Ralliant Corporation (RAL) Earnings Call Transcript & Summary

My name is Brandon Knutson. I'm on a multi-industrial research team here at Morgan Stanley. And this afternoon, it's a pleasure speaking with Tami Newcombe, President and CEO of Ralliant; and Nathan McCurren, Vice President of Investor Relations, and Tami is going to kick it off with some opening remarks for us.

Thanks for having us. Welcome, everyone. Thanks for being here. We did post the presentation after market close today. We'll spend a few minutes introducing Ralliant, we are a relatively new public company. This is our fifth quarter that we're in today. So if you haven't heard of us, I'll catch you up pretty quick on what we do. We are a premier player in precision technologies. That means we think highly precise test and measurement instruments, industrial sensors and safety systems for the defense and space industry. Our businesses design, develop, manufacture, sell and service this precision technologies. Our customers are engineers and scientists and innovators around the globe that are working in a number of different end markets. in markets where we're seeing terrific growth opportunities today. In the utility space, we work with the grid operators to ensure our sensors and monitoring systems help them keep the lights on. In our industrial space in the data center for liquid and air cooling, our industrial sensors are being used for pressure, flow and temperature. In the defense space, we are a critical supplier in a number of the programs that are going through significant replenishment or surge demand. And then in our test and measurement space, -- the energy here around data center and AI is exciting. We're enabling those engineers with the instruments they need for those electronics. And as that moves to the edge, and you see the AI edge and electronics show up in our wearables, our humanoid, robotics, medical devices, all of that electronics innovation, is where our test and measurement instruments play a very, very critical role. As Brandon said, we were a new company and it was September of 2024 that the spin was announced. At that time, we put forth a strategy where we could drive additional growth in the business. There's really 3 pillars to our growth strategy. The first thing around aligning more of the portfolio to high-growth vectors. The second is creating recurring value for our customers in what we call stronghold positions. These are often niche applications where we have technical expertise or long-standing relationships and we're embedded in an OEM product. And then third is our Reliant business system, and that's how we execute our strategy. That's the operating rigor that you will see in these businesses, how we deliver the fantastic free cash flow that we do. On the high-growth sectors, 2 places that we play across the portfolio, that's electrification and defense. In electrification, it's from the grid, as I mentioned, into the data center and the AI edge. In defense, it's both legacy programs, where we are embedded as well as defense modernization. Our capital allocation strategy has been very disciplined, and we started with giving oxygen to these businesses at spin. By that, I mean investing in organic growth. This year, it's been around capacity expansion, where we're seeing strong demand. We've also fueled some areas of supply chain to ensure that we can continue to deliver. And I'll probably stop there and kind of bring it home to questions that you have for us.

Great. Well, thank you for that intro. You're now, as you said, almost a year into your life as an independent company. What are some things that you can do as a stand-alone company today that you couldn't do under your previous parent?

I think the word is focused. We're a business of products and services, very similar go-to-market across the portfolio, very focused on precision and precisions from an engineering standpoint and also manufacturing precision products. So I think the focus in the company allows us to invest where we have the biggest growth opportunities.

Great. And then how much of the recent performance would you say is really a function of you seeing a return on those investments versus a real inflection in the cycle?

Well, we're certainly going to take advantage of a good market, but we're also very focused on making our own luck. And when I talk about making our own luck, that's about moves we've made to expand manufacturing capacity, investments that we're making in our innovation road maps. And then we do have some places where we're increasing our commercial focus and putting salespeople on the ground to fuel increased demand.

Great. And you talked about the Reliant business system. I want to highlight a little bit in there. What are the implementations you're using in order to facilitate the productivity cost savings that you've outlined already? And how are you seeing those returns on that AI enablement internally?

A couple of places. As the Ralliant business system, which was born back in Danaher, we were able to refine that to be very focused on our manufacturing, our innovation in a products company. We also have modernized it -- and with that, we've infused AI. A lot of the problem solving is about data collection to get to root cause. So there's a real opportunity there for AI. We've also focused on a couple of platforms One platform is for our software developers. And I call it a platform because it gives us the ability to monitor costs to be able to have a marketplace. So if somebody were to change jobs, we wouldn't lose some of the AI development that we're doing and to have good governance and cyber control. And we've done that both on the software development side as a platform as well as on the commercial side. Sort of early on, on metrics, we're looking more at adoption, utilization and sort of optimization of costs so that we're using the right model for the right solution. And then on the commercial side, it's about how we scale as we grow by enabling our sales teams without having to continuously add people.

And in terms of where you can improve the business, how the opportunity set look now a year into it versus 6 months ago when you initially kind of gave a level setting of expectations for cost savings for the next few years?

Well, I think there's 2 pieces there. If you go back to our preparation for Investor Day, it's almost 18 months ago that we were preparing for our Investor Day. And as we thought about setting expectations for growth at that point in time. We did an analysis looking backwards. We look from 2019 to '28, '24. And we said through that 5-year period, we'd had a growth CAGR of just over 3%. So we came out talking about 3% to 5% being our new 3 cycle growth rate. 18 months later, as I sit here today, we've got parts of the business that are growing high single to double digit. I believe that mid-single, even without tuck-in M&A is possible. And some of our shorter cycle business that our test and measurement and some of our industrial sensing businesses, we had strong Q2. We raised at the end of Q2, we raised our annual guidance for the year. And our guide at the midpoint right now for this year is double-digit revenue growth. about 200 bps of adjusted EBITDA margin expansion and growing our EPS over 30%. So we're seeing growth and firing on multiple cylinders across the portfolio.

And as you mentioned, you gave the long-term growth outlook, somewhat backward looking at 3% to 5%. As you see how the business has performed, your exposure to AI, defense, grid modernization, repurposing things like EA electro to more the battery power gen test for data centers. Does 3% to 5% feel like the right range? Or is it stale at this point?

Yes I think the -- In our defense business, we've talked about that being a double-digit type grower. I think utility businesses, high single digit, will be double digit in the second half year because we were slower in the first half. But the 5% through the cycle is the number we've been talking about now with still to be seen on our short-cycle business. In the presentation that we most recently -- we just posted here within the past hour, we talked about the momentum that we saw in Q2. We've continued to see in July and August of this quarter. So the short-cycle business and Test and Measurement and Industrials continues to perform.

Great. Shifting over to another kind of big secular theme with AI and data center. You've seen or could AI create a structurally high replacement or upgrade cycle for acelloscopes and other test equipment as bandwidth signal complexity advances more rapidly.

Yes. The test and measurement business is driven by innovation. And so when there's innovation happening in electronics like there is in the data center going from 400-volt to 800 volts and a lot of the equipment, the electronics equipment going into that data center needs to be upgraded or expanded those are good opportunities for test and measurement equipment. And again, where we see -- we talk about the explosion of electronics, it's really outside the data center and all the companies were building electronics that will take advantage of AI as it shows up to each and every one of us in our lives.

And for Tektronix, specifically, the products there sit very early in the electronics R&D cycle. where are you seeing AI-related demand show up for those products?

The -- so the test and measurement equipment, about 50% of our opportunity is in R&D. That's the place that really the edge of those instruments. We have our own in-house semiconductor team. They build the chips, the ASICs that go in that equipment. And that's a place where customers are willing to spend extra dollars to ensure they make the best equipment there. So I would say in the R&D space, anything related to electronics is going to drive growth for T&M.

Okay. And then shifting to AI infrastructure, how large is the direct and indirect revenue exposure there for you?

Yes. The -- there's a few places where we sit in the data center that would be more in our sensors that actually show up in the data center in cooling, whether it's air cooling or liquid cooling. Most of our other opportunity is for the echo of the AI data center, which is in the labs that are generating the electronics in the power grid, the expansion needed in the power grid, both for storage systems and for critical infrastructure to increase our ability to power the AI infrastructure.

I'd just add, Brandon, we've shared that about 10% to 20% of revenue has direct exposure to data centers, AI infrastructure. Some of it is a little bit difficult to measure of whether a chip is going into a server in a data center, a different application -- so certainly a bigger impact than that on the second derivative impact of all the investment that's happening there right now.

Great. Another strong end market for you all has been defense -- your backlog remains above $1 billion, double-digit revenue growth. How far does that backlog give you visibility?

Yes. So the reporting -- we report the defense and space as 1 of our end markets. And that will be about 15% to 17% of our revenue this year. And that would take us through this year through '27 and into the beginning of 2028. At the same time, there's a lot of activity right now with our customers, the defense contractors and thinking through what does this replenishment cycle in surge demand -- many of the programs that we're on, we're talking about 2 to 4x increases in productivity between now and 2035. And that's come to us in quoting a number of different scenarios. -- different volumes, different time periods. And we're still waiting to understand what the contracts will look like that will become part of our backlog there. But that is not part of the $1 billion backlog today.

Okay. And you have a line of sight now to capacity needs through 2030 on the defense side. You're expecting to do expansion past 2028 and beyond, you're good through 28. What level of revenue growth with this capacity expansion beyond 28 are you growing the business for growing capacity for it.

Yes. So we were in our footprint today between increasing capacity and that comes in both sell output as well as expanded shifts. We're comfortable through the demands in 2027. So we have announced we're moving this business into another facility, which we own in outside of Cleveland, Ohio. And that capacity is to come on late 27 and into 28 and then possibly a fourth facility after that. And that is to take us through now through 2035 at the double-digit rates that we're thinking about.

Okay. And then on the demand side, it's clear what's driving demand for defense -- but we know that margins are somewhat lower than company margin on the defense side as well. So -- how should investors think about the trade-off between faster growth and segment margin mix?

Yes. So our defense and space end market is in the Sensors & Safety Systems segment. talking about adjusted EBITDA margins there in the mid- to high 20s. And this will be a headwind to where we are today. You have to understand the context around that. These customers fund their new product development. So R&D is very low for us. They also fund a lot of the standup of the production lines as well as equipping the people to come on to the lines -- so we have guardrails on margin profile there. And it becomes a mix issue as we look forward that we'll have a higher mix of some of these programs with lower margins. Having said that, we still are very comfortable with the range that we gave of the mid-20s to high 20s and adjusted EBITDA margins. We're just making sure that people didn't get ahead of us and think that they were going to go beyond the high 20s.

Right. And is there any opportunity for RBS or volume leverage to offset some of this margin mix headwind?

Yes. And as we have done in the past, we will always continue to do that. And I think as the -- as we get orders in backlog and understand timing of some of this, that will be an opportunity for us.

And what are the levers within RBS to try to improve the margins for this?

Productivity. I mean if you think of our RBS tool set, it's all about getting efficiency and productivity out of the manufacturing facility.

Great. And then sticking with sensors and safety on the utility side, 14% of revenue expected to show growth in the double digits in the back half of the year, had delays in the beginning of this year. but how durable is that double-digit growth beyond the catch-up we're expected to see in the second half of this year?

Yes. So the first half of this year demand orders continued to be strong, called out Q2 being historically our strongest quarter ever in demand. So we are continuing to see strong demand. Some of the shipments shifted from first half to second half. So that was the double digit in the second half. And we stay -- I mean, this business was born 50 years ago, pioneering, how we monitor critical assets in the grid. We stay very close with those OEMs. And -- those OEMs we work with multiple years in advance to actually design sensors for that equipment. So the signals that they're giving us are strong for several years to come. If you know that industry transformers are backlogged 18 to 24 months. So there's good demand there.

Great. And grid is going to require a lot of investment to accommodate data centers, renewables, electrification, where does Ralliant as the strongest competitive position within the grid modernization spend?

Yes. I would say everything you said as far as expansion. There's also a tremendous opportunity for upgrades in the grid, Much of our grid is over 25 years old. And our opportunity is both in the generation side and the transmission side. We don't play as much in distribution. But the sweet spots transmission with opportunity also in generation.

And what's the mix between replacement of aging equipment versus new infrastructure?

I don't -- we don't break out I don't even think we would know the replacement. We think about retrofit, which is a business that has been building over the last 2 to 3 years, maybe 10%, 15% of the business today is retrofits where transformer going through a retrofit they'll add sensors to it. And with aged infrastructure, -- you can imagine people are more interested in monitoring that aged infrastructure now to know if they get an investment or they get a shipment of a critical asset where they want to put it.

And are you seeing across utilities, given the increasing cost of outages and things like we're saying fires and how that impacts the liabilities that utility is facing. Are you seeing a higher willingness to spend on predictive monitoring and other solutions that you provide?

Yes. The aged equipment, some of the penalties driving not only the monitoring, which is something we've traditionally historically done very well, but also is moving up in providing more insights and more predictive analysis to the grid operators or the new customer for us is the hyperscalers. We announced or shared on one of the earnings calls that one of the hyperscalers has selected us as part of the -- as a critical supplier to as they build data center they're staying really close to deciding who is in their design footprint.

That makes a lot of sense. Shifting to test and measurement. So organic growth reached mid-teens in Q2, and following a return to growth in Q1. So a very strong start to the year, book-to-bill above 1.2. Where are we in the test and measurement recovery cycle today?

We're clearly -- we're clearly in year 1. We saw strong growth both in Q1 and Q2. And we've seen in the past, we've seen these cycles run anywhere from 2 to 4 years. And you look around, I ask myself is there going to be more electronics in the world or less electronics in the world. It looks like there's a lot of opportunity here for electronics, which is good for test and measurement.