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Once beloved, some of its shine has faded Fortified (New York stock market :TVF) and stocks have continued to lag the industrial sector since my last updateI believe that some of the The problem is that Fortive doesn’t really stand out thematically, and investors have abandoned (or at least are paying less for) stories that were once fueled by SaaS growth and recurring revenue through M&A. Plus, with the recent economic downturn, Fortive’s growth doesn’t seem all that differentiated, which I think was also a big part of the bullish theses.
I have nothing against Fortive, but I think the stock is more sensitive to the economic cycle than management lets on, and I still question how much value has actually been created in the healthcare sector. I can make a case for some upside here, and I like the leverage that the test and measurement offerings can have on a potential short-cycle recovery (and the longer-term leverage on electrification), as well as the automation-focused business within Precision Technologies, but overall I think there are other more compelling ideas in the industrial space to consider.
Electrification is the new trend
One thing that has started to concern me more about Fortive is the extent to which there is a fundamental strategic direction as opposed to management sitting back and trying to pivot the story based on what is popular with investors at any given time.
For example, a few years ago, there was a lot of investor interest in SaaS companies that cater to non-tech and non-industrial markets, and Fortive spent a lot of money acquiring companies like Gordian (construction scheduling software), Accruent (facilities management software), and ServiceChannel (asset lifecycle management). Similarly, there was a lot of interest in recurring revenue in healthcare, and the company acquired companies like ASP (sterilization), Landauer (radiation measurement), and Censis (surgical inventory management).
Today, the story seems to be more about electrification and AI, with the company recently highlighting that 33% of its revenue is “aligned” with electrification and/or AI, and that the business as a whole is dependent on long-term secular growth trends like automation, digitalization, energy transition and productivity growth.
Perhaps I am getting ahead of myself. It is true that management has an obligation to pay attention to the market and to put its operations in the best possible light (including by highlighting companies that may have overlooked leveraging emerging growth opportunities). Nevertheless, it is a concern, and I should point out that the most recent acquisition, EA Elektro-Automatik, is another expensive transaction (EBITDA multiple of around 15%) that is based on a currently booming sector (electronic test and measurement for applications such as network storage, data centers and e-mobility).
Short cycle remains a risk
Companies like Fluke and Tektronix have long been sensitive to economic conditions, and with manufacturing PMIs below 50 for 19 of the past 20 months, it’s not the easiest task for companies that still account for nearly 50% of Fortive’s revenue base. At the same time, sensor-heavy Precision Technologies has seen weaker demand for automation (though it’s outperforming in food and beverage). Against that backdrop, both businesses have slowed significantly over the past year.
I still see some risk in short-cycle markets like general manufacturing (about a quarter of activity), as well as other markets like consumer electronics, consumer goods, and oil/gas. With many companies reliant on short-cycle industrials having issued warnings over the past month, it seems clear that many headwinds remain given elevated rates and uncertainty surrounding the upcoming election.
On a positive note, Fortive management noted that Keithley (a subsidiary of Tektronix, a maker of electronic test instruments) saw its business recover in the first quarter, and Keithley has been a leading indicator for other short-cycle companies in previous cycles. Still, I remain cautious that expectations for a meaningful recovery in the second half are still too optimistic.
Software companies hold the fort
Fortive’s SaaS software business doesn’t negate the cyclicality of Fortive’s business as much as bulls wanted to believe a few years ago, but it continues to perform relatively well. Overall, it has continued to grow at mid-to-high single-digit rates, and with the institutional construction business (schools, etc.) still healthy, that should be expected for Gordian, even if management has talked about the business “normalizing” in the face of tougher comparisons.
Health care is getting a little better
I’ve never been a big fan of the healthcare business that Fortive built, mainly because I thought the company repeatedly overpaid for businesses that needed a lot of work or didn’t offer much growth (or both). In that regard, I’d note that the GAAP operating margin for the AHS segment is still in the single digits, well below the other two businesses (it’s much better on a non-GAAP basis, with margins only slightly below the other segments).
I am managing the credit for the transition of the ASP business to a direct sales model in 2023, and I believe this has helped to reinvigorate sales. Provation has also performed better than expected, while the rest has been more in line with my previous views.
Perspectives
Fortive did more or less what I expected for FY2023, with revenue slightly above (0.2%) my estimates, while EBITDA was about 2% below. Free cash flow was also slightly below (by 1%), but given the challenges of modeling working capital movements, I am not concerned about that. However, I think at least some of the share price underperformance can be related to the company not performing better in challenging circumstances in FY2023; again, despite all the talk of recurring revenue, Fortive did not stand out for growth in FY2023, and guidance does not suggest it will in FY2024.
The company has real leverage for a potential near-term recovery (I think it will be in 2025), as well as longer-term leverage for automation, digitalization and electrification. Test and measurement equipment is leveraged for automation and electrification trends, as are the company’s sensing, monitoring and instrumentation assets, the latter of which provide leverage for markets such as food/beverage and life sciences.
I expect Fortive to grow its revenue by about 5% over the next five years, and I could see that number increase if the company can truly capture the underlying growth I expect from drivers like automation and electrification. Longer term, I expect growth to slow to 4% to 5%, but I expect ongoing M&A to boost actual reported revenue.
I don’t expect significant margin leverage at this point, only about a point from FY24 to FY26, and I expect free cash flow margins to slowly evolve from the low 20s to mid 20s, driving FCF growth in the mid to high single digits.
Between discounted cash flow and margin/yield driven EV/EBITDA, I think Fortive is slightly undervalued now with a fair value of $70-75.
The essential
I view Fortive as something of a story to watch, as I think the stock has fallen in value as revenue growth and margin leverage have proven less exciting than hoped and not worthy of the high EBITDA multiples it once boasted. None of this means that Fortive is a bad business, and indeed, an economically sensitive business that relies on stronger automation and manufacturing (especially electricals) is likely to be a good business to own in 2025. Similarly, I think Fortive could benefit from a rotation into names whose forward growth in 2025 looks solid and whose valuations aren’t as high. For now, though, I think there are too many other ideas that offer a better risk/reward tradeoff to make a case for Fortive.
