Fortive Corporation (FTV) Q4 2022 Earnings Report, Transcript and Summary

My name is Julianne, and I will be your conference facilitator this afternoon. At this time, I'd like to welcome everyone to the Fortive Corporation's Fourth Quarter 2022 Earnings Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] I would now like to turn the call over to Ms. Elena Rosman, Vice President of Investor Relations. Ms. Rosman, you may begin your conference.

Thank you, Julian, and thank you, everyone, for joining us on today's call. With us today are Jim Lico, our President and Chief Executive Officer; and Chuck McLaughlin, our Senior Vice President and Chief Financial Officer. We present certain non-GAAP financial measures on today's call. Information required by Regulation G are available on the Investors section of our website at fortive.com. Our statements on period-to-period increases or decreases refer to year-over-year comparisons on a continuing operations basis. During the call, we will make forward-looking statements, including statements regarding events or developments that we expect or anticipate will or may occur in the future. These forward-looking statements are subject to a number of risks and actual results might differ materially from any forward-looking statements that we make today. Information regarding these risk factors is available in our SEC filings, including our annual report on Form 10-K for the year ended December 31, 2021. These forward-looking statements speak only as of the date that they are made, and we do not assume any obligation to update any forward-looking statements. With that, I'd like to turn the call over to Jim.

Thanks, Elena. Hello, everyone, and thank you for joining us. I'll begin on slide 3. Fortive had another quarter of outstanding operating performance in Q4, delivering 14% core revenue growth, 50 and 110 basis points of adjusted gross and operating margin expansion, respectively, 11% adjusted earnings per share growth, 62% free cash flow growth, all ahead of the guidance we gave in October. Our strong purpose-driven culture is supported by our relentless focus on executing for customers and shareholders in 2022. The continued evolution of our portfolio within the markets we play is characterized by strong secular drivers, which powered 9% ARR growth in our software businesses and backlog expansion in our hard products businesses, contributing to record core revenue growth for the year. Our performance would not have been possible without the dedication of our 18,000 team members around the world. Team overcame continued supply chain and inflationary challenges, which will likely linger into 2023. We believe the power of the Fortive Business System is a key differentiator, contributing to more profitable growth, record gross margins and free cash flow generation. As we look forward, we're excited to update you on the progress we've made on our multiyear targets and strategies that are driving outperformance at our upcoming Investor Day in May. Turning to slide 4. Even against the backdrop of a difficult macro in 2022, Fortive continue to validate the investment thesis that we have pursued since 2016, delivering core growth of 10% and 20% on a two-year stack basis, accelerating over the last few years. Our portfolio transformation has also driven approximately 1,000 basis points of gross margin expansion since 2016, which has translated into higher operating margins and provides further opportunity to improve margins in the years to come. We also delivered free cash flow growth of $1.2 billion, with margins approaching 21%, underscoring our ability to compound cash flow off a higher base, a key Fortive differentiator and value creation driver. In summary, we had said that 2022 would be a show-me year and we delivered strong results across all of our segments, which I will highlight in more detail on the next few slides, starting with Intelligent Operating Solutions on Slide 5. IOS grew core revenue by 13%, representing its third consecutive quarter of double-digit core revenue growth. We had good growth in all regions, with low double-digit growth in North America, mid-teens growth in Western Europe and high 20s growth in China. Double-digit core growth in every workflow, combined with our rigorous application of FBS, drove 330 basis points of core operating margin expansion, more than offsetting inflation and FX headwinds. Looking at our performance drivers by workflow and connected reliability, look at low teens growth, supported by a strong backlog position and continued success with their new solar and calibration products serving the energy, renewables and electric vehicle markets. POS remains strong in every region. However, we expect to see some slowing as supply chains continue to normalize. Strong end market demand drove double-digit EMEA SaaS revenue growth in the quarter, with record net dollar retention of approximately 106%. In EHS, revenue grew by high teens with strong contributions from both Industrial Scientific and Intelex. Industrial Scientific revenue grew approximately 20%, as strong demand was supplemented by record iNet expansion and higher instrument shipments following the resolution of key supply chain issues at the end of the third quarter. Meanwhile, Intelex posted another quarter of low double-digit SaaS growth. They have successfully deployed FBS initiatives to accelerate software implementations and create upsell opportunities to customers. Moving to facilities and asset life cycle. We had low double-digit growth in Q4. Vontier revenues once again increased double-digits as customer labor shortages and deferred facility maintenance continued to drive higher volume through the company's job order contracting platform. Accruent SaaS revenue grew by mid-single digits, despite a sizable headwind from end-of-life products. Accruent continues to see good success from its recent go-to-market focus in asset management and workplace solutions to enable mid-single-digit revenue growth in 2023. And ServiceChannel saw another quarter of double-digit revenue growth taking their full year growth rate to just under 50%. As a reminder, we are transitioning from a largely pass-through revenue base to a better long-term business model that includes more recurring SaaS revenue. This change will create a short-term revenue headwind in the first quarter. However, we expect service channel to remain a strong double-digit growth business in 2023 with above 20% adjusted operating margin. Turning now to Slide 6. Precision Technologies delivered another strong quarter of double-digit revenue growth in every business. Core revenues increased 20%, driven by high teens growth in North America and greater than 20% growth in both Western Europe and China. PT also delivered 240 basis points of adjusted operating margin expansion with higher volume, price realization and productivity more than offsetting inflation in FX. Some highlights for the quarter include: record quarterly revenues and operating profit at Tektronix, which continue to benefit robust backlog, driven by new product launches, share gains and new entry in mainstream as sold scopes. We saw orders slow in Q4 as expected as demand normalizes following the 40% growth we've seen over the last two years. Sensing Technologies had another quarter of mid-teens growth, driven by strong price realization across all businesses and continued demand in Qualitrol's utility and power business, offsetting industrial and semiconductor demand softening. Combination of Gems and Setra in 2022 also drove approximately 200 basis points of margin expansion and four working capital turns improvement. Pacific Scientific EMC saw high 20s growth in the quarter, facilitated by capacity expansion and improved materials availability. Moving now to slide seven in Advanced Healthcare Solutions. As expected, revenues increased 5% in the quarter, driven by broad improvement across all health care operating companies. By major region, mid-single-digit growth in North America reflected the benefit of our higher installed base and some improvement in hospitals, partially offset by a low single-digit decline in Western Europe and a high single-digit decline in China. The exit rate on China elective procedures was the lowest we have seen post-COVID and roughly 30% of normalized levels. January 2023 volumes were roughly half of prior year levels, which was reflected in our Q1 outlook for the segment. In the fourth quarter, AHS segment margins were down 260 basis points, driven primarily by higher inflation, partially offset by favorable M&A. Notably, margins were up approximately 400 basis points versus Q3. Versus our fourth quarter guidance, margins were unfavorably impacted by additional transactional effects and lower margins at Fluke Health Solutions. As we look ahead, the team is starting to see traction on their pricing and productivity initiatives, which we expect will deliver margin recovery in 2023. Some other highlights of the quarter include; ASP finished the year with core revenue growth of 5% as capital share gains and consumable volumes more than offset COVID headwinds in China. Even with inflationary pressures, ASP ended Q4 with the strongest margins of the year and continued to deliver strong working capital improvements. While hospital profitability remains pressured, due to labor and inflationary challenges, Censis continues to drive robust growth and in Setra SaaS offering in Q4 and for the year with mid-teens net new ACV and record cross-sell opportunities. Lastly, Provation is ahead on its return expectations, having contributed $0.10 to earnings in 2022. As customers continue to standardize our probation across their health systems, we are seeing accelerated SaaS growth, setting them up for a strong 2023. Turning to slide eight, the Fortive Business System is a powerful mindset that makes continuous improvement a way of life at Fortive. We drive deep engagement across our teams and hold them accountable for delivering on high expectations. As a reminder, in October, we brought together over 400 team members and our CEO Kaizen Innovent. Our most senior Fortive leaders, including our segment leaders and a number of our operating company presidents, collaborated to drive significant improvements in growth, margin, free cash flow, and breakthrough innovations across four operating companies, Fluke, ISC, Tektronix, and Censis. We're proud of the success our teams are having sustaining results to directly attribute it to this event, including, at Fluke, we reduced bold change over time by over 50%, eliminating stock-outs on critical plastic components and reducing past due backlog. At ISC, we applied lean conversion in the Fortive material system to improve quality output and turnaround time for iNet and rental customers, dramatically reducing the cost of repairs and product redesign. At Tektronix, we applied lean conversion to circuit board repair, increasing on-time delivery to 98% by altering material flow, installing 5S part management, and building standard work and documentation of our procedures. In Censis, we applied value stream mapping and transactional process improvement to identify the inefficiencies and waste, resulting in a 50% reduction in time to onboard new customers. With Kaizen activity accelerating in 2023, we expect significant results across in the year ahead. I'm incredibly proud of the work we have done in 2022 to deliver powerful results and continue our progress towards building a more sustainable future, as you can see on slide nine. We believe in taking a holistic approach to creating value that includes setting aspirational and actionable targets across each of our sustainability pillars as shown on the page. Leading Fortive today is a diverse Board and leadership team, with recent hires and promotions advancing our commitment to top talent and diversity. Strong and inclusive culture is core to Fortive’s mission, with inclusion and diversity, a critical component of FBS. Last year, we published clear goals to increase our diverse supplier spend, gender representation, by pack representation and senior leader diversity by 2025. We believe this has resulted in part to an increase in our employee engagement scores, up five points from pre-pandemic levels. Our progress also extends to how we protect the planet. It includes the early achievement of our 2025 greenhouse gas goal in the adoption of our new ambitious goal of 50% emissions reduction by 2029. It's our shared purpose that also pushes us to create innovative and sustainable products and services. Today, approximately 60% of our revenue is derived from products and services that enable more sustainable outcomes, aligned to the United Nations' sustainable development goals. And we have award-winning products that promote sustainability for our customers. Lastly, the commitment to drive meaningful and sustainable outcomes that matter most to our stakeholders is reflected in our recognition by Newsweek for the fourth consecutive year as America's most responsible company. With that, I'll pass it over to Chuck, who will provide more color on our fourth quarter financials and our 2023 outlook.

Thanks, Jim, and hello, everyone. I will begin on slide 10, with a quick recap of our fourth quarter performance. We generated year-over-year core revenue growth of 14%. Acquisitions net of divestitures contributed 1.5 points of growth. FX headwinds were approximately four points. Turning to the geographies. We saw another quarter of double-digit core revenue growth in each of our major regions. North America revenue was up low double-digits with broad-based strength across our businesses, Western Europe revenue grew mid-teens, with volume contributions in hardware products and favorable pricing, partially offset by a decline in healthcare. In the fourth quarter, bookings growth slowed in North America and Western Europe as expected. Asia revenue increased high-teens, with low 20% in China, driven by robust growth in Intelligent Operating Solutions and Precision Technologies, more than offsetting a dramatic drop in elective procedures in China impacting Advanced HealthCare Solutions. Lastly, we saw a broad-based performance in our high-growth markets with mid-teens core growth. Turning to slide 11, we show operating performance highlights for the fourth quarter. Adjusted gross margins increased by 50 basis points to 58.3% as volume and strong price realization continued to demonstrate the value proposition of our products and solutions more than offsetting higher inflation. Adjusted operating profit margins expanded 110 basis points to 25.5%, up 230 basis points on a two-year stack basis. Adjusted earnings per share increased 11% to $0.88, reflecting a strong fall-through on higher volumes and productivity, partially offset by higher interest and tax expense. Normalized for tax earnings in the quarter were up 16%. Free cash flow was another standard. Strong year-end cash collections and the benefits of our FBS-driven working capital initiatives yielded $428 million of free cash flow in the quarter, taking the full year to $1.2 billion. Before turning to the guide, I wanted to provide some context on our 2023 outlook on Slide 12. We expect that 2023 will be another year of growth and margin expansion in each of our strategic segments supported by secular tailwinds, driving market expansion and new customer innovations. Our recurring revenue businesses at roughly 40% of sales are expected to benefit from the work we did in 2022 to increase demand generation and strengthen our go-to-market efforts, driving double-digit SaaS and license revenue growth. Elevated backlog in our hardware products businesses, particularly at Tektronix, is expected to derisk moderating demand as order rates normalize in 2023. Further, the benefit of 2022 pricing actions is expected to carry over into 2023, driving another year of above-trend pricing realization along with increased sourcing and value engineering savings contributing to gross margin expansion. We also expect our productivity initiatives to yield strong incremental operating margins, including actions in the first half of the year to countermeasure the slowing macro environment. Project paybacks related to these initiatives are expected to average one year. We have included these benefits in our margins and earnings outlook for the second half, with carryover benefits into 2024. In summary, we believe our 2023 outlook reflects a more resilient revenue and earnings profile, as we expect to weather the evolving macro environment. Turning now to the guide on Slide 13. We are introducing 2023 guidance. Starting with the full year, we expect core revenue growth in the range of 3% to 5.5%. Our outlook reflects a year-over-year foreign exchange headwind of just under 1% on revenue. Adjusted operating profit is expected to increase 5% to 10%, with margins in the range of 25% to 25.5%. Adjusted diluted net EPS guidance of $3.25 to $3.40, up 3% to 8%, which includes higher interest and tax expense. And free cash flow is expected to be approximately $1.25 billion, representing conversion in the range of 100% to 105% of adjusted net income and a 21% free cash flow margin. For the first quarter, we anticipate core revenue growth of 5% to 6.5% with an FX headwind of 2.5%. Adjusted operating profit is expected to increase 4% to 9%, with margins in the range of 23.5% to 24%. Adjusted diluted net EPS guidance of $0.71 to $0.74, up 1% to 5%, which includes higher year-over-year interest and tax and free cash flow of approximately $170 million, reflecting the stronger cash collections that pulled forward into Q4 as well as our normal seasonal variations. Turning now to Slide 14. We are expecting a 48-52 split of revenue first half to second half, which reflects a step-up of approximately $120 million of core revenue growth, which when you compare to last year, it's less than half of the increase we saw in the second half of 2022. The step-up in 2023 is largely driven by acceleration in new products, a ramp in the growth rate of advanced healthcare as we lap China COVID lockdowns and an increase in software and other recurring revenue streams. FX and interest account for abnormal earnings seasonality as FX becomes a tailwind in the second half of the year and interest expense is expected to decline as we pay down debt with available free cash flow as the year progresses, giving us a bigger than usual step-up in EPS first half to second half. In summary, our revenue outlook reflects a similar linearity profile to 2022 and while core growth decelerates first half to second half, it accelerates on a two-year stack basis. With that, I'll pass it back to Jim to provide some closing remarks.

Thanks, Chuck. I'll now wrap up on slide 16. In summary, I'm incredibly proud of the contributions of our 18,000 team members to make 2022 a record year for Fortive and further differentiate our more resilient financial profile. As we turn the page on 2022, that resiliency will be on display again in 2023 as our outlook reflects an expectation for slowing growth as customer demand normalizes after two years of robust double-digit hardware product orders, but it also reflects the benefits of the investments we have made to accelerate strategy, strengthen our market position, scale our software revenues and develop new innovations that are solving our customers' toughest safety, quality and productivity challenges. As you've also heard today, we are seeing the benefits of our continuous improvement culture, unleashing the power of the Fortive Business System to deliver more profitable growth and strong free cash flow, again in 2023, allowing us to compound returns through disciplined capital deployment. When taken together, this creates a powerful formula for value creation with a high-quality portfolio of desirable brands favorably leveraged to sustainable secular trends, industry-leading margins and free cash flow generation and best-in-class execution, enabling Fortive to outperform in almost any environment. With that, I'll turn it back to Elena.

Thanks, Jim. That concludes our formal comments. Julianne, we will now take questions.

[Operator Instructions] Our first question comes from Steve Tusa from JPMorgan Chase. Please go ahead. Your line is open.

Hey, good afternoon.

Hi, Steve.

Can you just talk about -- for iOS, the margin expansion kind of sequentially from the first quarter for the -- through the full year, the kind of key building blocks for that?

Yes. Hey, Steve, it's Jim. A couple of things. One, obviously, we play a role in that. And -- so as we continue to progress, we'll see that. As we noted, some of the asset life cycle, a little bit lower growth in the first quarter. We can talk about that, but that -- those margins will expand. So, the revenue coming back certainly in the software businesses there as well as just continued progression of -- a lot of the actions that we've got price will continue to be a helpful piece of this driving gross margin expansion along with our productivity initiatives. So, I don't think we've got anything dramatic from the first half to second half in terms of anything that you wouldn't normally see seasonally in terms of growth, price realization, productivity initiatives get more traction as you go through the year. Those are probably the big drivers outside of just normal revenue.

And then should we assume this excess $350 million backlog that that all obviously gets washed out this year? And then what's the pace of that being washed through?

Steve, this is Chuck. Actually, in our modeling, no, we wouldn't expect that all gets washed out based -- but of course, it depends on the order rate. It's one of the reasons why we think that we've got a pretty resilient forecast here. If the order rates moderate beyond where we think they're going to be, we could still do it. It's really still -- we've got -- supply chain is getting better. It's just -- it's not resolved. So it sounds like we can just flip the switch and get it all out. But we would -- we'd probably cut it in half.

Okay, great. Thanks a lot.

Thanks Steve.

Our next question comes from Julian Mitchell from Barclays. Please go ahead. Your line is open.

Hi. Good afternoon. I just wanted to start with some more detail on the product hardware orders. So I think those were up mid-single digit Q3. It sounds like they're up maybe low single Q4. And then you've got this slowdown commentary. And then also on slide 14, you talked about orders improving through the year. So is the way to think about that, you're trying to say that orders, I don't know, ended last year up low single, maybe they're down in the first half, grow in the second half? And then that's what informs the PT organic sales guide, because if I look at that on slide 17, you're starting the year up double digit. The year as a whole is up low to mid. So you're implying the organic sales in the year flat or down. Is that just, kind of, the orders flowing through with a six-month lag? Is that how we're thinking about it?

Well, I think, first, we would think of the second half of 2022 is basically flattish for orders for those businesses. So a little bit down in the fourth relative to -- and right along where we thought. If you remember from the third quarter call, we said, yes, we also saw some orders that came in, in the first half for the second half. So that's kind of the backdrop of what we just described, backlog in and around where we thought it would be from an ending year. So the backlog, obviously, as Chuck just described, that obviously helps in the -- with some of the order down slowing that we saw. We expect orders to be around the same in the first half relative to those product businesses, Julian. So you think about probably the second quarter -- first quarter and second quarter being probably negative in those businesses. But backlog obviously mitigates a number of those things. And then it starts to pick up a little bit. Some of that pickup is an easier comp, obviously, because of what I just described in the second half of 2022. And there's a little bit sensing probably stays flat through the year is probably not a big improvement through the year in sensing, but a little bit of improvement in Tek. And we think Fluke will come back as well, typically comes back a little faster.

And Julian, the only thing I'd just remind you is we have an easier comp in PT in Q1. So when you start -- when you look at $1 standpoint, it's not as dramatic as you move through the year. In fact, I think from $1 standpoint, we'd expect that it would -- there would be an upward trajectory in PT each quarter sequentially.

Thanks. And when we look maybe within PT at Tektronix, maybe flesh out a little bit more what you're expecting. You've got that high-teens growth first quarter. The year is up mid-single. But I guess if I look at a lot of what's happened in, say, electronics, it feels like people are in kind of the teeth of the destocking right now and have been for three or even six months. So, I understand maybe you're protected a bit by the backlog in Tektronix. That means you have a sort of gradual descent through the year. Maybe just help us understand kind of where you see channel inventories in that business? And again, on Tektronix, it looks like the guide implies down revenue in the back half. Just wanted to kind of confirm a couple of things there.

Yes. Well, number one, I think, on the back stuff, as we said in the prepared remarks, 40% order growth over the last couple of years. It's obviously a little bit higher growth rate than what we'd normally expect for Tek. So, what you start to see in the full year, it’s a moderation or a normalization back to that mid-single-digit growth. I would say when you think about customers, very much playing out the way we anticipated in terms of moving the business. The business just doesn't have as much of influence from consumer electronics anymore, where you're seeing a lot of that distortion with the things we've talked about in terms of power, data centers, industrial IoT, all of those drivers are really driving the business much more today than ever before, making it more resilient. So, I think those are all the things we've described that I think really continue to have the business. It does dissolve a little bit, but it moderates off of really, really large numbers. So I think mid-single-digit growth for the year is what we're calling out here. It could be a little bit better. We'll still end the year with a decent backlog, as Chuck was just describing a couple of questions ago. So, I think when we look at the business for the year, very healthy channels have almost no inventory. So we continue to see good point-of-sale strength. And some of that is just fulfilling past due to some extent, but there really isn't a channel inventory situation whatsoever. And so I think we're in a good place. Orders will slow a little bit, but some of that is just the big heavy comps that we've sort of had over the last couple of years. So we think we're in a good place, and we think we'll exit 2023 in a good place as well.

That’s great. Thank you.

Thank you.

Our next question comes from Scott Davis from Melius Research. Please go ahead. Your line is open.

Hey, Jim and Chuck and Elena. I hope you guys are well. If I look back at my notes, I think you said, the service channel probation would be like $0.12 accretive in 2022. It sounds like maybe that came in a couple of pennies better. Is that accretion step-up meaningfully in 2023? We think just given the growth rates of those businesses that would be a nice tailwind for you. But I know you did make some comments on the SaaS adjustment on service channel, though as an offset.

Yes. Scott, you got right. We came in at, I think, $0.14 in 2022. And I would expect that, that would grow as you expected. We build on that $0.14 in 2023. Faster growth rates there, also more profitability in the first half in service channel and things. All that are going to give us a nice tailwind.

And Scott, just to maybe add on to the first quarter service channel thing, as we talked about in the prepared remarks. This is really -- the SaaS revenues continue to be incredibly strong in the business. But we did have a little bit more pass-through revenue in the year than we anticipated. That's why we grew the business almost 50% on a full year basis. So really strong growth this past year. But we'll move to a better business model, which is a little bit less pass-through revenue and a much -- but the strength of the SaaS business has been there all along. We've now got a data analytics platform that we're offering as well. So we're really going to, kind of, get through that in the first quarter and a little bit in the first half, but the profitability really does raise considerably as well. We got what we needed in 2022 in that regard. We'll be an even better place in 2023, simply because the business model transformation that we intended to do is really start going to hit the -- full hit of the P&L through the year.

All right. That's helpful. And I think it was Jim. You mentioned in your remarks that the discretionary procedures in China finished the year at like a 30% number, which 30% of normal, I think I'm reading it as, which just sounds crazy. But -- is that -- are you still seeing that in January? I would imagine that the reopening -- just the timing of the reopening, that stuff would pick back up here in 1Q pretty aggressively, but I don't know. But are you still seeing that kind of...

Yes, I mean you got it exactly right. December, in particular, was really low. I think that speaks to the strength of AHF, quite frankly, on the revenue line is we were able to weather that storm because of the strength of other regions of the world. We talked about the 5% growth that we had in the segment. So we think, we're about probably 50% in January, so about half of where we were a year ago. But you're right, it's going to ramp. We're seeing some of that improvement. A couple of weeks ago, we think was the low point. But it's now picking up to 70 in a week, but we should see continued improvement. Again, on the other side of the Chinese New Year holiday, we'll get a better view of things, as we always do. But we anticipate that this will continue to improve throughout the year, as China just kind of gets back to normal, and we certainly started to see that.

Okay. Well, best of luck. Thank you. I’ll pass it on.

All right. Thanks, Scott.

Our next question comes from Jeff Sprague from Vertical Research. Please go ahead. Your line is open.

Hey, Jeff.

Hey. Thanks. Good day, everybody. Hello. Hey, Jim, as you're well aware, right, there's a process going on out there for national instruments and a lot of speculation out there about your interest. I'm sure you're fairly limited on what you might want to say, but any color you could give us on your appetite for any deal at large or you've expressed interest in the past and hardware-related deals? Anything there make any sense for you?

Yes. So, I think, number one, we obviously, know the company and have read the news. So you're exactly right. We wouldn't comment on any process that we'll be involved in or not involved in, particularly a public one. But I would say this. I mean we've known NI for a long time. I can remember meeting Dr. T 15 years ago or so. So we know them well. We partnered with them at Tektronix and have for a long time. So I think what we've said strategically about all of our funnel was there was a balance of large, small deals, hardware and software. So we can -- the balance sheet is an incredible place right now, as you know. So we're in a great place to do things. But we're going to be disciplined. We're going to make sure that every situation we approach, we approach it strategically, how well that accelerates, what we want to do, and I'll leave it at that. But I think more broadly around M&A, we're in a very good place relative to our opportunities ahead of us. And we'll -- we certainly are playing offense in that regard.

Great. Thanks for that. And then just totally shifting gears. Just back to kind of the inflationary pressures in AHS. At this point, do you have the cost and other actions in place to be neutral or better as we move through 2023? Maybe just put a little finer point on how you see kind of price cost and kind of the margin impact playing out over the balance of the year?

Yes. So I think, more specifically around AHS, we called out a couple of kind of onetime headwinds in the quarter. We -- I think there's a number of things that are working in our favor relative to the 2023 year. Number one is North America. We had good growth in North America and anticipate that will continue -- we're not necessarily calling everything getting perfect in North America, but we do believe it will get better. And we saw that in the fourth quarter, and that's a good thing for our margin structure. And then number two, to your point, we're seeing a little bit more price realization in the fourth and into this year. Things are starting to get a little traction. We've talked about that on the call that it just takes longer, and we're starting to see that. And then finally, productivity. The team has -- that leadership team has really adopted FBS, and they've really embraced a number of things to really drive productivity. So, we don't see the additional inflation either as well. So the combination of we don't see incremental inflation at this point and we have those actions getting deeper and deeper into the margin structure, if you will, through the year. So, we feel like we're in a much better place starting here in 2023, both from a market and obviously, the kind of actions that we need to continue to make the business better. And I would just kind of ask, but we have grown gross margins in AHS -- operating margins about 130 basis points over the last two years. So, despite those challenges, we're in a good place. I call that the launch path from where we are today.

Great. I'll leave it there. Thank you.

Thanks Jeff.

Our next question comes from Nigel Coe from Wolfe Research. Please go ahead. Your line is open.

Hi Nigel.

Thanks, good morning everyone. Hey guys, how are you? By the way, [indiscernible] is going to be very happy, you put them in that competitive basket. So, just want to follow-up on Jeff's question, obviously, the National Instrument news is out there. Where do you stand philosophically on issuing equity for a deal? Because based on the math of we're doing -- your leverage will get to very high levels. So, just wondering, what is the leverage ceiling you prepare to go to for the right opportunity? And philosophically, would you issue equity for the biopsy?

Nigel, it's Chuck. We've always felt we want to maintain an investment-grade rating. And so we wouldn't do anything that -- on any type of deal that would jeopardize that. I've pointed out in the past, we've done equity instruments, like the mandatory convert. And we've always said that in situations where we want to do something, equity has never been off the table. It just hasn't been needed at this point.

Okay, that's helpful. And then just going back to the FY 2023 plan. How much of that $350 million surplus backlog are you sort of planning to eat into underpinning your plan? And then maybe just touch on the service channel SaaS transition. It seems like it's a very sort of discrete sort of intra-quarter, maybe 1Q first half event. These SaaS transitions tend to be kind of drawn out when we look at other companies. So, just curious why that would be so short-term?

Nigel, I'll take the first part. We would expect to take of the excess backlog that we're talking about probably up to half of it is included in the assumptions for this year in this guide. But to be clear, this is what we consider excess. And that's still -- we get more out if supply chains get better. So there's a little more there, but it's still constrained by supply chain throughout this year. But getting back Nigel on the service channel question, I wouldn't think of it as a SaaS transition. The SaaS revenue has continued to be good. It's just -- we grew the business well over 70% in Q1 of 2022 and so with a large amount of this just pass-through revenue. And so if you think about it, we have a customer. Some of our contracts have. We're passing through a number of amounts of the facility maintenance costs that they have pain plumbers or electricians. We're just doing less of that. And so it's really not a SaaS transition in the traditional sense. That we're replacing that solution, though with some other added benefits. And so we -- that's why it's a short-term transition. It's really kind of going from losing some of this one-time pass-through revenue and quite frankly, we didn't make any money on. So I would see it as that, and that's why it's short-term as opposed to sort of a conversion of what you'd see traditional license revenue to SaaS revenue. We're not going to see that. This is -- service channel is 100% SaaS revenue company.

Right. Okay. Thank you.

Thank you.

Thanks.

Our next question comes from Andy Kaplowitz from Citigroup. Please go ahead. Your line is open.

Good afternoon, guys.

Hi Andy.

Jim, you and Chuck mentioned increased productivity initiatives planned in all segments that primarily benefits the second half of 2023. I think you already mentioned FBS in AHS, but could you give us a little more color around what the bigger initiatives are and maybe size these initiatives for us? And then if there's any sort of cost to undertake these initiatives?

Yes, Andy, the first half, we'd expect to put up $20 in $25 million to $30 million of cost. See cost to get after some of these structural things. Some of them are looked up, a few of those, but there'll likely be some outside of the U.S. Maybe there are some regions that we want to convert to a dealer approach rather than a direct approach, and I'm thinking here in our health margins. We've always thought that there was cost that we needed to improve our go-to-market there. And we're just getting after that.

Got it. And then Jim, can you give us more color into what you're seeing by region? It looks like Western Europe has continued to be strong for you. We've talked about China and AHS, but outside of AHS is strong. So what are you thinking for 2023? You talked about orders slowing in Western Europe and North America, but are that more a function of supply chain normalizing? Or are more of your customers are little cautious to start in 2023?

Yes, it's interesting. I think we've always thought for the last several months that customers would inevitably start 2023 out a little more conservative just given we've seen some of the Tek layoffs and some of those things, the PMI and where it is. And so that's number one. That's number one. That's kind of a planning assumption from an order perspective. Now we also knowing that we had -- we're starting here with a good backlog situation. I would say, if you think about it regionally, Andy, obviously, North America is going to be pretty good and pretty resilient, given the fact that we have most of our software businesses have the predominance of their revenue streams in North America. And I mentioned the health care, particularly ASP North American story. So, North America is going to be pretty resilient I would say that Western Europe and Europe more broadly, probably a weaker area for the year, just given a number of things. Some of that is supply chains normalizing a little bit back to normal. Some of it is just a little bit of weakness as well. China is going to be good all year. Healthcare will be weak in China in the first quarter because of the actives but should continue to get better through the year. So that's kind of the regional play, and that's sort of our planning assumptions going forward. I think it's still early days. Obviously, a lot of the year to play out here. But that was -- that's sort of fundamental to our planning assumption.

Appreciate it, Jim.

Thank you.

Our next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead. Your line is open.

Hi, Josh.

Hi. We do this every quarter. Morning, afternoon, sort of depends. I hope everybody is well. Not to beat a dead horse on this hardware backlog conversion and sort of what's in the guide but not, but I just want to be clear here, Chuck, on that comment that you only have about half of the excess backlog getting worked down. I don't know how fungible that backlog is even within something like Tek where it's a little bit more weighted. But am I to understand then that like orders on a volume basis could be down close to double digits. And you guys are basically still hitting the guide if you can work down that backlog fully this year, providing there's no like other governor in the way? Is that sort of a fair way to think about how that's calibrated?

Yes. I mean, that's not what we're seeing here in there. But what we are seeing is reason we can't get the backlog down more, it's more supply chain constrained we've got so much material is the way I'm thinking of it. So if orders go down $10 million more, that doesn't necessarily change our revenue guidance. That's what you say. I would agree with that.

Got it.

And that's where going -- yes, I was just going to add that it's -- as you said, it depends on the business as you pointed out, a little bit more backlog intact. So it does matter where the orders go down relative to how we can make it off. So that certainly is part of it. But we ought to think of that extra -- the half that isn't planned to go out as an insurance policy, again some additional decline.

Got it. That's helpful. And then I guess sort of related to -- I think it was Jeff Sprague’s question on price cost. Maybe taking a step back and just thinking about kind of total bullet effect on supply chain. I would imagine there were some frictional costs last year that probably get better, but maybe you're also kind of working down some inventories. So, is there some sort of like offsetting absorption hit to the absence of those frictional costs? Or how would you sort of balance those two as a net headwind versus tailwind for this year?

Well, I would take it this way. There are some spot buy costs that probably go away from 2022, for sure. But there are some embedded costs in the standards that are going to be with us here for a while. I think the real thought is we're going to have price cost like we have been, we grow gross margins more in 2023 than we did in 2022. So in that sense, I think we're going to be as we've shown over the last several quarters, the media had -- we're not too worried from a factory absorption perspective. If that's -- if you're going in that direction, we won't worry about that. We'll really be focused on is making sure a number of commodities are down or will be lower, things like metals, plastics, but the majority of our buy is electronic components. And that will take a little bit longer to sort of wean ourselves from some of that inflation that we saw this year. So, we plan to -- I think we're super aggressive in that regard. We'll get after everything. We have great supply chain teams, but it will take a little while. But I think you're going to see that throughout the year as the gross margins continue to look good.

Got it. Super helpful. Best of luck, guys.

Thanks.

Our next question comes from Deane Dray from RBC Capital Markets. Please go ahead. Your line is open.

Hi, Dean.

Thank you. Good day, everybody. Can we put the spotlight on free cash flow by here? It looks like Fortive is the only company we've seen that is over delivered in the fourth quarter significantly above your 4Q average. And Chuck, you mentioned some working capital initiatives you could take us through that? But also there was a reference about collections pulled into the fourth quarter from the first quarter. So what was the dynamic there?

Yes, a couple of things we have always have a lot of work as you know, working at our working capital across all of our operating companies is the focus that we've had all year long and it's been -- it's been a challenge. It is -- it always is, but we've really done a great, ASP actually was a stand up there. So I think that's really what we were talking about there. But they weren't building ones. We had a couple of really good place. I wouldn't say pulling so much is really thinking about it as just some time. We thought we had a really, we did have a really strong guide, and we came in a little stronger that. There could be -- sometimes you just get your on receipts, sometimes they come in a little late and show up in Q1, this time, I'm probably think maybe $20 million came in a little early. You really can't do much about that. It's just whether sometimes when they cut the check before New Year's or after -- that's -- but we were very pleased with our free cash flow performance all year along.

Yes, it looks -- it came in at $107 million. So that's right in the sweet spot for you all. And then a follow-up question on cross-selling. Jim, you mentioned sensing having some success in cross-selling. Just kind of take us through what's going on there? How much is that encouraged, how do you track cross-selling? And what are the opportunities?

Yes. Dean, I think number one is, as you -- I know you know when we've seen a little -- in a couple of places, we've seen new loan book. When things get a little slow, particularly starting the year out. New logos maybe a little bit harder to grab on to as people maybe take a month or so to maybe an extra 30 days to close the business. But cross-selling and up-selling is something you can do every day. And so our Presidents are very much tuned in times like this where maybe things are a little bit more -- there's a little bit more ambiguity out there as to how the year is going to play out. The teams are really conditioned to really move the sales motion to more cross-selling and that really drives our net dollar retention. We talked about it in a couple of individual places we've got over -- we've got a number of businesses that are well over 105 now, we're about 102. So the metric we really used to drive that is cross -- is net dollar retention. And so what we're really pushed on early in the year is get those renewals, drive gross retention up and then drive the cross-selling and up-selling as well. So, I think we're well -- from a process perspective, FBS has a number of tools that support those efforts, with customer success organizations. That's a big focus for us here at the start of the year.

That's really helpful. Thank you.

Thank you.

Our next question comes from Joe O'Dea from Wells Fargo. Please go ahead. Your line is open.

Hi, Joe.

Thanks for taking my questions. Hi. I wanted to start just more macro and I think you know what you're talking about on the orders front is more just kind of backlog normalization as supply chain corrects. But as you go through that mean, how do you think about coming out on the other side? And how do you think that it's sort of soft-landing type of environment when we see sort of industrial production and we see PMI, so just in general, what you're seeing on kind of structural growth or outgrowth and kind of confidence that backlogs normalize and then the growth is there on the other side?

Yes. Joe, I think it really goes back. It will have an opportunity to really give a lot of this detail on our Investor Day in May. But I think what we really think about this is really how we move the growth rate on long-term through the cycle growth rate to mid-single-digits. So we got two really strong years of growth 10% average in the last two years. That's on the backs of a number of things we've done from a portfolio perspective and just demand has been better than historically. But as we get into 2024, and we normalize around the kind of things that we would see. We certainly would continue to see that mid-single digit as a number on the backs of continued stabilization of the macro for some of our product businesses obviously continued improvement in our healthcare businesses and just the strength of success that we've had in software. And those sort of combination pillars are really are going to be what really drives that mid-single-digit growth rate. As we said, as things normalize here, hopefully sooner rather than later.

Got it. And then I think in the prepared comments, you mentioned some actions to counter some of the slowing. You're not sure what might be happening on the cost front, but anything that you could expand on there?

Well, yes, I think as Chuck described, it's really kind of across the segments. And it really deals with a number of things. Certainly, looking at certain product lines that maybe are a little slower than over the next few years, we closed a couple of rooftops, continue to do some things on the lease front as we continue to consolidate our real estate footprint. So a number of those things are really what we're talking about. It's an accelerated rate, given kind of after a couple of years of 10% growth, we've may be more focused on the growth, maybe a little bit more focused on supply chain. But now as things start to normalize here, we're back to getting after some things, and in the traditional sense, we want to be ahead of those things, and that's really what we're talking about.

Great. Thank you.

Thank you.

Thank you.

Our last question will come from Joe Giordano from Cowen. Please go ahead. Your line is open.

Hi, Joe.

Hey, guys. Hey, how are you doing? I just want to follow-up a couple of things on the orders here. Particularly, let's strip out like the AHS and look more on the hardware stuff in PT and Fluke and Tek. What gives you confidence that orders in the second half of the year start to get better? I guess like just the revenue guide suggest that you exited kind of the lowest point of the year. And you said, Fluke -- Tek orders were up like 40% over a period of time here. So, like is it just going from plus 40 to normal levels? Is that like reasonable or like could you see declines in orders because of the magnitude at which they expanded over felt relatively short time?

Well, as we said, I think in the first half, we're going to see some of those declines as we described. And I might note, point-of-sale is still really strong. So at Fluke and Tek, we normally get that scenario in a coal mine question around Fluke. And quite frankly, Fluke's point-of-sale has stayed strong. So, we think that will moderate as some of the macro impact certainly moves that number down. But you're working on such high comps relative to the last few years is that any moderation whatsoever could make it look negative, but really, quite frankly, is not a significant issue relative to both the backlog and kind of where we're at relative to the historical perspective. So, yes, we'll -- some of that improvement in the second half is comps for sure, but some of it -- we think Sensing probably as an example, probably stayed a little rough through the year. And we get -- we know what the OEMs are doing right now. So, we mentioned in the prepared remarks some places in industrial, like industrial automation and some parts of the world like China. But on balance, when we look at the sum total of Sensing, Fluke, and Tek, we still think there'll be a little bit of improvement in the second half. But we don't need a big improvement necessarily to really deliver what we described. It is as we talked on a couple of the questions, we've got some backlog as an insurance policy against those things may be declining a little bit more than we anticipated.

Okay. So, you're saying it's more of a dollar thing. I mean more of a comp mask think than dollars, I guess?

That's right. That's right. I mean we're really looking at some pretty significant growth rates over the last couple of years in orders that were much bigger than our revenue numbers because of the supply chain issues and the creation of a bigger backlog. And quite frankly, a bigger pass-through backlog, which we started to burn down as we've talked about throughout the day.

Okay. And then just last for me. You talked about, I guess, theoretical M&A on the call so far. But if you were -- in a theoretical situation where equity was a component of a purchase, like how do you think about what your return hurdles would be in scenarios like that where equity is part of it?

Well, first of all, I think it's clear we're trying to convey here is discipline will continue to be the word of the day relative to M&A. And I think we -- our return hurdles are going to be what our return hurdles are. We've talked about 10% ROIC for the various kinds of deals, and we'll continue to think about that. I think what we've been trying to describe is situations in which we'll be disciplined. I think what you've seen in 2022 is the strong returns of that, certainly the most recent M&A that we've done for patient and service channel, beating their first-year numbers as an example of that. But also the deals that we did five, six years ago. that are just performing outstanding like Gordian and eMaint and Landauer. So, I think we're in a great place from a balance sheet perspective to deploy capital. And I would be much more focused on our discipline around returns and our discipline around accelerating strategy in places where we can really do that.

Thanks guys.

Thank you.

We are all out of time for questions today. I would like to turn the call back over to Jim Lico for closing remarks.

Thank you, Leanne and thanks everyone for spending the time with us today. We really appreciate -- we know you're busy this week with a number of things. I think what you heard from us today is a real sense of pride of what we did in 2022. We said 2022 is going to be a showing year and I think what you saw through the quarters and certainly in the full year numbers, the real power of the Fortive Business System and the building for us -- use the FBS tool to accelerate. We try to convey the fact that getting back into in-person Kaizen is something that's really important to us from a cultural perspective and from an ability to deliver in any sort of economic time. And that acceleration of in-person events we tried to demonstrate and show you some examples of that. We're back to work in that regard as we get into 2023. We look forward to continuing to share our strategies in May with you, and I think, what you'll see this year and what you're seeing in our guidance is the continued improvement in our portfolio and the strength of our culture in our business system. Special thanks to our 18,000 teammates around the world who made that happen and make it happen every day. Thanks, everybody. Have a great day. We look forward to the follow-up calls, and we'll see you soon. Take care.

This concludes today's conference call. Thank you for your participation. You may now disconnect.