VNT - Fortive Delivers A Good Quarter But Still Has Work To Convince The Street

Summary

• Fortive beat sell-side expectations with strong results from the IOS and PT segments driving 14% organic growth and beats at the revenue and EBITA lines.
• A macro slowdown is a threat to Tektronix and Fluke, but Fortive has a good mix of less cyclical and acyclical businesses and should continue growing through the lows.
• Within the more rarefied air of "compounders", Fortive's valuation seems a little low, though further margin improvement would be welcome.

For as well-loved as Fortive ( FTV ) seems to be (at least in terms of sell-side analysts and readers who leave comments on my articles), the reality is that these shares have underperformed the broader industrial space since the Vontier ( VNT ) spin (by about 30%), as well as on two-year and one-year comps and since my last update . Interestingly, as a group, the stocks referred to as compounders (including names like AMETEK ( AME ), Danaher ( DHR ), IDEX ( IEX ), Roper ( ROP ), and Thermo Fisher ( TMO )) have also collectively underperformed, though by less than Fortive.

I believe at least some of this can be tied to simple multiple compression and derating, but Fortive does sometimes feel like the odd company out when compounders are discussed. Maybe that’s because there’s still more “old school” industrial businesses here or perhaps it’s dissatisfaction with the M&A program (I’ve had my issues with the targets they’ve chosen and premiums paid). In any case, while I do have some concerns about businesses like Tektronix heading into a slower macro environment, the shares are looking more interesting at today’s valuation.

A Beat To Close The Year

Fortive produced fourth quarter results that I believe will likely stand out as one of the better performances within the space, though it’s still relatively early in the cycle. More importantly, revenue and margins were healthy and guidance was relatively positive compared to expectations.

Revenue rose 14% in core organic terms, beating by about 2%, and stacking up well against Danaher (up 7.5%), IDEX (up 12%), Roper (up 7%), and Rockwell (up 10%). Revenue was driven by Precision Technologies (up 20%, beating by 5%), with very strong results at Tektronix, but Intelligent Operating Systems (or IOS) was also strong with 13% growth (a 1% beat). Advanced Healthcare Solutions brought up the rear again with 5% growth (a slight miss).

Gross margin improved 50bp yoy and 20bp qoq to 58.3%, while EBITA rose 16% (with margin up 110bp to 25.5%), beating by 2%. Segment-level profits rose 18%, with margin up almost one point to 19.3%. By segment, IOS grew adjusted profits by 32% (margin up almost four points to 23.9%), PT by 31% (margin up 290bp to 25.9%), and AHS shrank by 26% (margin down about five points to 10.8%). Relative to expectations, IOS and PT were ahead by 5% and 6%, respectively, while AHS was 8% short.

Management guided for core revenue growth of 3% to 5.5% in FY’23, with underlying software growth in the double-digits and AHS ex-software up low single-digits, suggesting some upcoming pressures on the hardware business, though they will be delivering on a sizable backlog for the first quarter or two.

A Slowing Macro Will Impact The Business, But A Few Self-Help Drivers

Fortive’s Fluke business has in the past been a pretty good lead indicator for a broad range of industrial markets, and the low-teens growth here is a positive sign, though likely inflated by a sizable backlog going into the quarter. New products addressing growth markets like renewables and EVs can help, but I think there will be growing pressures as the year goes on. Environmental, Health & Safety also remains strong, with Industrial Scientific (up 20%) and Intelex (up double-digits) both quite strong.

I would expect businesses like Gordian, Accruent, and ServiceChannel to be less macro-sensitive. While Accruent does meaningful business with “general industrial” customers, optimization of facility management may be more of a priority in a soft macro, and the business should benefit from past restructuring efforts, not to mention opportunities with utility and oil/gas customers that are less likely to see macro pressures. With Gordian, I think there are meaningful opportunities in school security projects that shouldn’t be macro-sensitive.

Within PT, I would expect to see Tektronix slow as the year goes on, and management acknowledged a modest year-over-year decline in orders in the quarter. Sensing is likely to see more pressure from softer industrial and semiconductor markets, though I expect the latter to rebound later in the year.

With AHS, further normalization of elective procedures should help drive more business for sterilization (the ASP business) and Censis instrument tracking software. I will say again, though, that I think this is a questionable collection of businesses that Fortive assembled at unattractive prices, and I really consider this segment a “show me” story at this point.

The Outlook

With Emerson ( EMR ) going public with its offer to buy NI ( NATI ), it stands to reason that analysts and investors would connect the dots and wonder if Fortive could be a suitor. Management didn’t exactly kill that idea, but did make it clear they were more interested in smaller bolt-on deals, and acquiring NI would cost more than the $5B that Fortive could easily spend on M&A (though management said they’re willing to use equity for the right deal).

One opportunity to consider might be a Reverse Morris Trust transaction where the company would effectively acquire NI, combine it with its Tektronix (and possibly Fluke) assets, and spin it off to shareholders. I won’t run through the numbers here, but it’s interesting enough to merit a mention.

On its own, I continue to look for Fortive to generate around 4% to 5% long-term core revenue growth, while continuing to deploy capital into M&A. I’ve been more critical of Fortive’s M&A program in recent times, with management spending more to get less (in my view), but premiums have come down and I think Fortive has likely learned some lessons with the challenges management has faced with Accruent and some of the medical businesses.

I expect around two points of EBITDA margin improvement over the next three years and I think the company’s focus on recurrent self-improvement could drive around a quarter-point of annual free cash flow margin improvement over time (averaged out). I also see opportunities to acquire more high-margin software/recurring revenue, particularly as valuations have come back a bit.

As I’ve written in earlier pieces, I do try to model future growth and FCF contributions from M&A. The issue in doing so is that estimating specific annual M&A contributions means that I’ll almost certainly be wrong on a year-to-year basis, but not attempting to model in M&A, in my opinion, means being even more wildly off-target down the road, as value creation from M&A is a core part of the Fortive business plan.

I end up with a “core” DCF-based fair value of around $67, with another $9/share or so from M&A, and that does suggest some upside from here. Looking at Fortive’s track record of revenue, EPS, and FCF growth, as well as margins and ROIC, I don’t believe the stock merits a forward EBITDA multiple on the high end of the range for compounders (20x-24x), but I do think 18x is fair, and that would give me a $75 fair value today.

I should note, though, that as is the case for almost all compounders, this is well above what the market would normally pay for an industrial with similar margin/return credentials, and we’ve seen multiples contract among the compounder group over the last year or two.

The Bottom Line

Within the compounders, Fortive is not really my favorite, but I do think there’s a good risk/reward trade-off today. I have some larger macro concerns, but I think Fortive is less vulnerable than many, and I believe there are still opportunities to build value through strategic M&A. All in all, this is a stock to consider.

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