On October 31, 2011, ITT Corporation (NYSE:ITT) will complete a spinoff that will separate the conglomerate into three standalone businesses – a defense company known as Exelis (NYSE:XLS), a water company known as Xylem (NYSE:XYL), and “new ITT," an engineering company involved in aerospace, transportation, energy, and industrial applications. The spinoff will be “one-for-one” and then new ITT will undergo a one-for-two reverse split. For example, if you held ten shares of old ITT, you will end up with 10 shares of Exelis, 10 of Xylem, and 5 of new ITT.
Spinoffs can be beneficial to shareholders for many reasons. The stock prices of conglomerate businesses are often held down by a “conglomerate discount” which suppresses the P/E ratio. Trading as separate companies can allow the market to evaluate a spun-off business on its own merits, and in many cases will lead to increased P/Es over time.
Management can also become better incentivized and more focused. In the case of the old conglomerate, excellent performance by the water division, for example, could be overshadowed by poor performance by the defense division. Even though the water managers had created value for shareholders, their conglomerate stock options would not increase in value and they would not be rewarded. Operating as a separate company, management decisions that create value are more clearly reflected in the stock price, aligning management incentives with shareholder interests. Academic studies have supported this theory – in an article published in 1993 in an issue of The Journal of Financial Economics, Patrick Cusatis, James Miles and J. Randall Woolridge found that parent companies and spinoffs beat the S&P 500 by an average of 18% and 30% respectively during the first three years after the spinoff.
For those of us who are not yet shareholders of the company, spinoffs may also create a built-in advantage. The following can be found in the form 10 (pdf) for both Exelis and Xylem, and it is really boilerplate language that you will find in any form 10, but it is so important that it bears repeating:
The shares of our common stock that ITT distributes to its shareholders generally may be sold immediately in the public market. It is possible that some ITT shareholders, which could include some of our larger shareholders, will sell our common stock received in the distribution if, for reasons such as our business profile or market capitalization as an independent company, we do not fit their investment objectives, or — in the case of index funds — we are not a participant in the index in which they are investing. The sales of significant amounts of our common stock or the perception in the market that this will occur may reduce the market price of our common stock.
Pay close attention to what that is saying. Some of the largest shareholders of Xylem and Exelis will sell their stock almost immediately upon receipt, not because of anything to do with their expectations of the future profitability of the business, but simply because the new business doesn’t fit their specific investment mandate. This can give us a chance to buy into the business at a bargain price. This potential bargain price, coupled with the fact that spinoffs have been shown to outperform the market historically, should make us want to look closer at each of these companies.
Xylem designs, manufactures, and services products for the water treatment industry. Its products can be found in over 150 countries. According to the form 10, 2010 revenue totaled approximately $3.2B, with 65% of revenues coming from outside the US (18% from emerging markets). It is likely to benefit from strong future demand for their products - the rising middle class in emerging markets will be able to afford and will demand treated water, and decreased availability of water in some areas due to the changing global climate will require more treatment-intensive solutions.
Xylem also benefits from its already large installed base of products. 16% of 2010 revenues came from repairs. The company finds that customers prefer to replace any worn or damaged products with the exact same part from Xylem, because it is often part of a larger system and that is the only way customers can be assured that part will work. This can be thought of as a “switching cost” and I believe provides Xylem with at least a narrow moat and moderate pricing power.
As a part of the spinoff, Xylem issued $1.2B in notes. $310M was spent on the acquisition of YSI, a water analytics company, and $817M was transferred to ITT (benefit to ITT to be sure). A parent loading spun-off companies with debt is not uncommon, and in the case of Xylem, with its strong growth prospects and adequate free cash flow of $301M in 2010, I do not view the debt as problematic.
Xylem’s major competitors include Gorman–Rupp (NYSEMKT:GRC), IDEX Corporation (NYSE:IEX), Danaher, and Pall Corp. (NYSE:PLL), which, according to Yahoo Finance, currently sport P/E ratios of 19, 16, 17, and 19 respectively (average of 17.75). Xylem’s when-issued shares are currently trading at 25.82. 2010 earnings of $1.78 per share give it a P/E ratio of 14.5. For the market to simply bring Xylem’s P/E ratio in line with the average of its peers, the stock price would have to increase 22%. Should the type of selling I outlined above take place in the first few months of trading, you may be able to purchase the stock at an even greater discount, and that is the opportunity that I will be looking for.
Exelis is a leading manufacturer of Command, Control, Communications, Computers, Intelligence, Surveillance, and Reconnaissance (C4ISR) related products. It also provides systems, information, and technical services. Its main clients are governments and militaries. According to the form 10, 2010 revenue was $5.8B, 73% of which came from the United States government.
Defense companies in the US are facing headwinds due to the threat of future budget cuts. The winding down of the war in the Arabian Gulf will also lessen the demand for Exelis’ products. Operating margins in 2010 were 11.7%; for the first 6 months of 2011, margins declined to 8.3%. This is due to a shift in business from relatively high margin products used in battle, to lower margin services. Management stated in the form 10 that they expect the 2011 margins will be the norm going forward.
Similar to Xylem, Exelis issued $650M in debt. It will make a $701M payment to ITT, which will leave it with $200M in cash and $890M in debt. I also do not view this debt as immediately problematic, but coupled with the dismal business outlook, it does not make the company look particularly appealing.
Exelis competes against Lockheed Martin (NYSE:LMT), Raytheon (NYSE:RTN), General Dynamics (NYSE:GD), Northrop Grumman (NYSE:NOC), and Level 3 Communications (NYSE:LVLT). Excluding Level 3, which lost money last year, the average P/E ratio, according to Yahoo Finance, of the group is 8.5. Exelis earned $2.32 per share in 2010, and the current when-issued price of $10.92 puts the P/E at 4.7. I expect earnings to fall closer to $1.75 per share in the future, but that still implies a P/E ratio of 6.25. Of all the three companies involved in this transaction, I would say that Exelis is the most likely to be sold indiscriminately. If the price falls much below $10 per share, the stock could be a bargain, even with the difficult environment ahead of it.
Last but not least, the new ITT will be coming out of this deal with $600M in cash and zero debt. Don’t forget that parent companies have been shown to outperform after spinoffs as well. New ITT will focus on highly engineered industrial products, and management has stated that it will target EPS growth of 10-15%. If it can achieve even the low end of this range, and the stock trades cheaply enough, it could make for a compelling investment opportunity as well.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.