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Exelis Inc. (NYSE:XLS)
The Fund @ Sprott Equity Research
Buy, Current: $17.06, Target: $24.86 July 13, 2014
Reza Syed BCom. Candidate 2016 Finance and Accounting [email protected]
Equity Analyst
Peter Tewolde BCom. Candidate 2015 Finance, minor in Economics [email protected]
Sector Manager
Investment Thesis
5-Year Performance
Source: Bloomberg, Student Estimates
A Focus on Lean Operations and Restructuring Exelis has just completed the bulk of a $100 million restructuring plan involving headcount
reductions and downsizing, aimed at increasing business efficiency. Continued restructuring
efforts coupled with a Six Sigma program will deliver increasing margins through a reduction in
costs.
Expanding International Presence
Secure Long-Term Contracts
Revenue from international sources is on track to increase almost 20% by year-end 2014, with
smaller 3-4% gains forecasted over the next 5 years. This limits Exelis’s dependence on the U.S.
defense budget, and provides exposure to promising foreign markets in Europe and the Asia-
Pacific region.
Exelis has several long-term contracts that provide stable, predictable revenue streams. Over
periods of up to 25 years. A recent $1.8 billion contract with the FAA and an $845 million U.S.
Marine contract are examples.
Expected Spinoff of Mission Systems Segment This segment specifically was decided by management that it should be spun off into a separate
entity called Vectrus. Current shareholders would be given share in the new company as
announced in December of 2013. This transaction is subject to SEC approval and is expected to
be completed in the summer of 2014.
Less Reliance on US DoD Spending Exelis post-spin will have less reliance on the Department of Defense (DoD) spending. This is
very positive as given sequestration and the US governments intent on reducing their fiscal
deficit, this is a positive change in mitigating this risk.
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Company Overview Exelis incorporated (XLS) was created in 2011 as a result of the spinoff of ITT Corporation’s defense
department into and independent company. It is publically traded on the NYSE, has a market cap of
$3.2 billion, and had revenues of $4.8 billion in 2013. They are a diversified aerospace, defense, and
information and services company that offers solutions in their two business segments: C4ISR, and
IT Services. Revenues come primarily (80%) from various U.S. Government agencies, but a growing
portion (13%) is coming from international operations.
C4ISR This segment includes communications systems, electronic warfare systems, radar and sonar systems, space systems, imaging technology like night vision, and GPS technologies. This segment also real-time analytics, data encryption, and data modelling. Finally, this segment also produces subassemblies for military aircraft. Some key C4ISR products are:
Intelligence, Surveillance and Reconnaissance Systems ISR provides technology that can collect, process, and extract intelligence from satellite
images. Currently, Exelis provides all of the commercial high resolution space imagery in the United States.
Communications Solutions CS provides various radio-frequency systems. They produce SINCGARS, a type of military
tactical radio program that is the largest in the world, with more than 650,000 units in 35 countries.
Night Vision The night vision sub segment provides various night vision technologies for both ground
and air combat. Exelis is the largest producer of night vision products in the world. Aerostructures The aerostructures sub segment manufactures assemblies, subassemblies, and
components. They manufacture these for both commercial and military applications. Information and Technical Services This segment provides systems architecture and broad, agency wide applications of information technology. This includes cyber defense strategies and engineering systems support. They also provide civil and aerospace solutions, primarily air traffic control. One key IT services product is:
Civil and Aerospace Systems This sub segment provides air traffic control navigation, communication, and radar
technology. This sub segment works with the FAA and NASA, providing radio communication systems and networks.
Figure 1: Revenue by Product Segment Figure 2: Revenue by Geographic Region
Source: Bloomberg, Student Estimates Source: Bloomberg, Student Estimates
0
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United States International
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Macro Outlook In December of 2013 the US Congress passed the Bipartisan Budget Act which increased discretionary spending for 2014 and 2015 to help ease the effects of sequestration. This has a direct impact on US defense firms like Exelis, which will likely see increased contract orders in the near term. This should also help lift the industries earnings outlook for 2014 and 2015. The sequestration cuts are directly related to The Budget Control Act of 2011, as the bill looks to reduce discretionary spending by $539 billion from 2016 to 2021. The issue with these cuts and the timing and scale required to reach these targets is still being debated. The Bipartisan Budget Act and Consolidated Appropriations Act have provided alterations in the near term. Additionally the Congressional Budget Office (CBO) has highlighted no additional cuts will take place in 2014 given the 2014 appropriation bill is approved and sets new defense and non-defense spending caps. This bill may be reviewed again in 2015 if Congress chooses not to remain within the set cap of $1.014 trillion in discretionary spending. There has also been a change in the Department of Defense’s (DoD) view of what the US armed
forces will look like in the future. They have disclosed a desire to shift to a leaner force that is
more agile, flexible, and technologically advanced. Geographical interest have also changed as
programs in Afghanistan and Iraq are scaled back, the department hopes to bolster strengths
in the Asia-Pacific region. Given current instability in the Middle East, the DoD has highlighted
an inability to make a complete pivot in allocation of resources to Asia-Pacific as desired.
Competitive Positioning Exelis competes in the United States against Lockheed Martin, Boeing, Raytheon Company, General Dynamics Corporation, L-3 Communications Corporation, SAIC Inc., Northrop Grumman Corporation, Harris Corporation, and BAE Systems. These same companies are also competitors in the international market, in addition to Thales Group, EADS N.V., and Finmeccanica S.p.A. In the US, the federal government is the largest purchaser of aerospace and defense products, and budgets an amount for these purchases. Exelis and its competitors are competing for various different contracts from the same customer, with a limited budget. This has created a competitive atmosphere that emphasizes maximum efficiency. Furthermore, the competitive environment of the aerospace and defense industry is
characterized by cooperation between companies. It is very common for work on a major
contract to be shared among companies, regardless of wins the contract. As an example, Exelis
manufactures the subassemblies of its competitor Boeing’s aircraft.
Figure 3: Military Expenditure % of GDP Figure 4: Department of Defense Spending
Source: Department of Defense, Bloomberg Source: Bloomberg
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Growth Outlook
Exelis is seeing impressive growth in international markets, which currently account for just
over 11% of revenue but are on track to make up 15% by year-end 2014. International
demand for night vision technology, electronic warfare systems, and communications
technology is driving this growth. Key markets for Exelis are Europe and the Asia-Pacific
region.
Management has been emphasizing lean operations through a Six Sigma program, focusing on
reducing headcount and downsizing facilities. This focus on increasing business efficiency is
key as the U.S. Defense Budget is seeing only slight growth over the next 5 years, and an
emphasis is being placed on efficiency. Margins in 2014 have not benefited from the programs
as Exelis is realizing a large cost associated with the spin-off of their mission systems segment.
Domestic growth is being achieved through diversification away from Government contracts,
with an increasing focus on commercial applications, especially geospatial systems. Exelis’s
technology is present on nearly every U.S. satellite with imaging abilities.
Figure 5: Total US Defense Budget
Major Risks
Regulatory
Due to the Arms Export Control Act, Exelis is required to request a license from the
government in order to export some of its products. These licenses may be denied for reasons
of national security or foreign policy, by either the Department of State, Department of
Commerce, U.S. Treasury Department, or Congress.
Government Dependence
The U.S. Government is responsible for 85% of revenues, and these revenues are affected by
the federal budget. Federal spending is affected by the state of the economy, and the security
of the state. Currently, estimated federal spending on defense will decrease slightly over the
next two years, and then increase slightly through to 2019, however this is subject to change.
Possible change in IRS’ opinion of the spinoff transaction
If the transaction is does not qualify for tax-free treatment due to misrepresentations on
behalf of Exelis, thus the amount equal to the fair value of the shares issued will be considered
a sale of property. As such, the fair value of the new share would be included in taxable income
on behalf of current Exelis shareholders. This is a relatively remote risk as management has
filed for the tax-free treatment and has expressed the current opinion for the transaction is
deemed tax free as per section 355 of the Internal Revenue Code.
Growth & Risk Analysis
Figure 6: World Military Expenditure
Source: United States Department of Defense Source: Bloomberg
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Income Statement
Revenue Revenue for both C4ISR Electronic and Systems segment and the Information and Technical Services segment both declined from 2012 by 14.1% and 11.7%, respectively. The C4ISR segment declined primarily due to lower sales volumes related to counter-IED systems and Night Vision products. Also adding to this decline was the near completion of the companies Worldview-3 satellite imaging program. On a positive note, a decline in both of these sub-segments was offset by an increase in sales related to the firms Advance Integrated Defensive Electronic Warfare Suite (AIDEWS) serving international customers. For the Information and Technical Services Segment, revenue declines were driven mainly due to lower net activity with respect to the segments Infrastructure Asset Management and Supply Chain Management program areas that are exposed to overseas operations in Afghanistan and the Middle East. With respect to the spin-off of the Mission Systems segment we can expect further declines in total reported revenue. Post-spin Exelis has given guidance in terms of 2013 Sales and references $3.4 billion can be classified in the existing firm. Diversified revenue streams will also change post-spin as the firms reliance on the Army, Navy and Air Force spending will be less than 50% of total revenue. Approximately 16% will be related to International clients with the remainder coming from Commercial and Other Federal Agencies. This is part of management’s focus on driving their Strategic Growth Platforms representing an incremental change in the firm’s corporate strategy. Given declines in each segment and the spin off, management has given guidance that it has announced an agreement with Boeing to produce components of the new 787 Dreamliner. This contract specifically is expected to provide returns and expected to become a large contributor to total revenue. As per the contract, Exelis is to provide composite airframe structures for the nose of the plane, and forward fuselage. Operating Margins: Research and development expense declined in 2013 primarily due to the completion of several projects related to integrated electronic warfare systems, and other communication and night vision technologies related to the C4ISR segment. Research and development spending declined 32.3% from 2012 helping improve margins by approximately 50 basis points.
Figure 7: Income Statement Forecast
Balance Sheet
Liquidity
Since the spin-off from its parent corporation ITT, its Long-term Debt to Equity ratio has been
improving. Much of this is a result of an increase in the equity of the firm as suppose to a
reduction in debt. Given that the firm has only been publically listed for the past three years it
is a result that the firm is under-levered given continued earnings and growth in equity and
retained earnings. As per Bloomberg, Exelis currently has a debt ratio of 39.29 and debt to
total assets of 13.29. This is a positive as the firm has the financial strength to take on debt and
develop its Strategic Growth Platforms.
Financial Statement Analysis
Source: Bloomberg, Student Estimates
2011 2012 2013 2014E 2015E 2016E 2017E 2018E CV
Total Revenue 5,839 5,522 4,816 3,937 4,030 4,256 4,581 4,786 4,527
Operating Margin 9.16% 10.16% 9.88% 8.32% 11.10% 11.40% 12.20% 12.40% 11.70%
Net Income 326 330 281 183 266 278 320 337 300
Profit Margin 5.58% 5.98% 5.83% 4.66% 6.60% 6.54% 6.99% 7.03% 6.63%
EPS $1.75 $1.76 $1.49 $0.99 $1.45 $1.52 $1.74 $1.83 $1.63
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Pension Funding Exelis as of Dec 31, 2013 has a pension funding ratio of 77%, highlighting that their pension obligation is under funded by approximately $1.2 billion dollars. The company has given guidance in increasing contributions for 2014 with expected contributions to total $185 to $200 million. Pension expense was considerably higher when compared to 2012 mainly a result of a lower expected longer rate of return on its current plan assets and higher amortization of net actuarial losses. This increase in pension expense for the year was partially offset with lower interest costs and a decrease in the firms discount rate. Plan assets currently comprise of mainly Alternative Investments, Equities, and Debt accounting for 51%, 35% and 14%, of the total. Expected pension payments for the next 5 years are to remain flat at approximately $370 million over the next 5 years. At the moment, not material risks with respect to liquidity have been highlighted. With respect to the Spin-off of the Mission Systems business segment, management has highlighted that they expect to continue servicing the pension liability for the new entity. It should also be noted that current pension funding obligations forecasted by management will likely continue to hinder growth in cash flow from operations. However, it is not expected that this will have material effects to the going concern or regular operations of Exelis.
Valuation The 52-week target price for Exelis post spin is $24.88 indicating it is currently undervalued by 46%. The target price was arrived at weighting the Discounted Cash flow and Relative Valuation at 50% each. For the DCF, growth estimates by management were incorporated and the spinoff of the mission systems segment to be completed in the summer of 2014. For the relative valuation two scenarios were applied focusing equally on the P/E and EV/EBITDA multiples. The first scenario assumed Exelis’ forward multiple equals the current multiple, with equal weights to both P/E and EV/EBITDA multiples (12.5% each). The second scenario assumes that Exelis forward multiple will converge to the current peer group mean, with equal weights on both P/E and EV/EBITDA multiples (12.5% each). The peer group selected for the relative valuation
Figure 14: DCF Calculation
Figure 8: Balance Sheet Forecast
Source: Bloomberg, Student Estimates
2011 2012 2013 2014E 2015E 2016E 2017E 2018E CV
Current Assets 1,669 1,713 1,740 1,675 1,553 1,587 1,752 1,854 1,797
Current Liabilities 1,274 1,215 1,044 993 875 924 994 1,039 982
Pension Liabilities 2,149 2,203 1,407 1,150 517 55 0 0 0
Long-Term Debt 649 649 649 649 449 699 749 799 649
Total Equity 893 1,016 1,652 1,897 2,308 2,757 3,010 3,123 3,147
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Figure 9: Relative Valuation Table
Figure 10: Forward Multiple Equals Current Multiple
16.3 17.3 18.3
$1.75 $28.43 $30.18 $31.92
$1.45 $23.55 $25.00 $26.45
$1.15 $18.67 $19.82 $20.97
2015E Price/Earnings
2015E EPS
8.1 9.1 10.1
$640 $24.50 $27.95 $31.40
$540 $20.13 $23.04 $25.95
$440 $15.76 $18.13 $20.50
2015E EV/EBITDA
2015E EBITDA
Figure 11: Forward Multiple Moves Toward Current Peer Group Average
17.89 18.89 19.89
$1.75 $31.29 $33.04 $34.79
$1.45 $25.92 $27.37 $28.82
$1.15 $20.56 $21.71 $22.85
2015E Price/Earnings
2015E EPS
9.15 10.15 11.15
$640 $28.09 $31.54 $34.99
$540 $23.16 $26.07 $28.98
$440 $18.23 $20.60 $22.97
2015E EV/EBITDA
2015E EBITDA
Figure 12: Target Price Calculation
XLS
Peer Avg
B HEI MOG/A CAE ITT SPR TDG LLL BEAV
Market Cap (Billions) $3,166 $5,377 $2,035 $2,971 $3,207 $3,427 $4,326 $4,666 $8,869 $10,367 $9,904
Debt Ratio 26.3% 17.9% 19.4% 11.3% 15.8% 24.6% 0.2% 19.8% 39.1% 25.9% 16.5%
Dividend Yield 2.42% 1.08% 1.17% 0.24% 0.00% 0.93% 2.00%
Price/Book 1.67 -0.07 1.78 3.80 2.09 2.31 3.58 3.15 -26.37 1.70 3.80
2014E Price/Earnings 17.26 18.89 16.61 28.99 18.67 15.97 20.05 11.48 22.32 14.31 21.33
2015E Price/Earnings 11.78 16.66 14.84 25.30 15.49 14.25 17.49 11.10 19.95 13.58 17.97
2014E PEG Ratio 0.37 1.73 1.40 1.99 0.91 1.32 1.37 3.36 1.88 2.68 1.14
2014E EV/EBITDA 9.11 10.15 9.20 12.73 9.59 8.06 9.84 6.29 13.40 9.06 12.75
2015E EV/EBITDA 7.05 9.22 8.39 11.50 8.62 7.40 8.70 6.03 12.13 8.98 11.04
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Figure 12: Comparables Table
Company Name EXELIS INC BARNES GROUP
INC HEICO CORP
MOOG INC-CLASS A
CAE INC SPIRIT AERO-
SYSTEMS HOLD-CL A
TRANSDIGM GROUP INC
L-3 COMM HLDGS
B/E AEROSPACE INC
RAYTHEON CO Median Average
Market Cap $2,826,544,128 $2,035,415,061 $2,970,656,023 $3,207,179,932 $3,426,948,370 $4,666,163,574 $8,869,148,206 $8,321,561,600 $9,904,238,701 $24,825,358,336
Credit rating BBB- #N/A N/A NR BB+ #N/A N/A #N/A N/A #N/A N/A BBB- BB+ * A-
GICS_SECTOR_NAME Industrials Industrials Industrials Industrials Industrials Industrials Industrials Industrials Industrials Industrials
GICS_INDUSTRY_Name Aerospace & Defense Machinery
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
GICS_SUB_INDUSTRY_NAME Aerospace & Defense
Industrial Machinery
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Aerospace & Defense
Screening Metrics
10 Year Average ROE 12.59% 8.66% 10.37% 9.65% 12.60% 0.27% 15.15% 10.37% 9.90%
5 Year Average ROE 22.46% 11.99% 9.92% 9.77% 13.93% -0.09% 31.39% 13.87% 11.24% 20.29% 12.93% 14.48%
Pitroski F Score -2FY 4 6 5 8 6 4 4 6 7 6 6 6
Pitroski F Score -1FY 6 6 5 6 4 5 8 6 5 7 6 6
Pitroski F Score Current 5 6 4 4 5 3 3 8 6 7 5 5
Unlevered Free Cash Flow Yield Per Share
9.58% -11.60% 4.13% 6.93% Unable to compute
Unable to compute
7.23% 11.43% 3.14% 6.93% 4.40%
Margin Analysis
Profit Margin 5 year average
7.24% 6.16% 8.91% 5.60% 10.40% 4.32% 18.64% 6.33% 5.31% 7.51% 6.79% 8.04%
Relative Comparables
Dividend Yield % 2.42% 1.17% 0.24% 1.70% 2.00% 2.60% 1.85% 1.69%
P/E Ratio 10.95 20.85 35.02 16.78 #N/A Field Not
Applicable 23.12 45.36 12.23 23.70 14.89 20.85 22.55
EV / EBIT(T12M) 6.78 20.63 22.30 12.66 18.09 #N/A N/A 16.64 9.84 16.72 9.93 16.64 14.84
EV / EBITDA(T12M) 5.67 13.50 18.58 8.86 11.04 #N/A N/A 15.15 8.41 14.63 8.62 11.04 11.61
Price/Sales Ratio 0.75 1.89 3.52 1.01 #N/A Field Not
Applicable 0.81 3.97 0.76 2.58 1.24 1.24 1.84
Price/Cash Flow Ratio 11.59 204.50 26.94 10.52 #N/A Field Not
Applicable 18.48 16.25 7.56 23.69 12.33 16.25 36.87
Price/Book Ratio 2.19 1.81 5.87 1.72 #N/A Field Not
Applicable 3.33 #N/A N/A 1.52 3.53 2.59 2.39 2.82
Average 5 year P/E (Aritimatic Average)
18.47 28.85 13.10 12.28 25.12 9.78 18.98 10.39 15.79 17.12
Forward EPS 5 year growth (CAGR)
12.50% 15.76% 11.49% 10.85% 17.00% 10.69% 3.58% 18.31% 8.66% 11.49% 12.09%
Basic 5 year EPS growth (Arithmatic)
47.90% 16.14% 1.59% 1.59% 10.00% 2.36% -9.17% 2.36% 10.06%
BEST Forward PEG (Year) 1.19 1.61 1.35 1.41 0.65 1.87 3.79 0.98 1.38 1.38 1.58
BEST Forward P/E 15.87 27.25 16.41 17.38 12.05 20.90 14.01 20.39 13.48 16.41 17.53
Short Interest Ratio 0.47 14.91 7.85 5.04 99.16 0.86 4.59 3.15 1.43 2.88 3.87 14.03
WACC 8.79% 9.70% 9.64% 10.00% 8.52% 11.29% 6.45% 6.94% 8.87% 8.09% 8.83% 8.83%
Return on Capital 24.17% 10.47% 13.48% 13.53% 7.91% -10.04% 9.78% 12.93% 10.21% 10.47% 10.27%
Return on Invested Capital 21.47% 5.51% 10.98% 10.68% 8.92% 10.07% 10.22% 10.22% 11.12%
EVA Spread 15.38% 0.77% 3.84% 3.53% -0.61% -21.33% 3.33% 5.99% 1.34% 13.27% 3.43% 2.55%
Earnings Yield 9.13% 4.80% 2.86% 5.96% 4.32% 2.20% 8.18% 4.22% 6.72% 4.80% 5.38%
Liquidity/Solvency Ratios
Altman Z Score 4.37 7.05 3.98 2.52 2.24 3.86 4.08 4.38 5.02 4.08 4.17
Total Debt/Total Equity 39.29 47.96 48.25 46.18 78.84 78.82 59.53 75.10 42.28 48.25 57.36
Total Debt/Total Capital 28.21 32.41 32.55 31.59 44.08 44.08 106.24 37.31 42.89 29.72 34.93 42.91
Current Ratio 1.67 1.92 2.74 2.28 1.40 2.20 4.09 1.84 3.59 1.69 2.06 2.34
Quick Ratio 1.35 1.10 1.07 1.34 0.79 0.73 2.65 0.60 1.28 0.74 1.08 1.16
Interest Coverage Ratio 15.11 9.24 49.39 9.36 3.11 -4.76 7.11 5.14 13.79 9.24 11.94
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Disclaimer This report was written by a student currently enrolled in a program at the Sprott School of Business. The purpose of this report is to demonstrate the investment analysis skills of Sprott students. The analyst is not a registered investment advisor, broker or an officially licensed financial profes-
sional. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any securities. This report is written
solely for the consideration of this student managed investment fund and should not be used by individuals to make personal investment decisions. Unless otherwise noted, facts and figures included in this report are from publicly available sources. We cannot guarantee that the information in
this report is 100 percent accurate, although we believe it to be from reliable sources. Information contained in this report is only believed to be
accurate as of the day it was published, and it is subject to change without notice. It cannot be guaranteed that the faculty or students do not have an investment position in the securities mentioned in this report.
Buy, Price Target $24.86
Investment Positives
Strong focus on developing Strategic Growth Platforms
Diversified product portfolio
Strong financials and low level of debt
Currently has the financial flexibility to take on debt and expand its products and services
Expected Spinoff of the Mission Systems segment will reduce the firm’s reliance on DoD
spending to less then 50%
Strong focus on developing international markets
Recently awarded a large contract with Boeing to provide critical components used on the
new 787 Dreamliner
Investment Negatives
US Fiscal budget deficit will likely provide headwinds for growth in government
discretionary spending
Regulatory constraints hinder the firm to introduce new products to new markets or
countries
Pension currently underfunded and will demand cash flows if satisfactory levels are not
maintained
Interest rate and foreign exchange risk my hinder spending on behalf of international
clients
Investment Recommendation
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Appendix A Pro-forma Financial Statements
Figure A1: Income Statement
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Figure A2: Common Size Income Statement
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Figure A3: Balance Sheet
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Figure A4: Common Size Balance Sheet
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Figure A5: Cash Flow Statement
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Appendix B Valuation Charts and Sensitivity
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Figure B5: DCF Sensitivities
5% 6% 7% 8% 9%
8.04% $24.76 $27.73 $30.69 $33.66 $36.62
9.04% $22.15 $24.60 $27.05 $29.50 $31.95
10.04% $20.20 $22.27 $24.34 $26.41 $28.48
11.04% $18.70 $20.47 $22.25 $24.03 $25.80
12.04% $17.51 $19.05 $20.60 $22.14 $23.68
CV Profit Margin
Cost of
Equity
44% 47% 50% 53% 56%
8.04% $31.62 $31.16 $30.69 $30.23 $29.76
9.04% $27.82 $27.43 $27.05 $26.67 $26.28
10.04% $24.99 $24.66 $24.34 $24.02 $23.69
11.04% $22.81 $22.53 $22.25 $21.97 $21.69
12.04% $21.08 $20.84 $20.60 $20.35 $20.11
CV CAPEX as % of Operating Cash Flow
Cost of
Equity
0.0% 1.0% 2.0% 3.0% 4.0%
8.04% $25.46 $27.70 $30.69 $34.87 $41.11
9.04% $23.20 $24.89 $27.05 $29.93 $33.96
10.04% $21.41 $22.71 $24.34 $26.43 $29.20
11.04% $19.97 $21.00 $22.25 $23.82 $25.83
12.04% $18.78 $19.60 $20.60 $21.81 $23.32
Cost of
Equity
CV Growth Rate
