2023-12-20 02:55:11 ET
Summary
- Fortive should see a reacceleration in growth due to bottoming orders in its Tektronix business and the completion of the transition to a direct sales model in the ASP business.
- The company's revenue growth is supported by strength in the Facility and Asset Lifecycle and software businesses, as well as potential interest rate cuts in FY24.
- Fortive Corporation's margins are expected to benefit from operating leverage, cost reductions, and productivity initiatives.
- FTV stock is considered a good buy due to its growth prospects and attractive valuation.
Investment Thesis
Fortive Corporation ( FTV ) should see a reacceleration in growth in the coming quarters with orders in its Tektronix business bottoming last quarter, and the transition from a distributor to a direct sales model in the Advanced Sterilization Products business getting complete. Further, the strength in the Facility and Asset Lifecycle and software businesses, coupled with improved demand conditions due to the potential for multiple interest rate cuts in FY24, are anticipated to support the company’s revenue growth in the future. In addition to organic growth, Fortive Corporation should also benefit from bolt-on M&As.
On the margin front, the company should see benefits from operating leverage derived from higher sales, cost reductions, and productivity initiatives. In addition, the company’s focus on improving the portfolio mix of high-margin businesses like software also bodes well for longer-term margin growth. Moreover, the valuation looks attractive when compared to the historical averages. So, healthy growth prospects coupled with an attractive valuation, make FTV stock a good buy.
Revenue Analysis and Outlook
After seeing double-digit growth in FY21 and FY22, the company’s growth rate has slowed in recent quarters due to demand normalization and some temporary headwinds in the Precision Technologies and Advanced Healthcare Solutions segment. In the third quarter of 2023, FTV reported a 2.6% Y/Y increase in sales with a 2.5% Y/Y core sales growth driven by a 4.2% contribution from price increases and continued momentum in the software and service businesses, which more than offset the impact of the slowdown in sensing business in China, channel inventory clearing in advanced sterilization products business ((ASP)), and continued weakness in the bioprocessing market in Invetech business.
Segment-wise, in the Intelligent Operating Solutions (IOS) segment, sales grew 5% Y/Y with a 4% Y/Y increase in core sales due to a 3.1% contribution from price increases, and strong demand in software and service offerings in EHS and facility and asset lifecycle ((FAL)) applications, which effectively offset the lower volumes in test and measurement instrumentation.
The Precision Technologies segment’s sales and core sales increased by 1.3% Y/Y and 0.9% Y/Y, respectively, attributed to a 6.4% favorable impact of price increases and increases in volume for energetic materials, partially offset by a decrease in volume in test and measurement products and sensing technologies.
In the Advanced Healthcare Solutions (AHS) segment, sales increased 0.3% Y/Y with a 2.2% Y/Y growth in core sales due to a 2.9% contribution from price increases and an increase in demand for software and related services, and dosimetry services, partially offset by the impact of U.S. channel inventory clearing in ASP and market-driven customer delays at Invetech.
FTV’s Historical Revenue Growth (Company Data, GS Analytics Research)
Looking forward, I expect the company’s growth rate to accelerate in FY24.
We have seen a slowdown in the company’s growth rates in the recent quarters, especially Q3, when the company’s core growth was up only 2.5% Y/Y versus high single digits in Q1 2023, and mid-single digits in Q2 2023. While the IOS segment growth rate was up mid-single digits Precision Technologies and Advanced Healthcare segments’ core sales disappointed investors and were in the low single digits.
In the Advanced Healthcare segment, the main reason behind the company’s slow growth in recent quarters is the transition from a distributor to a direct sales model in its U.S. Advanced Sterilization Products ((ASP)) business. This transition impacted the segment’s sales by about ~$10 mn last quarter and without this headwind, the core sales would have been up mid-single digits Y/Y. The good news is this channel situation is now behind and, in 2024, the sales growth in the segment can revert to the mid-single digits range.
This segment was also impacted by the slowdown in the Invetech business as some customers, especially in diagnostic and bioprocessing markets, delayed projects as the high interest rates are impacting return on these projects. However, with the upcoming reversal in the interest rate cycle, I expect the growth to pick up there as well.
In the Precision Technologies segment, the Tektronix business, which is the biggest piece of this segment accounting for ~46% of revenues, has been seeing a slowdown in order rates for the past few quarters. However, on its last earnings call, management noted that the orders in this business have bottomed in Q3 and should see an improvement moving forward. Below is the relevant comment made by James Lico, President and Chief Executive Officer of Fortive Corporation, on the company's Q3 earnings call .
We'll see Tek get a little bit better in orders in the fourth quarter than they were in the third. And our 90-day funnels actually look better now than they have been. So I think point of sale in a number of places, North America and Europe, as an example, we're good and will probably continue to be pretty good. We actually -- China POS was actually decent in Q3 as well.
So if I would just stay high centered on Tek, I'd say high Pareto bar is China, trend third quarter probably at the low point in many respects, will start to get a little bit better as we get towards the end of the year.”
This should benefit the segment’s sales. Another big portion of this segment is the Sensing business. This is usually short-cycle in nature and as the economy picks up next year due to interest rate cuts, it should see a recovery in 2024.
The company’s IOS segment has been seeing good growth driven by strength in the Facility and Asset Lifecycle business and software business. The company has done a good job in terms of transforming this business and positioning it for long-term growth. The good execution coupled with potential economic recovery should result in continued mid-single-digit growth in this segment in 2024.
FTV’s Intelligent Operating Solutions Segment Business Transformation (Company’s Investor Day Presentation)
In addition to good organic growth prospects, the company also has a good track record of bolt-on M&As. A reversal in the interest rate cycle should improve the return profile of inorganic growth opportunities and, moving forward, I expect an acceleration in bolt-on M&As for the company.
Margin Analysis and Outlook
In Q3 2023, the company’s margins benefited from strong price realization, high-margin software growth, productivity measures, and Fortive Business System (FBS) initiatives. As a result, the adjusted gross margin expanded by 160 bps Y/Y to 59.7% and the adjusted operating margin expanded by 150 bps Y/Y to 25.9%.
Segment-wise, the adjusted operating margin increased by 230 bps Y/Y in the Intelligent Operating Solutions, 60 bps Y/Y in the Precision Technologies, and 200 bps Y/Y in the Advanced Healthcare Solutions segments.
FTV’s Adjusted Gross Margin and Adjusted Operating Margin (Company Data, GS Analytics Research)
FTV’s Segment-Wise Adjusted Operating Margin (Company Data, GS Analytics Research)
Moving forward, the company’s margin should benefit from operating leverage from increased sales. In addition, the company’s continuous improvement philosophy and excellent track record of cost reduction and productivity initiatives under its Fortive Business System (FBS) operating model should continue to drive longer-term margin improvement. The company announced an incremental $35 mn investment in productivity initiatives in Q4 which should help margins in the next year.
The company is also doing a good job in terms of improving its portfolio mix through M&As as well as organically by focusing on growing high-margin businesses like software which should help long-term margins.
Valuation and Conclusion
FTV is currently trading at a 19.66x FY24 consensus EPS estimate of $3.67 and a 17.46x FY 25 consensus EPS estimate of $4.13, which is at a discount versus the Company's 5-year average forward P/E of 22.37x.
The company has good growth prospects driven by the completion of channel transition in the ASP business, recovery in order rates in the Tektronix business, continued growth in the IOS segment supported by strength in the Facility & Asset Lifecycle and software businesses, potential reversal in interest rate cycle in FY24 resulting in improved demand and bolt-on M&As. The margin outlook is favorable as well with benefits from cost reductions, productivity initiatives, operating leverage from sales growth, and improving business mix. Considering these good growth prospects and a lower-than-historical valuation, I have a buy rating on the FTV stock.
Risks
My thesis expects a cyclical recovery in the company's end markets as the interest rate cycle reverses next year. If this doesn't materialize, the growth rate may be slower than expected.
Fortive's M&A-driven growth model usually has inherent risk if the acquisition synergies don't materialize or the company overpays for an acquired company. While the company and its predecessor - Danaher ( DHR ) - from which it was spun off have a good track record of disciplined M&A and successful integration, there is always an associated risk with inorganic growth strategy.
For further details see:
Fortive: A Good Buy At Current Levels