Fortive Corp (FTV) — Q2 2022 Earnings Call Transcript

Thank you, Rob, and thank you, everyone, for joining us on today's earnings 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 Regulation G is available in the Investors section of our website at fortive.com. Our statements on period-to-period increases or decreases refer to year-over-year comparisons on a continuing operations basis. During the call, we will make forward-looking statements, 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 actual results might differ materially from any forward-looking statements that we make today. Information regarding these factors is available in our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2021. These forward-looking statements speak only as of the date that they are made, and we do not assume any obligation to update. With that, I'd like to turn the call over to Jim.

Thanks, Elena. Hello, everyone, and thank you for joining us. I'll begin on Slide 3. We had an excellent second quarter with strong broad-based execution across the portfolio, contributing to revenue, margins and earnings all above the high end of our guidance, resulting in our raised outlook for the year. Despite the effects of COVID-related shutdowns in Shanghai, significant FX headwinds and ongoing supply chain constraints, our team was able to achieve 9% core revenue growth, 190 basis points adjusted operating margin expansion, 18% adjusted earnings per share growth and outstanding free cash flow generation in the second quarter. Consistent with the first quarter, demand for our leading workflow solutions remains robust. Year-to-date, hardware orders and software ARR both increased low double digits, reflecting our more resilient and diversified product portfolio. At the same time, our rigorous application of the Fortive Business System allowed us to deliver for customers in a challenging environment and improved our profitability despite higher inflation and rising FX headwinds. Turning to Slide 4. I want to provide an update on what we're seeing and what we expect in the second half of the year. Starting on the left with the current environment, demand and orders remained strong in the second quarter, driven by accelerated innovation, continued share gains and leverage to favorable secular drivers. Hardware orders increased 9% in the second quarter, yielding a hardware backlog that ended the quarter 21% higher than year-end 2021. Our supply chain measures continue to gain traction while we expect that component constraints will persist for the rest of 2022 and into 2023. While ongoing COVID lockdowns in China remain a risk, we substantially mitigated the headwind from the lockdowns that commenced in late March in Shanghai and continued through most of May, shifting most of the $60 million of risk we previously highlighted in the first half. This is an excellent example of our team's ability to utilize FBS tools to navigate unprecedented obstacles, keep our employees safe and deliver for customers and shareholders. Moving to the right side of the slide, we expect higher core growth for the remainder of the year as our more resilient product portfolio positions us to benefit from continued customer demand. We also continue to build momentum in our software businesses, with upsell and cross-sell bookings, new logo generation and lower churn all contributing to double-digit ARR growth for the full year. Given the strength of our first half performance, we are raising the outlook for the year. Our revised outlook also includes a foreign exchange headwind of approximately $100 million on revenue and $0.08 on EPS that was not previously contemplated. Lastly, our ability to convert more earnings to cash underpins our investment thesis and allows us to reinvest in our businesses, accelerate our strategy and enhance our returns to shareholders. Turning to Slide 5. The work we have done over the last 6 years to build a stronger collection of businesses has resulted in a more diversified end market mix and durable recurring revenue profile as demonstrated by the shading in all the end markets we serve today. For example, in 2016, a sizable percentage of our revenue came from the retail fueling and vehicle repair markets. Today, our largest end market by revenue is health care, which has very durable revenue characteristics. And as you can see further in the slide, there are recurring revenue opportunities across a range of end markets. We have more than doubled the percentage of our total company revenue that is recurring. This includes the software and consumables business model additions we have made to the portfolio and the services revenue that we have expanded at businesses like Tektronix. When you look at our footprint today and the end markets to which we participate, we have several opportunities to globalize our leading brands and take advantage of the secular drivers that are driving sustainable growth in these markets. I'll now provide some more details on each of the 3 segments, beginning with Intelligent Operating Solutions on Slide 6. IOS continued its strong momentum, with revenues up 16% and core revenue growth of 12% in the second quarter, with strong double-digit growth in North America and Western Europe and high single-digit growth in China. The work that businesses have done to improve the availability of supply and offset inflation is contributing to better-than-expected core growth, with sequential improvements in shipments and stronger price realization driving 205 basis points of core operating margin expansion, more than offsetting incremental FX headwinds. Some other highlights in the quarter include: Fluke's product innovation and new service offerings, including the recently launched Fluke Solar Solutions, in addition to rigorous daily supply chain management drove mid-teens core growth, while their orders forecast has continued to move up throughout the year. Industrial Scientific saw strong bookings for iNet, up 55% year-over-year because of continued progress diversifying and globalizing the customer base. Intelex SaaS revenues continued the double-digit pace, on track to 10%-plus ARR growth for the year. Moving to facilities and asset life cycle management. Gordian revenues were up double digits as several customers, including the New York City Department of Education and the Pennsylvania Department of General Services, leveraged Gordian's procurement platform to manage large infrastructure projects with city and state customers. Accruent continued to build a strong foundation for second half growth with software bookings up more than 20% and an expectation of accelerated second half bookings. Their commercialization success is a reflection of the significant progress they have made building FBS capabilities across their sales organization. Finally, ServiceChannel had another quarter of double-digit revenue growth. ServiceChannel is continuing to see strong customer demand for managed solutions, with customers increasingly outsourcing their facilities maintenance work. Turning now to Slide 7 in Precision Technologies. Total revenue increased 6% with core revenue growth of 9%. Demand remained strong with robust core revenue growth and another quarter of double-digit orders growth across major geographies and end markets, particularly industrial, semi, medical, power and energy, raising backlogs to new record levels. China revenues grew over 20% as Tektronix mitigated the Shanghai lockdowns and continued strength in Sensing Technologies. PT continues to benefit from a number of secular drivers, including the expansion of power and precision devices going into the electronics innovation space and the expanded use of semiconductors broadly. We achieved 90 basis points of adjusted operating margin expansion, driven by favorable pricing and disciplined cost management, partially offset by higher component costs and FX. Some highlights in the quarter include: mid-20% bookings growth at Tektronix, with new product launches, including the 2 Series MSO, which continues to be strong globally and represents an example of another next-generation platform that provides innovative and differentiated technology for customers; mid-teens growth at Sensing driven by pricing, FBS countermeasures and continued growth in core end markets in the second quarter; innovation and vertical market strategies are gaining traction at Gems, etc., contributing to over 20% growth in those businesses. Moving now to Slide 8 and the Advanced Healthcare Solutions. Total revenue increased 9% in the second quarter with core revenue growth of 3%. Low single-digit growth in North America and low double-digit growth in Western Europe was partially offset by a high single-digit decline in China related to the COVID lockdowns, which reduced the number of elective surgeries in China. COVID pressures, associated staffing challenges, along with supply chain constraints within capital equipment persisted as expected, limiting revenue growth across the segment in the second quarter. Elective procedures improved in North America, contributing to mid-single-digit growth in ASP consumables. The team continues to implement FBS tools, driving productivity savings, which in addition to the accretive benefits of the ProVation acquisition, contributed to 300 basis points of adjusted operating margin expansion in the second quarter, including 150 basis points of core OMX. Some other highlights in the quarter include: Censis had another quarter of very strong performance from its CensiTrac SaaS offering, which was more than offset by a difficult prior comp in marketing hardware. On a 2-year stack basis, Censis revenues grew 17.5%. Provation's GI business grew revenues and orders double digits. They have several competitive wins, including a 16-site standardization order from Essentia Health, where half of the sites are SaaS migrations and the other half are new Apex wins. Turning to Slide 9. The Fortive Business System continues to be a differentiator for us, enabling our businesses to enhance supply chain resilience, drive innovation and profitable growth and build capabilities in our leaders to effectively deliver on our commitments and distinguish our performance in an otherwise very challenging environment. Examples in the quarter include using Kaizen to utilize closed-loop production and operations in our Shanghai facilities, accelerating the restart of production, ensuring availability of supply and creating new demand opportunities, effectively mitigating the impact of COVID-related lockdowns in the region in the first half; utilizing lean portfolio management at Fluke to align new products to strategic growth areas. Similar to what we're doing at Tektronix, this has meaningfully improved our product vitality, doubling the 3-year revenue potential for new products. Provation is utilizing Obeya Rooms to significantly accelerate SaaS migration bookings and daily visual management implementation at Accruent is driving a significant improvement in net working capital. As you can see by all these examples and our performance in the quarter, we had tremendous success applying FBS. And with that, I'll pass it over to Chuck, who will provide more color on the second quarter financials and our second-half 2022 outlook.

Thanks, Jim, and hello, everyone. I will begin on Slide 10 with a quick recap of our second quarter performance. We generated year-over-year total revenue growth of 11% with core growth of 9%. Acquisitions contributed 5 points to total growth, partially offset by FX, which reduced total growth by 3 points in the quarter. Turning to the major regions on the right-hand side of this slide. North America core revenues were up high single digits, with contributions from each segment and strong double-digit growth in software and services. Western Europe revenues grew mid-teens, again with favorable contributions from these segments, including a return to growth in Invetech. We had low double-digit growth in Asia outside of China, while China revenues increased to mid-teens as we mitigated the Shanghai lockdowns that Jim highlighted earlier. We also continued to build backlog in China with approximately 20% order growth in the quarter as customers looked to replenish inventories and assure access to supply heading into the second half and 2023. Lastly, we had strong double-digit revenue growth across our high-growth markets. On Slide 11, we show operating performance highlights in the second quarter. Adjusted gross margins were down 30 basis points, while adjusted operating margins expanded 190 basis points to 24.1%. Gross margin expansion and operating margin expansion were both negatively impacted by 70 basis points of transactional FX headwind in the quarter, which was more than offset by over 500 basis points of price in the quarter, demonstrating the excellent job our teams are doing implementing price increases to offset higher input costs. Adjusted earnings per share increased 18% to $0.78, reflecting strong fall-through on higher volumes as well as lower share count, partially offset by higher interest and tax expense. Free cash flow was another standout at $276 million, which reflects 98% free cash flow conversion in the quarter. Turning now to the guidance on Slide 12 and the outlook for the remainder of the year. We expect core revenue growth of high single digit to low double digit, with adjusted operating profit margins anticipated to be up at least 100 basis points year-over-year in both the third and the fourth quarters. Adjusted earnings per share are expected to be in the range of $0.74 to $0.77 in Q3, up 12% to 16%, and in the range of $0.85 to $0.88 in Q4, up 8% to 11%. For the full year 2022, we are narrowing the total revenue range to reflect incremental FX headwinds while raising core revenue growth to 8% to 9.5%, with higher core growth in every segment. Adjusted operating margins are still expected to be up over 100 basis points for the year, and we are raising the midpoint of adjusted earnings per share outlook to $3.07 to $3.13, reflecting better operational performance in addition to lower taxes more than offsetting $0.08 of incremental FX headwinds and $0.02 of higher interest versus our prior guide. We expect free cash flow conversion to be seasonally strong in the second half and average approximately 105% for the full year. Moving to Slide 13 and the updated revenue walk for the year, starting on the left. First half revenues reflect our outperformance in Q2, more than offsetting incremental FX headwinds with stronger-than-expected performance in IOS and the shift in Shanghai-related revenues back to the first half as lockdown countermeasures allowed us to recover volumes that were previously expected to get pushed to the third quarter. Looking at the right-hand side of the chart, we've updated the first half to second half revenue bridge we showed you last quarter. It now reflects a lower step-up of approximately $110 million in volume supported by our robust backlog position and continued pace of recurring revenue growth across our portfolio. We also continue to embed favorable price in the second half versus the first. On a net basis, the second half core growth average is 10% at the midpoint, and it is roughly 16% on a 2-year stack. Incremental margins on sequential volume are expected to fall through at attractive levels, contributing to strengthening margin performance in the second half. In summary, our portfolio continues to show the benefit of the actions we've taken to build a more durable growth company with a high recurring revenue profile, mitigating the risk of slowing demand in the second half. Turning to Slide 14. As Jim highlighted, the Fortive of today is delivering higher, more profitable growth, and there's nowhere that this shows up more than in our free cash flow. A strong free cash flow, which has nearly doubled since 2019, continues to be a hallmark of our investment thesis, compounding faster than revenue and earnings. Over the last few years, we've taken proactive steps to strengthen our balance sheet, which combined with higher free cash flow generation, yields ample capacity to invest for growth and compound returns through disciplined and accretive capital deployment. As a reminder, we deployed $2.6 billion towards M&A in the second half of 2021 and continue to prioritize M&A as the primary driver of capital deployment. In addition, we opportunistically bought back shares in the second quarter, totaling 4 million shares year-to-date. At the current share price, we continue to see compelling returns consistent with the return criteria of all of our investments. As we exit the year with relatively low leverage of approximately 1.5x net debt to EBITDA, giving us substantial M&A firepower to continue to invest in our businesses, accelerate strategy and enhance total shareholder returns. With that, I'll pass it back to Jim for some closing remarks.

Thanks, Chuck. We're now on Slide 15. Before we move to questions, I want to spend a few minutes highlighting the positive impact we are having for customers, employees, suppliers and communities as we advance our sustainability mission. As many of you know, we published our 2022 sustainability report in June, and I'm incredibly proud of what we've accomplished, the aspirational targets we continue to set and the robustness of our reporting initiatives, such as alignment with key ESG reporting frameworks, including GRI, SASB, TCFD and the UN Global Compact as a signatory. This report serves as our communication of progress toward the principles and the UN Sustainable Development Goals. We also made significant progress across each of our sustainability strategic pillars, including: achievement of our 50% greenhouse gas emissions intensity goal early; reducing Scope 1 and Scope 2 GHG emissions intensity by 51% between 2017 and 2021. As a result of achieving that target early and in keeping with our continuous improvement culture, we have set a new and more aggressive target to reduce absolute Scope 1 and 2 GHG emissions 50% by 2029 from 2019 levels, a goal which is aligned with the Science Based Targets initiative guidance. We improved on each of our inclusion and diversity leadership goals, including gender inclusion and senior leadership diversity. And lastly, we exceeded our performance on our supplier diversity spend target in 2021 and completed 100% of our supplier audits as planned despite COVID. There's much more in the report, including examples of our innovative and sustainable products and services, and we encourage you to check it out on our website. Lastly, on Slide 16, we are demonstrating successful execution of the Fortive formula, even in the most difficult of times to drive more resilient growth, double-digit earnings and free cash flow growth. We said that 2022 is a show-me year. We are on track to meet or exceed our commitments, including mid-single-digit annual core growth on a 3-year stack basis. More than 300 basis points of operating margin expansion, 50% growth in earnings and 90% growth in free cash flow, all while navigating unprecedented and prolonged headwinds. This differentiated growth and profitability amongst our industry peers is a testament to FBS, driving innovation, demand generation and profitable growth in 2022 and beyond that is helping to generate 50% more cash per dollar of revenue recognized. As Chuck highlighted, that creates more opportunities to deploy that cash to accelerate growth and compound returns through disciplined capital deployment. As you've seen with our first-half performance, we're incredibly proud of the contributions from our Fortive team around the world. This July, we celebrated our sixth year as a public company. Since our inception, we have endeavored to build a truly special company, one that yields best-in-class performance. As you can see in 2022, we have made considerable progress against this goal, with strong growth through the strength of our highly desirable brands and technology, outstanding margin performance through the quality of our portfolio and exceptional free cash flow through the power of our business system. I look forward to your questions, and with that, I'll turn it back to Elena.

Thanks, Jim. That concludes our formal comments. Rob, we are now ready to take questions.

Maybe, Jim and Chuck, just a first question around the AHS segment. That's the one where sort of pricing seems to have been stuck a little bit at 1% in the first half versus 700, 600 points higher at the other 2 divisions. And the overall core growth sort of 4% this year. How are you thinking about that, the main headwinds on the pricing and the volumes aside from the China impact in Q2? And when we're thinking about, say, the out year '23, there are some factors that could kick that growth rate a little bit higher.

Yes, Julian. In the second quarter, AHS performed as we expected from a core growth standpoint. There were some fluctuations with elective procedures, better performance in North America, and a significant decline in China. We still expect elective procedures to meet our annual projections. We are optimistic about the growth acceleration in AHS from the first quarter to the second quarter and anticipate this trend will continue in the second half. We have encountered some supply chain challenges with equipment, which we anticipated in our guidance, but we expect improvements. We have already started seeing the necessary equipment production in June for the upcoming half. Therefore, we believe core growth will increase. In terms of pricing, we expect to achieve slightly better pricing in the second half compared to the second quarter, although it is somewhat challenging to secure price increases in the current environment. However, we are managing to stay ahead of price versus cost. Overall, margins in the second quarter for AHS were in good shape. If it weren't for some foreign exchange impacts, we would have been right on target with our guidance. We are optimistic about the segment, looking forward to achieving better pricing and continuing to negotiate long-term contracts to enhance pricing, particularly at average selling price, although this process may take some time. Fortunately, we haven't experienced as much input inflation in our sector compared to others, which positions us well.

That's helpful. And then maybe one on capital deployment. Not going to ask you about the M&A pipeline. But if we look at, say, the buybacks that did step up in the second quarter, Chuck had talked about 1.5x leverage ending the year. So trying to figure out at current share prices, what kind of buyback spend are you planning on, I think, given the comment of sort of compelling returns right now? And there are matters of guidance numbers in the deck, which makes our lives a lot easier. Share count was maybe 1 that I missed. Just wondered what you're dialing in for the year on share count vis-à-vis the buyback discussion.

Well, Julian, as you know, M&A remains our priority here. What we're saying is that we will finish the year without any capital deployment. We're not forecasting share buybacks since it's not really a program; it's just being opportunistic. In the first half, we did buy 4 million over the first two quarters, and we'll continue to be opportunistic as we move forward.

And just, Julian, this is Elena. We ended the quarter with 358 million shares outstanding, so that would be the appropriate assumption going into the second half.

I would like to follow up on the M&A pipeline. Given the discussions around changing interest rates and the shifting environment, are you observing any fundamental changes, such as private equity exiting or a rise in strategic buyers? Are buyers' or sellers' expectations altering, or is it still too early to determine?

Yes, it's a complex question. But obviously, private equity is a buyer and a seller, so they're obviously seeing it on both sides. But I would say what we've seen really here at this point, Andrew, is really one where I don't think we've really seen reality set in, in a number of places. There have been some things transacted. It's still higher prices here in the last 90 days, but I don't think that's reality going forward. So I think it takes a little while. We've seen things take longer for sure. We would continue to remain busy. But we're going to be disciplined here in this kind of time horizon. So I think that's where it's at right now. I said a couple of quarters ago, it was a 12-month to maybe even 18-month kind of time horizon. We're obviously 6 months into that kind of time frame. I suspect maybe we'll start to see some things here maybe later in the fall, start to look what I’ll call more normalized.

Got you. And then that's another question for you. This earnings season, one of the surprises, I think sort of across the board, just Western Europe, just on the margin, just looks okay. And even for you, it's mid-teens core. Why is Europe so good? And why we’re not seeing more of a headwind from what's actually happening there?

Yes, I believe Western Europe has been a positive aspect for us. As you mentioned, it seems to have normalized a bit more in this quarter when compared to North America, especially in the first half. Orders in North America are slightly stronger. What we're experiencing in the quarter appears to relate to clearing out more backlog. We likely have a bit more backlog in Western Europe due to the location of our factories, many of which are in the U.S. In the health sector, we specifically noted Invetech in our prepared remarks, and currently, we are seeing strong business in Western Europe. However, when examining the entire European landscape, including high-growth markets like Eastern Europe and Russia, the narrative shifts slightly. There is noticeable slowing due to the effects of the situation in Russia. So, while Western Europe presents a good story, a broader view reveals a different narrative that aligns with some of the headlines we're observing. Nevertheless, I believe we will continue to perform well in Western Europe throughout the year.

What are you guys seeing in China? And in particular, I guess, outside of the health care stuff, just the more industrial type of stuff?

One of the key highlights of the quarter was the rebound in China. A data point that Chuck and I focus on is our point of sale at Fluke, which showed high single-digit growth in our shop channel, and was actually in double digits for the quarter. This indicates that the Sensing business performed well. Aside from our healthcare segment, which was slower, we saw good performance in China during this quarter. While the first quarter was a bit sluggish, the first half still showed decent performance in these businesses, and we expect this trend to continue into the second half. The growth is quite broad-based, particularly among our OEMs in Sensing. We are seeing strong business at Fluke and Tek as well. However, we anticipate that Healthcare may continue to face challenges for at least another quarter in relation to what we’re observing in hospitals, but the rest of the business is in a healthy position.

And then one last one. Gordian and Accruent, I think, you have up low double digit in the quarter, I think it was I saw on the slides. I think that's better than you guys had been expecting. What's going on at those businesses and how are you accelerating the growth there? I recall there being some question marks around the growth that I think it was Accruent over time.

Yes, as we think more about the business, we're focusing on the integration of those companies and likely ServiceChannel as well. We've swapped some product lines between these businesses and are pursuing opportunities with shared sales channels. As you mentioned, Gordian is performing well due to robust spending at state and local levels, which we believe will persist. Additionally, developments from Washington are expected to support that business. We have achieved significant wins with strong clients like the city of New York. Overall, we’re observing positive trends. We're beginning to see a turnaround in Accruent, thanks to Olumide and his team. We anticipate that bookings will continue to improve throughout the year. We have invested considerable effort into optimizing Gordian and supporting that team, who effectively utilizes FBS. Accruent, as we've indicated, has been a project in need of improvement, and we are starting to see positive outcomes from those efforts, which will continue to develop over the year.

I want to take a closer look at the guidance for ASP margins. We experienced flat margins in the third quarter, and we're expecting a 100 basis points increase in the fourth quarter compared to last year. I'm curious about the assumptions behind this forecast and what needs to occur to achieve that enhanced operating leverage at AHS.

So Nigel, I'll take that is in the second half, really not much other than normal sequentially growing, particularly in the fourth quarter, for us to achieve that, so nothing superhuman there, given the levels that we're seeing. They're shrugging off pretty well and showing that good margin expansion despite FX, so we're really pleased about that. We saw a little bit of that in Q2 as well. But I actually saw quite nice core margin expansion in Q2 of this year. So when you look at Q3 and Q4, you don't need some big step-up. It's just normal flow-through based on where we sit right now.

I think we had a pretty decent hit on onetime FX in the quarter and the second quarter for AHS or margins would have been even better. So I think when you take that into account, Nigel, this is really kind of a normalization of what we see, and as we said, a great margin story in that segment.

Great. I mean, it sounds like the transactional FX is heading AHS more than the other segments. Just I wonder if you could just maybe just clarify why that is because I don't sure I understand why. But on the free cash flow conversion, I did want to touch on free cash flow in my follow-up. You're obviously very impressive, especially compared to some of your peers. But are you absorbing the R&D tax credit headwinds this year within that number? Because if you are, it's even more impressive, but just wondering how that's impacting things.

Yes, Nigel, thanks for the question. Yes, we are. We anticipated that when we put out our guide for this year. And we've got about $20 million in the first half of this year and probably looking at another $40 million next in the second half. But again, that's already contemplated in the guidance. To the question on the transactional FX, it's actually hitting all of our segments. But what you're seeing there in terms of different from what we guided is at AHS, there are revenues coming really basically where we thought they would in Q2, and the other 2 are coming in a little stronger so it's hiding what is actually hitting all 3 of them.

I wonder if you could give a little more color on Tektronix, both kind of what's driving the order strength. I'm just looking at the book-to-bill at that level. I would assume there's still some issues getting yourself out the door kind of impacting the backlog and book-to-bill. But can you give us a little color on both sides of that equation?

Yes, we're really excited about the team's work over the past several quarters regarding orders. There's been a lot of innovation that we've introduced, as mentioned in the prepared remarks. The book-to-bill in the second quarter was around 1.3, indicating strong order activity even with mid-single-digit growth. The focus on innovation is key. We launched the 2 Series, which is performing well, and also had an enhanced launch of the 5 Series along with follow-on probes and related products. The technology landscape is favorable, and we're benefiting from semiconductor investments, as well as the increased demand for digital technology across various applications—from EV batteries to small IoT sensors. This digital transformation requires more R&D and investment, especially around power solutions. Our strategic plan from the past few years is proving effective, leading to continued order growth. We're catching up on backlog, with mid-single-digit growth this quarter, which means we have very low inventory with our channel partners. Overall, the opportunity to further expand the business in the second half looks very promising.

Interesting. And I think the last time we talked, you had mentioned some of the activity that you're seeing in Tek sort of show the kind of a reshoring element as people were kind of pivoting where they were investing or where they were maybe preparing to capitalize production. Could you maybe elaborate on that a little bit more? Is that still going on in the business?

Yes, we don't engage much in semiconductor production. However, with the ongoing onshoring of semiconductors, particularly the announcements from Washington, we expect to benefit because many of these developments will involve new designs that are essential for the key fleet. We have some opportunities in the semiconductor sector that will take advantage of this investment. More generally, the current legislation includes billions of dollars for technology investments aimed at enhancing all U.S. industries from a technological standpoint. Any funding directed towards innovation and R&D, especially in hardware, will positively impact Tektronix. As we mentioned earlier, there are several long-term trends at play, and recent news suggests that conditions may be improving slightly.

I was just noting that the order book is up 12%. That's a significant number, but sometimes we need to consider the context. Is the price in that order book aligned with the price you are currently reporting, around that 5% range, or is it a bit higher?

No, it's about the same, Scott, at around 5% of what we saw in the second quarter. We do expect that in the second half as well.

Okay, so it's strong. And then just to get a little of minutiae here, ServiceChannel, if you can help us kind of understand the sales cycle a little bit better. I mean, pretty big growth numbers this quarter. Are there any kind of variations in that sale? If there's kind of, I should say, updates or whatever that may cause people to buy ahead of them or price increases that people buy ahead of them or new product launches that people pile on. Is there kind of any lumpiness to that business that we should be aware of?

There is some variability in the managed services portion that involves procurement of services, which can occasionally be more intense. They did experience some benefits from this. However, the SaaS and AI segments of the business are performing exceptionally well, with over 20 percent growth. We are confident in their growth trajectory. The sales cycle with larger retailers or users who have multiple facilities tends to be lengthy, so we don't expect significant fluctuations in sales within short timeframes. We won’t see a rapid influx of customers within just 30 days. The sales pipeline looks promising for the second half of the year, and we are optimistic about our position. The team has been doing excellent work, and we anticipate making strides in core offerings by the end of the third quarter. We are also implementing innovations that we expect to roll out in 2023, which we are excited about. Overall, the business is off to a strong start.

Jim, you mentioned the higher recurring footprint that Fortive has, along with the record backlog that you have continued to add to. And you did also mention that your backlog should help you in '23 in the presentation. So how much confidence do those metrics give you as you potentially enter a slow growth environment? How likely is it that you could grow even if the world does moderately slow?

As we discuss the first half of the year, it’s important to note that while every slowdown has its unique characteristics and can be unpredictable, there are a few things we know to be true. We are likely to finish the year with twice the backlog we had at the beginning of January 2021. We will begin the next year with a strong recurring revenue base and solid performance in both software and healthcare, particularly in consumables, which we view positively. Additionally, we have long-term initiatives aimed at better aligning our business with favorable market trends, whether through the service strategy at Tektronix or the environmental projects we are advancing in Sensing. These initiatives will make us less reliant on macroeconomic factors. We believe these three elements will position us well moving forward, and we do anticipate growth opportunities in 2023. As the year progresses, we’ll monitor developments closely. It’s worth noting that even amid significant challenges from COVID-19 in 2020, we managed to grow our earnings and free cash flow. Our experience in applying our strategies during tough times gives us confidence, and we have structured our portfolio to be more resilient. We are optimistic about our ability to withstand challenges and emerge stronger than ever.

Jim, I just want to follow up on something you said earlier in this conversation. I think you said last quarter that channel inventory was a little elevated at Fluke and Tek, but you're generally feeling good about it. And I think, Jim, you just said that your channel in Tek actually was pretty lean. So am I hearing that right or maybe you could just clarify your channel commentary?

Yes, I think the inventory situation at Tek is quite lean due to strong demand. In certain regions, we are managing inventory closely. Regarding Fluke, I mentioned previously that as we analyzed both our channel inventory and the orders in backlog, we noticed that some orders from the second quarter shifted into inventory. While the total number didn't change significantly, there was a reduction in backlog and an increase in inventory. We view this as positive because we've experienced moderate growth in point-of-sale transactions without actively generating demand. We held off on demand generation efforts at Fluke since we didn't want to create demand that we couldn't meet. Now, we are moving forward with those efforts. We’ve already started and plan to invest in demand generation in the second half of the year, as our channel inventory is now in a better position, allowing our partners to deliver more consistently. We believe this increase in inventory will help us achieve higher point-of-sale numbers in the latter half of the year, which is beneficial for both us and our customers.

I guess two questions for me as well. First off, on the free cash flow, I was hoping you just talked about, when I look at the free cash flow projection for the back half, there's a pretty big uptick in Q4 free cash flow, both dollars and conversion rate. Maybe just talk about what is driving that dynamic for you? And then as we look and when you look at your working capital metrics, do you think those have sort of peaked and as you go into '23, more importantly, does that become a source of free cash flow generation incrementally for you?

Amit, this is Chuck. I'll address those two questions. The second half is typically stronger seasonally. In the first half, we distributed incentive compensation, so when comparing the two halves, the second half will show stronger performance. In Q4, we have a slightly higher volume of shipments, and then in Q1, we could see a decrease. Therefore, we are working to reduce some of our working capital, which contributes to the strong performance in the fourth quarter. We are pleased to report an 11% increase in free cash flow in the first half, which gives me confidence. The primary factor we were monitoring is that Q2 had a back-end load due to lockdowns in China during April and May. We believe that cash flow will improve even beyond our normal expectations, which is a positive sign. Regarding working capital trends, we expect that inventory levels are peaking. Although the supply chain remains challenging, we may recover some ground in inventory throughout 2023. Despite that, we have managed our working capital effectively and have benefited from the working capital characteristics inherent in our software business.

Fair enough. If I could follow up on Europe, I know you mentioned this earlier, but the growth in the mid-teens is quite impressive considering the macroeconomic concerns in Europe. I was curious if you could discuss whether your customers in Europe are using the imported products for specific applications or if they are stockpiling them as inventory. I am contemplating a scenario where, due to potential energy shortages this winter in Europe, customers might be accumulating inventory to mitigate those challenges. Are you observing any such trends or shifts in purchasing patterns between direct sales to OEMs versus channel sales?

Yes. We've experienced broad-based success, and the point of sale looks strong as well. I don't think our channel partners are significantly stockpiling products. When we look at our businesses, Fluke, which is one of our larger operations in Europe, typically doesn't see stockpiling; users generally purchase products for immediate use. Similarly, Tek operates in a comparable manner. Overall, a significant portion of our revenue is not coming from stockpiling but rather sales through channel partners that are being actively used. We've also seen growth in some of our software businesses we've acquired, although they initially didn’t have a large presence in Europe. This software expansion is contributing to growth as well, but I don't foresee it becoming a significant issue. However, we are monitoring the environment closely. In terms of the Sensing segment, we may experience a slight impact, but we have good visibility on our orders, and any potential changes in that outlook for Europe over the next three to four quarters aren’t expected to be substantial. On the whole, we feel positive about Europe, yet like everyone on this call, we are aware of macro factors, especially with potential challenges in the winter, and we are keeping a close watch on any changes in trajectory as we approach the end of the year.

If we go back to Page 5, I really like that updated mix, revenue mix. And how would you describe the target and the path for the 40% recurring revenue? Is there a time line that you can share today where you think it begins to level out?

We're continuing to explore new business models organically across our operations. For instance, our cloud offering at Tektronix is still in the early stages, but we expect it to develop recurring revenue over the next several years. Our software businesses are growing rapidly and are expected to outpace hardware in the long term. This compound growth will contribute positively to our business model. We anticipate seeing that revenue figure increase without the need for any inorganic growth. Over the past six years, our acquisition strategy has primarily focused on companies with recurring revenue models, whether that's in consumables or software. While this won't be our only focus, it will be the majority of our investment moving forward. Therefore, I expect the 40% recurring revenue target to rise over time through both organic and inorganic efforts.

Okay. And then back on Page 4, I just want to make sure I have the mechanics of this right on the COVID lockdown being mitigated. So does that $55 million, does that constitute a pull-in from what was expected to be in the second half? And was that in your second quarter guide?

So Deane, if you recall when we discussed the second quarter, we mentioned that revenue was shifting out due to the lockdown in China into the second half. I see this as a return to the second quarter. We didn't anticipate receiving this in Q2. The team did an excellent job of mitigating some of those issues. However, this is just a return to where we initially had it forecasted.

First question was just, if you were to think about your SaaS software assets, you've had them for several quarters now. Have you seen any discernible change in the pace of new logo adds or customer retention? Are you kind of accelerating? Has growth plateaued there? Just any color around that you can provide.

When we consider our growth in Annual Recurring Revenue, the bookings level aligns with our trailing 12-month figure, which is around 9 to 10 percent. We expect that to reach double digits by the end of the year. Our SaaS business is really gaining momentum, as customers are increasingly seeking cost savings, and many of our SaaS solutions are designed to deliver just that. We have consistently positioned our portfolio to focus on safety, quality, and productivity, which enables customers to meet their needs effectively. However, we have observed some delays in the health care software sector, particularly with new logos, due to staffing shortages and challenges within IT organizations. Despite this, we've had success with existing customers, such as Provation, where we quickly closed a deal that involved both a SaaS upgrade and a new logo. The upselling and cross-selling within health care are continuing at a steady pace, though acquiring new logos may take a bit longer. Overall, we haven't noted significant delays across the rest of our portfolio, which supports our outlook for continued SaaS acceleration throughout the year.

Great. I have a modeling question. You provided a lot of detail. If I look at IOS based on the ranges you provided, it appears that in Q4, that's the only one that might decline sequentially. I'm not sure if there's a mix involved or if it's just that there's a wide range on what the greater than symbol indicates on your guidance slide.

I think, first of all, there might be a slight rounding effect. IOS margins are expected to remain strong, and I don’t see any significant changes regarding that. We can follow up with more specifics about the modeling. However, I believe the strong margin expansion we observed in IOS this quarter will continue. Each of our business areas is showing improvement as the year progresses, which indicates that we will continue to experience robust margins moving forward.

A bit more of a rounding. So we just went to a solid number and we obviously did have the impact from FX and the one-time FX impact on the transaction component roll through into the full year. But there's really nothing else.

I think some of the pricing dynamics for many companies are kind of skewing their year-on-year comparisons a little bit. If I was to think about the orders from your more industrial businesses on a sequential basis from here, how do you kind of see them going? Are those going up consistently on a sequential basis still, or are they more like kind of staying flattish at a high level?

Prices have remained fairly stable from the second quarter into the second half, which can be considered constant. This can vary by business due to backlog volumes. For instance, we expect to start seeing orders in Sensing soon, likely reflecting dates from 2023 as we observe some customers in Sensing/Tek beginning to order ahead. We continue to see strong growth over a two-year period, which shapes our perspective. Tektronix is expected to maintain robust order strength throughout the year. Fluke may experience a slight slowdown, but this is primarily related to comparison reasons rather than any other factors. Overall, we anticipate that both volume and pricing will demonstrate ongoing strength as the year progresses. Revenue from our core offerings is also expected to improve, which is reflected in our upgrades. However, I do not foresee any significant changes in the dynamics of pricing versus volume in the latter half of the year. We will keep pursuing demand generation activities at Fluke and monitor the results as the year unfolds. We have been pleased with our pricing and volume performance in the first half and expect similar outcomes in the second half. And just last thing for me. When you talk about Gordian and Accruent and maybe even ServiceChannel starting to combine a little bit, like what does that actually mean for those companies? Does this ultimately become one single brand under Fortive? Or like what logistically needs to happen for those businesses to move that way? From an investor relations standpoint, our aim is to provide insight into our performance amidst some complexities. Our strategic efforts regarding branding, product lines, and portfolio are still being defined. We have a similar customer base in various scenarios and are managing that effectively while operating as separate companies. Over time, we do anticipate integrating some aspects, particularly from an architectural viewpoint, but it’s still early in that process. Our team is actively working to bring everything together. The narrative remains one of continued positive performance with significant margin expansion. Additionally, we are slightly ahead of our expectations in terms of earnings and earnings per share for the first half when we look at the merger of ServiceChannel and Provation. We are in a strong position for growth as well as maintaining solid margins in these businesses. With the combination of these businesses, we expect to achieve over $0.5 billion in revenue with robust margin capabilities. Currently, two of these businesses are nearly meeting the Rule of 50 benchmark, indicating substantial future potential for the entire segment. Overall, we are strategically well-positioned, whether we decide to integrate these companies or not, ensuring we are set up for long-term success in building this franchise effectively.

Thank you, Rob, and thank you, everyone, for joining us today. We couldn't be more excited as we recently celebrated our sixth anniversary with a lot happening. We truly appreciate the support from all of you over the past six years. We mentioned that 2022 was a show-me year, and we believe the first half has really shown that across our portfolio, highlighting both the breadth and depth of our business quality. There's so much to be excited about, and we are even more thrilled about the opportunities in the second half. We look forward to sharing more details in the follow-up call, and we feel well-prepared despite the uncertainty in the environment. We have navigated the challenges exceptionally well, and I am confident that we will continue to face any uncertainties ahead, regardless of the circumstances. If we don’t speak before the end of summer, I wish you all a wonderful summer, and I look forward to seeing you in person, hopefully in the fall. Thank you, everyone, and have a great day.