When you carry the legacy of Danaher (NYSE:DHR) with you, expectations are going to be high. That is already the case for Fortive (NYSE:FTV), as this high-quality industrial conglomerate has debuted with a premium valuation and high expectations for growth. That said, those expectations aren't necessarily unreasonable, as the company's existing businesses already enjoy good market share, solid margins, and attractive free cash flow.
Valuing a stock like Fortive is tricky. If you exclude the impact of future M&A, you're largely missing the point of the business (which is to add value by skillful M&A selection, integration, and execution). On the other hand, modeling the impact of future M&A is a level of guesswork above and beyond the assumptions that underlie all modeling. Consequently, while Fortive doesn't look particularly cheap today (particularly after the post-election run), I wouldn't ignore it simply on the basis of valuation and would, at the very least, keep this on a watch list.
Carved Out From Danaher, But Hardly Table Scraps
There are a lot of reasons that companies spin out businesses, but in the case of Danaher and Fortive, I believe this was a situation where continuing on as a single unit made less and less strategic sense. Fortive is very much like Danaher circa 2003 - a company focused on testing equipment, test measurement and monitoring, sensing, fueling systems, motion control, and tools. With Danaher skewing more and more toward healthcare (dental and diagnostics) and water/fluid management, Fortive was becoming less and less strategically relevant and was arguably reaching a point where acquisitions that would help the business would no longer be material for Danaher as a whole.
On its own, though, Fortive is an industrial conglomerate with the same basic underlying principles that fueled Danaher - a focus on very efficient supply chains, ongoing R&D reinvestment, and opportunistic M&A. As such, I think it's fair to say that Fortive is an "industrial Danaher".
With segment margins already in the 20%'s, Fortive stacks up well next to comps like Dover (NYSE:DOV), Roper (NYSE:ROP), Parker-Hannifin (NYSE:PH), Rockwell (NYSE:ROK), and Illinois Tool Works (NYSE:ITW). What makes that more impressive is that Fortive's R&D spending of around 6% is higher than most of its peers. The one "but" here is that with most of these businesses having been run under the Danaher Business System for many years, there's likely not a lot of incremental margin improvement opportunity without acquisitions - the businesses are likely being run about as well as they can be.
Fortive is also attractive in that it has recognized the growing shift toward software in industrial markets and has positioned itself accordingly. While Honeywell (NYSE:HON) has been bulking up its software capabilities and Rockwell is already pretty strong there, Fortive's high single-digit mix of software compares well to many in its comp group and helps to support attractive margins.
Fortive's balance sheet is in decent shape. At about 2x EBITDA, the net debt is a little more than I'd ideally prefer, but it's not so high as to be likely to limit deals. Moreover, the cash flow I expect the company to generate could pay that off in around three years, so I don't think Fortive management will be shy about adding leverage for the right deals.
A Leader In Multiple Markets
Industrial Technologies is the largest segment at Fortive, accounting for around 54% of sales in the last quarter. This segment also houses the largest business unit (or sub-segment), "Transportation Tech". This business contributes close to 30% of overall revenue and includes the Gilbarco Veeder-Root retail/commercial petroleum systems business (which sells fuel dispensers, point-of-sale systems, and other equipment needed to run a fueling business like pumps, leak detection, and vapor recovery). This is a roughly $4 billion market growing at a mid-single-digit clip, with growth being underpinned by a replacement cycle in POS systems (moving to chip readers) and increasing environmental and safety rules. Fortive has a small market share lead on Dover in this segment (in the low 20%'s), while Franklin Electric (NASDAQ:FELE) is a much smaller rival.
Telematics may well be an underappreciated growth opportunity within Transport Tech. Vehicle tracking and fleet management is a $3 billion market already, but it is under-penetrated and still growing in the high single digits. Fleetmatics (NYSE:FLTX) and Trimble (NASDAQ:TRMB) are both rivals worth watching, but this looks like a solid long-term opportunity for Fortive and one where product innovation can make a difference.
Other businesses within Industrial Tech include the Automation/Specialty Components and Franchise Distribution. Fortive has a smallish (10% to 15% share) presence in motion control products like motors, drives, and controls where it competes with companies like Rockwell and Siemens (OTCPK:SIEGY). This is a less attractive part of the larger industrial automation space, but is still quite large at around $10 billion. Within Franchise Distribution is Fortive's Matco professional tool business and its Ammco wheel service business - both of which are solid cash generators, but probably not major growth opportunities.
On the other side of the ledger is the Professional Instrumentation segment. Field Solutions contributes almost a quarter of Fortive's revenue, underpinned by the well-known Fluke business. This business sells testing equipment, thermal imagers, calibration equipment and so on, and has carved out a strong 20%-plus market share in a roughly $6 billion market that is still growing at a low-to-mid single-digit rate. Product Realization, headlined by Tektronix, contributes another 17% or so of revenue and is slower-growing and more cyclical than Field Solutions. Sensing Tech is another play on automation, as Fortive sells systems that sense, monitor, and control manufacturing processes and applications (and where it competes with companies like Honeywell). While this is a decent growth business, Fortive's share is relatively small (sub-10%, I believe).
Fortive is going to do M&A; I consider that a given. The company announced two software deals in the third quarter (one in maintenance management, the other in traffic management) that, at less than $200 million in total consideration, would have been immaterial to Danaher but make sense as bolt-ons for Fortive.
Looking ahead, management has a lot of opportunities. The company can use M&A to add to existing platforms, whether that is in adding new technologies/capabilities or new end-markets. I also believe Fortive can and will use M&A to add new verticals and/or new market exposures. Among publicly-traded companies today, I could see Spectris (SXS.L) (OTCPK:SEPJY), Franklin Electric, MTS Systems (NASDAQ:MTSC), MOCON (NASDAQ:MOCO), Oxford Instruments (OXIG.L) (OTCPK:OXINF) all being potential targets for Fortive, as well as a number of companies in businesses that would represent new verticals for the company.
In modeling Fortive, I try to estimate what I think is a reasonable progression of M&A-driven revenue growth, but I fully acknowledge that there is a lot of guesswork in this process. So while I arrive at a long-term revenue growth estimate of around 6%, there could certainly be upside to that number and particularly if management targets larger deals than I expect. I do see room for some incremental FCF margin improvement, but not too much given the strong starting point, and that supports a FCF growth expectation of around 8%.
Discounted back, I come up with a fair value around $50. That's below today's price, but Fortive's business skews better than its peer group for long-term growth potential and there is the possibility that acquisitions will add more growth than I expect. I'd also note that there aren't all that many cheap industrial stocks these days (particularly among the higher-quality subset) and that Danaher rarely traded at an obvious discount. Bears can argue that the recent run is excessive and that the company is getting too much "benefit by association" with Danaher, but I don't think the valuation is extreme.
The Bottom Line
I know there are investors who don't worry about the details and invest on the basis of simpler considerations like "good management trumps iffy valuation". If that works for you, go for it. I certainly don't dislike Fortive and I like the basic idea of a high-quality company that can simultaneously focus and deliver on good margins, product development/innovation, and accretive M&A. The valuation isn't right for me yet, but at a minimum I'll be keeping an eye on this stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.