Fortive Corporation (FTV) Earnings Call Transcript & Summary

Thanks very much, everyone. We're going to move on to Fortive now. It's my pleasure to have here Jim Lico, President and Chief Executive; Chuck McLaughlin, SVP and CFO. Jim is going to have a couple of slides, and then we'll roll into Q&A. And over to you, Jim. Thank you.

Thanks, Julian. Good after -- good morning. It's -- still working on time zones these days, but I guess it's early on the West Coast. Good to see everyone. It's great to be here. It's great to be back in person. I still say that even though we've been in person for a little bit now. Just a few slides just to maybe get everybody on the same page, obviously, on the forward-looking statements. I think we've -- after finishing a really strong '22, we're really excited to be here to talk about that as well as what we have ahead for us not only in '23, but in the years beyond. I think what you continue to see with Fortive is a high-quality portfolio, continuing to be designated around attractive growth markets, differentiated performance. I'll talk about that in a minute. But I think across the financial measures continue to make great progress. Certainly, great progress against 2016, but also, we think, against peers. Power of the Fortive Business System. We -- I'll talk about that in a minute, but I think what you saw in '22 is really the power of the Fortive Business System, whether it be supply chain issues whether it be some of the inflationary challenges or the integration of some great businesses across the board. We saw FBS playing an incredible role in our success last year. And then I think when you combine all that, it really continues to -- with the free cash flow component of our business being so strong, really the ability to continue to compound off a number of those great metrics. Many of you may know Fortive, but you may not necessarily be as familiar with our segments as we re-segmented a couple of years ago. I think what you saw in '22 was the power of those segments. In its simplest form, Fortive is about connected workflows that really give productivity, safety solutions to factories, commercial buildings, engineering labs and hospitals. It's -- in many respects, it's that simple. Now there's lots of products and some operating businesses, tons of technology and innovation in our portfolio. But each of those segments is providing those kinds of solutions, both hardware, software and in many cases, services to their specific set of end users. In the case of IOS, it's really mostly around factories and commercial buildings. In the case of precision technology typically in the engineering labs. And obviously, advanced health care solutions focused on hospitals. A new slide, this is in our earnings deck, just to give you a familiarize a little bit. We just wanted to give a little bit of a sense of where we've come from. I think when you see the comparisons to '16, accelerate our core growth, that's been intentional, in terms of how we continue to try to build a business that's really growth here, and really much more focused on secular growth drivers. Our gross margin is now up significantly 1,000 basis points since 2016. We continue to improve operating margins as well that comes with that. And I think most specifically is the strength of our free cash flow. Now at 20% free cash flow margins. I think we had a great year in free cash flow last year, up a little -- slightly over 20%. And it just continues to see the compounding of the business. We continue to get a lot more out of every dollar of growth. And I think what you saw this year -- or excuse me, in '22 and you'll see again in '23, is that not only are we growing well, and we've improved the growth rate, but the profitability of that growth and maybe just more importantly, the free cash flow that comes with that growth has been exceptional, and we're going to continue to focus on that. Fortive Business System obviously continues to be an incredibly important part of what we do. We talk about it from a perspective of leadership, growth and lean, lean manufacturing. All 3 components equal to our businesses, particularly in a portfolio like ours where we have software businesses, hardware businesses, service businesses. FBS means a lot to everyone. We just left our leadership conference last week, our top leaders in the company with our theme of unleashing FBS. And it was really about you really see so many great examples of things like how we dealt with supply chain issues and the fact that our free cash flow is outstanding and the ability to do that despite the supply chain issues that were out there. Our ability to continue to drive growth in a number of our newest businesses, in particular, where FBS really means a lot for our new business. And finally, just continuing to be more innovative and accelerate innovation. We see a number of places where we celebrated innovation. Finally, if you sort of bring all that together, we think it's a proven value formula. We're looking forward to giving you more detail here in our investor conference in May. We think that is an exciting time to really give you an opportunity to really dive into what we do and how we do it. We think that's one of the most exciting things that we have going. But what you can count on is that double-digit earnings growth and free cash flow growth, which we think is certainly, the currency for fueling continued success. And I go to -- we'll go to questions.

Perfect. Thanks very much, Jim, for that introduction. Maybe just -- it's a dynamic external environment. Maybe just sort of level set kind of where you think we are now, I suppose, product hardware orders are the most economically sensitive part, if you like, of your portfolio today? How are those starting out the year? How comfortable do you feel with sort of customer inventory levels, any concerns around de-stocking that type of thing?

Yes. So after 2 years of double-digit growth, right, 10% growth for 2 years in a row and really strong order growth in our product businesses, we would have always expected and anticipated some slowing of order growth given the fact that our orders were -- even outpaced that level of growth. And we've talked about backlog, and I'm sure we'll talk about it. So I think we're in a -- everything is coming in as anticipated. So as we look at it in real quick terms, we're going to be down in orders in the first quarter. Our product business is maybe down almost double digit, but maybe high single, more likely. But it's coming in as expected. And I think given that we'll have -- given the -- both the secular drivers that we've really worked towards as well as a number of things that we've got from a backlog perspective, we feel pretty good about the position we're in relative to inventory. Inventories are in good -- not in a scary situation in any way, shape or form. The only place and we look across all of our hardware businesses is in some small distributors in the U.S., we have a little bit of inventory, but that's not a big -- it's Fluke. But we think we're in a very good position. And Tektronix is our second biggest hardware business. Our channel partners have almost no inventory just given the demand cycles that have been going on for the better part of 24 months, those channels are still trying to catch up with their own demand. So we feel -- we don't feel like inventory is going to be a big issue here.

Got it. And when you mentioned backlog and there is this sort of confusing in this environment of sort of backlog orders, sales, normally, it's a very obvious relationship, but it's a bit complex right now. Do you see the sort of -- how do you think about the pace of that excess backlog coming down? Where do you think sort of book-to-bills look as you go through the year? Any thoughts on those topics?

Julian, we entered the year with over $300 million of what we consider excess backlog. That's just total backlog of the amount that we normally would have covered. What we put in our guide this year is to probably reduce that by half, but still carry more into 2024, and that has more to do with supply chains that are still tough. But bookings, we would expect to get into the second half of the year in our hardware products businesses. You start seeing those things move back into positive growth as you go forward. So we think we're in a good position here. Inflation and supply chains are really a bigger issue, of course, at this point in time, continue to be, although better than last year.

Thank you, Chuck. And I suppose the region that's been most back and forth, if you like, has been China for other companies. For Fortive itself, you've -- some had very good growth even last year. I'm not sure you ever got the credit for that from investors somehow. But maybe go into that a little bit, like what did Fortive do right? How did you manage to get good growth in China when almost everyone else was down? And what's your sense around how the Chinese economy that you sell into, how do you think about that pace of improvement from here?

Yes. After several years of good growth, we had double-digit growth last year, we had double-digit growth the year before. So China -- as you said, China has been a really strong territory for us. I think it goes back to our long-term strategy there, which was to be -- so it was to be local in the market. Not only with manufacturing but with engineering capability, designing products for that market, having a local team that's empowered to do things. And given COVID, that empowerment has been critically important. They've done an exceptional job of using FBS to work around a number of the issues that we know. As an example, in December, I think 85% of our employees had COVID, and yet we still delivered the numbers pretty strongly in the region. So we feel very good about our team's ability to continue to execute. First quarter is going to be impacted by -- in our health business. Obviously, it goes without saying some of the challenges that have been there relative, but those are getting better by the week. And we're going to have a good year in China. It's going to be our highest growth region for the year.

That's good context. And then if we think about the organic sales weighting for the total enterprise, I think it's sort of stronger first half, more subdued second half. Whenever investors see that kind of guide, they're always -- and [indiscernible] goes up, is this something slowing down? Is it just conservatism? Is it neither and it's a function of comps? What's your sort of explanation logic?

Julian, I think that the way we've laid out the year has our normal seasonality: 48% in the first half, 52% in the second half. And it really does get to the comps as you probably remember last year, Q1, there is the Shanghai shutdown. So you're going to see some things that move around. But when you just step back and look at it, we don't have any hockey sticks, we're pretty normal, exactly normal to where we would expect. So [indiscernible] about the comps.

And I think if you look at the 2-year stacks, we're actually getting a little bit better in the second half. So just to kind of give a little bit of context.

That makes sense. And there's some productivity actions. Companies like Fortive are always very on top of kind of keeping costs under control for how the top line is moving around. How is the productivity action kind of playing out? What business units are most affected by those efforts?

Yes. We talked about $25 million to $30 million in the first half. It's pretty evenly split to get about half of that done in Q1. The rest will be in Q2. When you think about it by our segments, I think of it 40% going towards the Health. There's a variety of reasons for that. Obviously, we've done some carve-outs. There's a little more to get after there. And the rest of it is evenly split, 30-30 percentage of the total between the other 2 segments.

Perfect. Thank you, Chuck. And maybe looking at some of the specific businesses, the facilities piece, FAL, you've brought together kind of 3 business -- 3 large businesses within that smaller pieces as well. How do we think about that business kind of as we go through the year? And maybe just give a broader context as to how integrated are the businesses inside it? How kind of satisfied are you with the size and shape of FAL today?

It's a great set of 3 businesses, as you said, Gordian, Accruent and ServiceChannel. And we're -- we had a tremendous year with that business in '22 after a very strong year in '21. So that's going to be a double-digit grower for sure this year and certainly into the future. We think -- what we really do in pure essence is we're really managing the assets and the facilities of most major companies in the world. So we manage leases. We manage the assets themselves. We do commissions, some maintenance systems, those kinds of things. But we're really focused on the facility manager and what they do every day. And in an age where the ambiguity and maybe the economy is a little noisier, people are looking to understand their assets better. They're looking to save money on their facilities. And so quite frankly, our value proposition just gets accelerated. And so we're going to have a good year. Now as we said on the call, we'll -- first quarter is going to be a little wonky because we had such tremendous growth in ServiceChannel last year in the first quarter. And we're converting them from a somewhat pass through -- part of the revenue stream was a pass-through business. Think of it as playing a general contractor, and with not a lot of high margins. And part of our strategy for higher growth and higher profitable growth was to convert that to a software solution, which has been really well received by customers. But there's a little wonkiness in the first quarter but we'll accelerate through the year, and we feel really strongly about the strength of the growth in that business. Accruent, again, getting better. And as you said, they're becoming more integrated, particularly ServiceChannel and Accruent where they do serve in many cases, similar customers. Gordian remains somewhat mostly focused on the end markets of public facilities, state, local governments, federal government buildings.

And maybe on that point, you mentioned ServiceChannel that was acquired 2021. Provation was the other large acquisition of that year for Fortive within the health care business. How are those 2 businesses performing inside the company? How do you feel about the returns profile 3 or 5 years post deal for those 2?

Well, I think in simple terms, we said we get about $0.12 of accretion in '22, we got $0.14. So I think, number one, we beat what we said we were going to do. So that's the high -- maybe the headline. But I think underneath that, I think we're incredibly happy with where those businesses stand. Both of them, one, we had our leadership conference last week. We give a little bit of internal awards, but they were all cleaning up with awards given their growth and improvements in profitability. So we feel very good about what the trajectory of those businesses where they're at, where the leadership teams are at. They're both going to, I think, be tremendous deals for us.

Great. And the Healthcare segment overall, I think it's had a sort of a tricky time because of the external environment since it was kind of -- since the ASP acquisition. How -- what are you thinking about longer-term growth in that business? Do you think it's the market that's been soft or maybe some share loss on Fortive's end? How do you see the sort of the top line growth from here in AHS?

Yes. I mean we -- obviously, ASP, our sterilization business is a big business there. I would say we definitely think that the segment is a mid-single-digit grower on a kind of regular basis. I wouldn't necessarily call the last couple of years in hospitals regular, right? So between COVID and the financial situations that's occurred in hospitals, that's obviously been a big challenge for the last couple of years. But '21 through '23, we're going to grow 4% in the business. So the margins are continuing to expand over that time as well. We're in a wonderful position. We saw some -- even some nice green shoots in the fourth quarter. Consumables were up high single digits at ASP as an example. So we're well positioned in our software solutions at Censis and Provation. So we think we're well situated. I mentioned the China impact that's going to have some impact at ASP, which will impact the growth of the segment in the first quarter. And some sort of headwinds at Invetech, which is a small business, but has some sizable COVID-related situations. But we feel really good about where that segment is right now relative to the year. I think it's a show-me year for that segment, but we feel good about their ability to pull that off.

And within AHS, are there kind of things you're doing differently today versus 3 years ago when the segment was kind of taking shape inside the organization? Or it's more about, no, you're doing the same things well? It's just some of those external factors become more helpful?

Well, I mean, our culture is always about being better. So I would say, number one, there's lots of things we could do better, and we're focused on that. But I think we start to get back to some of the secular drivers that made us interested. The durability of growth, the fact that in the U.S. and in Western Europe, health care is going to become a greater amount of spend just simply because of the demographics. In the developing world, people want higher quality health care. It's one of the first things they want. So I think those secular drivers, in the case of sterilization, there's technology that's related to surgeries, like robotic surgeries where terminal sterilization, where we mostly play at ASP, is needed more so. So there's going to be more sterilization, less -- maybe a little bit less to infection, more sterilization going forward. but we'll now start to see those secular drivers play out now that things normalize. I'm not suggesting '23 is going to be back to normal in hospitals. But it's going to be better than '22, we think. And we think it continues to -- so the secular drivers start to play out better, and we anticipate that certainly will be a beneficiary of that. And we've been doing a lot of work in terms of FBS in those businesses that we're starting to see. Provation and Censis as examples are some of the newer businesses certainly have been great practitioners of FBS in their early days. And ASP has really started to do that. I think we had tremendous working capital over the last couple of years as an example at ASP. So despite a little -- they've been a little bit challenged on the growth side, their free cash flow is exceptional. Because of the working capital improvements, I think, what, $70 million of...

Over the last couple of years.

Over the last couple of years of that working capital we've gotten out of the business.

Perfect. And then looking at sort of IOS and PT for a second. You've got the FAL piece that you built up. But if you look at sort of the base hardware businesses in those 2, Fluke and then Tektronix, how satisfied are you with the effort to sort of digitize those, make them less volatile, perhaps more recurring to the extent you can? Any updates on that progress?

Well, I think the Fluke story has been one over a couple of decades, right? You know it well. But I think, number one, we built a health business that was -- became so big that we moved it into the Health segment, right? So they don't get credit for that in the segment. But that's been a really steady business and will be a steady business and a little bit -- if we get a little bit more turmoil in the macro. We built a software business with eMaint and commission-based monitoring business. So yes, we've done a lot of things at Fluke. And then on the innovation front, we're probably going to have our best year for innovation at Fluke in 2023. So there's going to be things that are going to be able to fight a number of those macro things. On the tech side, I think we've just had a great story at Tektronix. I think the secular drivers that we've talked about, I think we've moved the long-term growth rate up at tech, by focusing on things like everything needs a battery, and that battery needs to last longer and it needs to be smaller, and that requires new designs. And tech is -- there's a whole bunch of signal analysis that you need to do to do that. So I think we're well positioned in tech. We put a service business on to Tektronix. So I think both businesses -- they won't be completely devoid of a severe macro situation. But I think maybe what we sort of think, which is maybe noisy, we think the businesses are both in good shape. And as we said, tech has a tremendous amount of backlog. So we feel good about '23 and '24 as we look out right now as far as the crystal ball can really see.

That's helpful. And on the subject of tech, clearly, people are interested in seeing how the National Instruments process plays out. I think maybe some investors were sort of concerned after the last earnings call, some of the commentary around willingness to issue equity for certain transactions. Yes, I just wondered sort of how you would approach this, the subject of National Instruments specifically, if there's anything to sort of point out or highlight?

I don't think we comment on any deal that's in a market, I'm sure you know that. Of course, we think our share price is undervalued. In any case, equity is a nonstarter for us, issuing equity.

Got it. And then more broadly, I suppose, on capital deployment. Last year was a quiet year for good reasons, and we'd expected it to be a quiet year for acquisitions. How is the environment overall for M&A right now? Last year was a tough year and a lot of good stuff came up. So I know it was a good year for you to be on the sidelines.

Well, we were busy. So it wasn't one of those things where we weren't doing anything. But M&A is hard to predict. And as we've said and we talked about this, it's hard -- given the valuations of where things were at, I would say, 2022 was a year where the bid-ask separation was pretty high. You started to see some of those things calm down a little bit. Not perfectly, but -- yes, we think there's opportunity out there for sure. We've got a number of things in a year where maybe we think the process has started to slow, maybe in the second half, but we're out cultivating. We're out doing market work, continue to assess opportunities. So we -- balance sheet is in great shape. So in that sense, we've got plenty of firepower. We'll certainly look for opportunities, but we're going to be disciplined. We're not going to necessarily -- I think we've got so many great businesses that are really contributing to Fortive today, that if we had to go a few quarters with not doing a deal, it's not -- we don't embed anything in our guide that we need to do in any way, shape or form. We can deliver, I think, continued outstanding results without it. And we hope we continue to accelerate strategy with some great businesses in the future.

Understood. And on the point on -- Chuck, you mentioned the sort of where the shares are and so on of Fortive itself. I think there's always a view among investors that anyone from a sort of a Danaher background is immediately very antithetical to buybacks philosophically. How is -- how are you thinking about the appeal of buybacks?

I don't think it's -- as we said, when we bought some shares back last year, we'd be opportunistic when we -- depending on this situation, that's probably where we're going to -- that is where we're going to stand. That doesn't mean it's in our program, it's not a commitment every quarter. But when we think we're undervalued, we'll consider it. But not -- it's not going to be all of our free cash flow for sure. But just -- we'll see how the year plays out.

Yes. And on the M&A approach, I just -- some investors are worried about the multiples that you paid for 1 or 2 deals in the past. Has anything evolved around how you approach M&A? Or the view would be, no, because we know we get very good returns on those transactions after a couple of years.

Yes. I think about a number of -- first of all, I think when we look at -- if we go several years back, the deals are all -- we've talked about ASP being sort of a corner case of a challenge, a little bit more challenged given the pandemic. But the other deals were -- as we come up on 5 years, we're hitting that 10% mark or better. And so -- and we keep going. I think that's the other thing with the way we've moved the recurring revenue from 20%, a little less than 20% to 40%, almost 40% now, we're going to continue to build that revenue base over time in these deals. So we talk about the first 5 years. But now you're starting to see the benefit of some of those deals in their 6 and 7 years. eMaint, the first deal we did which was a software deal, is probably our best software business in the 6th and 7th year. Net dollar retention approaching 110% margin, Rule 60 kind of business. So we just think that we'll continue to be disciplined. We're going to continue to use the benchmarks around ROIC that we've discussed. But we think bringing those businesses in, really helps the business. And I think you see that in the metrics in 2022, particularly in the free cash flow. I think when you look at our free cash flow differentiation, the businesses we bought, really contributed to strong free cash flow. The software businesses are a tremendous contributor. And the compounding that comes from that over time is pretty tremendous. So we feel good about where our strategy is. And I think we continue to -- as we said, '22 was going to be a show-me year. People would see the benefits of those things. I think we demonstrated that. I think every year is a show-me year to some extent. So we'll make '23 another show-me year. But I think you'll continue to see that, and we feel good about the returns we're getting.

And then lastly, before we move on to the audience response survey. Divestments, Fortive has been always an active portfolio manager. It's been a couple of years since Vontier came out. Should we expect most divestments, or divestments in general to be small in scale, and that was the last kind of big one.

Well, we just were with our Board in January where we reviewed our strategic plans for the next 5 years. I think we looked across the portfolio and felt really good about where we stand in the businesses. But as you said, we always reevaluate. That's why we do those plans every year. We do an assessment of the external environment. Did competitors consolidate? Are there changes in the secular drivers? So we'll always reevaluate. But I think where we stand right now, we feel like the portfolio is in a good place.

That's helpful. Great. So let's switch now, please, to the audience response survey. You've got those small gray devices on the desk. So the first question...

Do we get to vote?

No -- these should be locked up. Do you currently own this stock? [Voting]

60% no. The next question is around the general bias to the stock today, positive, negative, neutral? [Voting]

And so fairly balanced, very little negative. The next question, what do you think through cycle earnings growth for Fortive will be? And the peer set here, probably broad industrials or multi-industry if you like, so a pretty broad peer set I think is the right way to look at this. [Voting]

And so most of you think above average. The next question is around what should Fortive do with excess cash? A lot of different choices there. [Voting]

So mostly bolt-on acquisitions, not much appetite for the larger ones. And then we'll move to what PE multiple on 2023? There's a wide range. I think obviously, there's been a broad re-rating the last few years. [Voting]

So mostly, yes, 17 to 20x, it looks like. And then the next question is around why do people not own the stock or own less of it rather than more of it? [Voting]

So core growth and capital deployment. Clearly, the margins have run extremely well and the cash. And then lastly, does ESG play an active role in your decision-making relating to the shares? [Voting]

So very little impact in general. Great. Well, thank you so much. Thank you very much, Chuck.

Thanks, everyone.