Exelis (XLS): an out-of-favor child
Exelis is one of three companies born out of ITT’s breakup. The breakup, structured as a spin-off of two companies, Xylem (XYL) and Exelis (XLS), was announced in the 1st Quarter of 2011 and consummated this past October 31. Exelis comprises all of ITT’s former Defense & Information Solutions business segment. The Form 10 provides all the background information you need, so I won’t repeat it here. Andrew at the Frog’s Kiss did a nice analysis of the company in September, i.e. pre-spin. Let’s start there. With our 20/20 hindsight it’s interesting to look at his valuation of the company vs. where Mr. Market is currently valuing it. He came up with a valuation of $2.5 to $3.5 billion. The market cap today is around $1.7 billion at a share price of $9.25. Hmmm..Looks interesting, so let’s dig in a bit deeper.
Exelis is a relatively small player in the defense sector. Below is a table showing some of the major players with respective market capitalization, revenue, P/E, dividend yield and ROIC. Defense stocks are, in general, depressed right now as it is widely anticipated that defense spending in the US will decrease over the next several years due to the troop withdrawals from Iraq and Afghanistan as well as the general pressure for budget cuts due to the federal deficit. This has resulted in below market P/Es for most major defense contractors despite attractive dividend payouts.
Table 1. Largest Defense Companies
Looking at the other major defense contractors it appears that Excelis’ valuation metrics compare favorably. The company earned $262 million (or $1.42 a share) in the first 9 months of 2011. Extrapolating for the full year 2011, one might expect earnings of about $1.90 a share. At the current share price of $9.00 Exelis now trades at just under 5x projected 2011 earnings, considerably below the P/Es of the other defense companies in the table above. However, this year’s projected earnings are 19% below last year’s pro forma $2.32 per share, and the decline in earnings could potentially continue. Not only, as I noted above, is overall defense spending projected to decrease in the coming years but Exelis’ margins are contracting. By its own admission, the company is undergoing a transformation, with high margin project work being replaced by lower margin service work. This margin contraction is the reasons for the lower 2011 income despite a year-to-date increase of 2.5% in revenues. The question is how much longer will the transformation continue and how much more will margins contract? Service revenue already made up over 50% of total revenue during the first 9 months of 2011, so the contraction, in my very unknowledgeable opinion, shouldn’t continue too much longer. And there may even be a surprise or two on the upside.
Even with the bleak defense spending picture and Exelis’ margin contraction the company still, to my mind, appears undervalued relative to the other defense companies. Why? My first thought is that it is the result of a temporary distortion due to the spinoff (or is it hopeful thinking). Potential reasons are:
- Shareholders were attracted to ITT because of its water and industrial pump businesses not because of it’s defense business, so shareholders are dumping the defense ‘child’ after the spinoff
- The share price of Exelis is under $10, making it an unattractive institutional stock,
- Defense stocks are generally unpopular right now and XLS hasn’t yet developed an institutional following,
- We are in the year-end ‘window-dressing’ period and the above factors are therefore magnified.
I took a look at the relative volume of trading in the three spin-off company stocks to see whether it might offer some evidence to corroborate my theory, or at least, to see whether it was consistent. Indeed, the volume of XLS shares traded since the spin-off (Oct. 31) has been about 2x the volume in XYL shares. Likewise, volume of XLS shares traded during the when-issued period (Oct. 13-31) was also about twice XYL share volume. However, volume of ITT shares after the spin-off has been running at about 80% of XLS volume despite the 1:2 reverse stock split. My interpretation: XYL is the company most former ITT shareholders are comfortable holding. A number of investors think there is gold in the hodgepodge left at ITT after the spin-off (the share price has been bid up almost 20%), and most pre-spin ITT holders are getting rid of their XLS shares (down over 10% since the spin-off); total volume of shares traded since Oct 13 is about 2/3 of all shares outstanding. I assume that volume of all ITT ‘children’ stocks has been temporarily bloated due to arbitrage trading (for example, long pre-spin ITT shares while shorting XLS and XYL to create an equivalent of the post-spin ITT shares, or shorting XLS and ITT-wi to create a pure play XYL share price) but I still think the higher volume of XLS is indicative of share dumping for the reasons outline above. Furthermore, the selling feeds on itself; window dressing pushes institutional managers to sell those shares (of the three ITT children) which have declined the most, that is, XLS.
So does that mean I think XLS shares are a buy at current levels? Well, I don’t think the shares are overvalued, that’s for sure. But to answer the question I think you need to do more homework (and fast if you think the share price is temporarily depressed). Is the margin problem containable? What happens if defense spending really falls off a cliff? And my biggest bugaboo when it comes to large companies: are managements interests closely enough tied to shareholder interests? On this last point I think the jury is still out; from the form 10 we do see that there are guidelines for Board member share ownership (5x annual compensation), and management did receive ‘founders grant’ shares worth several times annual compensation as well as participation in a long-term incentive plan with restricted stock and options. However, as might be expected in a large company, management ownership is not as great as I would hope.
I’ve added a few shares at this level, but you should do your homework before investing. And if you should have any thoughts or insights about Exelis by all means let me and the other readers know!