Fortive Corporation (NYSE:FTV) Q4 2022 Earnings Call Transcript

Fortive Corporation (NYSE:FTV) Q4 2022 Earnings Call Transcript February 1, 2023

Operator: My name is Julianne, and I will be your conference facilitator this afternoon. At this time, I’d like to welcome everyone to the Fortive Corporation’s Fourth Quarter 2022 Earnings Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. I would now like to turn the call over to Ms. Elena Rosman, Vice President of Investor Relations. Ms. Rosman, you may begin your conference.

Elena Rosman: Thank you, Julian, 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 are available on 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 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.

Jim Lico: Thanks, Elena. Hello, everyone, and thank you for joining us. I’ll begin on slide 3. Fortive had another quarter of outstanding operating performance in Q4, delivering 14% core revenue growth, 50 and 110 basis points of adjusted gross and operating margin expansion, respectively, 11% adjusted earnings per share growth, 62% free cash flow growth, all ahead of the guidance we gave in October. Our strong purpose-driven culture is supported by our relentless focus on executing for customers and shareholders in 2022. The continued evolution of our portfolio within the markets we play is characterized by strong secular drivers, which powered 9% ARR growth in our software businesses and backlog expansion in our hard products businesses, contributing to record core revenue growth for the year.

Our performance would not have been possible without the dedication of our 18,000 team members around the world. Team overcame continued supply chain and inflationary challenges, which will likely linger into 2023. We believe the power of the Fortive Business System is a key differentiator, contributing to more profitable growth, record gross margins and free cash flow generation. As we look forward, we’re excited to update you on the progress we’ve made on our multiyear targets and strategies that are driving outperformance at our upcoming Investor Day in May. Turning to slide 4. Even against the backdrop of a difficult macro in 2022, Fortive continue to validate the investment thesis that we have pursued since 2016, delivering core growth of 10% and 20% on a two-year stack basis, accelerating over the last few years.

Our portfolio transformation has also driven approximately 1,000 basis points of gross margin expansion since 2016, which has translated into higher operating margins and provides further opportunity to improve margins in the years to come. We also delivered free cash flow growth of $1.2 billion, with margins approaching 21%, underscoring our ability to compound cash flow off a higher base, a key Fortive differentiator and value creation driver. In summary, we had said that 2022 would be a show-me year and we delivered strong results across all of our segments, which I will highlight in more detail on the next few slides, starting with Intelligent Operating Solutions on Slide 5. IOS grew core revenue by 13%, representing its third consecutive quarter of double-digit core revenue growth.

We had good growth in all regions, with low double-digit growth in North America, mid-teens growth in Western Europe and high 20s growth in China. Double-digit core growth in every workflow, combined with our rigorous application of FBS, drove 330 basis points of core operating margin expansion, more than offsetting inflation and FX headwinds. Looking at our performance drivers by workflow and connected reliability, look at low teens growth, supported by a strong backlog position and continued success with their new solar and calibration products serving the energy, renewables and electric vehicle markets. POS remains strong in every region. However, we expect to see some slowing as supply chains continue to normalize. Strong end market demand drove double-digit EMEA SaaS revenue growth in the quarter, with record net dollar retention of approximately 106%.

In EHS, revenue grew by high teens with strong contributions from both Industrial Scientific and Intelex. Industrial Scientific revenue grew approximately 20%, as strong demand was supplemented by record iNet expansion and higher instrument shipments following the resolution of key supply chain issues at the end of the third quarter. Meanwhile, Intelex posted another quarter of low double-digit SaaS growth. They have successfully deployed FBS initiatives to accelerate software implementations and create upsell opportunities to customers. Moving to facilities and asset life cycle. We had low double-digit growth in Q4. Vontier revenues once again increased double-digits as customer labor shortages and deferred facility maintenance continued to drive higher volume through the company’s job order contracting platform.

Accruent SaaS revenue grew by mid-single digits, despite a sizable headwind from end-of-life products. Accruent continues to see good success from its recent go-to-market focus in asset management and workplace solutions to enable mid-single-digit revenue growth in 2023. And ServiceChannel saw another quarter of double-digit revenue growth taking their full year growth rate to just under 50%. As a reminder, we are transitioning from a largely pass-through revenue base to a better long-term business model that includes more recurring SaaS revenue. This change will create a short-term revenue headwind in the first quarter. However, we expect service channel to remain a strong double-digit growth business in 2023 with above 20% adjusted operating margin.

Turning now to Slide 6. Precision Technologies delivered another strong quarter of double-digit revenue growth in every business. Core revenues increased 20%, driven by high teens growth in North America and greater than 20% growth in both Western Europe and China. PT also delivered 240 basis points of adjusted operating margin expansion with higher volume, price realization and productivity more than offsetting inflation in FX. Some highlights for the quarter include: record quarterly revenues and operating profit at Tektronix, which continue to benefit robust backlog, driven by new product launches, share gains and new entry in mainstream as sold scopes. We saw orders slow in Q4 as expected as demand normalizes following the 40% growth we’ve seen over the last two years.

Sensing Technologies had another quarter of mid-teens growth, driven by strong price realization across all businesses and continued demand in Qualitrol’s utility and power business, offsetting industrial and semiconductor demand softening. Combination of Gems and Setra in 2022 also drove approximately 200 basis points of margin expansion and four working capital turns improvement. Pacific Scientific EMC saw high 20s growth in the quarter, facilitated by capacity expansion and improved materials availability. Moving now to slide seven in Advanced Healthcare Solutions. As expected, revenues increased 5% in the quarter, driven by broad improvement across all health care operating companies. By major region, mid-single-digit growth in North America reflected the benefit of our higher installed base and some improvement in hospitals, partially offset by a low single-digit decline in Western Europe and a high single-digit decline in China.

The exit rate on China elective procedures was the lowest we have seen post-COVID and roughly 30% of normalized levels. January 2023 volumes were roughly half of prior year levels, which was reflected in our Q1 outlook for the segment. In the fourth quarter, AHS segment margins were down 260 basis points, driven primarily by higher inflation, partially offset by favorable M&A. Notably, margins were up approximately 400 basis points versus Q3. Versus our fourth quarter guidance, margins were unfavorably impacted by additional transactional effects and lower margins at Fluke Health Solutions. As we look ahead, the team is starting to see traction on their pricing and productivity initiatives, which we expect will deliver margin recovery in 2023.

Some other highlights of the quarter include; ASP finished the year with core revenue growth of 5% as capital share gains and consumable volumes more than offset COVID headwinds in China. Even with inflationary pressures, ASP ended Q4 with the strongest margins of the year and continued to deliver strong working capital improvements. While hospital profitability remains pressured, due to labor and inflationary challenges, Censis continues to drive robust growth and in Setra SaaS offering in Q4 and for the year with mid-teens net new ACV and record cross-sell opportunities. Lastly, Provation is ahead on its return expectations, having contributed $0.10 to earnings in 2022. As customers continue to standardize our probation across their health systems, we are seeing accelerated SaaS growth, setting them up for a strong 2023.

Turning to slide eight, the Fortive Business System is a powerful mindset that makes continuous improvement a way of life at Fortive. We drive deep engagement across our teams and hold them accountable for delivering on high expectations. As a reminder, in October, we brought together over 400 team members and our CEO Kaizen Innovent. Our most senior Fortive leaders, including our segment leaders and a number of our operating company presidents, collaborated to drive significant improvements in growth, margin, free cash flow, and breakthrough innovations across four operating companies, Fluke, ISC, Tektronix, and Censis. We’re proud of the success our teams are having sustaining results to directly attribute it to this event, including, at Fluke, we reduced bold change over time by over 50%, eliminating stock-outs on critical plastic components and reducing past due backlog.

At ISC, we applied lean conversion in the Fortive material system to improve quality output and turnaround time for iNet and rental customers, dramatically reducing the cost of repairs and product redesign. At Tektronix, we applied lean conversion to circuit board repair, increasing on-time delivery to 98% by altering material flow, installing 5S part management, and building standard work and documentation of our procedures. In Censis, we applied value stream mapping and transactional process improvement to identify the inefficiencies and waste, resulting in a 50% reduction in time to onboard new customers. With Kaizen activity accelerating in 2023, we expect significant results across in the year ahead. I’m incredibly proud of the work we have done in 2022 to deliver powerful results and continue our progress towards building a more sustainable future, as you can see on slide nine.

We believe in taking a holistic approach to creating value that includes setting aspirational and actionable targets across each of our sustainability pillars as shown on the page. Leading Fortive today is a diverse Board and leadership team, with recent hires and promotions advancing our commitment to top talent and diversity. Strong and inclusive culture is core to Fortive’s mission, with inclusion and diversity, a critical component of FBS. Last year, we published clear goals to increase our diverse supplier spend, gender representation, by pack representation and senior leader diversity by 2025. We believe this has resulted in part to an increase in our employee engagement scores, up five points from pre-pandemic levels. Our progress also extends to how we protect the planet.

It includes the early achievement of our 2025 greenhouse gas goal in the adoption of our new ambitious goal of 50% emissions reduction by 2029. It’s our shared purpose that also pushes us to create innovative and sustainable products and services. Today, approximately 60% of our revenue is derived from products and services that enable more sustainable outcomes, aligned to the United Nations’ sustainable development goals. And we have award-winning products that promote sustainability for our customers. Lastly, the commitment to drive meaningful and sustainable outcomes that matter most to our stakeholders is reflected in our recognition by Newsweek for the fourth consecutive year as America’s most responsible company. With that, I’ll pass it over to Chuck, who will provide more color on our fourth quarter financials and our 2023 outlook.

Chuck McLaughlin: Thanks, Jim, and hello, everyone. I will begin on slide 10, with a quick recap of our fourth quarter performance. We generated year-over-year core revenue growth of 14%. Acquisitions net of divestitures contributed 1.5 points of growth. FX headwinds were approximately four points. Turning to the geographies. We saw another quarter of double-digit core revenue growth in each of our major regions. North America revenue was up low double-digits with broad-based strength across our businesses, Western Europe revenue grew mid-teens, with volume contributions in hardware products and favorable pricing, partially offset by a decline in healthcare. In the fourth quarter, bookings growth slowed in North America and Western Europe as expected.

Asia revenue increased high-teens, with low 20% in China, driven by robust growth in Intelligent Operating Solutions and Precision Technologies, more than offsetting a dramatic drop in elective procedures in China impacting Advanced HealthCare Solutions. Lastly, we saw a broad-based performance in our high-growth markets with mid-teens core growth. Turning to slide 11, we show operating performance highlights for the fourth quarter. Adjusted gross margins increased by 50 basis points to 58.3% as volume and strong price realization continued to demonstrate the value proposition of our products and solutions more than offsetting higher inflation. Adjusted operating profit margins expanded 110 basis points to 25.5%, up 230 basis points on a two-year stack basis.

Adjusted earnings per share increased 11% to $0.88, reflecting a strong fall-through on higher volumes and productivity, partially offset by higher interest and tax expense. Normalized for tax earnings in the quarter were up 16%. Free cash flow was another standard. Strong year-end cash collections and the benefits of our FBS-driven working capital initiatives yielded $428 million of free cash flow in the quarter, taking the full year to $1.2 billion. Before turning to the guide, I wanted to provide some context on our 2023 outlook on Slide 12. We expect that 2023 will be another year of growth and margin expansion in each of our strategic segments supported by secular tailwinds, driving market expansion and new customer innovations. Our recurring revenue businesses at roughly 40% of sales are expected to benefit from the work we did in 2022 to increase demand generation and strengthen our go-to-market efforts, driving double-digit SaaS and license revenue growth.

Elevated backlog in our hardware products businesses, particularly at Tektronix, is expected to derisk moderating demand as order rates normalize in 2023. Further, the benefit of 2022 pricing actions is expected to carry over into 2023, driving another year of above-trend pricing realization along with increased sourcing and value engineering savings contributing to gross margin expansion. We also expect our productivity initiatives to yield strong incremental operating margins, including actions in the first half of the year to countermeasure the slowing macro environment. Project paybacks related to these initiatives are expected to average one year. We have included these benefits in our margins and earnings outlook for the second half, with carryover benefits into 2024.

In summary, we believe our 2023 outlook reflects a more resilient revenue and earnings profile, as we expect to weather the evolving macro environment. Turning now to the guide on Slide 13. We are introducing 2023 guidance. Starting with the full year, we expect core revenue growth in the range of 3% to 5.5%. Our outlook reflects a year-over-year foreign exchange headwind of just under 1% on revenue. Adjusted operating profit is expected to increase 5% to 10%, with margins in the range of 25% to 25.5%. Adjusted diluted net EPS guidance of $3.25 to $3.40, up 3% to 8%, which includes higher interest and tax expense. And free cash flow is expected to be approximately $1.25 billion, representing conversion in the range of 100% to 105% of adjusted net income and a 21% free cash flow margin.

For the first quarter, we anticipate core revenue growth of 5% to 6.5% with an FX headwind of 2.5%. Adjusted operating profit is expected to increase 4% to 9%, with margins in the range of 23.5% to 24%. Adjusted diluted net EPS guidance of $0.71 to $0.74, up 1% to 5%, which includes higher year-over-year interest and tax and free cash flow of approximately $170 million, reflecting the stronger cash collections that pulled forward into Q4 as well as our normal seasonal variations. Turning now to Slide 14. We are expecting a 48-52 split of revenue first half to second half, which reflects a step-up of approximately $120 million of core revenue growth, which when you compare to last year, it’s less than half of the increase we saw in the second half of 2022.

The step-up in 2023 is largely driven by acceleration in new products, a ramp in the growth rate of advanced healthcare as we lap China COVID lockdowns and an increase in software and other recurring revenue streams. FX and interest account for abnormal earnings seasonality as FX becomes a tailwind in the second half of the year and interest expense is expected to decline as we pay down debt with available free cash flow as the year progresses, giving us a bigger than usual step-up in EPS first half to second half. In summary, our revenue outlook reflects a similar linearity profile to 2022 and while core growth decelerates first half to second half, it accelerates on a two-year stack basis. With that, I’ll pass it back to Jim to provide some closing remarks.

Jim Lico: Thanks, Chuck. I’ll now wrap up on slide 16. In summary, I’m incredibly proud of the contributions of our 18,000 team members to make 2022 a record year for Fortive and further differentiate our more resilient financial profile. As we turn the page on 2022, that resiliency will be on display again in 2023 as our outlook reflects an expectation for slowing growth as customer demand normalizes after two years of robust double-digit hardware product orders, but it also reflects the benefits of the investments we have made to accelerate strategy, strengthen our market position, scale our software revenues and develop new innovations that are solving our customers’ toughest safety, quality and productivity challenges. As you’ve also heard today, we are seeing the benefits of our continuous improvement culture, unleashing the power of the Fortive Business System to deliver more profitable growth and strong free cash flow, again in 2023, allowing us to compound returns through disciplined capital deployment.

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.

Elena Rosman: Thanks, Jim. That concludes our formal comments. Julianne, we will now take questions.

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Q&A Session

Operator: Our first question comes from Steve Tusa from JPMorgan Chase. Please go ahead. Your line is open.

Steve Tusa: Hey, good afternoon.

Jim Lico: Hi, Steve.

Steve Tusa: Can you just talk about — for iOS, the margin expansion kind of sequentially from the first quarter for the — through the full year, the kind of key building blocks for that?

Jim Lico: Yes. Hey, Steve, it’s Jim. A couple of things. One, obviously, we play a role in that. And — so as we continue to progress, we’ll see that. As we noted, some of the asset life cycle, a little bit lower growth in the first quarter. We can talk about that, but that — those margins will expand. So, the revenue coming back certainly in the software businesses there as well as just continued progression of — a lot of the actions that we’ve got price will continue to be a helpful piece of this driving gross margin expansion along with our productivity initiatives. So, I don’t think we’ve got anything dramatic from the first half to second half in terms of anything that you wouldn’t normally see seasonally in terms of growth, price realization, productivity initiatives get more traction as you go through the year. Those are probably the big drivers outside of just normal revenue.

Steve Tusa: And then should we assume this excess $350 million backlog that that all obviously gets washed out this year? And then what’s the pace of that being washed through?

Chuck McLaughlin: Steve, this is Chuck. Actually, in our modeling, no, we wouldn’t expect that all gets washed out based — but of course, it depends on the order rate. It’s one of the reasons why we think that we’ve got a pretty resilient forecast here. If the order rates moderate beyond where we think they’re going to be, we could still do it. It’s really still — we’ve got — supply chain is getting better. It’s just — it’s not resolved. So it sounds like we can just flip the switch and get it all out. But we would — we’d probably cut it in half.

Steve Tusa: Okay, great. Thanks a lot.

Jim Lico: Thanks Steve.

Operator: Our next question comes from Julian Mitchell from Barclays. Please go ahead. Your line is open.

Julian Mitchell: Hi. Good afternoon. I just wanted to start with some more detail on the product hardware orders. So I think those were up mid-single digit Q3. It sounds like they’re up maybe low single Q4. And then you’ve got this slowdown commentary. And then also on slide 14, you talked about orders improving through the year. So is the way to think about that, you’re trying to say that orders, I don’t know, ended last year up low single, maybe they’re down in the first half, grow in the second half? And then that’s what informs the PT organic sales guide, because if I look at that on slide 17, you’re starting the year up double digit. The year as a whole is up low to mid. So you’re implying the organic sales in the year flat or down. Is that just, kind of, the orders flowing through with a six-month lag? Is that how we’re thinking about it?

Jim Lico: Well, I think, first, we would think of the second half of 2022 is basically flattish for orders for those businesses. So a little bit down in the fourth relative to — and right along where we thought. If you remember from the third quarter call, we said, yes, we also saw some orders that came in, in the first half for the second half. So that’s kind of the backdrop of what we just described, backlog in and around where we thought it would be from an ending year. So the backlog, obviously, as Chuck just described, that obviously helps in the — with some of the order down slowing that we saw. We expect orders to be around the same in the first half relative to those product businesses, Julian. So you think about probably the second quarter — first quarter and second quarter being probably negative in those businesses.

But backlog obviously mitigates a number of those things. And then it starts to pick up a little bit. Some of that pickup is an easier comp, obviously, because of what I just described in the second half of 2022. And there’s a little bit sensing probably stays flat through the year is probably not a big improvement through the year in sensing, but a little bit of improvement in Tek. And we think Fluke will come back as well, typically comes back a little faster.

Chuck McLaughlin: And Julian, the only thing I’d just remind you is we have an easier comp in PT in Q1. So when you start — when you look at $1 standpoint, it’s not as dramatic as you move through the year. In fact, I think from $1 standpoint, we’d expect that it would — there would be an upward trajectory in PT each quarter sequentially.

Julian Mitchell: Thanks. And when we look maybe within PT at Tektronix, maybe flesh out a little bit more what you’re expecting. You’ve got that high-teens growth first quarter. The year is up mid-single. But I guess if I look at a lot of what’s happened in, say, electronics, it feels like people are in kind of the teeth of the destocking right now and have been for three or even six months. So, I understand maybe you’re protected a bit by the backlog in Tektronix. That means you have a sort of gradual descent through the year. Maybe just help us understand kind of where you see channel inventories in that business? And again, on Tektronix, it looks like the guide implies down revenue in the back half. Just wanted to kind of confirm a couple of things there.

Jim Lico: Yes. Well, number one, I think, on the back stuff, as we said in the prepared remarks, 40% order growth over the last couple of years. It’s obviously a little bit higher growth rate than what we’d normally expect for Tek. So, what you start to see in the full year, it’s a moderation or a normalization back to that mid-single-digit growth. I would say when you think about customers, very much playing out the way we anticipated in terms of moving the business. The business just doesn’t have as much of influence from consumer electronics anymore, where you’re seeing a lot of that distortion with the things we’ve talked about in terms of power, data centers, industrial IoT, all of those drivers are really driving the business much more today than ever before, making it more resilient.

So, I think those are all the things we’ve described that I think really continue to have the business. It does dissolve a little bit, but it moderates off of really, really large numbers. So I think mid-single-digit growth for the year is what we’re calling out here. It could be a little bit better. We’ll still end the year with a decent backlog, as Chuck was just describing a couple of questions ago. So, I think when we look at the business for the year, very healthy channels have almost no inventory. So we continue to see good point-of-sale strength. And some of that is just fulfilling past due to some extent, but there really isn’t a channel inventory situation whatsoever. And so I think we’re in a good place. Orders will slow a little bit, but some of that is just the big heavy comps that we’ve sort of had over the last couple of years.

So we think we’re in a good place, and we think we’ll exit 2023 in a good place as well.

Julian Mitchell: That’s great. Thank you.

Jim Lico: Thank you.

Operator: Our next question comes from Scott Davis from Melius Research. Please go ahead. Your line is open.

Scott Davis: Hey, Jim and Chuck and Elena. I hope you guys are well. If I look back at my notes, I think you said, the service channel probation would be like $0.12 accretive in 2022. It sounds like maybe that came in a couple of pennies better. Is that accretion step-up meaningfully in 2023? We think just given the growth rates of those businesses that would be a nice tailwind for you. But I know you did make some comments on the SaaS adjustment on service channel, though as an offset.

Chuck McLaughlin: Yes. Scott, you got right. We came in at, I think, $0.14 in 2022. And I would expect that, that would grow as you expected. We build on that $0.14 in 2023. Faster growth rates there, also more profitability in the first half in service channel and things. All that are going to give us a nice tailwind.

Jim Lico: And Scott, just to maybe add on to the first quarter service channel thing, as we talked about in the prepared remarks. This is really — the SaaS revenues continue to be incredibly strong in the business. But we did have a little bit more pass-through revenue in the year than we anticipated. That’s why we grew the business almost 50% on a full year basis. So really strong growth this past year. But we’ll move to a better business model, which is a little bit less pass-through revenue and a much — but the strength of the SaaS business has been there all along. We’ve now got a data analytics platform that we’re offering as well. So we’re really going to, kind of, get through that in the first quarter and a little bit in the first half, but the profitability really does raise considerably as well.

We got what we needed in 2022 in that regard. We’ll be an even better place in 2023, simply because the business model transformation that we intended to do is really start going to hit the — full hit of the P&L through the year.

Scott Davis: All right. That’s helpful. And I think it was Jim. You mentioned in your remarks that the discretionary procedures in China finished the year at like a 30% number, which 30% of normal, I think I’m reading it as, which just sounds crazy. But — is that — are you still seeing that in January? I would imagine that the reopening — just the timing of the reopening, that stuff would pick back up here in 1Q pretty aggressively, but I don’t know. But are you still seeing that kind of…

Jim Lico: Yes, I mean you got it exactly right. December, in particular, was really low. I think that speaks to the strength of AHF, quite frankly, on the revenue line is we were able to weather that storm because of the strength of other regions of the world. We talked about the 5% growth that we had in the segment. So we think, we’re about probably 50% in January, so about half of where we were a year ago. But you’re right, it’s going to ramp. We’re seeing some of that improvement. A couple of weeks ago, we think was the low point. But it’s now picking up to 70 in a week, but we should see continued improvement. Again, on the other side of the Chinese New Year holiday, we’ll get a better view of things, as we always do. But we anticipate that this will continue to improve throughout the year, as China just kind of gets back to normal, and we certainly started to see that.

Scott Davis: Okay. Well, best of luck. Thank you. I’ll pass it on.

Jim Lico: All right. Thanks, Scott.

Operator: Our next question comes from Jeff Sprague from Vertical Research. Please go ahead. Your line is open.

Jim Lico: Hey, Jeff.