Fortive: Looks Expensive, But Long-Term Value Is Still There

Summary

• Fortive is well-positioned with its diversified business portfolio and has a long-term growth aspect with its exposure to the automation industry.
• After the spin-off deal, the company will seek additional investment opportunities, potentially adding additional value.
• The price is at a par value of $70, and my recommendation is to take a cautious approach to buy.

Thesis

Fortive (NYSE:FTV) is well-positioned for the reopening of the economy, and it will be a good selection for long-term holders. The resilience of the SaaS businesses has provided room for the company to continuously invest in R&D during the pandemic. The company has good exposure to the cyclical industries and automation, which will benefit the most from the economic recovery. After the spin-off deal, the company will seek additional investment opportunities, potentially adding additional value.

The potential business lineup from M&A activity makes the valuation very tricky, and it will always make the stock look expensive. However, I find that there is still long-term value that exists at the current price range of $70. I recommend the new buyers cautiously enter the position or buy at a potential dip.

Business

Fortive is a diversified industrial conglomerate. It has multiple business lines, and the company grouped them into three categories: Intelligent Operating Solutions, Precision Technologies, and Advanced Healthcare Solutions. The major businesses include Fluke (intelligent operating solutions, thermal imaging and remote display), Accruent (intelligent operating solutions, asset management software), Tektronix (precision technologies, measurement and monitoring technology), and ASP (advanced sterilization products, infection prevention). The business lines are well explained here.

The core businesses have an organic sales growth rate of 3-7% on an annual basis depending on the economic cycle. Its business model seeks growth from M&A activities, just like its origin company, Danaher (DHR). The company looks for attractive businesses or markets continuously and creates a business portfolio through merger activities. After acquisitions, it integrates the new businesses under the "Fortive Business System," the core value of the company. The company sharpens the merged businesses' strength through R&D and marketing efforts and makes the operation efficient via lean management or "kaizen."

Why Fortive is good for the long term?

Fortive is well-positioned for the ups and the downs of the business cycles, and it will be a perfect selection for long-term holders who wish to add more industrial names to their portfolio.

First, the company has demonstrated strong resilience during the downturn without cutting too much on R&D investments. The high percentage of recurring revenue (39% of total revenue from the latest quarter) from the SaaS business model is a constant operating cash generator. When the pandemic hit the economy in early 2020, the company had a stable stream of software revenues, while its cyclical businesses were hit hard by roughly -20% YoY.

A relatively high percentage of software revenue has helped the company to continuously invest in R&D, while its competitors were massively slashing their budget for overhead costs. Fortive's continuous investment in R&D is its competitive advantage, generating additional revenue from niche markets as well as constant gross margin improvements.

Second, the company's business portfolio is well-diversified and benefits from the reopening of the economy. The company serves multiple industries such as manufacturing & processing, healthcare, utilities/power/oil & gas, and construction. Those industries will benefit the most from an economic recovery in 2021 and 2022.

Third, the company's products and services help its clients in automation with technologies in sensors, IoT, and connected data. This area of business is expected to grow constantly at a decent speed. For instance, thermal images (Fluke) will have a growth rate of 6-7% CAGR. Process automation is expected to grow at 6-7% as well. The company's products and services are diverse, but most of the businesses seem to have a minimum revenue growth potential of 5% on an annual basis.

Spin-off deal

The company has made a spin-off agreement with Vontier (VNT) on Sept 2020 in a debt-to-equity exchange deal. Vontier now has an automotive business with brands including Gilbarco Veeder-Root, Matco Tools, and Teletrac Navman. This deal has reduced Fortive's net debt by about $3 billion. After this deal, the company is now expected to have cash of more than $3 billion with its net leverage dropping to 1.3X. As of Jan 19th, 2021, the company has disposed of its remaining 19.9% ownership stake in Vontier, according to the last earnings call, which is the final step of the split. The transaction has given the company room to expand its business with a focus on its core business.

There will be a couple of changes going forward in Fortive after the Vontier spin-off. First, the R&D investment to revenue will accelerate from mid-6% up to mid-7%. So, this will annually increase the R&D costs from about $20M to $50M. Focusing on R&D in data science and product innovation will create more business opportunities and margin improvements especially in the software segment.

Second, the company will look for opportunities to add additional business lines. Based on the last earnings call, the management has hinted that it is seeking opportunities in the software business since the SaaS business model creates more financial value without additional CAPEX spending. It has appointed a new VP of strategy who has experience in software and private equity. I am guessing that the company will go for the software business in the industrial automation or healthcare sector.

Valuation

	Low	Median	High
Enterprise Value($B)	23	26	30
EV/EBITDA	22	25	28
FWD PER	25	29	34
Dividend Yield	0.44%	0.39%	0.33%
Equity Value ($B)	21	24	28
Fair Price	$ 63	$ 72	$ 84

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I have assumed that the company will grow at an average annual compound rate of 5% for its revenue, after considering cyclicality. Of course, the growth of 2021 and 2022 is set to be higher than usual, and I used the growth rate of 9% and 6% for each year respectively.

Currently, the company seeks to achieve an adjusted operating profit margin of 21.5% to 22.5% and expects free cash conversion to be approximately 75% of adjusted net income. As the latest quarter has shown a gross margin of 58% and an operating margin of 23%, the company's guidance seems to be reasonable and achievable.

In my forecast model, I had input the potential revenue at about a total of $1B across the 10-year time frame. This is based on the assumption that the company will deploy its accumulated capital (a total capital spending of $4B, estimating that the company can utilize the free cash from 2023) to find M&A opportunities and grow its business at the same pace as Fortive. This is the tricky part for Fortive's valuation, where we wouldn't know the timing and the scope of M&A activities.

Because of this tricky part, the stock price will always look more expensive than its peers as their cash reserves will be valued at multiples assuming that the capital can be utilized for inorganic revenue growth. With the exclusion of the business potential from M&As, the model calculates a fair value of $60-$63 (PER 23-26), which is about a 10%-15% discount from the $70 range.

Based on the above assumptions, my fair value for FTV is $72, and I conclude that the current price of $70 is still reasonable for long-term holders.

Risks and Trade

I want to comment that a risk of M&A failures certainly exists, which can drag the valuation to a lower band, which, I believe, is slightly below $65 as of now. The risks to an M&A deal are the following:

1. The structure of an M&A deal (e.g. either company pays with cash, loan, or equity transaction)

2. The price of the target company. If the current bull market trend continues, there will be less of a price bargain that the company can offer to make a successful M&A deal.

3. The targeted company's "fit." The M&A target company may not have a "fit" to Fortive's businesses, or there are no meaningful "synergies" to be created. Although Fortive's management is experienced enough to figure out what should be a good deal for it, there will always be a risk in terms of integration of the new businesses.

4. The target company may not have enough margin or growth rate that can be matched with the rest of the company's businesses, and this can cause a drop in the valuation.

Potentially, any news of an M&A deal or sentiment changes in the broader market may create a hiccup for the stock price, and that will be actually a good time to enter this high-quality industrial stock with confidence.

Analyst’s 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.