Q1 2019 Select Holdings
Making the World Cleaner and Healthier
Clean water and renewable energy are multi-hundred billion dollar markets. Companies are learning that making the world cleaner and healthier is good business. Our review explores the testing, treatment, and transport of water. Using these three groups as a framework—and touching on solar energy—we review specific attributes of six investments, representing over 20% of your partnership, that have products and services providing environmental solutions.
Testing is a core basis for research, development, and implementation of process or manufacturing of product. We prize companies that provide instruments that test, measure, and evaluate. Both Thermo Fisher and PerkinElmer are premier scientific instrument manufacturers supplying equipment into the environmental markets. Thermo Fisher has revenues of $25 billion and has the broadest scientific instrument portfolio in the world. Perkin Elmer has revenues of $2.9 billion and a narrower portfolio than Thermo, with focus in the environmental area and an emphasis on materials characterization.
Thermo Fisher invests more than $1 billion a year in research and development and sells over $5.5 billion worth of analytical instruments a year. Thermo supplements this R&D investment with astute capital allocation on acquisitions to strengthen niche market leadership. In 2010, Thermo acquired Dionex, a leading manufacturer of ion and liquid chromatography equipment, and this expanded Thermo’s presence in environmental analysis, water testing, and food safety. The global water testing market is about $3.5 billion and is growing approximately 5% a year. Organizations across industry, academia, and government use Dionex equipment for environmental water testing for a wide range of regulated and emerging inorganic elements and organic compounds. Dionex has worked closely with the US EPA Office of Ground Water and Drinking Water to develop methods of water analysis that utilize Dionex’s leading ion chromatograph systems. Equipment such as Dionex’s Integrion TM HPIC TM System enables fast analysis without compromising data quality. The Dionex business continues to take share versus competition. The product has a razor and razor blade model, and users choose from a wide range of reagents to use when performing specific tests. Through this instrument, and dozens of other comparable platforms, Thermo has improved profit margins annually for years. Its analytical instruments segment has profit margins of 23%, which is a premier level relative to other equipment makers across multiple industries. Ongoing advancements in science and Thermo’s R&D enable faster and more sensitive instruments each year, which make the world cleaner and safer.
PerkinElmer’s mission is innovating for a healthier world. Its instrumentation and solutions test about 300 billion gallons of water a year and provide safe drinking water for one billion people. Our initial investment in Perkin Elmer dates back over ten years. We have been impressed by how the company has built on its leading positions in analytical instruments for the environmental and life sciences, while also improving its financial metrics. The company generated 19% operating profit margins in 2018 and expects to increase this to 22% by 2020. Free cash flow will double in this time as the company improves its working capital efficiency. The core of the company is innovation in detection technology. It has several dozen instrument platforms and associated consumables. It also produces spectrophotometers, which are used in the production of solar cells.
Similar to the water cycle, renewable energy is a key strategy for enabling companies to maximize business efficiency while minimizing environmental cost. The solar energy market is growing rapidly; there are over 500 gigawatts (GW) of installed photovoltaic capacity globally, which is about 3% of global electricity demand. Honduras is at the high end at 10%, while the U.S. is below the global average. Capacity grew 34% and 27% in 2017 and 2018, and there is great demand for improvement in the efficiency of all aspects of solar energy components. Perkin Elmer has more than 50 years experience as a leader in spectroscopy instruments and is the market leader in atomic absorption technology with a dominant 30% global market share. Atomic absorption spectrometry (AAS) is an analytical technique that measures the concentrations of elements. Perkin’s customers use these instruments to characterize and test the materials used to produce photovoltaic cells. The Lambda 1050 spectrophotometer helps the world’s leading solar cell manufacturers optimize surface texture and reflective and antireflection coatings, and assess the charge-transfer efficiency of materials used in thin-film photovoltaic production. Achieving higher conversion efficiencies requires highly crystalline, defect-free and strain-free silicon films and layers. The market for these instruments is growing at a high single-digit rate. Given the long runway for the world’s expansion of solar energy, Perkin Elmer should have this growth driver for years to come.
Following the testing and evaluation of the water, the next step is to determine how to treat the water. Xylem, Danaher, and Ecolab are three of the world’s premier water-related businesess specializing in water treatment technologies. With over $5 billion in revenues, Xylem is the largest company in the world focused solely on municipal, industrial, and commercial water requirements. Danaher is a diverse corporation with over $20 billion in revenues across four divisions. Two of these divisions—Life Sciences and Environmental & Applied Solutions—have businesses with revenues totaling about $6 billion focused on products providing air and water filtration or disinfection, and analysis of the environment. Ecolab has $15 billion in products and services in water, hygiene, and energy technologies.
Xylem is a global leader in innovations for water transport and waste water treatment—its products simultaneously improve water quality, streamline treatment processes, and reduce the energy needed to power these systems. The heritage of the company is in pumps that move water. To this foundation, the company has added innovative digital systems that connect the wide-ranging equipment employed across the water cycle. Xylem’s management “sees the potential for a world in which water issues are no longer a barrier to human health, prosperity, and sustainable development.” Our research on Xylem began in the mid 2000s, before the company separated from its larger industrial conglomerate parent, ITT Corporation. Stone Run Capital’s investment dates back nearly six years. Management has improved the business annually for the past several years and we see continued investment opportunity. Currently, profit margins stand at 15% and the company’s goal is to raise this to between 17% and 18% in the next two years. Xylem is well positioned to do this, with more than 40 brands comprising thousands of products designed to address crucial needs in agriculture, environmental monitoring, and municipal water and wastewater treatment.
Founded in 1975 and originally acquired in 2003 by Xylem’s then-corporate parent, Wedeco is based in Herford, Germany and is the world’s largest manufacturer of ultra violet (UV) disinfection and ozone oxidation water treatment systems. With more than 2,000 systems installed worldwide in municipal and industrial facilities, Wedeco’s UV systems are 100% chemical free and and do not carry the risk of forming such harmful by-products as trihalomethanes (THMs) or haloacetic acids (HAAs). Wedeco manufactures EcoRay glass UV lamps—comparable to highly engineered light bulbs—in Germany. It integrates this work with an automated system called OptiDose, which ensures the UV system is operated at an optimized power level. Through a SCADA (Supervisory Control and Data Acquisition) system, it communicates usage and status information to plant managers. This conserves energy, enables an increasing level of automation, and reduces costs—up to 20% of the disinfection operating costs at a facility per year. One customer, United Utilities Group PLC, reports that the EcoRay lamps and ballast system saved them approximately 50% in energy costs over the last twelve months. They plan to extend the use of the equipment to other facilities.
Wedeco is an example of Xylem’s technological leadership and of how the company is able to provide effective treatment innovations in its core water market. Pall and Hach, two Danaher companies, provide further insight.
Pall, part of Danaher’s life sciences segment, has about $3.5 billion in revenues and is the world’s largest and most diverse filtration, separations, and purifications company. Its products enable customers to reduce contaminants in air and fluids for industrial process, commercial transporation, and scientific investigation. With over 70 years of research and development in filtration, Pall has technology leadership across an array of products. A recently developed remote diagnostics monitoring system called Crixus enables customers to identify system failures proactively in a manufacturing process. Crixus incorporates Pall filtration, sensors and RFID technology, and a cloud-based software platform to provide “intelligent fluid management,” which reduces waste, improves process efficiency and saves energy. The Pall Athalon filter is a leading brand in hydraulic and lube oil applications and is used in industrial manufacturing processes. Pall is the first company to integrate digitization and automation into fluid cleanliness management, and it continues to innovate on Internet of Things (IoT) development for environmental solutions.
Hach is part of Danaher’s $2.5 billion water quality group and is the worldwide leader in water quality analysis. Hach’s mission is “ensuring water quality for people around the world.” Founded in 1933 by Clifford and Kitty Hach and based in Loveland, Colorado, Hach has a broad line of instrumentation and chemistries designed to make water analysis faster, greener, and more informative. The company possesses leading research and development in advanced detection technologies like liquid chromatograpy, mass spectrometry, and inductively coupled plasma optical emission spectrometry (ICP-OES). Scientists, lab managers, and plant managers use Hach’s instruments and the consumables associated with them to test water throughout the cycle of its use, and, importantly, to ensure that industrial facilities adhere to environmental standards. Similar to Pall’s Crixus, Hach has Claros, the water intelligence system. Claros ties instrument management, data management, and process management together to enable entire municipal and industrial water systems to operate more efficiently. In one example, the use of Claros was able to reduce the amount of chemicals needed to treat the water by 40%, which led to a payback period of less than two months for the investment. Hach Claros covers all the drinking water testing parameters to analyze and treat incoming raw water at a wastewater treatment plant. The analysis then enables customers to inform local governments of contaminants leaking into the aquifers. There are now over 3,000 Claros installations worldwide. During the past five years, Hach has continued to increase its leadership position, and Danaher’s water quality segment has grown at nearly twice the rate of its peer set.
Pall and Hach are two examples of the differentiated businesses within Danaher. Our initial investment in Danaher dates back nearly fifteen years—before the founding of Stone Run Capital—and the same attributes of the business that attracted us then—niche technology leadership and strong management discipline—continue today. Danaher stock has outperformed the S&P 500 by 65% over the last ten years, and we think the strong performance will continue.
Ecolab products make the world cleaner, safer, and healthier. The company has $15 billion in revenues, and every year it helps save 175 billion gallons of water, clean 40 billion hands, and reduce 1.4 billion pounds of industrial waste. At seven times the size of its closest competitor, the business has 90%+ recurring revenues and has had two decades of consistent, double-digit earnings per share growth. Management sizes the addressable market at $125 billion, and Ecolab’s predictable business model should have many years of growth ahead. The partnership’s investment in Ecolab dates back to 2011 and the stock has increased over four times. During this period, the company has consistently taken share across its global markets, used its free cash flow to acquire new capabilities, and returned cash to shareholders in the form of dividends and share buybacks. Management reviews the business in a number of formats, and one highlights our reason for investment: 37% of sales are focused on keeping the world’s food chain and supply safe, 23% of sales are focused on clean industrial water, 18% of sales are focused on healthy environments, and 17% of sales are focused on enabling an abundant energy supply.
In 2011, Ecolab acquired Nalco for $5.4 billion, and together the two businesses have built an even stronger water treatment platform. An award earlier this April highlights Nalco’s capabilities. The Edison Awards, a leading global program to honor innovation, presented Nalco Water with an Edison Award in the Lab Advancements category for its molecular-based test for Legionella. The test provides 14-times faster than current culture testing methods. Traditional microbiological culture methods to detect Legionella take 14 days to complete. Nalco’s quantitative Polymerase Chain Reaction (qPCR) DNA-based method detects Legionella within one day, enabling faster validation of water safety protocols and response to protect public health. The test is part of the water safety analytical services platform Nalco Water provides through its industry-leading Legionella Risk Management Program. Overall, Nalco Water has helped develop and implement more than 15,000 water management programs for customers.
The final piece of our discussion on making the world cleaner and healthier relates to the transport of water. Core technologies here include the pumps, valves, and pipes used to move water. A more differentiated technology is the measurement of how much water is being moved, and that is where our we end our essay. Roper Technologies has over $5 billion in revenues in a diverse number of niche markets in which it has leading market share positions. One of its premier businesses is Neptune Technology Group whose mission is to design and engineer for the business of water. Neptune was founded over 120 years ago, acquired by Roper in 2003, and has since tripled in size to revenues of over $600 million. It serves more than 4,000 water utilities across North America and provides software, hardware, and a smart wireless network via radio-frequency identification (RFID) that enables the utilities and their millions of residential and commercial customers to control and understand their use of water. Neptune manufactures water meters and the systems automating the process of collecting the data, and has about a 20% share of the revenues of the industry. Its share of industry profit from water meters is higher—above 30%—and we think Roper’s ability to invest more in research and development will help the company continue to expand its leadership.
Neptune’s smart cities initiative uses advanced metering infrastructure (AMI) to enable utilities to create an entire city network monitoring the use of water. The E-Coder Register is a water meter that connects to the cloud and provides 8-digit remote meter reading, as well as leak, tamper, and reverse flow detection. In 2010, the city of Toronto began a $220 million project to implement a full turnkey system for monitoring residential and commercial use of water. Most of their existing water meters at the time were from Neptune with the association going back more than a century. Working with Neptune, Toronto’s water utility was able to finish the implementation a year ahead of schedule and $40 million under budget. Each year, Toronto now receives nearly 1 billion meter readings from the network system. Both the business and environmental results have been positive. Dispute testings of meters after high water bills—generally also due to undiscovered leaks—have dropped dramatically. That means millions of gallons of water saved. Customers that used to have flat-rate accounts have been able to reduce their bills by 25-40% through their ability to monitor water usage in real time. Commercial and industrial customers, which know how much each drop counts, have better learned to monitor cooling systems, which are water intensive, and have reduced cooling costs. Overall, the system helps people think about water usage, and helps promote conservation. We look for both Neptune and Roper to continue to innovate and expand the corporation’s presence in the water market.