Fortive Corp (FTV) — Q3 2022 Earnings Call Transcript

Thank you, Dennis. And thank you, everyone, for joining us on today's 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 on the Investors section of our website at www.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 risk 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 any forward-looking statements. With that, I'd like to turn the call over to Jim Lico.

Thanks, Elena. I'll begin on Slide 3. We had another quarter of outperformance with 12% core revenue growth; 80 and 160 basis points adjusted gross and operating margin expansion, respectively; 20% adjusted earnings per share growth and 22% free cash flow growth, all above the guidance we set coming into the quarter. Our ability to outperform reflects the quality of our portfolio, our team's rigorous execution and the power of the Fortive business system, delivering higher and more profitable growth and free cash flow generation. The third quarter also demonstrated continued success launching a number of new products and solutions that solve our customers' toughest safety, quality and productivity challenges. We have strong conviction in the secular drivers favoring enduring growth in these markets. As a result, we are confident the work we do to create long-term sustainable competitive advantages for our operating companies and strategic segments will yield best-in-class returns for Fortive for a long time to come. Turning to Slide 4. We are delivering 2022 at the high end of our initial outlook we set back in February, reflecting continued strong momentum as we've moved through the year. Short cycle demand has held up well with hardware product backlog more than double what it was at the beginning of 2021, while our software businesses have continued their double-digit pace of growth. This speaks to the strength of our portfolio and our ability to countermeasure challenges. Our supply chain measures across the portfolio continue to gain traction, especially at Fluke and Tektronix, although, we expect some component constraints to persist into 2023. Our latest outlook now reflects a year-over-year foreign exchange headwind of approximately $175 million on revenue and $0.11 on EPS for the year. Despite these headwinds, we are driving higher growth and operating margins by leveraging FBS tools to accelerate profitable growth and position the company for continued outperformance in 2023. Moving to the right-hand side of the slide, we are preparing scenarios for a range of potential macroeconomic outcomes in 2023, including moderating hardware product orders growth. Lastly, our strong balance sheet, supported by robust free cash flow growth, presents several levers for earnings growth and continued value creation compounding. Turning to Slide 5. We just finished our annual strategic plans for each of our operating companies, and I'm even more excited about the depth of our strategy to take advantage of the secular tailwinds accelerating progress across our five critical customer workflows. Our solutions for managing facilities and assets, environmental health and safety, and measurement and connected reliability keep much of the world running safely, productively and sustainably. We are enabling product realization with precision measurement and sensing solutions underpinning many of the most exciting product innovations in the world from your phone and car to the electric grid and to safer food and pharmaceutical production. Our health care solutions for the perioperative loop keep clinicians and patients safe, serving over 5,000 customers, including all the top US hospitals, as well as hospitals around the world. Each workflow is well positioned to benefit from durable business models that underpin our vision and strategy to build a stronger collection of businesses with industry-leading profitability and free cash flow margins. They’re also aligned to our sustainability mission by helping our customers accelerate safety, good health and well-being, advanced industry and customer productivity, utilizing new and more efficient clean energy resources, and drive reductions of our customers' greenhouse gas emissions. Today, over 60% of Fortive's products and services enable more sustainable outcomes that are aligned to the United Nations' sustainable development goals. As we continue to accelerate innovation for our customers at scale, demand is proving more resilient even in the face of slowing economic growth, given the recognition of how our workflow solutions drive productivity benefits for our customers. I will now provide more details on each of our three segments, beginning with Intelligent Operating Solutions. IOS continued its strong momentum with revenues up 14% as unfavorable FX was offset by the ServiceChannel acquisition, which became core in mid-August. Our region growth was broad-based with low double-digit growth in North America, mid-teens growth in Western Europe, and low 20s growth in China. Double-digit core growth in every workflow drove 345 basis points of core operating margin expansion, more than offsetting inflation and incremental FX headwinds. Some other highlights in the quarter include: At Fluke, demand remains solid with double-digit point of sale growth in each major region. Using FBS Voice of the Customer and product development tools, Fluke launched a breakthrough platform serving the renewables market that reduces the time to test solar installations by as much as half. This kit combines multiple Fluke hardware tools with a software platform and has been awarded industry recognition for its safety and time-saving features. EHS had low double-digit revenue growth as we continue to see the benefits of share gains and efforts to diversify its customer base. Industrial Scientific saw a greater than 20% increase in bookings with strong iNet quotes and instrument bookings in both Europe and the Middle East. And Intelex had another quarter of mid-teens SaaS revenue growth. Moving to facilities and asset life cycle. Gordian revenues were up double digits once again with the business continuing to drive accelerated penetration of projects flowing through Gordian's job order contracting platform with an expanded set of customers. Accruent saw strong software demand with its SaaS offerings growing low double digits. Accruent also continued to utilize FBS tools to improve its annual recurring revenue profile, with the recent Kaizens focused on driving price and improved customer retention. Finally, ServiceChannel had another exceptional quarter with strong double-digit revenue growth and high teens growth in SaaS. As some customers face mounting cost pressures, they are increasingly turning to ServiceChannel to help them outsource their facility maintenance work, reducing their third-party contractor costs. As a result, we are reinvesting a portion of their upside into transitioning customers to our more profitable SaaS managed service offering to continue to drive profitable growth. Turning now to Slide 7 and Precision Technologies, which delivered core growth ahead of expectations in every business. Core revenues were up 19% with double-digit growth in all our major regions driven by continued investment in the industrial, power and energy, semiconductor and medical end markets. PT also saw 280 basis points of adjusted operating margin expansion with higher shipments and strong price realization more than offsetting inflation and FX headwinds. Some highlights in the quarter include seven consecutive quarters of double-digit orders growth in Tektronix, fueled by a number of new entry and mainstream scope product launches. As a result, trailing 12-month orders are now greater than $1 billion. Our teams are diligently applying FBS to countermeasure supply chain constraints to deliver on this record level of demand. Sensing Tech benefited from another quarter of volume growth and strong price realization. While supply chain constraints continue to limit output, Sensing book-to-bill was greater than 1, with strong demand in Qualitrol’s utility and power business. Similarly, Pacific Scientific EMC saw improved material availability and capacity expansion across key production lines, driving double-digit revenue growth in the quarter. Moving now to Slide 8 and Advanced Healthcare Solutions. Total revenue increased 3% in the third quarter with a core revenue decline of 1%, as continued supply chain constraints limited growth at ASP and Fluke solutions, resulting in lower than expected core growth in the quarter. Mid-single digit growth in Western Europe was more than offset by low single-digit decline in North America and a mid-single-digit decline in China. We saw a sequential improvement in core growth at ASP as their supply chain shortages constrained capital equipment growth started to ease in late September. Elective procedures improved to the low 90% range, excluding China, while rolling lockdowns kept elective procedure rates around 70% of pre-COVID levels there. AHS core segment margins were down almost 400 basis points stemming from lower volumes and FX headwinds in the quarter, as well as the recognition of a bad debt reserve in Invetech. As you can see, the team is diligently deploying pricing and cost controls to offset these headwinds, which we expect will deliver margin recovery in the fourth quarter. Some other highlights for the quarter include: an acceleration in new hospital bookings at Censis and double-digit growth in their CensiTrac SaaS subscription revenues. Provation SaaS offering is also seeing good demand from customers looking to further standardize on Provation across their health systems. Lastly, we completed the sale of Fluke Health therapy physics product line, which will be adjusted from core growth going forward with annual sales just under $20 million. Turning to Slide 9. Fortive Business System continues to be a differentiator for us, enabling our business to drive innovation and profitable growth. I'm excited to share that we just completed our annual CEO Kaizen event, accelerating our culture of performance. We brought together our most senior Fortive leaders, including our segment leaders and many of our operating company presidents with a total of 28 teams and over 400 team members, driving significant improvements in growth, margin, free cash flow and breakthrough innovations. In Fortive, how we do Kaizen is what sets us apart. It's the deep engagement of our leadership and teams as well as the achievement of our high expectations. Some highlights include the teams of Fluke identified gross margin opportunities, resulting in margin expansion through freight cost reductions and value engineering opportunities. At ISC, lean conversion Kaizen realized a 20% to 40% improvement in productivity across four product lines, and they improved the lead time for iNet quotes by 80% and time to market for newly developed software by 75%. Our teams reduced the average test time by more than 25% on a highly constrained production process in Tektronix. And Censis implementing Kaizens yielding a 2 times improvement in productivity and reduced time to onboard new software customers. These results are a continued example of how FBS is driving results at Fortive. With that, I'll pass it over to Chuck, who will provide more color on our third quarter financials and our updated 2022 outlook.

Thanks, Jim. And hello, everyone. I'll begin on Slide 10 with a quick recap of our third quarter performance. We generated year-over-year core revenue growth of 12%. Acquisition benefits were as expected, contributing approximately 4 points of growth, offset by higher than expected FX headwinds in the quarter. As a reminder, the ServiceChannel acquisition became part of our core growth in mid-August. Turning to the right side of the slide. We saw double-digit core revenue growth in each of the major regions. North America revenue was up low double digits with mid-teens growth in software. Western Europe revenue grew mid-teens with favorable contributions from each segment. Asia revenue increased in the low 20% range with mid-20% growth in China, driven by robust growth in Precision Technologies, partially offset by a decline in health care. Lastly, we saw high teens revenue growth across our high growth markets. On Slide 11, we show operating performance highlights in the third quarter. Adjusted gross margins increased 80 basis points to 58.1% as volume and strong price realization continued to demonstrate the value proposition of our products and solutions. Adjusted operating margins expanded 160 basis points to 24.4%, up 440 basis points on a two-year stack basis. Adjusted earnings per share increased 20% to $0.79, reflecting strong fall through on higher volumes, partially offset by higher interest expense. Free cash flow was another standout at $307 million, reflecting approximately 108% of adjusted free cash flow conversion. Turning now to the guide on Slide 12 and the outlook for the remainder of the year. For the fourth quarter, core revenue growth is expected to be approximately 11% at the midpoint and adjusted operating profit margins are still anticipated to be up at least 100 basis points year-over-year. Adjusted earnings per share are expected to be in the range of $0.82 to $0.85 in Q4, representing year-over-year growth of 4% to 7% or 10% to 13% normalized for a low tax rate in Q4 of last year. This reflects an incremental $0.03 headwind from currency movements not contemplated in our prior outlook. For the full year 2022, we are narrowing and raising our adjusted earnings per share outlook to $3.10 to $3.13 to better reflect operational performance in the third quarter, partially offset by FX headwinds. The tax rate is expected to be approximately 14.5% for the year. Lastly, we anticipate that free cash flow will be seasonally strong in the fourth quarter and we continue to expect full year free cash flow of $1.17 billion and conversion to be approximately 105%. Turning to Slide 13. I wanted to update you on our strong credit and liquidity positions. Early in the fourth quarter, we amended our $2 billion revolving credit facility, extending the maturity out to 2027. The amended credit facility utilizes a sustainability feature whereby pricing varies depending on our achievement of our recently published commitment to reducing our absolute Scope 1 and 2 greenhouse gas emissions by 50%. We also added a new $1 billion delayed draw term loan, giving us the financial flexibility to refinance the $1 billion term loan coming due in December, with a prepayable loan where we can deleverage with available free cash flow without penalty. We are now levered at roughly 2 times on a net debt to EBITDA basis with an average debt maturity of five years and a 3.2% weighted average interest rate. The proactive moves we made to strengthen our balance sheet, combined with our robust free cash flow generation, also give us ample capacity to invest for growth and compound returns through disciplined and accretive capital deployment. With that, I'll pass it back to Jim for some preliminary color on 2023 and closing remarks.

Thanks, Chuck. Turning to Slide 14. We wanted to share some initial thoughts on 2023. Starting with the hardware products business, which includes Fluke, Tektronix, and Sensing Technologies. Backlog across these businesses are roughly double pre-pandemic levels and the secular trends I mentioned earlier are driving market expansion and the development of new innovations where we have a strong right to play. As a result, that gives us increased confidence in our ability to grow through a potential decline in new customer orders in 2023. Our software services and other recurring revenue businesses, including facilities and asset life cycle, environmental health and safety, Provation, and others, are expected to benefit from enhanced market positions driving double-digit growth in our SaaS and license revenue streams. At the same time, our healthcare businesses, excluding software, are 70% recurring with consumables and services. On the capital side, we expect supply chain to normalize, while the overall pace of recovery in hospitals will continue to be slow given the labor and productivity challenges likely to continue into 2023. While we haven't completed our planning process for next year, we are confident the work we have done to build a more resilient revenue and earnings profile will enable us to outperform the evolving macro environment. Lastly, on Slide 15, we are demonstrating the results of our successful portfolio transformation, yielding higher cash compounding power having nearly doubled free cash flow over the last three years. Our sustainable competitive advantages are evidenced in our ability to outgrow the attractive markets we serve and deliver workflow innovations that solve our customers' most critical safety, quality and productivity challenges. The third quarter demonstrated our team's continued success launching a number of new products and solutions, generating compelling investment returns and adding to our ability to continue to compound results. Lastly, our ability to raise our earnings outlook for the year once again in the face of continued headwinds speaks to the power of the Fortive Business System and our culture of Kaizen, which is all about finding a better way. We have a strong culture of setting high expectations. And through the rigor, discipline and the unrelenting efforts of our teams, we are delivering strong results. When taken together, this creates a powerful formula for value creation with a high-quality portfolio of desirable brands favorably leveraged to sustainable secular trends, industry-leading margins and free cash flow generation and best-in-class execution, enabling Fortive to outperform in almost any environment. With that, I'll turn it back to Elena.

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

Can we start with the comment on '23 regarding the positioning on the hardware backlog of 2 times historical? Can you parse out how much of that is reflecting incremental demand versus supply chain inefficiencies? And when you talk to a few quarters back, you don't typically see a big backlog in Fluke. But are lead times normalizing? And so I just want to get a perspective on how that hardware backlog looks heading into '23.

Dean, as we mentioned, we will slightly reduce the backlog in the fourth quarter, which is our first decrease in quite some time. Order demand remains strong. Looking at the backlog, a significant portion is with Tektronix, primarily due to ongoing demand in various areas, and lead times are extended. We feel very optimistic about the backlog. Fluke is reducing their backlog, and their lead times have decreased somewhat. Most of the Sensing backlog appears to be advanced orders for 2023. Essentially, a portion of it is related to longer lead times for protection products getting aligned, which likely accounts for at least half, with the other half reflecting solid demand primarily in technology and also in other sectors. This is why we have increased confidence in our backlog compared to others, as we have thoroughly analyzed it and are optimistic about our delivery capabilities in 2023.

And a follow-up for Chuck. Can you break out the year-over-year margin decline in Advanced Healthcare Solutions? Just kind of how much is supply chain price cost, or is that bad debt included? If you could size that.

You're talking about the third quarter specifically?

Yes.

When comparing year-over-year, the primary issue is the bad debt at Invetech, which is around a $5 million reserve. We haven't given up on collecting that and hope to recover some, but it remains an accounting reserve. This reflects good management practices. Year-over-year, factors such as foreign exchange and inflation are likely contributing about 100 basis points to our challenges. Additionally, the lack of growth is mainly due to supply chain issues, along with some impact from Fluke Health and a bit in our biological indicators at ASP.

What was that last one?

Biological indicators that ASP…

It's literally a plastic vial. It's when you think about the BIs go through the sterilization process to calibrate the effectiveness of the sterilization cycle.

Jim, maybe just to kind of close out something that Dean was asking about in terms of the backlog. I mean we're hearing supply chain getting better pretty quickly here across a whole different host of verticals and product lines. It doesn't really look like 4Q guidance in IOS has a significant amount of backlog reduction, or is there some assumption about seasonality orders or something else going in there. But of that extra backlog, I mean is that something that you should be able to work down over the next couple of months? And would you prefer to keep more backlog in this business versus just kind of get it all out the door in a quarter or two for that excess?

First and foremost, it centers on our customers, and we are committed to providing them with the best service possible. Specifically regarding Fluke, point of sale performance is strong, as we've noted, with double-digit growth across all regions. This means we aim to capitalize on those opportunities. In terms of the supply chain, I would say it is generally improving, but we still face challenges with a few hundred components at Fortive that have lengthy lead times, around 50 to 60 weeks. While the overall number of these components has significantly decreased, some are still impacting our lead times. We have adapted to this situation, and we believe supply chain constraints will likely persist into 2023, which is well recognized in the electronics supply chain industry. We plan to reduce some backlog, but the strength of our operations relative to FBS and the ongoing improvements will support our success, which is why we anticipate strong growth in IOS during the fourth quarter. As mentioned in response to Dean's question, we expect to start the year with a healthy backlog, enabling us to navigate any potential short-cycle challenges that may arise.

So there won't be a quarter where you like blow out $100 million all at once because supply chain gets better…

No, we won’t be. I think we feel it's just that the supply chain situation is just not that robust in that sense.

And then just following up on tech. I mean performance in the quarter was pretty exceptional. I know you guys have talked about kind of the virtuous product redesign cycle that everyone's going through based on new chip availability. And I'm kind of wondering, how much is that determining kind of the go-forward visibility intact versus maybe some residual backlog that could be electronics facing and more susceptible as the economy slows?

One thing we've mentioned since Fortive's inception is our commitment to diligently enhance Tektronix's growth rate and minimize its cyclical nature. They've encountered cycles before, and we've frequently discussed our good progress in this area. The seven consecutive quarters of growth demonstrate that the long-term trends are materializing. The innovation cycle at Tektronix has aligned perfectly with market needs, particularly regarding power challenges in the EV sector and the shift towards IoT, which demands a strong hardware backbone and infrastructure. These trends are fundamentally long-term and are likely to remain influential in the investment cycle over the coming years. While some aspects of the business may still be vulnerable to macroeconomic factors, I believe that our backlog and the innovation efforts aligned with these long-term trends will ultimately lead to stronger and more sustainable growth.

I would like to follow up on Deane's question regarding the fourth quarter at AHS. It appears that while you are still experiencing core growth, margins are down. Could you provide an explanation for the margins in the fourth quarter for AHS?

So Steve, the main issue is a bit of foreign exchange, but I would also point to slightly more impact from inflation in AHS during the fourth quarter. In the health segment, it takes longer to adjust pricing, so I think we are lagging behind inflation there, unlike the rest of our portfolio where we've managed to stay ahead. This is likely the primary reason for our decline in the fourth quarter.

I wonder why this issue didn't impact you earlier, especially considering the inflationary pressures over the past 18 months. Why is it affecting you now in the fourth quarter?

Well, I think it has been hitting us, but FX has also accelerated and is hitting us a little bit more as well.

Steve, I think another factor is the volumes we ship in healthcare. Since a large portion of our revenue comes from consumables and services, we were able to manage some supply chain and expense issues for a longer time than in other areas of our business. As Chuck mentioned, we are experiencing some inflation, much of which was anticipated. We are also continuing to improve margins in healthcare. We believe that with mid-single digit growth in the fourth quarter and into next year, we will begin to see these improvements take effect.

I wanted to ask about Provation since we're discussing healthcare. Do you think that business is affected by labor shortages? At the same time, do you think it's challenging to handle installations when there are labor shortages? How does that business operate, and how does it fluctuate with the current issues?

You're absolutely correct about productivity. The productivity and value proposition offered by the GI suite is very promising, and we discussed the strong SaaS numbers in our prepared remarks. However, we've experienced some delays in our sales funnel, which has slightly slowed our services revenue as it takes longer to implement solutions. Despite this, we remain very optimistic about the business. The value proposition addresses specific challenges faced by hospitals and ASPs. We recently secured a significant order from a large government entity, which will take time to implement, but it highlights the strong recognition of our value proposition. We believe this business will continue to grow, although we need to navigate some challenges, particularly labor shortages within hospitals, which also affect IT departments. Looking ahead to the next six, 12, or even 18 months, we feel very confident about the business, and it remains on track in terms of profitability and returns. Overall, we are quite positive about the current situation.

You previously mentioned potential interest in public companies, which seems to have shifted. Can you clarify whether you're referring to acquiring shares of public companies or exploring opportunities for public-to-private or public-to-public transactions, which isn't something you've typically engaged in?

I would say first of all, when you look at public valuations, they seem to be in a certain range, which is more of a general observation. We're definitely keeping an open mind about potential opportunities. We have a specific list of areas where we see great investment prospects, but we're also being patient regarding those situations. As you know, I prefer not to predict our actions for various reasons, but we feel optimistic about the direction the environment will take in the coming months.

Just a little kind of geographic walk here, if we could. First on China, do you think the strength here is kind of reflective of just the lockdown balance, or I don't think you're expecting 20% organic growth to continue necessarily, but it does seem extraordinarily strong. So just what's driving that, and what are you expecting here in the next quarter or two?

We've experienced significant strength in China over the past few years, which speaks to the way we've developed our businesses there. The manufacturing and design processes in China are quite independent, and there is a noticeable recovery happening. Our outlook remains positive. In healthcare, both IOS and PT performed well, although growth in healthcare was somewhat slower due to the COVID lockdowns. Looking ahead, we anticipate continued growth opportunities, particularly in the fourth quarter and into next year. Some of the backlog we mentioned before also includes China. We believe this will be a strong market for us over the next several quarters.

And how about Western Europe, any signs of cracking there?

For obvious reasons, we're continuing to put a real microscope on everything we do over there. Point of sale remains pretty good. So I think when we look across some of the things that would typically tell us, we had good healthcare, I think it was our best region for healthcare. So I think at the end of the day, we continue to think Western Europe probably has hit some challenges here. But if you look at the signs that we would typically look at, still holding up there pretty well. But I would anticipate it's hard to believe that just given some of the challenges they've got that there isn't some issues certainly in '23, and it's part of our scenario analysis.

And maybe just the last one sort of on that on kind of thinking about scenarios. Obviously, there's a lot of mix even within the segments. But at a high level, how would you have us think about decremental margins if we were to get into kind of, call it, a moderate recession environment where you're putting up negative maybe mid-single digit type organic growth?

If we experience actual negative growth, you could expect a situation similar to what we encountered in 2020 with fluctuations. We aim to manage it at a consistent level. However, it's important to note that we have a robust backlog position. While we anticipate some slowdown, that may not be our primary expectation. We have always been prepared to handle both upward and downward changes.

I believe it's essential to consider our playbook when responding to Scott's question about our overall strategy. When we examine our solutions broadly, including Provation, it's clear that our focus is on enhancing productivity. Whether it's the Provation example or our initiatives at ServiceChannel, such as reducing innovation and design cycle times with our Tektronix solutions, or our efforts in solar with Fluke, we are committed to saving our customers money through our workflow strategy. In light of Chuck's comments, we have various scenarios to consider regarding the macroeconomic landscape. However, it's important to recognize that our workflow strategies are designed to support customers during their most challenging times. We are witnessing strong order levels in multiple areas because customers will increasingly need to save money in the future, making our solutions particularly valuable in addressing those challenges.

So when you guys talked about '23 outlook, and I appreciate it. It's very, very initial. How should we be thinking about the pricing as we frame '23, right? I think price was 6 points in the third quarter. So how much momentum do you have going to next year?

From a momentum perspective, we will see higher prices in the second half compared to the first half of this year. That's a key point. As previously mentioned, we don't take this lightly. We are examining opportunities for further price increases. While it's challenging to provide a 12-month forecast on a quarterly basis, I anticipate that the rate of price increases will not match this year's levels. However, we still have the capability to maintain pricing and potentially increase it further. I will refrain from sharing a specific number until we approach our guidance and assess how the fourth quarter unfolds. We believe there is still potential for price increases in our software and health care sectors, indicating ongoing opportunities to drive growth while continuing our successful strategies from previous quarters.

There has been a series of restrictions placed by the Biden administration regarding semiconductor production in China. I saw a report today indicating that SK Hynix may be considering exiting China. How should we view companies like Tech Keithley operating in China? Also, companies like Fluke are likely to be affected by regular day-to-day capital expenditures in China. Have you been able to assess or quantify the potential impact of these restrictions?

First of all, semiconductor exposure across Fortive is still quite limited. However, we are certainly aware of the current situation. Given the existing regulations, we believe the impact on our customers is not significant. We typically do not supply production fabs and are more focused on the innovation cycle. Some projects that may be halted or relocated from China are likely to be moved to other regions, which could benefit us, whether that be in the US, back to Korea, or elsewhere. We expect to gain from these changes as they develop. We will keep assessing the situation in China regarding these new regulations. Over the past three years, we've managed to counteract challenges in China effectively, achieving growth despite export controls that began several years ago. We have lost about 28 customers in tech due to these controls, but we have navigated these challenges successfully. We will continue to adapt based on responses from China and stay informed about the evolving environment. One consistent aspect over the years has been our success in operating within the rules while expanding our business globally.

So obviously, lots of impressive growth rates across the portfolio. What stood out to me was Gordion, Accruent up high teens and IOS. So it seems like that's really clicking now. But we don't really expect these businesses to grow high teens, maybe a bit slower and steadier. So just wondering to provide a bit more breakdown on what's driving that growth. You mentioned pricing in software, but just wondering what's driving the strong growth rate there. So maybe talk about net retention there as well.

We had a strong quarter following the integration of ServiceChannel with Gordian and Accruent into a unified business focused on facility and asset life cycle. We've always anticipated some self-improvement for Accruent over time, and we witnessed positive progress in that area. The ServiceChannel offering provides significant value for facilities managers, and we are transitioning that business to convert some of the pass-through revenue into sustainable SaaS revenue. Our execution has been solid, and as you noted, our net dollar retention is improving. This business is now our fourth largest and is poised to scale quickly due to its impressive growth rates. It's been a great addition to our portfolio, and there are still significant profitability opportunities available. Gordian is performing exceptionally well. Overall, we feel positive about our progress, although there is still work to be done. In the long term, we believe that the opportunities will remain consistent with our comments on value propositions and productivity. Our solutions give customers enhanced visibility of their facilities and assets, enabling them to reduce costs and investments. This value proposition is especially relevant in today's environment and will continue to resonate in 2023.

So it sounds like you're starting to see the revenue synergies from put together three businesses. Okay. And then going back to Tektronix, I understand the chip and everything secular themes, but you've had store the amount of product vitality this year. I think you launched the 2 Series midyear, and there's been other launches this year. So I'm wondering, have those new product families, has that had a disproportionate impact on growth rates this year?

I would say they've been incredibly successful, but the 2 Series just launched really in the third quarter globally, and it’s exceptional. I believe this product, along with the new version of our 6 Series, represents two significant launches; the 6 Series just won our innovation award at Fortive last week. We are still in the early stages of seeing the benefits from those innovations. Our capability continues to increase along with the value proposition of these products. Most of our success this quarter has been broad-based, and we still feel we are in the initial stages of some of these successes. Additionally, the innovations we've been implementing over the past 12 to 18 months continue to contribute to our success.

Jim, you said you examined demand break deeply at some of your shorter cycle businesses, and you mentioned point of sale is still very good at Fluke. Obviously, we've begun to see some destocking, more consumer-facing businesses than other companies, but it seems like you're suggesting that your short cycle industrial channel inventory is in reasonably good shape. But maybe you could just elaborate on that.

The sales performance for both Fluke and Tech has been strong. As I mentioned earlier, Tektronix inventories have been at historical lows for most of the year, so we are not concerned about any risk of destocking given the lead times. Orders have remained robust, and our revenue has been growing. We assess the combination of backlog and inventory to ensure they are aligned, and we are confident in that balance. There is slightly elevated inventory at Fluke compared to a few years back, but nothing recent. The sales figures and lead times indicate that this is likely just a result of longer lead times. We will focus on sales performance as it continues to be strong, and we are monitoring it closely. Overall, our current observations suggest things are still looking good. We are mindful that broader macroeconomic conditions might impact this, which is why we are diligently monitoring the situation every day and every week.

We believe that a conversion rate of 105% for the year is appropriate for this business. Two main factors are contributing to this. The first is FBS, which is helping us not only to get products out the door in a challenging supply chain environment but also to reduce the impact of elevated inventory levels. While our inventory is higher than usual, we've performed better than some of our competitors, likely due to FBS. The second factor is the addition of software businesses, which, despite having negative working capital collectively, generate stable free cash flow. We're pleased with how this aspect is developing, as it aligns with our expectations. I believe that as we reduce our debt, we will provide concrete guidance moving forward. However, I don't see it as a significant challenge at this time, despite rising rates, since our debt is decreasing. Overall, our debt levels are quite low. Currently, we are at 2.0 net leverage, and we expect it to decrease further by the end of the year.

Two quick ones from me. When we think about the elective volumes, and let's just focus on North America for this. We haven't really had like COVID lockdowns or anything for a long time now. Is there some risk that like maybe the bar to go in for an elective surgery has just changed, and like we're trying to get back to a level that like isn't the level anymore. Is that a possibility?

No. I think that at the end of the day, when you consider our progress this year, we've been very accurate. China has its own narrative, but in the US, we've hit our targets pretty well. Eventually, the discussion will shift away from electives and focus on the year-on-year growth rate. We believe electives will continue to improve. COVID was recent, and labor productivity and challenges are limiting. Many of our customers are not fully utilizing their operating rooms right now but would like to. We expect to see continuous improvement in that area over time. Regarding the hospital market in 2023, we anticipate it will improve from this year. We believe 2022 is likely the low point due to various challenges, including financial issues from 2021 and 2022, labor shortages, and COVID impacts. So, we see 2022 as the low point, and we expect to see recovery moving into 2023.

And just to be clear, I wasn't talking about your ability to forecast for electives. What I just meant like as a country, what do electives actually…

I think they'll continue to improve a bit, but they won't jump from 90% to 105% or 110% immediately. Instead, I expect them to gradually progress over the next several quarters.

And then just last, like we've been hearing from some companies that while the order environment is still pretty good, but like behaviorally, maybe customers are being a little bit more measured about saying yes to things. So are you seeing like any sort of like incremental behavioral shifts or like the bar to accept projects or anything like that is moving somewhat higher or taking longer to get to the end of the line?

We have discussed this previously. We are noticing that sales funnels are taking a bit longer, with what used to be a 60-day closing window possibly extending to 70 or 75 days. This trend is evident in both software and hardware sales. However, we're not losing any business. In cases where we've seen these extensions, we've not experienced any losses. It appears that customers are being more cautious with their spending. This highlights the importance of our value proposition, which keeps us relevant to our customers due to the cost savings and positive return on investment that our workflow solutions offer, developed over the past five or six years. While timelines may not align perfectly with our expectations, we are not witnessing any decline, which is encouraging as we look ahead to 2023.

Well, thanks, Dennis. And thanks, everyone, for taking the time today. We know you have a busy schedule today and this week. Hopefully, you heard from Chuck in our remarks on the Q&A as well as our prepared remarks. We're really proud of the quarter we just had. I think it demonstrates the power and the resiliency of the portfolio. I think the gross margin and operating margin expansion and free cash flow on the accelerated organic revenue is just demonstrative of the power of what we're building here, and we're really excited about what's going on. Obviously, a lot of noise out there, both from a macro perspective and geopolitical. We understand that. We're not oblivious to that in any way, shape or form. We're preparing scenarios for that. We'll continue to see how things play out here in the fourth quarter, and we'll look forward to talking to you through the quarter and obviously into '23 as we get ready for a guide in the new year. So thanks, everyone, for the time. Good luck this week, and we look forward to talking to you all soon. Thank you.

This concludes Fortive Corporation's Third Quarter 2022 Earnings Results Conference Call. Thank you for joining. You may now disconnect.