Welcome to ITT's 2023 Second Quarter Conference Call. Today is Thursday, August 3, 2023. Today's call is being recorded and will be available for replay beginning at 12:00 p.m. ET. [Operator Instructions]. It is now my pleasure to turn the floor over to Mark Macaluso, Vice President of Investor Relations and Global Communications. You may now begin.

Thank you, Ellen. Good morning. Joining me here in Stamford this morning are Luca Savi, ITT's Chief Executive Officer and President; and Emmanuel Caprais, Chief Financial Officer. Today's call will cover ITT's financial results for the 3-month period ending July 1, 2023, which we announced this morning. Before we begin, please refer to Slide 2 of today's presentation available on our website, where we note that today's comments will include forward-looking statements that are based on our current expectations. Actual results may differ materially due to several risks and uncertainties, including those described in our 2022 annual report on Form 10-K and other recent SEC filings. Except or otherwise noted, the second quarter results we present this morning will be compared to the second quarter 2022 and include non-GAAP financial measures. The reconciliation of such measures to the most comparable GAAP figures are detailed in our press release and in the appendix of our presentation, both of which are available on our website. With that, it's now my pleasure to turn the call over to Luca, who will begin on Slide 3.

Thank you, Mark, and good morning. I would like to begin, as I always do, by thanking our employees around the world who work hard every day to ensure we deliver on our commitments to all our stakeholders and to our shareholders and customers for their ongoing support and investment in ITT. Last quarter, the ITT story was about growth and execution. And in Q2, the story is again growth and execution with a significant step-up and record results on many fronts. Our order growth rate accelerated. We expanded our margin, especially in Industrial Process and Motion Technologies, and our teams generated significantly higher cash and we deployed it. Let me share some of the highlights. 12% organic revenue growth, 280 basis points of segment margin expansion, 36% EPS growth and more than $120 million improvement in free cash flow since Q1. And on top of that, orders, up 13% organically and 6% sequentially. Now let's get into the details. On growth. Industrial Process delivered a 23% revenue increase and the 15% organic orders growth with another record quarter driven by projects and aftermarket. On aftermarket, our daily order rates in parts and service remain at historically high levels, and we are realizing further pricing. On projects, orders grew 41% despite a tough prior year comparison. This includes a significant pumps award on an LNG project for one of the world's most prestigious engineering firms. Green project orders are up more than 100% in Q2 and year-to-date are already more than double the amount for all of 2022. Additionally, our Bornemann Twin-Screw and multiphase pump technologies are capturing share. For example, Bornemann was recently awarding content on one of the world's largest decarbonization project in Australia that produces roughly 16 million tons of LNG per year. When I was at…

Thank you, Luca. Let's begin on Slide 5. We continue to see strong top line growth in both Industrial Process and Motion Technologies. In IP, project grew over 100%, while baseline pumps and aftermarket grew mid-teens. In MT, Friction's perfect on-time delivery performance drove double-digit revenue growth. As I indicated at a conference in June, Friction's outperformance ramped this quarter. We also saw strong volume and pricing growth in KONI and Axtone, thanks to share gains in rail. . In CCT, the growth in our aero components business largely offset declines in industrial connectors associated with continued destocking in distribution, especially in Europe. The team is addressing the dynamics of strong demand, coupled with a challenged supply chain in commercial aerospace by reducing our internal lead types. Moving to our margin performance. Our incremental margin this quarter was nearly 40%, and 50% in IP. This is driven by over 300 basis points from volume and price and over 200 basis points of productivity, which collectively outpaced cost inflation and unfavorable foreign currency impacts. Motion Technologies delivered a strong sequential and year-over-year improvement. This will continue as productivity ramps and commodity inflation eases further. Finally, this quarter, we divested a small product line in CCT and incurred acquisition expenses related to Micro-Mode, which drove a net $5 million gain or $0.05 of EPS. This amounted to 50 basis points of margin improvement that will not repeat. On adjusted EPS, Q2 showed another big step-up in performance. The 36% growth is largely the result of strong operational performance, pricing realization that is now outpacing cost inflation. Finally, on cash, another impressive performance, both year-over-year and compared to Q1. Free cash flow margin was almost 15% this quarter. The $145 million increase in free cash flow year-to-date came from a combination of higher…

Thank you, Emmanuel. A few points to reiterate before our Q&A. First, Growth. We are positioned in attractive and growing end markets, and we are outperforming. Second, the team's execution in these end markets has been outstanding. They are fighting still challenging supply chain conditions, removing bottlenecks and finding new ways to deploy lean processes. And before you ask, let me assure you, we will have new long-term margin targets for industrial process in the not-too-distant future, given its current performance. It has been 1 year since we established a long-term segment margin target for ITT of 20%. And at 18.7% in Q2, we are already well on our way to achieving our target. Third, we're not losing sight of the long term. We're investing today in innovation, product development and capacity to support growth in pump projects, in electrified vehicles, in the high-performance vehicle market, and in aero and defense. Our teams have been working throughout the summer on their long-term strategic plan. And I'm sure that we will deliver on them as we have done so far. We've been improving our balance sheet for several years now, which enabled us to go on offense. We are deploying capital while cultivating a strong M&A pipeline and investing in our business organically. Lastly, we raised our full year guidance to over $5 of EPS at the midpoint. ITT is entering a new stepped up level of performance. Thank you for your time today and your interest in ITT. Ellen, please open the line for questions.

[Operator Instructions]. Our first question comes from Damian Karas.

Congrats on the quarter. Luca, I was hoping maybe you can share some more.

Thank you.

Absolutely. Maybe you could share some more color on what you're seeing across IP. I know you guys had expected some short-cycle pressures in the back half. What are you seeing on the short cycle side? And maybe if you could also just speak to the project funnel?

Sure. Thank you, Damian. So when we're talking about the orders overall, the orders are very positive, as you see, 15% growth. And if you look at the full picture, we are in a kind of, I will call it, reinforcing cycle. The revenue is up 23%. But the orders are very healthy with a book-to-bill of 1.2. So our backlog goes up to record level. But also the funnel is up sequentially year-over-year. So overall, a very good level of demand. Now let's go specifically on the short cycle. On the short cycle, the orders will stay at elevated level. So the growth rate decelerated. But just to give you an example, parts were very strong. Parts grew 14% in the quarter, 7% was price, but 7% was volume. And when you look at the July orders, the July orders are still solid and growing year-over-year. And as I said, project is still healthy across the board, across the different regions.

Terrific. And then maybe switching to margins. Obviously, you've seen some really nice expansion year-to-date and you called out the 39% incrementals in the second quarter. It looks to me like the guidance suggests just a good bit lower incremental. If my math is correct, maybe like 15% to 20% in the back half. So if you could maybe just talk about your margin expectations from here, any factors that might be leading to a little bit less uplift? And I guess, just more generally, like how should we be thinking about the incrementals for your business?

Yes. Thanks, Damian. So we expect segment margin to be generally in line with Q2 for Q3 and Q4. And here, it's important to keep in mind that MT continues to improve sequentially while IP will probably settle between 21% and 22%. I think it's important also to remember that last year in the second half, there are a few one-off positives that impacted mostly IP and that will need to lap in the second half. So overall, I think it's fair, a little bit of deceleration of incrementals in the second half, but still very, very healthy.

Our next question comes from Jeff Hammond from KeyBanc Capital Markets.

Just wanted to really get an update on the destocking progress in industrial connectors in Europe automotive. I think you pointed out some better orders in connectors and looked like the orders were pretty good in MT as well. So I'm just wondering if those issues are starting to resolve themselves ahead of plan or still thinking it kind of runs through the year?

Thanks, Jeff. Now when you look at the aftermarket in Motion Technologies, the aftermarket is still destocking. So the situation there has not changed. So the destocking probably will continue for all of 2023. This is when it comes to Automotive. When you look at Connectors. Connectors had a very good quarter in terms of orders and it was a record as a matter of fact. I think that we are still facing destocking, particularly in Europe, like Emmanuel was sharing in the prepared remarks. What the team has been able to do is to perform incredibly well on the orders with OEM. And also they worked very hard in the distribution here in North America to enlarge the product portfolio that we put through distribution. And this has led also to a very good orders intake in Distribution North America in Q2.

Okay. And then this $0.05 gain, is that in CCT? And am I thinking about that the right way?

Yes. This is in CCT. This is a small product line, roughly $3 million of sales annually that we decided to sell to focus really on the core business of CCT.

Okay. So -- but if you take out that $5 million gain, the margins were pretty low there. So maybe just what's going on with the underlying margins in CCT.

Yes, yes, you're right, Jeff. So CCT has had a little bit of an issue in Europe, dealing with low levels of demand and adjustment of the cost base. So we -- now we're happy to report that as of June, really the second part of June and also what we saw in July, we're back on track, and we're back to the previous levels of performance. So we feel pretty confident that CCT is going to be higher than 17% in the back half of the year.

Our next question comes from Joe Ritchie from Goldman Sachs.

So a couple of quick questions. First one, just on just on the organic growth that you guys saw this quarter in MT, can you just make that -- break that down a little bit further for us? Like what did you see in Friction versus the rail business? And then like any other geographic color would be helpful, too.

Okay. So first of all, when you look at Friction and Automotive, I think that there was a positive performance when you look at the OE. So we outperformed the market by 500 basis points, especially performing was China, where we were almost twice the growth of the market and we continue to win awards. I will give a little bit more color later. The aftermarket is still destocking. So overall, the OES was positive, but independent aftermarket negative growth year-over-year. Rail had a very good order intake. So when you look at KONI, for example, KONI orders in the quarter were up 25%, and we expect the orders to be up double digit for all of 2023. And also Axtone, you may remember, Axtone, 25% of the Axtone business was actually in Russia, and we got hit pretty hard last year. Now the team has worked incredibly hard to offset those Russian orders with more passenger orders in Western Europe and other regions. So we expect the orders for 2023 to fully offset the business that we suspended in Russia. So overall, positive across the board.

So Joe, to round it all up in terms of revenue Friction, so strong growth in Friction, mid-teens. This is really driven by Friction OE, plus 21%, which is a really strong number as Luca was mentioning, based on the outperformance. Rail also was up 25%. And this is both coming from KONI and Axtone. So not only we had strong revenue and we really -- the team really increased the output of our factories. But on top of that, we had really strong orders, as Luca was mentioning.

Awesome. That's great to hear guys. And then my quick follow-on. I saw the price/cost was a nice contributor to earnings on a year-over-year basis versus last quarter, I think you guys were flat. What's the expectation into the back half of the year, Emmanuel, for price cost and how that's expected to contribute on a year-over-year basis?

Yes. So you're right, Joe. We had a nice contribution from price cost clearly positive from a dollar basis and more than 100 basis points of margin expansion, thanks to that. And let me just precise that. When we talk about price cost here, we talk about price versus all our costs. So not only material, it includes also labor and overhead. And so in the second half of the year, I would say that we should still see a positive trend on price/cost, definitely positive from a dollar basis. And then from a margin basis, a little less than 100 basis points.

Our next question comes from Vlad Bystricky from Citigroup.

We can't hear you Vlad.

Sorry about that. guys. Can you hear me now?

Yes.

Yes.

Okay. Great. So I just wanted to ask you guys about the channel destock in CCT connectors and where you think that channel is in the destocking cycle and what you're hearing in terms of actual end market dynamics there?

So I think what we're seeing is the destocking that we're seeing is happening in Europe. We're not seeing destocking for the moment in North America. What we hear from our distributors' partners is that their customers are destocking, but we're not seeing a clear destocking movement at our customers in North America. I would say from a demand standpoint, we feel pretty good. As Luca was mentioning, we have been able to expand our product lines with our distributors, especially in North America, and that has yielded a significant share gains. And we'll continue to really insisted to develop new products, especially including the ones that we acquired with Micro-Mode to really boost our presence with distributors.

Okay. That's helpful. And then I just wanted to shift on the Friction announcement that you -- that you mentioned, quite interesting. So I guess just any color you can give on when you're expecting that plant to come online and how you're thinking about visibility to demand for product offerings out of that facility? And is this sort of displacing incumbents or more focused on winning new content on new vehicles as they're introduced. Just how are you thinking about ramping that capacity you're bringing online?

Sure. Thank you, Vlad. So the first part of the question is that the plant will be up -- the building will be up by September next year. The equipment will be installed in September next year. And the line will be running in October 2024. So you're talking about 15 months from now, yes, 14, 15 months from now. That's the timing. When it comes to awards, we have already won some of the awards that we will be producing in those plants. So we got a very good visibility. And also, this is something that we have been working in the last 12 months together with the customers. So that is going to be a good start-up with the line running from day 1.

And Vlad, this is a underserved market. So we are lucky enough to be able to guarantee our customers the same performance we deliver to them on conventional vehicles on those high-performance vehicles. And so given this -- the differentiation we have with the competition, we feel very confident that this is a high success -- we have a high success rate here. In fact, we already, as Luca was mentioning, got some awards, and it was a great combination because the awards that we got work for high-performance vehicles, but also including low emission break options. Which are fully fitting the Euro 7 requirements that we'll have to face in 2 years. So it's also a great testing ground for this new technology.

Our next question comes from Matt Summerville from D.A. Davidson.

A couple of questions. First, just on Friction OEM, what sort of production outlook are you looking at for '23 and maybe an early thought on how you're building your business plan around the '24 production outlook, regional color would also be helpful. And then maybe touch on 500 basis points of outperformance. I guess I thought you guys had talked about that gap may be starting to close. But indeed, you're still holding on to a pretty wide margin relative to global vehicle output. So maybe touch on that a little bit.

Sure. Thank you, Matt. So Q1 and Q2 production have been a pleasant surprise because they were better than the original forecast. So the first half is roughly plus 11% worldwide. So when you look at the forecast for the full year, today is mid-single digit. This is what IHS is saying, roughly 86.7 million vehicles produced. We tend to be more conservative. So we are more on the low single digit worldwide, right? 84 million, 85 million vehicle produced, and we continuously expect to outperform that market growth. Then you asked about the region. We think that Europe is probably growing mid-single digits. Year-to-date, they grew at 16% for H1. We think China is going to be probably flattish, whereas North America is probably growing mid-single digit. This is when it comes to the market and the region. As I said, we still expect to outperform, we are quoting 500 basis points in outperformance in Q2. I would say, the outperformance was outstanding in China. China did extremely well. I will talk a little bit about that in a second but we expect the outperformance to continue that because we keep on winning a very fair share of new platforms. To give you an idea, we have been awarded 100% of the front axle and 100% of the rare axle of a major EU premium OEM EV platform. This is for Friction, the largest award ever. The launch will be in 2025, and OE will last for 10 years. OES, will last for 20 years. So think about the visibility that you have on this platform. We won with BYD. We won the front axle of the Cybertruck with Tesla. So we continue to see that electrification is really a tailwind for our outperformance in the future.

That's great. Appreciate all that color, Luca. And then just maybe comment on the M&A pipeline, actionability, what you're seeing from a multiple standpoint among the 3 business segments, maybe where you're seeing the most near-term activity and maybe what your expectations are for incremental deals to close beyond the one you had made.

Sure when you look at the M&A, you know we have built a strong M&A function. We continue to build the pipeline. We see some good interesting opportunities move through the pipeline and those range from the bolt-ons to larger scale transaction. So we stay focused on the strategic fit and the asset quality, and I will say the area that we are making progress on, particularly because the pipeline is richer and because it's also our focus are really in flow, which means pumps and valves and connectors.

And from a multiple standpoint, I would say that we see still pretty high multiples I think it's difficult for sellers to give up on those high multiples that they had before. And so that's why we pay real attention to the business case that are presented to us with those opportunities. And I think that we've been pretty successful in rationalizing the business case and really discussing with sellers the logic of those. And in some cases, debunking also there assumptions because they were proved to be too optimistic. So we're very attention on the valuation. We're very attentive on the business spend that are presented to us because we want to make sure that we stay close to the returns we've been able to provide so far.

Our next question comes from Mike Halloran from Baird.

So two questions here. First, on the margins for Motion. Certainly, you heard Emmanuel's comments about sequentially up as you move into 3Q. Maybe just talk about the timing of the recovery curve given all the moving pieces on the costs, volume, et cetera, side of things.

Yes. Yes, Mike. So we're very excited with the Motion Technologies performance. At 16%, as we mentioned, this is 150 basis points over prior year and then 120 sequentially. And there's still more to go after. The growth engine in terms of margin expansion for Motion Tech is productivity and it will continue to be productivity and we see many more opportunities, especially as we grow rapidly our top line and expand into new types of products, new types of technology for our brake pad. So Friction, still a lot of runway in terms of productivity. And then if you look at our rail platform, KONI and Axtone, we see many opportunities, both from a pricing standpoint and also a productivity standpoint. So here in pricing, we have just scratched the surface, but there's still much more to go after. And because this is the longer cycle business, we're not seeing all the impacts of pricing yet in our P&L. So we're going to continue to drive this. And with further margin expansion from KONI, Axtone as well as from Friction, we expect really Motion Technologies to be in a position in 2024 sometime in 2024 to be at least 18% mark.

That's helpful. Appreciate it. And then following up on earlier question on the IP side, underlying trends, you talked about a pretty robust funnel, just a little help on the composition of that funnel. And in anyway you can delineate between underlying -- health of the underlying markets versus what's clearly some share gain going on in your efforts there?

So Mike, when you look at the funnel which is up just couple of stats. 38% year-over-year and is up 11% since January 1, is across most of the region, is very strong in North America, is up in also Europe, the Middle East as well as in Asia Pacific. And also when you look at the market, we're talking about both up in the oil and gas and the funnel is also up on the chemicals. I think that we have a good, green project. I think if you look at our booking in terms of in green project as -- it's very good. And today, they represent roughly 33% of all the orders that we booked in projects. And we have a good sight of opportunities in the funnel there as well.

Our next question comes from Nathan Jones from Stifel.

I just have a couple of follow ups, few questions that have been asked. First one on the capacity addition per MK, could you just give us a number for what capacity this is adding and over what time period you expect that to be filled up?

Okay. And that's -- you're talking about that these are high-performing vehicles. So these tend to be low volume, high mix and tend to be high value in terms of products. So you're talking about anything that could go from 5 to maybe 10 million maximum 15 million pads probably in the next, let's say, 7 to 10 years.

And so in terms of capacity, you know how we operate. We only book incremental capacity when we have our orders. So we don't have the expending the Termoli sites from an infrastructure standpoint by more than -- by more than 70% and so that's the infrastructure. And then we're going to fill it up with new prices as we receive orders. But we already started receiving some orders, especially from Porsche and also from Daimler with the AMG segment. Okay. So the revenue may not be that good bit, but it may not be that much further capacity expansions, you're quoting in the -- we would be expecting this to be some pretty high margin revenue that you're booking.

Yes. So I think it's fair to say that there will be lower unitary volumes per platform. The price is going to be much higher than what we are selling today. And I would say our expectations from a profitability standpoint is that it will be higher than our business with conventional brake pads.

And while we're at it, I was going to ask for an update on the Smart Pad. I haven't heard an update on that for a while. Just any update you've got on the progress being made there.

Sure. The Smart Pad is part of the initiative that we have on the innovation. We have several projects going on in the Smart Pad. We have a project on one sensor, where we are working together with some, I would say, unconventional customers in terms of some fleet management and look at that as a business opportunity, different than the OEM side. And then we are working together with a couple of OEMs and Tier 1 on the 3 sensors. And as you know, there are a lot of changing happening from a technology point of view on the breaking with autonomous vehicle, et cetera, and those are progressing well as well, Nathan.

Just one final one on the CCT destocking. Clearly, in Industrials, we've seen a lot of destocking going on, people built too much inventory in 2022. Some places you're seeing in market softening, lead times are coming down, supply chains are improving. So there's multiple inputs on why destocking is happening. Do you have any color on how much of this is being driven by the fact that lead times are getting shorter. People may be built too much inventory last year versus actual softening of underlying demand, which pretty clearly is going on in parts of Europe.

So I think that when we look at the destocking through the connectors in distribution, as Emmanuel said before, we are seeing that particularly on the European side, Nathan. North American distribution was incredibly strong in Q2. And the area where we were strong was Aero, Defense and also Industrial in terms of orders. And this is also thanks to the great job that the team has done in terms of enlarging the product portfolio that we are offering through the North American distribution. So distribution in North America and distribution worldwide because exceptional performance in North America has been strong for ITT connectors in Q2.

Our last question today comes from Joe Giordano from TD Cowen.

This is [indiscernible] on for Joe Giordano. Congrats on the quarter, guys. So my first question is on Motion Technologies, the 18% margin you guys mentioned. Just wanted to confirm how you guys view the sustainability of that margin. Like do you view that as a run rate margin? I know there is some pricing still being worked through, but long term, how do you do that?

So I think the 18% that we talked about is just the first step to get to our 20% target. You may remember that last year, we committed to those targets. And for Motion Technologies, they were 20% long term. So I would say we feel pretty good about this 18% first step. We continue to drive productivity, we continue to drive pricing also, as I mentioned, especially in Rail. And I think that as aftermarket recovers next year and we also have the platforms -- the new platforms with a better coverage in terms of cost inflation that are kicking into production next year and in '25, we feel that structurally Motion Technologies will be at a higher level of profitability. So we have definitely a good line of sight for that 18% in 2024. And then to build on that and get to our 2020 -- to our 20% long-term target in the next 3 to 4 years.

That's awesome. And last question would be just on your backlog. So you guys have currently, I think, , broadly speaking, how much visibility or coverage do you guys think that provides into 2024.

So yes, the backlog has been a really strong data point for us, really strong performance from a commercial standpoint. Our backlog in IP is almost $700 million. It's up $50 million in Q2 versus Q1. So think about that. We grew revenue by almost 23% in IP and despite that, we were able to grow our backlog by $50 million. So year-to-date, we have book-to-bill. So definitely, we expect that with this level of backlog, we'll be able to grow in 2024 in IP. In CCT, we continue to also drive a lot of backlog accumulation. Backlog was up $25 million versus Q1, 11% year-over-year, and the book-to-bill is at 1.15. So also here, really strong performance from a commercial aerospace standpoint. And so here, in commercial aerospace and in defense, we accumulate long-term backlog. So this bodes well for CCT's revenue in 2024. And then as I mentioned, in MT, backlog is mostly centered around rail and defense. And here, we're accumulating also some strong orders. So overall, I would say we have -- this definitely gives us really good line of sight for the second half and also because of some of the long-cycle awards that we got into 2024.

And it's not just the size, but it's also the profitability of this backlog, which is better and higher than it was as an example, 1 year ago.

Thank you. This does conclude today's teleconference. Please disconnect your lines at this time. And have a wonderful rest of your day.