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Exelis (XLS): an out-of-favor child

December 8, 2011

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

Dividend ROCI (%)
Tick Name Rev (bil) MarCap(bil) PE-Ratio Yield(%) Payout(%) LY 5Y-Avg
HON Honeywell Int. $36.3 $42.2 14.1 2.8 47 12.3 15.8
LMT Lockheed Mart $47.1 $25.2 9.3 5.1 33 33.5 29.6
GD General Dyn. $32.1 $23.5 9.4 2.8 24 16.7 16.1
RTN Raytheon $25.3 $15.8 9.2 3.8 23 14.1 14.2
NOC Northrop $28.5 $15.0 8.5 3.5 27 11.7 6.3
COL Rockwell Coll. $4.8 $8.3 13.5 1.7 24 30.9 32.8
LLL L-3 Comm. $15.4 $6.7 7.6 2.7 19 8.9 7.8
TXT Textron $11.1 $5.2 18.3 0.4 29 1 3.7
FLIR Flir Systems $1.6 $4.1 20 0.9 0 16.3 17.5
XLS Exelis $5.8 $1.7 4.9 4.4 22

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:

  1. 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
  2. The share price of Exelis is under $10, making it an unattractive institutional stock,
  3. Defense stocks are generally unpopular right now and XLS hasn’t yet developed an institutional following,
  4. 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!

From → Positions Closed

  1. kevin permalink

    fyi – xylem ticker is XYL, not XLM.

    • Thanks Kevin, made that change. Glad somebody’s checking up on me.

  2. Payments toward the unfunded pension liability + the dividend will consume FCF for the next 3 years or so, this accounts for much of the discount. Otherwise you could argue for a premium – being a prime takeout candidate (post Nov, ’13), excellent technologies, etc.

  3. El Flaneur permalink


    How does it follow that the dividend on the common is the cause of what looks like a low valuation?

    The definition of free cash flow that would be relevant to an investor is:

    free cash flow = dividends on common + buybacks

    Of course the usual definition is cash frow from operations less capital maintenance expenditures. Dividends on preferred, but not on common, are sometimes counted against free cash flow.

    If anything the dividend on the common should provide a floor or act as a mitigating factor against an excessively low valuation. After all the classic model for calculating the value of an investment is to discount the future estimated cash flows to get their present value. Dividends are not a cost or expense.

    I believe the funded status of the plan will depend on the return on plan assets. No one has visibility as to what the market returns will be over the next three years.

    I’m no pension accounting expert, so feel free to elighten me, but wouldn’t the cash effects of any funding YTD, be reflected in the 9/30 (9 months ending) free cash flow which I have at 1.55 per share, diluted. Based on the current market price, that’s an 18% free cash flow yield. I guess I’ll have to check out the filing disclosures regarding pension commitments.

    • See the investor day presentation. I’m merely stating that after funding the pension (in line with mgmt comments) and paying the expected dividend (while not an obligation to shareholders, mgmt knows the company’s relative valuation is at least partially based on its yield relative to peers and will not likely cut it) there is no capital left for growth, share repurchaes or to raise the dividend. This puts it at a disadvantage relative to defense peers, and other companies in general. The unfunded pension liability can be viewed as debt. Instead of using a P/E analysis use EV/EBIT with the pension factored in.

  4. El Flaneur permalink

    Management assertions from the investor day presentation:

    -“Strong cash generation to complement well capitalized balance sheet” pg. 6

    -“Stron cash flow available for incremental growth and return to shareholders.” pg. 67

    I think the above blog post nailed the key unknown and problem which is how much of the business will continue to transition to lower margin services and products, along with how much will the business be impacted by further cuts in defense responding. I think that’s what’s driving the current market valuation, along with poor current year versus prior year results, maybe that more than anything else.

    Regarding margins, I have gross margins at 9/30 for XLS at 20.6%, and 18% for LMT, and 10.7% for GD. So it appears XLS is generating better gross margins, at least for right now, compared to LMT and GD, its chief competitors. Its operating margins are being impacted in part by retirement expense, but will that be a long term problem?

    Regarding defense cut backs. I’m using a real back of envelope analysis here, but even if the defense budget is slashed by a drastic and unlikely $385B (43% from current budget of $685B) and if XLS earnings are commensurately affected it would still be cheap at around 6.5x earnings. 2010 earnings at 2.32 x 56.2%=1.3 $8.57/1.3 equals a PE of 6.58.

    Regarding EV/EBITDA, I calculated 7.7 for XLS, 12.4 for LMT and 11.8 for GD. So there appears to be some MOS on the basis of EV/EBITDA. Are you coming up with different numbers?

    With respect to cash flow and the impact of pension funding, according to the 9/30 10Q XLS contributed $33M for the nine months and still posted free cash flow of $288M. Based on the investor day presentation it expects to contribute $200M to $300M annually (pg.65). Annualizing the $288M to $384M and deducting an additional $217M (to get to $250M for the year) for pension funding results in $167M free cash flow. Deducting $74M for dividends leaves $93 million of cash lying around for management to get into trouble with.

    Regarding cash needs for growth, has management not been spending cash to grow the business for nine months of the year through 9/30? That doesn’t make sense to me. R&D and cap ex spending YOY look relatively stable. Also how capital intensive is it to win government contracts? Isn’t it mainly writing proposals? I think the 9/30 cash flow numbers reflect cash used for organic growth – which admittedly right now is not resulting in any actual growth. So the projected $93 million is above and beyond the normal cash required to sustain and grow the business and fund the dividend. As stated in the form 10 they will no longer have to compete with other the ITT businesses for cash so management will have more leeway in deploying cash where it sees fit.

    Anyways, this has been a healthy exchange since I have a better understanding of the numbers now. I intend to read the investor day presentation in more detail to try to ge a better feel for the future prospects of the business. I took an initial small position in the stock yesterday, to focus my mind, more than anything else. I need to do more homework before I decide whether to purchase any more.

  5. “I think the above blog post nailed the key unknown and problem which is how much of the business will continue to transition to lower margin services and products, along with how much will the business be impacted by further cuts in defense responding. I think that’s what’s driving the current market valuation, along with poor current year versus prior year results, maybe that more than anything else.”

    But all defense co’s are experiencing these problems. We’re trying to figure out what is causing XLS to underperform and trade at a lower multiple than its peers.

    I am expecting just ~$300M in FCF per year for the next few years. Maybe I’m wrong, and for the record I’m not saying the stock isn’t cheap even then, as I wouldn’t call $300M a normalized estimate. 🙂

    Are you adding the ~$2B unfunded pension liability to your EV?

    • El Flaneur permalink


      You make a good point about relative performance. I’m still very ambivalent about this stock and in no way sold on XLS. I’m still evaluating it before deciding whether to materially enlarge my position. The trend in margins is certainly disturbing. Maybe the trend is worse than its peer group and that accounts for the underperformance. I know Wall Street hates low declining margins.

      As noted in the blog post part of the underperformance may be due to the stock price trading under $10, and because it was sold indiscriminately by S&P500 based funds/etfs that could not hold it. Sure it was probably picked up by midcap funds but I would bet the supply created by the S&P500 sellers was greater than the demand created by midcap funds buying.

      I used the 6/30/11 pro forma balance sheet from the last amended form 10 to calculate EV/EBITDA. I just added all liabilities to the market price, which did include the pension liability. However, that was before I learned about some revaluation of the pension liability of $661 million, from an ITT 10/28 press release. If I add the 661M I get 8.74. Also I was only looking at immediate cash flow in the next year or two and didn’t factor in the future debt repayments. The 9% used as the estimated return on the plan assets seems overly aggressive. So that might be another negative, unless the market is accommodative over the next few years.

      However, the company will not be a takeover candidate any time soon so I don’t know why EV/EBITDA informs the investment decision any more than plain old PE. Admittedly, I’m not that conversant in EV/EBITDA.

      The thing is, if it was not underperforming, then it would not be potentially bargain priced, in which case I would not be interested in it, unless some other golden investment opportunity was evident. Part of my thinking about this stock, is that a management that is now directly accountable to the market, is properly incentivized (to be determined) and that has greater control of how to allocate capital will lead to good things happening.

      Also, while cuts in defense spending are certainly inevitable, to my thinking defense spending is one of the more protected areas of federal expenditures. Democrats don’t want to appear too dovish with drastic cuts and defense spending is the one way republicans can exercise their inner Keynesians without being labeled socialists. With China having recently launched its first aircraft carrier it’s not like they can take a hack saw to the budget.

      BTW, I just thought of this. What would the other side of the balance sheet entry be resulting from the 661M revaluation of the pension liability? I’m assuming that comes out of equity. If that’s the case then I’ve got book value nearly halved to $581M. Not good. Pro forma equity per the 6/30 form 10 was 1.242M. 1.242-.661=.581. That results in a MC/BV multiple of 2.7. Or was the revaluation contemplated in the last form 10 amendment? This is not clear to me. I’ll try emailing investor relations to get clarification on this.

      Link to press release regarding revaluation of pension liability.

      • El Flaneur permalink

        Well I’ve concluded that the $661M pension re-measurement was not reflected in the 6/30/11 pro forma numbers since it was re-measured as of 9/30/11. I’ve also concluded that it will be offset through accumulated other comprehensive loss and therefore against equity (see elimination entry f on pg 53 of the form 10). As a result book value is about half of what one may have initially calculated from the 6/30/11 pro forma numbers. The 10Q 9/30/11 is practically useless since it is just the segment balance sheet and doesn’t show the transfer of the ~$2B pension liability or the elimination of the parent company investment. This is not as bargain priced, at least on the basis of book value, as I initially thought. I was thinking I had a hybrid Graham/Greenblatt trade here, but it’s not looking like that.

  6. Jake permalink

    RE: Insider ownership and “On this last point I think the jury is still out”

    Isn’t the idea of executive ownership that the people in charge stand to make a lot of money if the share price increases (ie our interests are aligned)? It sounds like with founders grants and bonuses in stock that well exceed compensation that it would be the case here.
    What does total ownership % have to do with it? In cases where individuals own a large % of shares, they are typically fantastically wealthy and may not care as much. Or are too entrenched and wont necessarily pursue regular shareholder friendly proposals (ex. Jerry Yang). I would say that is not the norm for public companies of reasonable sizes.

    • Jake

      Thanks for your comment. In some ways you’re right, but what is really important is how much of their personal wealth managers have tied up in the company. Even a $2 million restricted stock grant can pale in importance to a $2 million annual salary, i.e. the $2 million annuity is much more valuable than the $2 million stock grant. We, as shareholders, want the stock (or option) grant to be more important than the annuity. I like to see ‘hungry’ management. Management that accepts a low salary with a large amount of options and stock grants. To me this better aligns their interests with mine. Of course if management is filthy rich (outside of their ownership in the company they are managing) then, you’re right, you can’t count on money to motivate them.

      So, it’s not the actual % insider ownership that counts. I was just using a bit of mental shorthand to imply that when management has a large ownership interest in the company (here I stretched the definition of to become high % of insider ownership) they usually have a large amount of their wealth tied to the outcome at that company. As you said, it’s not always true, some shareholders (your example of Jerry Yang) are so filthy rich that no matter how badly they company is managed they’ll never run out of money. In most cases, however,the key issue, what percent of management’s net worth is tied to the company’s future performance, is often hard to find out.


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