Fortive’s Next Big Testing Is Around The Corner (NYSE:FTV)

Writing about Fortive (NYSE:FTV) back in March of this year, I expressed some concerns about whether the company was really living up to its billing as a “compounder” that could consistently add value through M&A. While liking the company’s efforts to build up strong recurring revenue and exposure to long-term secular trends like automation, electrification, ESG, productivity, and safety, as well as the company’s prospects for above-average growth, I still had some concerns about the margins, M&A discipline, and valuation.

The shares did subsequently slip into the mid-$50’s, a point where prospective returns would have been in the high single-digits, before rallying and outperforming the industrial group. Close to 10% higher now, Fortive has been delivering more of late, and it looks better-placed than many of its peers/comps to navigate this next phase of the economic cycle. Valuation is less exciting now, and unless you’re willing to go back to the “good ole days” of 20x-plus EBITDA multiples, it’s hard to make the case that Fortive is fundamentally undervalued.

Far From Perfect, But Strong Nonetheless

Analysts and investors are going to fret a while longer about the weakness in Advanced Healthcare Solutions (not unreasonable, in my opinion), but even with the handicap of an underperforming segment, Fortive still delivered a strong all-around quarter relative to both expectations and most other industrials.

Revenue rose 12% in organic terms, beating by about 1%, with balanced contributions from both volume and price that had the company within the 11% to 13% range of average organic growth rates this quarter. The Intelligent Operation Solutions (or IOS) business grew almost 14%, meeting expectations with strong growth from Accruent, Fluke, EHS, and ISC. Precision Technologies (or PT) posted 19% growth that was 5% ahead of expectations, with double-digit growth across test & measurement, sensing, and PacSci. Advanced Healthcare Solutions (or AHS), was the outlier, declining 1% and missing by almost 5% with weakness across the board (including just low single-digit growth in ASP’s sterilization business).

Gross margin rose 80bp year over year and 110bp qoq to 58.1%, as the company continues to benefit both from pricing and a business mix that is less exposed to input cost inflation (like software). EBITA, which is management’s preferred operating income metric (because it eliminates the significant impact of amortization expense) rose about 20%, with 19% segment-level growth. IOS beat by 2%, with 25% profit growth and 260bp of margin improvement to 29.8%; PT profits rose 29% (beating by 11%), with margin up 280bp to 25.9%; AHS profits declined 8%, missing by 16%, with margin down 240bp to 20.6%.

Looking at more traditionally-defined operating income (albeit still adjusted for some items), Fortive’s profits grew 20%, with segment profits up 19% and segment margin up 120bp to 19.8%. By this approach, IOS profits rose 2% (margin of 22.3%), PT profits rose 11% (margin of 25.2%), and AHS profits fell 40% (margin of 6.3%).

Ready For The Cycle To Turn… But Also Leveraged To Long-Term Opportunities

Compared to many companies in the “multi-industrial” group, Fortive has less to fear from a weakening macro environment – an environment where multiple CEOs (including those at Dover (DOV), Eaton (ETN), and Parker-Hannifin (PH)) have alerted investors to growing pressures on the business outlook. Fortive management has acknowledged the risk of a slowdown for the hardware side of the business (about 55% of revenue), but the company is at least going into this with a backlog about $300M above normal.

Although a lot of Fortive’s “industrial/manufacturing” exposure is a black box, and it does represent around one-quarter of sales, even one-quarter exposure to short-cycle would not be that bad compared to many other industrials. Moreover, Fortive has been building up its software and service offerings to those markets – offerings that are less prone to meaningful cyclical downturns. In the cases of Fluke and Tektronix, for instance, while cyclicality is normal here, the company has been working to bulk up its software, IoT, and service offerings to mitigate that cyclicality.

Beyond that, end-markets like healthcare should see ongoing recovery as procedure counts continue to normalize (still around 5%-10% below pre-pandemic norms in most cases) and hospital capex gets back to normal, and markets like aero/defense and oil/gas should be set for further growth.

Beyond short-range cycles, Fortive does have some solid long-term secular exposures. Businesses like IOS are leveraged to increasing regulation and focus on safety, as well as ESG compliance, and PT has many businesses that facilitate automation and electrification – management has claimed that about half of its portfolio is tied to automation and/or productivity improvement in some fashion. Given the challenges in driving margin expansion, I can’t imagine that customers won’t be keen to adopt additional cost-saving productivity tools.

Fortive is also well-placed to take advantage of growing reshoring of manufacturing and longer-term capex cycles tied to automation, decarbonization, and electrification, as well as “catch-up spending” after years of underinvestment in internal manufacturing capabilities.

The Outlook

Not everything is great at Fortive. I’ve had plenty of doubts and criticism about Fortive’s acquisition strategy, particularly in AHS, and the recent performance there doesn’t lead me to think I missed the mark. Perhaps supply constraints, worker shortages, and capital budget turmoil are suppressing performance, but these businesses have yet to live up to the expectation established by their price tags.

I had initially expected $5.75B in revenue from Fortive for 2022, and I’m at $5.79B now, so not much has changed. Likewise with next year, while I’m more concerned about the overall short-cycle side of the economy, I’ve only modestly trimmed my prior $6B estimate given Fortive’s relatively well-shielded business mix. Longer term, I’m still looking for revenue growth in the 4% to 5% range, and I expect the company to continue to be active on M&A (though more on the bolt-on/tuck-in side as opposed to entering large new verticals).

I do expect margins to improve from here, though I don’t expect Fortive to have as much to gain from input cost normalization. EBITDA margins should be in the mid-20%’s for a few years, climbing toward the “mid-to-high” 20%’s in 2024/2025. Long term, I expect free cash flow margins to move into the low-20%’s, driving around 7% long-term FCF growth.

The Bottom Line

Even factoring in future value-creating M&A (the notion of which itself may be controversial to some readers), Fortive isn’t all that cheap on a discounted cash flow basis, and the prospective annualized return appears to be on the higher side of the mid-single-digits. An EV/EBITDA approach is no better, as the shares already trade at a robust multiple relative to the company’s margins and returns (ROIC, etc.); unless you’re willing to argue that valuations for “compounders” like Fortive should be back in the neighborhood of 20x, it’s hard to argue that the shares are significantly undervalued.

Valuation isn’t everything. The market will overpay for what it wants (namely growth and margin leverage), and Fortive could have more of those to offer than its peer group next year. I can go along with a more tactical or valuation-insensitive bull argument for Fortive on that basis, but for me the numbers just don’t work so well at this level, even though I do see Fortive as a fundamental outperformer next year on its less-cyclical recurring revenue base.