TEL - ITT Inc.: Delivering On Late-Cycle Leverage And Share Gain Opportunities

Summary

• ITT delivered strong revenue growth in the fourth quarter, as later-cycle end-markets accelerated, as well as margin leverage.
• Management remains cautious about the second half of 2023, calling for a broad-based deceleration.
• ITT has been gaining share in multiple markets and offers good leverage to aerospace, electrification, and clean energy, as well as internal margin improvement.
• ITT shares offer upside to around $100 on mid-single-digit revenue growth, high single-digit FCF growth, and near-term margins around 16%.

The markets had already been showing more comfort with the outlook for industrials going into the fourth quarter, and the combination of generally better fourth quarter results and benign guidance for 2023 has definitely helped the sector, including ITT ( ITT ), which has risen about 20% since my last update , outperforming the industrial space by a comfortable margin.

I’d call ITT’s valuation more “good” than “great”, but I like the company’s mix of short-cycle and long-cycle business, not to mention its strong share-growing brake business (Motion Technologies) and its longer-term opportunities in connectors for aerospace and EV markets. There’s also a self-help tailwind here that may still not be fully reflected in expectations or valuation. Mid-single-digit revenue growth with free cash flow margin leverage can support a high single-digit annualized return here, and this isn’t a bad option in an industrial space that has gotten pricier relatively quickly.

A Fourth Quarter With Little To Complain About

I can quibble with a few points in ITT’s fourth quarter, including margin weakness in Motion Tech and more reliance on a lower tax rate to drive the bottom-line EPS beat, but on the whole this was a very solid quarter. Better still, initial guidance for 2023 really didn’t spring a lot of surprises.

Revenue rose 17% in organic terms, one of the strongest performances in the industrial group, though only modestly above sell-side expectations. Revenue was driven by the Industrial Process business, which grew 27% on 16% growth in the short-cycle business and 74% growth in the longer-cycle projects business. Motion Tech grew 12%, with 12% growth in Friction (well ahead of low single-digit auto production) and 10% growth in rail. The Connect & Control (or CCT) business grew 16%, with strong 26% growth in the aerospace business.

Gross margin declined 60bp yoy, but did improve 120bp qoq, to 32.1%, with ITT still seeing pressures from commodity and labor costs, but seeing some benefits from pricing and efficiency offsets. Operating income rose 18%, with margin up 80bp to 17.6%, while segment profits rose 16%, with margin up 40bp to 18.6%. Segment profits beat sell-side expectations by about $0.02/share.

By segment, Industrial Process reported 88% profit growth, with a sizable margin improvement (up 710bp to 22.9%), while Motion Tech went the other way with a 24% profit decline (and margin down 500bp to 14.7%). CCT profits rose 18%, with margin up 80bp to 19.2%.

Healthy Trends, But A Slower Second Half Looms

Industrial Process performed well this quarter relative to its peer group, and as I had mentioned in prior articles, the company’s exposure to longer-cycle projects business came through in a bigger way, with the company benefiting from its greater exposure to markets like chemicals, oil/gas and mining. Looking at peers, Crane ( CR ) saw 8% growth in its Process Flow business, while Dover's ( DOV ) 4% decline in Pumps and Processing was driven by weaker biopharma. IDEX ( IEX ) posted 9% growth in Fluid & Metering, while Pentair ( PNR ) posted 11% growth in Industrial & Flow Technologies. Flowserve ( FLS ), which also has meaningful energy exposure, preannounced 13% revenue growth for the quarter.

In the CCT business, it’s harder to benchmark ITT, but Eaton ’s ( ETN ) Aerospace business (which includes connectors) grew 11%, while TE Connectivity ( TEL ) announced 14% growth in its Transportation business and 7% in Industrial (the most comparable parts to ITT’s segment).

ITT also did well with respect to order flow and bookings. While orders have been much more mixed among industrials, ITT’s <1% sequential decline wasn’t bad. The backlog rose 22% year over year, giving the company pretty good visibility on at least the first half of the year, and while the IP book-to-bill ratio did fall below 1.0 (from 1.09 in Q3’22), a drop to 0.97 isn’t terrible.

Management was pretty explicit in its call for deceleration in the second half of the year, with short-cycle industrial markets in Industrial Process and CCT likely to meaningfully slow from here. Longer-cycle businesses are holding up better, though, particularly LNG and clean energy in the IP segment, and ITT does expect low double-digit growth here for 2023. In CCT, while aerospace is growing strongly and the business is leveraging growing EV production, weaker auto and defense markets will likely limit growth to the mid-single-digits.

I believe management’s guidance for mid-single-digit growth in Motion Tech could prove conservative. I expect mid-single-digit auto production growth in ’23, with EV production (where ITT has larger share) doubling, and I think rail will be relatively healthy, even with weaker freight volumes, as passenger rail offsets that to some extent.

The Outlook

ITT clearly isn’t immune to short-cycle weakness, but the market seems pretty confident now that the cycle will bottom in the third or fourth quarter (of 2023) and that the lows will be pretty shallow. Better still, end-markets like chemicals, oil/gas, and mining remain healthy and I’m not too concerned about a sharp slowdown in 2024.

I also like longer-term opportunities here. ITT has good leverage to the aerospace recovery cycle through its connectors business, as well as some leverage to vehicle electrification with its growing EV connectors business. EV production is also a driver for Motion Tech, as the company has been winning more share on new EV launches (triple its lagging share in conventional vehicles). Public funding for passenger rail is pretty strong around the world and ITT has longer-term exposure to clean energy (LNG, hydrogen, et al) and electrification (connectors), as well as semiconductor volume growth (IP pumps and valves).

I also see margin leverage opportunities. Management has done a good job of automating production in Motion Tech and stripping out costs, but hasn’t really applied those same ideas to the other segments yet. I’m not expecting radical change, but enough to drive ongoing improvement in free cash flow margins.

I’m expecting long-term core revenue growth in the mid-single-digits (around 5%), with FCF margin improvement toward the mid-teens driving adjusted growth of around 8%.

Discounted cash flow gives me a near-term fair value in the mid-$90’s, while a margin/returns-driven EV/EBTIDA approach gives me a 13x forward multiple and a fair value close to $100.

The Bottom Line

I underestimated the Street’s willingness to look past short-cycle slowdowns, but I don’t think the valuation here is as stretched as it is for some other industrial names. ITT isn’t flashy, but management is getting the job done and I see share gains across many parts of the business. Apart from a general concern that the industrial rally may have overshot the mark, this is a name I like as a longer-term holding.

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