Danaher's Spin Off: What Investors Need to Know About Fortive

In May 2015, Danaher (NYSE: DHR) announced that it would split itself into two businesses, one of which, concentrating on life sciences, dental equipment, and water treatment, would retain the Danaher name and stock exchange listing. In December it finally revealed the identity it has chosen for the new industrial business:

Source: Danaher.

(Management's explanation for this name is that in Latin and Romance languages, the root "fort" means "strength." Unfortunately, "Fortive" sounds much more as though it derives from "furtivus," Latin for "stealthy," a cognate of the word for "thief.")

The transaction is expected to be completed in Q3. Shares of Fortive will be distributed tax-free to Danaher shareholders of record, at a ratio to be determined closer to the time. Fortive will consist of two broad business groups, Professional Instrumentation and Industrial Technologies, which in turn will comprise a number of more or less independent operating units:

Source: Danaher.

Note that Fortive has not issued any detailed disclosure -- presumably more will be revealed in time -- so what follows is pieced together from various press releases and presentations. Fluke ($1.1 billion) and the two quite distinct businesses that constitute its Transportation group ($1.6 billion) are its largest units in revenue terms. Fluke's operating margin, ">25%," probably makes it the largest in terms of income contribution (Transportation's margin is ">15%"). Organic revenue growth (neglecting currency effects) for Fortive as a whole is expected to be in the low-to-mid single digits ("GDP+").

Fortive is active in foreign markets, which account for more than 42% of its revenue, and consequently it will experience the effects of exchange rate fluctuations. In fact it may experience them more severely than other industrial companies: Although it certainly manufactures outside the U.S., it is an active exporter from the U.S.

Source: Danaher.

Many of its products serve restricted markets, and are challenging to produce. Since volumes are low and few products are bulky, it makes sense to manufacture and ship them from a single site where manufacturing expertise can be cultivated. But when the dollar is strong, Fortive is faced with a choice between sacrificing sales or accepting lower margins. Since the margins on its products are fairly rich, it has the luxury of choice, but either way, the result will always be loss of potential income when the currency of the country in which it manufactures is strong. The instrument businesses have average operating margins in excess of 20%, while those of the industrial businesses are in the high teens. Fortive expects to be able to increase these by at least 50 basis points.

In principle, test and measurement should exhibit modest but steady growth. However, these have always been rather difficult businesses, characterized by extended periods of weak demand. Standard products -- oscilloscopes, voltimeters, etc. -- last almost indefinitely. They are replaced only when times are good, and used equipment is generally not scrapped, but sold into a thriving secondhand market. More specialized devices, for large batch testing or restricted applications in specialized industries, are another matter, but given their cost, they are unlikely to be replaced until there are very significantly superior new models. In effect, it is only through innovation that the industry can stimulate replacement of the installed base.

Sensors are another matter: Almost all of them are components of major manufacturing installations, and thus exposed to the capital investment cycle. However, it is a rare sensor that does not require fairly regular replacement, so this business enjoys a large and fairly stable aftermarket. Again, many of these have quite specialized applications, and correspondingly large margins. The long-term outlook for these businesses is favorable, as automation penetrates more and more manufacturing processes.

Fortive's Industrial Technology segment has a much more diverse economic profile. The automation portion consists of both systems and components businesses, which of course may be customers for sensors. Oddly, this segment also includes engine brakes for heavy trucks, a business which has probably seen some weakness in 2015, since truck sales have been soft. Systems and engine brakes are capital goods businesses, while many components, although obviously sold with the original installation, must be replaced fairly frequently, and thus, along with service, provide a sizable aftermarket.

Franchise distribution consists of a supplier of standard tools to auto mechanics, distributed through franchisees (Matco), and a manufacturer of more specialized equipment for auto mechanics such as vehicle lifts, tire changers, etc. (Hennessy). The latter is not a franchise seller, but it franchises its service function. The business of supplying Craftsman tools to Sears was spun off in 2012. Matco should probably be regarded as a producer of industrial consumables, while Hennessy is more obviously a capital equipment business.

The Transportation segment comprises two distinct businesses. One supplies point-of-sale fuel-dispensing units to service stations, as well as fuel dispensers for non-retail applications. This has been a steadily growing business, with worldwide markets and 35% of revenue deriving from consumables and services. It has been significantly aided by increasingly strict emissions standards. The other business is fleet tracking, which permits both long-haul and local delivery services to monitor their cargoes and assets. This has been an even more strongly growing business, and is likely to remain so for some years to come, as new applications are developed. Regulation, especially in Europe, has also stimulated demand for this segment.

Fortive's strategy is to supplement relatively modest unit growth with acquisitions. In typical Danaher fashion, most of these activities have been built through roll-up purchases in fragmented industries. Danaher will launch Fortive with an investment-grade balance sheet, and Fortive expects free cash flow to exceed its normal investment requirements, so it will be in a position to continue to pursue such a strategy.

There are no stand-alone businesses that are strongly comparable to Fortive. The kinds of businesses Fortive pursues tend to be folded into much larger entities, and no such entity has the peculiar combination of, say, explosive devices (Pacific Scientific), semiconductor wafer inspection (Sonix), and auto mechanics' hand tools. National Instruments and Anritsu are the companies most comparable to Fluke, but since they are trading at 43.9 and 23.2 times trailing earnings, respectively, they do not provide very useful valuation guidance. Snap-on is trading at 21.9 times trailing earnings, and it provides an excellent comparison for Matco; but Matco is only a rather small part of Fortive. A reasonable guess would be a price/earnings ratio somewhere in the mid to upper 20s, but until investors are given better indication of what those earnings are and how they have developed over time, guessing is a rather arid exercise.