Fortive’s Valuation Is Fair But I Am Not Adding To My Exposure

On January 31, Fortive (FTV), a Danaher (DHR) spin-off, released its Q4 and FY2023 results and FY2024 outlook. I last reviewed FTV in this October 31, 2023 post at which time the Q3 and YTD2023 had recently been released. In addition to analyzing FTV's current results, I looked at material FTV presented at its 2023 Investor Day which provided:

• an overview of the company's performance following its spin-off from Danaher (DHR) in July 2016; and
• its plans to accelerate growth over the next several years.

At the time of that review, FTV's share price was ~$65. Using company and broker guidance, I concluded FTV shares were attractively valued.

Now that we have more current information, I once again revisit FTV.

Business Overview

I touched upon this in my October 31, 2023 post and dispense with another overview. Nevertheless, I provide the following brief descriptions of FTV's 3 business segments.

Acquisitions

Information about the companies under the FTV umbrella is accessible here.

In July 2016, Danaher (DHR) completed the spin-off of FTV. It is not surprising, therefore, that FTV is carrying on the tradition of acquiring companies to complement organic growth and quickly making them accretive to adjusted gross and operating margins; it closed 5 acquisitions in 2023 which added ~$0.22B of annualized revenue.

FTV has systematically driven margin expansion at the companies it acquires. For example, adjusted operating margin at ServiceChannel improved ~2000 bps and it improved ~200 bps at Provation.

In addition, it has increased Free Cash Flow (FCF) from ~$0.6B to ~$1.2B since 2016.

On October 23, FTV announced its most recent sizable acquisition - EA Elektro-Automatik Holding GmbH (EA) - a leading supplier of high-power electronic test solutions for energy storage, mobility, hydrogen, and renewable energy applications. This $1.45B cash acquisition, net of $0.215B of tax benefits from Bregal Unternehmerkapital, was expected to close in early Q1 2024. On January 3, 2024, FTV announced the completion of this acquisition. 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.

Financials

Q4 and FY2023 Results

FTV's Q4 and FY2023 earnings material are accessible here.

Free Cash Flow (FCF)

Management previously expected a FY2023 FCF conversion ratio of ~105%. FTV fell short on this metric at 102%.

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).

FY2024 Outlook

FTV's current Q1 and FY2024 outlook is as follows.

Credit Ratings

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

One look at FTV's dividend history and investors fixated on dividend metrics will likely rule out FTV as a potential investment.

With shares currently trading at ~$78, the $0.08 quarterly dividend yield is well below 1%.

From a capital allocation perspective, dividend increases are a low priority. Much like DHR, FTV focuses on retaining funds in the company to fuel its growth.

Share Repurchases

The diluted weighted average shares outstanding (in millions) in FY2016 - FY2023 are 347, 353, 351, 340, 359, 352, and 361. This has been reduced to ~354.5 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.

In FY2023, FTV repurchased ~$272.9 million of its issued and outstanding shares. This exceeded FTV's stock-based compensation expense of ~$113.3 million.

Valuation

I reference my October 31, 2023 post in which I look at FTV's valuation at the time of prior posts.

When I analyzed FTV's valuation in October, management's FY2023 diluted EPS and adjusted diluted EPS guidance had been revised to $2.30 - $2.33 and $3.37 - $3.40, respectively. With shares trading at ~$65, the forward diluted PE range was ~27.9 - ~28.3 and the forward adjusted diluted PE range was ~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 continued 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 estimated FTV's FY2023 FCF/share would be ~$3.56 (105% of $3.39). This resulted in a Price/adjusted FCF ratio is ~18.3 ($65/$3.56).

FTV has now reported diluted net EPS for FY2023 of $2.43 and adjusted diluted net EPS of $3.43. With shares currently trading at ~$78, FTV's diluted PE is ~32 and the adjusted diluted PE is ~23.

The adjusted FCF conversation ratio for FY2023 is ~102% and not ~105% as management expected. Multiply the $3.43 of adjusted diluted net EPS by 102% and we get ~$3.50 of FCF/share. Divide the ~$78.40 share price by ~$3.50 and the P/FCF is ~22.4.

The FY2024 diluted EPS and adjusted diluted EPS forecast is $2.58 - $2.70 and $3.73 - $3.85, respectively. Using the current ~$78 share price, the forward diluted PE is ~29 - ~30 and the forward adjusted diluted PE is ~20 - ~21.

Using the current ~$78 price and adjusted diluted EPS broker guidance, the following are the adjusted forward diluted PE levels:

• FY2024 – 19 brokers – ~21 based on a mean of $3.74 and low/high of $3.57 – $3.82.
• FY2025 – 12 brokers – ~19 based on a mean of $4.11 and low/high of $4.00 – $4.20.
• FY2026 – 4 brokers – ~17 based on a mean of $4.57 and low/high of $4.39 – $4.73.

I anticipate these estimates will be adjusted very slightly over the next several days as more brokers update their guidance.

If we use management's FY2024 adjusted diluted EPS forecast and assume FTV will replicate its ~102% adjusted FCF conversation ratio for FY2024, we get a FCF range of ~$3.80 - $3.93. Using this estimated range and the current ~$78 share price, the forward adjusted diluted P/FCF is ~20 - ~20.5.

Fortive's Valuation - Final Thoughts

I hold 300 FTV shares in one of the 'Side' accounts within the FFJ Portfolio. This position was too small for FTV to be amongst my Top 30 holdings when I completed my 2023 Year End FFJ Portfolio Review.

As noted in several previous posts, I am trying (struggling!) to identify great companies whose valuation has come under pressure because of short-term headwinds.

Based on my analysis, Fortive's valuation is fair. I am not, however, adding to my exposure because I am looking to invest in great undervalued companies. I remain cautious and am patiently waiting for a broad market pullback. Should one occur, I hope FTV's valuation will improve thus providing me with an opportunity to potential acquire additional shares.

Based on current adjusted diluted earnings estimates, I would want a share price at (or below) ~$71. At ~$71, FTV's FY2024 forward adjusted diluted PE would be ~19 and its forward adjusted diluted P/FCF would be ~18.

NOTE: In my prior FTV post, I concluded with a comment regarding FTV's share price volatility. FTV's current beta is 1.18; 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.