With Short-Cycle Markets Expected To Fade, Fortive's Next Big Testing Is Around The Corner

Writing about Fortive (NYSE:FTV) back in March of this year, I expressed some concerns about whether the company was really living up to its billing as a "compounder" that could consistently add value through M&A. While liking the company's efforts to build up strong recurring revenue and exposure to long-term secular trends like automation, electrification, ESG, productivity, and safety, as well as the company's prospects for above-average growth, I still had some concerns about the margins, M&A discipline, and valuation.

The shares did subsequently slip into the mid-$50's, a point where prospective returns would have been in the high single-digits, before rallying and outperforming the industrial group. Close to 10% higher now, Fortive has been delivering more of late, and it looks better-placed than many of its peers/comps to navigate this next phase of the economic cycle. Valuation is less exciting now, and unless you're willing to go back to the "good ole days" of 20x-plus EBITDA multiples, it's hard to make the case that Fortive is fundamentally undervalued.

 

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With Short-Cycle Markets Expected To Fade, Fortive's Next Big Testing Is Around The Corner

With Underwhelming Growth And Expensive M&A, Fortive's Compounder Credentials Are In Question

It took a little longer than I expected, but at least some of the derating process that I'd expected for the industrial sector is taking place and it's been unpleasant so far, with many higher-multiple industrials down 10% or more since the start of the year, including "compounder" stocks like Danaher (DHR), IDEX (IEX), and Rockwell (ROK) (Ametek (AME) and Roper (ROP) are in this group too, but have declined less than 10% since the start of the year).

Fortive (NYSE:FTV) is included in that group, with a roughly 20% year-to-date decline and a similar move since my last update on the stock. I wasn't that fond of the shares then due in large part to valuation, but now there seems to be more grumbling about the multiples that Fortive is paying and whether shareholders are getting good value for that money.

I do share many of these concerns, though I think Fortive is also building a less-cyclical "all-weather" company that can generate some pretty solid free cash flow over the long term. While not my favorite company in terms of drivers or business strategy, and the valuation argument is not at all straightforward, I do think the share price is getting more interesting.

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With Underwhelming Growth And Expensive M&A, Fortive's Compounder Credentials Are In Question

Fortive Setting Out To Show It Has Crafted A Durable And Superior Compounder Business Model

 

These are interesting days for Fortive (NYSE:FTV). While the company is certainly getting a pop from short-cycle businesses, the healthcare operations have been disappointing the Street with respect to growth and margins, and the bull-bear debate rages on as to just how cyclical Fortive is after the Vontier (NYSE:VNT) split. A recent return to M&A does ease some of the capital deployment questions, though the price paid was not low.

It’s been a while since I’ve written on Fortive, but I haven’t missed a lot in terms of share price performance. The stock has popped since the second quarter earnings report, but since my last article the shares are up less than 5% - lagging the 20% or so move in the broader industrial space, as well as fellow “M&A compounders” like Ametek (NYSE:AME), Danaher (NYSE:DHR), IDEX (NYSE:IEX), and Roper (NYSE:ROP), with Danaher up about 35% and the rest up by a mid-to-high-teens percentage.

At this point, I find Fortive’s valuation okay but not exciting. I do think the company can generate organic growth at a mid-single-digit clip with improving margins, and I’m relatively bullish on the company’s ability to drive organic growth from its software operations. I also like the leverage to factory digitalization and industrial sensing, and I think the medical business will be a nice acyclical offset. But again, I think that’s mostly in the share price.

 

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Fortive Setting Out To Show It Has Crafted A Durable And Superior Compounder Business Model

Fortive Still Checks A Lot Of The Popular Multi-Industrial Boxes

Fresh off its spin-off of Vontier (VNT), Fortive (FTV) has seen no lull in investor enthusiasm for this newly-streamlined multi-industrial. It certainly doesn’t hurt that Fortive checks a lot of the most popular boxes for institutional investors in the industrial space - not only is it more leveraged to automation than commonly appreciated (with exposure in sensors, asset tracking/monitoring, and motional control), but the company’s aggressive moves toward software (particularly SaaS) and healthcare have certainly not gone unrewarded.

I like the secular growth story Fortive offers, as I believe the company is well-placed to leverage growing automation in manufacturing and logistics, growing remote monitoring across a range of industries, and growth digitalization in industries/markets like real estate and construction. I also see a clean balance sheet that will facilitate management resuming M&A relatively quickly.

What I don’t see, though, is a lot of undervaluation. The market is happy to pay for growth now, and the Street especially loves the above-average growth and above-average margin setup for Fortive, but the shares already trade at a pretty high relative premium to other high-quality names.

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Fortive Still Checks A Lot Of The Popular Multi-Industrial Boxes

Fortive's Transformation Story Supporting Valuation

I wasn't excited about Fortive's (FTV) valuation and prospective returns back in December, but the Street continues to give the company credit for the transformative M&A and business evolution it has underway, including a Roper-like (ROP) pivot toward higher-margin, less-cyclical, industrial software, and SaaS operations. In the meantime, while the Vontier (VNT) IPO has been postponed, Fortive has a relatively solid mix of businesses for the coming downturn/recovery cycle.

Valuation is still problematic for me, but the shares do at least, finally, offer a pretty decent long-term total prospective return. Given the Street's love of businesses that fit the profile of what Fortive is trying to become, the post-split valuation should improve, though I wouldn't sleep on the potential of Vontier once it's independent and able to reinvest in its own operations.

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Fortive's Transformation Story Supporting Valuation

Fortive Getting Plenty Of Love For Its Transformative Potential

While short-cycle industrials have recovered in recent months, Fortive (FTV) is still on track for a rare year of underperformance relative to the “average” industrial stock. This comes despite the announced decision to break the company in two and reposition RemainCo to focus more on software, connected devices, healthcare, and workflow management, partly due to the company’s exposure to this short-cycle slowdown. Although I find a lot of things to like about Fortive, I just can’t get that excited about the shares now. While I don’t disagree with the direction/focus of Fortive’s (RemainCo) M&A efforts, some of the specific deals have been questionable in terms of valuation and growth potential. What’s more, while I do expect 2020 to be meaningfully better for important segments like test & measurement, the valuation seems to already reflect that.

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Fortive Getting Plenty Of Love For Its Transformative Potential

Fortive Pivoting Toward A Higher-Growth, Higher-Margin Model

Fortive (FTV) management has always espoused their belief in continuous transformation, and they're certainly living up to that philosophy. Roughly three years from the time of its split from Danaher (DHR), and about a year after the combination of its automation assets with Altra Industrial Motion (AIMC), Fortive is yet again launching a major restructuring that will see Fortive separate its retail fueling, telematics, and tool businesses into a new company, leaving the surviving Fortive more focused on higher-growth market segments with higher recurring revenue potential and potentially more robust margins.

That Fortive would make this move isn't surprising, particularly when you look at how companies like Danaher, Dover (DOV), Emerson (EMR), Honeywell (HON), and Roper (ROP) have been positioning/repositioning themselves in recent years. While bears could argue that Fortive may be doing this deal to blur some of the consequences of recent high-multiple acquisitions, I believe management has earned more credibility and benefit of the doubt than that. I wouldn't call Fortive's current valuation a "can't miss" opportunity, particularly with growing worries about the macro cycle, but the pullback does make this a name to consider.

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Fortive Pivoting Toward A Higher-Growth, Higher-Margin Model

Fortive's Valuation Already Assumes A Lot Of Improvement

Spun off from Danaher (DHR) and operating according to a broadly similar business philosophy, Fortive (FTV) has long enjoyed a benefit of the doubt with the Street, and that seems to be even more the case today. I like Fortive, but I’m surprised at how willing the Street is in this case to overlook fairly meaningful short-cycle exposure, broadening (or loosening) M&A standards, and a rich valuation for a company that doesn’t (yet) have the sort of recurring revenue mix or margin structure of companies like Danher or Roper (ROP).

I have little doubt that I’ll hear from Fortive shareholders for those comments, but so be it. Like I said, I like this company, and I like the direction it's heading – the premiums management is paying for M&A concern me, but I agree with the strategic rationales for the deals they’re doing. With the implied return looking pretty similar to Danaher and Roper, I’d rather overpay for those two than Fortive at this point in time.

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Fortive's Valuation Already Assumes A Lot Of Improvement

Ongoing Excellence And Premium Valuation Mean Loving IDEX From Afar

Playing a "I like it, but the shares are expensive" drinking game with my articles in the industrial sector would probably be lethal right now, but the fact remains that the market continues to reward many companies with robust valuations even though there are some pockets of weakness in short-cycle markets. IDEX (IEX) is one of my favorite companies, a disciplined deployer of capital with strong niche-based businesses and excellent margins, but it's hard to see how IDEX shares can keep generating attractive returns from this high level.

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Ongoing Excellence And Premium Valuation Mean Loving IDEX From Afar

ITW's Margins Seem To Be Holding Up Well As Growth Slows

With the blizzard of earnings reports from April 25, and those that came before, it seems clearer to me that shorter-cycle industrial companies are facing a much more challenging growth environment. In addition to the surprisingly weak revenue number from 3M (MMM) (down 1.1%), Sandvik’s (OTCPK:SDVKY) SMS business saw a 1% decline, and Stanley Black & Decker (SWK) saw a 3% decline in its Industrial segment, while all of the discrete automation companies have seen growth slow.

Considering all of the above, the 1.5% contraction at Illinois Tool Works (ITW) this quarter isn’t so shocking or alarming. Perhaps even more important, particularly relative to 3M and Sandvik’s SMS business, is that ITW’s margins held up better – lending some support to the idea that ITW is a company built more for margins and returns than growth, which isn’t such a bad thing when growth gets scarce.

Industrials have rallied since I last wrote about Illinois Tool Works on growing optimism that 2019 growth will be stronger than expected, and ITW has actually outperformed its peer group. Although I don’t have any particular objections to ITW as a hold, I don’t find the valuation exciting enough to start a position here and I still see more risks that growth in North America will slow as 2019 moves on.

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ITW's Margins Seem To Be Holding Up Well As Growth Slows

Danaher's Mix Likely To Be A Real Asset In 2019

It doesn’t seem like there’s as much disagreement now that industrial activity is slowing, and particularly in the so-called early-cycle sectors. Two years into this cycle, autos and electronics have weakened, and there are growing concerns about upstream oil/gas equipment, non-residential construction, trucks, and “general industrial” going into 2019. Challenging as that may be for companies like MMM (MMM) and Illinois Tool Works (ITW), it doesn’t really mean all that much for Danaher’s (DHR), and this multi-industrial’s strong leverage to less cyclical businesses like life science equipment, diagnostics, and water quality should add to the popularity of what is already a very well-regarded company.

Given Danaher’s end-market exposures, I think there’s a good chance that Danaher can continue to report healthy earnings growth trends in quarters where many of its industrial peers won’t. Although the valuation here is hardly cheap, that stronger relative growth could drive “flight to safety” investment decisions, though I do believe Danaher’s high valuation does create a risk of a sharper sell-off if its 2019 results disappoint and its end-markets don’t prove to be quite as safe as commonly thought.

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Danaher's Mix Likely To Be A Real Asset In 2019

As Expected, Evolution, Not Revolution, From 3M

When I previewed 3M’s (MMM) capital markets day in my last article on the company, I said that I expected a presentation that was more or less “more of the same”. It’s not really in 3M’s corporate DNA to make major course corrections, and besides, I think there is a lot of wisdom in following an approach of “if it’s not broken … don’t break it”. 3M more or less fulfilled those expectations, laying out a five-year plan that looks a lot like the company’s recent history, albeit with what I believe is a more growth-conscious focus.

Between a “steady as she goes” investor day and a disappointing third quarter hurt by what I’d call non-structural issues, there’s not a particularly strong case for liking 3M if you didn’t already like it. The valuation is not really in bargain territory and next year looks challenging given slowdowns in a lot of significant markets (including autos, electronics, and “general industrial”). Still, as a high-quality name and one of the most R&D-focused multi-industrials, I have no problem with holding on to 3M today as part of a long-term core portfolio.

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As Expected, Evolution, Not Revolution, From 3M

An Unexpected Leadership Transition Likely Won't Faze Roper

It’s hard to find much to pick at with Roper (ROP). Sure, the ROIC/CROCI could be a little higher, but this tech and software-driven multi-industrial has “out-Danaher’ed” Danaher (DHR) over the past 15 years with a 20% annualized return driven by well above-average revenue growth, operating margins, FCF growth, and FCF margins. What’s more, the company’s transition toward niche-based, asset-light, SaaS-driven recurring revenue puts the company in a sweet spot with respect to many of its more cyclical peers.

Roper investors got a negative surprise on Friday, though, as the company announced that Neil Hunn would be assuming the CEO position effective on September 1, with Brian Jellison stepping down. While this transition is coming about three years sooner than expected, Hunn has been groomed for this position for some time. Rising valuations and ample capital left to deploy will test Hunn early in his tenure, but my basic viewpoint today is that Jellison established a model that can continue to generate strong results without him.

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An Unexpected Leadership Transition Likely Won't Faze Roper

Fortive On Target In The Second Quarter And Doing Yet Another Deal

Investors can’t say that Fortive (FTV) management doesn’t deliver on its promises – management at this diversified multi-industrial said they wanted to deploy at least $6 billion into M&A that would skew the company toward more higher-margin recurring revenue, and they have done exactly that. While second quarter earnings were a little choppy, they basically met expectations and the turbulence seen in some of the businesses wasn’t all that different than what comparable multi-industrials like Illinois Tool Works (ITW) and Dover (DOV) saw in their operations.

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Fortive On Target In The Second Quarter And Doing Yet Another Deal

Fortive Ties The Knot With Gordian

Fortive’s (FTV) management is not letting the grass grow under its feet when it comes to M&A. While it’s easy to assemble a Greek chorus of industrial CEOs to bemoan the difficulty of doing accretive deals with today’s prevailing valuations, Fortive is beating the bushes, turning over the rocks, and finding interesting opportunities. The latest deal, the nearly $800 million acquisition of Gordian, is Fortive’s biggest commitment to date in the software/SaaS space, but it looks like a sound deal with good growth and margin prospects. Although Fortive’s prospective returns still look too low for me to be really bullish on the shares, it’s easier to like a company that's aggressively redeploying capital not just toward growth, but value-additive growth.

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Fortive Ties The Knot With Gordian

Excellent Results Supporting A Steep Valuation At Halma

I really like the businesses at Halma (OTCPK:HLMAF) (HLMA.L), but when I last wrote on the company in January, I thought there wasn't much room for the already-steep multiples (on both an absolute and relative) to expand much further. For a little while that call worked, with the shares losing about 10% of their value between late January and late March, but a positive late March update and renewed enthusiasm for companies exposed to the oil/gas recovery and commercial buildings sparked a big rally that has left the shares about 10% higher than they were back in late January.

I am still a big fan of Halma's business mix and management's strategy to augment its core strengths with selective M&A and greater internal investments in digital capabilities (including IoT and analytics). It's also very easy to like a company that is logging double-digit organic revenue growth and even stronger order growth. The "but" remains valuation; the shares are trading at multiples more than 50% above the company's long-term averages and close to 33% above a peer group of quality growth companies. Given the level of expectations built into the price, I'd rather err on the side of missing more of the run than risk jumping in ahead of even a partial reversion to the mean.

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Excellent Results Supporting A Steep Valuation At Halma

Fortive Following A Familiar Pattern

If you're well-acquainted with Danaher (DHR) and Roper (ROP), Fortive's (FTV) strategy is going to look pretty familiar in at least some respects. Like both Danaher and Roper, Fortive's management doesn't want to be the classic sort of industrial conglomerate and is instead pivoting towards more technology-driven markets, and particularly those with higher service/recurring revenue components. It's no surprise, of course, that Fortive would be similar to Danaher (from which it was spun out), and the company has yet to really follow Roper's SaaS focus, but in any case, Fortive management is not afraid to pay big multiples for businesses that it believes will generate attractive long-term margin profiles.

As far as the shares go, I'm not inclined to chase them here. The stock already seems to factor in healthy future cash flow growth, and I'm not willing to count on significant further expansion in short-term multiples for the industry.

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Fortive Following A Familiar Pattern

Fortive Accelerating Its Transformation Process

Fortive (NYSE:FTV) management had already made it clear to shareholders that they wanted services and software to be a bigger part of the future, but the pace of that transformation has been a little surprising. Between the recent transaction with Altra (NASDAQ:AIMC) and the prospect of $8 billion in M&A deployment, Fortive is certain to look different in 2020. Although this transformation carries unknowns and risks, including the extent to which the Fortive Business System is “portable” into these new target areas, the success of peers like Roper (NYSE:ROP) argues that it could be a very worthwhile shift.

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Fortive Accelerating Its Transformation Process

3M Comes Back Strong In The Third Quarter

With its high valuation multiples and above-average visibility, 3M (MMM) needed a better result than what it delivered in the second quarter – a quarter that was marked by average organic revenue growth, rare pricing weakness, and weak margin performance. Fortunately, for shareholders, 3M came through and delivered a quarter that, while not perfect, was still quite strong on a relative basis.

Valuation is still problematic. I can’t really come up with a set of circumstances whereby these shares look cheap, so I suppose the argument comes down to some version of “almost of all of its peers are expensive, so if you have to own an expensive stock, why not this one?” I still own these shares myself (but it is not a large part of my portfolio), and I think management still has moves to make to drive better results, but I do worry that today’s valuation is setting the stage for unimpressive returns down the line.

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3M Comes Back Strong In The Third Quarter

Fortive Exceeding Expectations And Deploying Capital Into M&A

Fortive (FTV) hasn't wasted time showing investors that it fully intends to follow the model and map left by Danaher (DHR). In addition to driving continuous internal improvement, Fortive has started putting shareholder capital to work in M&A – deploying more than $1.5 billion so far this year. Although the deals have been a little pricey, particularly the most recent acquisition, the businesses seem to very much fit in with the vision management has outlined for the company.

These shares have been quite strong year to date and over the last year, so I can't say that the Street is asleep on this name anymore. The appreciation potential in the shares is no longer in that sweet spot I'd like for a new investment, but quality doesn't often come cheap, and I'd note that Danaher did well for investors for a long time despite elevated valuations.

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Fortive Exceeding Expectations And Deploying Capital Into M&A