as the Argentine peso devaluation in Q4 2023 did not repeat.

This benefit was partially offset by increased investments in sales, marketing and R&D, along with a higher mix of equipment sales and dilution from the Tracking acquisition. For the full year, PQI delivered 3.3% core sales growth and 160 basis points of adjusted operating profit margin expansion.

Overall, it was a very good year for PQI and we continue to see positive momentum in our commercial execution and end market environment as we enter 2025. Turning now to our balance sheet and cash flow. In Q4, we generated $285 million of cash from operations. We invested $22 million in capital expenditures.

Free cash flow was $263 million in the quarter or 116% conversion of GAAP net income. At the end of the fourth quarter, gross debt was $2.6 billion and cash on hand was $1.1 billion. Net debt was $1.5 billion, resulting in net leverage of 1.2x. As Jennifer shared, early in the fourth quarter, we acquired TraceGains at a gross purchase price of $350 million.

The deal was funded with cash on hand. We also invested approximately $15 million to establish a minority interest in vaccine Water Technologies. Even after these investments, our financial position is strong and we continue to have flexibility in how we deploy capital. To that point, in the fourth quarter, our Board of Directors approved a 22% increase in our quarterly dividend. This is consistent with our approach to increase the dividend as we grow our earnings.

Over the long term, however, our bias remains to create long-term shareholder value through M&A. We have an attractive pipeline of opportunities in both water quality and PQI. We remain disciplined in our approach as we continue to deploy capital to create long-term shareholder value.

Turning now to our guidance for 2025, beginning with our expectations for the full year. We are targeting core sales growth in the low to mid-single-digit range on a year-over-year basis. At the midpoint of our guidance, we are assuming core sales growth consistent with the full year 2024. This assumes pricing in the range of 100 to 200 basis points. Consistent with our historical range.

We expect net acquisitions and divestitures to be neutral to growth as potential sales contribution from TraceGains is largely offset by the impact of the AVT divestiture. Our full year guidance assumes that currency rates as of December 31, 2024, prevail for the remainder of the year. Based on this assumption, currency is approximately 2% headwind to total sales on a year-over-year basis.

This falls through roughly in line with our adjusted operating profit margin, resulting in operating profit dollar headwind of approximately $25 million. This represents an $0.08 headwind to adjusted earnings per share. Our guidance assumes corporate expense at a full annual run rate between $100 million to $105 million.

Looking at adjusted operating profit margin, we're targeting 25 to 50 basis points of improvement in 2025. This assumes margin expansion at both segments and total company incremental margins around 40%. Our adjusted EPS guidance for the full year 2025 is in the range of $3.60 per share to $3.70 per share.

This assumes an effective tax rate of approximately 23%. Excluding the $0.08 per share currency headwind. Our adjusted EPS guidance represents about 5% year-over-year growth at the midpoint and about 7% growth at the high end of the range. And we are targeting free cash flow conversion between 90% to 100% of GAAP net income. This assumes CapEx in the range of 1% to 1.5% of sales and a modest working capital investment to support our growth.

Looking now at Q1 2025, we expect core sales to grow in low to mid-single-digit range across both segments. Currency translation is expected to be approximately 2% year-over-year headwind to sales. We anticipate adjusted operating profit margin in the range of 24% to 24.5%. And our Q1 2025 guidance for adjusted EPS is $0.84 to $0.88 per share.

This assumes a $0.02 currency headwind. That concludes my prepared remarks. At this point, I'll turn the call back over to Jennifer for closing remarks.

Thanks, Sameer. In summary, we capped off a strong first year as a public company. In 2024, we delivered on our commitments, invested in our future and improved our portfolio. We enter 2025 with a more positive outlook on our end markets and momentum throughout the enterprise. Longer term, we are confident that the essential need for our technology solutions and the strong thematic growth drivers across our end markets will provide steady, durable growth.

And we will continue to leverage the power of the Veralto Enterprise System to drive continuous improvement and bolster our agility through dynamic macro environments. Our financial position remains strong, and we continue to evaluate additional strategic opportunities within our disciplined capital allocation framework of market, company and valuation.

We are excited about the bright future ahead for Veralto and the opportunities in front of us to help customers solve some of the world's biggest challenges in delivering clean water, safe food and trusted essential goods. That concludes our prepared remarks. And at this time, we're happy to take your questions.

[Operator Instructions] We'll take our very first question from Andy Kaplowitz from Citigroup.

This is Nathalia [indiscernible] behalf of Andy Kaplowitz. First question that I want to ask is if you could break down or give more color into how you're thinking about your segments in terms of margin expansion. They've both grown that 25 bps to 50 bps range? And do you have trade schemes weighing you down a bit more in I

Natalia, this is Sameer. Yes, I think as you kind of think about the margin expansion, it's very similar. In fact, I would just take a step back and look at our overall company guide and how the segments are kind of contributing for both the segments, you should look at the core growth in a very similar place, low single digit to mid-single digit.

And also from a margin expansion perspective, pretty similar contribution coming from both the segments.

Got it. That's helpful. And then the second question I want to ask is I'm just curious about the progression of DDR what specific initiatives have you implemented under the VEF to drive cost efficiencies and enhance margins? And how has it been involved in since a [indiscernible] where do you see the most opportunity for further margin expansion in 2025 and how are you balancing those increasing growth investments with the whole of improving margin performance?

Thanks for the question, Natalia. I think we feel very good about how we have honed our VES tool set Certainly, we had a big push in 2024 really to drive growth in commercial execution, but we also drove considerable amounts of margin expansion in just good factory discipline. So the things that we did in bringing the VES tool set over from Danaher post-spin, were to really narrow the focus and drive a greater depth of application and competency in the use of those tools.

There are 5 to 6 tools that sit in our fundamentals and those fundamentals are relevant to everyone, whether you sit in a function or you're sitting an operating company. And so we feel good about both our deployment there for commercial applications, accelerate new product development and factory-focused optimization.

Our next question comes from Deane Dray with RBC Capital Markets.

You all know I have covered Danaher for many years. So whenever I hear about growth investments done at year-end, that's really read out of the Danaher playbook because it's a good sign. You're getting you're doing it from a position of strength. There's a way to jump start the new year. So I'm assuming that applies to you all. And if I look at the margin past couple of quarters sequentially down a bit.

Is it fair to say that, that's the impact of the growth investments can you size that impact? And anything about the benefits? And am I thinking about it the right way?

Yes. Thanks, Deane. As you know, some of us here in the room have spent nearly a lifetime at Danaher. And so the playbook there is very familiar. I think it's right. We took the opportunity here on the back of strong growth to continue to reinvest in the business in areas that we think will set us up for a good -- so that's spot on. And maybe I'll turn it over to Sameer to talk about the rest of your question.

Thanks, Jennifer. Yes, Deane, if you're going to look at the sequential margin, right, the first one is really [indiscernible] roughly 70 basis points dilutive to the PQI margins, right? But it really sets up really well in 2025 as you kind of look at driving the growth in PQI? The second 1 is actually great as you kind of think about the equipment sales coming back, so the mix of the equipment was a little higher, similar to the water quality as well.

Again, as the installed base grows, as you know, our future recurring revenue growth. So it's great to have that and last was a point that you kind of maintain really, as you're going to think about the investments in R&D, commercial cost optimization, these things are all, as you outlined, very intentional, very deliberate actions to make sure that we hit the ground running in 2025. So I think, as Jennifer also said, playbook is very similar.

Our focus is long-term value creation. And if you can zoom out for full year 2025, we delivered 80 basis points in the full year, while ramping up as a full year in the first full year as a public company, while investing in sales and marketing, while investing in R&D, all those things really positioning us really well as you're going to start 2025.

So we feel good about the margin expansion.

That's really helpful, and I appreciate all those specifics. And the second question, I might be tempted to ask about TraceGains because that's kind of the marquee first deal. But I'm actually more interested in talking about the investment in vaccine this electrochemical oxidation technology looks really promising. We've

spoken with [indiscernible] before. They're established. And it looks like it could have good application for on-site PFAS destruction because they've already proven the technology and other complex molecules. So look, it's still early. I get that.

I'm most interested in the strategy here of using M&A as a proxy for R&D, because you can make a really smart investment for $15 million with potentially significant payoff down the road. Does your funnel have more candidates, investment candidates like this because pound for pound, that's a great way to be spending your capital.

Yes. Thanks for the question, Dean. Look, we have a number of different levers to pull relative to capital allocation, and we look at all sorts of modalities there to create long-term shareholder value. I think we feel good about our level of investment in just relative to proving up the technology, making sure that it matures in the right way relative to the markets that we serve.

And we've got a very competent and capable science and technology team that's constantly canvassing the market for good opportunities to engage with other partners, be that a minority investment or be that outright acquisition. So I think everything is on the table there.

And our next question comes from Mike Halloran with Baird.

So let's just start with end markets and kind of a loose top. What's changed as we sit here today versus the last time we talked because I think 3Q earnings. It sounds like you're pretty constructive coming into the year, as just this been a continuation of the trends you were seeing then? Or is there anything new that you think has developed over this period of time?

I think it's largely a continuation of what we've seen, Mike. We've talked a lot about the strength in our industrial water businesses given a number of very thirsty industries, data centers, power generation and so on. that continues. We're seeing good, steady growth in analytics as well, particularly in the U.S. and Europe on the back of the secular drivers that require clean water for the population that they serve.

And then I think on the PQI side, we see the continued recovery in the strength of the CPG markets. We saw actually the sixth consecutive quarter of mid-single-digit to high single-digit recurring revenue. We know that, that recurring revenue always precedes sort of equipment growth. And now we've seen 3 consecutive quarters of year-over-year growth in equipment sales with, in fact, equipment sales coming in better than expected here in the fourth quarter.

So we think we're set up well given the macro and we enter the year here with continued momentum.

Great. Appreciate that. And then when you think about the foundation for the guide for the year, I understand all the moving pieces, gave a lot of color. Just -- 2 quick questions related to that. One, is the cadencing through the year expected to be kind of consistent with normal seasonality? And two, is the assumption that things just kind of hold trend as we sit here today? Or is there any improvement or [indiscernible] assumed in what your end markets look like?

Mike. Yes, from the guide perspective, as you kind of look at the top line, the growth side, it's going to be pretty consistent. As Jennifer just said right, from the CPG markets perspective, from a water perspective, we're seeing some good trends. We feel really good about as we going to enter 2025. Those trends are continuing.

So overall, from a seasonality perspective, as you know, we don't have a whole lot of seasonality maybe on the equipment side, instrument side, we see a little more pull-through in Q4 as people are kind of managing their budgets, but overall, not a whole lot of seasonality in our business. But coming into 2025, we feel pretty good about the trends continuing and the numbers.

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

I got a couple of questions around margins. comparing the margin expansion in '24 or '25 ramped up R&D investments 40 basis points. So without that, '24 would have been up like 120 basis points in the guidance for '25 and similar revenue growth is [indiscernible] So maybe you can just give us some more color on where you got that extra margin expansion in. Maybe you're not anticipating in 2025. I'll start there.

Yes, Nathan, I'll start off with that. As you're going to look at from a '24 to '25, right, of course, of the '24, the margin expansion was pretty broad-based, really, as Jennifer said, all the way from the factory load down to the commercial operations and functions did get offset a little bit by trade cans and some of the investments that we continue to make. As we move into 2025 from a price cost differential perspective, we still expect to be positive. I mean it's positive -- we expect that to continue.

R&D will be in a very similar level, Nathan, roughly 5% of the sales. So that trend will -- we expect to continue in 2025. And that's the stuff is really some really targeted investments on the commercial side, really in the sales and marketing as we continue to drive the growth. So that's kind of like how it's kind of panning out the 25 to 50 basis points. still going to be pretty broad-based across the board.

And then I guess I'll ask one on incremental margins. Jennifer, you talked about 40% incremental margins in 2025. Each year, it's probably relatively of a small change at low to mid-single-digit growth. But I think originally, when the business spun out, you guys had talked about 30% to 35% incremental margins.

Just wondering if you can comment on, is that structurally higher now? Or is it a one-off this year? Any video structurally higher? What's driven that?

Yes, Nathan, if you're going to look at 30 to 35, right, that's a long-term view. We expect to make the right investments in the sales, our marketing, R&D to continue to position the business for future growth as well, right? In 2024, we feel really good about what teams have been able to deliver. We are north of 45%, close to 50% on the fall-through for 2024, given the kind of investments that we have laid out and have visibility into what we're going to be doing in 2025, we feel pretty good about delivering 40%, all right?

So the year-over-year, depending on some of the investments, things will change. But I think if you think about the long-term value creation frame, 30 to 35 is a good 1 to keep.

And next, we'll go to Saree Boroditsk with Jefferies.

This is James on for Saree. I wanted to touch on the CPG market a little bit more. I mean, you talked about like continue like gradual recovery path here over the last several quarters. So can you provide a little bit more color on the recovery path? Like how far are we from like normalization in the industry? And like what percentage revenue is still missing from the like last like normal state of the [indiscernible] market?

Yes. I mean I think the way we look at the recovery of the CPG market is mothball manufacturing lines will be turned back on, and those will require spare parts, consumables that then is followed by equipment upgrades. We are not yet at the point where we're seeing line expansions per se and new build. So that would be another sort of extension of the recovery.

But given the fact that we've seen 6 consecutive quarters of mid- to high single-digit recurring revenue growth, which means those lines are coming back on and using in consultant, spare parts, filters and so on. And we've seen 3 consecutive quarters of year-over-year growth in equipment sales. It suggests that we're well into the recovery with the prospect of new builds still ahead of us should that happen.

Got it. Great. And I guess I wanted to understand like portfolio optimization initiated a little bit better here. So like how much are left to do here? Like what are some spaces that you can still do? And how will like this initiative affect the top line potentially margin like in 2025?

Yes. The way we think about this is that every product line has to earn its right to be in the portfolio. And I think as an independent enterprise we are tasked with being good stewards of the portfolio in terms of making sure that products that are part of the portfolio and services are at or better than the fleet average. And where we've got product lines that are below the fleet average in terms of core growth and operating profit, we'll look to make changes there.

Now those changes may be additional investment to get them on the right track. It may be that we attenuate them over time, and it may be that we divest them outright. But I think it's safe to assume that we're always looking to improve our portfolio and moving the portfolio towards nominally higher growth rates and increasing margins.

We'll next go to Andrew Buscaglia with BNP.

So I want to ask you a high-level question. You guys had a great year in the stock also had a pretty good year, but it sort of broke down the stock that is towards the end of the year on concerns around the Trump administration and what that means for your stock, I think, and you've got a couple of months to think about it now.

So I'm wondering, first, it was concerns around what it means for water quality, but then it kind of morphed into is this good or bad for PQI and you can hear different arguments on both sides. I'm just wondering, what are your latest thoughts for both segments under this administration?

Yes. We're certainly operating in a fairly dynamic environment, but from a portfolio standpoint, 85% of our sales are tied to water, food and essential goods. It's never been out of style to protect public health and safety and regulations to help us do that. But these are issues that are important to everyone regardless of the political affiliation.

So I would say sort of on the water side, because we are endemic to the operation environment of of discharging clean water and cleaning up industrial water, wastewater and so on, I think we feel like that is still going to be a need. As long as we've got people on the planet, they're going to need clean water.

On the PQI side, a lot of what we are focused on there is securing the inherent safety of the food supply chain, right? And we have a need to -- or consumer product brands have a need to ensure that what they are distributing to their consumers that the ingredients the formularies and so on are safe, traceable and can be recalled in the event that there is some sort of public health or safety issue.

So we think even in the current environment, we've got strength in both of these businesses. These products and services not only provide essential public health and safety information. But in many cases, the products and services we provide, provide economic benefits to customers as well. So Again, this is not a CapEx-intensive set of businesses.

We are focused on the daily operations and the essential need of our products and services there are, we believe, going to remain.

Okay. And maybe along those lines, with tariffs, is part of your guidance implies some disruption around tariffs? And can you comment around the latest -- your latest thoughts around China, Mexico and Canadian tariffs, how that might impact you?

Yes. And the guidance, we have not reflected any sort of a sustained impact from the tariffs. Look, it's a very fluid and dynamic situation. But if you kind of step back, we procure our materials from globally. We have a global manufacturing footprint. And over the years through the supply chain restrictions and things that have happened, we feel pretty good about the changes that the operations have made over the last 4, 5 years to really position and fortify our supply chain. So we feel pretty good. I will be keeping an eye just like you guys on the things that are coming out, but overall, we feel pretty good. But if you say, hey, there's a sustained level of tariff changes, that's not baked into the guide.

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

Maybe just a couple on the water side. So you highlighted some of the growth that you were seeing where it was really in the food and beverage and on the power side. Those striking is relatively stable market. So is the bulk of that share gain? And if so, I guess, can you help us to understand kind of what drove that? Was it some of the investments you've been making in North America? Or there are the things that we should be thinking about?

Yes. I mean I think we participate in a well-diversified set of markets with respect to our water business. And the 2 that you cite there are certainly strong growing industrial markets that we experienced in 2024. But the reality is, is the shift over time, and we have a good agility in pivoting our sales force to where the growth is coming from.

Generally, we've been up year-over-year in most of our markets, and we continue to feel good about industrial production and the need for our products and services, particularly as reshoring comes back to the U.S. and so on.

Got it. Fair enough. And then maybe just one question on the data center side. There's some growing excitement around direct to chip cooling -- there's also just an increase in general use. I guess, can you speak to whether you're agnostic as to how data centers cool going forward and some of the of growth that you're seeing in terms of the opportunities from the data center side.

Yes. I mean I think the predominant focus here for us is our water-cooled applications, right? But I would say that we have a very strong science and technology team on the ground that's regularly canvasing the customer base to understand sort of pain points and technology changes. I would say our mid-single-digit growth algorithm is really not tied to sort of single industry here. It's going to be broad-based, and we believe that the growth in data centers and power generation actually needed to run those centers will continue to be a potential -- have potential to be a meaningful growth driver, certainly throughout our treatment business.

And next, we're going to go to Andrew Krill with Deutsche Bank.

Looking at free cash flow, I know the guidance, 90% to 100% is a little below your medium-term target of 100 and extra working capital was cited. So just should we be thinking that's kind of a onetime 2025 event and that in 2026, we get back to that 100% or so. And are there any other factors you'd call out for this year on what's keeping you below 100%

Yes. Andrew, this, if you're going to look at the free cash flow conversion, yes, we had a pretty solid year in 2024 with a 98% conversion of GAAP net income. As you're going to move into 2025, there are really 2 things because of which we guided a little bit below. And one of the reasons is on the CapEx side, as you know, historically been, at least for the last 3, 4 years, we've been -- our CapEx is kind of like close to 1% of revenue.

We've guided towards 1% to 1.5%. That's again mostly tied to some of the growth investments that we are making in our sort of physical asset base in 2025. Some is just a good stewardship of the asset base. So if you kind of just looking at the CapEx going to 1% to 1.5% of revenue, that's impacted only 4% on the free cash flow conversion.

And the other one that we've built in is given the pretty dynamic world macro that we are living in, just from a working capital perspective, we modeled in a little bit higher working capital just to support the business and manage all the supply chain things from the tariffs that you're seeing.

Those are really the 2 things. As things normalize post 2025, of course, we expect it to be back up.

Okay. Makes perfect it's a good segue. Just following up on tariffs. How do you size what your sourcing is maybe for case from China, Mexico and Canada? And like would any of those be a particular pain point where you're not in region for region sales? I believe some business like Trojan has pretty meaningful can exposure -- so just any help or quantification there would be great.

Yes. Thanks for the question, Andrew. We started several years ago, a full decade certainly to source raw materials and semi-finished goods globally. We got a diversified number of manufacturing locations, and we've diversified the supply chain accordingly. Certainly, VES provides us the tools to proactively deal with countermeasures for different scenarios.

And obviously, we're focused on controlling what we control. Relative to exposure, our primary exposure in Canada is Trojan as you appropriately cited, which is headquartered in Ontario. We have taken actions there to localize consumables and spare parts for Trojan in the U.S. to derisk any supply gain disruption that we would see. It also gives us an opportunity to provide more agility in serving customers.

I think the way to think about this is all told, Trojan's annual sales to the U.S. are less than 5% of our total for all those sales annually. So we think we're well positioned to sort of weather the storm here and we've got the ES on our side to respond with agility and rigor.

Great. And just real quick on China because I think it is 78% of sales is a bit bigger than some peers. Is that fair that's mostly in region for region without a big like export imbalance?

Yes. We've spent actually a longer period of time diversifying our supply chain around what we have in China. We have a good deal of in China for China which certainly wouldn't be disrupted by any tariff changes. But again, we have spent the last several years diversifying that supply chain as well and think we're well positioned to be able to address any headwinds that we might see there.

And we'll take our last question from Brian Lee with Goldman Sachs

Just wanted to go back to a couple of margin questions. I guess, first off, on the PQI side, the 350 basis point margin contraction sequentially, I know part of that seems to be the higher mix of equipment sales. When we kind of back into it, it doesn't seem to explain the entire bridge. Can you kind of deconstruct the 350 basis points for us across different moving factors.

Brian, this is Sameer. Yes, as I kind of outlined earlier, right, the first one, of course, is the trace gain, that's almost 70 basis points dilutive to PQI on a sequential basis. The next one is we kind of talked about some of the cost optimization actions we took in my prepared remarks, I highlighted $7 million higher on a sequential basis. Majority of that is in PQI, that's 120-ish kind of a basis point, a little more than that for -- and I would say the third 1 is as you're going to think about the R&D sequentially up as well as tied to the investments we are making to drive the future growth in the business.

On a sequential basis, majority of the jump is actually tied to PQI as well. And then last one, you added the higher mix of equipment sales, which again really help us expand the installed base for future recurring revenue. So those are the 4 things you add them up, we kind of balance out the 300 basis points gap that you laid out.

Okay. That's great. Super helpful. And I guess fair to assume some of those factors do spill over to the early part of the year. I guess, if I look at the Q1 guide, it implies margins are going to be down a few tens of bps year-on-year despite the low single-digit growth. I know some of that is FX, but then your full year guide implies margin growth through the year off of Q1 with the same FX assumptions.

So maybe just kind of walk through the margin cadence, what's happening in Q1 that either does repeat through the rest of the year? What margin gains are you seeing start to play out off of the back of Q1?

Yes. No, I think it's going to move from Q4 to Q1, Brian. Not a whole a lot of these things are spilling over, right? Look, R&D, on a sequential basis, it should be consistent at a higher level. And I would say cost optimization stuff is there's nothing is spilling over into Q1. Really, as you kind of look at from anything that's moving from this year to next is traces is going to be, as we highlighted, going to be a little bit of dilutive upfront as we continue to drive growth business, so we have to make the right investments to make sure we're capitalizing on that.

Those investments will be. And then the trends that we are seeing and the higher mix of equipment sales in PQI continues, maybe a little bit of impact from that, but nothing more than that, that's kind of moving on or spilling over from Q4 to Q1.

Thank you. And at this time, I'll turn the call back over to Mr. Taylor for final remarks.

Thanks, Margo, and thanks, everyone, for joining us on the call. We appreciate the interest and engagement as usual, will be around for follow-up questions, just reach out to me if you'd like to ask anything to follow-up on the quarter or the guide for 2025. Thank you so much, and that concludes our call. We'll talk to you next time.

Thank you. And this does conclude today's program. Thank you for your participation. You may disconnect at any time.