One question I kept asking myself when reading about the ITT split up (Xylem and Exelis write ups from the other week) was if any of this made sense. Not the business, but what the business is doing. I addressed some examples of how one does this in my previous post. Does this split up make sense when I strip away the noise? I wrote about this in my post on where I've gone wrong with spinoffs, but will rehash it in terms related to ITT.
Everything equal, my take on the ITT situation is that it is a pretty nice tax free way to sell the industrial business, get the water business to be a sexy stock, and remove the negative sentiment towards the defense business from 2/3 companies. From a "corporate strategy," shareholder, and investment banking perspective, this all sounds wonderful. The total cost of this "transaction" is $500m. Transactions entail fees (there are some impairment charges in the mix too). This is a big fee that doesn't fundamentally change the earnings power of the underlying business. At the margin you have higher debt costs, regulatory expenses, and less robustness. If I owned the business to myself, would I be doing this? Would I do anything differently? Let's consider taxes.
On the face of it, ITT is paying $500m to unlock ~$1bn of value through market perception. That's a 100% ROI taken at face value. One thing to think about are the tax implications, which I view as important in spinoffs. For a moment, take that Exelis and Xylem are worth $6.5bn as a fact. That implies $1.5bn for the industrials business that I think is worth $2.5bn.
ITT currently trades for about $8bn. I thought that defense business was worth around $3bn and the water business $3.5bn. That's $6.5bn. The industrials business, which I haven't and won't write up, is probably worth around $2.5-3bn in a buyout at 10-12x EV/EBIT on 12% EBIT margins with around $2bn in TTM revenue. It will have zero debt and enough cash to cover to remaining projected asbestos liability. So the total is around $9bn.
Consider if ITT stayed together and returned all the money generated from selling the industrials business. Total assets in the motion & flow division are $1.3bn. Hypothetically, their cost is $1.5bn and they sell it for $2.5bn. That's a gain of $1bn (I don't really know the cost, but the cost is likely lower and a lower cost would result in a higher taxable gain). Taxed at 35%, ITT is left with $2.15bn. They then return this to shareholders who get to keep $1.82bn of that after taxes. So that makes the business staying together but being oblivious to taxes worth $8.3bn - around current prices. So at current prices, assuming no $500m transaction cost, I net myself $200m. That's $6.5bn for Exelis and Xylem plus $1.8 in cash from selling the industrial business. Well, that would be much ado about nothing, and Xylem and Exelis could very well be worth less than I think they are worth.
So lets consider what happens with the spin. Post spin, an all cash buyout for $2.5bn would result in $2.12bn for long term owners or $1.62bn for short term owners. So from a businessman's perspective, buying it today just doesn't really make much sense since $6.5bn of Xylem + Exelis with $1.6bn is basically the current price. It's basically just $500m down the drain since the total value of the parts is where we are now assuming Xylem and Exelis remain unchanged. In this instance, I want to point out that buying this business today and entering this transaction is not the same thing as having bought this business over a year ago and agitating for this transaction.
The long term shareholders who agitated for a shake up are in a better position, but I can't replicate a passage of time. If I seem wedded to the idea that the industrial business gets bought out within a year, it's because I am. I wrote about Treasury Wine Estates, which was spun out of Fosters. It was a wine company spun out of a beer company. As a standalone beer company with strong market share in a developed country, SABMiller probably thinks they have tons of synergies and that stuff to gain. They want to buy it badly. Once TWE was out of the picture, Fosters became much more attractive. Within a matter of months, it had its courter. Does the same narrative play out with the industrial business?
Now I don't like to do horse trading. Nobody is ever going to put accurate odds on the industrial business being bought out in +/- 12 months. ITT's industrial business will be sought after when looking at potential outcomes. There are several things I'm reading into when I establish this. First, it is not being spun out. This has tax consequences for the entire spin transaction, since a takeover triggers tax consequences. I think that means something. ITT Industrials is also being left with no debt and cash to cover the remaining asbestos liability. To me this all screams, "come and get me." Does it happen within the next 12 months? I have no clue. Interest rates are low, valuations have come down in recent months, corporations have strong balance sheets, and ITT industrials has a reasonable competitive advantage and complimentary product lines for many industrial firms. Does an acquirer knowingly extend the finalisation of the acquisition until 366 days after the spin? I don't know, but then that seems like a long time to be involved in an arbitrage play where anything can happen. Even if the acquisition is announced in 6 months and intentionally delayed until 366 days after the spin, I'd likely sell the business at a slight discount to the closing price.
Well once I realized this, it got me thinking about the entire transaction a little more. When I looked at Exelis and compared it to L-3, I intentionally included unfunded pension liabilities as a form of debt in the enterprise value. I went back into the nitty gritty to look at pension assumptions since I still remain dumbfounded by compound interest and pensions are probably a good example of where it hurts rather than helps investors. I have on good faith from my friend Warren, that pensions are an area where a lot of fudging is going on minus the chocolate goodness. Here's a simplified table outlining the effects of their respective projected returns and discount rates on their pension assets.
Pension Asset
|
Projected Return
|
Future Value Year 10
|
Discount Rate
|
NPV
| |
Exelis
|
1,000
|
9.00%
|
2,367.36
|
5.62%
|
1,370.26
|
L-3
|
1,000
|
8.55%
|
2,271.42
|
6.26%
|
1,237.66
|
Difference
|
96
|
133
|
I just used the pension assets in this example because both have unfunded liabilities. I just want to show what an all else equal example shows about the gaps that can emerge. Even based on just these two examples, Exelis is already a fudger. Correct me if I'm wrong, but both of these projected returns are kind of high. I'm under the impression that standard corporate practice - already fudged in general - is an 8% return. I don't know what the standard discount rate is, which does play a key role in the maths of it all as well. Judging from the established credibility of assuming a 9% return, a 5.62% discount rate doesn't offer firm ground to stand on and it is again aggressive compared to L-3.
The point is that every dollar in Exelis's pension fund is the equivalent of $1.133 in L-3's. A dollar contributed to Exelis's pension is not the same as a dollar contributed to L-3's. So that's a pretty big deal when Exelis has a $1bn unfunded pension liability, because that means it's understated. Unfunded pension liabilities are the norm for many defense companies, but that doesn't make it right.
This is a flaw that can arise in relative valuations. Just because everyone has the same problem does not make that problem not a problem. I think from a businessman's perspective, the obfuscation and implicit leverage from the unfunded liability make it less interesting. While I included the stated value of the unfunded liabilities in my original analysis, this needs to be upped at least another $100m to match L-3's standards, but L-3 also has a $780m unfunded liability. Their standards likely aren't conservative enough either since the incentive is clearly to understate the liability to boost short term earnings.
This was less risky when done at old ITT. Even if the defense industry is in the doldrums, which seems to be the current course, other businesses could pick up slack in pension contributions. When I realized this, I started to reconsider the stand alone risks. While filling in the gap would be around 1 year's FCF, it is closer to 2 years at Exelis and that is being kind with the lower revenue and margins they face in coming years.
Xylem will likely not face much financial risk as is, but they are taking on $1.2bn in debt that is about 3x EBIT. This is manageable. The business produces tons of FCF. Then I started to consider some risks. In my original write up, I highlighted their sales force and service centers foot print as a competitive advantage in every day business and quite possibly in positioning it to acquire companies. While ITT has never really done transformative acquisitions, they are a consistent bolt-on acquirer. Xylem seems to have similar intentions to get into some additional product lines.
There is nothing wrong with this idea. Acquire additional products, slice off the head of the company, plug it into your existing sales infrastructure. Xyelm will generate tons of FCF. Does debt get paid down? Does debt increase? With 40% of their sales from Europe, there is clearly downside risk. While water is a sexy long term theme, long term trends still go through cycles (ahem, China). The business is plenty healthy to survive a downturn, but the potential downside requires more of a margin of safety than 20-30% for the entire business on the bull case. In 5 years, the industrial business and Xylem will be more valuable than they are today, and Exelis should be fairly stable.
So I decided that I would rather own the businesses as a whole under one roof. If they are undervalued on a sum of the parts basis, why not just spend $500m on buying back stock at a depressed price. That is a pretty savvy long term investment to make assuming you agree with their implicit statement that the stock is undervalued. If the market doesn't agree with that move and punishes the stock, buy back even more stock. So I don't want to own ITT at this point in time, but it's 3 stand alone businesses in the future might be of interest.
One additional quibble is that a subdivision from the fluid segment and the motion & flow segment are being swapped. The only logic behind this is to make the fluid segment more of a "pure-play water business," but still maintain some balance between all 3 business divisions. A pure-play water stock sounds lovely. It's a real easy pitch to brokerage clients and appeals to all the fear about water resources these days. But then I thought to myself, why do I have to own this business? If it's because it's a "pure-play water business," then I should be looking at the whole industry and whatever I buy should be cheap on an absolute basis (Pall's business is 75% consumables, so that sounds nicer than Xylem's 15% of business from replacement parts). Abstractly, this made it evident that I was being sold something not based on the dry fundamentals of the business but on the grounds that this $500m transactions had to be sold to people - the theme, the trend, the sex factor. Bankers, advisors, auditors, and consultants do something to earn their money.
So I recognized I have no edge in this business. If I feel pretty comfortable that signs point to a sale of the industrial business, I'm not alone. It's only 25% of ITT though, so there are a lot of other factors that can play a role in the outcome that are beyond control. So I'll follow it and revisit it when the spin price is established. Part of the transaction is based on removing the stigma of the defense segment. Well, I'm certainly not alone in realizing this either. Will the defense segment get priced poorly and see even more selling pressure post-spin? Maybe. Again, it's worth following and waiting for a cheaper price since they have issues. Will Xylem be sexy and trade at 20x earnings? I don't think it's really worth that much - a 5% return on a cyclical company with exposure to public utility spending doesn't equate a margin of safety.
I have done work on the businesses and have a grasp of the fundamentals. If things get worse - and spinoffs can be predictably unpredictable with their trading in the first few months - then I can revisit them. There are some tax implications to buying ITT now in regards to potential returns. There are individual issues that would be better addressed at a conglomerate from a cash flow perspective. So who knows? Maybe some of these chickens will come to roost in coming months, a more attractive Stock Market Genius spinoff scenario will emerge, and I'll be ready.
