ITT Inc. (ITT) Earnings Call Transcript & Summary

Good morning, everyone. I'm Damian Karas from the UBS multi-industrials research team. Thank you for joining us for our Global Annual Industrials Conference. Very pleased to kick off today's conference with ITT. We have joining us, Emmanuel Caprais, CFO. So I will turn it over to Emmanuel to kick off with some opening remarks.

Thank you, Damian, and good morning, everyone. I'm going to start with some forward-looking statements. Our presentation and comments may contain forward-looking statements, which are based on our best view of the world and our businesses that we see them today. These assumptions and expectations can change, and we ask that you view them in that light. We encourage you to review the latest risks and uncertainties in our Form 10-K and our other SEC filings available on our website. Thank you.

All right. So now that we got that out of the way, it's really good to have you back, Emmanuel.

Thank you, Damian.

It's been quite some time since we've been able to do this in person. So I really appreciate you coming back.

So maybe we could just start off talking a little bit about recent trends, right? It's about a month since you reported results. We're hearing some signs of improvement with the lockdown situation in China. Could you maybe just give us a sense on how things are trending since the first quarter?

Sure, sure. So we are in a very strong demand environment, and we see also good commercial momentum. So if you look at IP, our industrial pumps and valves business, we have -- we see definitely strong orders from a baseline pump standpoint and from an aftermarket standpoint as well. Connectors also are very strong, and we see really strong demand for our products in distribution across the board; in defense, especially defense OEM; and then also in oil and gas. From an aerospace standpoint, we continue to see the recovery we've seen in Q1. And some of the strength we've seen in orders also is coming from the price capture we've been able to do, especially with our distribution customers. From a revenue standpoint, we expect that will be slightly up in second quarter versus Q1, and this is mainly thanks to IP and CCT. In CCT, those guys are focused on converting the backlog. And we see also some pretty good book-to-ship activity also in the month of June. In IP, we expect that we -- our revenue in Q2 will be stronger than in Q1. You may remember, in Q1, we had a very difficult January and also a difficult beginning of February because of Omicron, and that created a lot of absenteeisms in our factory. We started Q2 much stronger than that. And so if you look at our April revenue -- or April shipments, they were stronger than what we did in January. We continue to be hit by supply chain disruptions. Especially in IP, it's very difficult to get seals, to get casings, to get motors. But -- so that's why we're focused on accelerating our internal velocity in our factories. And so we expect June to be a fairly strong shipment month for IP, but certainly, we have the backlog for that. So we get a convert. It's very difficult still to get pricing from customers, especially in MT, but we're making progress. So -- and at least, we have all the customers at the negotiation table, which is very good. And then raw materials are moderating, but it's not enough to give us a benefit on the bottom line. So overall, this is obviously impacting MT the most, and we expect MT margins to go down in Q2 versus Q1. And we expect overall EPS in Q2 to be fairly in line with Q1 and growing low single digits versus our prior year.

Okay. Great. That's really helpful. Maybe just a few finer points around your opening there. So with respect to IP, you mentioned April much better than January, and you're expecting a really good May. Is it fair to assume that typically, the -- if you think about the kind of concentration for the quarter, is it usually June where you would kind of be more concentrated versus earlier in the quarter?

So typically, we have strong last month in the quarter. So June -- so in this case, June, we expect it to be stronger than what we've seen in April and May. We have more days usually in June also. And then also for projects, what happens is that we try to schedule -- we schedule a customer validation towards the end of the month. So that's why, usually, in the last 2 weeks of the month, we see some stronger shipping activity as customer verify all the pumps before shipping.

Makes sense. And then on the MT margins, you mentioned kind of a step down in the second quarter. But are you still kind of expecting that 2H uptick where you start getting some of the pricing to offset the inflation that you have?

Yes. So obviously, Q2 has been very difficult for MT. We had the lockdowns in China, and those have lasted a little longer than we were expecting. But it looks like June is recovering, especially compared to what we've seen in April and May. So we expect in the second half that those lockdowns are behind us. So that should provide incremental activity sequentially from an auto standpoint. And then the price capture continues. As I mentioned, it's very difficult to negotiate with OEM customers. But everyone is talking to us, which wasn't the case in Q1. So we still have a lot of work to get pricing from an MT standpoint, for sure.

Okay. Makes sense. I'll ask you a little bit more about pricing later on. But not to be a Debbie Downer here, but there's a lot of recession fears out there in the market. If we do have sort of this inflation-induced demand slowdown, just thinking about your portfolio, in theory, you're getting these longer-cycle IP awards, winning a lot of those right now. Obviously, commercial aerospace is much closer to trough than it is the prior peak. And arguably, auto production is sort of this deferred cycle. It really hasn't had its recovery cycle yet. So what would you say a recessionary scenario could look like for ITT?

Well, let me say that, first, let me start by saying that I think we've demonstrated, especially in 2020, that we have been able to manage a recession with a lot of diligence and with a lot of speed in terms of adjusting our fixed cost base. And so in the event of such a drastic scenario of an economic recession, we'll be ready to adjust our cost base, for sure. I would say, from a market standpoint, I think you're right. When you look at things from a macro standpoint, the auto production globally is around a little bit more than 70 million cars. And pre-COVID, we were around more than 90 million. So it feels that it's going to be difficult for this number to go down further, especially given the inventory that we see that are really low in North America and in Europe, and then the lockdown in China probably didn't help with the inventories also. So we think that on an auto standpoint, there's a lot of pent-up demand. From an aerospace standpoint, it's true, it's recovering. And so also the recovery could be stalled. But I think for the moment, there's no indication of that. In fact, we see the demand from Boeing, from all the Tier 1s to be pretty strong. Boeing, as expected, has gotten rid of all the excess inventory that they had talked about in 2021. And so we think that aerospace is going to continue to grow as well as defense. And then if you look at the industrial process end markets, oil and gas is in a situation where there's not enough capacity. The only open capacity that they can be -- that really can increase production is in Saudi Arabia, and I'm not sure they're going to open it up. So I think it's going to create a lot of investments and continue to create a lot of investments. And this is why we see oil and gas pipeline for projects to be fairly strong. So overall, I would say that entering a recession, our markets seem to have more upside than downside, I would say.

Okay. Well, that's good to hear. So maybe we can begin the segment conversation with Friction and kind of go back to this price discussion, right? You've talked about these tough negotiations with the OEMs. Is it fair to assume that some of these concessions that they're giving a little bit is kind of -- is that kind of happening across the board in the Friction market? Or do you think that you're kind of maybe gaining a little bit -- your positioning is unique there? And I guess thinking about the new bidding process, right, like historically, I know it's been pretty competitive in Friction. Like have you noticed any changes when you're bidding for these new awards?

So I think that every time we have negotiations with our customers, we remind them that our quality level is second to none. Our on-time delivery, as we mentioned for several times, is if it's not 100%, it's 99%. And so those are really differentiating factors. And so when we have the negotiation for price increases, we make sure the customer recognize that. And then so I think that in our negotiation, we really try to push that differentiation. And we expect that from a price recovery standpoint, customers are going to differentiate also. From a new business standpoint, we are very careful in adjusting our cost base to make sure that when we offer price for our customers, this reflect the expected level of margin. And so we've been very attentive to this. The environment is fairly -- still fairly competitive. The reality is that our peers, as you know, are much less profitable than we are. And so you wonder in such an environment, where there's a lot of pressure from a cost standpoint and customers are not really giving price increase and even less price increase to suppliers who are not really differentiated, I can't really believe that this is helping them. And so I think that we're very careful to continue to showcase the differentiation we have. And in some cases, if we can, we'll go after a price premium.

Fair enough. And just hypothetical here, so let's just say, tomorrow, all of a sudden, these material prices start deflating, coming down hard, right, supply issues ease, what does that mean? Does that mean that your OE platforms that you're executing on will also have a price adjustment? Or should we just be thinking more the new award bidding process where it will then get reflected?

Yes. So I think the situation we're in today is that, as I mentioned, we have fixed price contracts. So that means that the prices that we are -- the commodity costs that we're experiencing today are coming from prices that we fixed back in Q4 of last year and in Q1. So there's a little bit of a lag in terms of us benefiting from raw materials prices going down. I think that in our conversation with the customers, it's very tough to get 100% coverage. So we're less than 100%. And so the conversation we're having and we're going to have with customers is that if they're going to compensate just a portion of our cost increase, then we expect when our costs are going down that we're going to be able to recover that whatever percentage they didn't cover through price increases. And so it's going to be a one-on-one -- it's a case-by-case negotiation, but this is really the approach we're going to take. And so at some point in time, if you see a real reduction in commodity pricing affecting our cost, then over time, we would have to adjust our prices down, but being mindful of the overall equation where when it was going up, we didn't get 100% of the recovery, so we'll be looking to get the missing piece on the way down. And then for new products where we have to give the price -- the commodity cost that we are taking as an assumption in our prices that we give to them, and then so it will be fairly transparent how we adjust. We're paying attention to really learn our lesson from what we're seeing today. And so we're really making it clear with our customers that our new programs, we expect more compensation than what we're seeing today.

Got it. Got it. Well, it's good to hear that the auto manufacturers are giving a little bit. It seems like the sensible thing to do in this market environment. You kind of alluded to that your competitors that are not nearly as profitable probably aren't faring so great. I mean being sensitive to the obvious pain and suffering that this pandemic has brought to many people around the world, would you say that, ultimately, the pandemic and all these associated supply chain disruptions that we're living with like is ultimately a positive for the Friction business, if you think about your ability to deliver much more quality and efficient product? Or do you view it as it's actually kind of gotten in the way of you achieving what you would have liked to achieve in the market?

So I would say that every market disruption is taken -- we take advantage of every market disruption. So that means that here when -- at the height of the pandemic in China, when it started in China, our customers were unable to get brake pads from our competitors, we stepped in and covered that 2 to 3 months that they were unable to get their operation back in order. So definitely, in this case, our on-time delivery and our customer centricity played a very important role. And then you've seen in 2020 and 2021 that we would significantly outperform the market. And I would say, in general, the theme is that whenever there's a market disruption for Friction, we tend to really take advantage of it because we're faster and we're stronger than the competition. We've seen this for the copper-free disruption when we went from copper brake pad to brake pad without copper, where we were able to find a formulation that was -- that didn't have copper, replaced by several components and that we found that much quicker than anybody else. So we were able to capture a lot of market share. And then so much that as of today, we have a little bit more than 50% of our brake pads that have no copper in it on an OEM standpoint. So that was a pretty quick transition when you think that we first started in 2015, 2016. And in general, same thing for EV. On EV, we are focused on elaborating a specific formulation that takes into account the fact that the vehicle doesn't produce noise, the fact that the vehicle is heavier and the fact that there is a specific characteristic that the brake pad needs to have in terms of cleaning the rotor. And so that's why you hear us report on our 10 to 15 EV platforms that we win consistently every quarter. So I think that this is a business that is very much in tune with what's happening to our customers and ready to serve them so that we can win over our competitors.

Yes. A few follow-up questions on EV. So you're winning a high proportion of the new awards out there. Historically, when you -- ahead of execution, delivery of these new awards, there's a large investment spend that ITT has to make. Is that any different for EV versus ICE as we think about this large EV ramp that's supposed to happen over the next 5, 10 years?

We've been very careful as we've been developing our EV product offering to maintain the exact same process, production process, than regular conventional vehicle, ICE vehicle. And so as a result, from a infrastructure -- production infrastructure standpoint, we don't require any more investment. It's exactly the same production process. And so for us, we have facilities around the world. All those facilities are equipped with the same type of equipment. So that means that gives us a lot of flexibility on how to allocate production. And also, as you know, we have our newer plants in Wuxi in China and then also in Silao in Mexico, which are -- we still have a lot of open square footage. So we're able to put additional machines for additional production. In Silao, for instance, we probably are occupying something like 60% of our total surface. So you can tell we have significant room -- runway for growth there.

Right. Okay. And you've been mostly focused in the past on OE versus aftermarket. But I believe you've made some comments recently that you're maybe exploring some opportunities in the aftermarket in China, for example. Now I guess one frequent investor concern out there is that there's this longer life cycle for pads on EVs and on ICE vehicles. So how do you -- how are you evaluating the strategic decision, whether you pursue the aftermarket at a time when we're moving more towards an EV world?

Yes. So in terms of aftermarket, I just want to make sure that everybody understands the picture. So today, our aftermarket is predominantly in Europe. And we supply mostly the premium cars, so all the German manufacturers and all the premium models for the other vehicle manufacturers. We do export indirectly some of those brake pads because some of those models also export to mainly North America. So we do have a little bit of a sales market in North America, for instance, for our European brake pads. In China, you're right, we are looking at the China market from an aftermarket standpoint. We recently partnered with a distributor. And we're really focused on what makes the aftermarket model successful for ITT. So for our Friction business, what's successful is that we're focusing on producing the brake pads. This is what we're good at. We're not good at distributing. We're not good at marketing. This is for others. And so that success, we're looking to replicate, if we can, in other parts of the world. And we feel that in China, this is -- we found the right partner for that. And so right now, we're initiating. We have -- we are setting up the entire supply chain. And also, we're looking at the cadence of supplies with our customers -- with our customer. And so we're in the initial stage, but we're very encouraged by what we're seeing.

Okay. And correct me if I'm wrong, the aftermarket brake pad business in Europe is actually the most profitable piece of...

It's very profitable, yes. That's very profitable. So -- and then going back to your second question on the EV, so I would say the jury is still out in terms of aftermarket. What we're seeing today from our OE customers for new EV platforms is that you have a majority of manufacturers who are just replicating the braking system that they have on ICE vehicles. So not much of a change. You have some customers that are actually asking you to design a thinner brake pad. And the theory behind this is that if you design a thinner brake pad, then if you apply less friction on it, you'll still continue to have this replacement cycle that you had on the larger brake pad when the majority of the braking was done by the caliper and not the regen braking. So we're seeing that. And then we're seeing some other customers, and this is a very minority, which says, you know what, from my EV, and this is mainly what we see with Tesla, you're going to have brake pad for life. But this is really the minority. So the jury is still out. I think that brake pad replacement for our customers, OE customers, is so crucial in their aftermarket revenue flows that I think they're going to find a way to maintain that revenue. And I think we could be standardizing around a thinner brake pad for future EV models.

Interesting. So presumably, if it's to kind of maintain the same revenue level, these lighter brake pads, while they would have less materials, would it still effectively sell at the same price because of heightened engineering, this friction science?

So today, what we're seeing for the same brake pad for the same -- between EV and ICE vehicle, the brake pad, as I said, have the same thickness. The electric vehicle brake pad are a little bit more expensive. The reason for this is because they're bigger, so there's more content. And the reason for this really is because the electric vehicle is much heavier than an ICE vehicle, so there's more mass that you need to stop, right? And so as a result, I would say that if you have a thinner brake pad, you would step down from this more elevated price levels that we have currently on EV. And it's probably too early to tell how this would compare to ICE vehicles. But today, what I can tell you is that we're starting from a higher base because this is just a bigger brake pad.

Okay. Very interesting. Maybe if we switch gears to IP. Correct me if I'm wrong, but historically, at least in your -- the energy oil and gas value chain, you've been stronger in the Middle East, I think parts of the Americas. When you're thinking about the Russian-Ukraine war and various shifts that are kind of happening or anticipated to happen in production and associated kind of mid and downstream processes, what do you think it means for IP when kind of the dust settles around all this?

So our -- essentially, our Russian business has disappeared in IP. So we're not shipping anymore in Russia for IP and for all the other businesses. And so I think that what that means is that as the -- at least Europe and North America is getting rid of anything that's Russian oil. And we know that there's some specificity depending on the countries, especially in Europe, we expect the production to pick up in the Middle East. And so in the Middle East, where we've been, as you said, historically strong, where we think that we have a good opportunity to pick up a lot of those projects, especially with Saudi Aramco where we have a strategic agreement with them. So I would expect that, that capacity is going to have to be made up somewhere. And most likely, it's going to be in the Middle East. In North America, we don't really supply pumps, but we supply connectors to the fracking industry. And we're already seeing a nice improvement in our order rates for North American fracking.

Okay. And I guess bigger picture, how are you thinking about the energy transition, right? I mean there's some obvious potential negative impacts longer term as oil production declines. But then there's going to be some opportunities in areas like hydrogen. Do you need to pivot at some point? Maybe just kind of talk about how you view energy transition and what IP might look like 10 years from now?

So we are pivoting right now. And you've seen the acquisition we made, the Habonim acquisition for valves. And this is a business that is really focused on LNG and also hydrogen. And so as a result, we expect Habonim to fully take advantage of that wave, which is going to be in terms of new energy for hydrogen and in terms of transition fuel with LNG. In our legacy IP business, we have several opportunities. I think in 2021, we reported that more or less $20 million of project orders were for green projects. So that was significant. The year before, this was 0. And so we continue to see opportunities, and we continue to see application -- opportunities for application that use our current pumps. So we see opportunities for hydrogen to use our pumps for hydrogen, and we're quoting around the world. We're looking at carbon capture already also, but this is more of an embryonic market for the moment. In LNG, as a transition fuel, we believe it's going to be very important. And for LNG, we have a complete offering for everything that is liquefaction. And so we are partnering with a lot of customers there, and we think we're going to continue to be successful. So when you look at the long term, obviously, we're very attentive to the positioning of the IP portfolio, and this is why we're investing in those new markets so that we don't find ourselves with just oil and gas that's left after that. Oil and gas today represents, for IP, around 25% to 30% of our revenue. The LNG piece, as I mentioned, is most likely not going to go away as fast as the oil piece. And we expect to be able to make up the lower oil revenue that we don't see for the moment, but that will happen in the long term with those new renewable or, let's say, yes, cleaner energies.

Great. Why don't we take a pause for a moment and open it up for any questions on the floor that we might have? All right, while we wait for some incoming questions, maybe we can touch on connectors because you alluded to earlier that oil and gas connectors, you're gaining a lot of traction there. I think you've also commented recently that you're gaining market share back in the Connectors business. Could you elaborate on that? I mean is that having to do with past, I think, production issues possibly where you had a manufacturing shift from a location to another? Maybe just elaborate on the share gains, why you're gaining back.

Yes. So we're definitely gaining share, and we see it in our order growth statistics. We're gaining share a little bit across the board, mostly driven by industrial markets, in general industrial, but also electric vehicles and also medical. So these have been growing really fast. So for instance, electric vehicle connectors have grown, orders have gone 70% in Q1 versus prior year. So those are a huge number. Obviously, it's not going to go at perpetuity, but we're seeing some really, really strong growth. And we're present on the AC, DC and high power. So we have a full suite of products that we also -- and we have been investing in redesigning those products so we can lower the cost and add features to them. And so from a connector standpoint, we're seeing some really strong performance. We're also seeing the benefit of the aerospace coming back up. We sell a lot of general purpose connectors as well as infotainment connectors. And so this is helping us a lot. And then finally, we have a pretty strong portfolio from a defense standpoint, and we've seen a lot of defense activity for the past probably 6 months.

Okay. Good to hear. I guess bigger picture on connectors, you're still a fairly small player. There's obviously some much larger manufacturers out there. How does that business kind of fit for ITT? Like strategically, how are you thinking about what you can do there? And...

Yes. So obviously, the big players, the TE, the Amphenol, have a much bigger footprint, much bigger -- larger product offering. But if you look at where we stand from a connector standpoint, from a profitability standpoint, we're on par with Amphenol and TE. So that's the first observation. The second observation is that despite the fact that we have, I would say, good level -- a really good level of profitability, we still see that there's opportunities to increase that margin. So today, we're a little bit more than 20%. I still think that there's more to improve. And then here, we're looking at, obviously, pricing is one aspect, but also from a production process, automation is one big opportunity we have. Our Nogales site has been performing really well, but we see a lot of opportunities to automate our production processes there. And then from a supply chain also simplification standpoint, there are things that we can do. And then finally, from a redesign standpoint, I talked about the EV, electric vehicle connector redesign that we're doing, but it's true also from all sorts of other connectors, including defense connectors. And then so we're both redesigning and designed to cost our connectors, but also expanding our product portfolio. And so we think that all these opportunity give us opportunity to -- give us runway to -- for us to continue to grow our margin and to continue to increase our revenue and to increase our top line. It's going to take time, but I think that the path is clear. And our approach compared to TE and Amphenol is more to go after customized connectors. So we have a setup -- a product setup where we manufacture mostly standard connector, and we customize at a late stage. And here, what's really important is the response time. And then so we have built over the years really good customer intimacy because of our quick response time and the fact that we're so focused on the customer that we try to solve their issue ahead of everyone else. And so we have had a hiccup, as you mentioned, in 2015, 2016, but we fully rebounded from that. And now I think that Luca would say that our Connector business is a jewel and that he sees many other opportunity to make that jewel even more beautiful.

I believe it. You mentioned EV, and I think order is up 70% for EV connectors. I think -- correct me if I'm wrong, but autos has historically been a relatively small piece of that Connectors business. Could you maybe help kind of size that?

Yes, yes. So when I started with ITT in 2012, that business was around $3 million to $5 million. Today, that business is $20 million. And obviously, with those growth rates, we expect that business to really grow significantly over the next few years as we -- as the electric vehicle infrastructure gets deployed everywhere around the world. So obviously, we're not talking about the majority of the CCT business, which today is around $650 million, but this is a significant growth segment that we're exploiting fully.

Sure. Well, 70% can compound pretty quickly.

Exactly.

And then you touched on where you still think there's margin upside in connectors. And this is a question I get a lot from investors looking at, right, IP kind of mid-teens margins today and Connectors around 20%. How do you -- so apart from the obvious, okay, volume recovery and some of the price that you're going to be getting through the rest of the year, how much more opportunity do you think there are in those 2 segments, right? Are we talking another 100 basis points? 200 basis points? I mean where -- that these productivity and these costs and design initiatives that you're talking about, could you maybe put some numbers around that?

So it's a great set of questions for our Investor Day on June 16. So everyone is invited to our Investor Day on June 16. We'll be talking about long-term margins. We'll be talking about long-term potential for all these businesses. We see tremendous opportunity. We've made a lot of progress, as you mentioned. I was segment CFO of IP. And when I was there in 2017, it must have been the most horrible year IP has ever faced, and we were around 7%, 8% in terms of margin. Today, we're back on track to 15%. And we still see many opportunities to the next level. And so we'll be very happy to talk about long-term targets, revenue expectations. We'll be also presenting the leadership -- the more complete leadership team of ITT, which I think hasn't been exposed to the investing community so far. And so it will be very interesting. And then I think that you -- all the participants will see also live product demonstrations. And so I think that's a really good opportunity because when we sell several-ton pumps, we don't get the opportunity to showcase them. And so I think that seeing our products and to be able to touch our products is going to be very interesting for everyone that is interested in ITT.

Well, we'll be looking forward to the 16th and all you have to unveil next week. Unfortunately, we're out of time. So Emmanuel, really appreciate you joining us today, and thanks to everybody for attending the conference. Have a great day.

Thank you very much.