Fortive – More Resilient and Less Cyclical

I last reviewed Fortive (FTV) in this May 2, 2022 post at which time it had recently released Q1 2022 results and its FY2022 outlook. With the release of Q3 and YTD2022 results and updated FY2022 outlook, I now revisit FTV.

Business Overview

A good explanation of FTV, including high-level information about acquisitions and divestitures, is found in the Overview section within the Q3 2022 Form 10-Q commencing on page 31 of 51.

FTV was spun off from Danaher (DHR) in 2016. It has adopted the philosophy underpinning the proven Danaher Business System, which has its roots in the Toyota Production System (kaizen - continuous improvement).

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%. This has risen to ~38% in FY2021 and there is a reasonable probability this could reach ~50% over the next 5 - 7 years.

Financials

Q3 and YTD2022 Results

Links to FTV's Q3 Earnings Release, the accompanying earnings presentation, and the Q3 2022 10-Q are accessible here.

Free Cash Flow (FCF)

FTV's FY2017 - FY2021 FCF (in billions of $) is: $1.065, $1.275, $1.197, $1.361, and $0.911.

Management's definition of FCF is defined as 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.

On the Q3 earnings call, management stated it anticipates FCF will be seasonally strong in Q4. Expectations are that FY2022 FCF of $1.17B will be ~105% of adjusted diluted net earnings from continuing operations.

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).

FY2022 Outlook

On the earnings call, management stated the backlog in hardware products is roughly double pre-pandemic levels. This gives management confidence that the hardware products businesses can grow even in the event of a potential decline in orders.

The following reflect FTV's Q4 and FY2022 outlooks. In addition, management's FY2022 GAAP EPS guidance is $2.05-$2.07.

 

For comparison purposes, I include FTV's Q2 and FY2022 outlooks provided when it released Q1 2022 results.

• LSD: Low single-digit % growth
• MSD: Mid single-digit % growth
• HSD: High single-digit % growth
• LDD: Low double-digit % growth

Credit Ratings

Details of FTV's financing and capital commence on page 16 of 51 in FTV's Q3 2022 Form 10-Q.

In early Q4 2022, FTV amended its $2B revolving credit facility, extending the maturity to October 18, 2027 with an additional two one-year extension options at the company's request and with the consent of the lenders. The amended credit facility utilizes a sustainability feature whereby pricing varies depending on the achievement of the company's recently published commitment to reducing its absolute Scope 1 and 2 greenhouse gas emissions by 50%. Details on FTV's commitment are accessible here.

An overview of direct greenhouse gas (GHG) Protocol scopes and emissions across the value chain is found on the United States Environmental Protection Agency website.

The Amended and Restated Credit Agreement also contains an option permitting FTV to request an increase in the amounts available under the Revolving Credit Facility of up to an aggregate additional $1.0B. This gives it the financial flexibility to refinance the $1B term loan that matures in December 2022, with a prepayable loan where FTV can delever with available free cash flow without penalty.

FTV is now levered at ~2 times on a net debt to EBITDA basis with an average debt maturity of 5 years and a 3.2% weighted average interest rate.

The proactive moves made to strengthen FTV's balance sheet, combined with robust FCF generation, give it ample capacity to invest for growth and compound returns through disciplined and accretive capital deployment.

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 income and dividend yield.

Its capital deployment is likely to remain very similar to that of DHR; DHR maintains a low dividend payout ratio and retains funds to grow the business. This strategy has proven to be highly successful and investors should not expect FTV to change its dividend policy.

The dividend history reflects no change to the $0.07/share quarterly dividend that was instituted in mid-2016.

At the time of my prior review in May, FTV shares were trading at $57.50 and the dividend yield was ~0.5%. Shares now trade at ~$64.20 and the dividend yield is ~0.44%.

Share Repurchases

The diluted weighted average shares outstanding (in millions) in FY2016 - FY2021 are 347, 353, 351, 340, 359, and 352.

On February 17, 2022, FTV's announced that its Board of Directors 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.

YTD ended September 30, 2022 and FTV has purchased 6,000,000 shares of its common stock at an average share price of $62.67. This includes 2,000,000 shares at an average share price of $66.57 during Q3 2022. This leaves 14 million shares authorized for repurchase under the share repurchase program as of September 30, 2022.

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.

Shares currently trade at ~$64.20 and management's FY2022 GAAP EPS guidance is $2.05 - $2.07 and adjusted diluted EPS guidance is $3.10 - $3.13. This gives us a forward diluted PE of ~31.2 and a forward adjusted diluted PE of ~20.6.

Using FTV's current share price and adjusted diluted EPS guidance from the  brokers who cover FTV, we get the following 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 expects 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 will likely end up being ~$3.27 (105% of $3.115).

FTV's Price/adjusted FCF ratio ends up being ~19.6 ($64.2/$3.27).

I am reluctant to rely on FY2024 data because much can happen in 2 years...especially since FTV has a history of acquisitions and divestitures which can significantly change results.

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 have made it amongst my Top 30 holdings when I completed my Mid 2022 Investment Holdings Review.

Despite my relatively insignificant exposure to FTV, I do like the company's long-term outlook. Its portfolio has been modified following the spin-off from Danaher in July 2016, and the Vontier spin-off in October 2020, to become more resilient and less cyclical so that it can outperform even in a difficult environment.

I would add to my FTV exposure were my liquidity not being used to acquire a second residence.

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.