Credit Suisse Equity Research Americas/United States Fortive (FTV) Organic recovery and M&A should drive a re- rating; Upgrade to Outperform January 13, 2017 US EE/MI RESEARCH TEAM Julian Mitchell Ronnie Weiss Research Analyst Associate Analyst +1 212 325 6668 +1 212 538 6404 [email protected] [email protected] Lee Sandquist Jason Makishi Associate Analyst Associate Analyst +1 212 325 2245 +1 212 538 8125 [email protected] [email protected] DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. FTV: Upgrade to Outperform We upgrade FTV to Outperform from Neutral and increase our TP to $60 from $54. We think the recent underperformance in the stock has created an attractive entry point. Fortive represents an underappreciated way of playing a short-cycle industrial recovery as well as potential benefits from the incoming Administration. We see M&A activity picking up materially this year, which should act as a meaningful catalyst for the shares. EMV push-out: In December 2016, the liability shift for US outdoor payment systems at gas stations moved from October 2017 to October 2020, which has weighed on FTV’s share price, given that its Transportation business is viewed as a key growth lever (FTV had previously guided that this upgrade cycle could add ~1% to annual organic sales growth for a few years). Since this announcement, FTV has underperformed. However, we estimate this push-out to be only a slight headwind for FTV in the next couple of years (~$0.04 of EPS over 2017/2018), and also highlight that the smoother capex cycle removes the risk of a ‘cliff’ in Transportation sales at the end of the decade. Encouragingly, key peer DOV, on January 12 (after the close) guided for 6% growth in its Wayne business for 2017, with acceleration in 2018; we forecast a ~4% CAGR for Transportation Tech. at FTV over this period. Organic sales acceleration: FTV’s organic sales growth slowed to almost zero in 2016, and we think that 2017 / 2018 will see an acceleration in the Professional Instrumentation business (45-50% of sales) in particular. PI should benefit from a recovery in general short-cycle industrial demand, which comprises almost 50% of the segment’s sales. While many pure-play short-cycle stocks have seen substantial valuation multiple expansion in recent quarters (EE/MI: Sector Report - 2017 Outlook), FTV’s valuation multiple has stayed steady, suggesting that any organic growth acceleration will cause a re-rating in the shares. High incremental margins: FTV enjoys some of the highest gross margins in the EE/MI sector, which will translate into very high incremental profit margins once any revenue recovery materializes (decremental margins in PI were ~45% in the 1H16). This, coupled with the restructuring activities undertaken in Q416, should mean that management’s guidance for 50bps of annual operating margin expansion is rendered quite conservative. Potential Trump beneficiary: FTV would be one of the biggest beneficiaries from potential policy changes within our sector, given that a substantial portion of its cash is held overseas, it has a high tax rate, as well as one of the highest share of manufacturing facilities in the US. The stock, however, has lagged most peers since the Election, suggesting investors are not yet focused on these potential tailwinds. M&A opportunities & Blue Sky Valuation: FTV has exceptional cash generation, with FCF growth of 37% in the 9M16 period. We think this allows for substantial capital deployment, which so far has been minimal since the company spun out of DHR in mid-2016. In our Blue Sky scenario, we assume FTV deploys ~ $3bn towards M&A, alongside a reacceleration in organic sales growth (Sensing, EMV, AI&S, A&S), over 2017 & 2018, driving ~25% EPS accretion by 2018. Applying a multiple of 20x P/E (where it has traded on average since its spin-off), would imply that FTV could be worth $70+. 2 DHR has enjoyed many years of consistent share price share ofyears consistent many enjoyed hasDHR The stock has lagged in recent months, which we think creates an attractive opportunity Source: CompanySource: BloombergCredit Estimates, Data,Suisse The stock has a fairly low share of ‘Buy’ ratings among ratings of‘Buy’ share low fairly ahas stock The outperformance… theSell - Side 160 8% 140 6% 120 4% 100 2% 80 0% Perf Perf Vs S&P 60 -2% 40 -4% 20 Price Perf. FTV Rel to S&P -6% DHR Price DHR 0 EE/MIof theoneas investors by viewed beenFTV has companies least likely to benefit fromUS Election,the benefit to likely least companies -8% …However, FTV has performed in a muted fashiona mutedin FTV hasperformed …However, -20 not *Does due week include the volumefirstto low -10% Jul-16 Jul-16 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Oct-16 Oct-16 Jun-16 Jan-17 Jan-17 since it spun off from DHR in mid in fromDHR off it spunsince Nov-16 Nov-16 Dec-16 Dec-16 Aug-16 Aug-16 Aug-16 Sep-16 Sep-16 which we thinkis incorrect we which 100% 50% 90% 45% 80% 40% 70% 35% 60% 30% 25% 50% 20% 40% 15% - 30% 2016 % reccomendations Buy % of 10% 20% 5% 10% Share price performance (%) price Share sinceperformance Election 0% 0% -5% IR LII IR LII GE JCI GE JCI VMI FTV TXT ETN UTX VMI KMT RXN RBC CUB PNR DHR DOV ROK TXT FTV EMR HON UTX ETN CUB RXN KMT RBC PNR ALLE DHR DOV ROK MMM HON LXFR ATKR MTLS SPXC ALLE MMM FLOW LXFR MCRN ATKR SPXC 3 FLOW MCRN Investor concerns around the EMV delay look overdone to us In early December, the US liability shift date for outdoor gas …This has therefore hurt FTV’s share price as well as station payment systems shifted from October 2017 to certain peers in recent weeks October 2020, which led to concerns around a slowdown in customer spending on FTV’s US Transport business… 20% 15% “Demand for EMV upgrades in the US will continue to be an important and underlying driver of our results, but these upgrades are likely to be 10% deployed over a more normalized period of time…Despite the recent decision by the payment networks to push out the liability shift date, we (%) 5% still believe we're well-positioned via our Gilbarco partnership to capture what could be a significant revenue opportunity over the next 0% several years. And although FY17 will deliver lower upgrade revenue than we had originally anticipated, we nevertheless believe this will -5% mark the beginning of a multi-year uptrend.” price 12/2/2016 1/12/2017 Share performance to -10% - Verifone; 12/12/2016 PAY DOV FTV FELE XLI EE/MI Average As a result of the ‘EMV push-out’, in December we …We note, however, that the affected business only revised downwards our Transportation Technology comprises ~15% of total FTV sales and the earnings impact growth forecasts for 2017 and 2018… is less than $0.05 in the near term; key peer DOV, on Jan 12th, highlighted that it expects 6% growth for its Wayne 8.0% business in 2017 with a likely acceleration in 2018 7.0% 2016 2017 2018 2019 2020 6.0% Total FTV Revenue 6211 6306 6495 6740 6998 5.0% US EMV opportunity (organic sales %) -1.0% -1.0% 1.0% 1.3% US EMV opportunity (organic sales $) -62 -63 65 84 4.0% GVR margin 17.0% 17.0% 17.0% 17.0% 3.0% US EMV EBIT Impact -11 -11 11 14 2.0% US EMV EPS headwind due to delay in liability shift date ($0.02) ($0.02) $0.02 $0.03 Trans. Tech Organic Sales Growth Organic Tech(%) Trans. Sales Growth 1.0% Total Company EPS $2.70 $2.90 $3.15 $3.40 % accretion / dilution -1% -1% 1% 1% 0.0% 2013 2014 2015 2016E 2017E 2018E 2019E 2020E 2017 Wayne Growth US EMV Upgrade Opp. Length of US EMV Cycle DOV Expected EMV ~6% $500m 5-6 Years Opportunity (1/12/2017): 4 Source: Company Data, Credit Suisse Estimates, Thomson Reuters Transcripts Near term Growth Drivers (1) Short cycle recovery Professional Instrumentation represents half of total The Professional Instrumentation top-line is closely company sales; within which, short cycle industrial correlated with that of short cycle peers… KMT Industrial 3M Industrial end markets represent ~50% of the portfolio… Organic Sales organic sales ROK Organic Global IP, % YoY US IP, % YoY Period FTV PI growth growth Sales Growth (3mma) (3mma) Mar-09 -21% -17% -12% -14% Jun-09 -29% -27% -11% -15% Sales Split Sep-09 -24% -25% -7% -11% Dec-09 -18% -15% 1% -5% Professional Mar-10 6% 5% 10% 2% Jun-10 22% 25% 11% 7% Instrumentation Sep-10 20% 39% 27% 9% 7% 48% Dec-10 23% 37% 28% 8% 6% Mar-11 14% 29% 12% 24% 7% 5% Jun-11 11% 25% 9% 14% 5% 3% Sep-11 12% 17% 7% 17% 5% 3% Dec-11 2% 10% 9% 8% 4% 3% Mar-12 1% 9% 7% 7% 4% 4% Jun-12 0% 2% 4% 7% 4% 4% Sep-12 -6% -14% 5% 5% 3% 4% Dec-12 -1% -10% 4% 2% 2% 3% Mar-13 -1% -10% 3% -2% 2% 3% Jun-13 -2% -8% 3% 4% 2% 2% Sep-13 -1% 1% 6% 3% 3% 3% Dec-13 3% 5% 6% 7% 4% 3% Mar-14 1% 6% 5% 7% 4% 3% Industrial Jun-14 -2% 7% 5% 2% 4% 4% Sep-14 -1% 6% 4% 4% 4% 5% Technologies Dec-14 1% 3% 6% 2% 3% 5% 52% Mar-15 6% -2% 3% 3% 3% 3% Jun-15 2% -3% 1% 2% 2% 1% Sep-15 1% -8% 0% -2% 2% 1% Dec-15 -7% -9% -2% -3% 1% -1% Mar-16 -6% -5% -2% -3% 1% -3% Jun-16 -5% -7% -1% -5% 2% -4% Sep-16 1% 3% -1% -4% 2% -1% Correlations No lag w/ FTV PI 91% 68% 96% 89% 85% 1Q lag in FTV PI 85% 71% 79% 93% 76%