ITT Will Drive Continued Margin Expansion on Productivity and Aerospace Volume Leverage

Senior Equity Analyst

Joshua Aguilar

We think ITT is well-positioned to continue winning in its marque brake pad business (owning nearly 30% global market share), while a focus on continuous improvement will drive both its industrial process and connect and control technologies' segments to over 20% adjusted segment operating margins. 

In our view, the market is overly focused in the near term on raw material inflation and the semiconductor shortage. We think the semiconductor shortage should begin to ameliorate in 2023. More importantly, ITT regularly outperforms light vehicle production by greater than 800 basis points. While we expect about half of that outperformance looking forward in a low-growth light vehicle market, we still believe this is a good business that produces strong returns on capital (mid-30s). We think ITT will continue to win based on a combination of material science expertise, technological innovations like the smart pad, and its consistent record of on-time delivery (greater than 99%).

Furthermore, we expect that CEO Savi and CFO Caprais will implement the same successful playbook they used in motion technologies, or MT, in ITT's other businesses. Successful tactics from this playbook include lean tools and automation to drive shop floor productivity gains, improved supply chain low-cost sourcing, and better price management. While MT is extensively automated, that's not necessarily the case for all ITT's facilities, such as with Seneca Falls. 

Furthermore, recent acquisitions offer attractive synergy opportunities. For instance, Habonim's simplified and standardized design process is a core competency, and we think ITT can implement best practices to save on both manufacturing and engineering expenses. 

Finally, we think investors underappreciate the windfall from the commercial aerospace recovery as passenger desire to travel remains strong. Therefore, we think connect and control technologies will be ITT's strongest growth segment.

Business Strategy & Outlook

We assign ITT a narrow economic moat rating, although we believe the overall consolidated business is on the slimmer side of narrow. We base our rating primarily on switching costs and intangible assets, mostly anchored on ITT’s best and consistently growing businesses: motion technologies and, to a lesser extent, connect and control technologies.

We see switching costs related to ITT’s mission-critical, highly engineered products found in defensible niches in infrastructure; the high cost of failure in the end markets it serves; its ability to lower a customer’s total cost of ownership; the need for customers to comply with increasing environmental and safety regulations; and multiyear contracts, which can include provisions that require the use of ITT’s products. We also identify intangible assets based on well-regarded brands associated with quality and reliability; valuable customer relationships, including with original-equipment and Tier 1 manufacturers; and intellectual property, including patents and know-how.

We award the MT segment a narrow moat rating. Switching costs arise from a customer’s time and effort to find a comparable supplier that can deliver both safety and reliability, the need to maintain proper certifications, and the possible disruption to a customer’s production process. By our estimates, when including an apportionment of ITT’s corporate costs, which include shared services, and goodwill, ROICs have averaged in the mid- to high teens for the segment in recent years. On a normalized basis, we believe this segment can earn ROICs well into the 20s, which we find impressive given the cyclical nature of its end markets. Depending on how the market is defined, the company reports market share in the mid-20s. Nearly 85% of the business serves the automotive industry, with rail making up nearly the entire remaining portion. At 70% or so of segment revenue, the largest subsegment in MT is friction technologies, which manufactures a variety of original-equipment brake pads on passenger cars and light- and heavy-duty commercial vehicles as well as aftermarket brake pads designed for the automotive service and repairs market. 

Brake pads are highly engineered products. They must be specifically designed and fitted for each vehicle with reliable quality. Therefore, customer intimacy is vital. Brake pads will often vary slightly in chemical composition depending on the make and model of a vehicle. There are also several specifications that manufacturers look for in brake pads, including limits on dust, noise, and vibration levels, as well as performance expectations. Formulations for North American brake pads have evolved, which we believe reinforces MT’s switching cost moat source. For example, brake pads use molybdenum as a lubricant to reduce wear and tear as well as noise from breaking. Molybdenum is commonly used in steel alloys for its ability to form hard, stable carbides. It is advantageous in brake pads because it has one of the lowest coefficients of thermal expansion among commercially used metals, which further reduces vibration. The cost of this raw material has been historically volatile, however. This is problematic because many brake pad designs rely on this raw material. ITT was able to replace this material with a proprietary mix of compounds while still managing to lower a customer’s total cost of ownership.

We believe ITT’s continued development of advanced materials also evidences some intangible assets. These formulations can employ upward of 14 different organic and synthetic compounds. MT uses a dry formulation approach when it makes its brake pads, which is a powder-based manufacturing process of the brake pad that it codesigned with its suppliers. ITT has an agreement with its suppliers to lock up that technology for five years, which prevents imitation from its competitors. While this five-year technological advantage is shorter than our narrow moat rating time frame, it excludes ITT’s decade-plus aftermarket advantage. At 3.4% of sales, ITT’s proportional spending on research and development exceeds the median allocation in our diversified industrial coverage (typically 2%-3% of sales). Yet, at a consolidated level, ITT earns over $9.40 on five-year returns on research capital (current year gross profit over prior R&D spending over a five-year period), appreciably greater than the average of other innovative industrial firms we cover. 

Regulation is also changing the formulation of brake pads, driven primarily by environmental and safety concerns. A key element of ITT’s strategy that we believe was successful was its mass proliferation of copper-free brake pads, which were developed in 2012. Traditional brake pads are made with copper lining. Copper has a melting point above 1,000 degrees centigrade. It also has high ductility, meaning it can be made into a wire, given its ability to stretch under high-tensile stress. Copper forms a film on brake pads that increases thermal conductivity and heat resistance. However, this increased braking efficacy comes with a side effect: copper that’s discharged as friction powder when braking can contaminate the water supply. Some studies have pointed out that brake pads are the single-largest source of copper discharge to the San Francisco Bay, for instance. Excess levels of copper are toxic to wildlife. This phenomenon has prompted numerous jurisdictions, including Washington state and California, to not only ban sales of brake pads containing over 0.5% of copper by weight but also legally oblige auto repair shops to phase out their stock by no later than 2025. The U.S. Environment Protection Agency also signed an initiative with states to reduce the use of copper in brake pads. Brake pads that meet the new low-copper requirements are being certified by the Automotive Manufacturers Equipment Compliance Agency. Ratings include A, B, and N edge codes. Europe also favors MT’s copper-free innovation, as evidenced by MT’s win rates. We believe this preference should continue positively affecting share in MT’s front axle installed base, which in turn should help protect MT’s higher-margin aftermarket revenue despite market headwinds. Front axles wear more rapidly than rear axles. 

Brake pads must also meet strict safety compliance standards. In the United States, the National Highway Traffic Safety Administration promulgates national highway safety standards, but each state also has a transportation agency to enforce its own safety standards. These agencies implement regulation based on braking performance, including requirements for maximum stopping distance for passenger vehicles traveling at a certain speed, which indirectly affects brake pads when they are installed as original equipment. Multiyear contracts also evidence switching costs. Automotive platforms that MT secures can last from 2 to 30 years. MT is the largest supplier of brake pads to Ford and holds other vital customer relationships with North American OEMs like General Motors and Chrysler, as well as European OEMs like BMW, Audi, Volkswagen, Renault, Jaguar, Porsche, and Daimler. MT also supplies back plate brake pads to Tesla. While ITT does have some customer concentration (23% of MT’s revenue comes from Continental), certain contractual provisions protect MT’s competitive position. ITT’s annual report points out that about 50% of total MT revenue derived from Continental must use an ITT brake pad, generally based on supply agreements directly with OEMs. 

The remaining 20%-30% of MT mostly sells rail damping and absorption solutions as well as coupling components through its KONI and Axtone brands. We believe ITT is well positioned in the rail business, given its strong presence in the European market, where we anticipate most of the industry’s growth will come from. Switching costs are evident in this industry, given many of same dynamics, including concerns about passenger safety, security, and reliability as well as demand for energy-efficient transport systems. Passenger preferences are increasingly moving toward advanced trains for superior speed (less travel time) and comfort. When operated as intended, advanced trains also consume one fifth the energy per passenger kilometer compared with automobile travel. Advanced rail must still comply with noise and vibration limitations, and ITT makes damping and absorption solutions that meet customers' precise specifications. We expect the transition toward high-speed rail in China will further be a boon to the numerator in MT’s segment-level ROICs, where ITT consistently reports taking significant share.

We think the industrial process segment has no moat. To varying degrees, many of the dynamics that are prevalent in ITT’s two other segments are also at play in IP, including long lead times, highly engineered equipment, a sizable installed base, customer intimacy, numerous industry environmental and safety standards, and solutions that reduce a customer’s total cost of ownership. Even so, when baking in goodwill and corporate costs into IP’s ROICs, we think this business typically runs at its cost of capital throughout the cycle, though we expect this will improve.

We see several reasons for this dynamic. First, we think a large portion of the business serves engineering and construction firms as well as large multinational firms. E&C firms are inherently highly cyclical, are intensely competitive, lack significant customer bargaining power, and service relatively standardized projects as underpinned by our no-moat ratings on these firms. Aside from the inevitable commoditization to portions of IP’s product portfolio stemming from its E&C customers’ standardized projects, we believe these dynamics hit ITT in other ways. Specifically, customers that have their own competitive pressures will go through periods where their own order pace ebbs and flows. We suspect multinational customers also have a greater deal of bargaining power with IP, given the competitive nature of the industry. 

Second, only about 20%-25% of IP’s business is project-based with long lead times. These longer-term projects are where IP’s highly engineered pumps, which are inherently more complex, are sold. Even so, this business is a minority portion of the segment’s sales mix. Valves, by contrast, generally have shorter lead times.

Third, we believe IP lacks the large installed base of some of its other competitors, which leads to a smaller proportion of higher-margin aftermarket sales. Finally, we believe some of IP’s problems are self-inflicted, stemming from poor execution. We believe IP has underpriced some past projects to maintain share, which simply failed to compensate IP for its inherent participation risks. Aside from the apparent bargaining power of customers, from a Porter’s Five Forces perspective, we believe IP suffers from inherently weak bargaining power with its own suppliers, given that suppliers haven’t historically been held financially accountable for delivery delays. 

We assign connect and control technologies a modest narrow moat rating. CCT makes highly engineered connectors and specialized control products in mission-critical industries, like aerospace and defense, as well as harsh and hazardous environments, as commonly seen in the oil and gas industry. CCT’s connectors are manufactured to tight tolerances. This segment focuses on the harsh environment connector niche, which is lower volume but higher margin and more complex (not commoditized). Relationships with independent distributors, which further provide high levels of service in the aftermarket, can last for decades. In some end markets, OEMs and suppliers like CCT will collaborate closely in the development of products. Switching to an alternative would require a customer to potentially retrain and retool its manufacturing. The customer cost of switching to marginally cheaper products that meet a similar reliability standard is meaningful in terms of time, expense, and loss of revenue. CCT’s products are therefore often part of long-lived platforms that allow for contractually recurring aftermarket revenue, which typically ranges from 5 to 20 years. According to company transcripts, most of CCT’s aerospace and defense exposure, which represents nearly 50% of segment revenues, is commercial aerospace. Commercial aerospace has contracts that typically exceed the high end of the range. 

CCT’s content is on important commercial aerospace platforms, including the Boeing 777X and the 737 MAX, as well as their predecessors. While its products are predominantly found on Boeing airframes, CCT also has some Airbus content. CCT’s products, which include actuators and switches as well as noise-canceling components, are integrated into the design of an airframe. Connectors, which are used in avionics, cabin systems, navigation and control equipment, and commercial aerospace engines, must endure extreme temperatures and resist extreme levels of vibration with significant high costs of failure. For example, in the harshest shock environments, even the most reliable ratcheting coupling systems can decouple. While coupling systems are a small part of an airframe’s bill of materials, loss of power and control from coupling failure in critical applications could be catastrophic, both in terms of lives lost and protracted downtime. We believe these dynamics indicate switching costs.

CCT revenue tends to be consistent, with management reporting a steady mid-single-digit CAGR in the 30-year period preceding 2013. We believe CCT’s strong brands like ITT Cannon, which are strongly associated with safety and reliability, as well as its strong customer relationships contribute to this dynamic and demonstrate some modest intangible assets. CCT also has positive optionality, given the trend toward electrification. The segment can continue to expand into other mission-critical industries while leveraging its current technology, including medical (patient monitoring and diagnostic equipment), electric vehicles (charging stations), and rotorcraft. While segment ROICs, when including both goodwill and corporate costs have narrowly beat our estimated WACC, we note that estimated ROICs exceeded 14% in 2021. We think they can continue to exceed our WACC hurdle by a safe margin through midcycle.

Narrow

Economic Moat

ITT, Inc. engages in the manufacture and sale of engineered components and customized technology solutions primarily for the transportation, industrial, and energy markets. It operates through the following segments: Motion Technologies, Industrial Process, Connect and Control Technologies, and Corporate and Other. The Motion Technologies segment manufactures brake pads, shims, shock absorbers, energy absorption components, and sealing technologies primarily for the transportation industry, including passenger cars and trucks, light- and heavy-duty commercial and military vehicles, buses, and trains. The Industrial Process segment includes engineered fluid process equipment in areas such as chemical, oil and gas, mining, and other industrial process markets as well as providing plant optimization and efficiency solutions and aftermarket services and parts. The Connect and Control Technologies segment offers harsh-environment connector solutions and critical energy absorption and flow control components for the aerospace and defense, general industrial, medical, and oil and gas markets. The Corporate and Other segment is composed of corporate office expenses including compensation, benefits, occupancy, depreciation, and other administrative costs, as well as charges related to certain matters, such as asbestos and environmental liabilities, that are managed at a corporate level and are not included in segment results when evaluating performance or allocating resources. The company was founded in 1920 and is headquartered in Stamford, CT.

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ITT, Inc. engages in the manufacture and sale of engineered components and customized technology solutions primarily for the transportation, industrial, and energy markets. It operates through the following segments: Motion Technologies (MT), Industrial Process (IP), Connect and Control Technologies (CCT), and Corporate and Other. The MT segment includes ITT Friction Technologies, Axtone, KONI, Novitek, Wolverine Advanced Materials, and GALT brands. The IP segment refers to Goulds Pumps, PRO Services, Rheinhütte Pumpen, Bornemann, C'treat, Habonim, Engineered Valves, and i-ALERT brands. The CCT segment is involved in the Cannon, Aerospace Controls, Neo-Dyn, VEAM, Enidine, Conoflow, BIW Connector Systems, Compact Automation, and Micro-Mode brands. The Corporate and Other segment relates to corporate office expenses including compensation, benefits, occupancy, depreciation, and other administrative costs. The company was founded in 1920 and is headquartered in Stamford, CT.

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