Fortive: Business transformation is good, but overrated (NYSE: FTV)

P of Fortiveprospects and challenges

Fortive Corporation (NYSE: FTV) provides smart products, software and services. It also sells enterprise health, safety and quality software products for various industries, including manufacturing, healthcare, utilities, communications and electronics. The most significant change in the company’s business model has come from a shift to reliance on recurring revenue and diversification. For the remainder of 2022, its operating segments will likely improve revenues and profit margins. The globalization of its brands in various geographies will also help accelerate growth.

However, the economic impact of the current recession, supply chain issues, China’s lockdown and adverse currency movement against the US dollar would weigh on cash flow. Thus, free cash flow decreased in 1H 2022. The stock is relatively overvalued compared to its peers. Fortunately, it has low leverage and robust liquidity, which can boost its relative valuation multiples when the economy struggles. Nonetheless, I think the stock is still likely to hold for investors looking at a long-term return horizon.

Strategies: a critical look

Over the past few years, FTV has transformed its business portfolio, focused on a diversified end market and generated sustainable recurring revenue. The company added software and consumables businesses while expanding its services business model. Previously, the retail vehicle refueling and repair markets were strong contributors to the composition of its total revenue. Today, health care has become the main driving force. The advantage of the new model is that the revenues are recurring. In addition, it is aimed at a variety of end markets.

Tektronix is ​​a case at this point. In the second quarter, the company saw approximately 20% booking growth at Tektronix (which provides test and measurement instruments in various industries), mid-teen growth in sensing technologies, and more than 20% at Gems (Gems Sensor, a subsidiary). The Company also leverages its brand equity by marketing and globalizing its brands across various geographies. Thus, the share of recurring revenue doubled from 2016 to 2022.

Guidance for the third quarter and fiscal year 2022

In the third and fourth quarters, management expects revenue to grow by “single double digits,” while adjusted operating profit margins could rise 100 basis points year-over-year. Adjusted earnings per share may increase 12% to 16% in the second through third quarters and another 8% to 11% in the fourth quarter.

Each of its three operating segments is likely to see increased revenue. The company’s revenue for fiscal 2022 may increase by 8% to 9.5%. Improved operating performance and lower taxes may generate between $3.07 and $3.13 of adjusted earnings per share in fiscal 2022. Thus, improved performance may offset a projected charge of $100 million due to unfavorable currency movements ($0.08 per share).

Over the next three years, the company expects to achieve mid-single-digit core revenue growth. It is also looking to increase its operating margin by 300 basis points or 50% profit growth. Earnings growth may also reflect 90% growth in free cash flow.

Outlook and current drivers

At the end of the second quarter, its hardware backlog was 21% higher than at the start of the year. I expect its core business to grow for the remainder of 2022 due to a resilient product portfolio and continued customer demand. New logo generation, cross-selling bookings and lower customer churn are expected to keep its software sales high in 2022.

In 2022, hardware orders and software revenues grew, albeit moderately, following the company’s transition to a diversified product portfolio. Despite higher inflation and the loss of currency movements, its gross profit margin remained unchanged from the first to the second quarter, while the EBITDA margin increased by 140 basis points.

In the second quarter, on a geographic basis, Western Europe regions proliferated (revenue up “mid-teens”), while North America revenue grew “high single digit”. China saw order growth of around 20%, despite Shanghai lockdowns.

Analyze segment performance

In the intelligent operating solutions segment, revenue grew 16% in the second quarter year-on-year. Strong improvements in shipments and strong price realization led to an operating margin increase of 205 basis points in the second quarter in this segment.

In Precision Technologies, revenue increased 6% in Q2 2022 compared to Q2 2021. The industrial, semi-medical, electrical and energy markets saw steady growth. The increased use of power and precision devices and increased use of semiconductors have driven the revenue growth of this segment. Order books also increased during the second quarter. Superior operational performance from Tektronix and Sensing Technologies overcame the hurdles of the Shanghai lockdown. Favorable pricing and cost management also increased adjusted profit margin by 90 basis points.

In Advanced Healthcare Solutions, revenue growth in Western Europe outpaced revenue growth in North America in the second quarter. Increased sales of ASP consumables (Advanced Sterilization Products business) boosted sales in North America in the second quarter. However, disruptions due to COVID presented challenges due to personnel issues and equipment constraints muddied the growth rate in the second quarter. Investors may note that FTV acquired ASP in April 2019 for $2.7 billion. Following the acquisition of Provation, the company invested in FBS (Fortive Business System) tools, which delivered productivity savings and improved adjusted operating margin by 300 basis points in the second quarter ago more than a year.

Stable dividend

FTV pays an annual dividend of $0.28 per share, which translates to a dividend yield of 0.43%. The dividend rate has changed little over the past five years. The forward dividend yield of Dover Corporation (DOV) is 1.56%, while the dividend yield of Snap-on Incorporated (SNA) is higher (2.54%).

Solid balance sheet

In the first half of 2022, FTV’s cash flow from operations (or CFO) was up 20% from a year ago, driven by higher year-over-year revenues. Capital expenditures, excluding the acquisition portion, increased sharply in 1H 2022, leading to a modest 16% increase in free cash flow (or FCF) over the past year.

FTV’s cash (cash plus commercial paper) totaled $3.0 billion as of June 30. Its debt ratio (0.39x) is below the average of its competitors (DOV, OTCPK:TTNDY and IR) of 0.64x. Management views mergers and acquisitions as the primary driver of capital deployment. Since the beginning of the year, he has bought back 4 million shares. Stock acquisitions and buybacks have provided reasonable returns to its shareholders.

Analyst Rating and Relative Valuation

According to Seeking Alpha, 14 sell-side analysts rated FTV a “buy” over the past 90 days (including a “strong buy”), while six recommended a “hold.” None of the analysts called it a “sell”. Wall Street analyst estimates suggest a 17% upside at the current price.

FTV’s multiple forward EV/EBITDA compression from current EV/EBITDA is less pronounced than its peers. This implies that the company’s EBITDA may grow less sharply than its peers over the next four quarters. This would generally result in a lower EV/EBITDA multiple than its peers. The stock’s EV/EBITDA multiple (18.5x) is above the average of its peers (DOV, TTNDY and IR) of 15.6x. Thus, the stock is relatively overvalued compared to its peers.

What is the point of view on FTV?

Fortive Corporation’s focus on the healthcare industry away from traditional vehicle refueling and repair markets in recent years has led to a stable operating margin. Its investments in Fortive Business System tools have generated productivity gains and improved adjusted operating margins. I expect its core business to grow for the remainder of 2022 due to a resilient product portfolio and continued customer demand.

As of 2H 2022, its net income could take a hit of $100 million due to currency headwinds. Additionally, the lockdown in China and slower economic activity in the United States and some other regions may reduce its free cash flow. However, low leverage and robust liquidity can fend off any imminent risk. The stock has performed in line with the SPDR S&P 500 Trust ETF (SPY) over the past year. Stock acquisitions and buybacks have provided reasonable returns to its shareholders. Given the valuation stretch, I think investors might want to hold the stock now and invest at a lower price for long-term returns.