ITT Inc.

Welcome to ITT's 2020 Third Quarter Conference Call. Today is Friday, October 30, 2020. Today's call is being recorded and will be available for replay beginning at 12 p.m. Eastern. At this time, all participants have been placed in a listen-only mode and the floor will be open for your questions following the presentation. If you would like to ask a question at that time, please press star 1 on your touchtone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. If you should require operator assistance, please press star zero. We ask that you please pick up your handset to allow optimal sound quality. It is now my pleasure to turn the floor over to Alex Schurk, Investor Relations Manager. You may begin.

Good morning, and thank you, Lori. Welcome to ITT's third quarter 2020 earnings call. This is Alex Schurk. And on the line this morning are Luke Asabi, Chief Executive Officer and President, and Emmanuel Capre, Chief Financial Officer. Today's presentation, press release, and reconciliations of non-GAAP financial measures to the most comparable GAAP measure can be found on our website at itt.com forward slash investors. Our adjusted non-GAAP results include certain non-operating and non-recurring items, including but not limited to asbestos, restructuring, asset impairment, acquisition-related items, and certain tax items. All adjustments in the quarter are detailed in the reconciliations. Before we begin, I'd like to provide a brief overview of our Q3 GAAP results compared to prior year. Q3 total revenue decreased 17% to $591 million. Segment operating income decreased 22% to $84 million. Regarding EPS, we took our net asbestos liability to a full horizon estimate, resulting in a non-cash expense equivalent to $1.20. the main driver of the $0.55 EPS loss. Free cash flow increased 77% to $271 million. Please note that our remaining discussion will primarily focus on non-GAAP or adjusted measures, unless otherwise indicated. Lastly, today's call will contain forward-looking statements that are subject to risk and uncertainties, including impacts from the COVID-19 pandemic. Actual results may vary materially. All such statements should be evaluated together with the safe harbor disclosures and other risks and uncertainties that affect our business, including those disclosed in our SEC filings. Now, let's turn to slide number three, where Luca will take us through the Q3 highlights.

Thank you, Alex, and thank you all for being with us this morning. I truly hope that everyone stays safe. First things first, I'd like to thank all ITTs around the world who continue to work tirelessly during this pandemic to serve our customers and to take care of each other in challenging conditions. and to make sure we continue to operate safely, we are implementing our Ready, Safe, Go program across ITT, based on the successful containment strategy first developed by our Asia-Pacific team. Today, we will present the results of ITT's relentless efforts to drive our performance and fortify our resilience. During the last few years, we at ITT have elevated the strategic standing of execution. Q3's outstanding results are the proof of this and also a testament to our strengthening momentum towards full recovery. Last quarter, we highlighted our focus on protecting our employees and supporting our communities while providing superior service to our customers with flawless execution. We also committed to delight our shareholders with record cash flow generation and timely cost actions while playing offense for the future. This is exactly what we continued to do in Q3. We delivered record ITT operating income margin of 15.4%. We grew 92% sequentially in friction OE sales. We delivered 19% segment decremental margin and 40% segment incremental margin sequential to Q2. Lastly, we generated record free cash flow of $271 million. We are firmly on the road to recovery. ITT's execution capabilities and our unprecedented granularity delivered higher volume than expected, increased top line sequentially, and through strict fixed cost controls produced an ITT record quarterly margin performance. This is resilience. We achieved our highest ever quarterly operating income margin and our highest ever year-to-date free cash flow. This is even more remarkable given the current macro environment. This morning, we will share the highlights of our performance and the actions we are taking, as well as our outlook for the remainder of 2020. We will also provide our perspective on the markets we serve. Before going into Q3 performance, I'd like to highlight our safety record. Safety is, without a doubt, my top priority. We've made tremendous progress in all our businesses. Here today, we reduced the number of incidents by 30%. Our injury frequency rate is 0.8, and 50% of our sites have been incident-free for more than a year. I'm grateful to our teams for their accomplishments and for keeping our people safe. Now, let's turn to our Q3 results. On the road to recovery, we focused on what we control and broke some records along the way. We delivered solid EPS of 82 cents, up 44% sequentially, strong segment operating income margin of 16.2%, up 360 basis points sequentially, record operating income margin of 15.4%, and record-free cash flow of $271 million, representing a growth of 77% or $118 million versus prior year. From an operational excellence standpoint, we continued our journey of betterment. Our productivity and cost actions helped to offset the impact of materially lower volumes. In the third quarter, I was very fortunate. I was able to visit many of our sites in Europe and the US. Let me tell you, we have many opportunities, and we will go after them. I also experienced the progress made firsthand, progress that helped us to deliver 14.1% operating margin at IP. This is the highest industrial process Q3 margin ever, and we continue to confidently progress towards our long-term 15% plus margin target. The breadth of the operational improvements delivered by George and his team is impressive, not only because of the quality of execution, but also because of the care they put into structurally resetting IP for the long term. We are actively shaping our manufacturing footprint and redesigning our product portfolio to establish a lasting competitive moat and superior margin performance for IP in the years to come. This 14.1% margin performance represented 120 basis point expansion versus prior year, and 40 basis points higher than Q2 this year. Our progress was also evident when I was with the MT team in Barger. Motion Technologies delivered a strong operating margin at 18.5%, up 630 basis points versus Q2, and only 30 basis points below prior year. We continue to drive productivity through our factories, and China and Mexico in particular keep on impressing with margins near all-time highs. At CCT, I was encouraged by the many Kaizen events running in our Valencia site and all across ITT, we drove high levels of productivity that produced significant segment margin expansion compared to Q2. This operational excellence combined with our speed in execution enabled us to accelerate working capital reduction and post a year-over-year 180 basis points improvement. Lastly, I want to thank our leaders who helped to keep our people safe and advance ITT's operational excellence. On the customer front, our teams continue to focus on serving our customers with utmost dedication, showing through their actions that our customer-centric approach is a way of life at today's ITT. Our friction or e-sales grew 92% sequentially, and the momentum in share gains continued with each one of our main regions outperforming global production year-to-date. including over 1,000 basis points of outperformance in North America and China. While we still experience inventory adjustment issues in Europe with certain customers in the first half of Q3, we saw encouraging signs in auto OE production, particularly in September and October. We now expect friction OE outperformance for the full year, at the lower end of our expectations based on the timing of new platform ramps in the fourth quarter. IP grew organic short cycle pump orders by 14% sequentially, on the back of strong parts which improved gradually during the quarter, and showed year-over-year growth in September. IP delivered a book-to-bill of one, and as a result, our backlog at the end of Q3, was up 6% excluding foreign exchange compared to the beginning of 2020. IP continues to lead in on-time delivery performance. Today, our customers know they can rely on us to deliver top-quality goods pumps on time, at a competitive price, and consistently. This is a key differentiator. We've been talking a lot about Seneca Falls' 95% plus baseline pumps delivery performance for the last 12 months. And I want you to know that today, the rest of our facilities have been performing at an industry-leading level as well. Finally, at CCT, we've been busy playing offense and finding new ways to partner with our customers. Our elastomeric rotorcraft business has been nominated on the next U.S. military reconnaissance helicopter, codenamed FARA. This is a major recognition for our rotorcraft business, which we created organically just a few years ago. And our composites business is finalizing a strategic partnership with a large aircraft engine manufacturer that will propel our matrix business to new top-line heights. The team at CCT has been working hard to adjust our cost structure to the new aero market conditions, and at the same time, looking for growth opportunities by showcasing our engineering prowess. I was at our Valencia facility last week, and I was impressed by our new state-of-the-art sound chamber capabilities, as well as our new product pipeline. Lastly, on capital deployment. We continue to drive cash generation through working capital efficiency and strict capital expenditure focus, further strengthening our liquidity. As a result, we are raising our free cash flow margin target to a range of 13% to 15% for the full year. Today, we have $1.5 billion of available liquidity, and we have ample capital to fund all of our operational needs and investments. and position us to take advantage of other strategic opportunities. Our strong liquidity position prepares us well for what's ahead, whether it is facing headwinds or surfing tailwinds. Finally, in October, we successfully terminated and transferred our U.S. pension plan. This will not only provide our pension-eligible employees great service, but also reduce ITT's administrative costs and eliminate any future funding requirements. Let's now look at our Q3 financial results provided on slide four. We produced 16.2% segment operating income margin. We delivered these margins through productivity and aggressive cost actions that produced segment decremental margin of 19%. We continued to drive down corporate costs and delivered an approximately 20% structural run rate reduction versus prior year. EPS of $0.82 per share declined 15% and was ahead of our expectations. And on cash, we generated $271 million of free cash flow year-to-date, up 77% versus prior year. Our trading 12-month free cash flow margin now stands at a record 15.4%, a sequential improvement of 80 basis points. IT tiers deliver strong Q3 results versus 2019, and these results are even stronger when we look sequentially. Switching to our sequential performance on slide 5, our segment operating income jumped 48%, an impressive growth compared to an organic revenue increase of 12%. This is the result of our business stepping up efficiency and cost actions, as we continue to focus on what we control and benefit from operational leverage from a permanently lower fixed cost base. Our revenue growth was driven by a 92% increase in friction sales OE, mainly coming from outperformance in China and North America. Similarly, earnings per share grew 44% sequentially, despite a one-time environmental benefit realized last quarter. Whilst recovery remains uneven across markets, whichever way you choose to look at our financials, ITT's businesses delivered outstanding third quarter results. Now, let me turn it over to Emmanuel, my co-pilot and new CFO, who will discuss the Q3 results by segment.

Thanks, Luca. Let's start with motion technologies on slide six. Organic revenue declined 13% on lower auto production rates and slower activity in the rail segment due to reduced passenger traffic. In the quarter, friction OE sales were nearly flat to the prior year. This is a strong showing, with China and North America growing 11% and 14% respectively, which was offset by Europe, where we experienced destocking with some Tier 1 customers. Sequentially, friction OE sales skyrocketed 92%, gradually accelerating during the quarter to show mid-single-digit year-over-year growth in September. Segment operating income declined 12% to $50 million. NT successfully improved decremental margins to 21%, and sequentially, operating income increased 107%, a 36% incremental margin performance. We drove operating income recovery through productivity and restructuring actions. Motion Technologies delivered outstanding Q3 margins of 18.5%, 30 basis points lower than the prior year, but increased 630 basis points sequentially. These results were fueled by strong performance in Friction China, which produced its highest margin since Q1 2018, and Friction Mexico is now approaching pre-pandemic margin levels. The MT team delivered above our expectations given the revenue decline versus prior year. In Q4, we expect to deliver margin expansion versus prior year on the back of continuing restructuring actions and productivity, as well as low single-digit organic revenue declines. These structural cost actions add to MT's many competitive advantages. Material science leadership, best-in-class quality, and fastest lead times. All of these together form the foundation for continued outperformance. And lastly, from an award perspective, both Friction and Wolverine continue to gain share with Concur wins and new platform wins like the 15 new electric vehicle platform awards in the quarter. Moving on to industrial process on slide seven. IP clearly demonstrated the resilience of his business model considering the challenging environment. With 14.1% operating margin, IP expanded 120 basis points compared to the prior year, despite an organic revenue decline of 19%. Sequentially, the growth was 40 basis points on flat revenue. The IP year-over-year revenue decline was driven by short cycle bookings during the height of the pandemic last quarter. Lower project revenue is mainly due to large prior year chemical shipments related to the expansion of plastic production capacity in North America. Organic orders for the quarter declined 17% coming from 33% lower project bookings and 12% short cycle decline versus prior year. Parts orders recovered gradually during the quarter and posted year-over-year growth in September. IP's book-to-bill of 1 in Q3 and year-to-date backlog growth of 6%, excluding foreign exchange, provides solid revenue visibility into next quarter. Operating income declined only 12% to $27 million, despite significant revenue declines. Our proactive cost actions, shop floor and sourcing productivity, resulted in best-in-class decremental margin of 8%. IP will continue to benefit from our footprint optimization strategy, and in October, we completed step one of our European footprint project and announced a new facility closure. Industrial process segment operating margin of 14.1% was driven by productivity and cost control, sourcing and restructuring actions amid a decline in revenue. IP continued to fund innovation, such as the new diagnostic capabilities added to our iALERT remote monitoring platform and our product portfolio redesign projects. Let me expand on our BB2 pump redesign project as it demonstrates our strategy of playing offense. As you know, we have been hard at work improving our large chemical pump design to reduce materials content, improve manufacturability, and source components from best-cost regions while improving hydraulic performance. This design has generated so much interest from our customers that we booked 43% higher orders year-to-date than for the entire 2019. We also made some significant headway in our purchasing performance thanks to a team of experienced supply chain leaders. To date, we generated large sourcing savings and the team has established a long-term supplier strategy that will put IP on a path to supply chain excellence for years to come. Finally, IP improved working capital by 800 basis points as we reduced AR path use by more than 20% and inventory by 14%. We continue to see more opportunities to further reduce inventory as we consolidate footprints and optimize materials planning management. IP finished the quarter with 19% working capital as a percent of sales. IP's outstanding performance reflects the multi-year strategy that we outlined back in 2017 and that we are faithfully executing as we advance toward our long-term margin target of 15% plus. We expect to produce a similar margin in Q4 as sequential volume increase is driven by large project shipments. Let's complete the overview of our segments with CCT on slide 8. CCT organic revenue declined 26% on weakness across all major end markets. The steep reduction in passenger traffic lowered commercial aero demand and continues to cause a major slowdown in OE build rates. We are also impacted by the specific challenges related to the 737 MAX requalification process. Our CCT industrial business experienced only a 2% decline as our distribution partners reduced excess inventory and adjust to lower levels of activity. Our BIW or oil and gas connector business was impacted by reduced North American shale production and lingering difficulties with customer site access and service deliveries in the Middle East. However, we were able to gain share in that region on the back of better quality and delivery performance, and our year-to-date orders are up 30% year-over-year. Operating income declined 40% on the volume drop, and margin of 14% showed an improvement of 300 basis points over Q2. The primary driver of the decline versus prior year was volume impacts from error weakness. These impacts were partially offset by shop floor productivity, especially out of the Nogales and Valencia sites, restructuring actions, and benefits from product line transfers. In Q3, we continue to see aero debunkings, albeit at slightly reduced levels compared to Q2, and significant disruptions coming from customers ordering and receiving patterns. We expect weak OE build rates to persist, Additionally, lower aircraft utilization and weakened airline profitability result in a slow aftermarket recovery as less maintenance is required or gets deferred. CCT decremental margins of 28% improve sequentially from Q2 and reflect the aggressive restructuring actions executed by the business. Finally, in October, Ryan Flynn was appointed CCT president. Ryan had previously served as the president of our Asia-Pacific region, where he drove critical growth initiatives. Davide Barbon, who was head of our Kony Accent business, will now lead the Asia-Pacific region, one of ITT's growth platforms. Davide returns to China, where he previously led the expansion of MT in Wuxi. As you know, last quarter we raised our cost action target to $160 million. Let me now give you an update on our plan on slide 9. Our CAPEX reduction plan is progressing well. We are hard at work on the remaining $125 million of cost reduction, a large portion of which is structural. To date, we have completed more than 90% of the four-year headcount reduction plan. On the spending front, we are exceeding our savings expectations driven by strong cost controls and sourcing performance. We are driving footprint optimization at both IP and CCT with several new actions progressing through granular planning and internal approval stages. Overall, we expect these actions will generate more than $90 million of savings of benefits, $90 million of benefits in 2020. and additional carryover benefits in 2021, partially offset by temporary compensation actions that have been rolled back in Q4. As a result, we are improving our decremental margin targets, and we now expect total segment decremental margin for 2020 to range from 21 to 24%. Now, I'd like to discuss the results on our net annual asbestos remeasurement on slide 10. which is excluded from our Q3 adjusted results. As explained in our press release and 10Q, we extended our asbestos liability to a full horizon estimate as we benefited from favorable litigation developments that improved our visibility on insurance recovery and drove insurance settlements. These developments include a recent agreement with a group of insurers in which they acknowledge the availability of significant amounts of solvent coverage. These events, coupled with stability in our underlying claim data, enabled us to extend the period for which we provide an estimate through 2052 from our previous rolling 10-year estimate. Since then, excluding the full horizon transition, our net liability declined 44%, and when accounting for this quarter's non-cash $136 million full horizon impact, the net liability dropped 25%. This reflects our effective claims management and one firm defense strategy, as well as aggressive insurance recovery actions. that have improved the value of our insurance portfolio. Importantly, we now expect that our projected annual average net after-tax defense and indemnity outflows for the next 10 years will decrease to $20 to $30 million, a reduction of 24% from the midpoint. Before Luca provides his closing remarks, let me share some perspective on how we see Q4 playing out. We expect continued sequential improvement in Q4, but still anticipate year-over-year revenue declines to range between high single digits and the low teens. We expect MT to deliver on low single-digit revenue decline as friction revenue growth will be more than offset by lower Wolverine and Coney Accent volumes. We expect auto production rates to improve sequentially, reflecting a market decline of approximately 20% for the four-year. Friction OER performance is now expected to be at the lower end of our range. We also expect IP revenue to show sequential growth in Q4 and year-over-year declines to a low double-digit range. Most of our expected Q4 revenue is already in backlog at the end of Q3. Despite slowly improving passenger air traffic in Q3, we do not see commercial aero production rates materially improving sequentially. As a result, we expect flattish TCT revenue from Q3 to Q4. From a segment margin standpoint, we expect to produce strong Q4 margins, well over the 15.4% generated last year, driven by benefits from productivity and cost action. With outstanding margin performance to date, we expect IP to deliver healthy four-year margin expansion compared to 2019. Consequently, IP's Q4 margin will be similar to Q3 and prior year, while CCT may show a sequential reduction driven by unfavorable connector mix. We expect corporate expenses for the four-year to be down approximately 40%. We also expect Q4 EPS to show low double-digit sequential improvement, and we're now targeting segment decremental margins of 21 to 24% for the four-year. On free cash flow, we are raising our margin target to 13 to 15% for the four-year as we rebuild some working capital to support our business and customers. Let me now turn it back to Luca for his closing remarks on slide 11.

Thanks, Emmanuel. Today, ITT is firmly committed on the road to recovery, thanks to the resilience of our businesses and the resilience of our people. ITT's performance is the outcome of a sound and actionable strategy, one with clear priorities and a strong focus on execution driven by unprecedented level of granularity. As a result, we generated strong levels of profitability and record-free cash flow, We are managing through the storm, and ITT will emerge stronger and bolder than ever before. I look forward to continuing to share the progress we will make in our journey. And with that, let me now turn it back to Lori to take your questions.

Thank you. The floor is now opened for questions. At this time, if you have a question or a comment, please press star 1 on your touchtone phone. If at any point your question has been answered, you may remove yourself from the queue by pressing the pound key. Again, we do ask that while you pose your question, you please pick up your handset to provide optimal sound quality. Our first question comes from the line of Joe Ritchie of Goldman Sachs.

Thanks. Good morning, everybody. Morning, Joe. Morning, Joe. Hey, Luca, maybe just starting off, the performance and friction, particularly in China and the U.S., continues to be really strong. I'm curious, you referenced, or at least Emmanuel referenced, that the expectation now is that your outperformance tends to be at the lower end of the range of what you previously provided. I just want to maybe get a little bit more color on that. And then specifically, what are you seeing from a competitive standpoint in the market today?

Sure. Thanks, Joe. So when we look at the Q3, in Q3, we outperformed the market globally. We outperformed in China. We outperformed in North America. We did not outperform the market in Europe. What we experienced was still some destocking, particularly at the beginning of the quarter. and also some slower and lower ramp-up for the new conqueror or also some of the re-wins. To give you just a specific example, in Europe, in France, one of our major customers is a ramp-up of a new platform. We were on the existing that is coming down. We are in the new that comes up. but the old is coming down, the new is coming up a little bit slower, and therefore you have a dip in that platform, for example. So what we see is that when you look at 2020, this is the quarterly performance, but it's very important to look at year-to-date because year-to-date in a year where it's very bumpy is more relevant. So year-to-date, Joe, we have Europe outperforming the market by 380 basis points year-to-date, North America and China are performing the market by more than 1,000 basis points. So now the other thing that I would like to share with you is actually what has happened during the month of September and the month of October, where actually we have seen our numbers better year over year. And this is another positive sign. Looking at the order book, we see a good order book for Q4. So look good for November and good for December. Having said that, we are really working closely with our customers as we are investigating really how much of this is the real demand and to ensure that we have a better understanding of what is in the funnel in their inventory so that we are able to match demand with supply. Now, going back to the second part of your question, which is from the competitor's point of view, I can tell you that, for instance, we have been able to take advantage in Europe, exactly, of some of our competitors' strategic decisions. And therefore, in some of the awards that we reported in Q3, there has been some wins with a major customer of ours where we were able to further increase our market share. And this is thanks to some competitors' decisions in the region.

Got it. That's super helpful, Luca. And then maybe I'll just ask one quick follow-on. Emmanuel, I just want to make sure that I heard you well. For the Q4 guide, you're expecting Q4 to be sequentially up below double digits, so kind of implying like 90 to 95 cents or so in the fourth quarter. I just want to make sure I heard that correctly.

Yeah, that's correct, Joel.

Okay, perfect. Thank you both. I'll get back to you. Thank you.

Our next question comes from Damian Karras of UBS.

Hey, good morning, guys, and great job on the margin execution.

Thanks, Damian. Thanks, Damian.

Speaking of which, I wanted to ask you about, you know, the cost reduction progress that you pointed to on slide 19. You know, it seems that on the areas you're exceeding expectations, maybe it's tilted more towards the discretionary side rather than the structural. But I know you mentioned you're sort of at 90% of the execution on the structural cost savings. Just wondering as we kind of think about progression from here moving into next year. Is 35% still the appropriate incremental margin to think about as the business recovers next year?

Thanks, Damien. You're right. Last quarter, we mentioned that our expectations for incremental margins was going to be north of 35%. This remains the case. For the four-year, we expect to generate more than $90 million of impacts in 2020. We also expect a benefit of carryover into 2021. And remember that some of that will be partially offset by some compensation actions that we have rolled back into Q4. But we are very optimistic and very bullish on our ability to generate incremental margins that are higher than our decremental margins.

Okay, that's really helpful. And I guess specifically thinking about uh, MP and the, and the friction business, uh, Luke, as you, as you mentioned earlier in the call, you know, you're, you're, you know, it's near record margin performance in Wuxi and Mexico. Um, you know, as you think about, uh, you know, production ramping, um, you know, get back to the level where you, you know, might've been pre COVID, um, I'm wondering at what point does, you know, sort of that incremental margin maybe stabilize or perhaps invert as you need to start investing more on new platform build-out? Just maybe you can kind of think about – help us think about kind of sort of the longer trajectory on friction moving from sort of, you know, earlier production levels to actually, you know, expansion.

Okay. So one thing to bear in mind, a couple of points to answer your question, Damien. One is that our approach in this kind of situation is when the market is going down, we are treating our fixed cost as variable, and we variabilize as much as we can our fixed cost. And then when the growth returns, we are trying to retain those fixed costs This is a general approach. And in this way, it's helping us, obviously, to have a better incremental margin. Second is the overall friction and motion technologies DNA, which is really driving the improvement, the productivity to a different level. Just to give you an example, I was able to be in the barge plant during the month of September. This is our oldest, the most mature, the most complex plant, but they've reached level of labor productivity the highest that I've ever seen in my nine years in motion technologies and in ITT, to the point that, for instance, I met two shop floor workers that set up the SMED record, the fastest ever changeover run safely that we had in motion technologies ever. So that's the general approach. Did I answer your question, Daniel?

Yeah, you did. Appreciate that, Luca. I'll pass it along.

Thank you.

Our next question comes from the line of Jeff Hammond of KeyBank Capital Markets.

Hey, good morning, gentlemen. Hi, Jeff. Good morning, Jeff. Can you just tell us a little bit more about this management change at CCT, what prompted it, and just some of the early opportunities you see here as you move towards this kind of motion tech manufacturing approach?

Sure. So just to tell you, Ryan, I personally recruited Ryan a few years back while I lived in China, and I was scouting for talent there. So at the time, Davide, who was managing the motion technologies business in China, Davide started that, was moving back to Europe to manage the Axton acquisition and the rail business. So we recruited Ryan, a talented individual who knew Asia Pacific very well, is very focused on growth, and Ryan has performed incredibly well in the last three years in ITT. So Ryan has worked in Europe, is South African, has worked in Africa, knows very well Asia, has worked in Asia, and therefore has got a very global mindset. Now, CCT would benefit from Ryan's global leadership and focus on growth. At the same time, with Ryan moving, we have Davide who has managed the Coney-Axton and managed the Axton acquisition very well, returning to China to run the Asia-Pacific and be part of the leadership team. One thing that we like to stress as well, Jeff, is that if you look at the leadership team, what we have is you look at me, you look at Maureen, the CHRO, you look at Emmanuel, you look at Ryan, you look at Davide, five leaders in the leadership team are actually internal promotion, which tells something about the process and the succession program that we have within ITT. Ryan and Davide have both worked in MT several years, and therefore they will be able to expand the motion technologies and friction approach in Asia-Pac as well as in CCT.

Okay, great. And then just, you know, it sounds like auto production, you know, had been, you know, challenged and you have some inventory adjustments in Europe. You know, we're getting news that, you know, pieces of Europe maybe are, you know, shutting back down again and just wondering kind of how you're, you know, how you're thinking about that, you know, within the guide. And, you know, are you seeing any risk around, you know, around production in Europe into 4Q?

Okay, so... Let me frame, let me contextualize how we see the COVID situation first. So when it comes to COVID, the way that we see it in ITT is that we are in this COVID storm and we have been in it for nine months now. And we are roughly halfway through. So this is to contextualize it. Then looking back at how we did during phase one, when we didn't know anything back then about COVID. When this started in January in China and Korea, we didn't know anything at all. Still, when you look at our performance, the friction plant was the first plant getting back online. Our on-time delivery with our customers was top-notch across all the different businesses. The businesses were up and running all the time for IP, most of the time for CCT and emotional technologies. and we have limited infections within our employees. On top of that, we had also some opportunities. When some of our competitors stumbled, we were able to get some wins along the way. So this is how we performed in wave one when, as I said, we didn't know anything about it. Now we know. So now there is a second wave, most likely, or a continuous wave, to be honest with you, because as we get into the winter, particularly for the northern hemisphere, we see this happening. But at the same time, as I said, we know much more. Ryan Flynn, the new CCT leaders, actually led a task force that looked at all our, what we have learned, the benchmarks of each country, And we came out with this program, which is the Ready, Safe, Go, which is really our playbook now in terms of being ready to ensure that we have all the masks until, you know, April of next year, to ensure that we've got all the testing kits and we do not have any shortages, to ensure that we play safe all the time and safety is our top priority, and we keep on going and we keep on serving our customers. So this is really how we are working and how we are facing it right now. As you can see, at the end of the day, I believe we are halfway through, and therefore we will have to manage and live with COVID through the winter and spring. Okay. Thanks a lot, Luca. Thank you. Thank you, Jeff.

Our next question comes from Michael Halloran of Baird.

Hey, good morning, everyone. Morning, Mike. Morning, Mike. Thanks. So the IP side, maybe just some commentary on the underlying trends there. The short cycle business, I think you said, was year-over-year positive in September. Good sign. Maybe talk about the drivers behind that and how you think about the sequential trend moving forward, if that's a good piece to build off of or just some – you know, pent-up demand type things, and then compare that a little bit with how you're thinking about the longer, later, larger project type activity. Obviously, you're going to be booking that at better margins, but just a little sense for how you're thinking about the ability to convert or even the desire to convert some of the projects right now.

Sure. Thanks, Mike. So when you look at Q3 and the orders of Q3, which was a little bit better than Q2, sequentially, but you have two different stories there. You have, as you said, the projects and what you have in the project that we keep on seeing postponing and some delays to 2021 for the major projects, for the big projects, but also for some smaller ones. As a matter of fact, I was talking to one of our larger distributors, part of the GDPWW, the distribution network that we have in North America, which is the envy of the industry. And he was just sharing with me that three out of the five projects that he had for 2020 have been postponed to Q2 2021. And we see also in the Middle East some of the projects awards that are going to be a little bit longer in terms of the delivery. So we keep on seeing this project, but at the same time, what we're seeing is a 2021 that will be rich of quotation. At least this is the feedback that I'm receiving from customers and from our regional leaders. When it comes to the short cycle, we had a good sequential improvement, Mike. It was roughly 14% when you look at parts and baseline, and we know that baseline, this is our bread and butter. And that was what was good also that sequentially in the quarter improved. And when you look at October, actually, the numbers for the short cycle were better than what we were expecting and were also better than year over year. As a matter of fact, if I can take a tangent from IP, the entire ITT for the month of October, we had orders 2% increase. higher year over year. And this is the first month in 2020 where this has happened. So now when you look at the short cycle, we're specific on the short cycle, the Hydraulic Institute, for instance, was stating that the ANSI market in North America was probably down around 35%. And I can tell you that our ANSI business, as I said, the bread and butter, we would be outperforming the market by roughly 800 to 1,000 basis points. Then you ask also in terms of the project. You're absolutely right on the project. The story has not changed on the backlog of the project in the sense the project backlog is really more profitable business than was one year ago, but also is relevant to say that what we have shipped in the project that has been closed or billed are at a better margin than what was shipped and closed last year. So you have this reinforcing loop happening today.

Makes sense for that. And then a question on the friction business. You mentioned that the new platforms are getting pushed to the right a little bit, but obviously continue to see nice wins today. How are you thinking about the cadencing of those platforms over the next couple years here? Is this just a, you know, pick up and just push everything to the right from a calendar perspective? Or do you think that there's a little bit more of a slow adoption to start out and then accelerate later on? Any kind of context for what the latest thinking is would be great.

Okay, so I think that we have to differentiate in terms of awards and SOP. So having said that, if you look at this year, for example, this year we've been seeing a lower activity in terms of platform awards. Now, this situation plays to our advantage if you think about it in Europe where we have a very high market share. But obviously in countries like North America or China where we are going after market share gains, obviously we need those awards and we need those platforms to improve our market share gains. I think that, you know, these activities in terms of awards will probably accelerate in 2021 and for the next couple of years. One thing to highlight on the awards, Mike, is that when you look at all the awards that we won so far in 2020, 60% have been awards re-wins and 40% have been new awards and conquests. which is feeding the market share gains in the future. Obviously, that percentage is different for different regions. And then Emmanuel was talking about 15 awards in the quarter for electric vehicles. This is a strategic platform for growth in the medium-long term, because there is a lot of talk about it, but think about how much electric vehicles are as a percentage of the total vehicles, and it's still below 10%. And in Q4, there will be the start of production of EV platform where we are on with the leading EV manufacturer. But also Ford was talking about the launch of the Mach-E, a platform where we are in. So good story on the world, Mike.

Thanks for the call, as always.

Appreciate it, Luca. Thank you.

Our next question comes from Scott Davis of Milius Research.

Hey, good morning, everybody.

Good morning.

I am kind of curious. I don't know if this is the right way to ask a question, but when you think about the structural cost out, is there kind of a percentage of footprint that you've been able to take out? You know, if you think about just square footage reduction, is that a... a way that you guys look at it?

Yes, Scott, that's a great question. In our cost reduction plan, we have highlighted several areas, and footprint is definitely one of them, specifically for IP and CCT. And so at IP, we already completed one in Europe, and we're really excited about this because this is going to really help us reduce our fixed costs. We also announced one in October in North America, And we're really trying to implement the empty business approach, which is about a concentrated footprint close to our customers with very efficient manufacturing structures. So, so far, we are not realizing any of those savings in terms of footprint because it takes time. But this is going to be a 2021 and 2022 benefit. And the primary areas we're going to focus on are manufacturing smaller to mid-sized plants that we're going to consolidate into large plants for IP and for CCT.

Okay. That's helpful, Kalar. And then just as a follow-up, the pension termination, what are the mechanics? It's been, God, I feel like it's been a decade since I've seen one of these. What are the mechanics involved in closing out the pensions? Do you have to kind of write a check and firm things up? Is there... an upfront cash cost that kind of gets paid back because you don't have to do it anymore? How do you at least – I'll just stop there. What are the mechanics?

So maybe, Emmanuel, let me frame it first and then so you can answer the question. One thing, Scott, to bear in mind is that as a company, we made a very good decision at the time, at the end of 2019, to freeze the – the pension plan, and at the time we were 108% funded. So this is when we froze the plan, and this is when really the process started.

Yeah, and so in terms of process, it's a very regular process, a bidding process. We had five or six different insurers, we went with MassMutual because they represented the best proposal. I think the final cash outlays was around $8 million, which is at the lower end of our expected range. And so it's really we transferred the contribution that we had made and made that additional $8 million payment, and we terminated the pension plan consequently.

Oh, so only $8 million. Wow. Okay. I was thinking hundreds of millions, and now it's $8 million. So congrats on that. I'll pass it on to the other guys. Thank you.

Thank you, Scott.

Our next question comes from Brian Blair of Oppenheimer.

Thanks. Good morning, everyone.

Good morning, Brian.

Good morning, Brian. I was hoping we could circle back to the friction OE outlook from a slightly different angle and understand the timing difference kind of restricts outperformance a bit in 2020, but based on prior wins and, you know, the degree of platform and SOP visibility that you have, is it reasonable to expect your typical 700 to 1,000 basis points outperformance next year? Or are there reasons to lean above or below that range, you know, based on current outlook?

Okay. So I would say that it probably is a, we wanted to see really how the market is developing during Q4, because if I look at our outlook right now, Brian, on Q4, I risk of being over-optimistic, and we really want to understand how much of what we see in the other book of Q4 is real demand, rather than filling the funnel or the inventory of or being concerned of a second wave from some of the major OEMs. So we want to see exactly how Q4 is panning out to better understand, better give a guided range for 2021.

That's completely understandable. You've highlighted CCT's increasing adoption of the MC business approach, and look, you've talked for a while about making IT the motion tech of the flow world. We can see the operational momentum there. Thinking about CCT, what does the MT approach mean? I guess more directly, outside of resetting cost structure, what changes does that entail for the business?

Sure. So, Brian, it's a very timely question. I spent two weeks in California, in Valencia and Irvine, where we have our connectors and components planned, and together with the team. And so what the empty approach will mean is probably taking the level of granularity to a complete unprecedented level. And this is you're talking about when you're running for a new opportunity in sales, a new award, or when you're running into a production or a machine. So let me give you an example in terms of the level of data, in terms of overall OEE of the machines, of the level of productivity. and going really with curiosity and understanding every single step that you have in the operation. I spent some time every single day together with Rob or together with David, the new plant manager of Valencia, in looking exactly how the operation was running. They are doing a lot of Kaizen events, which have improved the profitability of the plant, but there is more to come. So this is really what we are looking for in terms of MT operations. playbook for CCT. Unprecedented granularity in every single step of the operations.

Okay. Appreciate the color as always. Thank you.

Our next question comes from the line of John Inch of Gordon Haskett.

Thank you. Good morning, everybody. What is happening and what has happened in to your friction aftermarket business in Europe. Presumably, lockdowns make it worse versus the recession of 08-09, right? Because, well, for obvious reasons of driving. And can you just remind us what percent of aftermarket is in the mix currently? And, you know, is it higher or lower in terms of margins versus the segment average?

Okay. So, first of all, when you look at the aftermarket and OE, we are roughly 65% OE, 35% aftermarket. And when you look at the 35% aftermarket, you can split half and half in independent aftermarket and OES. This is how it is split. Now, when you look at the performance in the quarter, I would say we didn't see any improvement in Q3. I can tell you that we are seeing a substantial improvement in Q4, and therefore we have improved our full year forecast of the aftermarket for the full year 2020. We were thinking last quarter what we communicated with you, that the aftermarket was going to be in the region between minus 22%, minus 24% year over year. We are today thinking of a negative high teens for the aftermarket for the full year. So the picture has substantially improved, but it's more related to Q4 and the other book that we see in Q4 than the Q3 performance. Now, when you talk about the margin, I would say obviously the aftermarket has got higher margin than OEM, but think about it. The highest profitability plans today are China and Mexico, and both of those are actually only OE. So I will not really draw any conclusion in terms of aftermarket margin and OE margin.

No, that's fair. You know, in aerospace, they track, you know, takeoffs and landings, flight hours, all that sort of stuff. I mean, these lockdowns being reimposed in Europe, Luke, I appreciate the wins. We all know it's a great business. I don't know if there's evidence that that's going to restrict driving capacity, but does that put a bit of a governor on the aftermarket business as you look ahead? So not about sort of the wins that you just chalked up, right, but looking ahead, is there this correlation between sort of these lockdowns and fewer cars then on the road and then just like less wear and tear in terms of driving the aftermarket business.

I think that's absolutely fair, John. It's absolutely logical. One thing that it happens conversely on the other side is the public transportation versus your own car. So just because of concern of being in public transport, then you have people then when some of these lockdowns, get lifted, they prefer to drive their car rather than going on a bus or on a plane. So you have some conflicting trends on that respect.

Yeah, I agree with that. And then just lastly, could you talk about, because Mexico and China are clearly doing very well operationally, how has Mexico, a particularly important region for you in terms of production, How has the integrity of your supply chain in Mexico fared over the past six months during the pandemic, and kind of what's the current status, and are there initiatives that you're trying to embolden to bump it up, or are you just happy with the performance?

I think that the team has really managed the risk and managed the process very well. So when we look at the supply chain, particularly in the motion technologies business, we haven't suffered any disruption at all. I think that, to be fair, we have seen some disruption. I remember on one project, for instance, in IP, where a major supplier of ours, just because of technical problems and COVID-19, delayed some of their deliveries. But we are working very closely with them. We're working with the customer, and everything is managed properly. Not major disruption on the supply chain. I mean, I can tell you about one, this event for all of ITT.

Perfect. Thanks, Luca.

Thanks, Emmanuel. Thanks, John. Thank you, John.

Our next question comes from Nathan Jones of Staple.

Good morning, everyone.

Hi, Nathan.

Morning, Nathan.

Just one follow-up on IP. I think, Luca, you mentioned that the project margins in backlog are better than they were a year ago. We do tend to see in environments like this where volumes are down pretty aggressively that the bidding, the pricing on these projects gets pretty aggressive. Can you talk about how you're approaching the need to fill your factories, the need to absorb your fixed costs with IP? not looking to fill the backlog up with low margin projects?

Okay. Sure, Nathan. So I think that as of today, this is pretty ingrained in the mindset of the people today. And the process, we are very disciplined today in what we go through in terms of reviewing the proposal, both from a technical point of view, from a cost point of view, and also from a terms and conditions point of view. So this process is very diligent, and I would say we will not be able to deliver this better margin, Nathan, if we will not have done this for the last three years. I will tell you, this is nothing new, Nathan. This is something that we started when we got into IP in January 2017, and we have improved since then. So that's important. One thing also to bear in mind is that as this is happening on the project side of the business and there are projects going down, there are some of the, I would call it service projects, small projects that you do on service that are coming up. And this is, if you stay close to your customer, if you've got the customer intimacy, this is what is coming into the funnel. On top of that, the profitable margin, the project margin on the backlog is better also because of all the VAVE initiative that we've been doing on the product, Nathan. That is also extremely helpful.

Okay, the second question I wanted to talk about was free cash flow. 15.4% trailing free cash flow margin. So while we were on the call, I went back and looked at it historically and And post the spin of Xylem and Exilis, from 2012 to 17, the margin was about 5%. 18 and 19, it was about 10%. Trailing 12 months, it's about 15%. Obviously, in environments like this, working capital throws off a bit of cash. Can you talk about how the approach to free cash flow generation has changed and what you think a sustainable free cash flow margin for the business is?

So let me start, and then Emmanuel, you can take it from there. is if you look at our working capital, that is an area where we have been focused tremendously. We have improved year over year for ITT at 180 basis points. And if you look at the improvement here, we have MT being stable, roughly. In CCT, we deteriorated a little bit year over year. And then at IP, we improved by 800 basis points year over year, and we improved again from Q2 to Q3. If you think about IP today, working capital is at 19%. They are the best in ITT. And the improvement has been particularly on the accounts receivable and accounts receivable past due, and there is still a lot of improvement to be made in inventory or other areas. But, Emanuele, I'll leave you to it.

Yeah, and in terms of long-term margins, I would say we're not really ready to give you a number, especially because the 15.4% free cash flow margins that we realized so far is, I mean, we manage really well working capital, as Lucas said, but there's also an impact of a lower revenue base, which is improving that number also. And so it's not really a long-term target for us. I would say that In addition to what Lucas said, with working capital being a major driver of our free cash flow performance, we still have some opportunities in inventory terms, for instance, and all our businesses have opportunities on inventory. AR past due is also a major opportunity for us, even though we have made a lot of progress. So I would say free cash flow performance is going to continue to be driven by working capital improvements We have implemented a really nice discipline around CAPEX, and we intend to continue to this, to continue to focus on productivity and innovation. But I think that I would say overall we would expect to be above 10% for sure in the future. Great. Thanks very much.

Our next question comes from the line of Matt Somerville of D.A. Davidson.

Hi, just one quick question. With respect to the incremental cost reduction benefits you're going to see in 21 from what you've done thus far in 20, can you maybe quantify that as well as what you expect to derive from the latest footprint actions that you just mentioned today in IP and CCT? Thank you.

Sure, Matt. As I said, we expect full 2020 P&L benefits of more than $90 million this year. The carryover impact of some of those actions that have started mid-year is going to bring us an incremental $40 million of positive benefits in 2021. Some of our temporary cost actions have been rolled back already in Q4, so they're going to be a headwind to that carryover in 2021. But as I said, this is when footprint is going to kick in. And footprint is going to bring a lot of benefits probably in the second half of 2021 and also into 2022. And this is obviously, this does not include the regular productivity that we are implementing and driving through all three value centers. Finally, I would say that for 2021, we expect to add more actions, and we're actively planning. We're in the planning cycle here, and so we're looking at what we can do incrementally in 2021 that's going to impact both 2021 and 2022. Thank you. Thanks, Matt.

Our next question comes from Brett Lindsey of Vertical Research Partners.

Hey, good morning, everyone. Just one for me on industrial process, specific to the orders down 17%. Just curious how you see the order profile in that segment playing out over the next few quarters. I mean, do you think Q3 is the low ebb here? And maybe just share some differences in that business now versus 15, 16, whether it be aftermarket mix, market complexion that might prevent those orders from worsening to those levels historically.

Thanks. Maybe I start, Emmanuel, and you can build on that one. When we look at the orders for IP, I think that for the full year, we are looking at probably a decline year-over-year of roughly 11% for the full year. And when you look at the geographic, I would say that there are some bright spots in this one, like, for instance, Europe, Latin America, or Middle East in terms of projects. Another element to give is probably we're seeing the supply chain, sorry, the short cycle improving, improved in September. It improved again in October. The trend is positive. And when I thought about ITT being positive on orders in October versus priority by 2%, the positive were really IP. That was positive 9% in October year over year and motion technologies as well. So this is what's happening from a trend perspective.

And I would say for the long term, when we look at our funnel, our funnel has been going down. There is a little uptick in October, but it's really too early to tell if this is a meaningful trend. And I would say when we look at the funnel going down, this is mainly coming from upstream and downstream oil and gas, as well as some chemical products. GNI, which is really the core of our IP business, is behaving pretty well, and it's showing some positive signs. But for the moment, in terms of project activity, the picture is pretty grim, given the current environment.

And I guess just to follow up on a point of clarification, so you said that total IP orders were positive in October?

That's correct. That's correct.

Okay. Okay, earlier I thought just short cycle. Okay, got it. That's all I had. I appreciate it.

Thank you, Brett.

Ladies and gentlemen, we have reached the allotted time for questions and answers. This does conclude today's teleconference. Please disconnect your lines at this time and have a wonderful day.