Fortive Corporation (FTV) Earnings Call Transcript & Summary

Thank you, everybody. Super excited to have Fortive here with us today. We have President and CEO, Jim Lico; and then Olumide Soroye, President and CEO of the IOS segment and recently named CEO of Fortive RemainCo. So congratulations on that.

Thank you.

Before we get into the Q&A, Jim is going to start off with some prepared remarks.

Yes, maybe real quick, just given the news of the day or the news of a week ago. We obviously announced some big news with the separation and we're really excited about it. You're certainly going to hear that in the words. I'm sure -- I know we've got some questions on it as well. I think it really does really a couple of things for us, which is, one, when we get to the spin, maybe a year from now, we really have 2 really great investable companies. And the growth story of both of those, which we talked a little bit about, I think, is really exciting. And you'll hear from Olumide today more on the IOS and PT -- or IOS and health front, which is going to be new Fortive. But our excitement around these 2 great growth stories is really high. And I would say the second thing is we continue to believe that the company's undervalued. And we think this unlocks a lot of value, both medium term but also long term. And the strategic clarity that this gives us, and then you'll hear a lot about today, is really exciting news for us. So as you mentioned, Olumide will be the new CEO going forward. Tami Newcombe will become the new -- CEO who runs our PT segment today, will become the new CEO of the new company. So also really, really excited about the new leadership going forward. I'll be around until the spin. But I think going forward, we've got really a great exciting 2 leaders to really run these businesses that is going to unlock a ton of value.

Yes. No. I mean I guess kind of just following up on that, on the value unlock. Do you believe that this move is primarily just a driver of value accretion? I mean that you're separating the 2 businesses, have 2 clean stories and kind of unlock that sum of the parts? Or do you think that separating the 2 companies could enhance the focus and the strategic views of each?

I think both, Chris. Really, when you look at it, as you said, where we're trading today and then you look at comps for the two, certainly unlock value, without a doubt. And we can talk about comps and things like that. But certainly, that's number one. We really see that the 2 independent growth stories -- we've got great investors, but some investors are looking for that more durable story. Some of our investors have been looking -- are okay with a more cyclical growth story. And I think what we give now is an opportunity as 2 wonderful assets to invest in. Well, and we also think there's tremendous long-term clarity. I'll speak to the NewCo side, and then Olumide can talk about the future of Fortive. But on the SpinCo side, we've got a business that's tied to great technology markets that are going to grow over time: data center, electrification, defense modernization, semiconductor. Those are really great growth stories. But they have some cycles to them. And so I think people now can understand we're going to have mid-single-digit growth through the cycle company that is a good foundational -- with great margins and great financial profile and a capital allocation story that's really clean. So I think the new company will definitely maybe talk about new Fortive.

Yes. And I think for NewCo, we kind of start with a much simpler and focused agenda for what we do for the world and for our customers. And it's this idea of bringing in safety and productivity to the places where people work and where they get health care. And everything we do in New Fortive is about that. It's about safety and productivity. We have a real focus on multiyear, enduring customer value, which means recurring revenues. So we don't tend to do things that are [indiscernible] and leave. We want to do things that add value to customer over multiple years. That could be software, it could be consumables, it could be subscription services, it could be differentiated technologies. That's why we're going to start off with this $4 billion company with 50% of that in recurring revenue models, and we expect that to expand over time. Importantly, we also will have a much more focused capital allocation strategy going forward. That's going to be more balanced between meaningful share buyback, whenever we see a dislocation. And then accretive M&A that's really, again, focused on recurring revenue assets, things that really tie to our domain expertise in IOS and AHS, and things where we have clear FBS value creation opportunities, which means it just helps us buy assets at reasonable multiples. So it's a much lower risk capital allocation strategy that we can now do because we have this consistent mid-single-digit growing company with very high margins, turning to revenues, into earnings and free cash flows, which on its own just compounds so nicely, you can be a lot lower risk into your capital allocation strategy.

I appreciate that. Jim, you talked about the sum of the parts story, some attractive comps that are out there. From my conversations with investors the last few days, I think people feel comfortable on Precision Tech comps, generally being industrial investors at this conference. I think there's so maybe more uncertainty around the RemainCo. So can you maybe just talk about -- and Olumide, you too, what do you think is underappreciated in New Fortive or RemainCo? And I mean, to the extent you do want to talk about comps you guys see out there, would love to hear that.

If you think about the financial profile that Olumide just articulated, which is going to be 50% recurring revenue, high gross margins, high operating margins and mid-single-digit growth, and the biggest piece of the business growing at high single digits, which means the growth rate is mixing up over time. You think about companies that have a much higher multiple, you might think about a Roper from a few years ago. You might think about Veralto today, as 2 good examples. Down the road as software becomes an increasingly part of the portfolio, you start to think about some of the industrial software folks. So we think there's a good set of comps out there. A little bit more complicated, but maybe -- but he just articulated this the safety and productivity story, I think the clarity of that story and how we build the company over time that -- and the fact that recurring revenue number is going to continue to get higher, I think you get to a really admirable comp set that's really good.

And then on capital deployment. You guys announced that, at least, until the separation, I think 75% of that cash is going to buybacks. Olumide, it sounded like even after this, maybe the allocation will be more balanced between M&A and buyback. So yes, like, is this focused on maybe more cash returning to shareholders is going to continue beyond the separation?

Yes, it will. And I describe it as really a progression, right? So for the first 8 years of Fortive that's behind us now, we've followed a model where incredible free cash flow generation, and we've done a lot of M&A to create the advantaged positions we have today. And we love the positions in IOS, in AHS and PT. Between now and the completion of the spin, we wanted to give investors kind of certainty on the path to return. And frankly, confidence that we believe in the value unlock that Jim talked about. So we are going to put 75% of our free cash flow until spin in share buybacks because we believe that's a really great investment right now. After the spin, the 2 companies will have their own capital allocation strategy. Both of them will be more balanced. But obviously, the new company will form its own Board and come up with that. So I'm going to focus on Fortive going forward. We will be balanced going forward. And that means that you will see us at any point in time look at what delivers the best risk-adjusted returns. There will be times when meaningful share buybacks make sense, and we will do that consistently when we see a dislocation between the stock price and the intrinsic value of the company. And it's the best deployment amongst the alternatives. We would also continue to do accretive M&A, but be a lot more focused and disciplined. We have a magnificent process for looking at assets, but our filter will have a few things. First, we would focus on assets that have a higher recurring revenue content because like I mentioned, at 50%, we want to walk that up, because we believe fundamental on your question on comps. We want to stand for this idea of enduring recurring revenues. So that will be one filter, assets that help our recurring revenue journey. The second filter will be assets that are close to our domain expertise. So we have strong positions in IOS and AHS that we've worked out over the last 8 years to create. We are going to build on that strength. So assets that we acquire, you will find are really close to what we do and they strengthen our positions. We've done 4 bolt-on acquisitions in IOS over the last 2 years. We really like those assets, incredible returns, they come in the land, we scale them on our existing platform. We'll do more things like that. And then we'll look for things that have clear kind of advantaged ownership in our hands, okay? If there's no [indiscernible] owner than 5 other players, you probably would find us back away, because those tend to drive you into multiples that are really not that attractive for us. So I think that balance between share buyback and M&A will be an important piece. Of course, we'll have a modest dividend that will grow with earnings and free cash flow. And we feel enough room for the investment in organic growth. That will be an important part of Fortive going forward. We really believe that the top line growth opportunity ahead of us will come from the innovation vitality that our teams have been working on over the last 3 years that will begin to unfold here.

I appreciate that. I guess kind of staying on the bigger picture topics, AI. What does AI mean for Fortive? You guys sell tools that help develop AI. But AI is a workforce productivity solution. You guys generally sell workforce productivity solutions. And I get questions on, "Is there an AI risk here?" And even I think came up on the last conference call. So really, would just be interested in what your view on that is.

Well, I would say, starting with how we thought about machine learning and AI for half a decade now. We've invested considerably in what we call The Fort, 6 years ago, which was our centralized activity around building capability around machine learning and AI, much like we have an -- the Fortive Business System Office to make sure that everybody in the organization understands the tools of the Fortive Business System. The Fort's responsibility is really sort of incubate AI ideas throughout the company. We've had a lot of progress in that regard. We think about it in a few different ways. We think about the acceleration of product -- maybe 2 in the productivity camp. How do we reaccelerate product development principally through software development using AI tools? We think about it just productivity in general, more broadly. And by the way, we've had about a 20% to 30% improvement in software development over the last, what, 12 to 18 months. We think about it on the productivity front. Just everywhere we have people and how do we accelerate productivity combined with FBS. And we've seen some really strong results there. The other 2 are maybe on the growth front. How do we interact with customers better? And then finally, how do we think about AI solutions better? So I'll let Olumide talk about the AI solutions because they're mostly in his world. I would take the AI competitive front. We've invested -- one of the aspects of investing in our -- the software businesses we've invested in. First of all, one of the reasons why we built the AI capability was I think we had some -- we definitely had some foresight as to how AI could be. We've been talking about workflow solutions for more than 6 years now, and those workflow solutions were hardware to software, software to AI. And so we always look for places where we had data, the data assets that we could leverage AI into, not that AI could attack. And so we really we sit in these places where our data capability and the data assets we have on our own, and we have an ability to monetize it. So we always ask ourselves, as part of why we do strategic plans. How can we be disrupted? Today's topic de jure is AI. But we're always asking ourselves, can we be disrupted? So the strategic planning process that we have also sort of make sure that we continue to ask ourselves those questions. I don't know if...

Yes. I think Jim covered it really well. I'll just add that we actually are excited about the AI use cases. Our teams right now across all our companies have a plethora of use cases that build on the proprietary data assets that are in our businesses and the domain expertise that we have to bring new solutions to customers powered by AI. Because to Jim's point, we have the foresight to start building this capability 5 years ago, before the current sort of spike in interest around AI. So we actually feel like this is an advantage for us. And one of the bolt-on acquisitions we did last year was an AI company that's building a model that we thought was interesting and we could scale. So as part of our recurring revenue, focused, [indiscernible] M&A, we look for chances like that. Because ultimately, you can have the best models, but you have to deliver it to customers at the moment they need to make decisions. And we find our domain expertise in our software deployment actually gives us a pretty big advantage.

Chris, maybe the last thing I'd add is, one of the reasons why we hired Olumide, he won't say this, so one of the reasons why we hired Olumide a number of years ago was his background in data analytics, his recurring revenue experience. And a lot of what Fortive is, is really why we hired him in the -- really, I mean lots of reasons. He's a great guy, too. But he brought a set of expertise and leadership to our leadership team that we didn't have. People always say, when do you go outside versus inside? And one of the reasons why we went outside and hired Olumide into IOS was to bring that expertise into the company. And he's been a thought leader on this ever since. So I think New Fortive is in really good hands relative to this because we've got a leader who's been playing in these circles for over -- well over almost 2 decades now.

Yes. No, maybe turning over to margins, which have really been a standout positive for the company. Even through this period of lower growth with Precision Tech cycling down, the company continues to generate 50%-plus incremental margins. Obviously, the great gross margin helps with that. But can you just talk about some of the drivers of margin expansion the company has been able to put through? And then looking forward, what opportunities do you see on the margin front?

Well, I would say there's really 2 pillars to our margin expansion. The first one is really FBS, and it's finding how are we better in everything we do on a consistent basis. Whether it's the 20% to 30% I talked about on software development or anything that we do. FBS has a set of tools that helps our professionals around the world drive productivity, which ultimately drives margins. And that's just not Olumide and I. It's everyone in the company because our culture of continuous improvement is so foundational to what we do. I think that's number one. I think number two, slightly is the business -- and maybe within FBS is also the innovation front. As we innovate and bring more innovation and accelerate innovation, we're doing that with deeper customer relationships, and we're obviously able to do that at a higher margin aspect because the recurring revenue strategy is a margin-enhancing strategy. And that really gets to the second point, which is the business model. The business model just is also -- is a huge accelerator, more software, more recurring revenue. How we've really built the business model going forward in and of itself is an accretive mechanism to both our gross margins and, ultimately, our margin expansion. One of our great stories is our gross margins, right? I mean I think one of the things that people have seen from us over really the history of the company is the continued commitment, dedication and success of gross margin expansion. And it's almost religion in our company because we ultimately know that when you have continued gross margin expansion, it gives you the degrees of freedom to invest in the business while at the same time delivering earnings.

Yes. No better way to generate operating leverage than getting gross margin higher.

Yes.

Maybe turning to the markets and starting with Precision Tech. That's really where we're seeing rate of change. Q2 kind of got the book-to-bill back to 1.0. It sounds like the end-markets haven't fully turned the corner yet. What are you seeing? And what's the outlook on Precision Tech?

Yes. As we affirmed last week, so what we've seen is, I would say, consistency for the most part, puts and takes. I wouldn't say we've seen necessarily a broad inflection positive by any stretch. We're going to see orders growth in PT in the second half. Some of that will be comp, some of that will be relative to some things getting better. Some of the order delays that we talked about in the second quarter, we've now seen. So I would just say it's a sustained -- we really didn't expect a big inflection up to begin with. And I think what we've talked about in -- or what we've been talking about is the fact that we're seeing sort of the sustained aspects of the markets at this point.

Yes. I mean the short cycle -- every short-cycle industrial end-market I cover has -- or the destock has dragged on or the softness has dragged on longer than I think anyone really expected coming into the year. What do you think is driving that weakness on some of these short-cycle categories?

Well, I think -- well, if I could predict that to great certainty, I would probably be doing something else. I would say, number one, and maybe this speaks to what we see. Most of the destocking is probably through for the most part, maybe a little bit with some of our OEM customers, specifically in our sensing world where -- that's probably, in the end of the day, it's probably more a demand challenge than an inventory issue. As I always like to say, inventory issues -- inevitably demand problems become inventory issues, right? So there's a little bit of a chicken and the egg there. But I think it comes in pockets. We've got some markets, I'll use our sensing business as a good example. Electrification continues to be really strong. On the other hand, we're seeing things like maybe some of our industrial automation customers and stuff like that. Maybe extending a little bit of slowness more into maybe later in the year, maybe even into '25. So I think it's a vertical-by-vertical story. And I think the beauty of kind of how we've been able to continue to be so successful this year financially is because, one, we've got a number of businesses that are really continuing to do really well. And I think we've gotten ahead of a lot of the challenges we've had in some of the businesses. So we continue to have margin accretion in most of those places, while despite maybe a lower -- a tougher top line. So I think just the way we're going to think about the rest of the year relative to PT and Fortive in general is probably not as big an inflection point, but I think what we said when we affirmed was basically a statement that says we believe we'll continue to deliver on our commitments and our -- with the environment we're seeing.

Yes. I mean you touched on sensing. Maybe hopping over to Tektronix. Q2 felt the impact of some of the delayed government and military spending. It sounded like before, maybe some of that has got going. So what do you see there into the back half? And then particularly on government and military into '25 and beyond, how does that outlook look?

We think good. Certainly, on the -- in the part of our business that's maybe more around programs and things like that, that are ongoing, is more production, like our EMC business. That business continues to be very good and it's going to grow really well and has a completely booked-out backlog for next year already and beyond. So we feel really good about that. The investment cycle -- but one of the other sides to that is that as people invest, as maybe those same customers invest in innovation, primarily Tektronix, they can delay from a quarter or 2 of their program, right? And so what we're really seeing is we're not seeing -- what we're trying to say in the second quarter is we're not seeing that business go away. We're just seeing a little bit of delay. But it can't be delayed indefinitely because those same customers are investing in innovation, they're investing in technology change, and we know that's going to continue to occur. So the business that we saw, we've seen we pretty much now have. So we feel good about that. We'll continue to probably see -- and maybe this gets to your broader point, I think the uncertainty -- certainly, some of the uncertainty we see around the world right now, just more broadly, I think leads some of our customers to maybe delay a spend for 1 quarter or 2. So I don't think it's necessarily the business is going down as much as the variability of the business. And that's what we were trying to articulate in the second quarter. So we're just seeing more of that variability. You just maybe don't count on the order as much as you did in a sales funnel maybe that you did a few years ago. And until we see more certainty in that, we're going to manage the business accordingly. And that's what we've got in the guide for the year.

Yes. I mean the big projects moving slowly is something we've pretty consistently hurt throughout. It's also weighed on EA Electro and some of the project pushouts there. But I guess, under the surface on EA Electro, how are the selling synergies going with Tektronix? And what do you see under the surface there that gets you optimistic about '25 and beyond?

Yes, the strategic thesis around EA was really around we believe deeply in electrification and in the engineering, R&D development and validation process, which is the development of all things known to batteries, as well as semiconductors and chips that need lower power in order to play in lots of markets. We believe deeply in that trend. And I think everything we've seen thus far would suggest that demand is there. It's more cyclical than we anticipated, and so particularly around EV mobility. And so that's why we said these projects have moved out. But the technology, the innovation capability of the business, the customer relationships have been better than we even anticipated in that sense. It's just that some customers have decided to move their investment cycles out a little bit, as we talked about. But relative to how we think about the business relative to synergies, we're actually ahead of the game. So the tech team in creating a run rate business, because the business is mostly project related, the ability for the team to build a run rate business is on track. So unfortunately, it's not the biggest part of the business. If it were, we wouldn't have had as many issues with the business this year, as we described. We've now taken the revenue down. But I think the long-term view of the products, the technology and the synergy with tech, very much intact.

Yes. Appreciate it. Maybe hopping over to IOS and that facility, asset life cycle. You guys are calling for better growth here in the back half of the year. What's driving this? And then more broadly on that business line, who do you guys compete against? And why do you win?

Yes. So that business for us over the last 2 years has grown mid-teens on a 2-year stack. So it really, the acceleration in the second half is just returning to the path we've been on, which is high single digits, sometimes low double digits. So the Q2 was a little bit lower in mid-single digits, mostly comp because we had a massive recurring kind of revenue quarter last year. So it's really returning to the path we've been on. What's driving the success in that growth platform for us is the work we've done on really improving the innovation vitality of those businesses, because a bunch of them are software data businesses. The work we've done on the go-to-market effectiveness, that's what we started with 2.5 years ago. And that's, as you know, that continues to yield result for us. And the fact that we picked really advantaged positions in this key workflow around facilities and asset life cycle, which goes to your point about what we compete with. The positions we've created are really unique, and there are a few players that do what we do. So in the plan stage, we have data that's the industry standard [ in RS ] means, for how you plan construction of buildings. No one else really has that same industry currency type data. And then we play in a lot of kind of procurement type for government agencies operations with our job program. Nobody else really does that at the scale that we do. And then for the things we do in maintaining and operating buildings, there are other players, but they don't have the marketplace that we have. And so the thing we like about our position is they're really, really unique and there are few players that do what we do. I'll tell you who we don't compete with, kind of the building controls players. We really do something totally different. In many cases, some of them are partners of ours because they pull through our solutions. And the facility management companies, we don't really compete with them because, again, they need the tools we provide to do what we do, so most of them are partners of ours. So most of the players we compete with are either nonexistent in some of the places we're in or really kind of small kind of players in most of the other areas. So that's one of the great things about the position we have in that workflow. And back to your original question, that's what's driving the growth. It's because we have these really strong positions.

Maybe hopping over to Fluke. Why has Fluke been able to avoid the downturn that we are currently seeing in tech? Is it just a function of the multiyear comps? Tech cycled up a lot harder coming out of the pandemic? Or are there specific secular drivers that Fluke's attached to that is just allowing it to remain more resilient?

Yes. I mean Fluke and tech are really different businesses. I think Jim touched on this. So Fluke is not just kind of tools for process engineers and maintenance technicians. In Fluke, we've got advanced calibrators that are over 100,000 per unit, and we've got digital multimeters. So it's really just a wide range of products. It's a much more global business. It's tied more to the operating rhythm of companies than CapEx cycles. And tech, on the other hand, is a lot more about the R&D, to Jim's point, and the CapEx investment cycle around that. It's a lot less global in terms of the market. And to your point, it cycled off and down a lot more for that reason. And so what we've seen at Fluke is it's a really resilient business that's been created both as a result of that composition of the business, but the work the team has been doing around NPI over the last 3, 4 years, the fact that we've now been growing the recurring revenue component of Fluke that's still just at 10%, but it's been growing low double digits now for the last 4 years. And so Fluke, very much -- that's part of why it fits in Fortive going forward, because it has this durability to it that feels recurring. And we believe there's a chance to keep expanding the recurring portion of Fluke. So it's really just very different types of business. It's both fantastic. Tech will ride off a lot more the technology trends, but then there's a downside on the other side of the slope. I think Fluke has got more of a strong, sustainable growth.

Yes. No, I certainly see that.

And Chris, I would just add, I think when we think about it, what were really part of this decision to separate is we've made tech a lot more durable, but it's not necessarily completely durable. Whereas the work we've done at Fluke to expand markets, expand geographies, go into different places, including most of the recurring revenue that we have in the company today, emanated out of ideas that came from Fluke. We got into FAW because of Fluke. We got into Fluke Health because of Fluke. So the breadth of customers, the breadth of applications, the geographic diversity, has always been an idea generation for recurring revenue and another -- and as well as fantastic free cash flow. And so not only -- it's got more durability, but also just -- it plays a special role in what Fortive will look like going forward.

I appreciate that. Maybe just one last one on AHS. Good, durable mid-single-digit growth business. What should investors be looking for as potential drivers that would take the growth above mid-single digits or potentially take the growth below the mid-single -- what drives it?

Yes. I would really think of growth as it's 1% to 2%, expanding the sort of elective procedures going up every year around the world. 1% to 2% on continued capital expansion and 1% to 2% of price, and you sort of get to a mid-single-digit growth rate. In years where maybe electives bump up a little bit for catch up with COVID, new technologies that may be come up, then maybe it goes up a little bit more. But I think that's really strong recurring model. And I think what we've demonstrated over the last few years is that mid-single-digit growth. You get a little noisy because of the channel change. But I think when you look at it just through the time we've had, it's been really strong.

Yes. And I would just add, we [ beat ] new product velocity. Our team is driving, that's the upside, because we're seeing those businesses really pick up their vitality. And that's what creates the upside.

Yes, absolutely. Well, we're up on the 30 minutes. Thank you guys both for your time. I loved the conversation.

All right. Thanks, Chris. Thanks, everyone.