Earnings Call Transcript - ITT Q2 2020

Operator, Operator

Welcome to ITT’s 2020 Second Quarter Conference Call. Today is Friday, July 31, 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. It is now my pleasure to turn the floor over to Emmanuel Caprais, Group Chief Financial Officer. You may begin.

Emmanuel Caprais, CFO

Good morning, and thank you, everyone. Welcome to ITT’s second quarter 2020 earnings call. This is Emmanuel Caprais and on the line this morning are Luca Savi, Chief Executive Officer and President; and Tom Scalera, Chief Financial Officer. Today’s presentation, press release and reconciliation of non-GAAP financial measures to the most comparable GAAP measure can be found on our website at itt.com/investors. Our adjusted non-GAAP results exclude 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 Q2 GAAP results compared to the prior year. Q2 total revenue decreased 29% to $515 million. Segment operating income decreased 65% to $37 million and EPS of $0.53 decreased 29%. Free cash flow increased 205% to $169 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 risks 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 the other risks and uncertainties that affect our business including those disclosed in our SEC filings. Now let's turn to slide 3 where Luca will take us through the key highlights.

Luca Savi, CEO

Thank you, Emmanuel, and thank you all for being with us this morning despite the many challenges and unique circumstances that you're dealing with at this time. I truly hope that everyone stays safe as we continue to adjust to the widespread repercussions of the COVID-19 pandemic. Before we start this call, I'd like to thank our customers and suppliers who have worked with us to ensure that we deliver our products safely and in a timely manner. I'm also very grateful to our shareholders for their support. And I want to give a heartfelt thank you to all our ITT workforce across the globe who continue to work relentlessly to serve our customers and shareholders in the most dedicated fashion and to take care of each other in challenging conditions. On our Q1 call, we highlighted our 2020 focus to strengthen ITT's resilience and to drive aggressive cost actions while playing offense for the future. This is exactly what we did in Q2. We delivered a 25% segment decremental margin. We accelerated and increased our cost and spend reduction actions to $160 million. We generated record free cash flow of $169 million, bolstered our liquidity to $1.4 billion, and we signed a letter of intent to acquire a niche European rail company. Building on this strong foundation, we will continue to drive operational execution that further reduces decremental margins while fueling future growth opportunities. We can only truly demonstrate our resilience through actions and results. This morning, we will share with you the actions we will keep on driving to strengthen the operational and financial performance as we continue to mitigate the COVID-19 impact and reinforce the resilience at ITT. Today we will also give our understanding of the markets that we serve and our expectations for the balance of 2020. Before going into Q2 highlights, a word on safety. Safety is my top priority. And when I talk weekly with our facilities across the world, I'm energized by the accomplishments of our teams who diligently and effectively execute our health protocol. This enabled us to contain the global number of infections to fewer than 70. Now let's turn to our Q2 results. We focus on what we control and produce better results than expected. During the second quarter, ITT's resilience, the resolve of our teams and our pivot to play offense were on full display. From a financial perspective, we delivered solid EPS of $0.57, exceptional segment decremental margin of 25%, record free cash flow of $169 million, representing a significant growth of 205% or $114 million. We also achieved a segment working capital reduction of 210 basis points compared to the prior year and 100 basis points compared to the first quarter. Operational excellence is a fundamental pillar of ITT's long-term success. During the month of June, I experienced it first-hand when visiting our Seneca Falls plant and seven facilities in Europe. Operational improvement enabled industrial processes to deliver a 13.7% adjusted operating margin. This is a 120 basis point expansion versus the prior year despite a revenue decline of 17%. The 13.7% margin also represents an improvement of 240 basis points over Q1. We moved quickly to take out costs and are progressing nicely towards our long-term 15% plus margin target. IP continues to impress with strong operational execution; the NC line at Seneca Falls achieved above 90% on-time delivery for the tenth consecutive month. In Europe, I was pleased to see all the Kaizen projects we have underway to improve our operations. From assembly line efficiencies in KONI Oud-Beijerland to boosting output in Axtone Stalowa Wola in Poland. In Barge, our Friction teams continue to improve our manufacturing processes by repurposing and driving the utilization of existing equipment. Across ITT, we drove high levels of operating efficiency at our manufacturing plants in Asia, Europe, the Middle East, and the Americas. Lastly, this operational excellence combined with our speed in execution enabled us to accelerate and boost our cost reduction plan adding $25 million of new actions that increase our target to $160 million. All of the operational excellence was possible because all our leaders ensure the safety of our people through the adoption of rigorous health protocols. On customer centricity, our teams passionately serve our customers and creatively meet increasingly demanding requirements, once again demonstrating that our customers are our priority. Let me elaborate. Momentum in Friction OEM share gain continued. In the first half of 2020, we outperformed the global market in each of our main regions. Based on platforms ramping in the second half, we continue to expect to outperform global markets by 700 to 1000 basis points this year. Our end ordering unit grew new business awards by 94% in the quarter. The improvements executed by Logan and his team have put this business back on a growth trajectory. IP grew organic pump project orders by 22%. Project orders were consistent with the level reached in the first quarter. As a result, our backlog at the end of Q2 was up 3% excluding foreign exchange compared to the beginning of 2020. The project order performance is an emerging sign of customers' recognition of IP's operational improvement and the innovation in our products. IP customers were delighted by Seneca Falls 95% plus baseline pumps delivery performance during Q2. This outstanding delivery performance pairs nicely with the rest of our U.S. facilities and our Korean and Saudi plants. Well done IP. This level of execution mirrors the Motion Technologies' playbook where our Friction business maintained 99% on-time delivery performance despite operating in areas hit hard by COVID-19. Lastly on capital deployment. Our effective capital deployment strategies consolidated and protected our outstanding liquidity position. This will enable us to continue to invest in future growth opportunities as we pivot to play more often. Today, we have $1.4 billion of available liquidity and we have ample capital to fund all our operational needs and investments and position us to take advantage of other strategic opportunities. We continue to protect our cash position through daily and weekly cash reviews, adding a record $169 million cash flow year-to-date. While we play offense for the future, we will continue to strictly control our capital expenditures. In Q2, we reduced CapEx by 25% compared to the prior year, and we are tracking to meet our $35 million reduction target for the full year. Our strong liquidity position enables us to weather the present storm while we sow the seeds of future growth. We will continue to invest in smart and energy-efficient applications that will drive revenue growth in the long-term. In 2020, the ITT Smart Pad is making new inroads in both aftermarket and OE customers. We are currently testing a revolutionary energy-efficient power source for our pumps. Finally, on capital deployment, we signed an LOI for a new niche rail acquisition as we continue to build out this long-term growth platform. All of these actions executed with speed helped us deliver the Q2 results provided on slide four. Segment operating income margin of 12.6% despite the revenue decline. We delivered this margin through strong operational execution and decisive actions that produced a segment decremental margin of 25% and an EBIT decremental margin of 20%. We achieved a 52% corporate spend reduction versus the prior year. EPS of $0.57 per share was ahead of our expectations and declined 35% excluding unfavorable FX of $0.03. Lastly, we generated $169 million of free cash flow year-to-date representing a 205% improvement over the prior year. In summary, we delivered a solid second quarter in a difficult environment by executing decisive actions early and with speed. Now let me turn it over to Tom to discuss Q2 results by segment.

Tom Scalera, CFO

Thank you, Luca. Let's start on slide five with Motion Technologies. MT organic revenue declined 35% due to wide-ranging auto production shutdowns impacting our Friction and Wolverine businesses. In the quarter, Friction declined 42%. However, for the first half of 2020, Friction outperformed each of our major OEM auto markets. In North America, we outperformed by 1,000 basis points. In Europe, we outperformed by 400 basis points. In China, we outperformed by 1,600 basis points. As discussed during our Q1 call, we expected Q2 top line results to be impacted by unfavorable customer order phasing. Nonetheless, we continue to project 700 to 1000 basis points of global OE outperformance for the full year as new platform awards enter the production phase in the second half. Wolverine declined 38% in the quarter but was able to deliver 800 basis points of outperformance for the first half. Lastly, KONI and Axtone revenue decreased 9%, as solid Europe OE rail growth partially offset lower aftermarket revenue in North America and Asia. MT's adjusted segment operating income declined 57% to $24 million due to volume declines and unfavorable FX of $2 million. However, MT successfully contained decrement margins to 27% due to increased manufacturing efficiency, proactive plant shutdowns, restructuring benefits, and aggressive discretionary cost actions. The 27% decremental margin improved sequentially and is also much lower than the decremental margins during the 2008-2009 recession reflecting the true resilience of today's MT. MT delivered solid Q2 margin of 12.2%, mainly reflecting the volume decrease. Axtone continued to expand margins both compared to the prior year and to the first quarter, and Friction China almost returned to pre-COVID-19 margin levels. Continuing restructuring actions in the second half will further bolster MT's structural competitive advantages, which are the foundation for our continued market outperformance. It is also worthy to note that MT improved working capital by 120 basis points and produced record operating cash flow. Lastly, from an award perspective both Friction and Wolverine continued to gain share with key wins and new platform wins both on conventional and electric vehicles. These awards continue the share gain momentum that will power MT's significant outperformance in the global markets we serve well into the future. Let's now turn to industrial process on Slide 6.

Luca Savi, CEO

IP delivered outstanding results considering the challenging environment, with organic revenue down 17%. However, margins expanded by 120 basis points compared to the prior year and 240 basis points sequentially. The IP revenue decline was driven by lower project revenue due to large project shipments in the prior year. Short-cycle revenue was up 4%, mainly driven by lower industrial valve activity, partially offset by relatively flat aftermarket and baseline activity. Organic orders for the quarter declined 9%, as 22% project growth, driven by general Industrial market share gains, was partially offset by reduced capital investments across major markets due to COVID-19. IP's backlog at the end of Q2 was up 3% excluding foreign exchange versus the beginning of 2020, providing solid visibility into the second half of 2020. Operating income declined 9% to $26 million, as George and the IP team confined decremental margins to a near 6%. This was a major accomplishment driven by proactive measures taken in late Q3 of last year and rapid restructuring actions implemented in 2020. As a result, IP segment operating margin grew 120 basis points to 13.7%. This operating margin performance was driven by mix, restructuring and sourcing benefits, continued strong project execution, price and government incentives, more than offsetting the impacts of volume declines and increased customer payment risks. Working capital improved by 760 basis points as the IP and shared services teams were hard at work securing payments from customers and deleveraging the balance sheet. Thanks to significant inventory reductions that resulted in a 20% improvement in inventory turns versus the prior year. IP's resilience reflects the Motion Technologies business approach as global on-time performance and product portfolio redesign accentuate differentiation with customers. IP will continue to reduce costs in the second half as we implement new restructuring actions and execute on footprint optimization projects. Now let's turn to CCT on Slide 7.

Tom Scalera, CFO

CCT organic revenue declined 29% and weakness across all major end markets. The steep reduction in air traffic lowered commercial aero demand and caused a major slowdown in OE build rates that was further compounded by specific challenges related to the 737 MAX requalification. Our Industrial Process business experienced a 7% decline as distribution inventory adjusted to lower levels of activity and there was a surge in demand for medical connectors to accommodate COVID-19 patient care. Operating income declined 55% due to the volume drop, and margins declined to 11.1%. The primary drivers of the declines were volume impacts from COVID-19 and OE production weakness. These impacts were partially offset by strong productivity, restructuring actions, government incentives, and lower materials inflation. We expect volatile market conditions to persist for the balance of the year affecting OE build rates at airframes. CCT's decremental margins of 35% improved sequentially from Q1 and reflected aggressive restructuring actions executed by the business. CCT executed a footprint move in Q2 and will continue to drive product line transfers to lower cost regions and additional restructuring for the balance of 2020 as part of a comprehensive operational reset designed to better align with current demand expectations. Now I'll turn it to Emmanuel, our future ITT CFO for an update on our cost actions, liquidity, and balance of the year expectations starting on Slide 8.

Emmanuel Caprais, CFO

Thank you, Tom. As you can see here, in 2020, we are laser-focused on what we can control. We implemented aggressive and significant restructuring cost actions in all our businesses as well as at the corporate level at the onset of the pandemic to protect margins and to produce strong free cash flow performance. In Q2, as a result of this focus, we increased our savings target to $260 million, exceeding the original guidance that we communicated during Q1. We've executed a large portion of our restructuring plan, and the remaining actions will mostly take place in international regions in the second half. We are also detailing incremental actions across ITT as part of our increased cost target of $160 million. Specifically, we added annualized savings coming from our global industrial footprint optimization, mainly focused on IP production facilities. We have already announced one closure, and the relocation into a larger production site is scheduled for Q4 this year. We continue to prepare plans for additional consolidations, and our discretionary spending cuts were very impactful in Q2, exceeding our original target for the year. Finally, we reduced CapEx by 25% in Q2 and continue to track to our overall target of a $35 million reduction. We remain flexible on our CapEx strategy and continue to focus the reduced capital allocation towards productivity and targeted growth projects. Overall, as a result of the great progress made to date and the decisive incremental actions we took, our 25% decremental margin in Q2 has significantly improved from Q1. We now expect total segment decremental margin in 2020 to range between 22% and 28%. Now on slide 9. We ended the quarter with liquidity of $1.4 billion, which was significantly strengthened compared to Q1. Our balance sheet and liquidity position are key strengths of ITT, providing us the ability to effectively deploy capital when opportunities materialize, and value creation targets are achievable. From a cash flow perspective, we continue our strict routines to monitor collections and other working capital improvements on a daily basis. We scored some good wins with customers, and our collections in Q2 helped generate a record $169 million of free cash flow year-to-date. This represents an increase of 205% versus the prior year. We also collected significant past due receivables early in July with key customers to continue our successful receivable harvesting actions. We optimized segment working capital by 210 basis points year-over-year, with more opportunities to further improve in the second half, especially concerning inventory at MT and CCT. However, we also expect demand to increase sequentially at MT and IP which will start to weigh on our second half receivables. Based on this, we are now targeting a free cash flow margin of more than 11% for the full year, which is 160 basis points better than the prior year. The next few quarters will continue to be unpredictable even though visibility has improved compared to 90 days ago. As a result, we will continue to suspend formal guidance until demand certainty improves. Let me provide some perspectives on how we see the year playing out for the balance of 2020. We expect gradual sequential improvement in the second half but still expect high-teen revenue year-over-year declines mainly driven by CCT. Despite improving passenger air traffic in Q3, we do not see commercial aero production rates materially improving sequentially. However, we expect defense revenue to pick up compared to the first half due to improved project order intake. We expect auto production rates to improve sequentially, reflecting a market decline of approximately 25% for the full year. We reaffirm that our Friction OE business will outperform this global market decline by 700 basis points to 1,000 basis points for the full year. Sequentially in Q3, we expect MT revenue to improve more than 20% versus Q2, with further improvement expected in Q4. IP revenue is anticipated to be consistent with Q2 levels in Q3 and show modest sequential growth in Q4. Finally, we expect corporate expenses in Q3 and Q4 to be similar to Q1. Overall, we have not integrated in our forecast another global lockdown like we experienced in Q2. Although we have seen improvements in June and July from certain end markets, we anticipate that the sequential recovery will be erratic because of COVID-19. We expect Q3 EPS to show mid-teens sequential improvement. The gradual improvement will come from cost actions combined with gradual market recoveries. We are now targeting segment decremental margins of 22% to 28% for the full year. Lastly, from a free cash flow standpoint, we're targeting more than an 11% free cash flow margin. Let me turn it back to Luca for his closing remarks.

Luca Savi, CEO

Thank you, Emmanuel. Q2 has been a very demanding quarter. I am very proud of ITTers' achievements regarding our customers. We served them even better than before by assisting them in navigating this crisis and delivering our products safely and on time day after day. For our ITTers, we kept our people safe by rigorously respecting health protocols. For our communities, the civil rights movements have been an inspiration to us all. At ITT, we reject racism. Racism has no place at ITT, full stop. We at ITT are upstanders and live by the principles of diversity, equity, and inclusion. We are taking concrete actions to make ITT a better workplace. For our shareholders, we delivered record free cash flow and aggressively reduced costs to limit the impact of lower demand. We are already playing offense and using our strong competitive position to our advantage. We will continue to focus on what we can control and drive operational excellence, customer centricity, and effective capital deployment. These are our value-creation drivers. Before taking your questions, I would like to acknowledge my colleague Tom Scalera. As you are aware, Tom will be stepping down as ITT's Chief Financial Officer in October. At this time, he and Emmanuel Caprais, who will be succeeding him as ITT's next CFO, are working closely on the transition. You should know that Tom and I recruited Emmanuel in 2012; this is when our partnership started. I want to express my deepest appreciation to Tom for all he's done for ITT, for our customers, our ITTers, and of course for our investors. Tom has been with ITT since 2006 and was named CFO in 2011, as we navigated the spin-off. Since that time, under Tom's leadership and many other accomplishments, ITT's market value has tripled. I'm sure many of you have gotten to know Tom professionally during his time with ITT. He has spent a lot of time with many of you in all his roles here. By my calculations, Tom has participated in more than 50 quarterly earnings calls. Also, between conferences and other meetings, he has been a part of over 1,700 investor and analyst meetings during his tenure as CFO. That number is even higher when you consider all the interactions he had with many of you up until he became CFO. For those of you lucky enough to have gotten to know Tom personally, you also know that he is not only a special financial leader but also a truly special person who cares about people and always brings a fresh perspective, along with a great sense of humor. I found his counsel and partnership during our time working together to be invaluable. When I was preparing to step into my new role as CEO, ITT provided me with some coaching on the investor relations side. Still, I can tell you today that the best coaching was the day-to-day work with Tom and listening to his perspectives and absorbing from his experience. As he moves on to his next venture to focus on the charitable foundation he co-founded with his late wife Rebecca, The Cancer Couch, I want to wish Tom the best of luck and from my heart, thank you, Tom. Now, we are ready to take your questions.

Operator, Operator

The floor is now open for questions. Our first question comes from the line of Mike Halloran of Baird.

Mike Halloran, Analyst

Good morning, everyone, and best of luck, Tom. I enjoyed working with you over the last decade. It was tough to look at all those earning seasons and conference calls and everything. I tried my best not to do that myself, but it has been very enjoyable, and best of luck.

Tom Scalera, CFO

Thanks, Mike.

Mike Halloran, Analyst

So a couple of questions here. First on the Motion side, certainly helpful with some of the sequential commentary, but maybe you could dig into the regions. What are you seeing on a regional basis from a recovery perspective? What type of production assumptions are you using at a high level for the back half of the year on a regional basis? The outperformance will be there, and it's always great to see, but a little bit more granularity on just what the end markets are doing would be great.

Luca Savi, CEO

Sure. So, Mike, let me tell you about our view of the market. As you know, IHS is projecting a global market decline for the full year roughly of 22%, heavier in Europe and North America, and in the minus 13% for China. Our projection today is a little worse than IHS but better than our previous forecast. We like to be a bit more conservative, as this helps us adjust our costs in a more aggressive way. However, I can tell you that in the last three months, we revised upwards our forecast for each of those regions: Europe, China, and North America. The reason for that is, of course, what we saw in China during Q2 with a strong recovery and growth of roughly 9%. You must watch carefully for any pent-up demand coming from Q1 and the feedback from our customers. Therefore, we revised our forecast upwards compared to our view three months ago. Let me share a couple more data points that might give you additional perspective. We do not have big concerns on programs. There may be delays, but we have not experienced any cancellations, and the majority of the programs are starting a little later, but no major cancellations that we are experiencing at ITT. Regarding the daily tracking of our order book, we monitor what we call the variation factor, which reflects the variation in our order book from the beginning to the end of the month. We have seen this variation factor, which was previously huge, continuing to improve in China during Q2. Europe and North America behaved in Q2 like China did at the beginning of Q1 and then in Q2. When we look at July's variation factor, it's almost at normal levels. All these factors indicate less volatility, a more stable market, and a more controlled supply chain. Therefore, Q3 will see substantial sequential growth over Q2.

Mike Halloran, Analyst

That's super helpful. On the IP side, maybe help with the backlog commentary and the order commentary in context. The strength in the general industrial side was surprising, and the overall orders were pretty reasonable relative to what the environment looks like. How does that inform how you’re thinking about the next 12 months here? How do you think this backlog spins off? What’s the ability to replenish as we sit here? Any context around that would be helpful.

Luca Savi, CEO

Sure. Thank you, Mike. When looking at the orders, the orders were down 9% year-over-year, roughly 10% sequentially. However, you have two different stories within those orders. First, you have the project side of the business which was positive, with 22% growth year-over-year and flat sequentially, while actually slightly positive. The short cycle was down 17%, with baseline and parts in the low-20s. Therefore, the backlog is up 3% year-to-date. Once again, the same situation applies to the backlog; you have project backlog which has grown since the beginning of the year, while short-cycle backlog has decreased. The significant improvement in margins seen in IP, despite revenue decline, also comes from this mix. This has provided a tailwind for our Q2 results. Expect the opposite when we move onto Q3 and Q4 as short-cycle orders decreased in Q2 because of the lockdown, so they won’t contribute as much in Q3. In the North American funnel, it has grown year-over-year since the beginning of 2020 and has also been growing since March 2020. So we are seeing a strong funnel in North America. However, we have encountered more challenges in the Middle East, which is our second-largest geography. The funnel in that region has decreased during Q2. This is mainly due to existing orders being assigned. But in July we’re seeing some positive signs in terms of growth opportunities coming into the funnel.

Joe Ritchie, Analyst

Thanks, good morning, everyone.

Luca Savi, CEO

Good morning, Joe.

Tom Scalera, CFO

Hey, Joe.

Joe Ritchie, Analyst

Tom, echoing what everybody else has already said, just really great work with you over the years and thank you for all the help. I wish you nothing but the best, and congratulations to Emmanuel as well.

Tom Scalera, CFO

Thanks, Joe.

Emmanuel Caprais, CFO

Thank you, Joe.

Joe Ritchie, Analyst

So maybe just starting out, I think I'm just going to focus my questions on really just the margins. And your comment on mix notwithstanding, Luca, on the IP business, the results this quarter from a margin perspective were really, really good. I'm just thinking about the longer-term entitlement we've talked about with the mid-teens type entitlement. Do you feel like the progress that you guys are making is allowing you to hit that—or is going to allow you to hit that number in a quicker way, even despite the backdrop that we're experiencing?

Luca Savi, CEO

I think that the performance has been outstanding at IP, and I really applaud George, Dave, and the entire IP team for what they've done. A decline of 17% in revenue and still an improvement of 120 basis points—consider that improvement! We faced a headwind of volume, which was approximately 500 basis points. However, we had a positive mix that contributed roughly 340 basis points. The net productivity is 250 basis points, which is a good sign because this net productivity comes from operations, supply chain, and restructuring savings—essentially, it’s a nice path toward reaching our 15%-plus margin. Regarding the timing, I would still say we are on track for our two-year goal to reach 15%. We may face headwinds from COVID-19 rapid demand in the next couple of quarters, but because of the extra actions we are implementing and our footprint actions, I believe that in the next couple of years we will hit our 15%-plus target.

Joe Ritchie, Analyst

Okay. That’s super helpful context, Luca. Just, staying on the margins for a second—maybe conversely just talking about the CCT and the headwinds that business is seeing from an end market perspective. How do you think about the path for that business from a margin standpoint as well? And maybe talk specifically around some of the actions that you are taking to drive better profitability longer term?

Luca Savi, CEO

Certainly. When you look at the CCT, I like to think about the business in CCT. You have the aerospace sector, which we know—you all know better than anyone else what's happening out there; it’s practically lower for the longer term. The other part of the business is the connector business, which is more short-term and can react quickly if recovery happens. From a margin perspective, I would say probably more than 300 basis points of improvement came from restructuring actions at CCT. But at the same time, we need to be ready to play offense in CCT because of the short cycles. Once the economy starts to recover, we want to capitalize on that. We can leverage the connector and short-cycle business to drive growth. In general, it’s about our aggressive approach to addressing costs and further reducing our structural costs.

Tom Scalera, CFO

Yes, Joe, if I could build on what Luca is highlighting there. We're on a good trajectory with the connector business. When markets do start to recover, I think we’ll see a more immediate or short-term benefit in the margin profile of our connector business, which has been gaining a lot of momentum before COVID-19. The actions we are taking will increase the potential upside for the connector side of CCT, especially when we have incremental margin performance. Certainly, the question of the duration of the segment target is around the aerospace component side of the business, which right now requires more management on cost as we observe and wait for more certainty in the top-line. But I think we have leverage and momentum on the connector side of the portfolio, particularly if the market demand returns.

Joe Ritchie, Analyst

That’s helpful, guys. Thank you so much.

Damian Karas, Analyst

Hi, good morning, everyone, and Tom, thank you for all your help over the years.

Tom Scalera, CFO

Good afternoon, Damian. Thank you.

Damian Karas, Analyst

I wanted to follow up on some of your comments on IP and specifically on the margins given the various moving pieces there with the cost productivity actions and then sort of the order dynamics with the short cycle but the higher project orders and obviously some timing around project delivery. What's the margin cadence that we should be thinking about for the second half in IP?

Tom Scalera, CFO

Yes, I think Damian, one of the things—so we mentioned that there's a mix pressure that we're going to be offsetting as we roll from Q2 into Q3. Fortunately, one of the offsets is the restructuring actions that we’ve been taking and the incremental restructuring benefits we expect in Q3. This will provide us with some nice cushion against a less favorable mix as we progress through the quarter. Thus, there's opportunity for us to outperform the prior year from a margin perspective in Q3, although sequentially we're seeing a little too much mix to overcome. I think we're going to be in the same range for the balance of the year from a margin perspective, plus or minus 20, 30, 40 basis points from where we ended Q2 due to the mix and restructuring savings. Fortunately, we have strong momentum with our cost actions and restructuring initiatives, which will gain momentum throughout the year.

Luca Savi, CEO

If I may add to what Tom said, regarding the mix, we recognize that the profitability of short-cycle work is generally more advantageous than project work. However, I can share this beautiful chart regarding the profitability of our project backlog; the line shows that it has consistently improved year after year. The backlog we had at the end of Q2 demonstrates that the profitability of projects is at its highest point ever, placing us in a favorable position.

Damian Karas, Analyst

That's really helpful. And then switching over to MT, it seems China is going to lead you out of the recovery for the Friction business. I want to understand how that business is progressing for you and your market share objectives in the region. Have there been any structural changes in the market or competitive dynamics that you’ve seen arising from the pandemic?

Luca Savi, CEO

Absolutely. When we look at China, we outperformed the market in the first six months by roughly 1600 basis points. Our awards year-to-date reflect that performance, with one-third of them in China this year. About one-third of the total awards are new, which also speaks to market share gains. I'm very optimistic about the trajectory of our market share gain momentum because of the new awards and conquer wins. In terms of overall performance in China, the utilization of machines and our equipment isn't where it was supposed to be globally, but the efficiency of those machines reached around 85% and labor productivity is above 80%. Given that we are not running a fully loaded factory, it's a significant achievement. Therefore, I am confident in our continue market share gain and how China is performing from a P&L standpoint.

Damian Karas, Analyst

Okay, great. Thank you. I’ll pass it on. Best of luck, guys.

Emmanuel Caprais, CFO

Thanks, Damian.

Tom Scalera, CFO

Thank you, Damian.

Matt Summerville, Analyst

Thanks, and I echo the same sentiments, Tom, best of luck.

Tom Scalera, CFO

Thanks.

Matt Summerville, Analyst

Sure. Regarding CCT, I want to ensure I understand correctly. Can you discuss the organic cadence for that business in the back half of the year? Incoming order rates are down 37%, so I'm curious to know if this business could potentially worsen before the situation improves?

Emmanuel Caprais, CFO

Yes, Matt. This is Emmanuel. Sorry. We don't expect a significant improvement in Q3 and beyond for the top line in CCT since much of it hinges on aerospace, which comprises 35% of our revenue. Passenger air traffic will likely not improve in the near term, and we don’t anticipate significant gains in OE build rates either. Therefore, year-over-year declines should be in line with Q2. Currently, our focus is on managing costs effectively during this period, reducing decremental margins to benefit from attractive incremental margins when the business picks up. We foresee recovery in aerospace mirroring what we saw after 9/11; this could take two to three years. However, within the connector business, we have short-cycle opportunities that may provide potential growth under economic recovery.

Matt Summerville, Analyst

Thank you. Just as a follow-up, what sort of P&L benefits should we expect to carry over into 2021 from all the cost reductions you're implementing this year? Thank you.

Tom Scalera, CFO

And Matt, you mean for all the businesses, correct?

Matt Summerville, Analyst

Correct.

Tom Scalera, CFO

Okay. Our $125 million plan is an accumulation of several actions. We expect that for 2020, the benefit will be around $90 million as a result of those actions. In 2021, we project about $100 million. This increase is due to the staffing of discretionary cost actions returning compared to 2020, along with full-year benefits from restructuring efforts. So, the incremental guidance is around $90 million in 2020, with an estimated $100 million in 2021. We anticipate most of these cost actions to be structural, with many being reinserted later, but we expect to remain north of 35% for the incrementals.

Matt Summerville, Analyst

Great, thank you, guys.

Jeff Hammond, Analyst

Hey, good morning, guys. Best of luck, Tom; I look forward to staying in touch.

Tom Scalera, CFO

Thanks, Jeff.

Jeff Hammond, Analyst

Just on, I guess back to MT, I'm just trying to better understand how you're thinking about production regionally and where you may differ from IHS's forecast. Additionally, could you please speak to what's happening in the aftermarket trends?

Luca Savi, CEO

Of course. Good morning, Jeff. I would say our position on IHS is more conservative across North America, Europe, and China compared to their projections. For example, they are estimating a decline close to 22%, anticipating about 69–70 million vehicles produced this year. We expect that number to be closer to 65 million with a similar sentiment for all three regions. Regarding the aftermarket, Q2 showed a more significant decline than Q1, with about -20%. For the full year, we're projecting lower performance between -15% and -16%, which we expect to continue for the year as evidenced by our major aftermarket customer's feedback.

Jeff Hammond, Analyst

Okay. And regarding the CCT, I acknowledge the pressures you are experiencing. However, in the context that orders are lumpy, could you provide more clarity on where the commercial business is currently and what you anticipate in defense?

Luca Savi, CEO

In the defense sector, we expect a more stable environment, with the market being flat year-over-year while we anticipate our decline in mid-single digits. The timing of programs influences this outcome. Speaking of commercial aerospace, we predict revenue will likely face around a 50% decline due to the decreased build rate among airframes. Notably, a portion of our business in interiors is hit harder, as airlines cut spending on refurbishment, leading to a disproportionate effect on this segment.

Emmanuel Caprais, CFO

We expect the market to remain stable in defense. Although modest growth is anticipated in the second half, the bulk of it will depend on the specifics of upcoming programs.

Jeff Hammond, Analyst

Is it simply a matter of timing for programs?

Emmanuel Caprais, CFO

Correct, Jeff. Defense is very programmatic for us, which is why we observe stronger prospects for the second half compared to the first semester.

Luca Savi, CEO

That's right; it's primarily program-based.

Jeff Hammond, Analyst

Okay, great, good to see you back on the road again, Luca.

Luca Savi, CEO

Absolutely.

Emmanuel Caprais, CFO

And just to finish on the industrial side of CCT. I’d say that all of the industrial-facing parts of CCT are generally outperforming their respective markets. We have differing pressures across the industrial aerospace sector, with defense showcasing a strong second half. The overall industrial portion of CCT is likely to exceed competitors in the markets they serve.

Bryan Blair, Analyst

Good morning, guys. Tom, thank you for all your help over the years.

Tom Scalera, CFO

Absolutely, Bryan. Thank you.

Luca Savi, CEO

Good morning, Bryan.

Bryan Blair, Analyst

I was hoping you could break out the monthly sales rate for Friction aftermarket in the quarter. I assume April was quite painful, and then there is some degree of recovery getting to the low 20s. Could you also speak about the July sales rate to gauge the pace of sequential recovery?

Luca Savi, CEO

Definitely. April was undoubtedly challenging, primarily because our aftermarket business is largely European. May showed little improvement, but with lockdowns easing, we saw notable improvement in June. July findings continue to reflect this trend as we recover. You mentioned M&A opportunities in the rail sector? It seems that build-out could accelerate over the near term. Could you remind us of the run rate size of your KONI/Axtone platform? While we discuss margins, do you have a target scale in mind for the rail platform regarding both organic and M&A investments? Certainly! The KONI/Axtone business generates roughly $200 million to $210 million in revenue. In the long term, we envision building the rail platform to approximately $500 million to $600 million. This acquisition opportunity we’ve been pursuing is a niche one, but it's a well-run company which may allow for a more significant customer service presence; thus, it’s a valuable addition. We’ve taken steps to cultivate this opportunity, pausing due to COVID but have recently reactivated our focus as lockdowns ease.

Bryan Blair, Analyst

I appreciate all the insights. Also, do you believe the long-term platform can reach Friction-type margins structurally?

Luca Savi, CEO

Yes, it can.

Brett Linzey, Analyst

Hey, good morning everyone. Many thanks to Tom, and congrats to Emmanuel.

Emmanuel Caprais, CFO

Thank you, Brett.

Brett Linzey, Analyst

Just for clarification on cost savings: Emmanuel, you indicated $90 million this year, $100 million next year. I want to ensure that $100 million is incremental to the $90 million?

Emmanuel Caprais, CFO

No, it's not. The $100 million includes a $10 million increment from 2020 and represents carryover benefits from restructuring and discretionary actions that roll back in 2021.

Brett Linzey, Analyst

Got it. Lastly, regarding the balance sheet, it seems solid. Is there an opportunity to move the frozen pension off-balance sheet? Moreover, could you elaborate on the qualified settlement fund mentioned in the slides? Strategically, will it be possible to eliminate this liability this year or next?

Emmanuel Caprais, CFO

Absolutely. We are focused on terminating the U.S. pension plan and moving it off-balance sheet. Our aim is to achieve this by the end of the year. Regarding the QSF, that fund stores all of our proceeds from settlements with insurance providers. The QSF continues to grow, essentially safeguarding cash for asbestos and environmental spend. Our approach means operational cash doesn’t go towards addressing those legacy obligations. We project substantial coverage for the next two years using that fund. We regularly review our options for addressing the asbestos liability to ensure we have appropriate strategies in place for any potential opportunities.

Brett Linzey, Analyst

Thanks, congrats on a great quarter and best of luck.

Emmanuel Caprais, CFO

Thank you.

Operator, Operator

The floor is now open for questions. Thank you. Our next question comes from the line of Andrew Obin of Bank of America.

Emily Shu, Analyst

Hi, Good morning. This is Emily Shu on for Andrew Obin. I want to extend my thanks and best of luck to Tom and congrats to Emmanuel.

Tom Scalera, CFO

Thank you, Emily.

Emily Shu, Analyst

Just a question about your supply chain—did you make any adjustments to sourcing during the quarter or shift production between regions? Additionally, how did operations run in your Mexican facility due to the extensive government-mandated shutdowns?

Luca Savi, CEO

Thanks, Emily. In terms of supply chain, we achieved significant savings across all regions, with minimal disruption caused by the shutdowns. Our preparedness allowed us to manage well and keep our operations running smoothly. Our Mexican operations in Nogales operated through the quarter, with varying functioning levels per government regulations. Our facility in Silao for Motion Technologies shut down temporarily during parts of April and May due to decreased customer demand. It was restarted and is currently operational.

Joe Giordano, Analyst

Hey, guys. Good morning and good to see you guys are finally upgrading the CFO role. It's long overdue. Tom, I'm going to miss you, man.

Luca Savi, CEO

Luca, you mentioned that project profitability in IP is at its highest it's been in years. Given the uncertainty surrounding the pandemic, what's the risk associated with the backlog remaining dormant for longer stretches? When we examine the last six months, we consider these the most difficult due to COVID-19. However, our project backlog has risen 3% since the beginning of the year despite the challenging environment. There's nominal expected volatility, no significant cancellations to report—just delays. We have not encountered any major issues with the project side of the business, and we expect our terms and conditions to protect the profitability of those contracts.

Joe Giordano, Analyst

That’s helpful. What can you share about the landscape in rail?

Luca Savi, CEO

The rail market is largely regionalized, with many smaller to medium companies dominating. If a firm operates in one region, globalizing that business can create some challenges while you scale. Specific products may have wider international applicability, but overall it’s a fragmented market.

Joe Giordano, Analyst

Thanks, guys.

Operator, Operator

And ladies and gentlemen, that was our final question. I'd now like to turn the call back over to Tom for any additional or closing remarks.

Tom Scalera, CFO

Yes, thanks. I wanted to take a moment to thank all the analysts and investors. It's been my pleasure and honor to work with you and represent ITT while helping you understand and appreciate both the company and its potential. I've enjoyed the experience and the opportunity to get to know many of you over quite a long period. I’ll certainly miss you all and genuinely appreciate your support. I want to extend my gratitude to my fantastic team, especially Michelle for her support over the years. You are many of you familiar with the they helped turn me into a much better leader. I also want to thank Luca for everything—his incredibly kind words were heartfelt. I wish Emmanuel the best of luck and congratulations. ITT is in great hands, as we have a solid balance sheet and a tremendous future ahead. Emmanuel, Luca, and the rest of our executive team will ensure we continue to realize even greater value creation going forward. Thank you all, and I hope to connect with you again in the future. Maria, we are ready to conclude.

Operator, Operator

Thank you. This does conclude today's teleconference. Please disconnect your lines at this time and have a wonderful day.