Fortive Corporation (FTV) Earnings Call Transcript & Summary

And welcome to the Fortive presentation this morning. I'm Rob Mason, senior analyst at Baird, covering the advanced industrial equipment sector for which Fortive is a key piece of the coverage. 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 -- or spinning off the Vontier business a couple of years ago and bringing in some very exciting software-related businesses. The portfolio is marked by strong franchises, market positions, profitability and free cash flow. And increasingly, those are all enhanced by the addition of the software businesses as well. So with us today to present Fortive and to provide an insight into the outlook and Fortive's prospects, we have Jim Lico, CEO. Jim is going to open up with a few remarks, then we'll take your questions.

Great. Thanks, Rob. Good morning, everybody, or almost good afternoon. Great to be with you. I guess we'll say this for a few more months, but it's just so great to be in person. So great to have an opportunity yesterday and today to spend some time as well and some of the one-on-ones. As Rob said, I'll go real quick relative to a few slides that just really set the tone for, I think, where we're at today at Fortive. And as we sit here on the sort of precipice of the finish of '22 and into '23, I think we're in a wonderful position in which to continue to grow the company. Just to maybe orient everybody, we talk a lot at Fortive about the 3 segments. As Rob mentioned, after the Vontier separation a couple of years ago, we created these 3 segments. And I think what you'll see as you get into the detail, it's just the high-quality segments that we have. And as Rob said in some of his opening remarks, the quality of the franchises, the great market positions we have in which to continue to build on. One of the things I call attention to more than anything is some of the secular drivers, particularly in a time when we're -- when there's kind of a noisy macro out there and trying to figure out what next year would look like. I think what we really see is the foundation of really where we position the company over the last couple of years. And so whether it's the digitalization of our customers that really help our hardware and software solutions, really enable them to do a number of things; or it's the advent of continued IoT and sensors everywhere and the challenges of power, as an example, in battery life; and pretty much everything we do, all of those are tremendous opportunities for us. And as we continue to look at a challenging labor market, both on the inflation side as well as the availability, what you'd see is across the portfolio, a number of our solutions are really driving towards better helping our customers drive better productivity and really helping them really deal with the challenges they have around less labor or labor inflation. I always like to say that everything -- almost everything we've constructed within the portfolio over the last several years really has to do with productivity and quality solutions. We talk about the -- for the people who accelerate progress in our shared purpose, and that's really about every operating company, really continuing to help our customers really deal with the challenges they have around productivity, quality and safety. Just to give you a sense, obviously, we're finishing up '22 here. We've had -- obviously, I think we've delivered exceptional performance. We're incredibly proud of the work we've done. A number of highlights here around the kinds of things we've been doing, certainly, both on the growth -- despite some of the supply chain and inflationary environments, we continue to grow gross margins at a good pace. We obviously -- one of the powers of the Fortive Business System is the continued growth in free cash flow and the ability to continue to really drive exceptional free cash flow. And you see that in the results both in '21 here on the slide and in '22. And one of the things I really like to sort of call your attention to is I think everyone understands the power of the Fortive Business System and how that really differentiates us in terms of our legacy and our history and how we really build these high-quality franchises into even better high-quality businesses. But over the last couple of years, I think one of the things we've been proud of is that we continue to be able to utilize the power of FBS in a virtual environment. And compared to no FBS, that's a good thing. But I think when we -- what we really tried to do this year, and you see the acceleration in our performance really in the third quarter -- all through the year and certainly in the third quarter, really, as we get back to work, as we get back into our factories, into our engineering labs into our sales organizations to really show the power of FBS and the demonstrated ability to see the power of FBS is really showing this year as we get back to doing things the way we used to do. So I love the performance and the things we've done during COVID and that kind of thing, but the ability to really continue to bring FBS back into everything we do every day in -- together in collaboration really is accelerating our performance in this year and certainly into next year. We talked -- Rob mentioned, we've done a lot on the portfolio side. You see the differences here, particularly as we think about a couple of key things here. We've really tried over the last 6 years to really make Fortive a higher-growth company. We've really taken our growth rate from a GDP-like growth rate to a mid-single-digit growth rate through the cycle, but just as important as the durability of that revenue base. And so now you see today, 40% of our revenue, over doubling our recurring revenue as part of the portfolio today sitting at 40%. As part of that, our software revenue is 18%. So what you really see is that really importance of durability and the importance of the things that we think are so important to continued customer relationships is the ability to continue to keep our product, services and certainly our software in front of customers, helping them deal with the challenges they have. And that's really helped us not only change the vertical exposure we have to a higher set of verticals, but also a more durable revenue base over a long period of time. Finally, just a little bit about '23, always on our minds. We -- in our third quarter call, we laid this out. I'll go through it quickly. What we really said is a couple of things. One is we don't know what next year will look like, but we're prepared for a number of scenarios. That's how -- our sort of playbook that we've utilized over decades, really around making sure we understand the various scenarios of how next year could play out both regionally and by business and the associated set of deep set of actions that we would take, depending on that environment. A number of our businesses, as I just said, are going to not see any issues next year at all. In fact, they'll continue to be very strong and maybe, in many cases, accelerate growth from 2022 to '23. But some may have some issues relative to the macro potentially, depending on what happens. And so we really think we're well positioned for that, not only with the way we built the business, but in a couple of different ways that we really want to call out. Number one is the exceptional backlog that we have in our hardware businesses. We have $300 million more backlog than we've had in years past. So the strength of the backlog in our hardware product businesses really give us sort of an insurance policy, if you will. I always like to say that we bought a company called backlog, and that company is $300 million. And so that's not our total backlog. That's the additional backlog that we have relative to a normal environment. So really feel confident that the quality of that backlog is strong and will certainly help us prepare for any kind of environment next year. Secondly is the amount of software I just mentioned and the recurring revenue that we have within great durable business models that are really attached to great secular drivers, over $1.4 billion worth of total revenue in the portfolio and a really -- a real strength and a path to growth ahead. And then finally, our health care business. Obviously, health care has been a challenge in the last several years. In the last 3 years, despite an incredibly challenging environment in health care, we've grown at 3% per year. So we think as '23 becomes better than '22, '24 becomes better than '23, the ability to accelerate that growth rate outside of a pandemic, outside of some of the challenges that have been in the hospital networks around the world, we really think that becomes a very durable business. Despite all the challenges in the last 3 years, it's been incredibly durable. We think that only increases over time with the work we've done and the quality of businesses that we have in the portfolio. All of that adds up to, I think, historically, our continued improvement in free cash flow. And really, as we've always said, we deploy that free cash principally in M&A. We look forward to those opportunities. I'm sure we'll talk through it with Rob here in a minute. But the portfolio is really positioned for outstanding free cash flow. We're getting 50% more from $1 -- 50% more free cash flow from $1 of sales than we did 4 years ago. And we think it will continue -- you see the numbers, 90% better during that time frame and then 40% better in the future. We really continue to the quality of the portfolio and the power of FBS to really continue to compound free cash flow and deploy that to outstanding opportunities in all three of those segments attached to those secular drivers. So a quick round around -- or a quick way to go around Fortive, but I look forward to questions and the conversation with Rob.

Fantastic. Jim, thank you. And again, if you have any questions, feel free to send those up, work those in. One of the topics that people have hit on this conference early on is just trying to get a handle around order rates, lead times, normalization, what that looks like. How do you properly diagnose if there's some normalization in your order rates to make sure that you're not misdiagnosing normalization of lead times versus weakening in demand? Just maybe speak to what you saw in the order rates as you came through the third quarter, maybe as we've entered the fourth. And how are you monitoring those to make sure you can pick up the right demand signal?

Yes. Well, I think I would kind of say in a couple of ways, one is orders were much better -- as we looked in planning for the year, orders were much better in the first half than the second half -- or excuse me, much better in the first half than we anticipated. So first half order growth was even better than we anticipated. And even with that, we've held our order growth rate in the second half, and in some cases, increased it in some businesses. So we've seen really the kind of the year play out pretty much how we thought, and I think that speaks to some of the longer-term demand signals that we've looked at. I think -- but really in the short term, businesses like Fluke, which often are called the canary in the coal mine, our point-of-sale data that we get with -- through our channel partners is very good, and we see it every week. And so that's a strong demand signal not only for Fluke but also more broadly about what we might be seeing in the industrial economy. The other part of it is we have a big part of our software businesses. A number of our other product businesses are direct and so talking to customers, seeing how things are going, and I think we're all anticipating something. But the truth is, right now, the demand signals that we see are -- remain very good. And you see that in a number of our -- also our publicly traded customers like Grainger and others, who are -- things are still going very well. So we're certainly preparing for scenarios, but thus far, all of these demand things that we look at are good.

And lead times are starting to normalize in some getting a little more...

Yes, I would say more predictable than normalizing yet. I mean, I think they're certainly getting better. But I would say the normalization, we still think next year and some of our businesses will probably build backlog next year so -- because demand is still very strong. Electronic components, Chuck always likes to say that we still see lots of issues with electronic components, but they're now more predictable. They're now at 50 -- they're 50- and 60- and 70-week lead times, but we now have a year under our belt of dealing with that kind of thing. And so our lead times will continue to get better, but we feel pretty strongly that the order signals that we're getting from customers are really much more about the demand on the other side than they are really about catching up on lead times.

And the other topic that's really been pushed on here so far, again, gets to the backlog, the quality of the backlog, the durability of the backlog you've -- it's unprecedented. So as we -- should we go into a downturn, you probably not have that backlog. How do you stress test that to make sure that it will be there, is convertible [indiscernible]?

Yes. Well, one, a lot of our -- a good chunk of our backlog is at Tektronix. And I think as we do data analytics on it and all kinds of ways to interrogate it, we see customers who really need products who are dealing with -- I think when people are designing the next generation of batteries, I don't think that's going to be less next year. And so one is making sure that the kinds of customers that are in that backlog are the kinds of -- are in the kinds of industries and the kinds of things that they're doing are very much not tied to a macro element of some sort, some are. And I think across the other businesses, the same thing is true. So I think we do -- not only do we scrub it by person, but we also do a lot of analytics, and we follow up with customers. And I think that's -- you sort of triangulate on all three of those areas in order to make sure the durability remains there, and we still continue to see it be durable. And don't forget, we're kind of turning that backlog over, right, about every quarter. So that backlog that's happening, we're seeing that backlog continuing to be strong through the year. And so there's no elements of that, that have gone from 3 months to 9 months. It's really that 3 months just kind of sits there.

It's a good point. So if we think about just to take a geographical tour, all of your regions were solid in the quarter -- third quarter. Certainly, a lot of focus around Europe. And I think Europe for you grew mid-teens, thereabouts. So what are you seeing in that region? That's where a lot of heightened focus is. Are you better positioned there to absorb any kind of weakness just given the business mix in that region? And what do you think that portends here over the next 6 months?

Yes. I think we've been pleasantly surprised in the durability in Europe. I think it has to do with some of the innovation that we've had at places like Fluke and Tek. Our software businesses, while small in Europe, have grown really well and continue to grow well. So that's mostly through sort of penetration, meaning we weren't doing a lot there. So as we accelerated our go-to-market, health has been really strong. So ASP in particular has done a nice job in Europe, particularly on the equipment side. So I think we've got a number of factors that are durable. That said, we're obviously -- it feels a little different over the last few months, I think, just relative to some of the inflationary environment, the geopolitical situation. So we certainly in our preparation for next year are probably not thinking that, that double-digit kind of growth that we had in the third quarter is going to be maintained. But again, I think as evidenced right now, things are still pretty good in Europe.

So as you mentioned in your remarks, again, as you think about '23, some businesses may have the potential to even accelerate. Where would that -- where would we look for that?

Well, I think we have some options in health care because health care has been so tough. And while '22 is probably the hardest year for hospitals in the history of hospitals, '23 is going to be better. And so it doesn't mean it's going to get back to normal, but we think it's going to be better. I think we have some opportunities there. I'll stay away from specific guides at any point in time. But we're seeing some acceleration in some of the things like we're doing in our facility and asset life cycle software businesses, which is Gordian, Accruent and ServiceChannel. We're seeing things continue to be good. And our solutions are certainly true in that -- those businesses and across the board really are helping people to save money. And in many cases, we're seeing an acceleration of things because simply people are looking at their facilities' footprint and want to decide how can I take cost out of my facilities' footprint. We're not tied to the number of facilities. We're really about trying to help them understand more deeply their assets and where they are and what the cost of those assets are. And so the solutions like that are ultimately even more beneficial during tough times.

You mentioned it earlier, Fluke is often viewed as perhaps the canary in the coal mine for Fortive, and you haven't really seen any signs there that cause concern. But if you think about other businesses, what might follow Fluke as an early indicator? And then to go back to Fluke, has that business evolved since maybe the last cycle? Have you done anything in that business to improve its resilience?

Well, staying on Fluke first. I mean one of the things we don't -- we've done a lot at Fluke around. We added the eMaint software business a number of years ago. We put together a condition-based monitoring solution, which I think has a lot of durability from a recurring revenue, both software and services. We've done a number of things on the innovation front around sustainability, solar tools as an example, EV charging tools to manage EV charging network. So a number of things that I think will be more durable in a cycle than ever before. And then finally, we built a very sizable health care business. But of course, we moved it over to the health care segment. So Fluke doesn't really get credit for that, but that was a big effort. So over a $300 million business now that is in our health care segment that really originated as a start-up within Fluke. So I think as we think about it, we've done a number of things. And if industrial production goes down deeply for a period of time, a portion of Fluke could potentially have some impact. But that backlog is going to be an insurance policy, plus all the things we've done to really make it more durable. And we feel good about what can really happen at Fluke even in a more challenging environment. Tek -- parts of Tek would be the other part of that as well, particularly in our channel business. But again, I think some of the secular drivers we played out with Tektronix, the service business. We got out of the most cyclical parts of Tektronix several years ago, our video business and some other things. So those are two fairly sizable businesses within the portfolio that I think we've done -- we've worked really hard for over a decade, really since '08-'09 to really make those businesses more durable and more -- and really be able to really continue to not see issues during economic cycles.

So you talked about being able to -- or being ready to take action if you see need to do so. How does the playbook or has the playbook changed for you over the last few years? Just given the challenges around skilled labor availability, do you -- does the playbook look different than it did to try to protect some of those assets?

Well, I think number one, the playbook has always evolved because what we know to be true is that every economic cycle, it looks different, right? I mean we might call them the same thing. But at the end of the day, they have their own challenges. I think number one, Rob, the most important thing for us is our operating model. The individual operating companies that sit in Fortive mean that presidents and their teams are taking on the economic environment of that business. And they're creating the scenarios, and we're reviewing those scenarios individually. So how a Gordian handles what the next 12 months versus how a sensing business handles, those are going to be independent ways, and they're going to -- and I think some companies get in trouble because they take a cookie-cutter approach to every business. And in some cases, they maybe don't take advantage of the growth opportunities or the share gain opportunities that might exist during some of these challenging times. So I think more than anything, our operating model is the most important piece in these times. And we manage things closer to customers and closer to where protection of operating profit and cash flow needs to happen. To your point, certainly in an environment where labor is a little bit more of a challenge, we certainly are thinking about that. But the reality is what we do with FBS is always around productivity. In some cases, that frees up additional resources to work on growth. In other cases, that becomes cost reductions that we take on if revenue doesn't show up the way we anticipated. So I think in most cases, our model is still pretty close to the same.

How do you get comfortable -- the pieces that you've added to the portfolio that are new, newer, how do you get comfortable with their resilience, having not owned those businesses through prior cycles?

Well, it's not a perfect science, I would say. But I think, first of all, we saw -- a number of these businesses we saw in 2020. And we saw how the SaaS revenue and the software revenue held up. The services may have not held up as much, but that was purely because we couldn't get on site, which is very specific to the pandemic. So I think what we saw in 2020 was those businesses were incredibly resilient. So yes, we do some modeling when we look beyond that to other kinds of recessions and stuff. But I think the fact that these businesses are mostly North American-focused, which I think will probably -- is a good thing and -- over the next 12 months given maybe some of the other economies may be a little bit more challenged, and the fact that customers are still really looking for these challenges. We've looked at sales funnels over the last couple of quarters to see if there's any big changes in those, and they're not. And so we really are confident that those businesses continue to have, what I would call, above their growth rate and really be -- really, really a resilient, durable growth aspect of Fortive next year.

And maybe we'll just dive into a few of those. So within the IOS segment, the facility management portfolio, those are effectively all new businesses to the portfolio. And I think you're starting to really see a sales cadence, a growth cadence that's kicking in there. Just share a moment what you've done there to bring that platform effectively, those 3 kind of core businesses up to the level of performance that you're generating now?

Well, we bought Accruent and Gordian at the same time. And I think we've done Gordian, a lot of the FBS tools that we have for continuous improvement. We applied early and did a really good job at executing against that, and that's why we've really accelerated that growth rate. It was already a very profitable company. We continue to do that. I think with Accruent, that was more of a self-help story. As we've talked about, we had to realign some product lines and things like that. We've realigned the go-to-market over the last 6 to 9 months. We illuminate who's our segment leader as -- ran that business for a while. We've got some new leadership there. They're rebuilding the go-to-market in a way that's more specific to the solutions that are higher growth. We're seeing the benefit of that over the last few quarters, where we've seen orders and bookings just get better. We've seen net dollar retention get better as well as we've applied a number of FBS' tools to churn. And then with ServiceChannel, I think it's just -- it's been a bit of a rocket ship in that business since we bought it. And effort there was to be more profitable with the revenue that was there, and we made very strong progress around that. So you bring those businesses, we're sharing in between them. Now we're starting to sell some of the Accruent solutions to ServiceChannel customers. So we're starting to see the starts of some of the synergy between the businesses. So as you said, the quarter was exceptionally good, and we think that business is going to continue to have really strong growth opportunities.

Just talk about how the FBS growth tools applied there. In those software businesses, you mentioned customer retention. Is that the first place that you try to apply those tools? That seems to make sense to hang on -- to retain the customers that you've already -- you're already serving and grow with them, but just talk about how that FBS like gets applied itself...

Yes. I mean the answer is -- the easy answer to the question will be yes, you're right. But I think what it really is about is a lot of our tools around value stream mapping and problem solving are things that can have immediate impact. We can go do a Kaizen, and we can look at how to improve churn, as an example, an important component of net dollar retention, which is an incredible metric for all software businesses. And we've seen real progress across the Fortive portfolio and software in that starting point. We work -- it takes a little longer, but we start to use the product development and innovation tools to improve the offering, which improves upselling and cross-selling. And we're starting to see the benefits of some of those things. But those take a little bit longer. So we go in first with the places generally in the sales and marketing areas where we can tune things a little quicker, get some early victories, which is really important to demonstrating to the culture that this is really an important thing that we can do. And then over time, we continue to improve through improving the product development tools.

Is there scope for more adjacencies around this facility...

There are. Some of them might be smaller deals, maybe more kind of, I call them bolt-ons, but maybe more feature enhancements, maybe some regional expansion. But yes, certainly in that -- that's a great high-quality franchise. All the sort of folks that rate -- Gartner and IDC and folks, these are really highly rated solutions. Customer satisfaction is really high. So our ability to maybe look around, find new feature sets that we can add on to the current architecture is certainly a place where we could get high returns from our investments.

Shifting over to the AHS platform, the health care platform. Clearly, I think you're articulating that you're starting to feel the end markets may be more cooperative next year. You've done a lot of work at ASP, and it's been held back by various constraints in the marketplace. I guess the question is, what are investors going to be most excited about, impressed with once that business is unleashed, so to speak, given the work that you've done on it?

Well, I think I said in the 3 years it has been an incredibly tough time in health care, the 3 toughest years probably in a long time, we've grown the business 3% per year. So I think that just demonstrates the durability. During one of the toughest environments in the history of the industry, we've grown the business. And so -- and we've expanded margins. So the idea that now we're going to see, I think, an improvement every year from here, I think, is overall very exciting. I always say that the ASP business -- I was at Fluke when we bought Fluke and obviously -- or went into Fluke shortly after we bought Fluke 20 some years ago. ASP is a better business today than Fluke was then. And we've quadrupled the size of Fluke since then. So when you think about what we've done with ASP, we bought a high-quality business with high recurring revenue with great customer satisfaction with good macros. The secular drivers for health care are still very good. People are -- the world -- the U.S. and Europe are getting older. As you get older, the demographic is very -- more people use more health care. That drives procedures. It drives higher technology into those procedures in order to do them at improved cost structures. All of those things play well to the portfolio that we built in health. So I think the long-term drivers are every bit there as they ever were. And I think now we start to see the short term get better as things start to get just a little bit better in hospitals over the next several quarters.

How dependent on the -- how dependent is the outlook in '23 in that space around what happens in China? Or what have you assumed with China reopening?

Not as much. I mean, I think if the U.S. -- our biggest businesses are in U.S. and Europe. So it's really probably more predicated on the U.S. and Europe probably getting better. We certainly would love for China to get better, and it's marginally gotten a little bit better, but it's inherent in that is not China getting dramatically better.

And then just to conclude on that piece of the business, you seem to have -- I think that there's opportunity around the ASC aspect delivery sector. How are you tracking your progress there? And how should we track progress there? And maybe where that stands?

Well, there is certainly a move, and there has been for years in the U.S., of moving processes out of the hospital and into ambulatory surgical centers. Some of those are owned by the hospitals, some of those are independently owned. And we have had a good position in ASCs for a long time. With the Provation acquisition we did last year in December, we accelerated our position because they had a very, very strong position in ASCs. So we feel that's a positive trend for growth in the business. We're well positioned to take advantage of that trend. And between the collection of businesses that we have today, both in the most important IDNs in the U.S. as well as the most important ASCs, we have very strong market positions in which to leverage throughout the portfolio.

And you touched on the strong free cash flow profile. How do you handicap your ability to redeploy free cash flow into the M&A market over the next 6 months?

We said -- we obviously did two big deals last year with ServiceChannel and Provation. So we felt very comfortable with where we're at right now, which is making those businesses better and that kind of thing. I think as we look at the environment, we said -- Chuck and I said, and I think the early part of the year that we thought it was 9 to -- 12 to 18 months of time before things -- bid/asks sort of came in line with maybe what was happening in the external markets. And we're halfway through that. And we're starting to see some of those things more on the public valuation side than on the private. But I think at the end of the day, we're going to continue to see those things, the IPO market being tough, obviously, cost of capital for -- particularly for private equity going up a little bit. Those are all things that are going to make the environment a little bit better. And we continue to have a strong funnel of opportunities in which to deploy capital.

Has there been any distinction between hardware and software asset valuations over the last 6, 12 months in...

High-quality software businesses are going to be high-quality software businesses. Every deal has its story in what it's worth. To me, more broadly, it's going to take some time for that to be more broadly in alignment. There are certain situations that have become more -- maybe become more actionable. But I think in the end, more broadly, I think the environment will continue to get better.

Very good. Well, we are basically at time now, so I think we'll halt there. There is a breakout session with Fortive if you'd like to join us there with additional questions.

All right. Thanks, everybody, for your time today.