EUR 850.00 For Business Accounts Only

Morningstar | ITT Should Remain on Cruise Control, but Consensus Needs to Pump the Brakes on Expectations. See Updated Analyst Note from 09 Jul 2019

We are initiating coverage of ITT with a fair value estimate of $61 per share, toward the bottom of the range of consensus estimates. We award the company a narrow moat and stable trend rating with a medium level of uncertainty. We assign management a Standard stewardship rating. ITT has valuable assets with multiple favorable tailwinds that benefit its earning power. While we like the company, we believe expectations have run ahead of economic reality. Our fair value estimate implies just over 17 times adjusted 2019 earnings per share, about the midpoint of where diversified industrials are typically trading.

We base our thesis primarily on ITT’s best segment, motion technologies. In this segment, we’re most bullish on brake pads, which present a robust growth opportunity in the medium term that should positively affect ITT’s intrinsic value. We believe positive motion technologies growth drivers include a strong secular trend away from copper and other metal brakes, market preference for smoother, noise-damping brakes, and demand for increased safety leading to additional adoption of ceramics. These dynamics play to ITT’s strength in material science development. We think these forces will drive aftermarket growth, particularly as vehicle production rates increase throughout our explicit forecast.

The biggest risk to our long-term ITT thesis stems from electric vehicle and hybrid disruption. We don’t expect this trend will cause material disruption to ITT’s original-equipment manufacturer channel, which represents about two thirds of its brake pad business. EV and hybrid disruption, however, poses a threat to motion technologies’ aftermarket. Morningstar predicts above-consensus global EV adoption rates. Even so, we calculate that EV adoption would eviscerate only about 1% of ITT’s sales mix by 2028 (just under $50 million), given ITT’s current sizable installed base (about 15% market share in North America).

Motion technologies is more than just brake pads, however. The remaining 20%-30% portion of the segment mostly sells rail damping and absorption solutions as well as coupling components through its KONI and Axtone brands. Europe has several rail OEMs, including Alstom and Siemens, and the motion technologies segment's position on the Continent should help it capture additional project wins. While the European Union is likely to fall short of its target to add 31,000 kilometers of high-speed rail by 2030, we’re bullish on Chinese high-speed rail infrastructure and believe the motion technologies segment's relationship with China Railway Construction will continue bearing fruit.

Aerospace and defense constitutes nearly 60% of the connect and control technologies segment's sales mix. On the commercial side, we expect revenue passenger miles will remain robust, with a 4%-5% 20-year compound annual growth rate that is front-end-loaded. We expect increasing fleet replacement rates will lead to a surge in aircraft production, with aging aircraft replaced by a new generation of more lightweight and fuel-efficient counterparts. Rising demand for fleet expansion with advanced avionics should also provide connect and control technologies with greater manufacturing, repair, and overhaul opportunities.

We have a very positive view of CEO Luca Savi, who took the helm Jan. 1 after the predecessor Denise Ramos retired. We think he is the right person for the job, particularly given his successful record as president of motion technologies. ITT’s brake pad business was Ramos’ top priority and overtook industrial process as ITT’s largest segment during her tenure. While friction technologies (housed in the motion technologies segment) was already the brake pad market leader in Europe, Savi helped ITT drive above-market growth with significant share gains in the North American and Chinese markets (the latter of which went from 0% market share to just under 20% market share, according to management).

Savi’s team’s top-line growth performance never came at the expense of operating margins, which grew over 400 basis points from 2012 to 2016. We think this is a testament to Savi’s abilities as a manager. We expect Savi will continue to drive operational improvements in ITT's other’s two segments, and we expect that this, coupled with organic growth, will remain ITT’s focus during his tenure as CEO.