Fortive Corporation (FTV) Earnings Call Transcript & Summary

Good afternoon, and welcome back to Day 2 of Morgan Stanley's Laguna Conference. I'm Josh Pokrzywinski, the firm's multi-industry analyst. Joining me from Fortive today is Chairman and CEO, Jim Lico. Before we get started, I just have to read a quick disclaimer. Please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect. For important disclosures, please reach out to the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please contact your Morgan Stanley sales representative. With that, Jim, welcome. I appreciate you taking the time. Not quite the same scenery as we have in Laguna. And unfortunately, for you on the West Coast, some of the fire part as well. So hopefully, everyone is staying safe and healthy there in HQ. But glad to have you all the same.

Josh, great to be here, and thanks so much for the time. Appreciate the -- as well the concern. Obviously, we're in a good place. Everyone's safe, which is, I think, the first question that we always have. I think we've had a lot going on here this year. And certainly, with what we've announced here over the last couple of weeks and certainly what we've put out yesterday, I think, is really a great opportunity for us to have a conversation. I think what, yes, what we said, if people haven't seen it yesterday, we've put out, that we would be effectuating the spin with Vontier on October 9. And so I think we're in the very final innings of completing that. And I think it's just a testament to the hard work. It was just about a year ago that we announced that we would be separating the business. And so to have real clarity here around what we're doing and be able to do that with -- despite some of the obvious challenges of working from home and all that, to be able to do that, we feel really good about it. And we feel really good about the future of the -- both businesses. And obviously, that's what we'll talk about.

Excellent. So before we dive into it on the business side, maybe just to make sure everyone's kind of on the same page in terms of the strategic thinking in terms of the pivot from this IPO exchange structure, which I think was plan a, into the spin and how much of that was kind of a change of heart on looking at capital markets versus maybe kind of the path of most certainty. So anything that informed that and how people should expect that to go from here, knowing that there's still maybe a stub left?

Yes. I think what we always said when we announced it a year ago is that we were fundamentally flexible in the sort of ways we could effectuate the change. I think where we were going down the path of the IPO was, in fact, it was a faster way to do it, right? With only spinning the IPO, we could -- we wouldn't need a full Board. We wouldn't need a lot. We could do a lot more on TSA, a lot more flexibility. Obviously, with what was going on with the markets at that time, we couldn't do that kind of change. Certainly, through that time period, we got a lot of those things done and people hired and all that. And so we're very much in a situation where we could do the kind of spin. So I think markets still are not at the level of certainty that we would necessarily like to do the kind of IPO. You need months of certainty in order to do something like that. And we feel really good about the retained stake spin that we talked about, where we'll spin roughly 80% of this with a retained stake. We feel the obvious places that this -- it certainly effectuates the change but, at the same time, gives us great flexibility from a financial perspective in which to really take -- move forward.

And then I guess on the remaining piece that you'll have after the initial spin, is there a time line you're thinking about for monetizing that? And what forms could that take, understanding that it's not cut and dry in terms of, hey, we'll -- a year from now, we'll just sell down the rest?

Yes. I think we have lots of flexibility. We're going to do what's right for everyone involved. I'm always reminded that these choices were obviously about making sure that we could have a tax-free sort of structures here going forward. But we've got lots of flexibility. We're not going to -- we've got about 12 months to do this, and we'll do it in a patient way that manages both the construct of what is there for shareholders but, at the same time, puts us in a financial situation that I think we're going to be in really good shape as -- after we get -- as we sell down the remaining part of our stake.

Got it. And then I guess what does -- what is the timing of cash inflows, whatever those may look like? Obviously, there'll be some debt offload and capitalization of Vontier initially. But what's the strategic vision and maybe the time line of returning to M&A for RemainCo Fortive? You guys should be in a good position sooner than later. But obviously, that requires a pipeline. That requires people focused on it as well if nothing happens in a vacuum.

Yes. I think what we've always said, we never take a day off on M&A no matter what the situation is. And I think if we harken back to the beginning of the year, we always said that this was going to probably be more of a bolt-on-like year anyway because of all the work we've done in '19. So we've really continued to cultivate. We've continued to do market work. We've really not slowed down in any way, shape or form because we know that, that's a consistent process that needs to be resourced and done over time. And certainly, our decades of time at Danaher, certainly we learned those valuable lessons over a long period of time. So I think we're in a very good place. We've certainly continued to look at things. We've not done some things that we thought weren't as value-creating as we would like. So I think we feel very good about where we're at. We'll be at about 2x leverage as we come out. After effectuating the remaining stake, we'll be much below that, probably closer to 1. So I think when you look at kind of our capacity, we're in a very good position futuristically in terms of where to -- or how to deploy M&A. And I think we've got lots of ideas and work to do or work that's done. So I feel very good about opportunities. Obviously, those ebb and flow over time with how opportunities become available. But we feel very good about our position to really be able -- both our financial position and our strategic position in which to do things.

And then I guess just on the strategic side because a lot's changed in Fortive, obviously not just the spin but prior to that with some of the other assets moving around relative to when you were separated out from Danaher. For the remaining business, what does a prospective Fortive business look like? There's been a high focus on recurring revenue. There's been some software deals in there. Some of those software deals have a natural partner inside of Fortive. Some of them are a bit more standalone. I think it's kind of gotten to the point where very few things would surprise people unless you guys bought an ice cream company. Well, like what -- with kind of the more focused approach, what would be right in your power alleys? And how would you identify kind of the nearest focuses for the coming months?

Well, who doesn't like ice cream? But that's probably unlike...

I hear they break a lot.

I think at the end of the day, what we've -- what we're going to see in new Fortive is this strong focus on connected workflows and really that taking the hardware advantage that we have and fundamentally the work we're doing with customers to be more pervasive in that workflow. As you mentioned, it means more recurring revenue. It means a more durable and resilient business model. It means higher gross margins. There's lots of financial aspects that we benefit from, certainly strong free cash flow. But I think at the end of the day, what you'll see as we come out and we bring out, which is likely 3 segments, we'll see within those segments the real vision of how we can participate in those workflows with the businesses we have today but also new ideas. Like you said, with independent businesses that are going to be a great -- they're going to find a great place in new Fortive.

And then I guess within that, there's still some latent cyclicality that is not necessarily a bad thing, certainly not now, as we lift off the bottom. And maybe one of the bigger surprises for folks, thinking back to the first half of '19 when there were some macro agita that, hey, is there -- this is still a high-quality business, but PMIs are PMIs. Is there any more of an idea to try to further shed that? Or is there growth or cultivation around the existing portfolio to say, look, we'll own the cyclicality we have, but we'll try to make it?

Yes. Well, I think we're always trying to make cyclicality better is a natural element of the work we do strategically, both organically and inorganically. And I think we've seen that. We're certainly over -- better than half the cyclicality we were back in the last economic downturn. COVID's got its own unique aspects, which are unusual. But I think at the end of the day, that continued effort around reducing cyclicality is very much a strategic intent of all of our businesses, whether they're in the software businesses they're in today or they're a sensor business in the verticals that they play in, and taking advantage of IoT and some of the real pervasive secular trends. So I think you'll see a continued evolution organically around that work, for sure, which will continue to improve. And I think we tried to outline the groups in our last earnings call -- or last couple of earnings calls to give people perspective of where we've come. Almost all of those Group 1 businesses were not part of Fortive 4 years ago. So if you start to think about capital deployed and what we can do over the next 4 to 5 years, you're certainly going to see a much more pervasive and bigger part of the portfolio be in that Group 1. And then the organic and -- so the combination of organic and inorganic work, I think, really continues to transform the portfolio. And I think we're really excited about it, and we're excited about telling that story here in the weeks and months to come. Today is really a starting point for that, but we think people will see more and more of that as we get out there and talk about Fortive.

Right. And I guess here in the near term, obviously, things are firming up a little bit for you. You put out the update on that last week. I think for a lot of folks, seeing kind of a firmer environment in the Vontier side, especially retail fueling, not as surprising given what's going on in the EMV world. But perhaps on the PI side, where you're also seeing a lot of strength, can you talk about some of the positive surprises there either relative to the 4 buckets or perhaps some end markets that have come back a little stronger?

Yes. Yes. I mean I think with the sort of 0 to down 3 kind of conversation that we had in the 8-K that we put out, that's certainly better than we originally thought. It's really a couple of places. And you mentioned it, so a little bit of color. Certainly in that group 4, where Tek instruments and Fluke instruments sit today, certainly better. And I think what we've seen is progressively through July, August, we saw better improvement in those businesses than we thought. The good news on that story is we don't believe that it's inventory. We're looking at point of sale. We're looking at selling out. We're looking at inventory trends. And here, as we can see today with pretty good view, particularly in the U.S. and Europe, we feel pretty good about that, that improvement is natural demand as opposed to any inventory build. And that was -- that's probably the story on the PI side for sure. The group 1 businesses remained resilient. ASP got a little bit better, too. So elective surgeries came back a little bit better in the U.S. and Europe, a little bit better capital even in places like China. So a little bit better. And that's probably the combination of Professional Instrumentation coming back. And then certainly, as you mentioned on the Vontier, what will be Vontier side, certainly businesses like Matco came back better than we thought. We knew Gilbarco would come back given the natural aspects of that. But I think what we've got now is we're seeing Matco. And Matco had historically been a resilient business, and we're certainly -- we certainly are seeing that in the third quarter.

Got it. And I guess thinking over the next, I don't know, 12, 18 months, we'll call it, beyond kind of the initial phases of recovery, I guess 2 things strike me. First. 2019 wasn't really a banner year for many industrial markets, right? I mean you guys certainly saw some slowdown in those group 4 pieces. And more of what you do is not heavy CapEx. There is large recurring revenue. It's kind of the cost of doing business. Should we expect to get kind of organically back to 2019 levels in PI kind of within the next 12, 18 months, just seeing kind of the liftoff in some of those groupings you see today?

Well, I think with 2 months of data here, it's a little early to sort of think about what it's going to be overall. Well, certainly, if you were to play out the trajectories here. But it's pretty early to call a recovery at this point. I think what we're -- so what are we watching, right? We're really watching -- we're watching elective surgeries. We're watching PMI. We're certainly watching the second wave of -- or third wave -- I'm not sure what wave of COVID we're in at this point and the impact to that. But I think what we're certainly watching is to what that impact will be here in the coming months as we start to get into cold and flu season. So I think those are things we're watching to really understand kind of will we see PMIs continue to get better as we've seen here a little bit. Will we start to see -- and we do have some capital in the business. Obviously, part -- small part of ASP is capital. That's really the hospital network. Some higher-end parts of Tektronix on the oscilloscope side are also that way. So I think when you play that out. But I think certainly, as we get to the tail end of the year, we'll have more data. I think we'll have a better sense of '21. I think where -- what Chuck and I have been trying to do is really make sure our businesses are positioned for a few different scenarios so that -- at this point so that we're -- we can deliver on the kinds of things we want to do, make sure we can invest, make sure we protect free cash flow, all the things we've been doing this year. And we're doing that still in a scenario analysis as we start to see some of the data trends that obviously we're all watching.

Right. Right. And then I guess within some of that scenario planning, clearly there's a cost backdrop as well. I think you guys have said in the past that you kind of manage decrementals to that 35% rate. Obviously, you did a little bit better initially. How are you thinking about, as demand starts to flatten out, what that looks like being? Do you have a period where you underperform that on the upside as temporary costs come back? In a flat to V environment, does EBITDA go up? How are you thinking about kind of that transition back into growth?

Yes. I think that 35% remains a pretty good guideline for us. It may ebb and flow between a quarter or so. Obviously, as you pointed out, it was a little bit better in the second quarter because revenue came back a little bit more than we thought in the short run, and we had taken some steps, primarily temporary steps, that were impacting us to the good. You may see that for a quarter or so on the other side if, in fact, it comes back -- doesn't come back the way we think. But I think we've been conservative in making sure that we're not putting anything back in businesses until we have trajectories that we're pretty confident in. I think at the end of the day, again, come back to 35%. We like that 35% number. I think it's -- it really holds true for the way we think about investment. As you'll recall, as I know you know and we've talked to you about, we really are also trying to play offense in a lot of places here, and not just in those group 1 businesses but even in some of the businesses like Fluke and Tek where they may see some shortfall. We also know there are some places where we have some real opportunity, and we want to make sure that we fund some of those things. So I think on balance, if we use that 35%, we'll -- we may get better. It might be -- it might vary a little bit in a quarter or so, but I think for a full year basis, that's a good number for us to continue to manage to.

Got it. And then you mentioned what the recovery wasn't and that it wasn't inventory, which I think you did have some destocking that you endured, especially in 2019. Your sense? Is that something that's on the come? Or are distributors just saying, no, I'm good this time, I don't need to restock? I think everyone says that, but they're kind of lying to themselves.