It would be naive to think that inputs for the US war machine will be in as high demand in coming years with scaled down foreign adventures. While Exelis is not the only one to do so, it is well positioned for lower overall defense spending and additional budgetary scrutiny on some of the Department of Defense’s biggest projects (F-35, Littoral Combat Ship). Exelis is broadly diversified over a range of electronics systems and services that should allow the business to survive, and is well positioned to benefit from broad trends in unmanned aerial vehicles, cyber warfare, air traffic management, and space based technologies.
Overview
The business is divided into 2 reporting segments: C4ISR and Information & Technical Services. This doesn’t even begin to scratch the surface of how broadly diversified the product lines are that the company offers. C4ISR stands for communications, command, control, computers, intelligence, surveillance, and reconnaissance. Just to name a few products this covers: communications systems, imaging and processing, radar/sonar, antennas, infrared sensors, nigh vision goggles, and various electronics packages that go on UAVs and satellites. Information & Technical Services includes base management contracts for logistics, security and maintenance, air traffic management systems, maintenance and support for C4ISR products, NASA support, and research. Revenue is currently divided 60/40 while operating profit is divided 80/20 between C4ISR and I&T Services. As more revenue shifts to I&T services in coming years, there will be margin compression.
Exelis has seen very rapid growth over the past decade, mostly due to organic growth and 2 acquisitions. In 2007, the company acquired EDO for $1.7bn. In 2004, the company acquired RSS for $730m. From 2001-2010, revenue grew from $1.3bn to $5.9bn while net income grew from $80m to $430m.
The business as a whole has high returns on capital. Retroactively applying the debt issuance to 2010 results, Exelis achieved a 34% return on equity. Without the debt, the business achieved a very respectable 20% ROE. Stripping out goodwill, the business has negative tangible equity. That being said, that Exelis can earn a 20% ROE when including the cost of their acquisitions
The business is very cash generative and even with $690m in net debt ($890m gross) leverage is only 1.5x FCF. The business is based more on technology, relationships, and research so it is not very capital intensive. At the same time, new entrants are rare because unproven technology takes a long time to gain traction and prove itself causing high upfront costs for entrants. Their main customer is only rated AA+, but participates alongside Exelis in researching new technologies. While the business model does not offer endless opportunities for reinvestment, it generates a lot of free cash flow relative to capital employed.
Outlook
The company has benefited immensely from the wars in Iraq and Afghanistan with huge sales of night vision goggles and improved explosive device jamming equipment. These sales are already dropping off from being 15-20% of sales in past years. This drop is being offset by some service contracts for bases in Kuwait and Afghanistan, as well as contracts wins in other product lines. The company has a $4.1bn funded backlog out of a total $11.9bn backlog, which includes various options in the contracts and payments that are not yet contractually certain, compared to 2010 revenue of $5.9bn, so business is not exactly falling off of a cliff.
Exelis has several products that are in demand and platform neutral. Their IED jamming equipment has had additional contract wins for being mounted on vehicles. Their air traffic management system combines radar and GPS for to improve air safety and efficiency. They won the contract from the FAA to build, own, and maintain the ground systems that the system operates with. This is a long-term source of revenue, and opens up additional contract wins in other countries for the same product.
The services segment has grown rapidly over the past 10 years. It includes security, maintenance, and logistics on military bases in the US, Germany, Kosovo, Kuwait, and Afghanistan. The air traffic management division is included in this segment. The segment includes divisions that provide engineering and personnel support for satellite launches, secure communications networks, and assorted jobs such as operating and maintaining tethered aerostats that perform core drug interdiction and air sovereignty missions along the U.S. southern border. The service segment has lower operating margins, but part of the business results from Exelis provided the equipment it is contracted to provide service for.
Valuation
It is not a stretch to predict that revenue and operating margins will be under pressure in coming years. There are some relatively comparable defense companies, such as L-3 Communications, FLIR, Lockheed Martin, and Northrop Grumman, but like all children each one is unique with their own strengths and weaknesses. With the exception of FLIR and its more diverse customer base, all trade at high single digit price to earnings ratios, reflecting the fact that future earnings are going to be lower.
If Exelis were valued at 8-10x earnings like L-3, LMT, and NOC, it would be worth $3.4-4.3bn. This “valuation” is not really reflective of reality since future earnings will be lower.
Of those 3 peers, L-3 trades at 8x earnings and is the closest peer in terms of being a pure play defense electronics company. L-3’s main segment is C3ISR systems, which is the same as Exelis’ C4ISR systems minus the extra “C” for computers. L-3 is dependent on governments for 90% of revenue, as is Exelis. Neither company has much exposure to massive expenditure programs such as the F-35 or refueling tankers like Lockheed and Northrop. The comparison below based on the first half of 2011 is not entirely fair since it is a short time frame. The assumed market capitalization and enterprise is just calculated based on applying L-3’s ratios.
2010 | 1H 2011 | |||
L-3 | Exelis | L-3 | Exelis | |
Revenue | 15,680 | 5,891 | 7,367 | 2,829 |
EBIT | 1,750 | 689 | 794 | 235 |
% EBIT | 11.2% | 11.7% | 10.8% | 8.3% |
Net Income | 955 | 587 | 242 | 162 |
% Net Income | 6.1% | 10.0% | 3.3% | 5.7% |
Debt | 4,126 | 890 | 4,126 | 890 |
Unfunded Pension | 780 | 1,050 | 780 | 1,050 |
Total | 4,906 | 1,940 | 4,906 | 1,940 |
Market Cap | 7,000 | 2,745 | 7,000 | 1,585 |
EV | 11,906 | 4,685 | 11,906 | 3,525 |
EV/EBIT | 6.8 | 6.8 | 15.0 | 15.0 |
Debt/EBIT | 2.8 | 2.8 | 6.2 | 8.3 |
P/E | 7.33 | 4.68 | ||
Based on 2010 results, Exelis should trade for about 8x earnings, on par with L-3. This seems to be vaguely correct when the declining operating margins at Exelis are balanced against its lower debt load. For every dollar of EBIT though, a higher percentage is for the benefit Exelis shareholders since L-3 has to service a greater debt load. Exelis has a larger liability balance when adding in the unfunded portion of pensions. Both have unfunded liabilities stemming from their pensions, although relative to their enterprise values, Exelis has a much larger gap.
The pension liability is probably the one legitimate knock against the stock as opposed to it being broadly exposed to US defense spending. That most defense companies have an unfunded pension liability is not an excuse, but it does influence a relative valuation. The total debt (debt + unfunded pension) is 3x trailing EBIT, which is something to keep an eye on, but not overly cumbersome or life threatening. If the company takes a charge post spin to top increase the funded portion of its pension, that would just be a short term blemish on the stock that would not damper its long term prospects.
Using comparisons as a valuation is not intelligent. Defense contract wins can be a zero sum game, so if L-3 won a contract at Exelis' expense and L-3's market value rose, so would the implied valuation for Exelis, when clearly the actual value would decrease. It does provide a vague guide for what this type of business might be worth, and it is in the vicinity of the valuation one would reach from independently valuing Exelis on its net income.
Revenue guidance from Exelis is $5.5bn for 2011. Assuming 8% EBIT margins, $30m in interest, and a 35% tax rate, the company should earn $266m in net income. This assumes margins really contract. If the company can achieve a 9% EBIT margin for the full year, net income would be $300m. At 10-15x earnings, the business would be worth $2.6-4.5bn.
Exelis has a backlog that amounts to about 2 years of revenue. Say revenue drops 25% from 2010 levels to $4.4bn and EBIT margin compresses to 7%, which results in net income of $190m. This could be worth anywhere from 10-15x earnings or $1.9-2.8bn. As it currently stands, revenue does not appear to be facing a steep drop as evidenced by the backlog and contract wins irrelevant to the current US wartime needs.
Conclusion
The lack of tangible assets on the balance sheet is balanced out by the long term projects that Exelis is involved in which generate a lot of free cash flow. Exelis plans to declare a dividend once it is spun off. ITT has never been a fan of repurchasing shares, although many defense companies find this a sensible use of cash flow. Exelis is well diversified and positioned to sustain its earnings power even with lower government spending on defense. The equity should be worth $2.5-3.5bn post spin, which is the equivalent of 30-45% of ITT’s current market capitalization.
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