ITT Spin - Xylem

This is the 2^nd part of my 3 part series on the ITT split up.  I wrote about Exelis last week.  This focuses on Xylem, the water segment.  This is a high quality business with a nice growth runway that operates in an industry with high barriers of entry.   The business is focused on the crucial aspects of the water supply chain for industrial, commercial, and residential customers.  Xylem is one of the bigger players in this fragmented but attractive industry.

Xyelm manufactures industrial components that transport, treat, and test water.  Their products range from pumps that maintain water pressure in buildings to water treatment devices at water utilities to pumps that remove water from mines.  The business is focused on the crucial elements of larger systems.  These crucial elements get designed into the broader system and are unlikely to be displaced by cheaper and unproven designs and competitors.  This creates a high barrier to entry, pricing power, and recurring revenue from replacement parts.  This has the markings of what can be a high quality business.

Business

Xylem divides its reporting in two segments: water infrastructure and applied water.  Xylem estimates that there are over 20,000 companies that serve the equipment and services segment of the water industry.  The figures below don’t include the full effects of the 2010 and 2011 acquisitions (YSI, Nova, Godwin Pumps). 

	2010 Rev	% Rev	Market Size	Market Share
Water Infrastructure	1,930		16,000	12%
Transport	1,436	74%	11,000	13%
Treatment	377	20%	3,000	13%
Test	177	6%	2,000	9%
Applied Water	1,327		14,000	9%
Building Services	723	55%	8,000	9%
Industrial Water	509	38%	4,000	13%
Irrigation	95	7%	2,000	5%

Revenue is derived 40-35-25 from Europe, the US, and rest of world.  End users are diversified between industrial, commercial, residential, and agriculture markets.  Public utilities make up 40% of revenue, followed by industrial (35%), commercial (13%), residential (9%) and agriculture (3%).  The company sells its products through its direct sales force and through distributors.  Many distributors are provided with technical training on the company’s products in exchange for exclusive distribution. 

Xylem is capable of consistently growing revenue with the exception of short-term hiccups in global growth.  Xyelm can grow organically on the back of economic growth or innovation and through acquisitions.  Xyelm spends 2% of revenue on R&D and didn’t decrease nominal R&D spending in 2008-2009.  Even though acquisitions look pricey on a PE basis, Xylem’s sales force provides a larger selling footprint than a small company could afford.  ITT has a decent track record with acquisitions.  The industrials sector as a whole has been quite successful at it since the recipe is finding a bolt-on company, removing a layer of management, and leveraging existing sales relationships.   

Xylem also has 120 service centers around the world, which serve 2 purposes.  First, it better positions to company to respond quickly to customer needs for maintenance, repair, and replacement parts which are high margin recurring revenue that are currently 15% of revenue.  Second, it gives Xylem’s products a competitive advantage against smaller companies that can’t afford this type of footprint.  Since pumps or filters can be the difference between a customer being able to operate their facilities or not, having this capacity is a competitive advantage.  While they are not precluded from having the capability in house or through distributors, competitors Gorman-Rupp and Idex make no mention of this in their filings.

Earnings

There are several factors that obscure projecting future earnings based on past earnings.  As part of ITT’s break up, the industrial process segment that was previously included in the water business in corporate filings is going to be part of the industrial business post split.  Exelis is receiving the control division from the industrial business in exchange.  In addition, acquisitions in 2010 and 2011 should boost 2011 earnings. 

	2010	2009	2008
Revenue	3,202	2,849	3,291
COGS	1,988	1,812	2,150
Gross	1,214	1,037	1,141
%	37.91%	36.40%	34.67%
SG&A	737	667	721
%	23.02%	23.41%	21.91%
R&D	74	63	64
%	2.31%	2.21%	1.94%
Restructuring	15	31	41
Operating Income	388	277	312
%	12.12%	9.72%	9.48%
Tax	59	14	88
%	15.21%	5.05%	28.21%
Net Income	329	263	224
%	10.27%	9.23%	6.81%

Going forward, the business will have $1,200 in debt.  The company hasn’t released the rate on the debt related to the YSI acquisition, but $890m of the debt has an average interest rate of 3.75%.  For the sake of figuring out what 2011 earning will look like on the conservative side, I calculate the average interest rate at 5% below.

Additionally, according to the Form 10 Xylem filed, they expect $25-35m in additional expenses in public company expenses not previously allocated to it by ITT.  Exelis, the defense spinoff, did not report expectations of higher costs.

The company’s pro forma disclosure indicates that Xylem earned $153m in the first half of 2011 and $317m in 2010.  This does not include the additional recurring expenses or the interest on the $1,200 of debt (only $890), which are included in the below rendering of Xylem’s earnings power.  The tax rate is calculated as 35%.

	1H 2011	2010
Revenue	1861	3347
COGS	1145	2062
Gross	716	1285
%	38.47%	38.39%
SG&A	464	824
%	24.93%	24.62%
R&D	50	74
%	2.69%	2.21%
Restructuring		15
Operating Income	202	407
%	10.85%	12.16%
Interest	30	60
Tax	60.2	121.45
Net Income	111.8	285.55
%	6.01%	8.53%

The first half of 2011 has seen year over year growth in revenue and profits, but the above calculation knocks this back a little bit by increasing SG&A and interest expenses.  In my opinion, the above most accurately reflects the business going forward.  It’s really anyone’s guess what the next 6 months will look like from an earnings perspective – impact from YSI acquisition, transaction expenses for the split and acquisitions, corporate overhead not ramping up as high as expected. 

Guidance for 2011 given pre-split announcement said acquisitions related to the fluid segment and which will remain in Xylem would contribute $35m to net income.  Post spin, with the effect of increased interest payments and stand-alone costs, the net effect of earnings growth and impact from acquisitions should be more or less neutral. 

The above calculation of net income, which tries to include the negative impacts neglects quantifying positive aspects from acquisitions since the information to base it on is non-existent.  What will full year 2011 earnings look like?  Probably around double what they earned in the first half when all the smoke clears.  Management states their internal forecast is low to mid single digit growth in the water market through 2015.  There will be some issues in the short term as public utilities are a major source of revenue and Europe and the US are stalling infrastructure investment.  Water is a necessity, which should protect against major drops in revenue, but spending on water projects can be pushed off into the future.

Valuation/Competitors

This type of business is fundamentally attractive, although the $1,200 in debt is a knock against the valuation.  The below chart includes several competitors of Xylem.

	PE (TTM)	EBIT (TTM)	EBIT Margin (TTM)	Debt (MRQ)	Mkt Cap	EV	R&D (2010)	% of 2010 Rev
Gorman-Rupp (GRC)	18.8	48	14.28%	25	583	608	n/d	n/d
IDEX (IEX)	16.1	285	17.19%	878	2,860	3,738	32	2.12%
Flowserve (FLS)	11.9	544	12.85%	489	4,980	5,469	29	0.72%
Pall Corporation (PLL)	18.8	388	14.71%	486	5,120	5,606	80	3.03%
Nalco (NLC)	17.2	620	13.95%	2,782	5,060	7,842	n/d	n/d
Xylem		407	10.85%	1,200			74	2.21%

 

With the exception of Flowserve, which is more concentrated in the oil & gas sector, peers trade at high multiples of earnings relative to the market.  While Xylem has a similar EBIT/debt multiple to IDEX, Xyelm has lower operating margins.  The operating margin is potentially depressed since it is calculated with recurring stand-alone expenses at the highest of the expected range given ($35m). 

Compared to GRC, Xylem has a large sales force and R&D spending, which GRC offers no disclosure on.  GRC sells its products through distributors and likely spends money on R&D, but the 10-K offers no breakdown.  This is at least a partial explanation for the difference in operating margins.  

Nalco and Pall are larger businesses with more diverse products and end markets, although they do compete with Xylem in water treatment.  They offer just a vague approximation of a similar line of business.  Pall gets 75% of its revenue from consumables, which is a different business model and likely worth its premium multiple. 

Nalco is being purchased by Ecolab, which provides a transaction multiple for the space, but they are focused on water treatment with manufactured products as well as chemicals.  According to Ecolab it is being done at 11x EV/EBITDA pro forma, but 9x EBITDA with the assumed synergies.  This tends to be the thinking behind many acquisitions in the industrial space, which allows for some pretty steep acquisition multiples.  Some pretty absurd numbers could be concocted if this type of multiple was applied to Xyelm - $4.3bn equity value at an 11x EV/EBITDA multiple.  This is not a valuation to hang your hat on, but does provide some backstop to the valuation remaining low.

What is the right multiple for Xylem’s earnings?  Vaguely, the 13-15x range.  That pegs Xylem’s value around $2.9-3.3bn.  This is the same as 10x EV/EBIT valuation, which is about the going rate for specialized industrial firms. 

This value is likely on the low end since taxes were assumed to be 35%, despite 60% of the revenue being international, the high end of the expected additional expenses was used, and some one time transaction costs are included.  Margins at the historical fluid segment in ITT filings were much higher, although they excluded corporate expenses and included the industrial processes business and excluded the flow control business.  The industrial business has higher margins than flow control, so Xyelm should have lower margins than the historical fluid segment.  There is still the possibility for margin expansion with sales growth if the company can leverage its sales force.  

The ironic Ichan cigar butt and other piles of cash

Cadus Corporation is a literally a pile of dollar bills for 80 cents.  Greenbackd originally wrote it up 2 years ago (link) and I've kept an eye on it since.  Nothing has really changed in the past 2 years except that a few million tied up in a stock fund has been converted to cash.  Carl Icahn owns 40% of the company and more or less calls the shots.

Icahn's presence is a mixed blessing.  On the face of it, Icahn is a savvy investor and will make good use of the shell.  That has been the premise for the past 10 years though.  Last year, Jason Zweig at the WSJ wrote an article on the company and the investor fatigue over a lack of action, which Greenbackd also chronicled and doesn't require a subscription to read (link).  There's a write up on Cadus from 2003 at the Value Investor's Club as well (link).  I can't really think of a longer time horizon for an investment.

My point is that Cadus is far from a well kept secret.  Greenbackd has written about them, Carl Icahn is involved, the WSJ knew about them, and the same thesis was being touted in 2003 for the company.  Nobody seems to give a shit.  Based on his inaction, even Carl Icahn seems to not care, hence the irony for a man who demands action from others.  To rehash the premise:

There 13,144,040 shares outstanding and $23,565,567 in cash on the balance sheet as of June 30, 2011.  This is $1.79/share in net cash compared to a share price of $1.37, so it is trading for close to 77 cents on the dollar.  The real upside kicker in this situation is the tax losses detailed below:

	Net Operating				Research and Development
Year		Loss Carryforward				Credit Carryforward
2011		$	1,044,000			$	310,000
2012			6,950,000				725,000
2018			8,949,000				935,000
2019			5,810,000				565,000
2020			275,000				-
2021-2030			2,517,000				-

The tax loss carry forwards total $25m.  This creates a side pocket of value that may or may not be exploited.  The looming expiration of $7m in of credits in 2012 might spur some action on behalf of the owners to make use of the cash.  At this point in time, the tax losses being used seems like a given since the company would have otherwise liquidated.  A few weeks ago, a director resigned, although no details were given.  Does this mean something is afoot?  I don't know.  


There's two things I want to highlight.  First, tax credits obviously expire in the short term.  Does this mean that something will be done?  I have no insight into that.  On one hand it would seem logical, on the other hand what's the rush?  There would still be $18m of tax credits, so it does not fundamentally change the appeal of the shell.  I'm unimaginative, but it would be hard for a $23m investment to generate taxable income of $8m in the next 16 months without impairing the principal value.  The business is not properly registered under the 1940 Investment Company Act to earn most of its profits from investing in public equities, although I might be incorrect.  This is really just tea leaf reading and I is quite illiterate.


The second thing that gives me pause is that I can't be the only person to recognize this.  Hypothetically, if the next 16 months pass with no action, even more investors might be fatigued.  They might sell and there would be even less willing buyers.  It's not that I'm worried about potentially holding something with a 25% loss when the cash balance remains unchanged, it's that such an occurrence will have zero impact on management's desire to act and there is an opportunity cost to this.  So an investor today could end up holding an illiquid security where they can only get back 75% of their cost for years when tons of other opportunities pass by.


That being said, it seems foolish to extrapolate non-action into the future.  It certainly is frustrating to see that nothing has been done in ages.  It is the same dynamic many large cap value stocks that haven't moved in 10 years but their multiples have compressed.  Yes the stock hasn't done anything in a decade, but underlying business is in fine shape and it trades at a pretty big discount for an easy to establish liquidation value.  


If we were to do a comparative valuation, there are 2 other micro cap cash piles controlling shareholders that I know of: Peerless and CoSine.  Peerless trades a shade above its net cash position, but has positive cash flow and a controlling shareholder.  Peerless seems further along towards making use of the cash as detailed on Gator Capital (link).  


CoSine on the other hand has $2.06/share in net cash against a market price of $2.04/share.  In a similar vein, Steel Partners has a controlling stake in Cosine.  Steel Partners is actually run by a former Icahn protege.  Despite having a near identical cash pile situation and most importantly, cash burn, it trades for cash instead of 77% of cash like Cadus.  Cosine has close to $600m in tax loss carry forwards in applied to federal, state, and capital gains taxes, which is a massive tax shield for practically a business of any size.  


Both Cosine and Cadus are in similar phases of being a cash pile with NOLs.  There isn't much action going on or signs of pending action.  Cosine's situation still has several years to go before it experiences the same investor fatigue as Cadus.  While Cosine has a large hidden asset with its NOLs, the market is not applying much of a cash burn discount to the valuation.  


These certainly aren't sexy stocks, but it's pretty hard to lose a lot of money when all you do is hold on to it.  Even for an investor with $500 to invest, these are illiquid stocks.  As I said above, you could end up carrying a position at a 25% loss for years before you realize a gain.  I don't have a position in any of the stocks, and so naturally fantastic things for all stakeholders will happen within the next 6 months.  I'm fine with that.  


I'd be interested in hearing anyone's thoughts about these types of investments from a practical or philosophical point.  These aren't typical cigar butts since they aren't operating businesses, although this minimizes risk in some aspect.  They have a certain Taleb-like quality in that they slowly bleed but have this abstract potential for high upside given enough time.

Why I don't like speciality clothing retailers

When I first started investing, it was all about low PE stocks. Earnings are a real important part of the formula for making money, but it is future earnings and not trailing earnings. A low PE on a retailer can be misleading though. It is a cutthroat business with no barriers to entry tasked with selling perpetually changing products. Oscar Wilde sums up the problem that clothing retailers face - "Fashion is a form of ugliness so intolerable that we have to alter it every six months." A clothing retailer reverting to the mean is incredibly difficult because of the constant change.

Too many value investors comfort themselves with past consistency. Selling clothing to people is not a steady business with the exception of men's dress clothing. Tastes can change rapidly - look at Crox. The clothing industry is not part of some broader cycle that allows any individual company to piggy back on the broader upswings like housing or steel. Marginal capacity remains just that even when clothing demand is strong. My scientific method for establishing that is looking at the stocks of steel and housing companies from 2000-2008 and 2000-2005 respectively compared to clothing retailers over the same periods. The former was correlated, the latter not at all.

To understand the differing economics a clothing retailer faces, it helps to put them against the backdrop of retailers in general, where there are many dominant players. Target is not likely to start carrying a small selection of lumber and Home Depot is not going to start offering fresh produce or 10 pairs of socks for $5. This allows for some modicum of a competitive advantage among certain retailers. The same competitive advantage is not available to clothing retailers. When skinny pencil jeans are all the rage, anyone that sells pants - i.e. any clothing retailer - is more or less free to jump on that band wagon regardless of what is perceived as their core focus. Even though this implies that a "brand" plays a key role, there are very few enduring clothing brands based on specialty retailers.  Brooks Brothers is the only one I can think of off the top of my head, but men's dress clothing is the exception to the rule.

The LBO of J. Crew centered less on the stores, logistics, etc than the presence of CEO Mickey Drexler, who is credited with J. Crew's success in recent years and Gap's success in the 1990s. Gap suffered in the year or two leading up to his departure though, so even the most skilled merchandisers run out of steam every so often.

The limited focus of some clothing retailers - Aeropostale, American Eagle, Gap, etc - makes it hard to rapidly adjust to changing preferences. The existence of retailers built on a model of rapid turnover and super short lead times makes the job of some of the more traditional retailers mentioned above a lot harder. H&M and Inditex don't "miss" a fashion cycle because they focus on rapidly duplicating current fashion and putting it on their shelves. This model rests less on a maestro merchandiser and more on a system focused towards a specific end. H&M and Zara don't stand for anything, they simply mirror whatever is fashionable at the moment.

Aeropostale is a name that keeps popping up in portfolios of many value investors, but I find that it has more traits that don't make it a value investment. The company caters to the 14-17 crowd and is suffering right now. People seem to be focusing on the broader economy leading to more intense discounting and higher cotton prices squeezing the company. While these seem transient at first blush, I don't know how accurately this portrays what is really hurting the company.

There is nothing fundamentally dishonest about such an interpretation, but it is narrow in focus. More broadly speaking, it is that their key demographic is suffering disproportionately to the rest of the economy. Cotton is a marginal issue in comparison to this. Every clothing company has to deal with cotton costs and a weak economy. Why have Aeropostale's recent results been so relatively weak?

I'd like to think that Aeropostale's weak results in recent quarters stem from the fact that teenagers by and large are a mindless and fickle group. When I think back to myself at this age, once some brand or style became uncool in my opinion, it was done. I never gave something a second chance. I moved on. There is such a variety when it comes to arraying oneself in fabric.

Maybe Aeropostale is just in a fashion funk and their clothes are no longer selling well. That seems hard to judge in the near term. I view fashion as practically random, in that in practice it is difficult to really know what items will be a hit. The issue of fashion applies to more than just the special focus retailers, except that they have their own distribution which leverages the business model. I have a hard time figuring out how one could have knocked one out of the park with Uggz or "luxury denim", survived the rollercoaster of Crox or recognize that Heely's now trades for below cash. The monstrous successes and failure would not have been apparent in SEC filings - perhaps incremental successes of sales growth outpacing inventory - and personally I would have scoffed at the idea of anyone buying any of these products before the fact.

You can't tell me that you would believe that these fabulous moon boots get sold in stores, except that they do:

Back to Aeropostale. It's the end of summer right now, when most 14-17 year olds should have gotten summer jobs that allow them to support their spending habits in lieu of the parental payroll. Except that according to the July BLS data on youth employment, 16-24 year olds, the labor force participation rate for all youth in July was the lowest on record. So when your store is targeting that specific demographic, it should come as no shock that same store sales are down and merchandise needs to be heavily discounted to sell it. My inclination is to believe that this is the major factor driving Aeropostale's results and that this is going to obscure whether or not Aeropostale is remaining relevant, since other teen retailers are not seeing as much gross margin or sales pressure.

Sentiment is clearly at an all time low with Aeropostale, but that is not a reason to buy a stock. How can you extricate the effect of cotton, youth unemployment, and a weak economy from a retailer losing its merchandising touch or its appeal to teenagers? That is, how can you establish the difference between a permanent impairment in the business and a temporary blip?  At 2.4x book value, there is no downside protection in the form of hard assets backing the valuation and I am skeptical of trying to peg their earnings power going forward with the potential for a fundamental change in Aeropostale's prospects.

I chose Aeropostale because it seems to be the most extreme of the bunch right now in terms of share price. Plenty of people have opinions about the company and its prospects. It just demonstrates why I don't like clothing retailers. It's a hard business with prospects that are difficult to evaluate. Talbot's, bebe, Wet Seal, or Cache are some other examples one might look to for evidence that reversion to the mean is a hard thesis to put forth for a retailer.

ITT spin part 1 - defense segment

Exelis is the defense segment of ITT.  If you weren’t aware, the past decade has witnessed a couple skirmishes around the world courtesy of the US and Exelis has never had its products in greater demand.  All good things must come to end though so Exelis is already starting to see the effects of operations winding down in Iraq and Afghanistan, as is every other defense company.  Exelis has a broadly diversified portfolio of products that can cushion the business as overall defense spending decreases.

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.