Value Investors Club / ITT INC (ITT)

Description

Investment Thesis

At current prices, ITT trades at 14x and <13x 2017E and 2018E estimated FCF*. With oil & gas + mining at trough

levels, the industrials space lagging and upside from both cost savings and new platform ramp-ups in the automotive

space, I believe these estimates may prove conservative.

*I assume cash on hand offsets the tax-effected asbestos liability.

Company Overview

ITT is the legacy entity after the spin-offs of Exelis and Xylem in October 2011. The company manufactures highly

engineered components in the energy, transportation and industrial markets. The business is split into four segments:

Industrial Process, Motion Technologies, Interconnect Solutions and Control Technologies.

The Industrial Process (34% of ytd revenues) segment is further divided into three units – Industrial Products,

Engineered Systems (large scale projects) and Aftermarket Solutions. This segment provides customized industrial

pumps, centrifugal pumps, valves and water systems - often for demanding environments. The aftermarket sub-unit

predictably captures parts and services, including standard repairs and upgrades. In general, this segment is tiedto

infrastructure, mining, oil & gas, chemicals, general industrial, pulp & paper and the power generation markets.

The Motion Technologies (41% of ytd revenues) segment includes brake pads, shims (prevents excess noise and

vibration), shock absorbers, damping and sealing products. Within this segment, the company has three sub-units –

Friction Technologies, KONIand Wolverine. The Friction Technologies unit includes brake pads sold to OEMs,

Tier 1 and Tier 2 suppliers* and the aftermarket. The KONI sub-unit (~15%) captures shock absorbers, dampers and

buffers used for rails, cars, buses, trucks and trailers. Finally, Wolverine (acquired October 2015) manufactures

shims, gaskets and other products used in automotive braking systems and for sealing solutions.

Post 3Q, ITT acquired Axtone, a manufacturer of energy absorption components (springs, buffers and couplers) for

safety applications in transportation markets such as railway (65%), aerospace and automotive. The purchase price

of $118 million will be funded from foreign cash and compares to 2016 revenues and EBITDA of $80 and $14

million, respectively. Aftermarket content represents >40% of revenues. The deal is expected to close in early 2017.

*Sales to Continental and TRW account for 40%.

The Interconnect Solutions (13% of ytd revenues) segment manufactures connectors and cable assembles to enable

the transfer of data, signal and power in critical applications and difficult environments. The main applications are

for commercial aviation, defense, truck and trains and oil & gas. For example, the company’s products include

connectors that power electric submersible pumps for oil & gas wells.

The Control Technologies (12% of ytd revenues) segment manufactures fuel and water pumps, valves, actuators and

switches for aircraft systems in addition to other engineered products for seating systems, sound dampening and

general equipment protection. Aerospace is ~70%. The industrial, automotive, chemicals/packaging and energy unit

manufactures shock absorbers for challenging applications and process control equipment.

Geographically, the business is split between the US (38%), Germany (12%), other developed markets (19%) and

other emerging growth markets (31%).

From an end-market perspective, the core markets are transportation, industrial and oil & gas. For 2014 and 2015,

oil & gas represented 20% of revenues. In 2016, this figure is ~12%. Total aftermarket contribution is ~30%.

Raw materials used in manufacturing include steel, gold, copper, nickel, iron, aluminum, tin and specialty alloys.

The company is also exposed to the euro, renminbi, Czech koruna, won and pound.

R&D expenses averaging ~3% of revenues.

Asbestos

ITT is exposed to asbestos via gaskets sold prior to 1985 at its Goulds Pumps subsidiary. Over the next 10 years, the

company expects to recover 40% of its costs from its insurers, although reimbursements are projected to decline

over time (i.e. 15% recovery rate by year 10). Payments over the next five years are expected to average $15 to $25

million and to increase to $30 to $40 million for the remainder of the projection period. Note that amount recorded

on the balance sheet is an undiscounted number, although the estimate is only for the next ten years. The same

applies to insurance recoveries.

The company has been successful reducing this liability. In recent periods, the gross liability declined 43%, total

claims fell 72% and the net liability dropped 20%. This is a function of changes in defense strategies (use of single

defense firm), improved dismissal rates and reduced settlement values. At the most recent re-measurement period,

ITT reduced the liability by $82 million (pre-tax).

As an aside, Barclays put out an interesting piece in early January discussing how ITT could enter into a reinsurance

transaction that would remove this liability from the balance sheet. Recent deals suggest a 40%-50% discount is

possible.

Capital Structure

The capital structure is straightforward as the company runs a net cash position. Commercial paper, short term loans

and other debt aggregate $254 million compared to cash of $373 million, pro forma for the Axtone acquisition. The

net recorded asbestos liability is $566 million (pre-tax effected and discounted).

Financials

In 2015 and 2016, the company encountered difficulties from weak oil & gas and mining markets, struggling general

industrial markets and a strengthening dollar. This was partially offset by strong performance in the Motion

Technologies segment, specifically market share gains in the automotive friction space. Automotive growth

averaged 11% for the past three years and over the past decade ITT outperformed the underlying market by 2x-3x.

Chinese growth of 36% is a reflection of similar market share gains.

On the operating margin front, the company benefitted from productivity initiatives (footprint optimization, in-

sourcing, exited non-core product lines, etc.) and other efficiencies, rising >150 bps since 2012. Additional

restructuring plans are scheduled for 2016, specifically focusing on the Industrial Process segment - to right-size the

oil & gas business and further rationalize the supply chain. From actions taken in 2015 and 2016, management

projects $30 million of incremental savings.

Free cash generation is used for organic investments (i.e. new brake pad facility in Mexico –completed by YE

2017), to acquire complimentary businesses (spent $250 million in 2015 for Wolverine and Hartzell Aerospace and

$118 million in 2017 for Axtone), pay dividends and repurchase shares.

Management targets long-term organic growth in the 5%-7% range, margin expansion of 50-70 bps and earnings

growth of 10%-15% annually. Unlike peers, free cash conversion is expected to exceed 105% of net income.

Earnings Upside Potential

The movement of oil prices back above $50 bodes well for the oil & gas-related business. Oil & gas revenue is off

between 30%-50% depending on the product line. This is a function of the well-documented capital expenditure

reduction for large unconventional projects and pricing pressures worldwide, plus weakness in midstream and

downstream markets. I view 2016 and early 2017 as the trough.

E&P expenditures are finally expected to rise and delayed maintenance will not last forever on the aftermarket side

(35%-40% margins). ITT’s higher margin shorter-cycle business is expected to be the first to see an uptick with

higher oil prices and increased North American activity.

In 2014-2015, oil & gas related revenues averaged slightly above $500 million compared to a sub-$300 million

figure in 2016. As an example, current budgeted revenue for this end-market is trending ~$100 million lower than

management expected at the start of 2016. I believe we will see this $100 million revenue return in 2018 at

incremental margins of at least 25%.

Still, the real growth driver is the automotive side as management expects healthy market share growth in the North

America and China (Wuxi facility), with smaller upside in Europe. The goal in North America is to double the

existing 10% market share over the next five years. A new facility in Mexico is scheduled to start production in 4Q

2017. New platform wins should fill out phase 1 of this plant expansion in 2018-2019. Similarly, in China, market

share of ~14% provides opportunities for further penetration. More recently, the company became the first non-

Korean OEM brake pad producer to be certified as a major Korean Tier 1.

On the cost front, management targets $19 million of incremental savings rolling into 2017 on the Industrial Process

side. Other restructuring actions should also continue to pay off in future years.

Lastly, an under-levered balance sheet (includeing asbestos) should facilitate growth without any dilution. At a

previous conference, management cited $400 to $600 million of debt capacity. The complimentary (to KONI)

acquisition of Axtone Group is a good example. The implied 8.4x pre-synergy EBITDA multiple will be funded

with overseas cash and is obviously immediately accretive.

Putting this all together, I believe in 2018 we should see FCF >$3.00/share and possibly hit the $3.50 area if the oil

& gas recovery gains traction, motion technologies continues to perform and incremental acquisitions are rolled in.

Risks

-Continued weakness in oil & gas, mining and industrial markets

-Peak SAAR? Sustainability of Motion Tech margins?

-Continued strengthening USD

-Negative commentary re: new Mexican plant

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

-Asbestos resolution

-Oil and gas recovery and margin improvement through cost cuts

-Share buybacks (~$50 million repurchased in 3Q)

-Acquisitions (under-levered balance sheet)

show sort by

			2017	2018
Price:	41.20	EPS	2.48	2.84
Shares Out. (in M):	88	P/E	16.6	14.5
Market Cap (in $M):	3,634	P/FCF	14.3	12.7
Net Debt (in $M):	-119	EBIT	325	370
TEV (in $M):	3,883	TEV/EBIT	11.9	10.5