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Like many value-oriented investors, I am a contrarian at heart. When I see a security fall off a cliff I'm immediately interested, and frankly, sometimes to my own detriment. On the whole though, sifting through the rubble of these crushed interests has yielded profitable results over time. On a fairly continuous basis entire industries are temporarily out of favor and their membership can be found strewn at the bottom right of your stock charts. We can all name a few - for profit education comes to mind presently, as well as the defense contracting industry. The latter peaked my interest recently when I noted Lockheed Martin Corporation (NYSE:LMT) trading at a single digit P/E and yielding 4.5%+. Though LMT continues to look cheap and is a high quality company, the hours spent trolling through defense industry data led me to an even better investment. What could be better than a cheap, high quality company in an out of favor industry you ask? I answer - a cheap, high quality recent spin-off in an out of favor industry. The combination of the (possible) misperception of a beaten down industry with the mispricing so prevalent in spin-offs has created an attractive investment candidate in Exelis Inc. (NYSE:XLS). To keep readers interested in the fine print which follows - I expect XLS should produce a better than 22% compound annual return over the next two years. My estimate of fair value is between $17 and $20 per share compared with a recent price of $11.38 per share.

The Business: XLS was spun off from diversified manufacturer ITT Corp. (NYSE:ITT) in Q4 2011. XLS is a mid-sized player in the industry at a market cap slightly over 2.1 Billion. Its business is currently split nearly half and half between services and manufactured products with the latter bringing in the higher margins. As the Department of Defense budget is reduced in the near term years XLS expects, and has already begun to see, its revenue mix move toward a greater emphasis on lower-margin services versus hardware. Its business segments are Electronic Systems, Geospatial Systems, Information Systems, and Mission Systems. XLS has an impressively diverse array of products and services as well as a wide ranging customer base - though admittedly a majority of revenue is still derived from various corners of the U.S. government. Per the 2011 investor day presentation, approximately 11% of XLS revenue in 2010 was generated by international customers and the international segment has grown at a 20% compound growth rate since 2008. Even so, revenue and margins will inevitably fall in the near term due to USG budget cuts. The primary question becomes, is XLS too cheap even with this moderately negative near term outlook.

Management: CEO David Melcher is a retired United States Army three star General. He joined Exelis ITT in 2008 and was a key driver behind the successful cost cutting program implemented in that year. Melcher prepared the company for its separation from ITT Corp. in October 2011 and was subsequently appointed CEO of the newly independent XLS. During his time as a General officer Melcher served in the Pentagon as the Army's Military Deputy for Budget and Deputy Chief of Staff for Programs. These roles undoubtedly resulted in a rolodex full of contacts useful to XLS. Further, Melcher earned an MBA from Harvard Business School and holds a Bachelor's degree in civil engineering from the United States Military Academy at West Point. He appears to be well qualified to lead XLS. A review of other key leadership positions produced an array of similarly impressive resumes and experience.

Valuation: First let's see if XLS is cheap by the numbers compared to General Dynamics Corporation (NYSE:GD), LMT, and Science Applications International Corporation (SAI).

XLS

GD

LMT

SAIC

Avg of Peers

Notes

Enterprise Value

2.69B

27.30B

31.24B

4.54B

EV data from Yahoo Finance

EV/EBITDA TTM

3.69

6.01

6.54

5.92

6.16

3.90B equity value = 86% equity upside

EV/Op. Income TTM

5.03

7.12

7.72

7.06

7.31

3.22B equity value = 58% equity upside

P/E TTM

5.72

10.66

11.31

8.06

10.01

Avg multiple = 75% equity upside

P/E Forward

6.22

9.49

10.39

8.69

9.52

Avg multiple = 53% equity upside

Debt/Equity TTM

32.8%

15%

22.8%

44%

27.3%

Reversion to mean = 20% equity upside

Div. Yield

3.6%

2.6%

4.5%

0

2.4%

Reversion to mean = 50% equity upside

Notes: XLS statistics from the latest quarterly press release on 2 March 2012. XLS items use adjusted earnings which exclude one time costs associated with the spin-off from ITT Corp.

It is extremely cheap in absolute terms. At 5.72 times trailing earnings, and 5 times operating income, it is being priced as if its earnings are soon to fall off a cliff. But wait. Didn't the entire industry price in a near term drastic cut in earnings? As we can see, on every metric above XLS is cheap even relative to primary competitors, which are themselves rather cheap with an average P/E of 10 times trailing earnings, and 9.5 times forward earnings. Assuming the industry should be discounted to current levels, XLS is priced even more cheaply, by a wide margin.

So. XLS is cheap, but is it undervalued? Is there reason that it should be trading at a valuation of a third (or more) less than competitors on almost every metric? As noted above, the business lines are diverse, as is the customer base. Operating margins have fallen but are expected to rise by 60 to 80 basis points in 2012 and stabilize for the foreseeable future. Given the diversified revenue streams, why might XLS deserve a further compressed multiple versus the industry? Let's take a look at some metrics for the efficiency and business health of XLS.

XLS

GD

LMT

SAIC

Avg

Notes

Lowest Analyst Estimate of Long Term Growth Rate

N/A

5.0%

4.5%

10%

6.5%

I found no estimates of long term growth for XLS but may not have access to all data.

ROE (cont. ops)

37%

19%

96%

12%

42%

Avg not meaningful as LMT skews the result

Operating Margin

10%

12.1%

8.1%

6.1%

8.8%

XLS entry represents "adjusted", reported is 9.2%

Backlog/Rev. TTM

2.02

1.76

1.74

2.31

1.94


Notes: Above margin data for competitors GD, LMT, and SAIC from Yahoo Finance. Backlog data from SEC filings for GD, LMT, and SAIC. ROE data calculated using income from continuing operations.

From this sample of data points, XLS appears to have strong Return on Equity, above average Operating Margin, and above average backlog when represented as years of revenue. XLS appears to be at least average when compared to peers and probably can be expected to grow at a moderate rate in the medium to long run based on the competitor average low end analyst estimate growth rate of 6.5%. What could we be missing?

Perhaps the business is less robust, and more sensitive to industry shifts than is apparent. Let's take a look at the effect on Operating Income should revenues fall and the product mix become more unfavorable than management anticipates. We will use the historical segment operating margins of 15.6% for products and 5.5% for services and management guidance of 5.5Billion for 2012 revenues as the baseline. For reference, products were 48% of TTM Revenue while Services were 52% of TTM Revenue.

Case

Revenue

Services Mix

Hardware Mix

Operating Income

Operating Margin

Equity Valuation at Average Peer Multiple

Best

10% above

55%

45%

608mm

10%

3.85B equity value = 83.5% upside

Base

5.5B

65%

35%

497mm

9%

3.04B equity value = 44.9% upside

Bad

10% below

75%

25%

397mm

8%

2.31B equity value = 10.2% upside

Based on this fairly simple analysis, we can see that even in the worst case - with revenues 10% below management estimates, product mix worse than management estimates, and therefore operating margin 20% below management estimates, the equity of XLS is still undervalued by 10% when compared to the competitor average multiple. At the baseline case, which is still below management estimates for product mix, the equity is undervalued by approximately 45% compared to the competitor average multiple. The best case nearly doubles this valuation gap.

Expected Value Analysis: As a rule I always incorporate a zero case in each EVA analysis. For XLS I assigned a 2% probability of the equity falling to zero. Let's use the worst case in the above table, which translates to forward earnings of roughly $1.50, and assign a 38% probability. We will also assume a dividend cut of 50% for this case. The midpoint of management guidance is $1.83 but we will use our base case above, which translates to earnings of about $1.68, to be conservative. As the most likely case, a 40% probability should do. Our best case above brings us to around $2.05 EPS in 2012 and we're left with the remaining 20% to assign to this case. Using these rather conservative estimates and probabilities results in an expected value of $15.04, including dividends, or a 32.2% return from the recent price of $11.38. Using this method with conservative estimates leads to an expected value below fair market value, so I would expect an even higher return than EVA projects.

Risks/Variant View: The shift toward a less profitable product mix focused on lower margin services versus higher margin products is a valid concern and is likely to occur again in 2012 and probably 2013. Further, industry wide malaise due to U.S. government spending cuts will affect industry valuation multiples until uncertainty is alleviated. There is the possibility that the budget cuts, once finalized, will be more drastic than has been discounted by the market. Further, XLS has fairly diverse revenue streams but is still only a medium sized player in the market. Should its higher margin hardware business fall off more quickly than management anticipates XLS may experience a faster and more sustained fall in earnings than the market has discounted into the stock.

Potential Catalysts: There are a number of potential catalysts for XLS to reach fair value. Should Wall Street analysts begin following the stock in larger numbers pricing on the stock will likely become more efficient and accurate. I would expect this will happen within a few quarters. XLS just submitted its first annual report as an independent company and its financials will soon start populating databases used by investors - bringing a larger audience to the stock. Should the public receive greater certainty on the future DoD budget, industry stock pricing should rapidly reflect the newly revealed fundamentals. As is often the case, I expect the uncertainty discounted too steeply the future prospects for the industry. Any unexpected continuance or increase in higher margin hardware products vs lower margin service products should positively affect XLS specifically.

Bottom Line: XLS is undervalued based on current, and conservative expectations regarding future business. The majority of valid concerns are faced by the entire industry. I see no reason for the massive valuation gap between XLS and the industry averages except for the temporary effects of the spin-off from ITT Corp. Should the industry as a whole leave the penalty box and receive a multiple expansion, the undervaluation of XLS is only magnified. With no multiple expansion, an investment in XLS has a 32% expected return based on a one year timeframe and given conservative probability weightings for the range of investment outcomes. Should XLS actually trade at a fair value multiple, an investment in XLS should return 25+% on a compound basis over the next two years.

Source: Exelis: Sometimes A Good Defense Is The Investor's Best Offense