Fortive Corporation (FTV) Earnings Call Transcript & Summary

And thank you for joining us to kick off Baird's 2023 Industrial Conference. I'm Rob Mason, the senior analyst at Baird, covering the advanced industrial equipment sector. Very glad to have Fortive with us this morning. Fortive is an industrial growth compounder with a high-quality portfolio that management has diligently and purposely shaped with a number of strategic actions to address critical workflows. We're very pleased to have with us this morning, Chuck McLaughlin, Senior Vice President and CFO; and also joining Chuck is Elena Rosman from Investor Relations. Chuck is going to open with a few comments. Then we'll be able to take your questions. We are Wi-Fi challenged this morning. So we'll -- during Q&A, if you have any questions, we'll ask you just to raise your hands, and we'll try to work those in. So Chuck, I'll turn it over.

Thanks, Rob. And good morning, everyone. Make some very quick comments on some of these slides, some of you may have seen before. I want to talk about the themes that we want to talk about, not only this morning, but throughout the day with many of our high-quality meetings that we have. And we want to emphasize how we transformed our portfolio since separation and more importantly, really over the last 5 years, highlight how our segment strategy is working with the connected workflows, we're going to touch on that. Remember that always, the 40 business system is the pillar that really gives us, we feel, differentiation and then talk a little bit about capital deployment and how we see remaining disciplined but actually being able to put to work quite a bit of firepower to work over the next 5 years. We have 3 segments in our business around 5 workflows. We've been, as Rob mentioned, have been purposely changing the mix here around these workflows to better secular trends and also to make the less cyclical in nature and then also bring in some capital deployment towards growth to your higher-margin businesses. These 5 workflows come around some -- we talked about secular trends and this is a slide that talks about just where the 3 biggest secular trends, not the only ones that we have in these workflows and where they show up in our businesses around automation and digitization the energy transformation that's going on and then also just productivity and growth in general. So CFO, I love this slide really shows where how FBS has really been making an impact with -- as well as the M&A strategy coming together, improving the growth we started as a business that was low single-digit growth through the cycles. We feel that we're showing and demonstrating mid-single-digit growth as we go forward. We'll talk a little bit more about that. Our margin expansion since 2019, averaging over 100 basis points of operating margin expansion. And that's obviously going in the right way. And the disciplined way the 40 businesses shows up in net working capital, you can see how that's trended the right way. And these -- both of these factors come in with stronger EPS growth over a multiyear period and free cash flow and both of those are trends that we expect to see going forward. We're not giving guidance at this point, but we are -- this is how we think about the business going forward with the hardware products being mid-single-digit growth through the cycle, we think of the cycle as 5 years, long usually peak to peak, trough to trough, and we expect and believe we are seeing that improvement to mid-single digit. We've added a health care business. Obviously, the pandemic wasn't the friend there and a few other onetime items here, hiding what's actually going on in that business, which is a recovery coming out of the pandemic and mid-single-digit growth going forward. And I think we're going to try to give more color on that and what that means to be the consistent grower we expect it to be. And then the last thing is around these software businesses that we've brought in, how they've been growing, actually a little bit better than we thought when you take on hold, and that gives us upward pressure on the margin or the free cash flow, the margin expansion as well as the topline growth. As a reminder, we have [indiscernible] in a great position with our balance sheet even after the most -- even after the EA business closes when we think in Q1, we've got a strong balance sheet and cash flow generation, just the cash flow alone over the next 5 years is going to be gives us $8 billion worth of capacity. So a lot of ability to work here. When you look out over what the next 5 years is going to do and looking back with the last 5 years, you can see why we remain excited about our future. With that, I'm going to sit down, and we'll talk about -- take a few questions.

Fantastic. Chuck, maybe just to start for Elena. Obviously, portfolio resiliency has been intentional, like you mentioned, and the strategic emphasis, and we've kind of seen that play out in third quarter results, even year-to-date results in certain areas. But no question where a lot of the conversation landed on this last quarter was around the product side of the business. You just kind of level set and again, when we're talking about products, a lot of that is concentrated around Tektronix, Fluke, Fortive sensing business just put it in proper context. Just kind of level set us on the momentum in those areas right now as you exited the third quarter?

Yes. I think what's happened was largely in context of what we expect to happen in the third quarter, maybe with a slight -- as we came out of the third quarter, China was -- we thought it would slow the rate of growth and actually maybe contract a little bit in the second half. And it just it contracted a little more than we thought, but not -- but directionally, what we thought, maybe back to what was stuff about China is in Q3 and Q4, as you go back to the beginning of the year, we thought things would slow. And then the first half of the year, it was stronger than we thought. And we said, oh, well, maybe it's going to be a little bit better. But now we're just back to where we started the year. So really not -- if we focus on the year, we really haven't changed from where we started the year. It's just the way the order pattern came in a little bit different. Keep in mind, we're running into some tough comps from last year, which makes it hard to talk about in terms of, is the business really slowing when you're coming off a 2-year comps that are strong double digit? This is a -- these -- the product hardware businesses are mid-single-digit growth through the cycle. And when you have multiple years of double digit, you're going to see we expect to see this slowing. Now the good news is that we've got this backlog that we've talked about. And we are continuing to grow, albeit slower in this year. But on a 2-year stack, it's great. But bookings actually have been going negative for the last 5 quarters in sensing and in the last 4 quarters at Tek. This is usually -- every downturn is different. But this slowing on that bookings is usually a 4- to 6-quarter event. So what we're looking for is, okay, when do these things start turning around? And when you look in sensing, we've got a Qualitrol business, that's already moved into positive territory because it's more focused on a little bit longer-term business on the power grid. So that's what we're looking for here. But largely, this is playing out as we expected. The backlog is protecting us, delivering sales growth as we expected. We're working through that. And then what we're -- 4 and 5 quarters of bookings decline in those businesses, that means we're that much closer to when does that move in the positive territory over the next 2 to 5 months.

And the, maybe call it fall signals, midyear in China, was that more concentrated in Tektronix? Or did that cover broader China?

I think it was, one, it was broader China in the hardware products group, sensing and [ Tek ], Fluke also held up well. We separate the health because they have a different dynamic going there in Q1 with COVID still there. And actually, they're not slowing. And so they're doing very well.

Okay.

I think it's also important that within those sensing businesses, they sell primarily to some discrete large OEM customers. So it's not -- we've had some questions following earnings as to how broad, right, some of the unexpected weakness in China could go. And I think it's very specific to a handful of these large discrete OEMs in certain areas that, as Chuck mentioned, have been -- have seen weakness for now 4 to 5 consecutive quarters.

That's a good point. And just maybe to that point, you talk about the excess backlog that you'll carry into next year and maybe round numbers $125 million or so is what you've talked about. Is that mainly concentrated in sensing? Or is that more broad-based across the product?

I think it's proportional across sensing, Tektronix and then Fluke.

Maybe a little bit bigger in Tek.

That's fair.

Okay. Okay. And so that's the product side of the house, which may be 50% or so of Fortive. But again, a lot of the effort portfolio effort has been on reconstituting the other 50% or so, adding more software, consumables and just the durability and secular growth aspects come with that. You've talked about aiming for a rule of 40 around those businesses to a degree. Could you just kind of fill in where the portfolio sits with respect to that objective on that side of the house?

Maybe if I could just, Rob, the point about the 50% that's hardware products, I think there has also been a lot of work done in those portfolios to reduce cyclicality. And right? So there's decisions made within Fluke, within Tektronix and even maybe to somewhat a lesser extent within sensing, but as Chuck mentioned, Qualitrol is very much aligned to the secular trends around grid modernization. So Tektronix today is 20% to 25% recurring revenue with the services business, right? Fluke, there's a much bigger calibration business with inside of Fluke that's growing with -- again, with a similarly similar to Tektronix growing software and service space with eMaint and getting higher attach rates on some of their services. So -- and then again, the secular trends that Chuck mentioned, I think, are have given the business to some extent, this really elevated orders pattern, which has turned into this backlog buffer that we have because of the work that's happened from a more organic innovation perspective.

No. Very good point. I mean we've definitely seen that play out in the Tektronix business, the end market, I'll say, diversification refocusing efforts there played into that as well.

Sorry, I know you wanted to ask about software. So...

We'll move -- can we move from products to software briefly -- we may come back to products. No, just to maybe put into proper perspective, this objective around Rule of 40 type businesses inside of Fortive. Where we sit today? Just to give some proper perspective, you talked about software businesses potentially even doing better as you brought them into the portfolio, doing a little bit better than over the medium term than you thought.

Well, I think taken on balance, the total business is our Rule of 40, pretty easy to see that, especially when you -- in a year where you've got double-digit top line growth and the margins, the great margins that we enjoy there. A couple of businesses when we acquired them, were more breakeven think service channel, but they accelerated quickly into that. So I think they're all Rule of 40. I think that with -- you take a look at everything, you can zoom in certain product lines, and that's where we see opportunities to do better than that. But we're really pleased when you think about having almost probably $1 billion of software in Fortive that's growing much faster than the rest. That puts upward pressure on every metric that we like, growth rates, operating margin, gross margin, most importantly, free cash flow. So all those things are growing faster than the rest. So when you talk about hardware products being maybe 50% of the business. Yes, we've got aligning around better secular drivers there over the last half a decade and make more resilient, but we've also got this other piece that's growing faster than that. So without anything else, you're going to see that become a smaller piece of the port...

Sure. Sure. Now the mix effect take hold. And maybe that's a segue into just the way that you're thinking about '24 with reference to the what you showed on the slide around some of those software businesses or at least over the intermediate term, high single digit to low double digit, not pinning you down on '24 just yet for that.

Certainly not guiding on '24, but thinking about high single digit, mostly because it's been growing so fast. And we -- one thing that's tough is that when you overachieve in 1 year, you got to be careful about like is that you're going to come into high single-digit growth, but you're still way ahead of where we expect it to be. And that's basically where our software businesses are right now.

Well, how do those line up as you think about entering 2024 with respect to what you could capture in terms of new logo growth in this environment where we do hear about more elongated sales cycles in software versus net dollar retention and cross-sell and being able to walk up existing customers.

I think the net dollar retention is an area where we're continuing to get better. And that's -- so that's going very well. I think that the software businesses -- the selling cycle has actually been creeping out here. But in this year, with where we're achieving on the top line growth, that's -- we're just blown right through that was really a headwind there. So I do think that selling cycles have moved out, but I think they've already moved out. And that doesn't mean they couldn't move more, but that's not what we're thinking at this point.

Maybe just step back high level for Fortive. How are you thinking about pricing as we go into this year or next year?

Well, we've always said that we want to stay ahead of inflation, and that's what we've been doing, and we'll continue to have that margin mantra. And then you see that show up in our margin expansion. So I would expect we're thinking of it that way first. Having said that, we have over -- probably around 4% growth price built in or that we're delivering in 2023 and yet inflation is starting to creep down. So you could maybe theorize that we wouldn't need to put as much in next year as we had in this year. But in normal times, we'd have 1 to 2 -- over 1% of pricing. I don't see us going all the way back to that. So above what our historical norms are, but probably not as high as what we did this year.

Somewhere in the middle.

And even in potentially if the bookings environment in pricing, should we think more pricing occurs in the product side of the business when we...

What we report. Yes, what we report is largely going to be in hardware products and somewhat in healthcare. And a lot of that is reflected in the backlog, Rob, right? That has been repriced over the last couple of years. But I think there's more price coming in healthcare, right? So we've -- that's one area you're seeing some acceleration on a multiyear basis.

Right. It does take longer to work through in that side of the business. And that -- so that should be a help certainly to that side of the business, but price overall somewhat staying ahead of inflation. You've also announced that you're going to take some actions here towards year-end to also better protect as you go into next year. Just -- how should we be thinking about overall incremental margins of the portfolio, which have crept up to close to 40% on more of a baseline level?

Well, the way we think about it is 40% is a good number for us. And then what I think next year, like this year, then you add on the -- any time we do these productivity initiatives. That's in addition to the 40%. And so that -- and that's what we're seeing. We're seeing more 60% this year because of that. I don't know that 60% is exactly the number for next year. But it's -- what I'm really just saying is, 40% is what we expect the incrementals to be. And then when we do these restructuring, we layer that on top of that.

So as a reminder, we talked about funding an additional $35 million of productivity initiatives in the fourth quarter. That's in addition to about $30 million that we did earlier this year. So a lot of that -- most all of that $35 million incremental funding for Q4 will show up in a 1-year type payback for 2024, and that's essentially a much higher incremental than the baseline 40%.

Additive, yes. Maybe we could turn just to the healthcare business. You've had some internal actions there to improve the selling motion and distribution around the ASP business. It sounds like we're now at the -- those are complete as we enter the fourth quarter. But again, just maybe just clarify for everybody what the -- I guess, the financial pickup could be as well as what strategically what that effort is intended to do for ASP?

Sure. At ASP, the biggest piece of the business is the consumables and the biggest single piece consumables in North America. This is about $135 million of the most profitable part of the business that was going through distribution. Going through distribution, you lose -- you pay them a margin. And usually, that -- so it should get better market reach. But what we had is we already have salespeople calling on the hospitals. We already have all the back-office work connected. It was -- this was a legacy from the carve out of J&J. Not saying that they were doing anything wrong, that was right for their business, but we've just been trying to find the right time. There's no great time to go through this dealer transition. But by doing that, we're going to take $135 million and add almost no new salespeople here, but -- so we'll pick up the 7% lift -- some of that's showing up, I think about half of that is showing up this year because how it's played out this year. And then we'll get it further lift, but we're going to pick up 7% just by making that move. We -- but the main reason we want to do this, we want to get closer to the customer, what's really happening in the hospitals. And we always had this not quite a disconnect, we didn't say is a tighter correlation between electric procedures rolling back and so like, well, we're not seeing it immediately in the numbers and why is that? and it's because we had so much inventory more than we thought -- more than they thought the distributors -- they weren't -- they just didn't know how much they had. No one was -- they weren't hiding it purposely from us. They just didn't not accounted that correctly. But we are through that in Q3. It's important to understand for our business at ASP is that the end user use of our products has been -- when you account for that has been delivering mid-single-digit grower really for the past 2 years. When you look at the 2-year stacks even from Q2, Q3. And so we expect to see that in Q4.

And if you think about just procedure rates annualized going forward, we still have some easier comps as we enter 2024 on that front?

I think procedure rates are probably low single digit, 1%, 2% in terms of the core growth in procedures. One of the other added benefits of the distribution model change and we just announced for Q4, the start of some new products. So we just launched some steam sterilization monitoring products, for example, that we can now go to market with because we have that direct channel on those -- these are biological indicators that we're working with a partner on. But it's -- the more we can add into that channel that obviously will drive growth in and above the procedure -- the underlying procedure rate.

Right. Real quick on -- before we leave health care. Could you -- just quick update on probation. You've been able to walk that growth rate up this year. What's been maybe the -- does that growth feel?

Well, I think -- first of all, we've been very pleased. It's grown -- got out of the gate well. And then this year has been stronger than we expected. But it's important to keep in mind is like where we thought we would be at the 3- and 5-year point. And we think that's the right place. So this year's stronger growth will be a little bit of moderation back to probably high single digit, but we're running ahead of where we expected to be, and that's a really good place to be for this. So we've had some success in Atlanta and a couple of big accounts. and some big wins here, which will pay -- are paying dividends right now. And we'll see what -- if we continue to run ahead. But we're pleased with how that's gotten off.

Very good. And maybe I'll pause there just to see if there are any questions, yes in the back.

And then are at the bill [indiscernible] I think you are mid-single digit organically at kind of the building blocks of active.

Are you talking about healthcare in total or...

Healthcare segment.

And for the segment, really, the last piece, there's been 2 things that we I'd say 3 things that we wanted to get in. One, we wanted to get the pandemic behind us and the hospital is back to normal. But I think we're at what we're going to call normal here and to not refer to procedures as a percent in 2019. So that's happened. Second thing is we want to get some -- especially in ASP, some more price into it, not as much as we're doing in the other products. But have that go in, and we've improved from 1%, more like 2% this year. And so that's the driver. And then the last piece is this dealer transition that we get through. It's -- by doing this dealer transition now, unfortunately, it's masking that we're already growing mid-single digit. And so now that we're through it in Q3, we're both sides have agreed that were done. There is nothing else another shoot, Paul, I think that we should -- we will be seeing certainly an ASP, we expect single-digit growth going forward. Now there's a little bit in the Tek.

I was going to say to the plus side, we have software. For example, we were just talking about probation, in our Sensus software business, albeit small, growing faster. So it's growing more in the high single, low double-digit range. But that is currently offsetting a decline we see in our -- in the Tek, which is a bioprocessing. They do contract engineering for medical diagnostic companies. And so you've seen that business kind of rise during COVID and then now is in its period of sort of normalization, we think is that a steady run rate level of revenue currently?

Chuck, I want to hit on real quick. You did see some -- we did see some capital redeployment here more recently around EA electric pronounces probably incorrectly [ Automatic ]. But it does appear to be a very good fit with your Test and Measurement business. You talked about being able to get very good sales leverage, channel leverage, maybe 10x just in terms of REIT around that business. It also looks to have accretive growth characteristics as well. As you look out just into '24 and think about how that could contribute, what's the level of -- because it is kind of implied, I think, low double-digit type growth. What's the level of visibility around that? How should we think about the level of visibility that comes with that business?

Well, first of all, we are very excited about this business. It fit strategically, it's got great complementary products, well, with no overlap in Tek, but other than the -- where the sales force calls. So going to the customer, these same customers where we're already doing things in power with Tektronix, this essentially puts a new product in the bag for them. It's really strong in Europe because -- in part because they're direct in Europe. And then there -- and distributors, think of it the rest of the world, where we can put more feet on the street right out of the gate, calling on customers, showing what the product does. And so that's where we think that there is at that 10x. We just need to train up I'm sure the sales force is like, hey, it's not that easy. But there's training on how to sell and what all the features are, but they're very excited internally to work with them. So we think that it really just starts with our strategy. We've identified that what we're doing already in power, and this is so complementary to that. We think that it gets off to a strong double-digit growth start. Now it's been growing faster than that, up to this point. And we're not -- and we think the market, over the next 5 years, will grow faster than the low double digit that we put in. So we think there's upside from what we've laid out so far. But first, let's get it on board, let's get this closed, and then we'll give a little bit more clarity as we get generally through our 100-day strap plan.

And it's margin accretive as well. I mean it appears to be a very...

Yes. I mean operating margin, gross margins and then growing double digit is we have other businesses that are growing double digit, but that obviously helps at be accretive to the business going forward.

But they do manufacture internally.

They do.

Okay. So obviously, they seem to be doing it pretty well, but I would imagine there's probably FBS opportunity...

I haven't seen a manufacturing facility where FBS can't -- can take a really good business and add some value there. So -- and I think that's what we're seeing here.

Okay. Well, we are out of time, so we'll pull up there. I would mention there is a breakout session that follows. So it's -- you're welcome to join us there.

Great.

Thank you.