ITT has a market capitalization and an enterprise value of $1,872 million and $1,077 million, respectively. I expect revenue, EBITDA, and EPS respectively to be $2,391 million, $334 million, and $1.90 per share in 2013. This implies an EV to 2013 EBITDA multiple of 3.2x and a price to earning multiple (net of net cash) of 6.2x. These numbers exclude pension, environmental and asbestos liabilities that will be discussed below.

ITT manufactures highly engineered products with a portfolio of 4 businesses:

1. Industrial Process ($767 million revenue, 36% of revenue, 34% EBIT, 12% margin): industrial pumps and valves for the chemical, oil and gas, mining, and industrial markets.
2. Motion Technologies ($634 million, 30% of revenue, 32% of EBIT, 13% margin): braking technologies and shock absorbers for the automotive and rail markets.
3. Interconnect Solutions ($418 million, 20% of revenue, 14% of EBIT, 9% margin): connectors for the aerospace, industrial, and transportation markets.
4. Control Technologies ($318 million, 15% of revenue, 20% of EBIT, 17% margin): fuel management systems, seat controllers, and interior vibration and acoustic isolators for the aerospace and industrial markets.

ITT has a diversified number of end markets: Auto & Rail (29%), Energy & Mining (21%), Industrial Process (18%), Aerospace & Defense (16%), and General Industrial (16%). It is geographically diverse: North America (40%), Western Europe (28%), and Emerging Markets (32%).

30% of the business is aftermarket (high-margin recurring revenue; drives 60% of profits) and 45% of the business consists of supplying products to Original Equipment Manufacturers (OEM; highly profitable, relationships can last decades and provide ongoing annuity stream). The remaining 25% of the business is project-based, which is less profitable but drives the aftermarket and OEM business.

The company has put out some long-term financial targets, which include organic revenue growth between 5%-7%, annual operating EBIT margin growth of 50- 70 bps, free cash flow conversion above 105%, and EPS growth of 10%-15%.

Investment thesis

• Good business: pre-tax return of capital (EBIT divided by PPE and NWC) around 44%. Highly engineered products; well-known brands in smaller niches that attract less competition.
• Significant free cash flow: the business has low capital intensity and generates significant amounts of free cash flow, which is targeted above net income.
• Strong aftermarket and OEM components (75% of the business): high margin, somewhat recurring revenue base; opportunity to grow the aftermarket business further.
• Emerging market exposure: higher growth than developed economies: 32% of the business;
• Attractive valuation on an absolute and relative basis: See below.

What are investors missing?

• (1) Spinoff dynamics – ITT conglomerate recently broke up into 3 new public companies (ITT Corp, Xylem and Exelis). The resulting ITT Corp. is a small new public company, not well covered by analysts with the usual trading dynamics of spinoff situations.
• (2) Asbestos liability – the asbestos liability is not well understood and is overstated by many investors. See below.
• (3) Unoptimized balance sheet – the company will have close to $9 per share in cash at the end of 2012. Many investors are valuing the company based on price to earnings multiple and not taking into account this cash.
• (4) 2012 EPS growth guidance is well below peers because the company has to incur a number of additional costs to build the infrastructure of a standalone company. While these costs will be recurrent, the incremental costs will affect 2012 only. In other words, there is negative operating leverage in 2012. That will not be the case in 2013.
• (5) The financials are complicated as 2012 is a transitional year.

Catalysts

I believe that ITT will rerate significantly over the next 12 months as the following take place:

• When the company announces its Q4 2012 results in March 2013, the company will provide guidance for its fiscal year 2013. 2013 EPS growth guidance will reflect positive operating leverage and growth that is consistent with the industry (as opposed to 2012 EPS growth guidance, which is well below peers because of incremental costs associated with becoming a separate independent company). That should help rerate the stock to a multiple more consistent with its peers.
• Balance sheet optimization: The company will start using its large cash balance for either M&A or additional share repurchase. These actions will be very accretive and value creative for shareholders as the cash will start to be reflected in the valuation. The company could increase 2013 EPS by almost 43% from $1.90 to $2.71 per share by using $600 million (around 75% of its cash at the end of 2012) to buy back stock at the current price. Since a majority of the cash is outside the US, the company should take advantage of low interest rates to issue debt and buy back stock.
• Financials will start getting cleaner as we move from a transition year (2012) to a more normalized year. Investors will also get increasingly more familiar with the company.
• Free cash flow generation and cash buildup: At the end of the year, the company will have almost 45% of its market cap in cash and trade at a free cash flow yield of almost 19.0% - 2013 free cash flow per share of $2 (1.05x EPS) and an enterprise value per share of $10.50 ($19.5 minus $9.00 in cash).
• M&A: ITT is a small public company that would fit in the portfolio of larger industrial conglomerates. Given the synergies and the low valuation, a very large premium could be paid. Given the acquisitive nature of the industry, I don’t expect ITT to remain undervalued and independent for a very long time. Either the stock will appreciate to the low thirties as a standalone public company or the company will be taken over at a price in the high thirties. Either way, shareholders will win. At this price, even an LBO would result in a significant premium. I think ITT would be a great acquisition target for Crane – similar businesses and end markets and significant synergies.
• Activism: the stock is very cheap. If the valuation stays where it is and the company does not start to deploy its capital, an activist will likely push the company to buy back stock or sell itself.

Longer-term catalyst

I think tremendous value could be created by focusing ITT on a couple of the divisions (instead of the 4 divisions they currently have). Some of these divisions have better owners. For example, the interconnect division (which has lower margins) could be sold to a strategic such as TE Connectivity for a very high multiple (north of 10x EBITDA - see below regarding Deutsch’s sale to TE Connectivity). Proceeds could be used to get scale in the other divisions by buying smaller businesses or buying back shares at much lower multiples. The end result of this transformation would be a much more focused company with greater scale and higher margins. A more focused ITT would also become a more attractive takeover target. I don't know if management is thinking like that. 

Asbestos / environmental and pension liabilities

ITT has been joined as a defendant in product liability lawsuits alleging personal injury due to asbestos exposure. These claims allege that certain products sold by ITT before 1985 contained a part which included asbestos. The company reports a net liability of $711 million as of March 31, 2012. This net liability is a pre-tax undiscounted number. This number overstates the true liability of the company. The company expects to make annual cash payments between $10-$20 million, net of tax benefits over the next five years and between $35-$45 million, net of tax benefits over the remainder of the projection period (2017 to 2026). Assuming a 40% tax rate, the after-tax asbestos liability is $426 million (60% times $711 million). I assume the following after-tax cash payments per year: $15 million for the next five years, $40 million for the following five years and another $30 million (per year) for the following five years for a total of $425 million. I believe that this number should be discounted. The discounted value of these cash payments is $195 million using a 10% discount rate and is much lower than the undiscounted pre-tax value of the liability on the company balance sheet. Nevertheless, sell side analysts consider the full $711 million liability and therefore significantly undervalue the equity.

The company has also a small environmental liability ($101 million – also a pre-tax and undiscounted number). ITT paid $11 million in 2010 and 2011 to investigate and remediate sites. The company expects to pay around $13 million in 2012. This expense in reflected in the 2012 adjusted EPS guidance of $1.62 to $1.72 per share and my 2013 EPS estimate of $1.90 per share.

The company also has pension liabilities. ITT contributed $32 million to its US pension plans in Q1 2012 ($15 million in discretionary and $17 million in required contributions). They don’t expect to make further contributions in 2012. As of March 31, 2012, in the aggregate, ITT’s net postretirement liability was $296 million.

Capital Allocation

The company has publicly said it wants to buy back shares to offset stock-option dilution, pay the dividend (36 cents per year – 1.8% dividend yield) and make acquisitions. It seems clear that their bias is to grow the business through acquisitions – their focus is on small $15 to $50 million revenue businesses close to their core business. While this is obviously a risk and I would rather have ITT aggressively buy back stock, I think that the risk is limited because of their focus on small tuck-in acquisitions. Management believes they can buy these small businesses at good valuation (4 to 6 times EBITDA).

Peer group

Pure comps are difficult to establish because ITT focuses on 4 different businesses with a number of different end markets. The following peer group consists of different industrial companies with somewhat similar areas of focus, end markets, and importantly financial characteristics (margins, revenue growth and return on capital):

• Crane – LTM EBITDA margin 14.8%; LTM Revenue growth 12.8%; Return on Capital 49.3%
• Flowserve – LTM EBITDA margin 15.7%; LTM Revenue growth 12.7%; Return on Capital 35.6%
• Pentair – LTM EBITDA margin 14.2%; LTM Revenue growth 13.2%; Return on Capital 35.8%
• Woodward – LTM EBITDA margin 16.9%; LTM Revenue growth 16.2%; Return on Capital 28.9%
• Eaton – LTM EBITDA margin 13.8%; LTM Revenue growth 12.4%; Return on Capital 36.8%

As a group, these companies have similar gross margin, EBITDA margin, EBIT margin and return on capital as ITT.

Crane is probably the best comparable with very similar EBITDA margin and return on capital metrics. Like ITT, Crane describes itself as a manufacturer of highly engineered products. It operates in 5 segments, including Fluid Handling (45% of the business), which is similar to ITT’s Industrial Process segment; Aerospace & Electronics (27% of the business), which overlaps with ITT’s Control Technologies and Interconnect Solutions (also note ITT’s 16% exposure to the Aerospace & Defense end markets); and Controls (5% of the business), which is also similar to ITT’s Control Technologies. Crane also has a large asbestos liability as well as environmental and pension liabilities. The 2 companies have similar geographical exposure. Yet as discussed below, ITT trades at a significant discount to Crane and other peers.

Valuation

A. Comparable companies

The multiples of the peer group based on 2013 consensus numbers are:

• Crane – EV to Sales 0.9; EV to EBITDA 5.4
• Flowserve – EV to Sales 1.2; EV to EBITDA 6.8
• Pentair - EV to Sales 1.4; EV to EBITDA 8.9
• Woodward - EV to Sales 1.5; EV to EBITDA 8.0
• Eaton - EV to Sales 0.9; EV to EBITDA 5.7

Average multiples for the group is EV to Sales of 1.2 and EV to EBITDA of 7 (given the similar margin structure between these companies, I am comfortable using these two metrics to value ITT).

Applying these multiples to ITT 2013 numbers (taking into account ITT cash at the end of 2012 ($825 million) and the $195 million asbestos liability) yields a stock price between $32 (EBITDA multiple) and $38 per share (Sales multiple).

I didn’t subtract the environmental liability because its P&L expense is already reflected in the EBITDA number. Also I didn’t subtract the pension liability because 1. all these companies have pension liabilities and therefore all the numbers should be adjusted accordingly, 2. pension liabilities are currently very large because of the very low interest rate environment but may not reflect a normalized environment, and 3. the P&L expense is reflected in the EBITDA number.

Applying the more conservative Crane multiples on 2013 ITT metrics and taking into account the EOY ITT cash yield a stock price between $29 (EBITDA multiple) and $32 (using sales multiple) per share. In this case, I am not even taking into account the asbestos liability because I am using Crane’s multiple and Crane has a similar asbestos liability ($650 million) so it should be reflected in its multiple. Note that Crane has also a pension liability ($181 million) and an environmental liability ($49.7 million).   

B. Normalized multiple of 2013 EPS + cash on the BS

Assuming 2013 EPS of $1.90 per share, applying a conservative 10x multiple (in line with Crane multiple) and adding back $9 of cash results in a $28 stock price.

C. Private market value

I think the following transactions are relevant to ITT:

• Tyco’s sale of its flow business to Pentair for 10.4x LTM EBITDA (relevant for the Industrial Process division)
• Goodrich’s sale to United Technology for 10.2x LTM EBITDA (relevant for the Control Technologies and Motion Technologies divisions)
• Thomas & Betts’s sale to ABB for 9.9x LTM EBITDA (relevant to the Interconnect Solutions division)
• Cooper Industries’ sale to Eaton for 12x LTM EBITDA
• Deutsch’s sale to TE Connectivity (relevant to the Interconnect Solutions division) for 11.8x 2011 EBITDA
• The fairness opinions of these deals include valuation sections based on comparables transactions. These imply multiples in the 10 to 12x range.

These multiples imply a transaction price for ITT between $36 (9x multiple) and $40 (10x multiple) per share taking into account the asbestos liability. I did not take into account the pension and environmental liabilities in this calculation for the reasons explained above.

Based on these different methodologies, I conclude that on a standalone basis, ITT should be trading at the end of 2012 between $28 and $30 per share implying an upside between 44% and 54%. The private market value is higher so in a sale of ITT, I would expect ITT to fetch between $36 and $40 per share implying an upside of 85% to 105%.

Hedged strategy

ITT is too cheap on an absolute or relative basis. Nevertheless if an investor is concerned about an economic slowdown (which would have an impact on an economically sensitive company like ITT) and want to hedge that exposure, I suggest hedging ITT by either shorting Crane or a combination of the peers.

Risks

• The company may take a while to optimize its capital structure. They have said they would buy back shares to offset dilution and I am not sure how much capital they can deploy on a yearly basis making small tuck-in acquisitions. Given the cash flow generation of the company, it may take a while for the company to get to a more optimized balance sheet (like Crane for example). A company like ITT should be in a net debt position. I would like them to be more aggressive deploying the cash through stock buyback which would not only take advantage of the stock undervaluation but also remove one of the causes of the undervaluation (the excess cash not recognized by the market). I am not sure management gets it. 

• Economic slowdown – I think this risk can be hedged

• Poor acquisitions – I think this risk is small assuming the company sticks to what it has publicly said – small acquisitions ($15 to $50 million) close to the core at low multiples (4 to 6x EBITDA)

• Management – CEO Denise Ramos was the CFO of the ITT conglomerate. This is her first CEO position so she doesn’t have a track record.