ITT Inc. (ITT) Q3 2010 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the ITT Corporation Third Quarter 2010 Earnings Call. [Operator Instructions] I would now like to turn the conference over to Mr. Tom Scalera, Director of Investor Relations. Sir, you may begin your conference.

Thank you, Paula. Good morning, and welcome to ITT's Third Quarter 2010 Investor Review. Presenting this morning are Chairman and CEO, Steve Loranger; and Chief Financial Officer, Denise Ramos. 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. As always, please note that any remarks we may make about future expectations, plans and prospects, as well as other circumstances set out in our Safe Harbor statement constitute forward-looking statements for purposes of the Safe Harbor provision. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in ITT's Form 10-K, as well as our other public SEC filings. And now let me turn the things over to Steve.

Thanks, Tom, and I thank all of you for joining us this morning. Our strong third quarter results demonstrate that our attractive portfolio produces consistent and reliable results time and time again. This strong performance reflects our intense focus, as always, on strategic execution. And in this quarter again we saw some top-notch operating results by teams all across ITT, and it wasn't easy. Our focused productivity and cost management programs more than offset external headwinds, including some significant volatility in commodity pricing and foreign exchange. We saw some very strong organic growth in our Fluid Technology and Motion & Flow Control businesses where our markets continue to strengthen across the majority of our product segments and geographic regions. We're extremely pleased with the prior investments that we've made in emerging markets where we continue to see great results, in fact, growing 22% in the quarter, and of course we're expected to maintain strong growth rates in emerging markets for the next several years. In our Defense & Information Solutions business, we saw a 25% improvement in orders. And in addition, we recently generated several key strategic wins that validate ITT leadership position in a number of important programs. For example, in early October, we were awarded a $1.4 billion contract to provide comprehensive support services for all U.S. Army facilities in Kuwait. And this represents the fourth major facilities operations contract awarded ITT in 2010, and it solidifies our role as a premier provider of base operation services in the Middle East. In the third quarter, ITT was also recognized as a leading provider of space-based imaging payloads, winning two very important contracts to build next-generation imaging systems that are going to serve commercial and government markets. Our technologies will ultimately support imaging programs for both DigitalGlobe and GeoEye. And as a leading provider of electronic countermeasures, we've also won several pivotal 2010 awards for both ground and airborne jamming capabilities. This includes CREW 3.2 and CREW 3.3 programs and the development technology under the Next Generation Jammer program for the Naval Air Systems Command. Our ongoing strategy to further align our business portfolio with macro trend is progressing very, very nicely. We're expanding in air traffic management, and we're pleased with the investments that we've made in the Fluid Technology business, notably in the Analytics business and the Godwin Pump businesses, both of which are exceeding our expectations. Another point of specific pride in the quarter is the nice accretion that we're already seeing from these 2010 acquisitions. And so all of these execution and this performance and program wins gives us great confidence in increasing our guidance for the full year. We're on track to deliver $4.30 per share in 2010, which represents a 15% increase in full year adjusted EPS. And that's another record performance for ITT. In fact, a performance that follows the best in class results in 2009, and it handily tops our prior record during the 2008 pre-economic crisis period where our EPS was $3.99. Our performance is even more notable when you consider these growth rates are being achieved while we're also investing in our future. As you know, we take a long-term approach to sustainable, predictable growth. And in 2010, we are elected to reinvest the equivalent of six EPS points of growth into incremental investments for our future, the third straight year of incremental investments to an already strong base. These investments are in all attractive growth areas such as air traffic management, emerging market expansion, product innovation, our defense adjacency, diversity strategy and analytical instrumentation. Absent those critical investments which are already benefiting our bottom line, our 2010 earnings would actually be on track for some 21% growth. So simply put, we believe our quarterly results and the full year outlook demonstrate that this portfolio continues to produce solid results. And now let's turn things over to Denise to review the financials.

Thanks, Steve. Let's turn now to Slide 4. We exceeded our third quarter EPS guidance by $0.12 due to stronger operating productivity, exceptional acquisition, integration and execution and lower corporate expenses. Third quarter revenues were flat as the growth of 17% at Motion and 11% at Fluid nicely offset the 9% decline at Defense. Organic revenue grew 3% at Fluid due to strength in both the U.S. and the European municipal markets, and Motion continue to deliver stellar organic results, growing 22% with double-digit improvement in all of those businesses. Defense's results included anticipated declines in CREW 2.1 and U.S. SINCGARS. So total organic orders in the quarter were extremely strong, and we are particularly pleased that the 18% improvement included growth at every one of our 10 value centers. Defense orders doubled compared to the second quarter and improved 25% compared to the prior year. Motion orders were strong at 20%, and Fluid orders were solid at 5%. Segment operating income exceeded expectations, declining 3% to $339 million. Exceptional operating productivity in the quarter contributed 100 basis points to the margin improvement. In total, margins declined 40 basis points due to negative foreign exchange, higher pension and a 60 basis point increase in incremental growth investments. During the quarter and throughout all of 2010, we've continued to make incremental investments in key growth platforms, including oil and gas, energy efficiency and emerging market expansion. And as just a reminder, we do include a chart in the appendix that provides a nice walk of our margin performance drivers versus the prior year. Lastly, our third quarter adjusted continuing earnings per share grew 6% to $1.8 due to solid operating performances, lower corporate expenses and a favorable tax rate. In addition, our 2010 acquisitions were $0.02 accretive in the quarter, and that includes the impact of purchase accounting. For the full year, we are raising our adjusted EPS guidance to a record $4.30, which puts us on track to deliver a 15% improvement compared to 2009, which as you'll recall was a year of best in class adjusted EPS performance for ITT in a difficult macro environment. And as Steve indicated earlier, included in this forecasted 15% EPS growth are about six points of incremental investments that we made during 2010 to support our future growth. Turning to our financial position on Slide 5. Our consistently strong financial position is built on a legacy of strong free cash flow generation and disciplined capital deployment, and these hallmarks of our performance are reflected once again in our third quarter results. The solid third quarter net debt to net capital ratio of 14.4% incorporates continued investment in organic growth platforms, such as the U.S. nationwide build out of FAA ADS-B air traffic management system. The ratio also reflects the net funding of the 2010 portfolio alignment action with the acquisitions of Godwin, Nova and Canberra. And at quarter end, we still have more than $900 million in cash. Year-to-date free cash flow of $480 million was nicely ahead of our internal expectations due to stronger operating results, and we now expect to exceed our full year free cash flow conversion target of 100%. Now let's take a look at Fluid Technology's third quarter results, turn to Slide 6. Total Fluid revenues improved 11% to $920 million. Our successful 2010 acquisitions contributed $87 million of incremental revenue. And keep in mind, we just closed the Godwin transaction this August. Foreign exchange cost of revenue headwind of about 2%, so excluding acquisitions and foreign exchange, organic revenue improved 3%. We are particularly pleased to see that Water & Wastewater grew 6% organically and 24% in total. The results exceeded our expectations due to stronger demand across global municipal markets. For example, U.S. and Asian municipal markets delivered double-digit growth, and we were very pleased to see that the pace of activity in parts of Europe added some nice growth to the quarter. The revenue performances of the newly acquired Analytics and Godwin businesses were simply extraordinary, immediately validating the strategic fit with ITT and the strong demand drivers in those markets served. Residential and Commercial Water delivered a third straight quarter of organic growth growing 4% in Q3 and organic revenue and industrial process declined 5% due to lower industrial project deliveries that were partially offset by strength in Latin American mining. However, IP's organic orders continue to be very strong, growing 12% with improvement in each of the seven primary end markets served. Fluid operating income grew 7%, operating productivity improved 200 basis points, and these improvements reflect the structural benefit of prior aggressive restructuring actions and expanded global strategic sourcing activities that have repeatedly offset cost inflation and mix without the benefit of significant volume expansion. In total, operating margins declined 50 basis points due to increased strategic investment and negative foreign exchange. Total fluid organic orders grew 5% in the quarter, and the book-to-bill ratio exceeded one due to double-digit growth at industrial process and Residential and Commercial Water. For the fourth quarter, we're now forecasting Fluid organic revenue growth of 3% to 5%. This growth will be driven by a recovery in the late cycle Industrial Process business and continued stability in the municipal markets. Our full year 2010 organic growth forecast has now improved from flat to 1%, and the strong acquisition results have further driven our total fluid revenue growth forecast from 6% to 8%. Now let's turn to Slide 7, and lets review another exceptionally strong quarter for Motion & Flow. Motion's organic revenue growth of 22% exceeded 20% for a third straight quarter. And keep in mind that this 2010 strength follows a decline of only 14% in 2009, which as you know was pretty good, comparatively speaking. The Q3 segment strength continue to be broad-based, with each business generating double digit growth in the quarter. And emerging market results were particularly strong. They increased 50%. The strong revenue growth was lead by Interconnect Solutions with a 37% improvement due to strong demand across most end markets. Motion Tech exceeded expectations for the quarter and delivered organic revenue growth of 19% on stronger OEM deliveries from recent platform wins. Now exiting Q2, we expected to see a meaningful Q3 slowing from the expiration of the European auto stimulus. But clearly, it didn't happen in the quarter and we're now expecting to see that flowing in the fourth quarter. Motion & Flow Control's operating income improved 13%. Operating productivity improved 50 basis points. However, margins declined 50 basis points in total due to higher investment, FX and pension. Motion & Flow Control's organic orders improved 20%, with all businesses contributing double-digit growth. As a result of our strong year-to-date performances and the positive demand indicators, we are maintaining Motion & Flow Control's 18% organic revenue forecast for 2010. This implies a 3% organic growth rate in the fourth quarter. Now the deceleration is mainly caused by an anticipated slowing in the European automotive market after the expiration of the stimulus benefit. Excluding this impact on Motion Tech, the balance of the motion businesses are expected to grow in the mid-teens organically in Q4. Now let's turn to Defense, which is on Slide 8. While not always evident in the quarterly results, our Defense team has continued to aggressively position itself for the future through key strategic wins, customer diversification and transformational performances. In the third quarter, organic revenue declined 9%. This decline primarily reflected lower activity on software engineering service contracts, anticipated declines in U.S. SINCGARS in CREW 2.1 and some night-vision and jammer delivery delays on firm orders that just moved into Q4. In the quarter, we did see nice revenue growth from air traffic management activities, special purpose jammers, radar equipment and composite structures. Strong third quarter operating margins of 13% reflected operating productivity of 50 basis points, derived from the Defense transformation and strong contract execution. In total, margins declined 30 basis points, largely due to higher pension expenses. Turning to orders, we were very pleased with the strong organic growth delivered by each Defense business. Q3 orders were 100% better than Q2 and 25% better than the prior year. Geospatial orders improved 53% due to strong demand for our commercial imaging satellite payloads. Electronic Systems orders improved 34%. This included a SINCGARS orders for Iraq under the U.S. Foreign Military Financing program. Now you may recall in the second quarter we reduced our forecast because of the challenges associated with executing a direct sale to Iraq. So we're very pleased with the progress our team made to transform a portion of these opportunity into a U.S. FMF order. Lastly, information systems grew 8% due to increased activity on the FAA ADS-B program and the U.S. Army Prepositioned Stock program in Kuwait. For the full year, we maintained our forecast of $6 billion in Defense revenue. This forecast includes strong sequential and year-over-year growth in Q4, and the main drivers of the incremental performance are some recently awarded international SINCGARS FMF contracts including Iraq, Taiwan and Bahrain, increased activity under the new Afghanistan Army Corps contract, incremental jammer shipments and recovered Q3 production delays. Turn to Slide 9. We've added a summary of some different backlog metrics to help provide additional perspective on the future opportunities that our Defense team is winning today. And in recent years, we have seen some changing dynamics that are driving variation in our order intake patterns and backlog statistics. Today, we have a much more diversified customer mix than we've ever had. Nearly 25% of our customer base is outside of the U.S. Armed Services budget, and these new customers including international customers follow unique new order patterns. In addition, we no longer expect to see large block orders for surged products like CREW and SINCGARS that have been ramping down for a couple of years now. So these factors add to the volatility of our quarterly metrics. In addition, we're seeing an increase in protest activities from incumbent, especially for those large multiyear contracts. These protests may delay the recognition of orders in revenue and complicate our ability to forecast outcomes. And lastly, we believe that customers may reduce funding levels and frequencies in response to current budgetary pressures. Keep in mind that our current calculation for funded backlog include orders that have been authorized and appropriated for funding by the customer. In Q3, our funded backlog increased to $4.3 billion, represented a $175 million increase from Q2 levels. The ultimate 2010 backlog will largely be determined by the timing and the duration of funding for large service contracts that we've already won. As a result of the changing customer mix I described, we are also seeing increased service revenues. This increase reduces our sales to backlog ratios because service contracts and even multiyear one, typically fund in periods ranging from three to nine months increment. Also keep in mind that services represent about 40% of our revenues, and that's relatively high compared to many of our defense peers. So as a result of the factors discussed above, we're providing an estimate of our funded and unfunded awards. This combined calculation totals over $10 billion. The funded and unfunded calculation is not intended to be a replacement for the funded backlog metrics. But we will periodically provide this information to show the aggregate size of the opportunity pipeline in our Defense segment. We've also listed five recent key wins that further demonstrate the strategic strength and diversity of our Defense segment. These all reflect the magnitude of the impact that the changing dynamics in our business are having on our backlog statistics. In total, the awards listed here represent $4.8 billion of potential future value, and they are all excluded from both our funded and unfunded calculations. The first two multiyear service award totaling $2.7 billion are excluded because they are currently being protested by incumbents. We also excluded potential orders under three recent major IDIQ awards, totaling $2 billion. We won a $1.4 billion SE2020 air traffic management IDIQ award from the FAA. And we won two important IDIQ award for critical next-generation technologies from the U.S. Armed Services. $455 million for CREW 3.2 Jammer capabilities and $260 million for enhanced night vision goggles. So in summary, while the ultimate outcome of some of these awards remains uncertain, we are certain that our Defense business is very well positioned to continue to generate solid return on investment and cash flows in the future. Despite the difficult budgetary environment, this Defense team is clearly continuing to win the future. Let's turn to Slide 10. In the third quarter, we had two major special events, the annual asbestos update, and the gain on the sale of CAS, the Defense sit of business. So here's an overview of those two items and how they impact our reported results. The asbestos liability update announced today is part of our normal annual accounting process, designed to ensure that our asbestos liability reflects the most current information available to us. Future annual liability updates could involve increases or decreases, and we can't predict the direction or magnitude of future changes. We believe that our process in rolling ten-year model that we used to estimate our probable future asbestos expenses and related third-party recoveries is consistent with best practices in the industry. In the third quarter, we are increasing our asbestos liability with a related after-tax charge to continuing operations of $204 million or $1.10 per share. Now this charge has been categorized as a special item in the quarter, and is not reflected in our adjusted EPS results or projections. The increase in the liability reflects more recent data that points to higher expected net cost over the next 10 years, including increased settlement values in the last year. We've also seen significantly increased activity in several higher cost jurisdictions, increasing the number of cases to be actively litigated and increasing expected legal costs. In contrast to an approach that's used by other companies, we do include estimated future defense costs in our estimate of future liabilities. It is important to note that the average projected net annual pretax cash flow impact of future asbestos payment is $25 million per year for the next five years and $50 million to $60 million over the remaining years of the projection period. We do not, at this time, expect a material impact on our free cash flow over the next 10 years. The other special event in the third quarter was the recognition of after-tax benefits of $152 million or $0.82 per share, associated with the divestiture of CAS. So now let's turn to our adjusted EPS guidance, and that's on Slide 11. Based on our strong year-to-date performances, the strength of our acquisitions and solid end-market demand, we are raising our full year adjusted EPS guidance midpoint to $4.30, 15% higher than 2009. We've tightened the range to $4.28 to $4.32 to better reflect our expectations for the full year. The $0.17 guidance midpoint increase includes the $0.12 of incremental Q3 performance and incremental Q4 performances of $0.05. Now big driver of the increase is the positive contribution from the successful 2010 acquisition that we're initially expected to be $0.04 dilutive, but they're now expected to be $0.03 accretive. Strong operating performances and favorable corporate results account for the balance of the increase. 2010 continuing ITT revenue is now expected to grow 4% in total and 2% organically to $11.1 billion. Segment operating margin guidance was increased to 12.6% due to expanded productivity initiatives that are expected to more than offset material cost pressures and some margin dilution from acquisition. The full year operating margin performance is 70 basis points better than the prior year. So in summary, 2010 has been a year of tremendous progress for ITT. We're improving our portfolio alignment. We're investing in future growth platforms and we're delivering premier earnings growth once again. So now I'm going to turn it over to Tom, and we will start the Q&A.

Paula, we're ready now to start the Q&A session.

[Operator Instructions] Your first question comes from Scott Gaffner from Barclays Capital.

I just wanted to dig in a little bit deeper on this acquisition performance. I mean that's pretty solid going from expectations for $0.04 dilution, now $0.03 accretion. Can you maybe just give us a little bit more color on how you achieved that, whether maybe the guidance going in with conservative or you outperformed on certain areas? And then whether or not you think you can take this experience forward and apply it to future acquisitions?

Well, let me say first that we are extremely pleased with the performance that we've seen on these acquisitions. And to have them accretive so early after we've acquired them, I think, is pretty strong performance. I think the first thing to understand is that these businesses that we bought are very strategically aligned with our current businesses. So that gives us a lot of capabilities when we first acquired these businesses to be able to get incremental value out of them. These were very high quality assets that we bought. They were very good companies. And what we've seen is we have seen some strong end-market demand, particularly with Godwin on the Dewatering side. So that actually performed much better for us than we thought. And again, these are very strong businesses and so we're very happy with how they're performing.

I just wanted to add on top of that is, it all starts from having extremely strong operating performance in the markets. We've actually had sales and operating income conversion that have been nicely in excess of our model. So we're pleasantly surprised. We're getting some early leverage of the organization, particularly in Fluid Technology, where we're able to leverage the scale of our distribution and selling networks. And I think the teams have been very cautious on the cost of integration. We make certain assumptions in our model when we make the acquisition to tie into appropriate valuation. But I think the teams have really done a very good job of not adding any additional cost for acquisition integration that was necessary. So all in, I think we've had a lot of practice in the last several years and we're getting better at it.

It sounds like maybe the sales synergies came in higher than you were expecting, selling through the ITT channels?

No, I would say that was not the biggest piece. The biggest piece was actually just pure operating performance in the markets they currently serve. But we are seeing nice setups for getting those sale synergies, starting to see some nice progress.

So I think what that says, as we integrate those businesses even more what we've done today, particularly with Godwin, which we closed that acquisition in August, we're going to see some nice accretion from these businesses as we get into 2011.

And then what's the acquisition pipeline look like right now? Are there any other businesses out there that are close to coming to fruition or is it still later in 2011 until we see some more acquisitions?

I won't speculate on any near-term deals, but we certainly do have a robust and active pipeline in most of the areas that we've talked about in the past in cyber, in some networking systems, in terms of geospatial, in air traffic management, in a number in Fluid Technology. So I would say the pipeline is robust. We're actively working them. We are in due diligence with a couple of companies, but other than that, I can't speculate. But I'd like to say that we are strongly on our course to be appropriately deploying capital in areas that we find to be more attractive for our portfolio in the future.

If these acquisitions don't materialize, obviously, your stock price has been relatively low and trading at a relatively low multiple. When do you sort of start to deploy the cash more towards share buyback rather than acquisitions? And how long do you kind of weight that time frame out?

That's a hypothetical question because we're pursuing a certain course. But the answer is we'll deploy cash in the areas that we think will create the most value. And until we get to that point on the acquisitions, we're essentially going to be maintaining our cash on the balance sheet to deploy for the acquisition. Obviously, if things change down the road, we'll re-evaluate it for the nature of your question.

Next question, comes from Jim Lucas of Janney Montgomery Scott.

First question, more housekeeping, with the strength that you're seeing in the emerging markets, could you bring us up-to-date on where you stand in terms of emerging markets as a total percent of sales? I know that it's been more heavily weighted toward China. Maybe break out China separately as well?

Let me give you an overall number. So when we think about emerging markets on a full year basis on the commercial side, and I'll focus my answer there. We're looking at about $1 billion in total on a full year basis. Out of that, I'd say China and India is about $200 million or so within that. So we already have a nice presence in emerging markets at $1 billion, when you look at that as part of the overall commercial revenues of $5 billion. That represents a little over 20% of emerging markets. And so we've got a nice presence there. We've built a lot of capability within these emerging markets, and we expect to see continued nice growth in emerging markets as we go into 2011.

On Defense, in your prepared remarks, you had referenced going into the fourth quarter outlook, recovered third quarter production delays. Could you expand on that comment please?

Those were some delays that we had in delivering some night vision and some jammers. And so that will fully fall in to the fourth quarter for us from Q3.

And from a revenue standpoint, how material was that?

It was around $40 million or $50 million.

Following up on the last question, capital allocation, you've been very busy on the Fluid side. And for quite some time now, you've referenced other areas like cyber and air traffic and there were a couple of smaller properties that you announced acquisitions on. When you look in your pipeline today in the non-Fluid side, so those cyber and air traffic opportunities, are those going to be more of the single-type acquisitions or are there larger properties which falls? Then secondarily, what types of valuations are you seeing on those properties?

Jim, it varies all over the map. We have large and small acquisitions from $5 million, $10 million, $20 million type companies all the way up in the multi-$100 million companies in every one of the areas you mentioned. So I think there's really no one answer to your question because the landscape of our pipeline really does include a variety of different sizes. We're not focused on size per se, we're focused on strategy, and what we want is to create value as an example of the recent OI and SRA type acquisitions are relatively small. And we've got a couple of other relatively small acquisitions that are just giving us a very, very nice suite of technology. I can go back and point to acquisitions we did with Allen Osbourne, with Insight, with Dolphin, those were all small-scale acquisitions. But as an example, a couple of those we're central to our ability to deliver the miniature soldier radio wave form and other secure GPS technology as adjuncts to our jamming and communications. So those are the kind of things that really give us a lot of benefit in the marketplace. So Jim, it really is a wide landscape.

And following up on that, the valuations that you're seeing in those properties?

I don't think there's any trend because when you look at a venture-capital company that has a lot of technology and no revenue, you're going to be looking at very high valuations as a percent of total multiples. In the most recent space, we were paying in the eight to 10x EBITDA, the 1.5x to 2x sales. Those metrics in those Water acquisitions were really just applied because the operating margin was extremely high. And the performance of the business this quarter validates that they were appropriate.

And finally, just wanted to touch on Fluid. You highlighted a strong municipal and the U.S. and Asia and Europe showing some improvement. Can you talk a little bit about the European muni outlook? What you're seeing in your order book today?

Yes, we didn't have very strong municipal performance in the third quarter. So when we look at -- in the U.S., it was up about 10% or so. When we look at Europe and EMEA, it was up about 4%, and even Asia was up, very strong for us at about 20%. So we are looking for some nice growth as we go into Q4. And in fact, that some of the expected performance that we expect to see out of Fluid Technology into the fourth quarter. So we've had nice orders, we've had nice growth, and we expect that to continue into Q4.

Your next question comes from Jeff Sprague of Vertical Research.

Could we just spend a little more time on the asbestos? I think it's a bit of a surprise that this is kind of going up relative to going down just given kind the legacy and age, et cetera, people who are might be making this sorts of claims. Has there been something in particular to tap in legislatively? Or some other construct that is kind of changed the profile of what you're seeing?

Jeff, as an overarching legislative change, the answer is no. However, when we look at what we have seen in prior years versus what we saw this year, we did see a few changing dynamics. On a local base, we did see greater than expected activity in several of the high-cost fee jurisdictions. We also saw, in some areas, a substantial increase in the settlement values of various cases. And we also saw some aggressive behavior last year with some of the national plaintiff firms. And these are examples of things that we saw that we think in this charge that we took our very best estimate to make sure that we were covering the future impacts of these kinds of changes. And I'll point out as we have disclosed in the last year or so in all of our Ks and Qs, these charges can go up and down. But at this point in time, this new charge we think adequately reflects this sort of unexpected and new developments that we saw throughout the various components of the liability calculations.

Are the settlement values going up? Because the more frivolous have been kind of weeded out and you're getting into settling with truly sick people? Why would settlement values be going up?

In last year, there was an abundance of some cases that were put on in the state of New York that did drive some of the settlement values up. They were older cases that came to fruition. But as a generality, the amount of -- when you say frivolous, let's just say that there are claims in that system which have merit and those that don't. And we don't see that changing dramatically.

And just finally, on Defense, you introduced I think a warranted discussion here on some of the complexity of understanding the backlog. Are you specifically coming off the view that though that the backlog will be $4.5 billion to $4.7 billion at year end? The Q4 sales in the sense of a $1.7 billion, I think, would be the strongest revenue in the quarter ever for the sense. You do pick up $40 million or $50 million on this timing issues, but it seems like that potentially could put a pretty big dent in the backlog if you shift that hard in the fourth quarter.

First of all, on the fourth quarter shipments, the Defense team is confident that we'll be able to make that. And the forecast, we certainly think the year-end will be higher than the 4.3 that we have. And right now, we have some timing issues with a couple of large service contracts that may or may not get into the backlog. So we're going to be in that range. But right now we're just saying it's going to be more than 4.3. And by the way, the only thing I would add, Jeff, is that, that does not change our view in terms of the Defense business for 2011.

Right because you have more service rolling in it and it doesn't touch the backlog basically.

Correct. There's a lot of complexity I think is in these outline, but this service mix that has a 60 to 90 day backlog, coupled with diversification and then a lack of some of the block surge orders, and the expansion of the IDIQ makes this metric really less represented, if it's accurate. But it's less represented than it was in times past, which is why we want to show you that we got well over $10 billion of funded and unfunded and coupled with the other major wins while putting it up into the $14 billion, $15 billion range, would suggest that we have already earned an extremely strong opportunity shift. And so when we kind of look at the probability of these things coming in, even with this variation, we do feel good about 2011. We'll have another very nice year on Defense in 2011.

I guess, could you take that over to the margin side though, Steve? Given the shift, you're going from I guess a lot of high higher margin towards in the life product businesses towards service, and you're running pretty high margins now. What should we expect next year as these things kind of blend together?

I think, fair question. And I think the answer to the question, first of all, validates the capability of the team because we have had a substantial reduction, as you know, in our core businesses in the last couple of years to the tune of $900 million of sales in the higher-margin CREW and SINCGARS business. And that has been offset by this very aggressive adjacency strategy that has, coupled with the defense transformation, actually lays the operating margin. And considering the fact that, that CREW and SINCGARS headwind had actually higher than defense average margin, I think really supports the fact that this team is working it really, really hard. With the transformation that Dave Melcher and the team lead is going to give some nice incremental run rate benefits. They're continuing to do some productivity, and we actually expect to increase some of our restructuring activity in Defense to be able to position for the future. And that's overcoming an additional pension headwind. So all that in, we're going to have about the same margins next day. The Defense team is going to hold the margins about where they are.

Your next question comes from Terry Darling of Goldman Sachs.

I wanted to try to understand the margins on the commercial side a little bit better, I guess, specifically in Fluid. On the bridge here, you're talking about a negative impact from FX on the margin side versus a positive on the revenue side. Can you talk a little bit about that where you'd expect incremental margins to trend here as you move into 2011? You've done a lot of growth investing and restructuring and stepping up the productivity and trying to think about whether you get an upsized, incremental margin profile in 2011 relative to what you'd expect normally in that 30% plus or minus range?

In terms of Fluid and productivity, we are very pleased with the productivity that they are putting up this quarter and on a full year basis. So we are seeing some nice productivity based on the restructuring and the growth investments that we're making. As I said, we are investing in growth in Fluid for this year, and so that is keeping their margins at the level that we have indicated here. As we transition into 2011, we are expecting to see some very nice margin improvement in our commercial businesses. And that's due to continued productivity improvements. The investments that we've made over the years will now start paying a very strong benefit for us in 2011. And then with that top line growth that you're getting, we're expecting to see some very nice flow through into their margin performance. And so the investments and the incremental investments, we would expect that those will be lower than they are, than what we're seeing in 2010 and that will also help the margin in performance. So we're expecting to see nice margin improvement in Fluid and in Motion & Flow next year as the top line, especially, recovers.

Can you be a little more specific there? First on the third quarter in Fluid, what happened to this FX drag when FX had a favorable impact on revenues?

We had both transaction and translation impacts that impacted our foreign exchange. We get impacted not only by what happens with the euro but also with what happens with the krona and the relationship there. So when you put all that together for Fluid, it impacted the margin by the 120 basis points.

And can you be a little more specific about what rolls off in terms of the growth investments in '11 versus '10? I mean it sounds like you would expect incrementals in the commercial businesses well north of the 30% next year. But maybe you could just help us with some of the things that are readily identifiable that are falling off here from activities in '10?

Due to the comprehensive portfolio nature of a global multi-industry, you can imagine that our investments are in a lot of different areas. So let me just give you some generalities. When we talk about growth investments, we talk about positioning the company in emerging markets. And as you know, we built 11 all-new facilities in emerging markets, all of which are up and running and being populated. That level of investment is coming down quite a bit. Also in emerging markets, we've also been populating the teams with new application engineers and selling and marketing folks. As an example, three years ago, we had two people in India. Today, we have well over 200 in India, and that's tapering off. That's tapering off right now. We're investing a lot in value-based commercial excellence, which is to upgrade the overall process capability of our selling and front-end on the commercial side of the business. That will taper off a bit. So those are some examples of things that are tapering off. In terms of new product technology, the engineering product development, that's probably going to be about the same, maybe slightly down as some of the new mining and the new residential commercial pump lines are coming to production. But that gives you an idea of what's happening.

And then just lastly, the 20% order pickup in MoFlo in the quarter relative to the 3% organic in the fourth quarter, I think you said that called out some impact from the European auto business on that. Weighing that down and the underlying would be up 15%. Can you talk about that European auto business a little bit more? Is that just production or do you have some adjustment to inventories going on there or what else is going on there?

That was due to the European stimulus program that was put into place that we saw some benefits from in the fourth quarter of last year, continued into the first quarter of this year and a little bit that fell into Q2. So we're expecting that in Q4, we're going to see a lower number because of that pull forward for the reasons for that. If you excluded that and you look at the other Motion & Flow businesses, you're going to see that the other ones are up about 15%. Motion Tech in general, we're very pleased with their performance on a full year basis. They've had a very strong win rate with new platforms. And we think that, that is going to serve them well as they go into 2011. So it really is just this European stimulus program and the fact that got pulled forward in Q4 and Q1.

Your next question comes from Deane Dray of Citi Investment Research.

I had a couple of questions regarding Water and the business mix for the quarter and specifically on the municipal North America up double digits. I know there's this expectation about municipal austerity. So I'll be interested in what type of business are you seeing? This has to be more than just the MRO break and fix, so all of their projects, with their stimulus, what's driving that?

Deane, I don't think there's a macro trend. Remember, in North America, we have 75% of our muni market is in aftermarket. At certain point in time, with respect to some of the abatements we have seen in the past, they're going to come to fruition. And we are seeing a slight increase in the restoration of ongoing projects. But I wouldn't say there's any major trend there other than that.

And then over on the analytical instrument side, this is a new venture for ITT. But the idea, you've added Nova which gave you a clear to the cornerstone acquisition [indiscernible], could you just update us on what the go-to market strategy is? Is this all leveraging your channel or will there be differentiated technology? But it's still a very fragmented market.

Yes, it is, Deane. So we have a two-pronged go-to-market strategy. First of all, a lot of the analytical instrumentation goes through its own distribution network today, and we're going to continue to drive through that distribution network. Most particularly for those Analytical customers who are not in the mainstream of Fluid technology or on-site Fluid Technology. On the other prong of the strategy is, in fact, as you suggested, leveraging our marketplace. We, as you know, have a very substantial footprint. In fact, several thousand salespeople around the world who are accessing municipal and commercial customers. And we will also, to the extent we don't conflict with the distribution channel, we will also be flowing the analytical instrumentation through those channels. So it's the best of both worlds. I should say also that's very similar to our Godwin strategy and it's very similar to the cross-selling strategy we referred to even within our own ITT distribution. And so we're taking advantage of the geographical benefit of this huge selling and distribution network, really, which is second to none in the world. And we're able to offer through this geographic benefit, the transport treatment and CAS technology that gives us the only capability of a comprehensive suite of technology to be able to address these needs. So that was what we referred to earlier about starting to see the opportunity for leverage in our existing Fluid Technology channel.

Would it be safe to say that the growth strategy could also include additional bolt-ons of additional test products?

Without a doubt. When we bought the business, we bought the business on the basis that we can build it into a lag, into a fundamental platform. And while it currently is embedded because of high commonality in the Fluid Technology, Chris McIntire and Gretchen McClain and the team have a very substantial growth strategy. And I'm pleased to say we're on that growth path. We're looking at a variety of incremental adds an we executed the first one with OI, and we've got several more locked and loaded to go.

Just lastly for me for Denise, on the asbestos, just a couple of clarifications, if you could. First would be, has there been any change on the insurance carriers in terms of expected insurance recoveries in your assumptions today?

No, there has not been any change. We do, do a deep dive on that also as part of this annual process. And so you know we have multiple insurance companies, multiple policies. We've looked at all of them, and there was really no major impact or change in our estimate for that versus a year ago.

And that $25 million number, the annual, that is net of insurance recoveries?

That is net of insurance recoveries, but it is also pretax.

So it's on a pretax basis because if then if we look at -- and the way we look at the asbestos liability, it's also as a percentage of annual free cash flow. And prior to today's announcement, this was low-single digit 1% or 2%. So even when tax affecting that, you're still very small percent, low-single digit of free cash flow. Is that correct?

That's correct.

Your next question comes from Steve Tusa of JPMorgan. C. Stephen Tusa - JP Morgan Chase & Co: A lot of good detail on the call. I just wanted to ask kind of a bigger picture question and maybe this isn't a platform for this question but I'm not sure when we're going to talk again.It's been a relatively frustrating year from a stock performance perspective, and obviously, the elephant in the room is the Defense business. I think a lot of people out there continue to believe that this business is just facing massive secular headwinds over the next couple of years, and you see it in all the Defense multiples. And sure enough all the defense companies this quarter like General Dynamics missing its revenue guidance, but the margins are better than expected, not really getting credit for that. You guys talked about the acquisitions you're executing on the big pipeline. It seems to me like you're kind of setting us up for running acquisitions. But at what stage do you get frustrated with the degree of misunderstanding at a portfolio and do something a little more aggressive on the portfolio management side, maybe lever the company up buyback a ton of stock? You've done a very good job with the card you've been dealt over the last six or seven years, Steve. And I'm just wondering at what point do you get frustrated with the street view that just seems like no matter how much you explain the diversity and the growth potential of this Defense business, it just doesn't seem to me that you're going to be able to get out of this rut over the next year or so. So I'm just curious as to what level of frustration you guys have over there in the board room?

I think one can never get frustrated in this business. What you need to do or what we do is we do our very level best to continue to communicate what we think is the right perspective on the defense business. And I will say that very specifically, Steve, to the point of your question, there is more concern about our Defense business in the street than we believe is appropriate. There is no question that some pieces of our Defense business are under stress. I think we're being extremely transparent about that. But at the end of the day, we're going to continue to communicate the reasons why we think the Defense component is a strong and robust component. Let me just review some top-level statistics with you. If you take a look at the $700-ish billion dollar top-level market that we think about in Defense, Secretary Gates has already articulated that he's going to drive around $100 billion of productivity through efficiency in the acquisition process and other cost elimination. When you take that efficiency through the budgets and recognize that just slightly over half of the budget is the piece of the budget that we really, really like and that we really want to preserve and Secretary Gates really wants to preserve, which is the operation and maintenance in the RDT and the yearly investment equipment side of the budget. The current DoD plan is to hold that essentially flat, in fact it's flat to up 1%. That's the place that we play. So the first thing you have to understand is that in the market segments where we play, the Secretary in Defense and everyone else is trying to drive this efficiency that you are all hear about to actually preserve the budget component that's the sort of non-logistics, non-personnel and non-transactional piece of the business. So that's actually good news. Now obviously, as it becomes a deficit a based impact on the budget, that would certainly be the wild card. But the fact is, is that where we play is expected to be relatively constant with the plan. And then the next thing you have to do is you have to go in and look at what pieces of the budget actually are growing and which ones are most susceptible. Clearly, platforms are more susceptible than the C4 I squared R [ph] which is really the intelligence piece of control, communications, surveillance and electronic capability, which as you know is the bulk of where we play. And so the market segment where we're playing, we think, are actually going to be slightly positive. When you take a bigger picture perspective and you take a look at the segments of the business, the segments of the whole government business that are going to grow the most or go down the most, you're going to see the FAA and the cyber and IT components are expected to be strong single-digits growth, 6% to 8% growth in this environment. So maybe, Steve, what I'm doing is I'm essentially repeating the point of the question. Our Defense business is growing very, very nicely in these adjacencies. And so at the end of the day, I think we've got a strong position. That's why we talked with you about the backlog. And in that regard, that's how we feel about Defense. We think it's a strong business. And even though we understand your concerns in terms on the street, in terms of cyclical, secular issues, we think we've got a strong Defense business in the future. We're going to continue to compete in our core markets. C. Stephen Tusa - JP Morgan Chase & Co: So this is execute and the market will realize the value over time, which is perfectly fine and what you guys have been doing for the last couple of years. I appreciate the addressing the question and good luck through the end of the year.

Our final question comes from Gautam Khanna of Cowen and company.

The first one, I think people understand kind of the more mature Defense product areas in your portfolio that face pressures. But beyond sort of the top line DoD budget concerns, it seems like DoD the rhetoric is more ominous each quarter about how they're going to squeeze profitability of service contracts, and you've won a lot of service contracts of late. Can you characterize sort of how the margins on these wins compare with your portfolio of legacy service business? And just beyond that also if I might ask, the direction of operating income at Defense in '11 and beyond, irrespective of margin?

There's no question the Department of Defense is going to drive efficiency. But unlike sometimes what you hear in the rhetoric, productivity is not the antonym of operating margin. In fact, we prove year-after-year that we can get both in this business. And I think that, that applies in the Defense contracting model as well. So we should be able to hold up the operating margin. I think the operating income number to your question is going to be proportional to the amount of actual revenue opportunity, revenue growth that we have. So we'll continue to be working the operating income. That will obviously be under pressure as sales tend to be in the flattish range as we go through this transformational mix into the Defense budget. But at the end of the day, I am convinced as we drive for more fixed costs, we continue to drive for productivity at these efficiency initiatives. We should be able to maintain our operating margin.

And to jump to Fluid at Water & Wastewater, given the Q3 order results in Europe, as well as kind of your early read in Q4, do you think it's safe to say European municipal has bottomed from an order perspective? Or did Q3 have some been lumpy serendipitous orders that got you in the positive territory?

We do expect that in the European municipal market that we are beginning to see some stability and some more favorable trends. So we do anticipate as we go into the fourth quarter in Europe that the spending on the municipal side will be higher than what it was in Q3.

And just a related question to that, U.S. was up, I think, was it 20% in Q2? And now it's up 10%. Are we seeing sort of a wind down in stimulus in U.S. that we should be concerned about going forward?

No, not at all. I think we never saw the wind up from stimulus. It was somewhat mythical in terms of its impact in the capital infrastructure markets. I can't say that we actually saw anything subsitive in that area. Thank you for your questions, and let me just close the call here by saying that we understand that we have a lot of changes in our business. We have been very clear about the portfolio transformation, which includes not only the Defense adjacency which is going extraordinarily well, dealing with the stress in the defense budgets and also migrating the portfolio into more valuable, commercial and emerging market opportunities. That's both done on an organic basis with our investments and with the allocation of cash. We're proud of the fact that we think that strategy is working well for us. And even with all these changes and with these headwinds, we wanted to confirm and conclude this call by saying that each and every quarter, you can count on us to be delivering and executing as has always been expected of ITT. So I want to thank you for your interest and let you know that we feel pretty good about the quarter. We hope you do as well, and we look forward to talking with you in December. So thank you very much.

Thank you. This concludes your conference. You may now disconnect.