Description

1. I.         THESIS

Since the spinoff of XYL and XLS ~18 months ago, ITT has fallen off of the radar of many buy-side investors who were involved in ITT only for the event itself, and has also seen its sell-side coverage diminish considerably.  2012 was a transition year for ITT, and 2013 will shed a much more positive light on the businesses operating leverage.  Further, the stock is currently trading at a clear and significant discount to its comps – ITT is trading ~6x ’13 EV/EBITDA while its peers trade at ~7-11x ’13 EV/EBITDA.  A prime reason for this discount is ITT’s on-balance sheet asbestos liability of ~$700mm – this liability is vastly overrated as its true economic impact will only amount to a net cash payment of ~$15mm per annum for the foreseeable future.  I believe several potential catalysts, along with solid 2013 results that will provide a ‘clean’ look at ITT’s strong earnings and cash flow potential, will continue to propel the stock.

 II.        RISK / REWARD

A.       Reward

ITT is mispriced on both an absolute and a relative basis, and given its huge net cash balance there is a ton of optionality value that is being discounted as well.  My long recommendation in ITT is predicated on the following tenets:

-          ITT is a very solid, albeit unspectacular, business.  The company derives ~30% of sales and most of its profits from aftermarket parts and services (~60% of EBIT).  Additionally, about 45% of sales are from parts and components on major OE platforms with long lives (and high switching costs for the OEM).  I estimate 2013 ROIC at a solid ~23%.

-          ITT has high quality earnings and is a very good generator of free cash (and free cash conversion should >105% of net income).

-          ITT is very cheap on both an absolute and relative basis.  Moreover:

• The market is not giving ITT very much credit for its net cash balance of $518mm (and the optionality value this represents).
• And, some analysts are including ITT’s asbestos liability of ~$700mm as debt – this is an egregious error in my opinion.  This asbestos liability is being ridiculously overrated as related net cash payments will only amount to ~$15mm per annum for the foreseeable future.

-          Since the spinoff of XYL and XLS on 10/31/11 I believe ITT has fallen off of the radar of both the sell-side and buy-side.

-          There are several scenarios that could lead to significant value creation for shareholders:

• Recapitalization – ITT has $518mm of cash (most of which is located overseas) and zero debt.  ITT should issue debt in the US and buy back shares.
• Dividend – ITT can/should increase their dividend payment, or look into issuing a special dividend.
• Activism – ITT valued under a reasonable sum-of-the-parts basis could mean a double in the share price.  Activist investors will certainly see the value proposition here.

Overall, I believe a cleaner set of financials derived in 2013 will make the ITT story easier to understand.  Assuming that ITT should at a ~10% discount to perceived comps on ’13 EV/EBITDA, I believe ITT is worth ~$36/share.

Below is a comp table – while pure comps are difficult to establish given the diverse businesses and end markets ITT participates in, the table below lists companies ITT competes with in one business line or another.  As depicted, ITT has similar growth, margin, and return profiles as most of these peers, however, the stock trades at a material discount on both an EV/EBITDA and a P/E ex. net cash basis.

B.       Risk

As I see it, the two main risks to a long position in ITT:

-          Macro slowdown – as an industrial conglomerate with large exposures to construction, auto, industrial, etc. end markets, ITT is susceptible to a further slowdown in global macro activity.

-          Poor capital allocation decisions by management – in essence, management making a large and expensive purchase would most likely not be received well by an investor base who wants management to return cash via a larger dividend and a big share repurchase program. 

III.      BUSINESS DESCRIPTION

Founded in 1920, ITT is a maker of highly specified components (i.e. valves, connectors, switches, brake pads, etc.) and aftermarket services provider for a wide-range of global industries.  ‘Old ITT’ was broken up into three companies on 10/31/11 – XYL (water business), XLS (defense focused business), and ITT, which is now led by the CFO of ‘Old ITT’.  ITT’s stated per annum long term financial goals include organic revenue growth between 5%-7%, operating EBIT margin growth of 50- 70 bps, free cash flow conversion above 105%, and EPS growth of 10%-15%.

Approximately 30% of ITT’s revenue (and ~60% of operating profit) is derived from aftermarket products and services where they often capture repeat sales because of their large installed base of specialized products.  Additionally, approximately 45% of ITT’s revenue is derived from positions their products hold on long lived customer platforms; similar to the aftermarket, these are also long-term recurring revenues.

As depicted below, ITT reports under four distinct segments:

IV.      FINANCIALS

Summary

Catalyst