Fortive Corporation (FTV) Earnings Call Transcript & Summary

Good morning, and welcome to the session for Fortive. I'm Rob Mason, Senior VP Research Analyst at Baird covering the advanced industrial equipment sector. Fortive is an industrial growth compounder, a high-quality portfolio that management has diligently and purposefully shaped with a number of strategic actions since 2016, the most recent being the spin-off of what is now Vontier just over a year ago. Fortive's portfolio is marked by strong franchises, market positions, profitability and free cash flow and, increasingly, that is all enhanced by the addition of software businesses. With us today to present Fortive and provide some [ significant ] outlook and prospects we have Jim Lico, President and CEO; and Chuck McLaughlin, CFO, is also with us. So Jim is going to run through a few slides real quick. We'll take your questions afterward. Again, send those in, and we'll weave those into the conversation. So with that, I'll hand it over to you, Jim.

Thanks, Rob, and good morning, everyone. It's great to be with everyone virtually. Hard to believe we're sitting here on November 10, but it is that time and hopefully, we'll get a chance to be in-person here in the not-too-distant future. I thought we would take a couple of minutes just to frame kind of where Fortive is today. Rob, as you said in your opening with the split and separation of Vontier, it's just always good to kind of come back to first principles and kind of where Fortive is at right now. You can see the key metrics. I think what we've demonstrated again in the third quarter and what you see in terms of where we're at from 2021 is the continued good strength of our business on the backs of strong recurring revenue, the continued expansion of gross margins and operating margins as well as really strong free cash flow. So in a good position. You see our new 3 reporting segments, which are in a very good place relative to long-term organic growth, the ability to continue to grow gross margins and really improve that gross margin profile, which we think is really important to accelerating the flywheel of compounding. And then finally, our recurring revenue. Very high recurring revenue in health care on the backs of our consumable businesses, both at Fluke Health and certainly at Advanced Sterilization Products, or ASP, and also high recurring revenue in Intelligent Operating Solutions where that is mostly software. So good -- really good improvements over the last few years there. And still in Precision Tech with mostly the recurring revenue there being our service business at Tektronix, but continued evolution of recurring revenue opportunities. I think across the segments, it really continues to build a more resilient durable growth rate for us going forward. So we feel really good about where we're positioned and certainly the future of the company. If you really think about where we've been, we started 5 years ago with these incredibly strong hardware advantaged positions, really the enablers of the positions we have today in software and data analytics, and we've continued to move, if you will, up the stack to continue to take that hardware advantage to bring, enable software within those core markets to really enable customers to do different things, to build different business models that are more resilient, that are really tied and secular drivers that are really driving better organic growth and fundamentally bringing better answers as we continue to bring -- utilize that software to really take and give data solutions that are really important. That results in now almost 3/4 of $1 billion in software, which in the quarter has got a double -- grew double digits, has a double-digit growth profile. So we'll continue to compound at a rate certainly above our core growth rate overall for Fortive and continue to be an increasing part of our value proposition with customers that fundamentally, as I said, builds a more durable, resilient growth rate, which we think is really an important part of compounding into the future. I think that really speaks to the free cash flow. I love this chart, up 66% in 2 years on a trailing 12 months look. So just -- it really speaks to the power of the Fortive Business System and the change in continued improvements in our business models, both on the recurring revenue and the software standpoint. It really adds to our ability to continue to drive strong free cash flow. Now we'll be over $1 billion in 2021, really puts us in a really strong position as we said in Investor Day, right towards that target of being closer to $1.6 billion here in about 5 years. So we're really on track with that and really continue to really drive, I think, the currency that really is a critical part of how we drive growth in the company. And then just to come back to our model. Again, now today, core revenue growth in the mid-single-digit range through the cycle, that ability now with the strength of the portfolio as well as the power of FBS to really drive core margin expansion in the 75 basis points area. Again, continue to build on that flywheel of free cash flow, which ultimately gives us more currency in which to acquire and accelerate strategy in our businesses, apply that discipline around FBS and our culture of continuous improvement to add value, not only in the businesses we have today but also the businesses that will inevitably become part of Fortive over the next several years. So a great runway for continued strong free cash flow growth and obviously, the ability to drive double-digit earnings growth into the future. So we think 2021 has been a good work in that regard. We're excited about the quarter we just put up. Certainly a lot of challenges. I'm sure we'll talk about some of those things out there. But at the end of the day, I think we've endured really and speaks to the business model and the quality of the portfolio. So Rob, we'll end the prepared remarks and we can talk a little bit.

Perfect. Perfect. And again, if you have any questions, send those in and we'll work those into the dialogue. Jim, just to start, if you'll indulge me. We've been trying to pull leadership teams at the conference this week just to get your pulse on maybe around risk tolerance right now. And again, as we look ahead to '22, a number of puts and takes, what we're all aware of around just inflation, you've got supply chain challenges, vaccination rates, et cetera. But at the same time, many companies have record backlogs, demand has not really decelerated and even in Fortive's instance, as you just highlighted, increasing resilience in the portfolio around the recurring revenue businesses. So that's a long lead in. Maybe just your thoughts around risk tolerance as you go forward over the next 12 months or look ahead.

Yes. Let's -- let me take the risk side of the ledger first. As you said, I think, certainly, as we look out, and we talked about this on our quarterly call a couple of weeks ago, we certainly see the supply chain challenges not getting any better, maybe not getting worse. But I think it's pretty well documented by a number of companies besides us that these things carry well into next year and are going to be a part of our operating cadence as we just run the businesses day to day. And I think that's probably the combination of inflation, as you described, as well as availability, probably more of an issue for us and also logistics just getting things even if you can get secure availability, getting it into the right place at the right time, just given well-documented port situations and things like that. So I think that's number one. I think when we -- certainly, there's other inflationary aspects to things. But I think at the end of the day, when we think about it, we're doing that against the backdrop of really good backlog, as you mentioned. And I think that certainly plays to a real advantage. We've dealt with a lot of risks, whether it be tariffs several years ago or certainly the early onset of COVID around the world and now being more mature into that pandemic. I think what we've seen is the ability to be resilient in that world. So we're going to walk into next year I think with a deeper understanding of what those challenges are, we'll have those supply chain issues for a while. We'll -- I think COVID starts to become a little bit less of an issue, hopefully. But I think at the end of the day, we do that against the backdrop of more -- of better backlog position as well as, I think, a more mature aspect of our operating businesses, which is always a good thing. So I think we're going to -- we leaned in, in the second quarter in some investments because we thought 2022 would be good. I don't think we regret those decisions at all. We're certainly going to continue to be optimistic. But against the backdrop of understanding what issues are out there, and I would say probably being much more diligent about making sure those things are -- we're really on top of those things, as I said on the earnings call. I'm personally spending more time on supply chain issues maybe than I ever have in the last 5 years. That's just how we're going to run the business here for the next probably 12 to 15 months.

Understood. Understood. And you've got some businesses in the portfolio that haven't fully participated yet in the recovery. You've spoken to those, I think, coming out of the most recent earnings call, ASP in particular. There's also Accruent, which had some very strong bookings in the third quarter, Gordian as well as a business. These businesses that haven't fully participated yet, how do you assess their prospects for recovery as we go forward? What needs to continue to go right for these business to come along and contribute in a bigger way as we -- if you look ahead into next year?

Yes. I would kind of -- I think each one has their own story. I would say Gordian is already on that pace. They've posted 2 quarters of double-digit growth. They're a very profitable business. They've done a great job at continuing to secure business. Their backlog, from a project perspective, is growing and it's accelerated rate. I think we feel very, very good about Gordian's prospects here. They were doing wonderful before the pandemic. Because of not getting on site, they slowed for a couple of quarters, but back on track and I feel very good about that business. ASP, again, I feel very good about the things we've done. We've grown our installed base over the last couple of years. We've grown the business in total over -- outside of the United States. So really kind of waiting for the U.S. to come back a little bit and I think that certainly happens in 2022. That's really a consumable story as electives come back. We believe they will, and I think that speaks well for that business. The most profitable part of the business coming back on the consumables side, likely to certainly get -- continue to get better as we get into next year. Accruent, as you said, low single-digit growth in the third quarter, but double-digit bookings. And we think we got another quarter or so to transition there. We've got some really strong high-growth product lines that are doing fantastic. We're leaning into those. They take over more of the revenue profile over time. We got a little bit on the SaaS conversion side. That's still going to get that -- we always said Accruent was probably a mid-single-digit grower. We see that we -- I think that's very likely in 2022.

And you mentioned some of the investments that you made earlier this year, you carved out about $35 million, I think, is what you talked about on the second quarter call. Just update us on some of those. That was around digital strategies, as I recall, AI going into The Fort. Some of those were directed. But just kind of update us where those are coming out of those as we go into next year.

Yes. So that's why I think we, despite some of these challenges, we did make some decisions to lean in on some things because we thought -- well, first of all, we could continue to really continue to perform in this environment. I think the third quarter showed that. But I think what we tried to do, Rob, was, number one, earmark about half of that money towards accelerating product development within businesses. So operating businesses that had ideas, things in launch, if you will, to try to accelerate, pull those launches in a little bit. And we'll see some of those returns in 2022 in a number of our businesses. So that's number one, solidifying some of the product development launch. I won't give away when those products are going to get launched, but we'll see those in 2022, and we'll see those returns in 2022. The other half, as you mentioned, really more longer term, thinking about The Fort, which is our AI and machine learning capability that we built corporately in order to deploy towards our operating businesses as well as our Pioneer Square Labs partnership where we're doing some early-stage incubation. Those are probably '23, maybe even '24 in some cases, kind of returns. But I think that's how we've seen those play out. We've continued those investments so that $35 million will play out through the year. We didn't -- we'll continue to do those things in this environment. And we feel really good about the way we've deployed that money and the way the teams have used those investments wisely in order to get good returns towards them.

Yes. Yes. And you have gone to some length to build some more resilience into the portfolio, reduce the cyclicality. I'm just curious, if you think about -- and some of that has to do with portfolio additions, but some of the things that you've done within the, I'll say, legacy businesses are within the core business to also reduce cyclicality and improve the resilience. And is there anything that we should be watching for as we go deeper into the cycle in terms of how they perform or on a secular basis?

Yes. Well, first of all, I think within -- what we've tried to do over the last few years in our strategic plans was really to be more -- really more directed of investments towards -- even within our core businesses around places where there were better secular trends. So Tektronix, as an example, into the data center market or into the EV market. We've done something similar at Fluke. So even within the core business. At Tektronix, we got out of our video business, which was a real -- which was a more cyclical part of the business. So it's both a strategy side on how we've really built strategy in a number of our businesses, around better secular drivers in our sensing businesses, directing things more towards IoT enablement and towards drivers that are really going to, I think, be more resilient over the next 5 years. And then -- so that's really what we've done. And you see that higher service revenue numbers in places like Tektronix. Certainly our -- and then one of the secular drivers, certainly, everything we've done in health is really about better secular drivers and a much more recurring business model. 70% recurring revenue in health is certainly one example of good secular drivers around the needs for hospitals to have a better -- some of the things that are going on in hospitals make them more productive, higher quality. And then just more broadly, just to be quick in the answer, is really all of our software acquisitions have really been very much focused on really those great secular drivers, whether it's health and safety or some of the facilities management, things we've done or connected reliability. It's really -- and it really focused on Industry 4.0. It's really about making sure even within the businesses that we're really driving our strategies towards those things that are going to have -- that are new and interesting and have better long-term growth rates to them.

Yes. Yes. You touched on it when we talked about just the risk profile as you look into next year around supply chain, and you highlighted as well on the call around where some of those pressures are obviously around semiconductors, anywhere you have exposure there, like everyone, a little higher on the constraint side. I'm curious, though, as you've kind of assessed the challenges around supply chain, are there areas where you felt like you've been able to take advantage, maybe be more offensive just because of where you've been positioned and ready for it?

Yes, I think -- well, certainly I think that some of the things we did on the investments in the second quarter, probably the first example of us leaning in. A number of those places are things where we put -- we're putting investment into our operating businesses where we think new product launches in this environment can do some -- can take some accelerated market share. Another area I'd point to is the investments in some of the things we've tried to do from an FBS perspective of really making sure we're investing at ASP on our installed base. And despite the electives being down, which means the consumable stream might be a little lower, the ability to get that installed base increased during this time is the second example. So I think those are 2. The last one I would point to certainly is within our sensing businesses, the construct of the challenges out there is that every business has these challenges, so it's around supply chain and such. It's really about how well you deal with it. And a number of our sensing businesses that are really doing a great job on dealing with their backlog and some of their constraints have been able to take market share because in some cases, they've been dual sourced. And so instead of being a 50-50 proposition, they're now 75-25. So I'm thinking where we have some OEM businesses and OEM customers were mostly in sensing. Where we have those sort of dual sourced opportunities, we've really leaned in to try to take some market share. And we've been -- we've seen some success in that. And we're continuing to push the teams. They're continuing to lean in to do that, and we'll see where that plays out. But so far, it's playing out pretty well.

Okay. Interesting. Interesting. Just along with the supply chain pressures has been inflation. You've been able to stay price/cost positive as we've gone through this year, being proactive on that front. How do you see the -- as we go forward and perhaps inflation is with us, it's not as transitory as people hoped, how do you see the elasticity around pricing?

Well, I think number one, on the cost side, I think we're probably seeing a little bit more on the material cost side, a little bit more transitory, meaning kind of we're paying more for availability in some cases. Because in some respects, it's the demand that's been the surprise here that's been so much better. And so we have the supply chain constraint issues, but -- and part of that is demand related. And so we were able, given our high gross margins and given the price we've been able to take, we'll pay for a little bit extra on the component side in order to get the availability. And we've done a little bit of that. I suspect that comes -- gets better a year from now or something like that. I think the logistics stuff, it's a little bit not unclear where we've seen additional freight costs. It's unclear -- some of that's driven by labor shortages and truckers and things like that in the U.S.. Unclear to me right now whether -- how transitory that is. But I think against that backdrop, we've been able to, as you said, in the third quarter, we had 300 basis points of price in our hardware businesses. We've been ahead on price cost all year pretty dramatically, grew gross margin significantly in the third quarter. So I think we continue to stay ahead. The franchises that we have in the portfolio are strong. And so that does give us a little bit more latitude, if you will, on the price side. We've always gotten good price in our -- in those businesses beyond -- not just in 2021, but historically, and I think we'll continue to do that. Chuck and I will go through the budget season here next week. It will be part of our conversations. And our deep dives into the businesses is to really understand those assumptions around how -- what they think is going to happen in their marketplace with the idea that we need to stay ahead on price and we'll continue to do that. I'm confident we'll continue to do that through the end of the year and well into next year for sure.

Have you addressed price with -- certainly on the freight side, with those costs? And have those been surcharges? Or do you think those -- your pricing is fairly sticky?

It's -- I think when we think about freight, I would say there's a little bit of surcharges, but there's just an elevated cost to get stuff around the country through the ports, around the world, globally. We don't think of -- we just think of total inflation. So we think about material cost inflation, labor inflation, which is not a big number, and we think about logistics and freight. We think about those as one pool, and we don't really delineate. What we're going to do is we're going to sit down with the business and look at that as a pool and then look at our price and say, "How do we make sure we stay ahead of all those things?"

Okay. Yes. I'm going to shift gears a little bit here. Just -- you've had some recent leadership appointments. It's been a mix of both internal and external appointments across the business units. And I'm just curious, how can new leadership of a platform at Fortive kind of change the flow of priorities? Or is it once these strategies are in place, which were put in place ahead of time, is it more around keeping those in motion? Or just what kind of influence does new leadership coming into a platform have at Fortive?

Well, we certainly would be disappointed if we promoted or brought someone in and they didn't contribute. So I think in the case of -- as you said, we announced a few moves that have occurred during the quarter. Tami being promoted to PT, Pat Murphy moving over to Healthcare and Olumide obviously taking on at iOS. We think they bring tremendous insights and things to the business. Now I wouldn't expect wholesale changes in strategy because our strategy process is pretty rigorous. We review that with the Board. I think it's been thought through. But we expect those leaders, it's certainly, from a nuance perspective, to certainly bring new insights. Olumide brings a real software and data analytics perspective to the business for sure. Tami certainly brings a new perspective into PT. Pat's been a long time senior executive for us and certainly has a long-standing tradition of developing leaders. So they'll bring in their own -- they'll put their own stamp on the business for sure over time. I don't see a wholesale change in strategy. But we do give them -- those are CEO titles for a reason. We do give them the freedom to sort of rethink things. We don't want to just be static in our view of the world. When we bring in new leadership, we always want them to have a fresh perspective, knowing all 3 of them pretty well, I can guarantee you they will do that.

Yes. Yes. So you were able to restart the acquisition engine again this year after a slower year last year. ServiceChannel, a significant addition to the software portfolio. Just speak there, that's a business that had a history of 30% type growth, if I recall. You want to sustain it kind of mid-teens, but where should we be thinking growth in that business could trend here over the next couple of years? And what will support that?

Yes. Well, that's a great question. Well, I'll just start with -- you're right, last couple of years have been 30%. They're getting a little bigger. We think next 5 years is a 20% grower, probably over the 10 number, that's probably 10 years, it's probably more in the high teens kind of number sustainable. It's going to come from really, number one, the underpenetration of the market, facilities managers, facilities owners who really are looking to ServiceChannel to solve their facilities challenges, the digital transformation that goes with that, the network that goes with that. There's a network effect to that business because not only do we have a SaaS solution to help them manage their facilities, but we also have a network of facilities -- contractors and people who do that, and we marry those 2 together. And so we get revenue on both sides of that. It's a flywheel for sure or a network effect. So that's number one. Number two is we've just started from a data perspective, data analytics solution. They've got a solution called Scout that we've just started, early revenue days, that will certainly be a driver of growth into the future, not in the next couple of years, but certainly beyond that. So we've got a number of things, not only in the short run from a penetration perspective, but also in the features and ability to upsell and bring new solutions to those customers over time that will -- we really think gives a strong sustainable growth rate to the business.

Yes. And that business came in at a lower contribution, [ rather than ] some businesses do with Fortive. Just how do we get comfortable, though, that the incrementals will be there on this growth here over the next few years? Is there anything that could sway that one way or the other?

Well, yes, I mean it wasn't a -- in many respects, they had built a business for a revenue level that was much higher. They did that in a private environment where they were already building that business for maybe twice its size. We believe that we can grow into that rate similar to how we did with Intelex. We got Intelex to 20% operating profit, I think, within 12 months. We think we can do the same thing with ServiceChannel. And we'll balance that, right? We'll continue to invest like we have at Intelex. In Intelex, we have continued to invest in the business. We've continued to do the things from an accelerated perspective to perpetuate that growth rate, but we also see that the faults around these businesses tends to be pretty high. And so we can get the incrementals off pretty quickly. So still early days, but we will do our 100-day strategic plan here in a couple of weeks. And we'll get a deeper sense of the actions to get us there. But I think thus far, the early read on things is it's got good growth dynamics and certainly the opportunities for margin expansion.

Beyond ServiceChannel, as you look out into the pipeline, how do we -- what can you inform us around what's in there? How maybe market rationality currently is? And you've been pretty consistent saying that the M&A pipeline doesn't solely consist of software, that there's a hardware element that you're still interested in as well. And I'm just curious what does a good hardware business look like today for Fortive?

Yes, those are great questions. And I think it's -- we -- I think from our own experience back in the Danaher days, we know that we want to keep it constant level of work activity and staffing towards M&A. Whether prices are high, prices are low. We haven't seen prices low from a historical perspective in a while, but I think what we really are always doing is filling that funnel, cultivating acquisitions. It's something that just we've learned over decades that you want to keep -- for companies like ours that have such strong free cash flow the opportunity to continue to advance our strategies through M&A. We want to keep a constant funnel of opportunity out there. And that's what we've done. We've continued to be out there even in a virtual environment. We've virtually cultivated. We're on the road now, again, talking to folks. So I think that's number one. Two is I do think the funnel is a combination of software and hardware, that's for sure. We think back to the software deals like a ServiceChannel or we think about a Censis, but we also remember that we did PRUFTECHNIK for Fluke, which was mostly a hardware business. Even Landauer. And ASP certainly is a hardware business with consumables. So I think we continue to like the idea of advancing strategy in both ways. Hardware, I think is going to be a couple of things. One is it's going to be accretive earlier. It's going to be -- number one is it's going to come with synergy. You think about a deal like PRUFTECHNIK we did a few years ago, well within the construct of a couple of years' kind of return on invested capital at 10%, accretive almost from day 1. So I think what you typically see with those hardware deals probably going to be a little bit closer on accretion, a little bit better -- a little bit faster returns just given the multiples and our ability to integrate those into the hardware businesses we have today. On the other hand, software is going to have those enduring values too and accelerating the growth rate in most cases. So it's just going to start, first and foremost, with liking the market, our ability to really see great businesses and then number three is, can we add value. And I think that's going to be those -- that's that sort of how we think about M&A strategy is that way, and I think there's hardware and software opportunities that fall into those categories.

Okay. Okay. In the time, which is not much, that we have left, just a couple of business unit questions, ASP that you mentioned. I think everybody is anticipating seeing what that business can do under full streak, so to speak, when procedures come back. So just any initiatives that you can point to that you think are going to stand out with better volumes in that business, what we should watch out for?

Well, I think, number one, as you said, I think consumables coming back is really driven by electives. A lot of FBS opportunities on the margin front to go after productivity in the business. It's not a business that was thought of productivity as something, those are throughout the value chain, not just from a manufacturing and supply chain perspective, but throughout the enterprise, continue to be there. So our exit rate on that business is going to be in the 25% kind of operating profit margin. We think we take that well above with the combination of consumables and additional service. A lot of the breakthrough strategies that we had was to improve our attach rate on services. We did that in a number of countries over the last few years. So there's a lot of blocking and tackling and just good old FBS in terms of things we know how to do in the back office and in the supply chain, but also lots of growth initiatives. We haven't even begun to see the impact of innovation given that takes a little while. So I think across the range, a lot of things that we're doing to create some tailwinds. And then, of course, certainly, as electives come back, that will be helpful, for sure.

Perfect. Perfect. Well, we are up against time, so we need to leave it there. I would mention there is a breakout session. So both Jim and Chuck will join us in the breakout session. So if you have additional questions, meet us there. So thanks again, guys.

Yes. Thanks, Rob. Good to see you. We'll see you in a second. Thanks, everyone.