Fortive Corporation (FTV) Earnings Call Transcript & Summary

All right. There we go.

Hey, John.

All right. Good morning once again, everyone, and welcome to the 8th Annual Credit Suisse Industrial Conference. We're very excited to have Fortive with us today. During the fireside, we have Jim Lico, Fortive's CEO; and Chuck McLaughlin, Fortive's CFO. And I believe we're going to be heading straight into Q&A. So why don't I kick it off?

And we've been giving every company an opportunity, if they'd like to make any kind of comments about what they're seeing thus far through the fourth quarter. If I remember correctly, you had a top line guide of flat to up 3%, with about 35% incremental margin. And with that, I'll just pass the floor over to Jim.

Thanks, John. It's great to be with you. Chuck and I appreciate the opportunity to be in front of everyone, particularly in this environment. First, I hope everyone is safe and healthy. Obviously been a principal focus for us as we've continued to work in this environment. I think as you said, we -- I think we feel very good about where we're at right now. As you mentioned some of the numbers, I think Q4 is largely playing out as we expected. So I don't think any real change there. December is always a big month, and we're -- as always, as we see customers wanting to do things at the end of the year in many ways in a number of our businesses. We're watching COVID closely around the world as we continue to see how things play out, particularly as we start to think about what the launch point for 2021 will look like. So we feel very good about where we're at, I think, is the bottom line.

Great. And then, obviously, an additional congratulations on getting the separation complete here. One of the questions we still get, right, post separation of Vontier is kind of how to think about Fortive going forward, kind of where are the key areas you really want to focus on. And a lot of times, that often leads into, as we think about you redeploying capital. What kind of -- maybe I'll just -- I'll leave it there. And we do get a lot of questions around software and where your ultimate end aspirations are in terms of software. I guess, today, it's 12% to 13% of the mix, but I'll just kick the question back over to you, gentlemen.

Yes. Sure. Thanks. I think, first, I think we feel very good about the Vontier separation. A lot of work in 2020 to get it done, but we feel very good about it. We know Mark and Dave and the team will do a wonderful job as we go forward. I think as you sit here today, and we can talk a little bit more deeply about the segments. So I won't talk deeply about each segment yet. But I'd say if we look through the 3 segments that we now have, we certainly, first and foremost, focus on the workflows that exist in those. And I would say, when we think about the question of already becoming a software company, I think, fundamentally, it's first and foremost about are we taking care of customers and are we helping them with the challenges they have in the next decade? And I think that brings into bear software. So we take and we look at these workflows that we participated in many -- in some cases, for 50 to 60 years, where we have tremendous customer relationships and deep domain expertise. We see the opportunity to bring software into those solution sets and those workflows in order to be a bigger part of the customer solution. And fundamentally, what that brings us to the fact that software gives us a better gauge -- or gives us more data, and with that, gives us more ability for data and analytics solutions, which ultimately can give customers answers faster and bring us into a position where we think we're in a much better shape from just a customer relationship standpoint. So I would say, first, we're following our customers. We're listening to their needs, and we're dealing with those challenges and industries that we've been in for decades. And I think that brings us to the transformation of the company through bringing digital solutions. We're incredibly excited about it because we're in such early days of that -- those opportunities.

Great. Maybe just thinking about a little further on that question. So a lot of where the M&A dollars have been focused is around some of these software assets you've acquired to kind of follow the customers, as you've said. I think, post Vontier, one of the things that we noticed is that you do end up in a much or in a very attractive leverage position on a net basis, but part of that delevering does require the monetization of Vontier. Is that a gating factor for you as you think about your pipeline and the ability to get something across the finish line? Or should we not think that the actual monetization is a gating factor?

John, I'll take that. I think it's the second question, it's not a gating factor, I'd say, at all. I think there's a defined period where we'll monetize that, and it's not impinging anything we're looking at and really hasn't been for most of this year.

Great. I guess, maybe before we kind of go into some of the larger, more traditional businesses that we talk about with Fortive, I wanted to focus and help people maybe understand this net retention ratio that you've been talking about relating to your SaaS businesses on the earnings calls. And maybe first, you can define that metric for us, and then I have a couple of follow-ups around what you're seeing in that calculation.

Yes. Sure. So I think first and foremost, maybe if I just step back and maybe to one of your previous questions around how we think about solutions and workflows. I think what we've tried to do over the last 4 or 5 years is to really -- let's take one example like what we've done at Fluke. Fluke, traditionally, an instrumentation player, decades -- over 70 years of heritage. What we've done with that business through the addition of our Fluke reliability solutions with eMaint software is really help us build a better, more recurring revenue business at Fluke and a great advantage there, bring it -- make it -- help it become more growth year over time. As I said, give us a deeper set of solutions in which to work with customers with, and I think, fundamentally, gives us this ability to sort of have more than sort of a one-off relationship with customers, right? We sell test equipment to them. Now we sell them a solution, right? We sell them software. We have an annual recurring revenue relationship with them, and that brings me to the equation because I think that's -- it's really important. We start with, to get to that net retention number, which I think is as important a metric as you'll find in most software businesses is, first, it starts with our starting point of annual recurring revenue. One is the SaaS contracts add up to in dollars. We subtract churn from that. So customers that would have left us in a period of time. As we talked in the quarter -- we talk about it very often, both quarterly and year-to-date because you're going to have some movement in a quarter, but fundamentally, the year-to-date number is an important metric as well. So you subtract the churn. You add pricing. You add upselling, and you add cross-selling. So in some cases, you're always developing new features in which to upsell people to. And in the case of where you have multiple offerings, you're cross-selling, right? And that probably plays out like in an occurrent where we have a number of point solutions where we go in with one set of solutions, but we have the ability to then sell other solutions over time. So that's the equation. The equation itself, over 100%, is a good number. We continue -- and we have a variation of those numbers, obviously. But a good number, over 100%, means you're going to start the year at 100% plus of revenue, and then you're going to grow off that base. And so fundamentally, if you're at 102%, 105%, you're fundamentally starting as an example with 5% growth if you were at 105%, and then you move on from there. So anyway, that's the metric itself and how we think about it. And we look at it -- obviously, we look at it and talk to people about it as Fortive, but we also look at it in each business as well.

Yes. And so I guess the follow-up to that, right, I mean, having lived through Q2, which was arguably probably the trough in one of the worst quarters we've seen, you still grew that ratio. So I guess, if I think about what goes into that ratio, either -- or maybe it's your -- what you're offering the customer is incredibly important, so they're not going to turn off that subscription or they actually decided to say, hey, we need more productivity. We need those additional features. So I'm just curious what you've seen over the last couple of quarters from customers is, is that ratio really being driven by the pricing and the cross-selling? Or is it being driven by that churn is actually happening and/or staying relatively stable?

So over the long term, we want to drive that number more through upselling and cross-selling. So I think, fundamentally, we think about that over the course of several years -- when we do strategic plans, we think about moving that number more long term with cross-selling and upselling. I think in the near term, there's a couple of things. One is the numbers don't move around as much in the near term. That's the benefit of those businesses. They're durable. They don't go up superfast in a short period of time because you're amortizing that revenue over a longer period of time, not a onetime sale. But I think what we've seen in those businesses where we've been able to really make sure that number has been good has really been on the churn side. We have a lot of Fortive Business System tools that are really addressing churn and really -- intuitively, they're really a benefit of our problem-solving tools and how we think about our customer success playbook. So we can work on the churn side. I would say during COVID, as we pushed through the year, early days, we were not in front of customers as much. We were trying to -- as customers were moving to work-from-home, and we were trying to ramp our virtual selling capability, I would say the cross-selling and upselling didn't happen as much during the second and third quarter. I think what the teams have done is an exceptional job over the last few months of really ramping, not only our selling capability, but also our setup capability, our remote service capability as well as doing things like user conferences virtually and where it would really help us benefit from those metrics over time. So the long story short is, on the numbers continuing to improve through the year, thus far, has mostly been a story of working on churn. Although in some of the businesses like Intelex as an example, eMaint, we've seen -- we've still been able to do a nice job, I think, in upselling, as an example.

You're muted, John.

Right. You touched on it a little bit in your answer there, but I remember when you did Gordian and Accruent, right, they obviously didn't both happen on top of each other, and we were all trying to figure out how do these fit together with what you were trying to do with -- around the portfolio? And one of the things that struck me I remember at one of the trade shows is, when you think about your competitors in this set, they really are offering that kind of point solution, whereas when you put together a couple of these different assets, to your point, you start offering a solution. And so you have some decent competitors in that space around what Gordian and Accruent are doing, but I think that's really what differentiates the business. But maybe you can help me, is that correct? And do you have any examples there to kind of actually hammer at home?

Yes. I think there's a couple of things. One is -- I think you're exactly right. What we saw when we bought both of those businesses was the challenge of facility owners to really understanding a variety of challenges that they have in the world. Gordian really works on the sort of small project phase of the business because there will -- the real strategic advantage is network effect that they have around cost data and the cost data, their RSMeans business, really gives them an ability to help contractors -- merely contractors with facilities managers who are doing upgrades to buildings and facilities. It gives them that sort of cost estimating capability in which to manage their cost for projects, and it comes with project management skills, the job order contracting business that exists at Gordian just is very -- it's really sort of an upsell, if you will, to the RSMeans, right? RSMeans we're providing cost data in the job order contracting business. We're really providing the whole solution, right? We're mirroring contractors and facilities managers to help them really get those projects up and running and do them at the best cost. That led us to some thought processes around the continued challenges that exist with facilities managers, and that's where Accruent is with a variety of solutions. What we've been at really mostly today is really helping those businesses really benefit them -- really take advantage of the opportunities within the businesses they have. Today, Accruent has mostly been a point -- set of point solutions. But over the last couple of years, we've done a nice job of helping. They were already on a path to working through cross-selling, being able to take advantage of the data. There's some technology advantages that -- we've launched our second version of Accruent analytics as an example, to take advantage of people who have more than one solution. And so we're in the very early days of both of those businesses of really helping them take advantage of the solutions they have within themselves to really leverage that. And then as you said, certainly, over time, it's slightly different customer bases, but there are places where we have an opportunity to work together, and we're starting that work very much so today.

Great. Maybe shifting gears over to the new segmentation. Definitely appreciate that. Our models are now in better working order. But when you look forward, right, where do you see kind of the greatest, maybe, margin opportunities is where I'd like to start? Because, right now, you've kind of -- I'll just leave it there at that.

Well, I think -- we'll tag team this a little bit, too. I think, first and foremost, we feel the margin opportunities exist in all 3. So whenever we think of -- I mean, that's our mindset. I think first and foremost, for those who are new to us, our mindset is never to look at any of our businesses and say there isn't huge opportunity for improvement. That's decades of thought process that exists throughout the company. So I think first and foremost, we start there with each segment. I think the benefit of the segments is, obviously, you see the benefit of some transformation, iOS being in a very good place relative to maybe the margin structure versus maybe a couple of other places, particularly in the gross margin opportunity. And so you see -- even though the margins are high, the opportunity is also remains high there. But I would say we have equal margin opportunity throughout the segment.

Yes. And I think as you see the top line recover in a couple of the places, like Precision Technologies is maybe a little bit more impacted than where we've got the new acquisitions, that's going to rebound in the near term. But as Jim said, all 3 of these segments will and have delivered operating margin expansion, and we would expect that to continue going forward.

Yes. And so I guess, when we think about what you laid out here as the new gross profit margin of the company, right? You probably know exactly where this question is going.

Yes.

But you historically talked about these 35%, 40-ish percent incrementals. How should we think about them going forward? I mean, it's the same kind of collection of assets largely as your prior segmentation, but it just seems like the incremental margin opportunity is higher now that we get that GP line of these businesses.

Well, historically, we used to say 30% to 35%. For 2021, where we're saying because of the temporary costs coming back, that 35% is how we're going to manage the business going forward. The biggest variable is the top line, and that's what we're not ready to give yet. But I think what you're asking is when you get to the other side of that, we do expect it to be higher. And I think that -- we'll wait until we get there, but I can see where your going with our high 50s in gross margin. We're very pleased with the profitability and the margin expansion possibilities we have.

Maybe coming at it also a different way, too, here is just the R&D intensity, right, ex-Vontier, I mean, Vontier had a pretty good R&D percentage of sales themselves. I mean, do you see anything fundamentally really changing for Fortive from that perspective? Does it need to tick up higher as a percent of sales, as a high single-digit range, mid single-digit range? How do you think about that?

Yes. Well, I think first and foremost, I think we've always had a successful innovation agenda here in Fortive. And even really going back to the Danaher days, we may not have spent -- the whole separation belief was more inorganic than organic. We were continuing to, I think, invest in technology to make sure we can continue to create opportunities for the businesses. We'll continue to do that. I suspect as software becomes a higher percentage, our software business, obviously, have a higher percentage of R&D. That number will tick up a little bit as software -- as you said before, software is in the teens now. As that number obviously continues to grow and gets into the 20s and 30s at some point in time, you're going to probably see a little bit of a higher R&D percentage, but that'll be more of a -- less of a decision taken in any individual business than just as the mix improves. As gross margins improve, you would expect some of that to go towards a little bit more R&D just by nature of how those business structures exist. But obviously, with it also comes at better profitability and significantly better cash flow.

And John, keep in mind that with separation, we're probably north of 6.5% in total. And as Jim mentioned, those dynamics start pushing towards 7%. And again, it's not because we're underfunded, it's just that as -- we look at it business by business, but that's -- we feel -- and we know that's a very healthy R&D investment in innovation. We'll continue that.

Great. And maybe just thinking a little bit about the top line. I mean, we have the historical data. We can see that Fluke and Tek do track IP pretty nicely, right? No surprise. Do you see anything changing this cycle? Or would you kind of expect those businesses to track the IP recovery as we move through next year?

Yes. I think what we've seen -- if we look -- think about 2020 and maybe we look back over time, certainly, those businesses have tracked IP less so than a while ago. As we think about what we've done in those businesses, at Tek, it's been really a focused strategy around end markets and customers and how to really go after businesses that are less cyclical -- or opportunities that are less cyclical. And we put the service business -- we've really built up the service business. So now where that sits today is a more durable business. And we'll continue to focus on making that business more durable. I think the Tektronix team did a wonderful job as an example during the strategic plan this year of articulating that over the next several years. I think relative to Fluke, we've done the same thing, probably even more aggressively because of the M&A side of what we've attached to Fluke. A little bit unfair of Fluke in some respects because we've moved the Fluke health business, which is now a quarter of a billion health care business into health care. So when we think about Fluke today, that sits in iOS, we'd say, yes, it tracks with industrial production, but also that's ex health care. So I think what we've seen with Fluke is an incredible ability to build on the strength of the brand, and to wish to continue to build on that business with. If you think of what we've done over a couple of decades here as we've quadrupled the size of the business and even more so on the profitability side through continued work, and I think that'll continue. So I think we'll continue to be less tied to that number as well over time. And certainly, Fortive will be the beneficiary of that, even if Fluke, individually, isn't in terms of how the context of how we talk about it within the segment. Obviously, when a Fluke health business is in, Fortive is getting that -- a tremendous benefit from that for sure.

Great. And I guess maybe one business that now we're going to get a little bit more granularity around it is kind of the sensing portfolio. And maybe that's something in our view that's been a little bit underappreciated within Fortive. We've had so much focus on Fluke and Tek, but maybe you could just give us a little bit of kind of what actually sits in there and kind of why you guys are excited about that platform?

Yes. I think, I think -- go ahead. No, I'm sorry. I was just -- I think you were going to go with sizable, right? I mean, it's a sizable part of Precision Technologies. So -- and I think at the end of the day, if I were to articulate -- this is the starting points of Danaher, right, from having been around for a quarter of a century now. In my time, those were early days businesses. We have very -- I think I would characterize our Sensing platform as wonderful niche positions in terms of several segments, whether it's in pressure Sensing or flow and some of those things. But in niche applications, our Anderson-Negele business as an example, has an incredible position in dairy and in sanitary markets, some of the things like biopharma, things like that. So when we look across the board in Sensing Tech, I think what we probably underappreciated about it -- historically, run those businesses -- haven't acquired much, mostly run them for organic opportunities. We've accelerated, I think, a number of IoT investments. We've talked a little bit about some of our growth accelerator work that we've done relative to new stage innovation, early stage innovation. Our Sensing Tech platform has done a wonderful job of creating some new business opportunities that are very early days. As an example, at Anderson, we now have a -- we make a chart recorder. We now have a digital process recorder that really does more than that. It has a software application to it. So I think we're continuing to see those opportunities. In our Setra business, we've gone into environmental monitoring, which is a really good high-growth part of their business. Still small, but we find those opportunities through innovation and what we've done based on the backs of really IoT enablement, if you will, and thinking about that as we're either a sensor or a controller in these niche markets, but we see the opportunity to add on features and add on solutions to those businesses. So I think it's a story to still be told. As we continue to pivot those businesses, they haven't historically been high growth. They've been very profitable. And we think there is opportunity to accelerate the growth path there with them as they continue to see some of the investments they've made in IoT start to get the benefits of those in the years to come.

Great. And then, I guess, maybe another question just thinking about, and maybe this should have been earlier here in the list, but now that you've separated, we have the new financials kind of. What's the top 2 priorities, right, for you right now? And maybe I'll leave it there.

Yes. I think what we've certainly seen across -- I would say -- I'll give you 3. You asked for 2. I would say, number one, is to continue to build the innovation capability and -- around what we think the opportunity is around data. We have a -- we set up the 4 -- our data -- our centralized sort of data analytics organization, we're really -- we made considerable investments in those. We're seeing high returns in some of those projects, and we think we can continue to leverage that capability. We're still in the very early days of those opportunities within the business. So I'd say, across the businesses, we certainly see the opportunities for us to really add that capability into our businesses both on an early stage innovation capability and leveraging the data that we create in all of our businesses, which still, today, are primarily hardware, right? So I think that's number one. That goes across the board in Fortive. I would say we're certainly incredibly excited about the workflows that we've got in iOS. We talk about EH&S. We've talked about facilities and management. Those 2 places -- those workflows are incredible opportunities. We certainly think that infection prevention and what we do around sterilization in the health care side is an incredible, very early days opportunity. Again, another workflow that we think is really a place where our combination of ASP and senses can really add considerable value. And then there's untapped opportunity, like we talked about in Sensing and in -- at Tek, but those are still very early days. So I go back to those first 3 because we've made considerable investments in those places already. We see the benefits of those opportunities, and we think there's real scale capability to continue to build both organically and inorganically within those workflows.

And I guess, thinking about the pricing part of the equation, I remember in 2019, there were a couple of quarters, the old PI segment. You got asked questions around pricing. You've been pretty stable here at about 100 basis points, a little bit above better to pricing year-over-year. Is that the normal we should expect? Is that the right range, about 100 basis points of price? Or should we think of something different?

John, I think 50 basis points is historically more where we've been. That doesn't mean that we won't continue to see quarters where it'll go up to 100. Some of what you see on that 100 is, remember, we were still trying to counteract some of the impacts of the tariffs, and I think that'll continue. But 50 is probably a better number.

Got you. Fair. And then, I guess, when you think about the EHS opportunity, obviously, when you acquired that business, it might not have gotten as much attention from investors, but it really does feel like there's an opportunity here where you can almost go from just cataloging these events to actually maybe, I don't know, helping do some preventive around having these events actually happen. I mean, is this something we could start to hear more about in the future? It's just seems like a very interesting opportunity within that space. And obviously, you have an entitlement to play there given your customer set.

Yes. We -- first of all, I think we've always had a sort of safety mantra because a lot of what we've been doing for decades at Fluke is really around electrical safety. So we've always had that sort of bias for understanding the safety challenges in facilities, both industrial and commercial. It's been a long-standing thesis for us, if you will. We were incredibly excited to bring industrial scientific into our business because they were 100% safety, right? Gas detection and the iNet solution is really about a recurring relationship with customers around safety and really understanding the needs of safety. That led us to the acquisitions of Intelex and SAFER Systems, which just broadened our capability. And now we have well over $0.25 billion of opportunity here in the business we have today, really, and what we've built since the time of the start of Fortive. So that gives us a much greater opportunity. We've recently acquired an artificial intelligence capability, very small business, but a great capability to do exactly what you just described, which is to not only have the software solutions, but to build on the data from an environmental perspective, to really give people the opportunity to do predictive work. We had some predictive capability, a predictive analytics business that was small at ISC. This just builds on our capability to do predictive work to help customers really leverage the safety and environmental data they have today, to harness that data into not just sort of compliance, but also thinking predictably about how we can prevent injuries. And I think we're in the very early days of that, but we think it's an incredibly exciting opportunity. It's got great secular drivers. And obviously, COVID has only made health and safety an even bigger issue for companies today. And certainly, ESG initiatives have made the regulatory side of this also more important, the reporting side of this, all of those wonderful dynamics play into the ability to grow that business over time.

Great. Well, I'm just looking at the clock here. I would like to thank both of you gentlemen for joining us. Hopefully, we're back to Florida next year, but I would like to extend my appreciation. And then I don't know if there's any closing remarks you'd like to make. Otherwise, I would just like to say thank you and be well.

John, maybe we'll just echo, Chuck and I, appreciate the time and good to see you even if it's on video. I know we'll have an opportunity to see a bunch of investors. But to all of our investors, stay healthy, stay safe, and we'll hopefully see in 2021. Thanks.

Thank you.

Great. Thank you.