Exelis Inc.

Leo Tolstoy once said “Happy companies are all alike; every ugly spinoff is ugly in its own way.” [Editor’s note: Well, maybe he said it. Who are we to know everything he ever said?]

Trading at less than 5x trailing earnings with a fat 4.2% dividend yield and a trailing free cash flow yield of 20%, Exelis (ticker: XLS) is clearly considered quite the ugly spinoff despite its history as a solid ROIC business. In fact, it currently appears in the Top 50 across all market caps in the Magic Formula screen, which as most members of this site know is focused on both cheapness and returns on capital.

Exelis Inc. is the defense business recently spun out of ITT Corp, which was written up in March by clark0225. In that write-up, the author noted that Exelis was considered the “problem child” of the ITT businesses, and it’s hardly a secret that ITT management felt that the potential for drastic cuts in US defense spending in the coming years could very well hamper the overall conglomerate’s valuation. As such, the spinoff (on 10/31/11) gave old ITT investors shares in 3 separate companies: the industrial business which remained as ITT (market cap $2B), the water business named Xylem (market cap $4.8B, considered the sexiest of the bunch – it has emerging markets exposure!), and the defense business which became Exelis (market cap $1.8B).

We refer you back to clark0225’s write-up to get more details on why the other businesses are generally considered more exciting. Exelis essentially has two business lines: defense equipment and information solutions. Its “Big 3” products (which were 28% of total sales in 2008) are electronic jammers (which help prevent remote detonation of explosives), combat radios, and night-vision goggles. Those sales have been declining substantially (to 10% of total sales now) as the war efforts in Iraq and Afghanistan have scaled back, and the result has left investors with a cloudy outlook they evidently would rather not face. The company has a range of other products, however, including as a leader in GPS systems (not retail), all of which have grown rather steadily to offset the declines in the Big Three.

The stock is off over 20% from its opening trade after having recovered a bit from a steady drift downwards post-spin. It has clearly been viewed by old shareholders as the unwanted castaway business of the lot. Let us count the ways Mr. Market thinks Exelis has been beaten with the ugly stick:

First, US defense spending is facing the knife as the wars in Iraq and Afghanistan draw down, and Exelis’ “Big Three” products in this arena have seen sales decline markedly over the past two years. With 70% of its revenue coming from the Department of Defense, Exelis’ top line is viewed as heavily at risk. Not many analysts cover the name, but present forecasts are naturally for declining sales and net income the next two years.

Second, as part of this ongoing decline in its Big Three product sales, the company’s revenue mix has shifted to the point that its products and services groups now have roughly equal sales. This has created a drag on margins, as services carry mid-single-digit margins and defense products have been in the mid-teens.

Third, as part of the spinoff ITT levered up Exelis to the tune of $840mm, from which a $700mm transfer payment was made back to ITT. Might as well fatten up the pig before sending it to slaughter, right?

Fourth, while ITT Corp kept its asbestos liabilities, it unloaded the entire pension plan onto Exelis, and that action along with a re-measurement (astutely lowering the discount rate by 75bp, among other things) has taken the net liability on the books to roughly $2B (important details on this number later). This will require a large ongoing contribution from Exelis for the next several years to get the plan back up to funded status.

Fifth, as a condition of the tax-free nature of the spinoff, Exelis has to wait two years before it can be purchased. If it were to sell prior to that anniversary, it would create a substantial tax burden on ITT that Exelis would have to reimburse, unless Exelis could prove to the IRS that the purchase had not been discussed prior to the spinoff. We are unclear as to the difficulty of this burden of proof, but investors for all intents and purposes appear to hold little hope for such a transaction to occur and are treating the stock as dead money from that standpoint.

Sixth, only two sell-side analysts cover the stock. One has a neutral rating and JPM’s recent upgrade was as tepid as you’ll ever see, essentially saying the entire group is worrisome but he’s required to have some stock overweight, so it might as well be the one with the lowest P/E.

Seventh, the Xylem piece alone remained in the S&P 500, while ITT and Exelis went to the Mid-Cap 400.

So why might the company not be as ugly as it seems?

For one, the company’s backlog grew in the third quarter to $12.3B (+7% YTD, over two years of sales), of which $4.0B is funded. For the full nine months, the company’s funded orders received increased 25% y/y to $4.3B. Imagine that, growth! The company can still win contracts!

Despite the decline in defense product sales as a share of overall revenue, management has noted that they envision keeping the sales mix at the current level, and sees current operating margins (9.0% through the first nine months of 2011, down from 11.0% in 2010) as a likely sustainable level. When the stock trades at a mere 0.3x annual revenues, 9% operating margins are plenty attractive.

Importantly, management is not myopically focused on growing the top line or presenting a pretty line item on margins. In fact, when pressed about the low margins of the service business at the recent Credit Suisse conference, CEO Dave Melcher noted that “Well, the truth is that our service business is an excellent ROIC business, right? We invest very little in it. We get the returns out of it. Of course, the margins are lower, but it's still a very high ROIC business. We want to be mindful of good returns on invested capital across all the different fronts of the business.” They noted that the only invested capital in the service side of the business is “split between our accounts receivable and accounts payable.” It is rare to find a high ROIC business trading at a discount to book value like Exelis.

Meanwhile, the company has compiled a rather impressive board of directors which includes the CEO of Jones Lang LaSalle, CEO of PJM Advisors (former CEO of Smurfit-Stone), the President of General Motors North America, the former CEO of AmerisourceBergen, the former CEO of Maytag, the former CEO of Western Union, and the current CEO of the Center for Strategic and International Studies. At that Credit Suisse conference last month, management noted that the company was yet to have its first board meeting, which was slated for later in December. There they expected to come up with more of a long-term plan, some of which we will likely hear about in the near future. Incidentally, in December a few managers (including the CEO) purchased decent amounts of stock on the open market.

The pension liability is not as large as it seems – this caveat is kind of a big deal

A recent sell-side initiation piece on the name noted that Exelis’ pension liability is “larger than its market cap.” Nowhere in the piece was it mentioned that the 2/3 of the liability that is defense-related is recoverable through US government defense contracts. JPM notes the recoverable portion should not be considered a true liability and estimates $2.35 a share ($435mm) of unrecoverable liability, though that number is based on the company’s re-measurement as of 9/30/11 and doesn’t reflect the strong equity market in the fourth quarter. To be sure, the situation does create a timing difference in funding the plan versus recovering the net liability over a period of years through its contracts, but that is much different than considering the entire amount a liability.

The company has made some changes, such that all new entrants to the company do not have the option of the defined benefit plan. Further, as of early December approximately 54% of the current workforce had elected to take an enhanced 401k with no pension rather than the prior defined benefit plan with no 401k match. It is clear that as soon as the company is able to make a few contributions to get the plan back to funded status, it will not be an increasing problem for them, market conditions aside.

Even with these payments, liquidity is not an issue as the company obtained a $600mm revolving credit facility as part of the spinoff. As a result, management does have some leeway to pursue acquisitions in areas that are not expected to get hit severely by future defense spending cuts.

Management ownership and compensation

As with all spinoffs, investigating management incentives post-spin can give clues as to how motivated the team will be to get the share price up. Executive Compensation is an extensive section of the form 10-12b filed here:

http://www.sec.gov/Archives/edgar/data/1524471/000095012311088751/y91928a5exv99w1.htm

We are admittedly not highly versed in examining management compensation with spinoffs to gauge how well the anticipated Exelis system stacks up versus others. From the surface, however, it looks to be satisfactory from a shareholder’s perspective. For instance, Exelis expects to keep the old ITT policy that executive officers are required to hold multiples of annual base salary in stock (5x for the CEO, 3x for the CFO, 2x for SVPs, 1x for VPs).

Further, we like to see that annual incentive compensation have not been based just on revenues (20%), but Free Cash Flow (20%), ROIC (20%), and EPS (40%). For CEO Dave Belcher, that total can equal his entire base salary for the year. On top of that, the long term incentives he can achieve will be entirely equity-based, and can be up to 4x his annual salary. All of the NEOs were awarded founder’s grants of 1.5x their target long-term incentive potential (or 2x-6x base salary), of which half is in restricted stock that cliff vests in three years, and the other half is in options which vest ratably over those three years. CEO Dave Melcher’s agreement can be seen in the 8-K filed on October 20^th here:

http://www.sec.gov/Archives/edgar/data/1524471/000095012311090990/a93147exv10w1.htm

Valuation

184mm shares outstanding x $9.87 = market cap of $1.82B

+ Net debt of roughly $690mm

+ Non-recoverable pension liability of $435mm

= EV of $2.9B

2011 EBITDA (of which 4Q is an estimate) = $710mm

EV/EBITDA = 4.1

Below is a comparison of XLS’ valuation to a selection of peers, using one sell-side group’s estimates. At least 0.6 turn on our different 2011 EV/EBITDA number for XLS is due to the pension; if we tack that on to the 2013 number to say it’s 4.5, and XLS is merely able to get to the average of its group, the additional 1.3 turns would result in over a 50% move for the stock):

While the numbers here do not imply the sort of home run potential that we have seen in other names we have posted here, we think at the current valuation this is a safe bet on a solid return-generating business and investors can get paid while waiting to see what tricks management has up its sleeve to make this ugly duckling fly.

Risks

• Defense spending is cut far more drastically than the few-percent-a-year currently postulated by analysts
• 20% of services revenue is up for re-bid next year; always the risk they get underbid in what is becoming a highly price-competitive segment