In February, I wrote a post on the conglomerate ITT Corp. (NYSE:ITT) and its spin-off plan into three separate companies, Defense, Water, and Industrial Products. The market loved the announcement, sending shares of the company from $51 to a high of $64. When I wrote about ITT I felt that because of the run-up it didn't quite offer the margin of safety I was looking for.
On October 17, the spin-off will be complete. For each share of ITT, investors will receive one share of Defense and one share of Water. Additionally, the remaining ITT shares will be reverse split on 1:2 basis. The Defense business will be called Exelis, Water will go by Xylem, and the industrial products division will creatively be christened ITT. Since the initial announcement, the company has performed well, growing revenue and profits despite the uncertain economic environment and the certain distraction the corporate restructuring causes. The market on the other hand has traded its excitement for the gloomy outlook and valuation of other companies, sending shares into the low $40s and giving investors an opportunity to get 3 very good companies with a margin of safety. Value investors like Michael Price are also interested in the company.
Due to the company's restructuring and shifting of assets, liabilities, and revenue between the three new companies, some of the top line numbers in my original valuation have changed. For example, management now projects Exelis to have about $200M less in revenue, while Xylem will add around $150M versus my February estimates. While the numbers may have changed, what is important is that ITT currently sells for $8B in market cap and the three new businesses are worth more than that.
Exelis will suffer from US defense spending cuts. Other defense contractors have seen their share prices drop significantly due to these concerns. Though we are certain to see cuts from drawdowns in Iraq and Afghanistan, I am skeptical of the alleged demise of the military-industrial complex, and defense may have even benefited from the recent debt deal. Either way, Exelis isn't tied to any huge, legacy program. Their core products are communications and GPS technologies, which will still be needed even with major cuts in the Pentagon budget. The company has a strong history of returns, a good balance sheet, and low capital intensity. Margins will drop as the demand declines and the product mix shifts to more maintenance and service contracts. Management forecasts long-term operating margins at 11% versus the current 11.5%. Even if margins drop further, in line with the larger defense contractors at around 8%, Exelis should still be able to average at least $360M in free cash flow over the next five years. Based on that, I valued Exelis between $3B-$4B, or $16-$21 per share, using a discounted cash flow model under various declining revenue scenarios. Historical acquisition activity in the defense industry also justifies the valuation.
Xylem (XYL), the water business, provides water transportation (think pumps, not trucks), testing, and treatment products. Xylem has the potential to be a great business. The products are crucial, relatively inexpensive parts of much larger systems. For example, once a pump is installed in a municipal water system, it is unlikely the water utility will replace the pump with a competitor's, requiring reconfiguration of other parts. Having these types of products allows Xylem to obtain maintenance and parts contracts, something its large, global distribution network is setup perfectly for. Rising urban populations require updated water infrastructure, so even in a slow economic environment, the industry has the wind at its back. Xylem is expecting organic revenue growth in the mid single digits and low double digit growth after acquisitions. Xylem enters the spinoff with $1B in net debt but with 2010 free cash flow of $300M, a manageable amount. Using conservative estimates, my valuation of Xylem comes to around $5B, or around $27 per share.
At its recent $43 share price, the pre-spin-off conglomerate is trading for about the value of Exelis and Xylem, giving no value to the remaining industrial products company. In fact, the new ITT has generated return on assets of 10-12% and operating margins around 12% over the last 5 years. Making a variety of industrial pumps, valves, shocks, and control devices for just about every major industry, ITT will benefit from an economic rebound (60% of the company is tied to early and mid-cycle economic activity). The new ITT will also have a pristine balance sheet with around $675M in net cash. I feel comfortable in saying that the new ITT is worth more than zero, thus justifying an investment in the pre-spin-off company. Using normalized earnings and previous M&A valuations, I peg the new ITT's worth between $2B and $3B or $11-$16 per share ($22-$32 after the reverse split).
A weakening global economy will hurt all three of the new companies. Defense budgets will likely be cut, water infrastructure projects may be delayed, and overall industrial activity could slow. Because of these fears, an investor can now buy the water and defense business and get the industrial products company for free. All three of the companies boast good balance sheets, global capabilities, and competitive advantages to survive another slowdown. Once the economy turns around, these companies should trade for a lot more than the current quote.
Disclosure: I am long ITT.