Fortive Corp (FTV) — Q3 2021 Earnings Call Transcript

Thank you, Alexander. Good afternoon, everyone, and thank you for joining us on the call. With us today are Jim Lico, our President and Chief Executive Officer; and Chuck McLaughlin, our Senior Vice President and Chief Financial Officer. We present certain non-GAAP financial measures on today's call. Information required by SEC Regulation G relating to these non-GAAP financial measures are available on the Investors section of our website, www.fortive.com, under the heading Investors Quarterly Results. We completed the separation of our prior Industrial Technologies segment through the spin-off of Vontier Corporation on October 9, 2020, and have accordingly included the results of the Industrial Technologies segment as discontinued operations. The results presented on this call are based on continuing operations. During the presentation, we will describe certain of the more significant factors that impacted year-over-year performance. All references to period-to-period increases or decreases and financial metrics are year-over-year on a continuing operations basis. During the call, we will make forward-looking statements within the meaning of the federal securities laws including statements regarding events or developments that we expect or anticipate will or may occur in the future. These forward-looking statements are subject to a number of risks and uncertainties and actual results might differ materially from any forward-looking statements that we make today. Information regarding these factors that may cause actual results to differ materially from these forward-looking statements is available in our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2020. These forward-looking statements speak only as of the date that they are made, and we do not assume any obligation to update any forward-looking statements. With that, I'd like to turn the call over to Jim.

Thanks, Griffin, and good afternoon, everyone. Early in the third quarter, Fortive celebrated its fifth anniversary as an independent public company. This quarter, we continue to demonstrate the success of the strategy we outlined in 2016 to enhance growth and margins across our businesses through the successful execution of the Fortive Business System, the acceleration of innovation and the impact of disciplined capital allocation. Our third quarter results were highlighted by 32% growth in adjusted earnings per share. We continue to generate significant revenue momentum throughout the quarter, realizing 9.1% core revenue growth, an order growth of just over 20% against the backdrop of strong broad-based demand. Strong execution and application of FBS helped to generate 325 basis points of core operating margin expansion, along with very strong free cash flow despite widespread supply chain disruption. In the third quarter, our software businesses grew by low double digits, supported by strong demand and improving net dollar retention. In total, we now have almost $750 million of annualized software revenue across the portfolio with a double-digit organic growth profile as well as a high share of recurring revenue and high operating margins. In August, we closed the acquisition of ServiceChannel, adding another differentiated high-growth software asset to our Intelligent Operating Solutions segment. The ServiceChannel acquisition significantly enhances our strategic position in the facility and asset life cycle market, extending our leading suite of offerings for facility owners and operators and providing a variety of potential avenues to deliver unique value-added solutions in combination with Gordian and Accruent. As you can see on Slide 4, across Fortive, we continue to invest in product development to drive organic growth and enhance our competitive position. Many of our investments in organic innovation are focused on enabling digital transformation across our customer base. This includes vertically tailored software offerings at Tektronix and Fluke Health, emerging IoT solutions in Sensing as well as early progress with new tools for improved workforce management at TeamSense. In addition, our investments in The Fort continue to drive data analytics and machine learning opportunities across all of our businesses. Our success in accelerating the pace of innovation across our portfolio is demonstrated by examples such as the Fluke II900, a groundbreaking product, which was recently recognized as Test Measurement and Inspection, 'Product of the Year,' at the 2021 Electronics Industry Awards...

Thanks, Jim, and good afternoon, everyone. We delivered another quarter of strong margin performance in Q3, using FBS tools to deliver strong pricing and successful value engineering to implement component substitutions across a variety of hardware businesses. This FBS execution and the continued strength of our software businesses helped deliver adjusted gross margins of 57.3% in Q3. This reflects 90 basis points of expansion on a year-over-year basis as we accelerated to 220 basis points of total price realization. Q3 adjusted operating profit was 22.8%, reflecting solid execution across the portfolio, including counter measures enacted in the face of ongoing supply chain challenges. We had strong margin performance across all of our segments, resulting in 325 basis points of core operating margin expansion. On Slide 9, you can see that in the third quarter, we generated $252 million of free cash flow, representing a 105% conversion of adjusted net income. Free cash flow over the trailing 12 months increased 22% to $991 million. Our current net leverage is approximately 1.6x and we expect net leverage to be around 1.3x at year-end, excluding any additional M&A. Turning now to the guide on Slide 10. We are raising the low end of our full year 2021 adjusted diluted net EPS guidance to $2.70, resulting in a range of $2.70 to $2.75 for the year. This represents a year-over-year growth of 29% to 32% on a continuing operation basis. This assumes that total revenue growth of 14% to 14.5%, adjusted operating profit margins of 23% to 23.5% and an effective tax rate of approximately 14%. We continue to expect free cash flow conversion to be approximately 105% of adjusted net income for the full year. We are also initiating fourth quarter adjusted diluted net earnings per share guidance of $0.74 to $0.79 representing year-over-year growth of 6% to 13%. This assumes total revenue growth of 6.5% to 8.5%, adjusted operating profit margin of 23.5% to 24.5% and an effective tax rate of approximately 15%. The adjusted diluted net earnings per share guidance also excludes approximately $12 million of anticipated investments in strategic productivity initiatives that we expect to execute before the end of the year. For the fourth quarter, we expect free cash flow conversion to be approximately 125% of adjusted net income. With that, I'll pass it back to Jim for some closing.

It's a pretty good quarter overall. I'm just trying to nitpick a little bit. If price up 220 basis points is - did that fully offset your cost, Jim? And is price still going up as you go into Q4 here to offset kind of the deltas as costs continue to rise?

Yes, Scott, thanks. I think number one is we've been ahead - as you know, we've been in a really good position all year relative to price cost. And hence, our gross margin's going up 90 basis points in the quarter. So yes, we're ahead. I think one of the things about price is when you think about it, we really think about it in the big hardware businesses as Fluke, tech, and Sensing. And in those businesses, we were over 300 basis points. So yes, and we'll see improvement from there in the fourth quarter. So yes, we're in good shape. You'll see the price in the software businesses in the net dollar retention. And so net dollar retention at 102 or so with some of our businesses even higher means we're also - we're getting that price in a number of the software businesses. It just doesn't show up in the metric the way you'd like it. But I think we're in a very good shape relative to price cost in the hardware businesses relative to any inflationary pressure we might have.

Just maybe start with Fluke. And in most circumstances, something has not gone right if you're building backlog in Fluke. My guess is that was a factor with the supply chain issues. Maybe some color there would be helpful.

Yes. Sure. I think we had a very, very strong quarter at Fluke. As we mentioned, we did build backlog. As you know, any product that has a range of electronic components here is going to be a little bit of a challenge. So orders were in the high teens. So we're in really good shape on the order side. We built backlog as you mentioned. I've been with the team a couple of times on the shop floor, and they're doing some really good work to get on with many of the component challenges they've had. But we're in a very good place with backlog and with the position of the business. I like where we're at, as we mentioned, from an innovation perspective in the prepared remarks, a number of examples of where I think we're really handling things well, and we're taking market share. And of course, all of that's also really driving strong margins there as well.

Interesting answer to the prior question, absorbing that. Also, is there some dilution from ServiceChannel in Q4 as you bed that down? And any change of view of kind of that year 1 accretion, I think, in the $0.04 to $0.05 range?

So Jeff, this is Chuck. No change to the year 1 accretion around that $0.04 range. And actually, it's coming in just as we expected. But in the fourth quarter, we're going to get revenue with really not a lot of operating profit as it moves into profitability, really, in next year. So that's not different. And so inherently, there is a little bit of dilution there in Q4.

Just a question on pricing. Just going back to the tariffs. I just remember that putting in pricing, price cost was an issue, and we have a lot more cost and all of a sudden price is not an issue. What has changed inside Fortive to enable this kind of pricing power? Because I just recall, like, 3 years ago, it was a lot more of a drag.

Well, I think a couple of things. One, we've been working at pricing all year long. And I think what you're remembering is we offset the tariffs, but on a one-for-one basis, and so that created an operating margin drag because equal amounts of price and cost will do that. In this case, what we've been doing is staying ahead of that and getting, as Jim mentioned, in our hardware business, it's up to 300 basis points of price, and we still are getting PPV and taking it out of the business.

Our current net leverage is approximately 1.6x and we expect net leverage to be around 1.3x at year-end, excluding any additional M&A. Turning now to the guide on Slide 10. We are raising the low end of our full year 2021 adjusted diluted net EPS guidance to $2.70, resulting in a range of $2.70 to $2.75 for the year. This represents a year-over-year growth of 29% to 32% on a continuing operation basis. This assumes that total revenue growth of 14% to 14.5%, adjusted operating profit margins of 23% to 23.5% and an effective tax rate of approximately 14%. We continue to expect free cash flow conversion to be approximately 105% of adjusted net income for the full year. We are also initiating fourth quarter adjusted diluted net earnings per share guidance of $0.74 to $0.79 representing year-over-year growth of 6% to 13%. This assumes total revenue growth of 6.5% to 8.5%, adjusted operating profit margin of 23.5% to 24.5% and an effective tax rate of approximately 15%. Thanks, Chuck. We're very pleased with our performance in Q3. We worked diligently to countermeasure supply chain challenges that persisted throughout the quarter and which we expect to continue into 2022. Our teams are doing an excellent job deploying FBS to navigate those headwinds while also delivering strong margin performance and free cash flow generation. Looking across our end markets, the demand backdrop we're seeing is very strong with significant momentum in our order flow, driving continued growth in our backlog and double-digit growth across our software businesses. While continuing our focus on execution, we're investing in innovation, expanding our base of leadership talent and pursuing additional capital deployment opportunities as we look to enhance our competitive advantage and pave the way for consistent double-digit earnings and free cash flow growth in the years to come.

Thanks, Jim. That concludes our formal comments. Alexander, we are now ready for questions.

It's a pretty good quarter overall. I'm just trying to nitpick a little bit. If price up 220 basis points is - did that fully offset your cost, Jim? And is price still going up as you go into Q4 here to offset kind of the deltas as costs continue to rise?

Yes, Scott, thanks. I think number one is we've been ahead - as you know, we've been in a really good position all year relative to price cost. And hence, our gross margin's going up 90 basis points in the quarter. So yes, we're ahead. I think one of the things about price is when you think about it, we really think about it in the big hardware businesses as Fluke, tech, and Sensing. And in those businesses, we were over 300 basis points. So yes, and we'll see improvement from there in the fourth quarter. So yes, we're in good shape. You'll see the price in the software businesses in the net dollar retention. And so net dollar retention at 102 or so with some of our businesses even higher means we're also - we're getting that price in a number of the software businesses. It just doesn't show up in the metric the way you'd like it. But I think we're in a very good shape relative to price cost in the hardware businesses relative to any inflationary pressure we might have.

Just maybe start with Fluke. And in most circumstances, something has not gone right if you're building backlog in Fluke. My guess is that was a factor with the supply chain issues. Maybe some color there would be helpful.

Yes. Sure. I think we had a very, very strong quarter at Fluke. As we mentioned, we did build backlog. As you know, any product that has a range of electronic components here is going to be a little bit of a challenge. So orders were in the high teens. So we're in really good shape on the order side. We built backlog as you mentioned. I've been with the team a couple of times on the shop floor, and they're doing some really good work to get on with many of the component challenges they've had. But we're in a very good place with backlog and with the position of the business. I like where we're at, as we mentioned, from an innovation perspective in the prepared remarks, a number of examples of where I think we're really handling things well, and we're taking market share. And of course, all of that's also really driving strong margins there as well.

Interesting answer to the prior question, absorbing that. Also, is there some dilution from ServiceChannel in Q4 as you bed that down? And any change of view of kind of that year 1 accretion, I think, in the $0.04 to $0.05 range?

So Jeff, this is Chuck. No change to the year 1 accretion around that $0.04 range. And actually, it's coming in just as we expected. But in the fourth quarter, we're going to get revenue with really not a lot of operating profit as it moves into profitability, really, in next year. So that's not different. And so inherently, there is a little bit of dilution there in Q4.

Just a question on pricing. Just going back to the tariffs. I just remember that putting in pricing, price cost was an issue, and we have a lot more cost and all of a sudden price is not an issue. What has changed inside Fortive to enable this kind of pricing power? Because I just recall, like, 3 years ago, it was a lot more of a drag.

Well, I think a couple of things. One, we've been working at pricing all year long. And I think what you're remembering is we offset the tariffs, but on a one-for-one basis, and so that created an operating margin drag because equal amounts of price and cost will do that. In this case, what we've been doing is staying ahead of that and getting, as Jim mentioned, in our hardware business, it's up to 300 basis points of price, and we still are getting PPV and taking it out of the business.

Thanks, Chuck. We're very pleased with our performance in Q3. We worked diligently to countermeasure supply chain challenges that persisted throughout the quarter and which we expect to continue into 2022. Our teams are doing an excellent job deploying FBS to navigate those headwinds while also delivering strong margin performance and free cash flow generation. Looking across our end markets, the demand backdrop we're seeing is very strong with significant momentum in our order flow, driving continued growth in our backlog and double-digit growth across our software businesses. While continuing our focus on execution, we're investing in innovation, expanding our base of leadership talent and pursuing additional capital deployment opportunities as we look to enhance our competitive advantage and pave the way for consistent double-digit earnings and free cash flow growth in the years to come.

Thanks, Jim. That concludes our formal comments. Alexander, we are now ready for questions.

It's a pretty good quarter overall. I'm just trying to nitpick a little bit. If price up 220 basis points is - did that fully offset your cost, Jim? And is price still going up as you go into Q4 here to offset kind of the deltas as costs continue to rise?

Yes, Scott, thanks. I think number one is we've been ahead - as you know, we've been in a really good position all year relative to price cost. And hence, our gross margin's going up 90 basis points in the quarter. So yes, we're ahead. I think one of the things about price is when you think about it, we really think about it in the big hardware businesses as Fluke, tech, and Sensing. And in those businesses, we were over 300 basis points. So yes, and we'll see improvement from there in the fourth quarter. So yes, we're in good shape. You'll see the price in the software businesses in the net dollar retention. And so net dollar retention at 102 or so with some of our businesses even higher means we're also - we're getting that price in a number of the software businesses. It just doesn't show up in the metric the way you'd like it. But I think we're in a very good shape relative to price cost in the hardware businesses relative to any inflationary pressure we might have.

Just maybe start with Fluke. And in most circumstances, something has not gone right if you're building backlog in Fluke. My guess is that was a factor with the supply chain issues. Maybe some color there would be helpful.

Yes. Sure. I think we had a very, very strong quarter at Fluke. As we mentioned, we did build backlog. As you know, any product that has a range of electronic components here is going to be a little bit of a challenge. So orders were in the high teens. So we're in really good shape on the order side. We built backlog as you mentioned. I've been with the team a couple of times on the shop floor, and they're doing some really good work to get on with many of the component challenges they've had. But we're in a very good place with backlog and with the position of the business. I like where we're at, as we mentioned, from an innovation perspective in the prepared remarks, a number of examples of where I think we're really handling things well, and we're taking market share. And of course, all of that's also really driving strong margins there as well.

Interesting answer to the prior question, absorbing that. Also, is there some dilution from ServiceChannel in Q4 as you bed that down? And any change of view of kind of that year 1 accretion, I think, in the $0.04 to $0.05 range?

So Jeff, this is Chuck. No change to the year 1 accretion around that $0.04 range. And actually, it's coming in just as we expected. But in the fourth quarter, we're going to get revenue with really not a lot of operating profit as it moves into profitability, really, in next year. So that's not different. And so inherently, there is a little bit of dilution there in Q4.

Just a question on pricing. Just going back to the tariffs. I just remember that putting in pricing, price cost was an issue, and we have a lot more cost and all of a sudden price is not an issue. What has changed inside Fortive to enable this kind of pricing power? Because I just recall, like, 3 years ago, it was a lot more of a drag.

Well, I think a couple of things. One, we've been working at pricing all year long. And I think what you're remembering is we offset the tariffs, but on a one-for-one basis, and so that created an operating margin drag because equal amounts of price and cost will do that. In this case, what we've been doing is staying ahead of that and getting, as Jim mentioned, in our hardware business, it's up to 300 basis points of price, and we still are getting PPV and taking it out of the business.

Thanks, Chuck. We're very pleased with our performance in Q3. We worked diligently to countermeasure supply chain challenges that persisted throughout the quarter and which we expect to continue into 2022. Our teams are doing an excellent job deploying FBS to navigate those headwinds while also delivering strong margin performance and free cash flow generation. Looking across our end markets, the demand backdrop we're seeing is very strong with significant momentum in our order flow, driving continued growth in our backlog and double-digit growth across our software businesses. While continuing our focus on execution, we're investing in innovation, expanding our base of leadership talent and pursuing additional capital deployment opportunities as we look to enhance our competitive advantage and pave the way for consistent double-digit earnings and free cash flow growth in the years to come.

Thanks, Jim. That concludes our formal comments. Alexander, we are now ready for questions.

It's a pretty good quarter overall. I'm just trying to nitpick a little bit. If price up 220 basis points is - did that fully offset your cost, Jim? And is price still going up as you go into Q4 here to offset kind of the deltas as costs continue to rise?

Yes, Scott, thanks. I think number one is we've been ahead - as you know, we've been in a really good position all year relative to price cost. And hence, our gross margin's going up 90 basis points in the quarter. So yes, we're ahead. I think one of the things about price is when you think about it, we really think about it in the big hardware businesses as Fluke, tech, and Sensing. And in those businesses, we were over 300 basis points. So yes, and we'll see improvement from there in the fourth quarter. So yes, we're in good shape. You'll see the price in the software businesses in the net dollar retention. And so net dollar retention at 102 or so with some of our businesses even higher means we're also - we're getting that price in a number of the software businesses. It just doesn't show up in the metric the way you'd like it. But I think we're in a very good shape relative to price cost in the hardware businesses relative to any inflationary pressure we might have.

Just maybe start with Fluke. And in most circumstances, something has not gone right if you're building backlog in Fluke. My guess is that was a factor with the supply chain issues. Maybe some color there would be helpful.

Yes. Sure. I think we had a very, very strong quarter at Fluke. As we mentioned, we did build backlog. As you know, any product that has a range of electronic components here is going to be a little bit of a challenge. So orders were in the high teens. So we're in really good shape on the order side. We built backlog as you mentioned. I've been with the team a couple of times on the shop floor, and they're doing some really good work to get on with many of the component challenges they've had. But we're in a very good place with backlog and with the position of the business. I like where we're at, as we mentioned, from an innovation perspective in the prepared remarks, a number of examples of where I think we're really handling things well, and we're taking market share. And of course, all of that's also really driving strong margins there as well.

Interesting answer to the prior question, absorbing that. Also, is there some dilution from ServiceChannel in Q4 as you bed that down? And any change of view of kind of that year 1 accretion, I think, in the $0.04 to $0.05 range?

So Jeff, this is Chuck. No change to the year 1 accretion around that $0.04 range. And actually, it's coming in just as we expected. But in the fourth quarter, we're going to get revenue with really not a lot of operating profit as it moves into profitability, really, in next year. So that's not different. And so inherently, there is a little bit of dilution there in Q4.

Just a question on pricing. Just going back to the tariffs. I just remember that putting in pricing, price cost was an issue, and we have a lot more cost and all of a sudden price is not an issue. What has changed inside Fortive to enable this kind of pricing power? Because I just recall, like, 3 years ago, it was a lot more of a drag.

Well, I think a couple of things. One, we've been working at pricing all year long. And I think what you're remembering is we offset the tariffs, but on a one-for-one basis, and so that created an operating margin drag because equal amounts of price and cost will do that. In this case, what we've been doing is staying ahead of that and getting, as Jim mentioned, in our hardware business, it's up to 300 basis points of price, and we still are getting PPV and taking it out of the business.

Thanks, Chuck. We're very pleased with our performance in Q3. We worked diligently to countermeasure supply chain challenges that persisted throughout the quarter and which we expect to continue into 2022. Our teams are doing an excellent job deploying FBS to navigate those headwinds while also delivering strong margin performance and free cash flow generation. Looking across our end markets, the demand backdrop we're seeing is very strong with significant momentum in our order flow, driving continued growth in our backlog and double-digit growth across our software businesses. While continuing our focus on execution, we're investing in innovation, expanding our base of leadership talent and pursuing additional capital deployment opportunities as we look to enhance our competitive advantage and pave the way for consistent double-digit earnings and free cash flow growth in the years to come.

Thanks, Jim. That concludes our formal comments. Alexander, we are now ready for questions.