Nordroden/iStock via Getty Images
Above-average organic revenue growth and margin expansion haven’t helped sentiment around ITT (NYSE:ITT) all that much, as this diversified industrial has continued to underperform relative to the broader industrial group. A cautious tone from management about 2023 hasn’t really helped (even if I think it’s a more realistic view than what other companies have offered), and investors are trying to figure out just what the macro outlook for 2023 is going to be.
Down more than 10% since my last update on the company, I have mixed feelings about the stock. I think the company has better cycle exposure than the valuation reflects, but delays in driving better price/cost mix and a heavy exposure to auto builds are not what the Street really wants now. High single-digit long-term annualized return potential isn’t bad, but I think it may take a few quarters for these shares to work again, and it’s hard to call this a must-own when investors have a wider selection of undervalued industrial stocks to choose from at the moment.
Margin And Forex Pressures Evident In Third Quarter Results
I’d call ITT’s third quarter results okay on balance, but there were definitely some points of pain that are going to continue into the coming quarters and weigh on sentiment and estimates – namely forex pressures and delayed leverage on price/cost mix.
Revenue rose 15% in organic terms to $0.75B; while the beat was modest in terms of reported revenue (due to higher forex impact), organic revenue was stronger than expected and ITT’s performance stacks up as better than average (the average industrial reported around 11% organic growth, with the top tier coming in at the high teens to low 20%s).
Gross margin declined 130bp yoy and improved 60bpq qoq to 30.9%, a somewhat lackluster result. ITT has been less aggressive on pricing and is seeing slower neutralization of costs relative to some of its rivals. Management’s commentary on pricing wasn’t entirely clear to me, but it sounds as though the 15% organic growth was split evenly between price and volume; if that’s accurate, ITT was above-average on volume and a little below average on pricing.
Operating efficiencies helped mitigate some of the gross margin pressure, with the company reporting 19% operating income growth (margin up 130bp to 16.8%) and 18% segment profit growth (margin up 140bp to 18.2%). Compared to other industrials, ITT is still doing well with modestly above-average operating margins.
Looking At The Segments
Industrial Process
ITT’s Industrial Process business saw 15% organic growth in the quarter, with short-cycle business up 14% and project business up 17%. Segment profits improved 59%, with margin up 550bp to 21.%. Orders grew 11%, with short-cycle up 10% and projects up 19%, and IP had a 1.09x book-to-bill for the quarter.
Looking at comps, Crane (CR) posted 9% revenue growth and 130bp of margin improvement (to 16.8%), with core orders up 9% and a book-to-bill of 1.0x, with management noting healthy project demand (especially for debottlenecking) and strong industrial, chemical, and pharmaceutical demand. Dover‘s (DOV) Pumps and Processing business grew 2%, with segment margin down 460bp to 29.7% and orders down 15%; management noted healthy short-cycle demand but saw weakness from difficult comps in its biopharma business (boosted by COVID-19). IDEX (IEX) reported 17% revenue growth and 2% order growth, as well as 250bp margin improvement (to 30.7%) in Fluid & Metering, with strong industrial and agriculture demand. Flowserve (FLS) was also strong, with revenue up 7% and orders up 41%, but the heavier mix of oil/gas and water makes comparability more challenging.
Management was more cautious here on the short-cycle business than other companies, and that could tie into its larger “general industrial” exposure and its smaller leverage to mining, food/beverage, water, and biopharma. To that end, though, I like the company’s acquisition of Habonim earlier this year, and I’d like to see more expansion in new energy (LNG, hydrogen, et al.) and biopharma.
Motion Technologies
ITT reported 15% growth in its Motion Technologies business, with strong 22% growth in Friction (brake products for autos) that included 40% growth in original equipment sales and 1% growth in aftermarket. Segment profits declined 6%, with margin down 160bp to 15.8%. Orders/backlog aren’t as relevant to this business, but the company did report 26 new EV wins, bringing its year-to-date total up to 60, and it’s worth restating that ITT’s EV awards are higher-value than its traditional auto business.
Comparability to other companies is limited, as Akebono (OTCPK:AKBIF) and Nisshinbo (OTCPK:NSHBY) haven’t reported their most recent quarter, but relative to global vehicle production up 28% ITT wasn’t too far out of line.
Management was cautious on vehicle production in 2023 on supply issues, and while I agree with the conclusion, I think higher rates and lower consumer confidence will play a role too, as component supply is improving. I’m a little more bullish, looking for mid-to-high single-digit production growth, mostly on inventory rebuilding.
Connect & Control
Connect and Control grew revenue by 15% in the quarter, boosted by 34% growth from aerospace as build rates continue to improve. Profits rose 21%, with margin up 150bp to 18.6%, and orders rose 12% (book-to-bill of 1.03x), with 20% growth in aerospace orders. Specific comps are challenging here, but Eaton‘s (ETN) Aerospace business was up 8%, with margin up 200bp to 24%.
Management was cautious on short-cycle industrial demand here, and that makes sense in the context of a weakening macro environment. Still, aero demand should be strong in 2023 and well beyond.
The Outlook
Weaker short-cycle industrial demand and sluggish new auto builds in 2023 raise the spectre of around half to two-thirds of ITT’s business seeing low growth or some contraction. Some of that can be offset by strength in longer-cycle end-markets (like chemicals, aero, energy, and rail), but I think cautious guidance is a prudent move at this point.
In the short term, ITT’s mix is what it is. Longer term, though, I look for the company to add more exposure to clean energy, biopharma, and semiconductor markets in the IP segment. I also see longer-term drivers in aviation (commercial builds accelerating), rail (public funding for rail projects), EVs (brakes and charging), energy (LNG especially), and industrial automation/electrification (connectors and control products).
On the margin side, I expect to see management replicate what it did in IP in the other segments, using more automation to reduce manufacturing costs and further refining its product lines to focus on products with wider moats and better margins.
I’ve trimmed back my revenue expectations for 2022 on forex and for 2023 on a weaker macro outlook. Long term, I’m still looking for around 5% revenue growth. I’m continuing to expect free cash flow margins to improve from the low double-digits to the mid-teens over time, driving high single-digit FCF growth.
Discounted free cash flow suggests okay upside potential, with a prospective annualized total return in the high single-digits (around 8%). A margin and return-based approach to EV/EBITDA gives me a forward multiple of 13x and a fair value in the low-to-mid-$90s on my ’23 estimate.
The Bottom Line
ITT is an okay prospect today, and I do like the company’s longer-term end-market exposures, but getting over the hurdle of weaker short-cycle markets in 2023/24 will be important. I still believe this is a worthwhile name with opportunities to surprise to the good on margins and business restructuring (mostly through M&A), but I can’t aggressively recommend this at a time when other industrials offer even better risk/reward tradeoffs.
Be the first to comment