Veralto - Q2 2024
July 26, 2024
Transcript
Operator (participant)
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. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question during that time, simply press Star, then the number one on your telephone keypad. If you would like to withdraw your question, please press Star, then the number two on your telephone keypad. I will now turn the call over to Ryan Taylor, Vice President of Investor Relations. Mr. Taylor, you may begin your conference.
Ryan Taylor (VP of Investor Relations)
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 investor 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 24 July, 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-K was filed yesterday.
These materials are available in the investor 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 L. Honeycutt (CEO)
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 are 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 benefits 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.
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 cloud 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 trusted 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. 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, save 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 two 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. 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 continued 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 continued 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. 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 points 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 (CFO)
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 standalone 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 nine. 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 and 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 a 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, or 118% conversion of GAAP net income. As of 28 June, 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 1.3 times. 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-$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. Our guidance for free cash flow conversion remains in the range of 100%-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. Our Q3 2024 guidance for adjusted EPS is $0.82-$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 L. Honeycutt (CEO)
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 (participant)
At this time, if you would like to ask a question, please press star one now on your telephone keypad. To withdraw yourself from the queue, you may press star two. Please limit yourself to one question and one follow-up. Thank you. We'll take our first question from Scott Davis of Melius Research.
Scott Davis (Analyst)
Hey, good morning, Jennifer, Sameer, and Ryan.
Sameer Ralhan (CFO)
Good morning, Scott. I've got to ask... Good morning.
Scott Davis (Analyst)
I got to ask about gross margin, just because they've been so incredibly strong. It is, 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 (CFO)
Yeah, Scott, let me just touch on the, on the margin, and then I'll have Jennifer just talk about the price. On the gross margin side, you know, it's really been 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, you know, 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 tends 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 know, you should expect the gross margins to come in a little bit as the growth rate, you know, equilibrates between the equipment and consumables over time. But, you know, we feel really good about 60%, but I think once the transition happens, we'll be more in the, you know, high 50, 50, or 59% roughly range.
Jennifer L. Honeycutt (CEO)
Yeah, 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. The teams commercially are executing well around the world, but we have seen price normalize to historical levels, which we believe sit in the range of 100-200 basis points.
Scott Davis (Analyst)
Okay, fair enough. I just 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 and your enthusiasm about the assets that are out there?
Jennifer L. Honeycutt (CEO)
Yeah, 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, kind of on both sides of the fence, and more to come.
Scott Davis (Analyst)
Okay. Best of luck. Congrats on the first two quarters here of the year.
Jennifer L. Honeycutt (CEO)
Thanks, Scott.
Operator (participant)
We'll take our next question from Dean Dray of RBC Capital Markets.
Jennifer L. Honeycutt (CEO)
Morning, Dean.
Deane Dray (Analyst)
Good morning, everyone. Good morning. Hey, 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 looks like your printer sales are stronger. I know the 2380 sounds like that was a boost. Just can you comment on the mix and the go forward, especially with the recovery expected in the consumer packaging goods?
Jennifer L. Honeycutt (CEO)
Yeah. Thanks for the question, Dean. You know, our PQI businesses, in the main, are performing well. I think you see that both in terms of our marketing 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, you know, our marketing and coding businesses are performing well, and I think in line with the recovery of the consumer packaged goods market. So we see, you know, this fourth consecutive quarter of mid-single digit recurring revenue growth. And we also see, as you rightly point out, you know, Q2 marking the return of growth in equipment sales.
This follows a nominal recovery that we see when we're coming out of a down cycle, where consumables and by way of inks and 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 a 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 departments.
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)
It's all very helpful. Just a geographic question. Just 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, you know, over the next couple of quarters?
Jennifer L. Honeycutt (CEO)
Yeah, I think, Dean, our view of China hasn't materially changed from quarter to quarter. I think, you know, we believe that China is 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, you know, China is anticipated to improve. They've got a large and aging population. Those folks are gonna require clean water, safe food, and trusted medicines. But you know, our China team has stepped up to the challenge here in this slower growth macro. And you know, we continue to ensure that we have a China business that's creating incremental value for Veralto.
And then, Dean, from a guide perspective, effectively, you have seen China will be sequentially flat, right? So as you know, we were down quite a bit in the Q3 and Q4, so you're gonna see a little bit of an uptake on year-over-year basis as we kind of get into the second half, but sequentially, it's effectively flat.
Deane Dray (Analyst)
That's real helpful. Thank you.
Operator (participant)
We'll take our next question from Andy Kaplowitz of Citigroup.
Andrew Kaplowitz (Analyst)
Hey, good morning, everyone.
Sameer Ralhan (CFO)
Good morning.
Jennifer L. Honeycutt (CEO)
Good morning, Andy.
Andrew Kaplowitz (Analyst)
Jennifer, Sameer, you raised your revenue guidance by $100 million for 2024, 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, you know, starting to accelerate. What are you baking now, baking 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 L. Honeycutt (CEO)
Yeah, 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 the deployment of VES and the increased focus that we have as a standalone company continues to help us execute well commercially. From a macro standpoint on where the demand is occurring, you know, water and municipalities, particularly in the 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 benefit from things like CHIPS Act, in terms of build out there, data centers, which are requiring an extensive amount of water in their cooling towers. And those kind of two 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 L. Honeycutt (CEO)
Yeah, I think you are right, that M&A is clearly episodic. You know, we can't guarantee, you know, the intersection of when we will see market company and valuation come together. As we've mentioned in the past, we're gonna stay disciplined to that approach. We have to like the market, right? It's gotta be adjacent or near adjacent to where we play. The company's gotta be, you know, a strong company that has secular drivers that we value under the umbrella of safeguarding the world's most vital resources, and we gotta be able to get it at the right price. I think right now, valuations are still a little bit inflated. So, you know, we're looking at the intersection here, but we gotta fundamentally get to all three of those variables.
All I can say is we're working hard in this area.
Sameer Ralhan (CFO)
And Andy, I'm just gonna think about the equity side. It is just one of the components of how we think about funding any transaction. You know, the main thing is value creation, right? Anything that's gonna ultimately help us create long-term value. We'll look at all forms of funding, as we have kind of talked in the past. Main thing for us, as we kind of think of any kind of funding, is maintaining investment-grade balance sheet. That's sacrosanct for us.
Andrew Kaplowitz (Analyst)
Appreciate the color, guys.
Operator (participant)
We'll take our next question from John McNulty of BMO Capital Markets.
John McNulty (Analyst)
Yeah, thanks for taking my question. 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, you know, if we see more things that you can kind of wring out from, whether it's the 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 (CFO)
Yeah, John, you know, thanks for that. You know, as you're gonna look at the free cash flow conversion, you know, quarter to quarter, it can vary. As you know, we have, you know, the bond payments that come in the first and the third quarter, so that impacts timing of the cash payments. So I would say, when you look at the free cash flow, cash flow conversion, really look at it from a full year basis. Overall, you know, given the, the strength that we're seeing in the business, the execution, we feel pretty good about delivering 100%-110%, free cash flow conversion. That's off GAAP net income.
John McNulty (Analyst)
Got it. Fair enough. And then just a question on SG&A. Took a reasonable jump up to 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, first investment for growth? I guess, how should we be thinking about the various buckets there?
Sameer Ralhan (CFO)
Yeah, as you know, I think it's. Let's take it in two buckets, right? One is first 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, you know, inflation's there a little bit. I think just like everybody else, there's nothing outsized, but it's true, 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 gonna see.
So I would say on the business side, we are more or less in a normalized state, so to speak, and so SG&A as a percent of revenues. On the corporate side, you know, we were very judicious in how we bring the cost in. You know, so what you're gonna see is more of a run rate view of the corporate expenses in the second half of the year. So there's gonna be a little uptick in the second half versus the first year, that you're gonna see on the corporate side, but that should normalize in the second half. So nothing extraordinary on that front.
John McNulty (Analyst)
Great. Thanks very much for the color.
Operator (participant)
We'll take our next question from Mike Halloran of Baird.
Michael Halloran (Analyst)
Hey, good morning, everyone. So, just some thoughts on the product rationalization side of things, some of the initiatives you're doing there. You know, maybe just how far along do you think you are in that journey in general? Have most of the areas been identified already, or do you think that there's more to come on that side of things?
Jennifer L. Honeycutt (CEO)
Yeah, I think, Mike, what you've seen us do here is just pruning around the edges, right? And, you know, 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. You know, 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, you know, 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)
Makes sense. And then just to follow up on, I think, Andy's question earlier, you know, 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 you actually having it materialize, that gives you extra confidence? In other words, has there been really any change in your thinking about how these end markets were going to progress?
Jennifer L. Honeycutt (CEO)
Well, I think we've come out of a pretty, you know, 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 gonna see that benefit.
Michael Halloran (Analyst)
Appreciate it. Thank you.
Jennifer L. Honeycutt (CEO)
Thanks, Mike.
Operator (participant)
Our next question is from Brian Lee of Goldman Sachs.
Brian Lee (Analyst)
Hey, everyone. Good morning. Thanks for taking the questions. I guess, the first one, hey, Sameer, good morning. Sameer, or maybe Jennifer, you mentioned during your prepared remarks some favorable mix, I think, in the water quality segment that might have helped 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 (CFO)
Hey, Brian. Yeah, 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 and little spares and the some of the SaaS software side, but predominantly consumables. You know, 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 gonna be a multi-quarter journey as we kind of move.
So you're not gonna see a big variation, quarter to quarter, but that's sort of, you know, 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 know, you're talking about improving end markets kind of across the board. You know, 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 and packaging in color. You know, our understanding is that that's more of a short cycle business. So where's 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, your business. Thank you, guys.
Jennifer L. Honeycutt (CEO)
Yeah, relative to packaging and color, you know, as we mentioned, we've just concluded our drupa trade show. That's a trade show that runs once every four years, and given the pandemic, this is the first time that show has been conducted in eight years. So there was some really good kind of pent-up demand that we saw there. But I think, you know, our solutions, and particularly those around innovation that we're providing in 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.
You know, the teams, all three teams, in terms of Esko, Pantone, and X-Rite, really did a, did a great job there. And I think the, you know, 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, of that, and I think we're well positioned to be able to help them with their solutions.
Brian Lee (Analyst)
Okay, I appreciate the color. I'll pass it off.
Operator (participant)
We'll move next to Brad Hewitt of Wolfe Research.
Brad Hewitt (Analyst)
Hey, good morning, guys. Thanks for taking my questions.
Jennifer L. Honeycutt (CEO)
Morning, Brad.
Brad Hewitt (Analyst)
I guess 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. Just curious if you can talk about kind of the drivers of the sequential margin pressure there.
Sameer Ralhan (CFO)
Yeah, Brad, this is Sameer. Effectively, really two things here. The first one is, is the mix comment that we made earlier. You know, 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, you know, we finally saw positive revenue growth on the equipment side. So we 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.
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, corporate expenses, so that's impacting the margin side as well. So it's really those two things that are kind of impacting the margin.
Brad Hewitt (Analyst)
Okay, that's helpful. Then I guess going back to the long-term incremental margin framework of 30%-35%, I know that that includes kind of some reinvestment in the business, but just given the strong execution on VS since it's been, as well as the implied 50% incremental margins this year, despite volume growth kind of in the 1%-2% zone, does that give you confidence in perhaps something more like 40% plus incrementals going forward over the medium term?
Sameer Ralhan (CFO)
Yeah, no, no, thanks for that. Look, I mean, it's 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, you know, as you're gonna think about 30%-35% is really over the longer term, right? We do wanna, you know, 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%-35% is the right way to look at it.
I think in the near term, really good performance and execution of the teams is driving a fall through close to 50%.
Brad Hewitt (Analyst)
Great. Thanks, Sameer.
Operator (participant)
We'll take our next question from Nathan Jones of Stifel.
Nathan Jones (Analyst)
Morning, everyone.
Jennifer L. Honeycutt (CEO)
Morning, Nathan.
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 in sales, investment in R&D, kind of over the next several years rather than, you know, just any one year to the next?
Sameer Ralhan (CFO)
No, I think as you're gonna think about long term, Nathan, these investments should be supportive of the mid-single-digit growth framework, right? And, you know, and that is 4%-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're gonna think about in the commercial execution business. So those are 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, as revenue?
Sameer Ralhan (CFO)
Yeah.
Nathan Jones (Analyst)
Okay.
Sameer Ralhan (CFO)
Now, look, the other question, it kind of depends, right? Just to make sure, Nathan, right, on average, right, this is, 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 there's 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, you know, five to ten year kind of time frame, long-term growth rate you're expecting out of that, just because I think that's gonna be a pretty good driver of incremental demand.
Jennifer L. Honeycutt (CEO)
Yeah, thanks for the question, Nathan. We do see great demand here in recycle, reclaim, and reuse. The businesses most impacted by that certainly is our Trojan business, who is well-positioned there to help customers with their sustainability initiatives in this space. ChemTreat also has a play here, and certainly, if you're gonna be moving water around, you're gonna 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.
Nathan Jones (Analyst)
Great, thanks for taking my questions.
Operator (participant)
Our next question is from Andrew Krill of Deutsche Bank.
Jennifer L. Honeycutt (CEO)
Morning, Andrew.
Andrew Krill (Analyst)
Thanks. Good morning, everyone. Wanted to circle back on margins again from a little bit more of the medium-term perspective. I know a lot—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 of, like, the findings you've had since the spin on that, and whether you would consider explicitly 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? Thanks.
Sameer Ralhan (CFO)
Yeah, Andrew, thanks for that. You know, as you're gonna look at, you know, the opportunities on the margin expansion, right, you know, this is the work that the teams have been doing on the procurement side, really our folks on the front lines, on the shop floor, on the factory optimization. So these are lots of singles and doubles. As I said earlier in the call, it's not one or two, you know, factors that are driving this margin expansion, and that, frankly, really is the beauty of the Kaizen culture, right? That's where you're gonna 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.
Or we've instead of 50-75 basis points, what we've said, raise the guidance to a 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 year 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 TQI margins in the back half? Thanks.
Sameer Ralhan (CFO)
Yeah, very brief, right, and Andrew, as you're gonna look at Argentina, as we said at 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 gonna move into this year, effectively our exposure is much smaller, and that's reflected in the guide.
Andrew Krill (Analyst)
Okay, great. Thank you.
Operator (participant)
We'll take our next question from Andrew Buscaglia of BNP.
Jennifer L. Honeycutt (CEO)
Morning, Andrew.
Andrew Buscaglia (Analyst)
Hey, good morning, everyone. Morning. You know, I'm just looking at your guidance and trying to map out, you know, the ranges. Looking at the high end, I'm wondering, kind of, what's contemplating or what informs the high end of your guidance? 'Cause it's difficult to get there. So you either need sales to accelerate, you know, for some reason, or maybe you have some extra margin expansion, you know, in your back pocket. I guess, of those two or, you know, what, you know, what's behind that high end is my question.
Sameer Ralhan (CFO)
Yeah. No, thanks for that. It really comes down to how we're gonna 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 gonna look at the guidance range, one of the big drivers is how we kind of think about the CPG markets and the impact they'll have on the PQI top line. I would say if there's one thing I can say, that's one of the key things. And then on the margin side, right, I mean, there's always, you know, raw material price versus raw material contribution we always look at. You know, we believe we have baked in, you know, pretty prudent view here.
Any benefit from that will be more accruing towards the high end of the range.
Andrew Buscaglia (Analyst)
Okay. Yeah, that's helpful. Yeah, I wanted to ask any update on, you know, the PFAS, PFAS regulation opportunity, you know, in terms of whether, you know, anything new around your discussions with customers? Or, you know, I know you guys were talking about product development. Just what's the latest there?
Jennifer L. Honeycutt (CEO)
Yeah, 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 tests 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 you know, real fit-for-purpose solutions that are focused on, you know, at-site or in-line testing and at-site real-time destruction of PFAS are gonna 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 microcontaminants that come into the regulation frame.
Andrew Buscaglia (Analyst)
Okay. All right. Thank you.
Operator (participant)
We'll take our next question from Joe Giordano of TD Cowen.
Jennifer L. Honeycutt (CEO)
Morning, Joe.
Joseph Giordano (Analyst)
Hey, guys. Good morning. Thanks for taking my question. You know, I was interested in the industrial growth commentary. We're—it's just, we're not hearing that in a lot of places, right? The industrial data is pretty bad, and most companies, we're seeing orders decline, so it was, it was interesting and good to see that there. Can you kinda... What's driving that? Is it new project ramps? Is it, like, is it, is it optimization at existing facilities? Like, what's the nature of this kind of growth there? It's just, it, that does seem somewhat unique.
Jennifer L. Honeycutt (CEO)
Yeah. I think what you're seeing here is that there's really three 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 into food, water, and pharma, it's these are not elective, you know, 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-razor blade 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, you know, 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 from me on the margins, so we touched on this a bunch, but, you know, with gross margins at 60%, it's, it's excellent. You know, if I look at the spread between gross margins and EBITDA, you know, 30% in SG&A seems a little high, like, you're a newer company. Like, long term, what's, like, a real realistic level that that should normalize out at?
Sameer Ralhan (CFO)
Yeah, Joe, I'll take that one. It's really the sales and marketing, right? If, you know, just to take you back, effectively, you know, when you look at a P&L, it really aligns with how we create value in, in, 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, and our competitive strength is a direct business model that effectively does result in the sales and marketing that you impact that you see in, on, on, in the numbers. Overall, you know, we feel really good about our business model that is more direct, and it really drives a competitive advantage in, in the marketplace.
Joseph Giordano (Analyst)
Thanks, guys.
Operator (participant)
This does conclude our question-and-answer session. I'd be happy to return the conference to Ryan Taylor for closing comments.
Ryan Taylor (VP of Investor Relations)
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 (participant)
This does conclude today's conference. You may now disconnect your lines, and everyone, have a great day.