ITT Inc. (ITT) Earnings Call Transcript & Summary

Good morning, everybody, and welcome to the Goldman Sachs Industrial & Basic Materials Conference. Thank you all for joining us today. I can't believe that it's a year later, and this is now our second virtual conference. Hopefully, this will be our last. My name is Joe Ritchie. I head up our U.S. cap goods research, multi-industry companies. And we're really excited to kick off the conference today with ITT. We have both the CEO, Luca Savi; and CFO, Emmanuel Caprais here with us today. I'm going to read out a disclosure to kick off our conference. Then I'm going to turn it over to Mark Macaluso from ITT to read the safe harbor statement. So really quickly, we're required to make certain disclosures in public appearances about Goldman Sachs' relationships to companies that we discuss. The disclosures relate to investment banking relationships, compensation received or 1-or-more percent ownership. We're prepared to read out loud disclosures for any prior issuer upon request. However, these disclosures are available in our most recent reports available to you as clients on our firm's portals. Maybe I'll turn it over to Mark to quickly read the safe harbor, and then we'll kick it off.

Thanks, Joe. Good morning, everyone. This presentation and our comments this morning may contain forward-looking statements that are subject to certain risks and uncertainties, including, but not limited impacts from the COVID-19 pandemic. All such statements should be evaluated together with the safe harbor disclosures and the risks and other uncertainties that affect our business, including those discussed in our Form 10-K and other SEC filings. Actual results may vary materially from the assumptions presented today. With that, I will turn it over to Luca to kick off.

Okay. So can we share the presentation as well, Mark?

Yes, shared. Yes.

Okay. So well, good morning. Good morning, everybody. It's a pleasure to be here with you, Joe, and with everybody. Let me give a -- spend a couple of minutes on ITT. Well, ITT is a diversified engineering and technology company, a manufacturer of components for niche and many times, harsh environment applications. We supply critical components to the industrial, energy and transportation markets. All our lives are touched directly or indirectly by one of ITT's products. When your daughter eats Nutella and gives you a chocolate-filled toothy smile, chances are that the Nutella was moved with our Bornemann twin screw pump technology. When you're looking in awe at your unborn child's image, chances are that the connector transferring the data is an ITT Cannon connector. Or when you're driving on the I-95 and then suddenly, you need to brake, chances are it's ITT's brake pad that are keeping you safe. ITT enables everyday life in unexpected ways, and we are doing so while we're driving outstanding value for our shareholders. Let me quickly share some hard facts. In Q1, ITT grew organically 2%, led by 17% organic revenue growth in Motion Technologies. ITT's operating margin was 17.5% in Q1, a 300 basis point improvement year-over-year thanks to operational excellence programs as well as structural cost reductions. And these drove incremental margin above 70%. We continue our strong cash generation journey with free cash flow up 71% year-over-year and a 16% 12-month free cash flow margin. With that, let me hand it over to Emmanuel.

Thank you, Luca. So as Luca mentioned, we had a really strong Q1, which gave us confidence to raise our outlook despite the challenges from a supply chain standpoint. So let me walk you through a little bit on each of our businesses. Motion Technologies' performance has been outstanding, with 17% top line growth generating sales that are higher than 2020 and 2019. This was driven by all our businesses within motion tech, with friction leading the way with nearly 30% growth with our original equipment business. And this is an outperformance of 1,500 basis points. We continue to win new platforms, especially in EV, with 9 new awards this quarter. From a profitability standpoint, we expanded margins at motion tech by 280 basis points versus the prior year, thanks in part to a strong performance in friction obviously but also in Wolverine and KONI. Moving on to Industrial Process. This -- Industrial Process has been a great story for us with margin growing 450 basis points versus prior year to a segment margin of more than 15% despite lower revenue, impacted by the pandemic, especially in oil and gas and chemical. However, our Q1 orders were 17% higher sequentially, and our book-to-bill was above 1.1x, which bodes well for the revenue in the next quarters. Finally, from a Connect and Control Technologies standpoint, this is a business that has been severely impacted by the downturn in aerospace, but we have started to show some signs of improvement with both Connectors orders and sales that are now higher than the prior year. So now if we move to the guidance page. As a result of all that I've described, we raised all the different pieces of our outlook with revenue growth organically, 5% to 7%. Previous margin, high end nearly becomes our new low end, and this is the same thing for EPS and free cash flow. So we are confident that we can execute this plan despite pressure from a supply chain standpoint and that we will more than offset, thanks to additional volume and productivity. With that, let me kick it back to Luca.

Over to you, Joe, for Q&A.

Yes, perfect. Yes, so thank you both for that introduction. [Operator Instructions] So Luca, maybe a first question to you. So my kids actually love Nutella. So love that you gave that example. But I wanted to start with the brake pad business. One of the questions that we get a lot from investors is the margins in that motion tech business are incredibly strong. And we consistently get the question, what is it about your brake pad that allows you to earn the margins that you earn in that business today?

Thanks, Joe. When we look at the friction business, our brake pad business, you do not have one silver bullet that is really justifying this exceptional performance, but is -- there are many factors that are helping in our differentiation and in our value-creation model. Let's start with our cost structure. So when you look at our manufacturing footprint, it's very concentrated. We have roughly 5 plants around the world. One in Mexico for North America, one in Wuxi, China for China and Asia Pacific and 3 plants in Europe for the European market. And when you look at the competition, the competition who make the same number of pads that we are making, they have more than 15 plants, so 3x as many plants as we do. So you can imagine the cost structure and the difficulties of running more plants, keeping them efficient and keeping them fully loaded. That is one factor. The second element is the level of automation that we do have in our factory. If you come to Barge in our plant in Italy, it's the biggest plant in the world manufacturing brake pad at the bottom of the Alps. And we have more robots than people. We have roughly -- approximately 400 robots, and you have less than 200 people per shift running in the plant. So a level of automation that is -- guarantee our competitiveness but also our quality performance. And this comes another differentiation factors. We are measuring our quality in PPB, in parts per billions. When I meet with our customers on a regular basis, they are showing in their two-by-two matrix, how many pads we are supplying to them compared to the competition and our quality in PPMs or PPBs. And we are there on the top, on the top of number of pads and at the bottom in terms of PPMs, so much better quality. All of these, combined with the technology manufacturing with a superior R&D in material science, help us really differentiating ourselves from the competition and allowed us to win market share and outperform the market.

Yes, Luca, that was a great explanation. Thank you for that. And I've been pushing Mark Macaluso, when things open up, I do want to make it out to Barge with you guys. So yes, count me in on that trip. The quick follow-on to that, right, is like, look, you've done a tremendous job. You started out -- the friction business started out as a very European-centric business, right? And over the last like 5 to 10 years has become a much bigger player in both China and in the U.S. I know that you have an intention to double your market share in both of those regions over the next few years. So maybe just talk about how you're going to be able to do that and what your progress has been over the last, call it, 12 to 18 months.

You're absolutely right. When we started, both Emmanuel and I started approximately at the same time in ITT in Motion Technologies and we worked together in MT. The business was mainly a European business. Our market share in China was really a few percentage points and the same was in North America. So the most important thing was really to invest in the region and to be in the region for the region. That has always been our strategy, to go to China not for cheap labor, to go to China for the Chinese market. And we invested there with the same level of automation, the same technology we have in Europe, we have it in China, we have it in Mexico. And that is another differentiation factor that help us compared to the competition. This has enabled us to really win market share in China from few percentage points to roughly 24.5% market share in OE friction in 2020. How did we get that? We invested in R&D, in being close to our customers and going to China with the same value proposition that we had in Europe. Think about if you are a German OEM, a BMW or a Daimler, and you have been to our plants in Europe. You're coming to China. You come to our plant in China and you see the same level of technology, the same level of automation, the same line, the same manufacturing, the confidence that you will have, knowing that it doesn't matter where that brake pad is made, it's going to have the same level of quality, the same level of performance. We have done that in China successfully. And we have done that in North America, where our market share at the end of last year was roughly 23%. And the confidence that the customers have in our approach, our ability to execute, really made GM give us the order of T1XX platform, both front axle and rear axle, and this is the largest platform in the world, whist we just had a piece of line in Mexico. We really didn't have the plant. We didn't have the line. They gave us that award and in less than a year, we built a plant. In less than 2 years, we had the lines installed, and we were executing flawless at the start of production.

And I would say, Joe, also today, we have enough infrastructure in Mexico and in China to be able to double their market share. So the only thing that we need to do is to add production lines within those plants to ensure we provide additional customer demand.

Yes. No, that's great to hear both of you. And maybe, Emmanuel, I just got a question in from the audience, and it was a question I was going to ask next anyway, so it's perfect. The performance from a margin perspective across your businesses has been really good over time. And what's really stood out is your ability in the Industrial Process business to make the progress that you've made in a tough growth environment. So specifically on Industrial Process, and then we can talk about the other subsegments as well, is -- the question specifically, is 2021 a year that you do 15-plus percent operating margins? Because we're teetering, right, right around that number. And then how do you think about the entitlement for this business longer term?

We've certainly started well 2021 with 15.8% in IP. And we're really happy with this because this is the result of really hard work. And we did this despite the fact that we have declining revenues. We pointed out in the quarter also that some of that performance was due to some nonrecurring items, which we expect -- we think that impacted the margin something like 140, 150 basis points. So the actual level of IP's margin is a little bit below 15% right now. So right now, we are focused on solidifying that level of profitability, which is not a small task, given all the pressure we're facing globally from a supply chain standpoint. But we have identified already a playbook. We have a large reservoir of initiatives in order to continuously improve efficiencies and reduce costs. And when we are ready to come out with a different target, we'll let you know. But for the moment, we're just focusing on making sure that we solidify that 15%.

That makes sense. Maybe just sticking with IP before we talk about the other segments. You talked about a third consolidation project. Can you maybe just elaborate where you see the margin opportunities in IP?

Sure, sure, absolutely. So in IP, we can start with the footprint consolidation projects that we have. As you mentioned, a third -- we kicked off a third one. We have one facility that has been fully closed in Europe. We have -- and 2 other ones that are going to be closing in the next few quarters, we expect to have the benefits towards the end of this year, full benefits in 2022. So that's one big item that's going to help us reduce our fixed costs. We have obviously an ongoing initiative in terms of sourcing. And we replaced completely the purchasing team in IP at the beginning of 2020. And 2020 was a really great year in terms of sourcing performance at IP. And we expect sourcing to continue to bring savings in IP for the years to come. We have talked also in the past about our VAVE initiatives, which is about redesigning the entire IP portfolio, and we are well progressing -- we are progressing well on this. We have kicked off -- we have commercialized already 2 redesigned pumps, and we've got great orders for our BB2 pump, and we're going to continue to do this. So the redesign of the product portfolio, we expect is not going to only help us reduce costs, but it's going to help us also from a commercial standpoint as we improve the hydraulic performance of those pumps. And then finally, I would say, we have the ongoing manufacturing efficiency projects that we have in each of our plants. Seneca Falls is one good example where we've really increased on-time performance, improved quality, and we're going to replicate that playbook across the world in all the IP facilities.

Great. That's helpful. Thank you, Emmanuel. Then shifting gears maybe to the other segments because there's a lot within those segments, right? So we talked a little bit about friction, but you have a rail business as well, within rail, several different components. And then you also have obviously the connector business, CCT business. When you think about the progress across the other pieces of the portfolio, maybe talk us through like where you think you've made a lot of progress and still have room to go. And then talk to us about some of the businesses that are still just starting to see improvement. And I think of the Wolverine business, for example, or parts of the aero portfolio within CCT and then where the margins could go for those businesses.

I go?

Yes.

Okay. So when we look at Motion Technologies, we have a good platform within Motion Technologies, which is rail, as you rightly pointed out, Joe. Rail is roughly, today, a platform in excess of $200 million, around $200 million, I would say. And our goal is really to create a platform of $500 million, $600 million through organic and inorganic acquisitions. Our profitability here is in the teens, and we have seen good improvements in the KONI profitability. In Q1 this year, we had actually a headwind in Axtone, which was an acquisition that we made in 2017, where our margin actually declined 30 basis points, and we were not able to compensate the increase of raw materials in Axtone as yet. Having said that, Axtone had an excellent year in 2020, improving the profitability, being double-digit. So you have a business which is double-digit profitability, but there is no reason why this could not continue to improve to go to a similar level to what our friction business is performing. When it comes to Wolverine, Wolverine was an acquisition that we made in 2015, and it improved triple digits in Q1 of this year, made very good improvement also in 2020. It was hit hard in 2019 because of the tariffs. But even this business is in the low teens and has got room to improve in terms of margins. When you look at the business in CCT, we have the connector business, which has already given a good sign in terms of the recovery, a good sign in terms of orders in Q4 of last year, Q1 of this year, good revenue growth and also good orders growth. And despite the fact that the level of revenue is not back to the same level pre-COVID, our margin is already at pre-COVID level for the connector business. Even though on the Connectors, we are a small competitor, if you compare to -- a small player if you compare to some of the big players in this sector, we believe that there is no reason why we shouldn't achieve the same level of profitability because the way that we play and how we play. So it's very niche, very engineering, very close to our customers, and therefore, we think that we can achieve the level of profitability. Obviously, when you talk about the aerospace, we are not there today in Q1 in terms of profitability, not where we were in the past. And this is mainly because the sector has been impacted heavily by COVID, but it will -- Q1 was the last quarter of decremental margin. And what we will start seeing in Q2 is really a good incremental also for the aerospace and CCT.

That's great to hear, Luca. And I guess maybe just a follow-up on that. So Connectors, I thought of your connector margins as being low double digits, both -- prepandemic. Am I kind of ballpark, right around that? Is that where we are today?

I would say it's more mid-teens.

Okay. Okay. Great. So that implies that the aero business is maybe high single digits, low doubles. And so there is a lot of opportunity there because that business, at one point, was, I think, had a 2 handle on it, at least high teens, but possibly a 2 handle on it. Is that fair?

Very, very, very fair. Very fair.

Okay. Can I ask then -- maybe just shifting gears because you made the comment about rail. And it was interesting to hear your desire to expand that business and to scale that business. It was interesting to hear you on the most recent earnings call also talk about your potential aspirations to get bigger in aero, right? So maybe talk a little bit more around like your M&A ambitions at this point and where you see some ancillary opportunities across the portfolio, whether it's technology or channel, however you think about it.

Okay. So absolutely, aero is one of the platforms that we are looking in terms of acquisitions. And here, we made a few small acquisitions on the composite material. We made an acquisition in the U.S., Matrix in 2017 -- no, in 2019, sorry. And that is a specific technology that they had, proprietary technology in the composite material, working on the structure as well as on the engines. And so the composite material is an area that we continue to look at as well as other technologies and as well also in the connector side. So those are the areas where we are looking in aerospace. We are very active on the cultivation side. And what we have found still, Joe, is the valuation are still on the high side. So it's important for us to be very rigorous in our process, both strategically in terms of is this technology something that fits or -- and -- but also strategically, but also financially, is this acquisition be able to create value. So technology is one element. And the second element is also geography. We do have -- we are probably more on the U.S. side and the European and the business with Airbus is something that can be expanded and developed even further. And of course, together with aerospace, you get also some defense business, a business where we are traditionally quite strong because of the ITT legacy.

Got it. That's helpful. And then I guess the follow-on question would be, Emmanuel, what kind of comfort level do you have in terms of just expanding the balance sheet and the type of capacity that you could have at this point for M&A?

Well, as we mentioned in the call last Friday, the great thing with ITT is that we can do all things, right? We can increase our CapEx, which are providing us the best returns and the lower level of risk. We can increase our repurchases like we did in Q1. We did $50 million. We can increase our dividend. We increased by 30% in 2021. And we can still do acquisition with the amount of cash we have. So I think that, for the moment, we have something like a little less than $800 million in cash on our balance sheet. We have a $1.5 billion liquidity. So we have a significant level of comfort in terms of using our cash. And before we face a situation where we have to borrow, we have significant opportunities in front of us. So for the moment, we are pretty comfortable in terms of leveraging our balance sheet. Obviously, we want to stay investment grade. But we believe that complementing our business from an inorganic standpoint is essential for the strength of our business.

And Emmanuel, maybe just on the off-balance-sheet items, like the pension, asbestos, is there any update that you want to provide there either on pension funding or whether there's any progress made on the asbestos liabilities?

Sure. So on pension, specifically the U.S. pensions, we really were happy to be able to offload that liability from the balance sheet, and we did that in Q4 of last year, and it cost us only $8 million. So we're freed from any pension -- U.S. pension obligation. And this is great because it's going to provide our retirees and pensioners, great service, probably better service than what we were providing before. From an investor standpoint, we are also very proud of what we've done because we've continuously, over the years, reduced the liabilities through strong management. I believe in 2015, we consolidated defense -- our defense under one firm defense strategy, which has allowed us to really reduce significantly a liability by $100 million. And we're going to continue to look for opportunities to further reduce that liability. And so we're very active in managing that asbestos liability.

Great. Switching gears back to Luca. So Luca, EV is a big part of the story, EVs, hybrids over the next 10 years. You guys highlighted 9 wins this past quarter, I think 42 wins last year. Talk to us about like the progress that you're making on EV specifically and then -- and how you think about that as an opportunity or potentially a structural concern for your business over the next few years.

So when you look at EV, I see that as an opportunity for ITT. It's true what people are saying that with the EV, it's likely that there will be an impact in the aftermarket. That's probably true. When you look at our friction business, we tend to be mainly an OE player. So when you look at -- as an OE and EV, the requirements on the breaking, the requirements on the brake pad will become more and more stringent, more and more sophisticated. Think about it. When you draw -- when you're driving an EV, an e-tron or a Tesla, it's very silent. You don't have any noise from the engine, which means that the breaking, the requirement on the noise of the breaking is going to be even stricter. So there is going to be more requirements, stricter requirement on the noise because you're using less of the brake and your rotor will rust more, there will be more vibration. So the tribology, the material science, the link between the brake pad and the rotor is going to be even more critical. So for that reason, I think it's an opportunity. Exactly for that reason, we opened in China our research and development focused specifically on brake pads and material science for brake pads for electric vehicles because China is the largest market in the world in terms of automotive, and it will be the largest market in the world for EVs. And we're making good progress on that. The last point I would like to make on EVs is that when you look at our win rate in awards, our market share -- our win rate in awards for EVs is considerably higher than our current market share, which makes us confident that we will continue in our path of outperformance and market share gains.

Yes, that's an incredibly important point. So on that point, and I know that you guys outgrew the market, global auto production by 1,500 basis points this quarter. I know that there's some reluctance, I think, to give a number, markets still very fluid given some of the supply chain constraints, but maybe just talk about your confidence to continue to outgrow, particularly in North America as the year progresses.

Sure. I think that when you look at historically, we have outperformed the market in average for the last 9 years by 880 basis points. Now we are confident that we will continue to outperform the market in 2021 and in 2022. And the reason why we are saying this is because really the way that the dynamics work. So we usually win the award, Joe, and then the start of production is really 18 to 24 months later. So if you're executing properly, if you're doing the right things and delivering for the customer, means that you know what you're going to produce in the next 2, 3 years because you have won those awards last year or 2 years ago. And therefore this is what makes us confident that we will continue to win market share across the region, obviously North America and China but also a little bit in Europe, even though at a different level, just because the relevant market share that we already have in the continent.

Yes. That makes sense. I love the precision, Luca, 880. Couldn't even round up to 900.

Well, when you're in engineering, it's difficult to take that out of your DNA.

No, I love it. I love it. Emmanuel, I'd be remiss if I didn't ask you about the headwinds that you're seeing from an inflationary standpoint. You talked about $0.25 to $0.30, I believe, for the rest of the year. I think that's mostly in the friction side of the business. Maybe just talk about what you guys are doing from a either pricing or productivity perspective to help offset some of that. And then does that help you next year?

So yes. So we're seeing quite a bit of raw materials inflation, commodities inflation, mostly on steel, copper and tin. We -- so this is mostly impacting our friction and our Wolverine businesses. And so we're -- we were covered, we hedged steel all through the year, and we have rolling 6-month hedges. So the -- our hedge with lower price levels ended at the end of Q1. And so now we're slowly but surely facing the impact of inflation starting in Q2, and then it's going to intensify in Q3 and Q4. As you mentioned, this is an impact on our guidance of $0.25 to $0.30. So what we're doing about it. The first is productivity. For sure, productivity has been a strength of our model, of our business model, in Motion Technologies but also in the other businesses. And so we're driving hard productivity, whether it is shop floor productivity or even also materials productivity. One of the items that we talked about a little bit in the past is that we're removing copper content, for instance, from our brake pads not only to serve an environmental purpose because right now, all the brake pads will move copper-free but also it is a nice advantage in terms of cost. And then there's the commercial piece that we're doing. So let me start first with IP and CCT, where we have a lot more margin in order to go to our customers and request price increases, and we're pretty confident in our ability to do that. In Motion Technologies, on the rail business, we're also pretty confident that we can get price increases from customers. On the friction side, it's going to be a little bit more difficult. And the reason for this is because this is a very, very competitive environment. And you usually -- customers hear from you to decrease prices, not to increase prices. And so here, we have significant competitive advantages. One of them is our cost-competitiveness. And so our plan is, is to try to reduce the price erosion with our customers to a lower level in order to offset some of the headwinds we're taking from a commodity standpoint.

Got it. That's helpful. Basically, my one last question, and I know I'm not -- you guys don't want to put out a new margin target today, but it just seems like your portfolio is kind of heading towards 20%, something with a 2 handle on it potentially over the long term, right? At least, that's my view. What do you guys think about the free cash flow side of things? Like how do your -- how can your free cash flow margins change over time? Where is the opportunity? And if you were to do 20%-type OP margins, what could free cash flow margins for the business be?

So we -- in Q1, we've just cleared the 17.5% ceiling. And so we're very happy about this because really, this is a step-up in profitability. So we're not ready yet to issue a target for 20% segment operating income -- margin. But we're definitely working really hard to raise the margin profile of ITT overall. And keep in mind, Joe, that we reached 17.5% at segment operating margin with the CCT margin level at a little above 11%, where you remember, prepandemic, this was more like a 17% profitability business. So obviously, we have a lot of room to grow. In CCT, we said that we can recover, but we need a little bit of -- we can recover to that 17%, but we need a little bit of aerospace volume to come back. From a free cash flow standpoint, we increased our guidance in terms of margin to 11% to 12%, which is a significant improvement. I would say that we see further room to improve, and this is mostly in terms of working capital as a percent of sales. We have significant opportunities in our businesses to reduce working capital. And so that should help our free cash flow profile. In IP, we are -- we have, we believe, best-in-class working capital at 20%, and yet, we see more opportunities to improve. In MT, we have also other opportunities, even if we're at a really good level. And CCT really is where we have significant improvements to make from an inventory standpoint, from a receivable standpoint. And then so focusing on improving our working capital is going to be a main driver for improving the free cash flow performance of ITT.

Sounds good, Emmanuel. Luca, Emmanuel, Mark, I know you're back there as well, thank you. Thank you all for spending time with us today. Have a great rest of your week, and we'll talk soon.

Thank you very much, Joe. Appreciate it.

Thank you, Joe.

Take care. Stay safe. Bye-bye.

Bye.

Bye, guys.