Jessica Kourakos - Head, IR Denise Ramos - President and CEO Tom Scalera - CFO.

Brad Vanino - KeyBanc Mike Halloran - Baird John Inch - Deutsche Bank Nathan Jones - Stifel Matt Summerville - D.A. Davidson & Co. Walter Liptak - Seaport Global Joe Giordano - Cowen.

Welcome to ITT’s 2017 Fourth Quarter Conference Call. Today is Friday, February 16, 2018. And starting the call from ITT today is Jessica Kourakos, Head of Investor Relations. She is joined by Denise Ramos, Chief Executive Officer and President; and Tom Scalera, Chief Financial Officer.

Today’s call is being recorded and will be available for replay beginning at 12:00 pm 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. [Operator Instructions] It is now my pleasure to turn the floor over to Jessica Kourakos. You may begin..

Thank you, Krystal. I’d like to highlight that this morning’s presentation, press release and reconciliations of GAAP and non-GAAP financial measures can be found on our website at itt.com/ir. Please note that our discussion this morning will primarily focus on non-GAAP measures.

During the course of this call, we will make forward-looking statements as defined in the Private Securities Litigations Reform Act of 1995. No forward-looking statements can be guaranteed, and actual results may differ materially from those projected.

We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events or otherwise. Forward-looking statements made on this call should be evaluated together with the risks and uncertainties that affect our business, particularly those disclosed in our SEC filings.

So, let’s now turn to slide number three where Denise will discuss our results..

Thank you, Jessica. Good morning, everyone. Thank you for joining us today to discuss our strong Q4 and full year 2017 results and our solid 2018 outlook. As I reflect on 2017, I’m so proud of our many record achievements and how we’ve focused on driving operational improvement and share gains in our key growth markets.

So, let me recap our outstanding 2017 results and significant strategic highlights. We delivered 2.6 billion in revenue, representing an 8% increase including $74 million from our Axtone acquisition, favorable foreign exchange, and 3% organic growth. Adjusted segment operating income increased 11% and margins improved 40 basis points.

Excluding foreign exchange, operating income grew 14% and margins expanded 90 basis points. All three segments contributed to the OI growth with each one producing double-digit increases in 2017, a further validation of the execution delivered by our new operating system.

In addition, we produced record adjusted EPS of $2.59, record segment operating cash flow, 15% free cash flow growth and a 100% free cash flow conversion. So, now, let me share some of the strategic highlights from 2017 that I believe will position us nicely for future growth. We continue to focus on optimizing execution.

In addition to the record operating cash flows, we also drove strong underlying operational margin expansion of 170 basis points before acquisitions, FX, and investments. Again, all three value centers contributed here to the strength with IP and CCT up 200 basis points and MT up 90 basis points.

Global productivity actions, restructuring benefits, and strong volumes fueled our margin expansion. We also expanded in our markets. In 2017, MT continued its track record of gaining share across multiple global market categories.

MT was awarded 75 new automotive platforms including 42 in China and 9 in North America as we continue to build momentum in these growth markets. In addition, 15 of those 75 wins were for electric vehicle platforms, primarily in China and Europe.

Also in Q1 2017, we introduced the revolutionary SMART Pad that is already generating significant interest all across the transformation world. And we are currently working with customers on both development and onboard opportunities. We also advanced key strategies in rotorcraft, aerospace and defense, EV connectors, and high-speed rail markets.

In these categories, we secured significant multiyear awards that also provide attractive aftermarket opportunities. These awards include critical components on Bell Helicopters, Paveway missiles, the Bradley fighting vehicle, the Boeing 777X and high-speed rail in China.

In terms of capital deployment, we funded critical, organic investments, including our phased investments in Mexico, China and the Czech Republic to efficiently align our friction footprint with the significant share gains we’ve already secured. We also purchased Axtone early in 2017 to expand our global rail platform.

In addition, we effectively reduced our legacy liabilities by $65 million. And consistent with our balanced approach to deployment, we returned $75 million to shareholders in the form of solid quarterly dividend and discretionary share repurchases.

So, in summary, not only did we deliver strong free cash flow and record EPS, we also continued to greatly advance ITT’s strategic potential for long-term growth and value creation. The details behind the 2017 results, you’ll see on slide four.

And as I reflect on the comprehensive strength of the results that j dedicated teams produced, I’m reminded of the strength of our culture at ITT. Commitment to ITT’s culture has been one of my goals for this Company for several years. And I believe that collectively we have made tremendous progress. The key element of our culture is appreciation.

So, this feels like a perfect place to pause to appreciate how our people have done so many amazing things this year for our customers and for our Company. We’ve really had some tremendous successes in 2017.

And these include the IP team’s significant transformation, progress and sequential margin expansion, the foundational improvements at our recently acquired businesses, the global share gains at MT and the successful facility launch in Mexico, the efficient and effective combination of the ICS and CT teams to form CCT, and we’ve enhanced our operating model under Luca’s leadership while also increasing our focus on growth and innovation through a recapitalized and reenergized strategy and business development team.

For all of these accomplishments and so many more, I want to sincerely thank our 10,000 employees all across the globe for their dedication in these results. So, with that, let’s turn to our strong fourth quarter results on slide five. And these really demonstrate the operational momentum that we have going into 2018.

So, in the fourth quarter, we delivered exceptional results in all performance categories, revenue, up 16%; orders, up 16%; segment OI, up 29%; segment margins, up 120 basis points; and EPS, up 33%. The 8% organic revenue growth reflected gains in all three major markets.

Oil and gas improved 12% on strong upstream pump and connector activity; transportation grew 9% on double-digit growth in auto and rail, partially offset by defense; and general industrial grew 4% due to increased short-cycle pump activity; organic orders were up 9%, driven by 14% growth in global OEM friction and strong aerospace and defense component wins on key platforms; pump projects declined 28% due to lower upstream oil and gas activity.

Q4 adjusted segment operating income of $86 million grew 29%. This growth was driven by strong contribution margins on higher volumes, restructuring savings at IP and CCT, and benefits from the Axtone acquisition. These were partially offset by higher commodity costs and accelerated strategic investments. Fourth quarter adjusted EPS of $0.64 grew 33%.

The growth was driven by our strong operating performance partially offset by higher incentive compensation costs. In addition, the Q4 tax rate reflected the benefit of a proactive rate reduction strategy implemented in Italy. So, with that, let me spend a few moments on tax. As you know, ITT is a very international company.

And compared to many of our peers, we currently have a smaller portion of our profits coming from the U.S. So, our tax team focused this year on proactively lowering our international tax rate. And I’m pleased to report that in Q4, we were ultimately successful in bringing down our effective tax rate due to a beneficial ruling Italy.

This action drove our full year 2017 tax rate down to 24.3%, resulting in a 19.5% rate in Q4. But most importantly, this will continue to benefit us in the future. Slide six shows our Q4 adjusted segment margin walk. Margins improved 120 basis points in total or 290 basis points from an operational perspective before FX, investments, and acquisitions.

The expansion reflects the benefits of the operating model that we implemented under Luca’s leadership at the beginning of this year. The operational drivers in Q4 included restructuring benefits at IP and CCT, improved efficiency at Wolverine and MT, and improved execution at IP.

Our enhanced approach to driving operations is clearly producing results. And I’m confidence that the operational momentum that Luca and the value center teams have generated will continue into 2018. So, let me pause a moment and provide some additional 2018 perspective.

As we move into a dynamic 2018, it is important to note that our guidance is based on current market conditions. We are not projecting incremental growth in the second half of 2018 based on tax reform benefits. At this point, we just don’t want to get ahead of the markets in determining how demand may respond to the additional stimulus.

And just like we did in 2017, we will continue to drive strategic growth in 2018 by focusing on what we can control.

The four strategic pillars supporting our 2018 guidance include execution under our new operating model, innovation and growth under our new strategy and business development teams, and continued focused on deploying capital in a balanced and efficient way.

So, at a high level, our guidance reflects our expectation of improving execution in key markets and our intensified commitment to advance long-term strategic opportunities in a relatively stable to modestly improving end-market backdrop.

So, with that, let me pass it baton to Tom who’s going to take a deeper dive into our Q4 segment results and the 2018 outlook..

Thank you, Denise. Starting on slide seven with Industrial Process. Q4 total revenue grew 10% to $233 million on 8% organic growth. Short-cycle revenue increased 8% due to aftermarket and baseline pump growth in the low-teens, partially offset by weak biopharm and general industrial valve activity.

Project activity grew 6%, primarily in Latin American upstream oil and gas and mining. We also drove petrochem sales in the Middle East in Asia.

Organic orders at IP were flat, primarily reflecting a 28% decline in projects due to lower upstream oil and gas activity that was offset by an 11% increase in short-cycle demand, primarily in general industrial and mining. IP’s adjusted segment operating income increased 53% to $27 million.

The increase primarily reflects a favorable short-cycle mix that includes some price realization and improved project performance, partially offset by $3 million in negative FX. Compared to the prior year, margins improved 330 basis points to 11.7%, capping a year where IP delivered sequential margin growth every quarter.

In 2017, Industrial Process nicely advanced their strategic transformation. The structural reset coupled with improved IP project execution allowed the business to exit the year with double-digit quarterly margins for the first time in six quarters, and placed us on a trajectory to see low double digit margins for the full year 2018.

We will continue to be disciplined in our project business, and we will be willing to walk away from deals that just don’t make economic sense for us. That said, we are optimistic about the short-cycle activity we’ve seen and by the capital spending that may be on the horizon, particularly in the U.S.

Now let’s turn to Motion Technologies’ results on slide eight. Total revenue in Q4 increased 31% to $299 million, including $18 million from the acquisition of Axtone and $22 million from FX. Organic revenue increased 13% due to a 16% increase in friction.

For the full year 2017, friction OEM outgrew the global market by 6X due to growth in Europe at 2.5 times market, growth in China at 16 times market, and U.S. growth at 10% in the declining market. In addition, KONI revenue grew 9%, driven by rail in Europe and high-speed rail in China.

Adjusted segment operating income at MT increased 34% to $38 million. The income growth reflects volume leverage, increased productivity, and benefits from the Axtone acquisition. Operational margins excluding foreign exchange, strategic investments, and acquisitions of 14.3%, grew 200 basis points versus the prior year.

The improved productivity at Motion Tech was partially offset by price pressure and rising steel costs. In the quarter, we continued to invest in our new friction facility in Silao, Mexico, and we are gaining momentum. The facility is receiving positive reviews from customers, and we have already successfully produced several hundred thousand pads.

For 2018, we forecast that MT will continue to significantly outpace global OEM production rates due to share gains. This strength will be partially offset by lower aftermarket activity and low single digit growth in non-friction.

The solid MT margin expansion projected in 2018 will be driven by improvements in the recently acquired businesses which will create a new, more balanced quarterly margin pattern. Now let’s move to Connect and Control Technologies on slide nine. Q4 revenue grew 3% to $153 million on 1% organic growth.

General industrial markets were flat due to strength in heavy vehicle and EV connectors and actuation components, partially offset by weak medical connectors. Oil and gas connectors improved 25% and increased activity in North America and the Middle East.

And lastly, aerospace and defense revenue was flat on weak defense connectors, partially offset by A&D component strength. CCT’s organic orders improved 15% due to a 29% increase in aerospace and defense, partially offset by a 5% decline in industrial.

The A&D strength includes orders from long-term aerospace agreements with Boeing and increased Paveway missile demand in defense. In addition, several key awards were generated in the quarter including a multiyear $40 million Boeing 777X award and a strategic EV charging station award. Adjusted segment operating income increased 2% to $21 million.

The segment operating income growth primarily reflects improved productivity and restructuring benefits, partially offset by higher incentive compensation costs and investments. Excluding investments of 50 basis points and unfavorable FX of 40 basis points, operational margins improved 70 basis points.

In 2018, CCT is expected to produce modest topline growth as new growth platforms continue to ramp and offset legacy product transition. The real story for CCT will be the triple-digit improvement in margins that we will drive through improved execution in our ECS business and sustain momentum we have generated in connectors.

In addition, CCT is expected to benefit from additional restructuring and efficiency actions as we enter a new phase of opportunities from the integration of the controls and connectors businesses. Now, let’s turn to our 2018 guidance highlights on slide 10.

We expect total revenues to be up 5% to 8%, including foreign exchange and underlying organic growth of 2% to 4%. Some of the primary drivers of the growth include global friction and rail share gains, and improved short-cycle industrial and chemical demand.

We expect to expand our adjusted segment operating margins by 100 basis points to 150 basis points, driven by higher volumes and stronger productivity in all three value centers, partially offset by increased commodity costs and strategic investments. We expect to grow our adjusted EPS 16% at the $3 midpoint of our guidance range.

80% of our EPS growth will be driven by operating income expansion. It is also important to note that our tax rate in the range of 23% to 24% provides only modest benefits compared to the 2017 rate of 24.3%. In addition, favorable FX tailwinds are expected to offset incremental strategic investments and higher non-functional corporate costs.

So our 2018 growth will effectively be driven our continued focused and operational execution and stabilizing market. Now, let’s turn to slide 11 for 2018 revenue guidance by market, excluding currency impact. Starting with auto and rail, we expect mid single-digit growth due to our recent global share gains.

In automotive OEM friction, we project double-digit growth in North America and China, and mid to high single-digit OEM growth in Europe, our largest market, partially offset by a lower aftermarket.

Aerospace and defense is expected to grow low single digits in 2018 as we continue to offset and mix shift from wide-body to narrow-body platforms, and lower defense connectors with accelerating global categories including rotorcraft, environmental control systems and defense components.

In general industrial, we expect low single digits growth due to strengthening conditions in North America and the benefits from the new product development. Conditions in the chemical and industrial pump markets have recently improved.

We’re expecting growth in the mid single digits range, led by North American and Asian petrochemical projects and improved short-cycle demand across industrial markets.

And lastly, oil and gas, which today represents only 10% of ITT’s revenues, is expected to be down mid single digits on lower upstream project activity, partially offset by increased midstream and downstream activity. And please note that market assumptions are based on WTI at $60 per barrel.

On slide 12, we provided an overview of our 2018 adjusted segment margins. We expect adjusted segment operating margins to expand 100 to 150 basis points to a midpoint of 14.7%. The strong margin expansion is being primarily driven by improved volumes, strong operational execution and FX, offset by higher commodity costs and growth investments.

We expect operational margins before investments and FX to expand 140 to 190 basis points. We are also driving incremental margin expansion in our recently acquired businesses of Wolverine, Axtone and ECS. Let me provide a few additional 2018 segment margin perspectives here. All three value centers are expected to deliver solid margin growth in 2018.

Second half 2018 margins are expected to be stronger than first half due to the timing of restructuring actions and accelerating benefits of productivity actions. IP is expected to build margin momentum from productivity during the year and finish 2018 in the low double digits.

MT will produce solid margin expansion with a more balanced quarterly phasing than we’ve seen in recent years. And CCT is expected to produce triple-digit margin expansion in 2018. Now, let’s turn to slide 13 where we have our 2018 adjusted EPS walk.

So, you can see the key performance drivers and assumptions supporting our 16% EPS growth of $3 per share. The tailwinds primarily include operational actions within our control combined with increased volumes, partially attributable to share gains in key markets.

Headwinds include commodity and price pressures, oil and gas market weakness, and higher non-functional corporate costs including environmental and lower assumed returns on investments, reflecting recent market volatility.

Our operating execution is expected to more than offset price and commodity pressures and drive $0.38 or 80% of our total EPS growth. Our $0.19 of strategic investments represent an increase of approximately $0.03 compared to 2017. Based on the expanding set of growth opportunities in 2018, we’ve decided to increase our level of strategic investments.

These incremental investments will be funded by the $0.03 of tax rate benefits and the remainder of the strategic investments will be offset in our EPS walk by projected foreign exchange favorability net of corporate costs.

These strategic investments reflect an 11% increased in R&D that includes accelerating the commercialization of market-leading technologies including i-ALERT, SMART Pad and E-Pads.

In addition, we are continuing the expansion of MT’s Mexico and China manufacturing hub, the expansion of CCT’s capabilities to serve the rotorcraft market, and increased investment in leaning out IP Seneca Falls location.

And finally, we are estimating our 2018 effective tax rate to be in the range of 23% to 24%, representing a modest 3% benefit compared to 2017. As Denise indicated earlier, based on our significant international presence, we only received modest benefits from the Tax Cuts and Jobs Act of 2017.

As a result, our world-class tax team effectively implemented international strategies that drove our rate down in 2017. In addition, based on applying foreign tax credits and offsets, we have reduced the anticipated cash tax on our $1.2 billion of foreign earnings to approximately $7 million in total cash to be paid over eight years.

Also, in the fourth quarter, we recorded a $129 million provisional net GAAP charge, primarily related to the write-down of deferred tax assets and federal foreign and state taxes on deemed repatriation. Lastly, I just want to touch on the key remaining assumptions in the walk.

We expect unallocated corporate and other expenses to be up year-over-year to 46 to $50 million. The increase is primarily due to environmental and lower projected investment returns. We also expect interest and miscellaneous expenses to be in the 8 to $10 million range including the 2018 impact of required reclass of non-service pension cost.

I’d also like to provide some highlights into our Q1 expectations. We expect our organic topline to grow around 2% in Q2 compared to the prior year. In Q1, automotive OEM share gains are expected to be partially offset by lower defense. We expect Q1 adjusted segment margins at IP in CCT to improve at least 200 basis points versus 2017.

MT margins are expected to decline versus 2017 in Q1 due to higher commodity cost investments and unfavorable independent aftermarket mix. Q1 corporate costs are expected to be higher than the prior year due to prior year favorable items including environmental.

So, putting it all together from Q1 adjusted EPS perspective, we expect to grow low double digits compared to Q1 2017. So, now, let me turn it back to Denise..

Thanks, Tom. Turning to slide 14, let me just give a 2018 strategic recap. So, in 2018, we’re focused on creating value from execution, innovation, and growth, while we continue to deploy capital in a balanced and efficient way. Execution will drive our 16% EPS growth that is built on strong triple-digit margin expansion.

We will drive our operating model to accelerate productivity across our footprint and we will continue to execute upto $25 million in restructuring actions later in the year. Innovation and growth will drive our 5 to 8% growth rate. We have been gaining share in a number of key markets.

We will continue to deploy innovation and growth strategies to capture these opportunities. We are increasing our investment in R&D by 11% to 4% of revenue, and growth-oriented CapEx investments are also projected at 4% of revenue. Today, the ITT business system is intensifying its focus on growth and leadership.

And in January 2018, we held our first ever Global Growth and Innovation Leadership conference. ITT leaders from all around the world gathered to discuss our corporate strategy and future growth opportunities in a rapidly changing market. The feedback from our employees was fantastic.

And I couldn’t be happier with the energy and purpose that came out of that event. We have tremendous opportunities ahead and we are all invested in capturing these. In summary, we delivered a strong 2017 that reflects strong execution and the acceleration of our strategic priorities.

Heading into 2018, we plan to maintain our operational and strategic momentum as we continue to leverage the benefits of our global and market diversification. In addition, we plan to focus more of our efforts on growth and innovation in 2018 that will provide long-term benefits for years to come.

And in 2018, we are also raising our dividend by 5%, which represents our sixth consecutive year of dividend increases and we remain committed to opportunistically repurchasing shares, targeting up to $50 million in 2018. So, now, let me turn it back over to Krystal to start the Q&A..

The floor is now open for your questions. [Operator Instructions] Thank you. Our first question is coming from the line of Jeffrey Hammond with KeyBanc..

Hey, everyone. This is Brad Vanino filling in for Jeff. Just on the platform wins, clear momentum there.

Kind of what’s driving that by region? Is it still just the copper-free and the front axle action or are there some other elements there? And is the SMART Pad, kind of when is that expected to start contributing there too to the wins?.

There is a lot of things that drive that momentum, Brad, and a lot of it has to do with just a process that we’ve put into place in the MT, and how we focus on, on-time delivery, quality, R&D, working closely with customers.

And so, then, as we planted ourselves outside of Europe into China and into North America, we just continued to have those wins with our customers, and in China with the local OEMs also. So, part of it and a big part of it is just the fact that how we operate the baseline business.

Now, in addition to that, we spend a lot of time focusing on R&D and working closely with customers for evolving technologies and things that are changing in the industry. And as you know, the automotive industry is changing significantly. So, we have been focusing more on front axle, and we’ve been increasing our wins from a front axle standpoint.

And then with copper-free pads, we’ve made some nice inroads with our copper free pads. In addition to that, we’re working closely on time to focus on EV and creating new brake pads for electric vehicles, which as you know is something that’s quickly evolving. So, we’re focusing on that.

And then, with the SMART Pad, we announced that and began talking with customers in the first quarter of 2017 more from a development perspective, but we’re also looking for onboard applications with that. And I would tell you that’s progressing nicely. And that’s something that’s going to evolve over the year and into 2019..

Okay.

Then just kind of building off that, could you reconcile kind of what you’ve seen with the recent project wins and the order growth in that business with the mid single-digit market expectation? I know, you mentioned the lower aftermarket, but kind of what’s driving that and what’s the magnitude of the lower aftermarket next year?.

Yes, Brad. So, the OEM growth that we outlined is reflective of the share gains that we’ve had. So, we’re significantly outgrowing our core markets on the OEM side, as I mentioned. So, we’re five times the market in North America, we’re 10 plus times the market in China and three times the market in Europe.

So, the share gains are manifesting in very strong growth compared to market, again in 2018. One of the variables, our biggest market Europe, the growth rates are down in Europe; we’re still up performing even at a higher rate we did last year, but that has the effect of bringing down the OEM portion of our business to high single digits.

So, very much in line with what we’ve been discussing. The aftermarket part of that business, a friction is probably going to be about up only 2%, low single digits. And then, the non-friction business is going to be up also low single digits.

So, you’re getting real high single-digit growth in the OEM aligned with those platform wins that we’ve talked about. And really in the aftermarket where we have just the 2% growth, it’s timing; it’s win some of these platform so to ramp up when they go from the OE cycle to the OES cycle.

We had a strong independent aftermarket year last year; we expect that to moderate a little bit. But those dynamics work themselves through. I think that the important point is that our OEM growth rates are right in line with what we’ve been doing in the past couple of years just in a little slower market environment globally..

Our next question comes from the line of Mike Halloran with Baird..

So, what’s driving the Motion margins? Not really surprised that you’re expecting little first quarter pressure given where the price cost is. I think, earlier you guys suggested margins should still grow year-over-year. Maybe just help with a couple of things there.

One, how you’re looking at the price cost curve and catching up to the year? I’m guessing, a lot of it is productivity.

But, was there any pricing that happened there? And then, secondarily, what the sources of upside to the margin line looks like as you work through the year?.

Yes. Sure, Mike. So, price cost, the price out of Motion Tech is pretty consistent with where we’ve been over the last couple of years. It’s generally the known headwind to the contracting; there is no change in the profile on the pricing side. I’d say what’s different this year is as we’ve been highlighting as the commodity cost increases.

So, we do have a bigger headwind this year on the commodity side, which puts more pressure on the Motion Tech margins. We saw some of that in the back half of 2017 as well. What is kind of new in 2018, as we kind of progress through the margins, is our non-friction businesses.

So, 30% of the portfolio that’s not friction is going to be driving a lot of margin expansion throughout the course of the year from productivity and restructuring actions, particularly in some of the acquired businesses. Those benefits, restructuring and productivity, are going to be more second half weighted.

So, we are going to see a little bit more of a smoother margin trajectory at MT as these non-friction businesses start to really move forward from the margin expansion perspective. Because you may remember when we acquired those businesses, it was really predicated on operational performance, and we’re starting to gain some traction there.

So, those are some of the major dynamics. I think, the productivity inside the core business remains strong.

If it wasn’t for the material costs, you’d see a much bigger drop, but that clearly is the biggest headwind and that’s going to be with us from the beginning of the year, probably at a much higher rate, because the second half costs in 2017 were already elevated.

So, we would expect to see on a year-over-year basis, more margin pressure for materials; it smoothes out a little bit in the second half of the year..

And then, just getting back to the Denise’s comment about the establishment of guidance assuming the fourth quarter run rate, is how you’ve layered that guidance through or that was at least the assumption.

Maybe, you could talk a little bit about that in the context of the IP segment? You obviously gave some nice color around the motion side already.

But in the industrial side, how are you looking at, one, the project funnel, as you work through next year and the ability to have that roll through? And then, secondarily, what are you seeing on the short-cycle side of things, sequentially, and the momentum there.

And is there any concern that the momentum is not sustainable?.

Yes. So, Mike, from a project perspective, what we’re looking at is for what was put into the guidance for 2018 is basically what we have in backlog today. May times, these projects take a long period of time until we can deliver them. So, basically, the projects that we have in 2018, we have about 90% or so in backlog today.

Now, a good part with projects is when we look at the funnel and we look at it on a year-over-year basis. The funnel for projects is actually up about 21% versus what we saw a year ago. And where we’re seeing strength in that funnel is in petrochemical, basic chemical, and then, from an oil and gas standpoint, in downstream.

So, those are really the strengths that we’re seeing from a project funnel perspective. Now, the projects that we’re seeing, they are not as large as what we’ve had in the past. They tend to be smaller to medium sized projects, but at least we’re getting more customers coming and talking with us about projects.

And so, we’re hoping that throughout the year that will get some of those orders coming through. But, if they do, that probably will not benefit us in 2018 but more in 2019. That’s on the project side. On the short-cycle side, we’ve been happy to see some of the slowly increasing momentum that we had in 2017.

And so, as we get into 2018, we’re still expecting to see some gradual increases in the short-cycle; and where we expect to see more of that would be on the chemical side of things and on the general industrial side. Oil and gas still tends to be a little bit weak because of what’s happening in that marketplace.

So, when I say that we’re forecasting current market conditions is -- the current market conditions would say it’s just this gradual increase as we go into 2018..

Our next question comes from the line of John Inch with Deutsche Bank. .

So, 8% order growth in Q3 core, 9% order growth Q4 core; you’re guiding to kind of 3% organic growth this year.

Just from a high level, I’m sorry, why are you so conservative on your core growth guide for 2018?.

We think we’ve kind of captured what we’re seeing underlying the market conditions right now. Obviously, one of the big drivers of that growth has been the friction business and Motion Tech. We’ve recalibrated that to where we see global production rates going in 2018. We expect to outperform the market by at least 4X on the OEM side.

So, that’s down from 6 times, I guess, a little bit. But, we’re optimistic that we’re going to gain momentum potentially if the market stays strong on the global OEM side. So, production rates are down in Europe. That’s our biggest market today in automotives. So, that’s one of the variables that we kind of factor through.

If you go back and look in the second half of 2017, I think Europe was probably, by market, twice as strong as it’s projected to be going forward. If Europe has another year like it had in 2017, we would expect to see our rates start to inflect upward. But, it’s a little bit early to kind of call the overall European automotive market.

I think the rest of the businesses, there is always some project variability in orders and what have you. But, I think, probably one of the biggest drivers, maybe just the way we see the automotive market as this point. But as the markets continue to move forward, I think, we will capture a good share of that..

Okay.

So, that’s basically the swing factor is the outlook for automotive and Motion Tech, is that fair?.

And I would say, probably even within that is probably just Europe market rates coming down a little bit. We’re still going to outperform Europe by a factor of we think around 3 times. So, if Europe production rates improve, that would be a real positive. We do have lower aftermarket expectations. So, it’s only 2% growth this year coming into 2018.

We had a pretty strong year last year. So, I think, we are probably up about 10% in the aftermarket last year. So, one of the other categories is just aftermarket, timing and just some variables there that are a little bit harder to project at this point..

Connector weakness -- or the connector business was weak in the quarter, for your slides, right, or what you said. Why would that be the case? I understand that it’s a bit of a harsh condition niche business. But, the United States and global economy short-cycle economies are improving, accelerating actually.

Why would your connecter business be weak?.

Yes, John. Some of the connector overhang is probably within the defense market, some of the tightness that we’ve been seeing there, a little bit of timing, particularly, on the order side there is a lot of variation. But, from a revenue perspective, we did have good oil and gas order activity in our connector business.

I think, we had -- the biggest overhang was really in the defense side of the portfolio, which is not obviously tied to what we’re seeing in general industrial markets or other major markets. Medical is also a little weak for us. That’s been a strong growing market for us.

But, generally speaking, at the core, the industrial part of that business, which is probably what we would expect to see, is being most reactive to improving market conditions; it was reasonably solid in Q4..

Yes. In your guide, Tom, the walk to $3, volume, price and mix are $0.10. It seems a little skimpy.

What’s the variable contribution margin assumption that’s underlying that?.

It’s around the 30% range, John. I mean, obviously, we have price in there, as you know, primarily from automotive. Mix is a little bit of factor this year because of the aftermarket mix that we’re showing, but nothing dramatically different I would say from what we typically would project.

Where we’re seeing more of an overhang is in the net productivity due to the higher commodity costs. So that probably is one of the categories where we would have been able to produce perhaps higher net productivity, but we just have to deal with the headwinds on the commodity side..

And the mix pressure you have seen in the past on the Industrial Process business due to those larger, less, if not unprofitable projects anniversarying.

Is that all through, so, we’re kind of apples-to-apples; there is no more of that and 2018 is kind of a clean slate?.

A lot of those....

In other words, you’re not going to be see a natural margin uplift from here, if in fact there is no more of the anniversarying impact of the drag of those prior year projects?.

I would think that we just would have less of those kind of those impacts going forward. So, while we had a lot of large projects that were complex from the past, the project business by nature is always very challenging.

The new procedures and policies and practices that we’ve put in place with David at IP and Luca is really to make sure that when we book a project, we have really good a line of sight to execution and that we’re able to deliver the margin that we book it under when we take the order.

So, I would say, there is always certain degree of execution risk within projects. I’d say, we certainly have a done a significant amount of process reengineering to mitigate those risks. The big projects that you’re referring to, a lot of those have gone through the system and are out. And I think, we’ve just improved our execution.

So, our goal is to keep driving project margins up from what we’ve seen over the last couple of years, just based on better order to cash execution..

Is there any reason structurally you think that IP margins can’t get back to prior cycle highs based on all of the years of heavy lifting, project work through et cetera? I mean, over time, I realize that’s not your guide for 2018, but over time?.

Over time? Yes, over time, John, I don’t see any barrier to doing that. I think, it’s going to come from a lot more productivity, a lot more good execution. We’re doing some restructuring throughout the course here to continue to fine tune the IP business. But, if you go back to the peak cycle way back in 2018-2019, a lot of it was price.

And that’s not something we’re assuming is going to be part of our margin trajectory for the long term. This is going to be about productivity and operations. And we see a lot of entitlement opportunity there..

Our next question comes from the line of Nathan Jones with Stifel..

I’d like to start off talking about the strategic investment pickup in 2018. I had a look back through your last few year slide shows. And it’s incremental 80 basis points in ‘17, 70 basis points in ‘16, 50 basis points in ‘15. So, you’re clearly ramping up the level of investment here.

And I would probably say that prior to the spin out of the Xylem and Exelis business is that these businesses probably didn’t get the investments that they needed.

Can you talk about way you think the level of investment is now, way you think the level of investment goes? I think, at this time last year, you talked about not anticipating a big ramp up investments in 2018. So, it’s great that you found more opportunities. Maybe how you see that progressing over time.

Some of the pigs through the python or are you getting to a sustainable level of investment in the business?.

So, Nathan, I think, when you think about the markets that we’re in and what we need to do for the future, we are driving the productivity and what needs to be done there.

But, at the same time, we’ve got to stay focused on all the technological changes that are occurring in all of our end markets, particularly when you think about the automotive space and what’s happening there. And so, we have a lot more focus around these new innovations and these new growth initiatives that we have.

And so, we’ve got the SMART Pad, we’ve got pad for EV, we’ve got the rotorcraft, we’ve got i-ALERT, all of those opportunities that are in front of us is really important for us going forward. So, we made the decision that it’s important to invest in that for the future.

And with some of these investments that we’re making, some of them are productivity related. And so, those that are productivity related, you get a really quick payback on that. And then, you’ve got these other investments that’s going to keep us from a leadership position in the automotive space, as it changes and as it evolves.

So, we think it’s really important to continue to do these investments. And with driving the productivity and the benefits that we’re giving productivity that gives us that much more capability to be able to invest in these strategic initiatives..

Do you think you continue to find avenues for further investment and we should expect incremental growth in investments in 2019, 2020, continuing to go forward or have you reached a plateau level now that you think is sufficient to do all of those things in the businesses?.

I think, the hope Nathan is that we continue to see opportunities like the ones we’re particularly looking at right now, kind of game changing technologies that are coming into the marketplace that allow us an opportunity to perhaps establish new standards in some of our industries.

And I think, not only do we have R&D, which is probably a good half of the strategic investment increase, but we also have front-end activities to really kind of get those products fully kind of commercialized and realizing their full potential, so, in addition to the productivity that Denise mentioned.

So, I do think we’re hitting a point right now where we’re seeing a lot of nice opportunities that are relatively mature from a development perspective, from a customer interaction perspective. A lot of this investment is for technologies that are already gaining a lot of traction in the marketplace.

And yes, we’re certainly hopeful and we’re doing a lot of things this year to hope that we produce an opportunity set next year that’s of similar size, if not bigger. But, I think you’ve heard us talk about EV and rotorcraft, and the categories Denise mentioned, we’re excited about them.

And this feels like the right time to really back those up and accelerate the opportunities there..

And when we think about balanced capital deployment, one of the things we’ve always said is that our first choice will be organic investments because we know what we’re doing, we can really spend our time in the areas that we’re most invested in. And so, this is just a demonstration that we’re continuing to invest in our organic growth..

Absolutely. I’m going to slide one in on IP margins, the guidance for 2018 here a little lower than maybe I would have expected. I mean, I think, you’re probably looking at a better mix in 2018 with these projects going away, operational improvements and restructuring savings.

And I think, Tom, you said still only exiting 2018 in the low double digit area. I know you’ve talked about Luca improving the operations there.

Why we’re maybe not seeing a little better exit rate in the margins in IP in 2018?.

Yes. Nathan, when you look at the Q4 margin, you’ll see sequential improvement. So, we usually start Q1 as our lowest margin quarter of the year and then will build momentum as the year goes on. The exit rate will be for the full year -- the full year margins will be low double digits.

But, if you look particularly at Q4, you’ll see that we’ve been building pretty significant improvement throughout the course of the year. Won’t be quarter-over-quarter; I think Q3 might be a little bit kind of in line with Q2, as it progresses through. But, fundamentally, Q1 is always our lowest margin quarter at IP. That’s natural seasonality.

We’ll see that again. And Q4 will be our strongest, and will build productivity and restructuring benefits as the year goes on. So, as we kind of get into year two with David at IP and -- David Malinas and Luca, we’ll see sequential strength as we go. And each quarter in IP will be stronger than the prior year’s margin as well.

So, we feel that it’s a good trajectory..

Okay. So, I thought you said that you would exit the year, which I thought meant 4Q margins were going to be low double digits. So, that’s not the implication there. The implication is….

That’s not – exactly. Low double digits for the year but are highest margin will certainly be 4Q of 2018 and that will be higher than the year’s total..

Our next question comes from the line of Matt Summerville with D.A. Davidson & Co..

Four questions.

First, just in terms of the number of wins you disclosed that you had on the OEM side of friction in 201, how does that compare to say 2016? Maybe asked another way, how much is the file value, if you will, of OEM wins improved year-after-year-after-year in this business? And to what extent, that gives you visibility already into the ‘19 model year?.

Yes, Matt. So, our wins in 2017 were up by volume compared to 2016. What typically -- they were pretty close. They were well ahead of what we planned on for the year. So, coming into 2017, we identified a number of platforms. They just don’t all get competed in the same timeframe.

So, you really set the budget, based on the amount of awards that are available in that given year. So, what we targeted for 2017, we exceeded our expectations from win rate perspective, I think about 10% or 11%. It was more in line with a number of pads won with the 2016 level.

But, I think that’s more a reflection of the fact that there just weren’t as many competitions. So, for example GM awards, those get competed every several year. So, basically, 2017, we produced more wins than we thought we would coming into the year, which is what’s really backing up our growth rates in 2018 as well which are 4X the global market.

We would expect those trends to play right through into 2019, particularly, in North America where we will see in a more noticeable ramp from our North American production. It’s going to ramp up in 2018 and really accelerate into 2019. So, we would even expect more momentum in North America in 2019. The visibility remains good.

We haven’t really given kind of platform-by-platform projection, but we did end 2017 with more wins than we planned on coming into the year..

Got it. And I think you mentioned before that you’re targeting attaining 25% OEM friction share in China. I think, you mentioned in part of the release that you are currently in the mid or maybe in high teens range at this point.

So, does that 25% not only look incrementally more achievable but does that perhaps -- could that be a conservative number? And how are you currently capacitized in China to get to the 25% or beyond? Thank you..

So, I’d say, our target is 25% plus in a market that hopefully continues to grow. We are definitely exceeding our expectations in China. And we initially were targeting 25%, I think internally. We’re starting to talk more about what -- when is 30 available to us. So, we’re ahead of projections.

We have been scaling up CapEx, and some of our investments are certainly going into Wuxi, China facility to ramp up for additional volumes that we’ve been winning. So, we would have additional square footage, if you will, in our existing locations. We would need to bring in more capital equipment for more production.

And then, we’ll see over time if we need additional footprint in China, but for the foreseeable couple of years, we have enough footprint space to produce what we see on horizon..

I think, the other important thing about China is we’ve centered our R&D efforts on EV in China. So, as China becomes stronger and stronger from an EV perspective, we’re going to be able to participate in that because of the work that we’re going to do with R&D in China..

Our next question comes from the line of Walter Liptak with Seaport Global..

In your prepared remarks, you talked about first half versus second half spending and you made a comment about second half not benefiting from something, I thought you said U.S. tax reform. I wonder if you can clarify that comment for me.

And what are you thinking about for the second half for oil and gas, and chem, industrial, especially for longer cycle?.

Walter, I think second half, we’re not projecting major upticks in our markets, based on kind of potentially U.S. additional demand or activity, driven by the tax reform. So, if there is more capital spending, if the markets really move up, we didn’t try to extrapolate what that could be and include that into our guidance.

We’ve kind of built our guides off of what we’re currently seeing now and our typical pattern. And we’re positioning and hopeful that tax reform drives and uptick in the U.S., but we have not imputed that into our businesses. So, we’re really gearing up fort. But, it’s not really included in our key assumptions..

And is that something based on conservatism on the outlook or is this coming from valuation of customers and kind of the project funnel that’s coming in?.

I think it’s not want to get too far ahead of the markets. Our short-cycle businesses will obviously react very quickly. And we’ll see those pretty quickly in the market around the same time that you all will. Projects, as Denise mentioned, the funnel is strong at 21% on the project side.

Obviously, projects, with a longer tail, I think there is just a lot more conversations, a lot of exploration around spending levels and activity. But, those are probably going to take even longer to funnel through the system. So, I think we’re geared up for short-cycle, too early to see the patterns yet.

On projects, funnel looks stronger, but it’s -- we’ll have to get those funnel ideas converted in the orders. So that’s probably going to take several quarters to see manifest..

And there is also comment that was made about willingness to walk away from pricing on projects. I wonder if you’re referring to chemical industrial pumps or is that the oil and gas side..

Well, it’s really on all projects that we have in the IP business. And what we’re doing there is just making sure that we’re going to have the right profitability associated with them. Some of the biggest challenges we’ve had in the past were with oil and gas projects.

And so, we’re just going to be much stronger in that and not bidding projects that we don’t think we have a good rate of return associated with it. So, that’s really what we’re referring to. We’re not going after volume. We’re going to after profitability here..

And so, I guess, we can assume that the bidding process and pricing is still pretty competitive in the oil and gas market?.

Yes. It’s very competitive out there. That hasn’t led up. In fact, it’s probably a little bit more competitive. So, that remains. But, as what Tom said before, what we’re trying to drive is our cost structure, so that we can reduce the cost structure. And then, we can be more competitive in bidding with these projects..

Our final question comes from the line of Joe Giordano with Cowen..

Hey, guys. Thanks for taking my question. So, a lot of good things to look at here, but Tom, I did want to touch on some cash issues with you.

If we back out -- if we don’t add back like the restructuring and some things like that, conversion, some more closer to 70% for the year, still better than last year but still bit below where, I’m guessing you like to be.

So, if you can maybe frame out how that looks next year, where do you anticipate restructuring spend to be, where do you anticipate working capital getting to, receivables looks kind of high here.

So how do you kind of see that progressing?.

Yes. Joe, I think, restructuring expense and dollars have been pretty consistent. So, as far as the ratio impact, restructuring generally kind of washes for the most of. We’ve been averaging around 25 million of expense. Cash is usually pretty closely aligned with that. So, I think, next year, we’re targeting free cash flow conversions above 90%.

We’re going to be driving working capital about 50 to 70 basis points of improvement there is what we’re targeting. And obviously, Luca and the teams at the value centers are really driving a lot of inventory and additional efficiency actions to make that happen. So, I think the core of our cash flow is certainly strong and improving.

We had record operating cash flow this year at the value centre level. That’s going to be internal measure of the cash that our businesses are generating, which really doesn’t get impacted by some of the corporate variables and some taxes. It’s really just the good core of the business is going in the right direction.

So, I think, we have more opportunities there that we’ll be targeting for next year. But, our goal is to get to a 90% conversion or better in 2018..

And that 90% is adding -- just to be clear, adding back realignment and restructuring, just to make the maths….

Yes. That’s right. And basically on the assumption, Joe, the expense and the cash are going to be the same. So, you’re -- the ratio of 90 is not going to be impacted either way really by restructuring in particular.

Now, one thing I would point out though is that we are anticipating a $40 million gain in 2018 for the sale of a property that we think will happen in Q2. We still have to complete the terms of the sale, but something that we have in our GAAP guidance for the year is a gain on a sale.

And that would be another cash inflow that we think from a P&L and cash perspective, provides us a net positive coming into the year, all else being equal..

Okay, great. And then, on the R&D, Denise mentioned the ramp up there. Is that widespread across the portfolio? And then, I did have a specific question on the EV pads. And it seems like you’re doing quite well there.

But, I think, we’ve been talking over the last couple of quarters about -- there hasn’t been this change yet in EV kind of specific pads that you’re anticipating for the future, like you’re generally using somewhat of a traditional pad on an EV platform and that’s probably going to change as we move forward.

Have you seen any like movement along that front yet?.

Yes. With EV pad, you’re correct. Right now, we use the typical traditional pad on EV vehicles, but there is a lot of work taking place because you can make them very specific to EV vehicles and deal with some of the challenges that the traditional pad has on EV vehicles, one of them being noise associated with it.

So, that’s work that’s being done which is why we’ve put the R&D centre for that in China. In terms of R&D, a lot of that is MT related.

We do have R&D spending in the other value centers, but with the changes taking place in the automotive industry and trying to stay ahead of those and developing a lot of new products and new ideas, that’s where a lot of the R&D spending is taking place..

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