ITT Executing Well, But The Bull Case Has Become The Base Case

Summary

• ITT posted better than expected revenue and margins in the fourth quarter, with particular strength in Motion Technologies, but guidance for '21 looked a touch conservative.
• Motion Tech remains the sizzle to the story, as the company continues to gain share on established platforms and new EV/hybrid programs.
• Aerospace, chemicals, and oil/gas will still be under pressure in 2021 (collectively one-third of sales), but all should start seeing better demand in the second half.
• ITT's outperformance has shrunk the relative discount, but I believe there's still a "first among equals" argument for owning ITT, particularly with more self-help and M&A opportunities.

As a shareholder, I can’t really complain about the performance of ITT (NYSE:ITT) over the last few months. I liked ITT better on a relative value basis to names like Dover (DOV), Eaton (ETN), Emerson (EMR), and Parker Hannifin (PH) back in November, and ITT shares have outperformed that group, as well as outperforming the broader industrial space by more than 15%.

All good things come to an end, and so too with ITT being a standout value/GARP option in the industrial space. I still like ITT operationally, and I’m still bullish on under-appreciated opportunities in auto, control technologies, and process, as well as margin improvement potential and M&A optionality. Still, I feel like more of this is recognized in the share price now. ITT shares still offer a better-than-average total return potential, but it’s not a name I can pound the table as hard for as before.

Outperformance In A Tough Quarter

ITT’s fourth quarter wasn’t good in an absolute sense, but it was pretty respectable relative to peer group performance and sell-side expectations.

Revenue fell 4% in organic terms to $709M, matching the broad industrial sector average for the quarter and beating expectations by 8%, with each segment beating. Gross margin declined about a point (to 30.8%), but operating cost management was good, and operating income rose 8% to $112M, beating expectations by 12% and beating by 60bp on operating margin (margin improved 160bp to 15.8%).

Industrial Process

Industrial process revenue fell 10% in organic terms (to $228M), beating by 1%, as the company saw significant pressure in short-cycle (down 13%) and project (down 4%) due to weaker demand and project delays in verticals like chemicals and oil/gas (more on the refinery side). Segment profits fell 5%, beating by 5%, with margin up 90bp to 15.1% - a strong performance with a double-digit decline in revenue.

All told, I think ITT did pretty well, as SPX Flow (FLOW) reported a 22% decline in its Industrial segment and Emerson (EMR) saw a 9% decline in its Automated Solutions and weaker results in the more comparable Final Control sub-segment. Guidance for a sharp decline in Q1’21 but a return to growth in the second half seemed pretty consistent with other process companies, and it’s possible that higher oil/gas prices could drive a little better recovery there.

Motion Technologies

ITT’s brake pads business (the bulk of Motion Tech) continues to be a star performer. Revenue rose 10% overall to $352M (beating by 17%), with Friction up 13% on 14% growth in autos (OE up 19%, aftermarket up 5%). Rail wasn’t as strong, but wasn’t bad. Segment profits rose 46%, beating by 21%, and segment margin improved more than four points to 19.5%.

This is a harder business to comp out, particularly with companies like Akebono deprioritizing the U.S. market. Relative to an auto market down about 5% in the quarter, though, I think it’s pretty clear that ITT continues to gain share, and management announced another seven EV platform wins in the quarter.

CCT

ITT’s Connect and Control Technologies (or CCT) business remains under real pressure from weakness in aerospace and oil/gas end-markets. Revenue fell 21% to $129M in the quarter, still good for a 2% beat, with Aero down 30% on well-understood pressures in aftermarket (weaker flight hours) and new-builds. Segment profit fell 39%, missing by 4%, and margin declined four points to 13%.

Orders remained weak (down 20% yoy), but I think we’ve seen the worst in aero. Performance in aero was broadly consistent with the 25% decline at Eaton, and ITT has relatively less leverage, I believe, to defense, which has been an important offset for aero suppliers like Eaton and Honeywell (HON).

A Mixed Bag Of Secular Drivers

ITT reported overall order contraction of 2% from the year-ago period, but a 16% sequential rebound driven by Motion (up 30% qoq) and CCT (up 18% qoq). Process is going to need a little more time, and that’s basically consistent with the “down 1% to down 2%” guidance many process companies have reported. Remember, these are longer-cycle markets.

Looking at ITT’s end-market exposures, I’m excited about the company's high leverage to autos (about 40% of overall sales), particularly given the momentum in the business and the ongoing share growth potential as the company leverages its strong material science capabilities and new products designed specifically for hybrid/EV applications (including “smart” brake pads for regenerative braking). Management’s guidance of 10% growth in 2021 seems light next to the IHS 14% growth forecast for ’21, particularly with that share-gain momentum.

I’m also relatively bullish on the company’s shorter-cycle industrial exposure (around 15% to 20% of the business), as companies across a range of end-markets see improving demand. End-markets like mining and medical should be positive in ’21, but they’re relatively small contributors.

Aerospace, chemicals, and oil/gas are different situations. I think we’ve seen the worst in aerospace, and results will improve through ’21, but the real recovery is likely a 2022/23 and beyond driver. With chemicals, some companies have offered bullish outlooks (Rockwell (ROK) expects mid-single-digit growth), but I’m still a little cautious given project delays. Oil/gas is an interesting case, as ITT’s exposure is more downstream (refineries); I think refineries will recover faster, but this is still likely to be a weak area until the second half of the year, and that assumes more normalization after widespread vaccination.

Specific Drivers

I do still see some company-specific drivers worth monitoring. I believe sentiment has shifted on the asbestos liability to where the base-case assumption is now that the company will contract with an insurance company to manage that liability – I would regard that as a “when, not if” event, and so I suppose there’s downside risk if that doesn’t happen (or takes longer to materialize).

ITT has a strong balance sheet, even with a 30% dividend hike, and I likewise believe the base-case is one that now assumes some M&A. Management made it clear that they’re not looking to be adventuresome with their M&A spending, but I could see tuck-in deals in IP (particularly if it would bring in new tech/capabilities for the portfolio redesign that is underway) and CCT. I don’t dismiss a deal in MT, but it would probably be outside of autos unless there’s some interesting technology held by a small private company that ITT wants.

The Outlook

I’m still looking for long-term revenue growth of around 3% to 4%, although that’s been creeping toward 4%. I expect ITT to regain pre-pandemic revenue levels in 2022, and I expect multiple years of above-trend growth, driven by growth in auto braking and supplemented by recoveries and growth in IP and CCT (particularly aero).

Management’s guidance for 2% to 4% organic growth in 2021 was light of what I think the Street wanted, but it’s consistent with cautious guidance from other multi-industrials, and I think there could be upside, particularly in autos.

ITT did well on decremental margins during the downturn (better than average), and the 35%-plus incremental margin guide for 2021 wasn’t bad. Overall operating margin only fell 40bp in 2020, so 2021 will already see the company back above pre-pandemic levels, and I expect progress toward 17% margin in 2023/24. All of that feeds into a long-term FCF growth rate of 7% with ITT holding on to double-digit FCF margins.

The Bottom Line

Discounted cash flow valuation suggests a long-term annualized total return potential in the neighborhood of 8% - not bad in a market where most industrials offer something around 7% or less. A margin/return-driven forward EBITDA multiple of 13x gives me a fair value in the mid-$80’s (in line with the price today), but ongoing margin/return improvement should drive further upward rerating.

I can’t say that ITT is a hands-down bargain today, but I do think the company still offers better-than-average upside in an expensive market. I really like the share growth potential in the MT business and the recovery potential in CCT, and I don’t want to underrate a management team that has already driven a lot of internal improvement. Accordingly, while it’s a more borderline buy for me, it’s still a stock to consider.

Analyst’s Disclosure: I am/we are long ITT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.