ITT Inc. (ITT) Earnings Call Transcript & Summary

Good afternoon, and thank you for attending virtually the UBS Global Industrial and Transportation Conference. I'm Damian Karas from the UBS Electrical Equipment and Multi-Industry team, and in this session we'll be speaking with ITT. We're pleased to be joined by Luca Savi, Chief Executive Officer; and Tom Scalera, Chief Financial Officer. I thank you for taking the time out of your busy schedule to join us. For those listening who aren't familiar with the company, ITT is a roughly $3 billion in revenue, 15% EBIT margin and $5 billion market cap, diversified manufacturer of engineered components and customized technology, primarily serving transportation, industrial and energy markets. This call will be in fireside chat format with interactive questions and answers, so just a reminder to listeners, please go ahead and enter any questions you may have through the web portal. And with that, let's get started.

Luca, in these unprecedented times, maybe you could just start off by giving us an update on how you've seen things progress at your business over the last month.

Sure. So good afternoon, Damian. Good afternoon, everybody. Let me share some comments and developments and trends since Q1 by market, if I may. So when we look at the oil and gas and aerospace, we do not expect a meaningful recovery from these markets. We continue to outperform and focusing on outperforming in these markets. So for instance, if we look at the oil and gas, we outperformed in Q1, we will outperform the oil and gas in 2020. And when we look at aerospace, I'm encouraged by some of the good news that we've seen on the 737 MAX start-up. But in here is really where we have been very aggressive in adjusting our cost structure, both in IP and in CCT, and where we are shifting some of the engineering resources, for instance, from commercial aerospace to defense in the case of CCT. On the general industrial market, the North American short-cycle activity is weak. And as expected, I would say, we have the trough probably in Q2, Q3, depending on if you are talking about orders or on the revenue side. But still staying on the general industrial, we are encouraged by what we see in China, for instance, and showing expansion during the month of May. And also here in general industrial, we are focusing on outperforming and really in beating our tough competitors in the service that we are providing to our customers. Moving to the other 2 markets we are in. In terms of rail, rail has been a relatively stable market. And this is supported by the long-term secular trend. The KONI Axtone business, we have a lead that we own. We do have a leadership position in rail and we are happy on how we are performing in rail, how we have performed in Q1 and what we see in 2020 as well as the long-term visibility that we do have. We entered the year 2020 with a good backlog. And most of our 2020 revenue is already in our backlog. So that's good. Now on the automotive side. What we have done on the automotive is, usually, we like when we developed our scenario, we tended to adopt a more pessimistic scenario from some of our competitors or also from IHS. And the reason for that is to be more on the prudent side. If we can attack our cost structure more aggressively and then if the picture is better, this is going to be the cherry on top. I might say that I'm encouraged by what I see in China and also from some of the numbers that they came out, for instance, today in Europe. Let me elaborate on that. When we look on the European front, Europe is recovering in a different way. If you look at Germany versus the Southern European country because they've been impacted differently by the COVID-19. But today, came out the May vehicle sales for France, Spain and Italy, for example, which represent roughly 35% of the European car market. And whilst the decline was 55% year-over-year, this was a good improvement sequentially and also was better than what many expected. That is for Europe. North, that is still a little bit too early to tell. When it comes to North America, it's still too early to tell, but talking to some of our customers, they see pent-up demand, particularly when it comes to pickup trucks. And this is a segment where we are quite strong. So we might see some positive development there. And then when it comes to China, this is where I'm more -- I'm probably the most pleased in terms of their recovery that I see there. It's moving in the right direction. It's a very good recovery, a strong recovery. We saw good recovery in April. The CAAM, the China Automobile Association, actually came out with an expectation for sales in China in May, which is growth year-over-year. So that is vehicle sales that we'll have to translate in production, but eventually, it will. So we see very good recovery in China. And this is really what we have seen since the closing of the quarter.

That's really helpful color there. I guess staying on the China outlook, and it seems like you're most positive there, I mean maybe you could just elaborate on kind of what you're hearing from your customers on the ground. And it sounds like there might potentially be a path back to normalcy there this year. I mean what would that suggest, kind of, when you think about the new platforms that were in your backlog that, sort of, were expected this year and then this big vail of uncertainty disappeared -- or came up, I should say. Maybe you can just a little -- elaborate a little bit on the China business?

Sure. So when we are talking to our customers, so there are several things. We -- what we do, Damian, is we talk to our customers, of course, and we look at the market, we talk to the association, also, we look at some leading indicators. So for instance, our outlook, our order book and how the order book in the month changes from the beginning of the month to the end of the month, what we call the dilution factor. And what we have seen is that when we look at the data, this leading indicator, which is the dilution factor of the order book from the beginning until the end of the month, we see that is stabilizing. It doesn't change as much as it was changing a few months ago, and this is a very good sign. When you're talking to Volkswagen and the GM, you -- they are quite positive about the China market. And when you look at the production rate of some of our customers, German customers like the Daimler, the BMW or the Toyota or the Honda in China, actually during the month of April, their production went up month-over-month. So both from the customer feedback and from what we see from some of these leading indicators, the signs are positive in China.

Okay. That's very helpful.

And maybe one thing that I was forgetting to mention is that also when you look at the inventory level, even though the inventory level probably is a little bit too high, we were likely to see that there is an inventory index that they're measuring in China, which is a mix of a formula with different things. At the same time, it's lower than it was 1 year ago. So all of this is positive. Sorry.

No, that makes sense. Maybe you could also give us a sense on the corporate, the cost actions, you guys are targeting about $100 million, I think, on the operating side. Are you on track there? Does it seem like about half of that is going to be done by June, I think, is what you are hoping for?

Yes. So when we look at our restructuring actions, these restructuring actions are across the board. So you have that at corporate and you have them in each of the businesses. So when you look at the different regions, geographic region, you have the structural actions that have already been executed in North America fully on time, perfectly done by the business. Now when you look at some of the other regions like, for instance, Europe, just because of the legislation and the steps that you have to go through in countries like Germany or U.K. or in Italy, then we are on track, but they've not been fully executed yet. But all the corporate actions, I would say, as of today, have been executed, and they represent roughly 40%, 45% reduction in head count.

Okay. And thinking about margins, you've talked about targeting about 30% to 35% decrementals this year, inclusive of those cost actions you're taking. How should investors think about when we get to a demand recovery environment? Hopefully, you're growing top line next year, how should they think about incremental margins when businesses are actually recovering?

So you're very right. I mean at this moment in time, with this restructuring asset, we have been very focused on reducing the decremental as quick as possible and to get to the low 30s. And this is what this $100 million of cost reduction, which are 75% structural. Now, given the magnitude of the cost structure adjustment and the fact that many of these are actually permanent reductions and we are working hard to ensure that they stay permanent, we expect that the incremental will be higher than our decremental margin. So when practically saying a different way, when you're returning to the same level of revenue, then our margin would be higher than what they were.

Okay. So about 30% is what you would anticipate?

Yes.

Okay, great. One last question sort of on kind of what you're seeing right now. I think you had discussed your supply chain and actions you were taking. I think you discussed some rationalization and you're working on productivity efforts there. In the last month, has anything changed? Is your supply chain holding up across the business?

Yes. What we've done -- obviously, Damian, there are some difficulties. And therefore, there is more effort in the day-to-day management. And it's a little bit different for the different regions and the different businesses. But for instance, when we look at the Motion Technologies business, which is very resilient and where we have, in the supply chain, a good, let's say, redundancy system so that we build up in our backup scenarios. I would say that we have been able to manage the difficulties in the supply chain quite very successfully. In the other businesses, I would say, it is more of a kind of day-to-day management that we have to go through. We had some challenges, but we have been able to focus and to guarantee for the moment a supply chain continuity. And this has enabled us to deliver in our projects, for instance, in IP and also to our customers in CCT.

Okay. So I guess on that latter point, if we had, I guess, a quicker snapback on the demand side, I mean you -- would you foresee any roadblocks, I guess, just executing should the demand start recovering?

Not major. Obviously, we will have some difficulties, like for instance, when I remember when we -- when China started ramping up, and we were up and running on the very first day on February 10, and we had some challenges just because of transportation and logistics, just because you couldn't move in a certain way, you couldn't move from one region to another. You had to change the routes. There were not enough transportation. There were not enough trucks or drivers available. So we will have to -- we will hit some obstacles, and we will have to work hard to plan ahead to foresee those obstacles and have some backup plans. The fact that we went through the restart in China, the restart in Korea, the restart in Europe are all good lessons learned that we can apply also over here in North America.

Okay. Makes sense. Maybe we could kind of take it to the segment level here and starting with friction. You guys have obviously been gaining share in North America and China in recent years. Maybe you can discuss what you believe has been driving friction gains and what gives you confidence that you can basically double share there over the next 4 or 5 years. And along those lines, I'm just kind of curious if you feel like there's a natural feeling perhaps in terms of how far you can go, how much market share you can capture, just wondering about the OEMs and how they might be seeking to diversify their own supply chains, given the crisis and the environment we're in now.

Okay. So why are we gaining market share? So there is no silver bullet, Damian. When we look at our automotive business, the success, the market share gain, the profitability that we have is a mix of things. It goes from the concentrated manufacturing footprint that we have. We've got 5 plants to make a certain number of pads. Our competitors have got more than 15 plants. So think about our cost competitiveness that our cost structure, fixed cost structure. And how easier, less complex it is to maintain 5 plants running versus 15. So that is one reason. A best-in-class quality when we are less than 1 PPM of quality issues or a production, which is fully automated and standardized, every single plant, same equipment, same process. Think about if you have to implement a chain, it's easier when the process is exactly the same. And these are just some of the value-creation drivers behind Motion Technologies, superior customer intimacy and speed of response, on-time delivery, always 99%. So all of this has enabled us to take advantage of a gap that was in the market in China first, in North American after. Now when you look at the market share today, worldwide is 25%. Europe is more than 50%. China closed last year at 22%. North America closed last year at 19%, from roughly 0% 5 years ago, so that -- so there is room to grow. Now when you look -- so that is to answer your first -- the first part of your question, the former. The latter is there a ceiling there? Well, it's interesting because when I joined Motion Technologies in 2011, 2012, our market share, we were mainly a European company. Our market share was in a high 30s, 40%. And already, we'll say, okay, you cannot go higher than that in Europe. Today, we are above 50%. So I'm sharing this with you because if you're able to continue to differentiate yourself from the competition, if you're able to constantly perform and deliver for the customer, ensure that they have a frictionless experience when they are dealing with you, that you continuously create value for them and help them win I think that, obviously, you have to be careful because you cannot -- eventually, you hit the ceiling. But we have proven in Europe that you can go quite high. And I don't -- and personally, I just don't like thinking about ceilings. I like to think about what else can we conquer, where there is a gap. Let me give you another example. In Europe, light commercial vehicles. It's true that we got a very good market share in Europe. But in the light commercial vehicle, our market share is not that high. It's lower and this is a great opportunity for us to specifically target those platforms because with the e-commerce, those platforms or commercial vehicles will grow. And those platforms will have more aftermarket. So it's going to be more strategic in the long term. So there are opportunity to gain across the board in all the different regions.

That's helpful. While we're talking about sort of the opportunity there and market share, EV, and the ICE transition to EV is a topic that comes up a lot. Maybe you could just discuss some of your recent wins and address how you generally view EV as an opportunity and what the potential challenges are in this market.

So every time there is a technological disruption, it was copper-free a few years ago. It's going to be the change from internal combustion engine to EV now. It's an opportunity for a company like ours to leapfrog the competition, because of the strength that we have in our R&D, the in-depth knowledge that we have in the material science, and exactly the same way that we have done it with the copper-free, which we took it as a jumping point, jumping up point to gain market share in China as well as in North America, we are using EV in the same way. So what we see is that when you look at our market share wins, in the awards for electric vehicles, it's actually higher, considerably higher than what is our market share existing. So this is what makes us think that we will continue to improve our market share. Now the challenges that you have on the EV tend maybe, and I say -- I emphasize the word maybe, to be more on the aftermarket side. Because when you think about the aftermarket, I don't know if you have ever driven electric vehicles, I'm driving an E-tron, an Audi E-tron, fully electrical. And you don't use the brake pad that often, and that -- because you brake with the engine. So what will happen is that the replacement market is probably going to be affected if you keep the brake pad the same thickness, but what we've started seeing sometimes in the European market, for instance, companies like Daimler or BMW or others, they must start -- are requiring brake pads that have -- that might be larger, and I will explain it later why, but half as thick so that they can keep on having their service business and us going to the dealership and have this replacement business. So there will be the challenge on the EV more on the aftermarket, maybe. But when -- but on the OE side, I think that there is more of an opportunity. The reason why I'm saying that is because the requirement that you have on the EV are more demanding. Electric vehicles are completely silent, which means that your braking noise will not be covered by the engine. So the requirement from a noise perspective, you just must be perfect. On top, your rotor because you're not clean -- you're not braking on the rotor very often, rusts more. So the tribology, the material science between the brake pad and the rotor needs to be even more sophisticated. And because it's a heavier vehicle, then you might have a higher surface. So all of these requirements will be stricter. On top of that, I would say, I want to add also the point that when you look at the electric vehicles, probably the dynamic will become more and more material, I would say, probably between the next 8 and 12 years, Damian, because this is when we will see the electric vehicles more in the market, I would say.

Got it. That's really helpful. And that's also, I think, a good segue to this question about OEM versus aftermarket. And the aftermarket tends to be a lot lower volatility than you see in OEM. Given that what we've seen happen in the market with that volatility, do you anticipate you will continue to focus on the OEM side of the market as opposed to the aftermarket?

Yes. I would say, when you look at our split, Damian, we are roughly 65% OE, 35% aftermarket. And that 35% aftermarket is split roughly half and half between independent aftermarket and OES, what you get at your dealership. And we play aftermarket only in Europe. We don't play aftermarket in North America. We are trying a few things in China at this moment in time. So we are very much an OE manufacturer. And I want to emphasize this because when you look at the profitability of the business, we, of course, that the market is a little bit more profitable. But if I look at Q4 of 2019, our highest operating margin plant was actually our Silao, Mexico plant, which is only OE. So this -- so we like to be an OE manufacturer, we are profitable with this model. We put this strategy in place to win more in the aftermarket and the OES, but I would say we are an OE player and our profitability is even more exceptional because of that.

Great. Maybe we could switch gears over to IP. Luca, you highlighted earlier that you have seen like North American short-cycle industrial weaken a bit over the last month. When I think about -- when you talked on the project side of IP, you mentioned though previously that nearly -- it was just oil and gas that had been deteriorating a bit, but the rest of your markets, chemicals and industrial were holding stable. Have you seen those pressures on the project side start to creep in? And just as a follow-on to that, what -- barring a second virus outbreak later this year, like how would you think about on the product side, the growth trajectory as easing starts happening here, like are we talking a few quarters? Or given the nature of this business, are we talking longer-lasting impacts on the project side?

Okay. So when you look at in the short term, we think that the project work will be impacted negatively. Now when you look at the oil and gas market, what we see is that the oil and gas market this year would probably be impacted minus 25%, minus 45%. But we will outperform the market in oil and gas. We will probably be around flattish, maybe a little bit -- little negative, low single digit, flattish, but I would say flattish. And the reason why I'm saying that is because what we see is a very great performance in Q1. We've got a very good backlog already in our pocket, and we see how the funnel is evolving. I would say that for the moment, the project funnel looks stable. We had a good order intake in Q4, which was positive 13% year-over-year, and also in Q1 which was negative year-over-year, but over a previous year Q1, which was extremely strong. So I would say we're focusing on really executing well on this project so that we stay very close to our customers. And we are increasing our chances to win the follow-up orders just because of our execution. I was on a project review, for instance, of a project that we won in the Middle East early this morning, and I was pleased to see the progress that we are making on that project that might follow-up with additional orders in the same complex. So this is really what we are focusing on. Keep on executing on this project, executing well, ahead of time, flawless customer experience so that we increase our chances of winning more of the projects we have today in the funnel.

Okay. And I guess more generally speaking, how are you thinking about the balance of revenue growth versus profitability? And I look at today, you're about 75%, kind of, MRO and about 1/4 project. Is that sort of the right mix? Or could that vary over time? And also just thinking about all those end markets you kind of play in, is there any sort of increased or less -- or heightened or less focus that you would want to have on many of those markets?

Okay. So when we look at IP, I would say that we have a good list of activities to improve the profitability of IP. And I think that I'm very happy of how George and the team is executing. If you think about the IP, they improved more than 500 basis points in 3 years. We closed Q4 of last year at more than 14% operating margin. The margin of Q1 was 60 basis points improvement year-over-year, and this after compensating more than 100 basis points of negative FX. So we are on the right track. And what we are working on is really operating income resilience. So it's ensuring that, a, when you look at the project business, we are making the right decision upfront so stay close to our customer, with customer intimacies, win the right project, execute rigorously and diligently so that we deliver the proper margins on these projects. And this is really the game that we are playing. There is no percentage of -- I say, okay, we need to have this mix of projects and this mix. No, today, the mix is probably 25%, is our project business. But there is no dictate that we are giving, this must be the percentage. It's more a question of improving our cost competitiveness in operations, in supply chain, in VA/VE on the products and staying close to our customer. And this is what has really delivered improvement and the resilience that we have built and are building in IP.

Okay. That's helpful. Maybe we move over to CC&T (sic) [ CCT ]. A lot of questions kind of on commercial aerospace. So maybe you could -- and you alluded to before, Luca, that, you think you can outperform in that market. So maybe you could just elaborate on how you're thinking about that path for commercial aerospace, the whole 737 MAX situation. And then how you -- what gives you confidence that you can outperform in this tough market environment?

Okay. So I would say when -- the strategy here in ITT is really to take the model, the business model that we implemented in Motion Technologies and expand and adopt in IP and in CCT. So I think that what I was saying before is that we will outgrow the market in oil and gas, probably we will perform at market in aerospace. And the reason why I'm saying that is because in this transformation to the Motion Technologies way of operating, CCT is further behind. IP is more ahead. So I'm encouraged from what I see in the commercial aerospace with the Boeing restarting the MAX production. But I would say in CCT, we are further behind in terms of adopting the Motion Technologies model. So we will build an even more resilient CCT, but it will take some time to get there, Damian. I'm very comfortable on IP, outgrowing, outperforming. On CCT, commercial aerospace, I think that we will be at market, I think, in 2020. What we will do is also -- this is why also we have been more aggressive in tackling our cost structure at CCT than probably in the other value centers. And also what we are trying to leverage some of our engineering aerospace resources into defense where we see more opportunities in the short term.

Okay. That makes sense. Maybe we jump to sort of capital allocation, balance sheet type questions here. Before this pandemic's drop, Tom, I think you guys had said you're opening to levering up a little bit more, maybe around kind of 2x net leverage compared to historically, kind of, hung around the 1, maybe a little bit higher than 1 net leverage level. Should we still expect that coming out of this crisis? Or has your perspective changed?

Well, our focus right now is obviously liquidity preservation, and you've seen what we've been able to do there, Damian, $1.2 billion, strong balance sheet, good financial metrics, investment grade. I think it's not necessarily about the leverage target per se or kind of where we want to go, but really about valuations of the opportunities that we might see on the M&A front. So right now, obviously the market is kind of locked up. It's hard to get a lot of momentum around M&A cultivation, but we're certainly actively discussing with all the targets that we've had in our pipeline, and we'll see over time as the year unfolds if any of those close to core. Small, medium-sized targets might become more actionable, but we don't really see anything on the short-term horizon. So I think the goal for our balance sheet is very simple. We want to maintain an investment-grade profile. We could lever up to in normal times, right, 2, 2.5, even up to 3x and maintain our investment-grade rating if we see a good close-to-core acquisition that gives us geographic reach or technology in our core spaces that we want to build out. So I think we're in a good situation. Our balance sheet is very strong. We -- as you know, we've reduced our asbestos liability by 46%. We're under $400 million. We reduced our environmental liability by 64%. Our U.S. pension plan is 107% funded. So all of those "legacy obligations" have very minimal cash requirements to service based on the way we kind of proactively manage those, some settlements that we've negotiated with insurance carriers, good funding strategies. So we do maintain a good cash flow generation, as you know, and most of that cash can be used to fund our organic investments, which, as you heard Luca talk, ITT is an organic opportunity-rich company. And we still have the ability to gain share to drive our margin expansion. And our opportunity to grow and invest organically still remains, I think, very high relative to what you might see in other peers. So we'll continue to prioritize organic as time goes on. We've obviously moderated CapEx this year, but as time goes on, the organic investments are still plentiful. And when M&A kind of kicks back in, the valuations make sense. We certainly could look to use the balance sheet, but it's nothing that we see kind of materializing in the short term. And obviously, as you know, lastly, Damian, we don't see those opportunities develop, we have returned to shareholders, and we did quite a bit of that in Q1 this year, I think $73 million of share repurchases, plus a 15% increase in dividends. So we want to kind of maintain that redeployment to shareholders if we don't see the opportunity to invest elsewhere.

That makes sense. And I guess along those lines, kind of a specific question on, is there any signpost that you're kind of monitoring when you think about when you could resume sort of your buyback activity, the acquisition framework and all that?

Yes. We kind of set a little bit of the initial very simple. Let's get through Q2, take the pulse on the market, the dynamics, the customer sentiment, what have you and then take a look there and see how the balance of the year plays out, obviously, gain more information on market conditions and look at liquidity and all the other measures that go into making those kinds of decisions. So we don't have any kind of clear-cut formulaic triggers. But I think our view is let's get another read on the broader end market dynamics and see how things progress through Q2 and then take a fresh look and assessment. But I wouldn't say there's a hard trigger that we're using. We're obviously adding to our liquidity and maintaining good balance sheet discipline. And we just don't want to get ahead of recovery scenarios and market dynamics that are hard to predict. So we're probably going to look at it quarter-by-quarter. But the good news is we have the strong balance sheet, very strong balance sheet and a lot of flexibility and optionality to make those choices when we feel a bit more comfortable with the environment we're dealing in. I don't know, Luca, maybe you want to add to that thought process?

No, if I may say, very quickly, Damian, is that this is all about building resilience. On capital allocation in Q1, we increased our dividend by 15%. And we like to keep our dividend steady, and we have made no changes over there. In Q1, we also repurchased $73 million in terms of share repurchases. So -- and when we look at the liquidity, it's very strong. We're likely to keep it that way. And this is why we have a process in place where every day, we are reviewing our cash position worldwide. And every week, the team reviews it with me and the cash on the balance sheet as well as operating cash flow. How are we going to generate cash? How is it working, the receivables, the past due, the top 20, region by region, business by business? And this is how we are going to keep the strength of the balance sheet for when we are getting out of this crisis.

Got it. Makes a lot of sense. Well, unfortunately, we've run out of time. So I would like to thank you, Luca and Tom, and everyone listening for joining us today. I hope everyone has a great rest of your day.

Thank you, Damian. Thanks, everybody. Good day.

Thanks, Damian. Bye-bye.