Fortive – Attractive Valuation Makes It A ‘Buy’

I last reviewed Fortive (FTV) in this July 31, 2023 post at which time I concluded that shares were fairly valued. Rather than add to my exposure, I expressed my interest in increasing exposure to companies facing short-term headwinds which appeared to have temporarily fallen out of favour with investors. Following a ~16% share price pullback within the past couple of weeks, however, Fortive's attractive valuation makes it a 'Buy'.

When I completed my July 31 review, FTV had recently released its Q2 and FY2023 financial results and revised FY2023 guidance. In addition, at its 2023 Investor Day on May 25, FTV provided investors with an overview of its performance following its spin-off from Danaher (DHR) in July 2016 and its plans to accelerate growth over the next several years.

FTV also disclosed ambitious FY2028 targets.

I now revisit FTV given that it released its Q3 and YTD2023 results on October 25.

Business Overview

FTV provides essential technologies for connected workflow solutions. It operates and reports results in three segments:

• Intelligent Operating Solutions;
• Precision Technologies; and
• Advanced Healthcare Solutions

A good explanation of FTV and each of its 3 segments is found in Part 1 Item 1 in the FY2022 Form 10-K.

FTV has adopted the philosophy underpinning the proven Danaher Business System (DBS), which has its roots in the Toyota Production System (kaizen - continuous improvement). By following the highly successful DBS, FTV can generate impressive annual free cash flow conversion much like DHR.

The Fortive Business System involves the acquisition of companies with 'moats', the expansion of operating margins through Lean manufacturing principles, and the redeployment of cash flows into further mergers and acquisitions. FTV targets companies with reputable brand names, large installed bases, and strong cash flows.

Management focuses on recurring revenue and digitalization to reinforce the company's moat by increasing customer switching costs and enhancing its intangible assets. Following the spin-off from DHR, management has focused on boosting recurring revenue in its portfolio. At the time of the spin-off, recurring revenue was ~18%; management's objective was to increase this to ~50% over the next 5 - 7 years.

Acquisitions

In Q3, during the 3 and 9-month periods ended September 29, 2023, FTV made three acquisitions in its Intelligent Operating Solutions segment for an aggregate cash consideration of $59 million, which includes an immaterial deferred payment, net of acquired cash. The Q3 2023 acquisitions accelerate the company's strategy and strengthen its product portfolio.

On October 23, FTV announced that it had entered into a definitive agreement to acquire EA Elektro-Automatik Holding GmbH (EA), a leading supplier of high-power electronic test solutions for energy storage, mobility, hydrogen, and renewable energy applications, for $1.45B in cash, net of $0.215B of tax benefits from Bregal Unternehmerkapital. The acquisition is subject to customary closing conditions and regulatory approvals and is expected to close in early Q1 2024.

This acquisition is expected to be accretive to adjusted gross and operating margins and neutral to modestly accretive to adjusted diluted net EPS in FY2024.

Information about EA's capabilities is accessible on its website.

Divestiture

On September 30, 2022, FTV completed the sale of its Therapy Physics product line, which was reported in the Advanced Healthcare Solutions business segment. This sale was to an
unrelated third party for a total consideration of $9.6 million.

Cybersecurity Issue

In early October 2023, the BlackBasta ransomware group expanded its list of victims to include FTV.

BlackBasta is a ransomware operator and Ransomware-as-a-Service (RaaS) criminal enterprise. It first emerged in early 2022 and immediately became one of the most active RaaS threat actors in the world, racking up 19 prominent enterprise victims and more than 100 confirmed victims in its first few months of operation.

It targets organizations in the US, Japan, Canada, the United Kingdom, Australia, and New Zealand in highly targeted attacks rather than employing a spray-and-pray approach. The group’s ransom tactics use a double extortion tactic, encrypting their victim’s critical data and vital servers and threatening to publish sensitive data on the group’s public leak site.

Financials

Q3 and YTD2023 Results

Links to material related to FTV's Q3 2023 Earnings Release and its Q3 Form 10-Q are accessible here.

FTV's Q3 core revenue growth was 2.5%. This growth was tempered by specific headwinds in health care and a slowing in parts of FTV's business in China. FTV, however, generated a substantial improvement in gross and operating margins, earnings and free cash flow.

Free Cash Flow (FCF)

FTV's FY2017 - FY2022 FCF (in billions of $) is $1.065, $1.275, $1.197, $1.361, $0.911, and $1.207.

FTV has generated ~$0.833B in YTD FCF and management continues to expect $1.25B of FCF which is a conversion of 105% of adjusted net income and a 21% free cash flow margin.

Management's definition of FCF is cash provided by operating activities calculated according to GAAP minus payments for additions to property, plant, and equipment.

I look closely at a company's FCF and trend because it provides useful information in assessing a company's ability to:

• generate cash without external financing;
• fund acquisitions and other investments; and
• in the absence of refinancing, repay debt obligations.

FCF, however, is not without its drawbacks. As a liquidity measure, it has material limitations because it excludes certain expenditures that are required or to which a company is committed, such as debt service requirements and other non-discretionary expenditures. This is why I look at the credit rating and outlook assigned by major rating agencies (see Credit Ratings section below).

FY2023 Outlook

FTV has adjusted its Q4 outlook to reflect caution regarding China's recovery.

Adjusted diluted EPS of $0.92 - $0.95, represents 5% - 8% growth and includes a $5 million one-time additional corporate expense related to the remediation plans following the early October cybersecurity incident.

Credit Ratings

Details of FTV's financing are in Note 5. FINANCING on page 15 in FTV's Q3 2023 Form 10-Q.

FTV's senior unsecured long-term debt credit ratings and outlook are the same as at the time of my prior review.

• Moody's: Baa1 and stable
• S&P: BBB and stable

Moody's rating is the top tier of the lower medium investment-grade category. S&P's rating is 1 notch lower and is the middle tier of the lower medium investment-grade category.

These ratings define FTV as having an ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to meet financial commitments.

Both ratings are satisfactory for my conservative nature.

Dividends and Share Repurchases

Dividend and Dividend Yield

FTV is unlikely to appeal to investors who focus heavily on dividend metrics.

On August 4, 2016, FTV declared its first $0.07 quarterly dividend. There has been no change since such time (see dividend history).

FTV was spun off from Danaher (DHR) whose practice is to maintain a low dividend payout ratio; the retention of funds to grow the business is the primary component of FTV's capital allocation process. This has proven highly successful and no change in FTV's quarterly dividend is likely in the foreseeable future.

At the time of my May 2, 2022 post, FTV shares were trading at $57.50 and the dividend yield was ~0.5%. When I wrote my October 29, 2022 post, shares were trading at ~$64.20 and the dividend yield was ~0.44%.

When I wrote my July 31 post, shares traded at ~$77 and the dividend yield was ~0.36%.

FTV's closing share price on October 30 is ~$65 resulting in a ~0.75% dividend yield.

Share Repurchases

The diluted weighted average shares outstanding (in millions) in FY2016 - FY2022 are 347, 353, 351, 340, 359, 352, and 361. This has been reduced to ~356 in the quarter ending on September 29, 2023.

On February 17, 2022, FTV announced that its Board authorized a share repurchase program under which up to 20 million shares can be purchased from time to time on the open market or in privately negotiated transactions.  There is no expiration date for the repurchase program, and the timing and amount of repurchases under the program are determined by FTV's management based on market conditions and other factors.

In FY2022, FTV repurchased 7 million shares at an average share price of $63.25. As of December 31, 2022, 13 million shares were remaining for repurchase under the share repurchase program.

During the 3 and 9-month periods ended September 29, 2023, FTV purchased 1 million and 3 million shares at an average price of $78.74 and $69.27, respectively. During the 3 and 9-month periods ended September 30, 2022, FTV purchased 2 million and 6 million shares at an average price of $66.57 and $62.67, respectively.

As of September 29, 2023, there were 10 million shares remaining for repurchase under the share repurchase program.

Valuation

At the time of my May 2, 2022 post, FTV shares were trading at $57.50 and management's revised FY2022 guidance was diluted net EPS of $2.07 - $2.16 from continuing operations and adjusted diluted net EPS from continuing operations of $3.04 - $3.13. Using the current share price and the ~$2.12 mid-point of diluted EPS guidance, the forward diluted PE was ~27. Using the ~$3.09 mid-point of adjusted diluted EPS guidance, the forward adjusted diluted PE was ~18.6.

FTV's valuation based on broker guidance was:

• FY2022 – 22 brokers – mean of $3.10 and low/high of $3.06 – $3.16. Using the mean estimate, the forward adjusted diluted PE is ~18.6.
• FY2023 – 22 brokers – mean of $3.44 and low/high of $3.21 – $3.65. Using the mean estimate, the forward adjusted diluted PE is ~16.7.
• FY2024 – 9 brokers – mean of $3.79 and low/high of $3.46 – $4.25. Using the mean estimate, the forward adjusted diluted PE is ~15.2.

When I wrote my October 29, 2022 post, FTV's share price was ~$64.20 and management's FY2022 GAAP EPS guidance was $2.05 - $2.07 and its adjusted diluted EPS guidance was $3.10 - $3.13. This gave us a forward diluted PE of ~31.2 and a forward adjusted diluted PE of ~20.6.

Using FTV's ~$64.20 price and adjusted diluted EPS broker guidance the following were the adjusted forward diluted PE levels:

• FY2022 – 22 brokers – mean of $3.12 and low/high of $3.07 – $3.15. Using the mean estimate, the forward adjusted diluted PE is ~20.6.
• FY2023 – 22 brokers – mean of $3.35 and low/high of $3.17 – $3.55. Using the mean estimate, the forward adjusted diluted PE is ~19.2.
• FY2024 – 11 brokers – mean of $3.71 and low/high of $3.45 – $4.15. Using the mean estimate, the forward adjusted diluted PE is ~17.3.

Management expected FY2022 FCF/share to be ~105% of adjusted diluted EPS. Using management's adjusted diluted EPS guidance of $3.10 - $3.13 ($3.115 mid-point), FY2022 FCF/share was likely to be ~$3.27 (105% of $3.115). Using this, I arrived at a Price/adjusted FCF ratio of ~19.6 ($64.2/$3.27).

At the time of my July 31 post, management's FY2023 diluted EPS and adjusted diluted EPS guidance were $2.38 - $2.44 and $3.36 - 3.42, respectively. With shares trading at ~$77, the forward diluted PE range was ~31.6 - ~32.4 and the forward adjusted diluted PE range was ~22.5 - ~23.

Using the ~$77 price and adjusted diluted EPS broker guidance, the following were the adjusted forward diluted PE levels:

• FY2023 – 18 brokers – ~22.7 based on a mean of $3.39 and low/high of $3.34 – $3.42.
• FY2024 – 18 brokers – ~20.8 based on a mean of $3.71 and low/high of $3.57 – $3.95.
• FY2025 – 8 brokers – ~18.5 based on a mean of $4.16 and low/high of $3.93 – $4.50.

Management expected an FY2023 adjusted FCF conversion rate of ~105% of adjusted diluted EPS. Using management's adjusted diluted EPS guidance of $3.36 - $3.42 ($3.39 mid-point), I estimated FTV's FY2023 FCF/share would be ~$3.56 (105% of $3.39). Using this, the Price/adjusted FCF ratio was ~21.6 ($77/$3.56).

Management's FY2023 diluted EPS and adjusted diluted EPS guidance are now $2.30 - $2.33 and $3.37 - 3.40, respectively. With shares trading at ~$65, the forward diluted PE range is ~27.9 - ~28.3 and the forward adjusted diluted PE range is ~19.1 - ~19.3.

Using the current ~$65 price and adjusted diluted EPS broker guidance, the following were the adjusted forward diluted PE levels:

• FY2023 – 18 brokers – ~19.1 based on a mean of $3.40 and low/high of $3.37 – $3.46.
• FY2024 – 18 brokers – ~17.7 based on a mean of $3.67 and low/high of $3.52 – $3.80.
• FY2025 – 11 brokers – ~15.9 based on a mean of $4.07 and low/high of $3.85 – $4.30.

Management continues to expect an FY2023 adjusted FCF conversion rate of ~105% of adjusted diluted EPS. Using management's adjusted diluted EPS guidance of $3.37 - $3.40 ($3.39 mid-point), I estimate FTV's FY2023 FCF/share will be ~$3.56 (105% of $3.39). Using this, the Price/adjusted FCF ratio is ~18.3 ($65/$3.56).

Final Thoughts

I hold 300 FTV shares in one of the 'Side' accounts within the FFJ Portfolio. This position is too small for FTV to be amongst my Top 30 holdings (see my Mid-2023 Investment Holdings Review).

I would add to my FTV exposure given its attractive valuation and promising long-term outlook. However, I am building cash reserves for purposes other than investing and will not be adding to my exposure in the short term.

If FTV appeals to you, make note that its share price is somewhat more volatile than the broad market. This is borne out by its current 1.18 beta; beta is a concept that measures a stock's expected move relative to movements in the overall market. A beta greater than 1.0 suggests the stock is more volatile than the broader market. A beta less than 1.0 indicates a stock with lower volatility.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long FTV.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.