Fortive Corporation (FTV) Earnings Call Transcript & Summary

Hi. Good morning. I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for day 3 of our 9th annual Laguna conference, still virtual this year, in-person next year, I promise. And for people who've heard me say 15 times over the last few days, that's how serious I am. So I'm doing that out of my hotel room regardless. Joining me for our next fireside chat, I have the team from Fortive, President and CEO, Jim Lico; and Senior Vice President and CFO, Chuck McLaughlin. Guys, thanks for making the time this morning. I know it's still fairly early out on the West Coast. Before we dive in, I do have a quick disclaimer I need to let folks know about for any questions about our research disclosure, please visit the appropriate website at morganstanley.com/researchdisclosures. And for all other questions, please reach out to your Morgan Stanley salesperson. With that, Jim, Chuck, thanks for joining us. Jim, if you want to just dive in and kind of let us know what you guys are working on, thinking about, what you see out there in the world, and we'll jump into Q&A after that.

Yes. Thanks, Josh. And we're on West Coast time, but of course, the conference was going to be on West Coast time. So only appropriate here, as Chuck and I sit here in Washington. First, I just want to thank everyone for joining us today. Always good to be with everyone even if it's virtual, to have an opportunity to talk about everything going on at Fortive. I'll keep my prepared remarks hereto somewhat limited. Maybe just to start with, I think maybe to reiterate a couple of the things that we saw at the investor conference, we'll certainly get into some of the details here, I'm sure, as we -- through the course of conversation. But what we tried to do in May is really build a construct for what the future of Fortive would look like. And I think as we seen here today, we've done -- we've really taken some nice steps forward even from our investor conference in May. I think Fortive maybe remains a little bit new, the new Fortive because of our -- the amount of transformation we've done over the last several years. Now sitting here with 3 segments, I think what we tried to -- I think what we described in May was all 3 segments, well positioned for growth and earnings and significant free cash flow and the ability to continue to leverage the balance sheet. We've got the best balance sheet we've had since we came out, certainly the opportunity to do that to use M&A to strategically advance our businesses at an accelerated pace. What you've seen from them, I think, is very much that. We overdelivered in the second quarter despite some challenging supply chain environments. And through the course of that, I think we demonstrated the power of FBS. We also announced early in July, the ServiceChannel acquisition, really a great addition, I mean, that next chess piece to our facilities management software business, along with Gordian and Accruent, which we give now gives us a tremendous advantage, I think, in the marketplace to take advantage of the great secular drivers there. So I think we outlined in May as well, the power of FBS throughout the portfolio. And we remain incredibly excited about how FBS is really adding value into these new businesses here. We've closed ServiceChannel. We did that a few weeks ago. We now have now have the ServiceChannel team as part of us. We're running hard into the integration process, bringing them up to speed on the tools of FBS and those kinds of things that happen in our 100 -- first 100 days of an acquisition. So I think we're off to a great start. As you mentioned, I'm sure we'll get into it. The topic du jour recently has been the supply chain environment. And I'll speak to that maybe in a little bit in more detail, but we remain diligent in everything we're doing. And I would say the demand -- demand is good right now. So the supply chain challenges are out there, certainly talked about them in our second quarter call. But we certainly are -- part of that as a very good demand environment, which we feel good about going forward. So we're in a great position relative to, I think, where we've been at the start of the year with the 3 segments moving forward with new Fortive. And we're looking forward to having an opportunity here for the next 25 or so minutes to give you a little bit of a deeper dive into the things that are important.

Awesome. Thanks, Jim. Appreciate that. I definitely want to save some time for the supply chain discussion because it's so topical today. But maybe just to start off, because there have been so many changes in Fortive over the past few years on the portfolio side, is the major focus today kind of keeping the flywheel going on the M&A side? I mean we've kind of come through the works of the pandemic, we've seen I think of those 4 kind of tiers of impact from COVID on -- across your lines of business. A lot of the more impacted ones have started to recover. You've reflated the cost base. ServiceChannel would suggest you guys are getting back and in on the M&A. Is that the main focus today? Or are there other things that are sort of dominating your time as well?

Well, I think certainly, now with the 3 segments that we have today and maybe just real quick on the 3 segments, when you look at Intelligent Operating Solutions, incredibly well positioned to help facilities managers and maintenance managers deal with the future challenges of what they have to deal with. Our Precision Technologies are really a set of sensors and instrumentation, focus on advancing our customers' ability to want to bring technology into their own markets. And then finally, in Advanced Health really our ability to help hospitals, really deliver high-quality health care at the lowest cost. So those sort of themes, if you will, and building on those themes, both organically and inorganically really remains the main focus for growth. So we think the organic story, we sort of outlined our new organic growth belief over the next several years, raised our view of that as well. And I think that -- I think we build on the organic base we built or on the inorganic base that we've already acquired. And now we have an incredible ability now to acquire, I think, into those 3 segments to really advance our strategies even more so. So we're busy both delivering on the organic front, but also thinking a lot about the inorganic opportunities as well.

Got it. If I think about 1 kind of centerpiece of the portfolio or a major theme that you guys talked about a lot, workflow solutions is a big piece of that. I think for a lot of folks, maybe contextualizing that is a little harder the way -- relative to, say, like a robot assembling a car. But is this just a different way of saying automation? And when you guys think about the benefits to the customer, is it sort of the same metrics around time and cost avoidance? Like, is that sort of getting to the same equation even though it's not banging a wrench or putting a door on BMW?

Well, I think in a sense, it is automation, but let me give you a little bit of a picture of what that might look like relative to your point. We use the term digital transformation, but I think those are somewhat interchangeable. But we -- I think the workflow strategy is playing out throughout the quarter, but a place where it's been playing out for pretty much the last 5 years is probably the place where I could get to the answer to your question. If we think about this idea of connected reliability, it really started with Fluke and Fluke's ability to bring handheld instrumentation and data, the data that comes from troubleshooting and advance maintenance organization's ability to do preventive and predictive analytics was really only in the data we served. And normally, that data was in, was really literally in spreadsheets and then notebooks around maintenance organizations. By adding eMaint software 5 years ago, now we have a place for that data and an asset tagging ability to add that data to assets. So now, all of a sudden, we've automated, if you will, the ability from that data that used to be on a spreadsheet or a notebook, now it's in the maintenance system. We had PRUFTECHNIK, and now we add additional vibration data, a hardware company, but also with incredible domain expertise around one of the most important modalities. And so now, those solutions now start to integrate over time, independent solutions when we first started, but more and more automating to your point, the maintenance organization's digital workflows. And so I think that's a good example of how those started independent efforts, but more and more every year, we're both organically and inorganically, we're adding to the solution. So fundamentally, we're automating that workflow over time, to your point.

Got it. And then if I think about maybe a more specific application, you touched a little bit about this in your prepared remarks where you're building out a suite, it's Gordian and Accruent, now ServiceChannel. It seems like you have several avenues in this project management, floor space management with the institutional client. I guess, first, how do you think about the overlap or interplay amongst those 3 that says owning all 3 is better than owning a larger version of each one? And then what has sort of attracted you to the space given that you didn't have necessarily a starting point before Gordian and Accruent that would have given you that insider total?

Yes. I think number one, we saw the -- for years, we've known what the -- the maintenance organization being part typically of the broader facilities organization. We've seen that from the Fluke perspective for a number of years, decades really. So we sort of understood the challenges that were existing in the broader set of challenges for facilities managers. That's what led us to Gordian, Accruent, them being in the market ServiceChannel. To your point, to your question, I think where we stand today is an incredible position. Primarily independent solutions, there is overlap in some cases with some customers. But now with the customer base and the -- Gordian really sort of focused on state and local governments. It's really a vertical play around facilities management, if you will, really in that regard. But really, what we do, it -- the business model is very similar to ServiceChannel in the sense of software and a network that provides linking the network of contractors and folks, being able to facilitate the work that goes on between the facilities management organization and the contractors and do that in a seamless way. ServiceChannel has that same sort of solution-based model. So in that sense, the business models are similar. And in the sense of some of the things we do at Accruent. And at ServiceChannel, we're calling on the same customer with somewhat different solutions and different value propositions. But we now -- over time now with this network a bigger network, the ability to facilitate customer conversations to be able to bring new discussions around different data analytics that we can provide through the knowledge that we get through all 3 of those companies is a tremendous opportunity for us. So going forward, we'll see mostly independent businesses running independently, doing great things in their market, driving growth and operating margin expansion. But over time, we'll find those synergies, many of which are -- we know and we'll go after, some we'll work through in more detail through the 100-day plan. But I think in general, we really see a real opportunity around this workflow to really bring the kinds of solutions that are needed for facilities organizations to really drive the kind of productivity and asset life cycle management that they really want to do in the years to come.

Are there any natural kind of overlaps amongst those where that same person also has problems on something like payments or that contractor could use help with lead generation such that you're kind of interweaving common application in there? Again, payments come to mind as something that everyone has to do. But is that something that kind of adds a platform for future M&A?

Yes, there's a number of places. That's exactly right. One would be that we have a Lucernex platform at Accruent that really drives lease management, helps facilities managers manage their entire lease portfolio, driven by some of the accounting regulations a few years ago on leases. And that whole ServiceChannel customer base is open to that sort of solution as well. So just a couple of examples of where we can find, with this breadth of customer base, the ability to sort of cross-sell a number of our other solutions here in a broader way is certainly part of the opportunity.

Got it. So just moving on to kind of the topic of the day, and I think a lot of management teams have described this as whack-a-mole lately. I've heard it, I think, 3 times without prompting over the last 24 hours. Supply chain, whether it's price cost, actually being able to get materials at any price or just the logistics delays on the back end and freight availability. How would you say that's gone from Fortive? Which of them -- those has been sort of the most acute? And how do you see the resolution playing out?

Yes. I think, Josh, we were, I think saw -- we're really proud of the work our team did in the second quarter. We saw demand start to accelerate. Our teams using FBS really did a phenomenal job of really driving and beating our revenue number in the second quarter, right? And we talked about that in the second quarter call. We also talked about the fact that we thought that the supply chain issues were accelerating, and we certainly thought that they would continue through the end of the year for sure. That put us into a mode of making sure that we were prepared as you point out on the price cost side. Our hardware business, as an example, will double their price from the first half to the second half. We'll stay ahead of price cost. We'll still get material cost reductions in total year-on-year. So we'll still have material -- net material cost reductions for the company for the year. We're 40% recurring revenue, and we don't really see the availability or the inflation issues necessarily on the material side and our recurring revenue. So we're in, I think, a good place. That said, the issues are worse in the third quarter than they were -- than they have been all year. We -- it is a daily grind with our supply chain teams. It's more of an availability issue, I would say that. We're certainly seeing inflation, particularly on the logistics side, but we're ahead of that. And so I think it really remains the availability. That is the challenge, and it's really hard work every day. September is a big month for us. We got a lot of work to do between now and the next 3 weeks to get after all this. But to the point of where do you think this ends, I don't think it ends this year. And quite frankly, I think it rolls into next year for sure. How far it goes into next year, I think, it still is a bit of anyone's guess. But I think as long -- the good news is our demand profile is strong, but I think the ability to get things and get it through and get it around the world is the challenge for sure.

Any place that's particularly acute in the portfolio. I remember back in with kind of the heat of the China tariffs that Tektronix had -- was most impacted there. Anything stick out to you in that regard?

Well, certainly, broadly, anywhere where we buy -- where we have a lot of semiconductors is going to be probably -- and electronic components is probably going to be the place. That's more at Fluke and Tek than in other places. I think -- so if I were to just sort of think about it from a commodity perspective, it's going to be where we have a more complex solution or a more complex instrument where we might have multiple semiconductors, where we might have more memory, the various control components. The more complex the componentry, the more likely there's going to be some challenges there.

Got it. And I guess, maybe just sticking with Tek for a moment here. I mean electronics and semiconductor markets are clearly too good for their own good, right? So it's hard to envision supply chain aside kind of a better starting point for tech in that ecosystem. I think we got new a iPhone out as of yesterday or a day or so ago. Clearly, all the semiconductor companies are really busy. What gets better for tech from here? Again, availability supply chain side, like is this sort of the best that market can enjoy?

Well, it is -- we are in a good place. I think you're right. I think we've made some of our own luck with the work we've done, particularly at Tek on the mid-range scopes that are really advancing solutions in places like -- where power is an important thing in the data center market, where all these electronics have to put data somewhere, right? So I think we certainly have advanced our solutions in that regard at Tektronix. We certainly participate more in the semiconductor side, particular in our Keithley product line. And we've seen Keithley do well here in the last several quarters. So yes, I think that remains certainly an opportunity for us. I think the demand profile remains good. Customer conversations remain good. Now we don't participate necessarily on the capital side of manufacturing as much. So as the capacity side comes up, it's a little bit not necessarily where we would play, a little bit more volatile than what we would want as that CapEx cycle moves up and down. But I think at the end of the day, we're going to see more R&D spent in these industries. We're going to see -- and quite frankly, that's going to require more solutions from Tektronix. That's going to bode well for our demand pattern for sure.

Got it. So everything you're seeing today would sort of say this is a business that's sort of shored up its position and kind of earned its right to win in the market and in Fortive.

That's right. I mean it's -- our leadership, we're really proud. We're going to be with that team in a couple of days for their strategic plan. And I, having already seen the plan, I think we're really excited about the things they can do, not just on the hardware side, but now starting to bring more software into the solutions and be able to advance -- oscilloscope is an example, have always been about data, but the ability to sort of help customers use that data in different ways, help monetize that in different ways, Tektronix team is ahead of the game in terms of innovations in that regard, organically. We're excited to see that play out over the next few years.

Got it. And maybe that's a good jumping off point for a software discussion. I mean you guys have a collection of stand-alone software businesses and businesses that integrate with a hardware piece, I guess, how do you see the M&A funnel and your relative attractiveness of what's out there in the marketplace for favoring one side or the other on pure play versus some integrated solution?

Well, I think we probably tag teamed this a little bit, too, in terms of our ability to get some things done. But I think at the end of the day, we like hardware and software. And so I think this idea of bringing those things together is where our competitive advantage is. In the segments we serve today, we see tons of opportunity relative to both hardware and software in today's -- in our M&A funnel. So we're in a great position strategically to advance those. And maybe talk a little bit about the balance sheet, too.

Yes. And Josh, just point out, in the first 5 years, we've really deployed half of our capital is pretty much evenly split between hardware and software. Can't promise that going forward, but that's -- we have the same balanced approach going forward there. We came in to this year post the Vontier split. We're thinking that we had every bit of $4 billion to $5 billion of capacity in the next 3 years. As we move through the year, generating cash flow roughly paying for the ServiceChannel with that, we look to the next thing, next 3 years with the same amount of capacity. So we have the capacity. Certainly, we didn't demonstrate the ability and there's a lot of opportunity out there.

And then when you guys benchmark your software assets because I think it's tough for non-pure play software companies to want to completely disclose everything out there, especially with the breadth of your portfolio that -- your earnings call would be 3 hours. The -- when you guys benchmark internally, though, is it on kind of those common metrics on dollar net revenue retention, SaaS versus perpetual logo versus user growth, those sorts of things? Like how do you feel like you stack up on kind of the traditional software KPIs when you see what's out there in the public domain?

Yes. First of all, I think we're incredibly fortunate to have a Board of Directors that has a breadth of experience in software businesses to keep our benchmarks contemporary. So I think, first and foremost, we certainly benchmark each other, but we have partners and companies that we've sort of built in our sort of network that we continue to learn from their pure software plays, that have helped us over the years really more deeply understand where we should be relative to our businesses. And the first metrics we look at are the same metrics, organic growth, margin expansion and free cash flow. Those are going to be the metrics that inevitably are going to drive high returns in those deals. As you point out, then you start to peel it back and say, what are some of the key metrics. New logo wins is one of them. Are we -- we've got some great secular drivers in these businesses, new people coming into the digital transformation opportunities that we have. And so we're going to look at new logo wins, and we're going to look at net dollar retention. We're going to peel back net dollar retention. We're going to look at our ability to upsell. We're going to look at the ability to cross-sell. We're going to look at our ability to drive churn and improve churn that will drive net dollar retention. So those metrics are incredibly important. We have FBS tools to drive every one of those things and to help operating companies where they think their biggest opportunity is. I think we at the investor conference try to give a lot of examples to where that's playing out in a variety of businesses. So I think we're well positioned. We've got a net dollar retention in the high 100, 102, 103, ServiceChannel is 104. So now when you look at percent -- when you look at that $750 million now in software revenue, you've got high net dollar retention, you've got low single -- low double-digit growth now in that part of the portfolio. So the ability to compound off that, drive really strong free cash flow negative working capital already in that part of the portfolio. So really strong financial metrics and the ability for FBS to drive the important sub metrics that will continue to grow the business.

Got it. And I think as an adjacent market, you sort of laid out, I want to say a few years ago now, employee health and safety sort of bears some ecosystem resemblance to what you guys have on the institutional side. Is this something we should think of as being kind of the next platform opportunity similar to what you guys have with Gordian, ServiceChannel and Accruent?

For sure. I mean I think what we tried to lay out is now, as you say, we've got a plus $500 million set of businesses on the facilities management side. On the EHS side, a little bit short of that, but what we've done with Industrial Scientific, which is really more a small acquisition than SAFER Systems, really on the safety side. And then what we've done with Intelex and a small artificial intelligence acquisition, ehsAI, or -- those businesses, really on the EHS part, really the sustainability and what enterprise customers are trying to do to drive sustainability. So those really -- those drivers are incredibly strong secular drivers as COVID has really driven people to be even more focused on employee safety and as well the sustainability drivers that are -- every company in the world trying to reduce their carbon footprint to really understand how to continue to improve, how to be more sustainable. Our software solutions really drive that. So I think we're incredibly well positioned. We have a good M&A funnel around those opportunities. We think it's a real ability to grow that well beyond where we're at today for sure, both organically and inorganically.

Got it. And then maybe kind of adding the last piece of context on the M&A agenda, valuations everywhere, especially in the software world are pretty frothy at the moment. How do you see that trending? Are you able to find -- I guess, diamond in the rough is probably putting it too lightly because they're not going to be too rough. But how do you see that kind of stacking out here? And given the breadth of what you guys are looking at portfolio-wise, clearly, you have some options on where to focus.

Well, I think we remain disciplined. So I think what we -- what the 5 years has taught us is to be patient, to understand what really good looks like. And so as you said, valuations have moved up. High-quality software businesses are the ones that have higher net dollar retention, the ones that have higher growth, the ones that have -- can go well beyond the rule of 40, if you will. Those are priced because they're high-quality businesses. And so what's really important for us in the valuation game is to really be able to identify those really high-quality businesses. Because I think the -- if you will, the bottom has moved up. The maybe less quality businesses might resemble the higher -- those are the valuations that have really come up. And so I think for us, the due diligence, the understanding of where we want to go, the ability to see synergies, that's how we're going to get returns. And that's what you see with the ServiceChannel where it's a high valuation, but we get to our return hurdle because we see the growth. We're in the domain today. We have high degrees of confidence that we can drive the business in that regard. We've walked away from a lot of things because we're disciplined. And I think at the end of the day, we will -- we see plenty of opportunity to deploy capital in ways that can drive strong returns.

Got it. Maybe a question for Chuck here on the incremental margin side. It seems like you guys have sort of reflated the business now coming out of last year, restored a lot of those costs. Travel is back, I guess you're going down to meet with the business tonight in person. With all of that kind of back in the business, should we expect incrementals to be kind of within that long-term, 30% to 35% band? I know supply chain is sort of an irritant to say it mildly in the near term, but is that sort of a reliable target where we are today?

I think that's where we'll likely average out this year, but that's with the Q2 drag. I actually think we've been talking about being closer to 40% incremental as you go forward. Now that's going to have some variation by quarter and by business. But I think with our gross margins in the upper 50s, pushing 60% and the growth rate. I think that's what we've been seeing going forward.

Anything from a seasonal perspective? I know some of the higher-margin businesses have big second halves, big 4Qs, but you got ServiceChannel coming in as well. So anything that sort of contorts that, that we should be kind of mindful of this year in particular?

ServiceChannel comes in. We got a great -- we think, a great value from ServiceChannel because it's actually just cresting into the positive territory. So won't expect much in the back half of this year from that. But there's normal seasonality in -- from going from Q2, Q3 into Q4 that drives more volume. And that's what actually gives us a little bit more normal seasonality lift here. But we -- obviously, Jim talked about supply chain, and that's going to -- we won't be able to meet all of our backlog and demand, I think a lot of people are in that area. But we still expect Q4 to step up from Q3. And that's how I'd see it in almost any scenario.

Got it. And then anything on the ASP side where some of that's kind of beyond your control on the procedure count that is wobbled around with Delta variant that folks should be aware of?

Well, I think we certainly see electives a little bit lower in the year than we originally -- than we thought a few months ago, just given the Delta variant. I think well documented that electives are probably going to be -- we thought they might come up in the 92%, 93%, maybe even a little bit higher by the end of the year. It's probably a little bit lower. We're probably in the high 80s to 90% for right around now. And we'll continue to watch it and see where things play out. So I think within the grasp with the total portfolio, we'll -- that's -- we can manage that. I think where we're at we'll continue to see, as I said, the demand pattern. I think the real lever on revenue for this year is really going to be more about our ability to get components and to turn that into revenue. Demand is good across the board. We're in a good place relative to share positions, relative to the companies. We're doing nice things on the installed base relative to ASP. So I think more broadly, just as we think about Fortive, it's really about managing the supply chain in the near-term availability. That's the work we're doing every day. We're fortunate to have the FBS kinds of processes within our facilities to manage that. But as you said, whack-a-mole every day with what we hear from our various supplies and really the second and third tier suppliers more than anything.

Understood. And then I guess final question, well, we talked a lot about M&A today and a lot of good perspectives on that what you guys have given. Maybe the size of the overall funnel. You guys have clearly been at this for a while, even with the other machinations inside the portfolio. Environment is arguably pretty weird today with the strong demand, all the supply chain stuff, valuation is high. Has the overall size of the funnel continued to grow over the last 12, 24 months? Or have you seen that engagement sort of freeze here given the backdrop of everything that we've talked about macro-wise?

I think given valuations, given maybe even potentially where tax rates might go for some parts of the world and some -- we've never been busier than today. We're actively deployed and working on various things. I wouldn't size that other than to say that we feel very comfortable that within the construct of the numbers Chuck just talked about, we could easily deploy that. I think the importance is making sure that we understand the business, can we get the -- be disciplined about returns, make sure we're truly advancing strategy. And when we do that, we're going to compound really well off that. And I think the best example of that is that $0.75 billion of software revenue I described, that's going to grow organically tremendously, whether we do any M&A over the next 2 years or not, the ability to add to that while at the same time building in these great hardware positions like we did with ASP or like we did with PRUFTECHNIK and some of the other opportunities. I think across the segments, we've got good hardware opportunities as well.

Perfect. I see we're out of time here. So I appreciate you guys taking the time. Good to see you as always. Thanks for, well, I guess, not getting up early. You were definitely up anyway, I know you guys. Hope to see you in person next year, and be well in the meantime.

You as well. Stay safe, everyone. Thanks, Josh.

Thanks, Josh.

Great to see you.