Ralliant Corporation ($RAL)

Hi. Good afternoon. I'm [ Chiusano ], a multi-industry analyst at JPMorgan. Very excited to have with me here today, Ralliant, Tammy Newcombe, President and Chief Executive Officer; and Nathan McCurren, Vice President of Investor Relations. I think we'll kick it off with some remarks from Tammy.

Excellent. Thank you for having us today. I'll just start a little bit. We're a new public company, 3 quarters into our life. So I'll give you a little bit about Ralliant and who we are. We're a [ Persian ] technologies company. We specialize in instruments, sensors and safety systems. I say where it matters most. And that is often in environments where accuracy, reliability of those measurements and also safety really matter. Our customers are engineers and innovators who work in end markets like utilities, defense, test and measurement or industrial technologies. If I think about what we've been doing for the last couple of quarters, really been focused on executing our profitable growth strategy. And our profitable growth strategy has three pillars: one pillar is around higher growth vectors and driving higher growth. The next pillar is around stronghold positions. Our stronghold positions are low single-digit type growth markets where we are differentiated and have competitive moats with a very large installed base, which gives us a recurring opportunity with our customers on maintenance and repair. [ The ] third part of our strategy is the Ralliant business system. And this is how we execute with rigor. This is our continuous improvement mindset of getting better every single day. I'll go back to or higher growth vectors. So there's a lot of exciting things happening in our end markets that touch electrification and defense. And if you start in electrification, the first layer of electrification is the power grid. And with the excitement around AI and electrification around the globe, that first layer of a power grid that is reliable, that keeps the lights on, that is intelligent is where we have a play. And our precision sensors attach to the most critical assets in that power grid and ensure that the operators of those power grids get the intelligence that they need to keep those systems up and [ running ]. The next piece in electrification is around the data center and how AI is driving that data center. Inside that data center, any of the electronics in there would be our test and measurement equipment would be used by those engineers and innovators that are building that equipment. Also in the data center, there is cooling and thermal issues where our industrial sensors for temperature, [ for ] flow and pressure are being used in different cooling systems. And then at the edge, where AI is showing up in robots and humanoids and different electronic devices, that innovation also requires more test and measurement equipment. So that's the electrification piece of our higher growth and how we play. On the other side of secular trends is the defense space. And in defense, we play in the production side and that's the programs that have been around 10, 20 years, mostly in missiles and munitions, where we are a key critical supplier to many of the programs that are going through a big replenishment cycle. And then in defense modernization, where you'll find in the R&D labs, our test and measurement equipment, as the defense community is working on next-generation communication protocols. And then the last piece of defense, I think it's still to be determined. What does the new budget look like the $1.7 trillion in defense spend that's being talked about, not approved yet, but that is the surge or frameworks that we've been talking about that could take our $1 billion backlog that we have today in defense and space and make it even bigger. So that's a little bit on who Ralliant is and how we're executing on our profitable growth strategy.

It's a great overview. Thank you, Tammy. Just to follow up on the defense. I think you announced PacSci [ War ] this morning. Can you just talk a little bit about how that ties into our overall defense strategy?

Yes. There was an announcement made this morning by the Department of War that our business that is in the defense and space end market is called PacSci EMC. They've been awarded $27 million to help with some of the build-out of the capital equipment required to keep up with the demand in the standard motor business that we have. And this is in addition to what I talked about last week in our earnings where we are making organic investments in additional sites and additional equipment thinking out to 2028 and beyond that we will need some physical capacity. Up until now, we have doubled the business by using productivity initiatives in our factories. We've added shifts. We've leaned out cells through the Ralliant business system and we've built out a strategic sourcing team to ensure that the supply chain keeps up with what we need to do in the factories. But it was an exciting award from Department of War. I think it's -- it's a testament to the critical nature of our business to some of the key programs.

That's great. So you highlighted over $1 billion of [indiscernible] in space, and it sounds like there's upside to way you expect double-digit growth in 2026 and beyond. I think at the Investor Day, you highlighted like a long-term growth rate of 5% to 7% in defense and space and maybe 2% to 4% in communications, where there's a big defense business there, too. But is this still the right framework? Or do you think there's upside here?

Yes. Let's talk a little bit about what's changed since we were at an Investor Day. And one thing post Investor Day, I think it was a couple of months later. We started to see this replenishment coming through in our backlog in defense and space. And what we can see today in backlog gives us confidence to say that this business is a double-digit grower, maybe double-digit plus grower, not only in year, but in some of the out years here. And the business that you -- let's stop there with defense and space end market. The other end market that is a little higher than we talked about at Investor Day, is in the utility space. Both of those are in sensors and safety systems.

Yes. And then you mentioned a little bit about the capacity or the supply chain constraints in the defense business. But where are the key kind of constraints there like around [ wood ] products? And then on the margin side for defense. As the defense business grows faster, I think the margins are lower than the company average. Are there any actions you can take to mitigate the mix headwinds?

Yes. So for the defense space, the the growth rate, as I talked about, would be double digit. Given the government is helping us with some of the capital expense, they do put some guardrails on the profit areas. It's called TINA compliance is the government language that they use. So we have guided -- our sensors and safety systems is about 60% of the overall business. And in that business, we talked about adjusted EBITDA margins from the mid-20s to the high 20s. And we're already at the high 20s. And our guidance for people [ is ] don't think above that because we're going to have some pressure on the margins here as we grow that business.

Makes sense. And then following up on the utilities side, I think this quarter was a little softer due to the shipment lumpiness, but how much visibility do you have here? And what kind of are your expectations for growth for this year? And I think you touched on it a little bit earlier, but it's 5% to 7% still the right long-term growth rate for this end market?

Yes. So the utilities end market is also part of the Sensors & Safety Systems segment, again, 60% of the overall business. And in utilities, this past quarter, our revenue growth was plus 1% on a quarter when our orders hit a record. So the orders for -- and a historical record, not just an annual record, but historically, the highest orders quarter that we've had. So robust demand, we're still experiencing in utility space. And this is another market post Investor Day, [ Investor ] Day, we talked about 5% to 7%. I see that as more of a high single-digit grower this year and into the future. If you know this space, you know that critical assets for the grid are very difficult to to get right now, there's a long lead time on them. We work both with the new placements of critical assets, and we also have a play in retrofits for that space.

Yes, that's very helpful. So I guess the defense growth framework and the utility growth framework is both better than what you expected at the Investor Day. So what does that kind of mean for the overall Ralliant organic growth?

Yes, what you saw -- what you saw is as we came out of Q1 and our test and measurement business that's the 40% segment in our portfolio. That business performed about as expected from a revenue standpoint. But we saw the orders come in hotter than we expected, 1.2 or so book-to-bill. So that, combined with the backlog visibility, test and measurement, orders being stronger combined with the backlog that we have visibility to in defense and space gave us the confidence to first, give you a guide for Q2. We have good visibility in the next 90 to 120 days as well as raise, we raised all metrics for the year. So move the growth rate up to 5% to 8% on the year.

And following on that, your full year outlook, I think it assumed some deceleration in the second half to the low single-digit to mid-single-digit range from kind of the high single-digit organic growth in the first half. [ But ] can you talk about the drivers here?

Yes. The business across the portfolio is about 70% short cycle business. The other 30% is in services in what we call reoccurring business around maintenance and repair. And the short cycle business, you get about 90 to 120 days of visibility, and that gave us the guide for Q2. As we thought about the second half, there's still a lot of uncertainty out there in the macro. We have seen some spots where we've seen some supply chain issues. I think we've navigated all of them quite well right now. But I mentioned transformers. There -- they've got a backlog right now and shipments are out 1 to 2 years in that space. So I think just we're a little cautionary on the second half. We'd opened the year thinking 48% of our business in the first half. I think we're [ 49-51 ]. So about 1 point shifted there, first half, second half.

Just two more questions on sensors and safety before moving on to [ T&M ]. On industrial manufacturing, I think this vertical grew 4% this quarter. And we're seeing overall directionally positive trends from others, but I think the strength in lengths kind of remains a question mark. So I was curious what's your outlook for industrial manufacturing this year and your thoughts on whether you think the trends are of gradual recovery or there's an inflection driven by onshoring trends?

Yes, I'll put together our end market called industrial manufacturing with other. And those are critical environments, all, I guess, somewhat industrial in nature. That's about 30% of the Sensors & Safety Systems segment. And an area which historically maybe 0% to 2% type growth over a period of time. And we're definitely seeing above that right now. I think that if you look back on the last 2 years, 3 years, it's been really tough go in that space. There's been a lot of pent-up demand that we've seen come forward in some markets, Americas doing very well, China pretty good, and Europe still suppressed when it comes to industrials. But I think this will moderate. I think this will come back over time. I don't know how many quarters we'll have at this higher growth rate when I think it will normalize in the out years more back to what we had seen.

That's helpful. And going back a little bit on utilities, I'm guessing margins are quite attractive here, I'm guessing, in the 30%-plus range. But where are the key capacity or supply chain constraints in the utilities business that might limit growth?

Yes. For us in utilities, it's our customers being able to go fast enough. We have about 30% of the business that's a project business. The rest of the business is tied to customers either retrofitting critical assets or getting critical assets out into the field. And they're the bottleneck right now more than we are. We are prepared today for volumes that would go out to 2027, late '27. And then we're adding some capacity that would come online in '28 and beyond in that space. But we we see lots of opportunity here, and we just work with our customers on the timing of shipments.

That's helpful. Shifting to T&M. You talked about how it's the short cycle limited visibility here. But this segment grew strongly this quarter, and you now expect it to be up high single digit for the year versus last quarter, I think you were talking below the midpoint of the 2% to 6% guidance range. But can you just talk about what changed over the last 3 months? What are kind of the indicators that you track internally? And what are they saying maybe today versus 90 days ago?

Yes, we spun in Q2 and at that time, we believe that Q1 would be the lowest point in the quarter for demand. And that turned out to be right. Every quarter, we sequentially improve the business there. And as we came into this year, we thought -- we looked back and we said, hey, Q4 to Q1, typically maybe 3% to 8% type step down in revenue. And we did see that. We saw a 3% to 4% step down in revenue. What surprised us was the order strength. And we're seeing strong orders across where our specialty is, which is around power electronics for the power grid, for the data center, for Edge electronics, as well as in the defense space and defense modernization. So all very strong. Americas, again, the strongest. And actually, China finishing a little better than we expected with the investments there in AI and energy. You asked about what are our early indicators. The best indicators are orders. We said that last quarter. We said all of these early indicators are great, but we need to see our funnels convert to orders. That's what we saw happen. We continue to monitor funnels. We model channel inventory. We model channel sell-through and point of sale. Those are all the best indicators for this business.

That's great. Maybe can you talk about market share trends in test and measurement? So I think Ralliant has strong capabilities in R&D and you're expanding into validation and production with new products like the MP5000 platform, but how is your traction here? And then high level, if you can talk about the key drivers of your test and measurement business and how it differs versus some of the other players in the T&M space.

Yes, when you look across test and measurement, test and measurement tools are used in advanced research development, validation, production and then the services part. We predominantly play in advanced research and development. That's probably 40% to 45% of where we play. And then validation, production and services are all 10%, 15% of revenue getting to the 100% for the whole workflow piece. When you think about share, our highest share is going to be in that R&D space and where we're particularly good is around power electronics. You add the noise floor in the oscilloscopes, which is brought to life through [ ASICs ] we built in-house with the [ Keithley ] portfolio, which I think of as like the atomic clock of precise measurements for current and voltage -- with the recent acquisition of Electro automatic, that power portfolio is extremely strong. Couple that with some new products we announced last year in the high end of [ the ] AssiloScope family, the [ 7 ] Series and the strength that we have in defense and some of the communication protocols that are used in that space. I think the best measure of market share is growth rate. So durable growth through the cycle, continual growth. It comes with innovation, and it comes with taking share. But at the end of the day, that's the best metric.

That's helpful. Maybe shifting to -- just quickly touching on book-to-bill. I think it was 1.1x for the overall company and test and measurement, I think you said it was about 1.2, 1.3. How kind of do you expect this to trend for the year, if you have any thoughts there?

Yes. I think we're off to a strong start with a [ 1.2 ] book-to-bill, and this is something that we monitor on a a monthly basis. The business, again, is a short-cycle business, 90 to 120 days. So we can see through Q2 and into halfway through Q3. And every indication is that the business environment is going to be similar as we go forward. So that's probably the key indicator for us on the future of the business.

Sounds good. Now I'm going to shift to the margins. The underpriced productivity [ pram ]. You talked about this quarter, $50 million to $60 million of cost savings targeted by 2028, but can you flesh out the drivers for us? How much is driven by COGS versus SG&A?

You want to take this one?

Yes. I can jump in. So we've shared that there's two main buckets: cost of sales and G&A specifically. And it's about [ $370 ] the split between those. So cost of sales is about 30% of the savings and then G&A, about 70% of the savings. And of the $50 million to $60 million, we've already taken action on $20 million of that. And we've said we expect that $20 million of annualized savings that we've already taken action on to drive about $10 million to $12 million of in-year savings in 2026. And then we're taking action really over the next 18 months on the remainder of that. And so expect to complete by the end of 2027, driving to the full run rate of $50 million to $60 million of annualized savings by -- into 2028.

Sounds good. What are kind of the lower-hanging fruit that you can get in 2026 in terms of the buckets versus the cost savings that will take more time and how will you kind of govern or verify the real savings versus maybe like the cost avoidance?

Yes, I'll talk about that. So the actions that we have taken in 2020 and early 2026, the first was around dissynergies in the business as we carved out some of the services business that stayed with our parent company. And second was some restructuring that we did early this year. I'd say of that $20 million, it was predominantly in the [ Test ] and Measurement segment. And as we move forward, one of the reasons we put an [ umbrella ] program over all the initiatives going on is because we wanted to be sure we had good project management, governance and real targets for the team. A couple of actions we took. We consolidated the IT department, the legal department and the HR department. They're all working on programs using AI, reducing or optimizing their workloads, but we wanted to capture that and make sure we knew how it was hitting the P&L. So the enterprise productivity program is really the governance and oversight the way the work is getting done is all through our [ rolling ] business system, leveraging AI.

And one thing [indiscernible] I'd highlight is this is really possible like why is now the right time? This is us taking the the organization saying, what's the right custom fit for Ralliant. So 2025 was really focused on get the spin completed, do that successfully. And now it's really saying now that we've gotten that behind us, it's how do we really organize the company in a way with 6 operating companies that all look similar to each other, have a similar business model and saying, how can we find some areas that we take centrally or have synergies across those companies to bring together and drive productivity.

That's helpful. And the AI-infused [ RBS system ] is really interesting. I think you referenced previously AI foundry and AI enhanced workloads. Can you talk about the top use cases that you're deploying and how kind of you quantify the impact?

Yes. I'll give you a couple. I'll start in manufacturing as this is one hot off the press from our CEO [ Cosan ] 2 weeks ago. But we had already digitized one of our factories and had access to all of the data that comes out of the factory which traditionally had been done on what's called the acute Board and manually entered and manually updated it moved off to digital. And now what we're doing, leveraging that data to be able to do more predictive. So can we predict -- one thing that's difficult to predict is repair work. And if we've got good insights across the business on Monday, Tuesday, Wednesday, Thursday or different months where we tend to get more repair work we can plan for that ahead of time. Instead of that hitting us and reacting, we can see it coming through our trending in data analysis and make sure we have the right people, we have the right supply and everything comes together to be able to take care of that. So in our manufacturing lines, we're leveraging AI to make us more productive as we go forward. Second example I would give you is in the commercial space. How do we get our exciting and wonderful portfolio into the hands of more engineers, more innovators, more system integrators. And the -- our persona tends to like looking things up for themselves, and they're pretty savvy. So we have put capability into our websites to allow for take a picture of what you're trying to replace, that sensor in the field that you're looking for. And if it's not our sensor, we'll cross reference you to something that we can supply. We've put all of our technical and knowledge out there so that people can search it and learn how to best use our products for their applications and workflow. And the best thing about this is when you put AI and digital together, it works 24/7, 365, any place around the globe. So we have pretty small and mighty commercial teams and this allows them to feel bigger to our customers.

And you've been investing in AI, I think ever since you were part of Fortive. So it's been a few years.

Yes.

And then maybe on the margins again. I think you laid out a 50% increment margin target through 2028. How much is this dependent on volumes? And how much growth investments are you embedding?

Yes. We have -- so we have looked at what we think the forecast would be over the lean years, of course. And the incrementals are similar to what we said at Investor Day from a base business and what we added to that is our [ custom ] program. That's how you get to the 50%. And I'm separating those 2 things because as we get into midpoint of our low 20s to mid-20s adjusted EBITDA margins, we will be continuing to invest in the business and some of the organic parts of the business, just important to us right now that we demonstrate demonstrate our profitability, and we demonstrated returning cash to shareholders.

And how should we think about the incrementals at T&M as volumes continue to recover versus sensors and safety where margins are already in the high 20s?

Yes. The -- it's -- the test and measurement incrementals are strong as we get back to growth and get to a bigger volume level. And then in the sensors and safety systems, you've got two things going on. You've got -- you do have high margins today, but we have to keep in mind that as the defense business grows, we will have a lower or I guess, a headwind there in our adjusted EBITDA, still in that mid-20s, the high 20s, but with that volume will come some headwinds.

On that point, defense is dilutive to the overall company margin. But how big is the margin differential defense versus the other [ Simpson ] safety versus T&M?

So a couple of things. test and measurement has a significant amount of operating leverage. There's a pretty big fixed cost base in that business. And so you see in periods of growth that can deliver very meaningful incremental margins. So we can see upwards of 50%, 60% plus type incremental EBITDA margins on that business. Whereas defense, we've said, is more in line with overall company margins closer to 20% type margins. And so this is where there is a pretty big difference in terms of where the growth is coming from, there can be a decent mix impact. The thing we'd point out is we've taken into account and talking about 50% incremental margins over the next few years, [ is ] that, that includes double-digit growth within defense. So we're already taking that into account that we expect some mix headwinds on the incremental margins. And despite that, and even including some organic growth along the way, expect to be able to drop down [ 50% ] incremental EBITDA margins.

Got it. And then going back to maybe the AI data center exposure, can flesh out for us again, the exposure to AI data center? And what percent of sales, if you could quantify, are exposed to these verticals and what are the growth rates you're seeing here?

Yes. I think there are two answers to that question. One is directly tied to the AI data center, which across our entire portfolio is [ right ], 10% to 15% higher in test and measurement, maybe 20% in test and measurement. I give you approximate because I think AI is sort of lifting all boats across the portfolio. We had an example last week of an industrial tool manufacturer that's using one of our pressure sensors in a device that's specifically made for cutting cables for data centers. So I think there's an ecosystem out here in a wider tail to how things are being lifted by what's happening in the AI data center attributing to the power grid, attributing to electronics at the edge and even industrials that are being used for some of the capital build out.

Yes. It seems like there's good direct and indirect exposure to that theme. Maybe touching on capital allocation. I think you're now targeting repurchases around 50% of free cash flow and announced $100 million ASR in the second quarter. But how do you weigh this share repurchase versus funding incremental growth CapEx or tuck-in M&A?

So we have a -- with a strong bias for the value of this company. And we believe that we're doing all the right thing to grow that valuation. And with that, we think this is the right time to be buying our stock. We also as we thought forward to being a new company, we wanted to lay out or we wanted to put a stake in the ground that we're going to -- we're not just going to say we're going to do this. We're actually going to do this in Q2. Therefore, we instituted a program a share repurchase program for $100 million, as you stated. This is on top of the $50 million that we executed in Q1, which means this year, our free cash -- our free cash flow, about 50% of it is going to buyback and dividend. This is what we have said over time, we will continue to do. We have been very specific in sing over time. That means that it's not every quarter we may span a year and it will be lighter in some years. But right now, we believe it's a good use of our dollars. And we will continue even in the incrementals we talked about, that leaves us some room for organic investment and we continue to cultivate M&A. And tuck-in M&A for us will be something that fits into the portfolio that we have, and we are estimating double-digit returns on capital in a 3-year type or last period.

On that point, what is missing in your portfolio that you could look to add? And on the flip side? Are there any areas of the portfolio that are noncore and you could look to prune?

Yes, I'll start -- I'll work backwards. Before we spun in the time before we spun, we did prune a couple of parts of the portfolio that we got out of to different areas. And we actually consolidated some businesses. It's something we're constantly evaluating and constantly looking at like what's core and it's [ not ] -- and what do we want to do with that business, we have options to invest to divest or just stop doing something, shut something down and we make those trade-offs all the time.

Okay. And then on the CapEx, you touched on it a little bit earlier, too, you indicated that CapEx is moving towards 2% to 3% of revenue, and I think investments are focused in defense and utilities business. But what are maybe two or three of the high-return projects these end markets that you're targeting the CapEx investments to you? And when should they show up in revenue and margins?

Yes. So exactly right. The traditional CapEx for this business has been around 2%. We talked about that moving 2% to 3% in this year and maybe some of the near-term years that we invest in production capacity for both the defense space and the utilities. That's business that would come online late '27 and into 2028, but an opportunity to continue to grow those businesses.

And that's one thing I'd add is this is really a continuation of growth. We've been seeing in utilities and defense about high single-digit growth for the past 5 years or so that hasn't shown up as much at the segment level because there's been some headwind on the industrial manufacturing side, which Tammy mentioned was about 30% of total revenue. So half of that segment is industrial, manufacturing and other. So it's really saying how do we keep that growth going, the high single-digit utilities growth, double-digit defense growth. It's starting to invest to be able to continue that growth and accelerate that going forward.

Makes sense. I'd like to turn it over to the audience to see if there are any questions.

Could you reference your [ histo ] margins in test and measurement, I think you were at 23% in 2023 and around 21% in 2024. So just wondering if there's anything unusual from a pricing perspective or supply chain that caused those?

The only -- I don't think that's going to be apples to apples or [ just ] oranges because that wouldn't have the public company cost. So at the core of our corporate expense, we have [ seen ] costs and then corporate costs. So there would be -- I don't know if we have normal done.

Yes. So I would say there's -- it's about 1.5 points that you take off of that for what the segment is now receiving as an allocation of the post-spin cost. So I would say to make it apples-to-apples, take about 0.2 to 2 off of that.

Yes, because there was allocated cost at the segment back at the time, but we are smaller now. So it's a little bit higher.

[indiscernible]

No, I'd say that's in line with the -- saying that the target for that segment is mid-teens to low 20s. And so the low 20s would be kind of indicative of a year, like '22, '23, which were 2 years where we had seen 3 years, we'd seen the last 2 years of 3 years of pretty significant growth.

Okay. With that, I think we're up on time. Thank you so much for coming today and for your time.

Thank you.