Sometimes, valuing spinoffs early in the process can be difficult due to lack of individual segment data. Fortunately, ITT broke down the key financial information for each business in previous financial statements. I will value each business in three different ways: by applying a multiple of 15x “Owner’s Earnings” (Net Income + Depreciation – Capital Expenditures), 10x EBIT, and a multiple based on similar publicly traded competitors. I chose 15x OE and 10x EBIT as a starting point for fair value because both would provide an initial 7% after-tax “yield” on investment. Of course, I look for a Margin of Safety, so my buy price would be much lower. I also used total value (in $B) instead of stock price, since we don’t know the number of shares that will be used for the new companies.
Defense Valuation ITT is usually lumped in with defense contractors because their Defense segment makes up about 60% of ITT’s revenue. The Defense business manufactures and distributes night vision goggles, communications systems, satellite imaging, and surveillance services. They also sell air traffic management systems and services to the FAA. Obviously, the US Government is the largest customer (70% of revenue) and with the economic downturn is a big reason ITT’s stock has recently underperformed. Despite rumblings of lower defense budgets, I’m skeptical of major cuts not only because of the wars in Iraq and Afghanistan, but rising tensions in the Middle East. Either way, ITT Defense seems to be in a sweet spot for a more focused, efficient military by providing essential, cutting-edge gear and services. ITT is projecting a slowdown with 2011 Pro Forma revenue of $5.8B, a 5% decline from 2009 levels.
The past 5 years of margins have been fairly consistent in all of ITT’s businesses, therefore they serve as a reasonable guide when evaluating a normalized level of earnings. Using the information from the 10-K, I applied the 5 year average for EBIT Margin and Owners’ Earnings Margin to the 2011 projected revenue to obtain a normalized 2011 EBIT of $676M, and Owners’ Earnings of $496M. Applying the 10x multiple to EBIT and 15x multiple to OE gives me values of $6.8B and $7.4B, respectively. To give me an indication of where the defense business would sell today as a standalone company, I compared the multiples of 5 year average EBIT for fellow defense contractors Raytheon (RTN), Northrup Grumman (NOC), Lockheed Martin (LMT), and General Dynamics (GD). Their average multiple on 5 year average EBIT was 8.66.
Applied to ITT, this equates to a value of $4.8B. A value range of $4.8B – $7.4B, indicates that the Defense segment would likely sell off if the spinoff occurred today. A valuation of $4.8B is an attractive price because it would imply an approximate Owners’ Earnings yield of 10% ($496M OE/$4.8B Mkt Cap).
Water ValuationThe Water business provides pumps, systems, parts, and services for transporting, testing, and treating water and wastewater for commercial, residential, and municipal customers. Over half of the revenues come from foreign markets, and the company will be the largest “pure-play” in a sector which many respected observers judge as the “next great investment theme”. ITT management thinks highly of this area too, as current CEO Steven Loranger will become Chairman of the new Water company and the current President of the Industrial Products division will become CEO. Evaluating the business based on the 2011 revenue projection of $3.6B (a 7% increase over 2009) gives us a value range of $4.3B to $6.7B, with the comparable company valuation being the high point. The interest in the water business is the primary reason for the recent run-up in share price as this division clearly has the strongest growth potential. In fact, there are already rumors that the new company will pursue an acquisition of Pall (PLL), one of the similar companies I used in this valuation (the others were ROP, GRC, IEX, and PNR).
“New ITT” ValuationThe “New ITT”, formerly the Motion and Flow segment, manufactures and distributes a variety of products for use in harsh industrial environments. Products include pumps and valves for oil and gas producers and miners, as well as shock absorbers and brake pads for aerospace and railcars. This division is the smallest part of ITT and the most cyclical. Over the last 5 years, revenue has grown 5% annually, but margins and returns have not been as consistent as the other segments. Using the pro forma revenue of $2.1B, the new ITT is valued around $2.6B, with comparable multiples of Eaton (ETN) and Crane (CR) coming in slightly lower at $2B. The relatively small size and cyclical business could lead to an early sell off of this relatively staid and boring company. With historically good cash flow, the new ITT could end up being a winner for a value investor willing to go bear some ups and downs.
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Looking at the combined companies today, a “sum of the parts” value for the operating businesses gives a range of $58-$89 per share, with a median value of $73. At its current price of around $60, the company appears slightly undervalued. There is some uncertainty as to how the relatively small debt and liabilities will be allocated amongst the new companies, however this shouldn’t have a major impact on the valuation, especially if purchased with an appropriate margin of safety. I won’t be a buyer of the combined company at the current price, but will keep an eye on it in the event of a market correction. I will also watch closely after the spin off for opportunities created by those who may indiscriminately sell these solid, cash flow generating businesses.