Description

Summary

ITT Corp is a conglomerate operating in three disparate business segments; Defense (50% of revenue, 47% of EBIT), Fluid (36% of revenue, 38% of EBIT) and Motion & Control (14% of revenue, 15% of EBIT).   All three segments were created through a string of acquisitions (and divestitures) spanning decades. 

On January 12, 2011, ITT announced plans to separate into three separate companies substantially similar to the three operating segments as they are presented today.  ITT will become a focused industrial component manufacturer selling everything from shock absorbers to industrial pumps.  The Fluid segment will trade industrial assets to ITT in for water based pump assets and be spun into a water focused industrial systems & component manufacturer currently called "Future Water".  The Defense business will remain intact and will at least initially be called "Future Defense".

While exact details regarding the cash flow profiles and capital structures will not be available until the company files its Form 10 (estimated to be the end of May or early June), it seems highly probable that each segment will have a net cash balance sheet when split.  ITT should produce mid-single digit organic growth, generate low double digit operating margins, and exhibit returns on capital in the low teens.  It is my belief that this segment will cease to exist in the short / mid term.

Future Water is projected to grow organically in the mid-single digits, but potentially be able to manufacture double digit revenue growth consolidation in what appears to be a fairly fragmented industry.  Water also produces low double digit operating margins (over 12%) and has returns on capital in the low double digits (which are obfuscated by goodwill created through consolidation - returns on tangible capital are closer to 20%).  This is the business the current CEO / Chairman of ITT will remain with as Executive Chairman.  For various reasons discussed in more detail below, I believe this will be the "sexiest" of the companies and likely will become a consolidator of water service assets.

Future Defense is the problem child that likely sparked the spin-off conversations between members of the board's Strategy and Finance committee.  A vast majority of the segment's revenue (~70%) comes from the DoD's "land based" budget which apparently is equipment for troops (night vision, radios, etc) and will suffer as Iraq and Afghanistan wind down.  What's worse, much of the segment's revenue in the past two years is related to services around the "surge", which is certainly going to take an outsized hit as US troops withdraw from Iraq and Afghanistan.  All of this nets to low / mid-single digit organic revenue declines with relatively stable low double digit operating margins and mid-teens returns on capital.  This segment is a wild card, but there are some programs growing rapidly which likely makes the business attractive as a takeover target longer term.  In the interim, this segment is likely to be challenged both fundamentally and in terms of valuation.

Investment Positives: 

1) Known positive corporate action coming in ~7 months

    a. Believe this provides a layer of downside protection

2) Bulk of the value lies within growing, high return businesses

    a. The Water business has recurring revenue characteristics through its service contracts

3) Absolute and SoP valuations are compelling

4) Consolidation potential of "stub" industrial and defense assets not priced into the shares today

5) Balance sheet is effectively net debt zero at the time of the split

Investment Negatives:

1) The Defense business appears to be in secular decline

2) The Industrial and Water assets are economically sensitive

3) The Gould Pump business (within Water) has Asbestos exposure currently estimated to at $440 million over 10 years

4) ITT has an underfunded pension to the tune of $1.3 billion

5) There isn't a significant discount to my estimation of wholeco fair value, and the risk / reward is less than my preferred 3 to 1

    a. The catalyst has at least partially been priced into the shares

The bottom line - I believe an investment in ITT today represents a risk reward of almost 2 to 1, which is compelling given the known corporate action coming in 7 months.  Further, I believe there will be opportunity to create an enhanced risk / reward through the monetization of the Water business and retention of future ITT and Defense for a potential takeout.

Best Case            $77

Base Case            $60

Low Case             $46

Catalyst Calendar:

1) Late April 2011 - Q1 earnings

2) Late May / Early June 2011 - estimated Form 10 filing

3) Late July 2011 - Q2 earnings

4) Mid October 2011 - estimated split effective date

5) June and October 2011 - 50c combined dividends

6) Unknown - potential takeout of the "stub" industrial and defense assets

Segments

ITT currently operates three segments called Defense, Fluid and Motion & Flow.  For the spin off, the Defense business will mirror the current Defense segment, but the company will transfer industrial fluid assets into the Mo & Flo segment in exchange for some water related pump assets.

Current and Pro Forma Segment Financial Comparative:

Future ITT

Future ITT consists of the assets that remain with the current ITT post the spin off of the Water and Defense businesses.  Future ITT is a mix of industrial component businesses serving the transportation, oil & gas, and mining industries with everything from shock absorbers to electrical connectors & switches used in telecommunications.  Revenue sources for ITT will be very geographically diverse with over 60% coming from outside North America and roughly 30% coming from emerging markets.

The current CFO of ITT, Denise Ramos, will become the CEO of Future ITT.  The Chairman (non-executive) will be Frank MacInnis, currently the Chairman and formerly the CEO of Emcor Group and a current ITT director.

Historical and Projected Financial Profile:

While these three companies don't compete across the board, their size, end markets , returns on capital and margin structure makes them a reasonable proxy for valuation.

There has been some M&A activity in the industrial space recently, though much of it has been sales of small private companies or sales of segments within larger corporations.  To try and asses the valuation in a takeout scenario, I used three recent transactions with particular attention paid to the last of the three. 

Applied Signal is a telecom equipment manufacturer and Dionex manufactures products for chemical extraction.  Baldor, however, produces industrial motors / power transmission products / various drives and generators.  All of which seems to fit Future ITT's product lines more directly. 

As a stand-alone company, I believe Future ITT generates ~80c per share in Free Cash Flow and ~85c per share in EPS.  Using peer group multiples, fair value for this business should be about $13.  If taken out, using the EBIT multiple adjusted for taxes as a proxy for a reasonable earnings multiple this business go for more than $20.

Future Water

Future Water consists primarily of the Fluid Segment assets minus industrial non-water pumps (called "industrial processes") plus some "flow control" control assets (I believe those are beverage related pumps, etc).  Revenues are generated primarily from municipal water / wastewater treatment and from residential and commercial building services.  Future Water has a smaller presence in so-called dewatering, water analytics, ag irrigation, beverage, marine and general industrial water products.

Revenues are generated primarily in North America and Europe (~40% each, ~80% total) with the remaining coming primarily from Asia.  Revenues are projected to grow 5% organically for 2011 and 12.5% in total (the rest coming from acquisitions).  Organic growth is driven by population growth and general infrastructure spend in developed economies and urbanization and development in emerging economies.

I believe that the Water business is the "sizzle" in the SplitCo story, and that the company's size, financial profile, and secular growth story will sell for a premium in the public markets.  I also believe this business will be well capitalized on the split due to the likelihood Future Water becomes an industry consolidator.  The current CEO of ITT, Steve Loranger, will become the Executive Chairman of Future Water, and the current head of Fluid, Gretchen McClain will be the CEO. 

Historical and Projected Financial Profile:

For 2011, this unit is expected to produce over $520 million in operating income on $3.6 billion in revenue for an operating margin of 14.5%.  To that estimate, I subtract about $75 million, which is my estimate of shared corporate overhead.  As with the Future ITT business, I used revenue initially (which would equate to $60 million), then added 25% to account for the significant International revenue which will likely make shared services more expensive.

Capex is estimated to be 2.2% of revenues for 2011. To estimated pro forma capex with the different product mix, I kept capex as a percent of revenue consistent with reported segment results.  I adjusted D&A commensurately in 2007 with the adjustment to capex and did the same for the total tangible assets.

Additionally, I've allocated 17% of the total interest expense to the water segment - again, based on cash flow generation through the end of Q3, it is highly likely each of these segments will be net debt zero once split apart.  I've assumed a 25% tax rate because of the geographic mix of the revenue and profitability.

I expect fully allocated operating margin to be almost 12.5%, EBITDA margins of 15%, free cash flow of roughly $1.80 per current ITT share and returns on capital in the low double digits.

Although Future Water will be the largest pure play Water services company (that I or the company are aware of), there are several public companies that compete in one or many of Future Water's product / service lines. 

With the exception of Roper, the margin structures for the group are fairly similar as are the returns on capital.

As a stand-alone entity, I believe the Water business produces $1.80 in free cash flow and $1.75 in EPS next year.  At peer multiple averages the Water segment is worth ~$30 per current ITT share.  At the higher end of the range, the stock could go for as much as $35 per share.

Future Defense

Future Defense will be left substantially unchanged after the split with the exception of allocated shared overhead expenses.  Roughly 70% of the Defense businesses revenue comes from the Department of Defense which I understand to be primarily "land based", or product that is used by troops and thus revenues are directly correlated to US troop deployment around the world.  Clearly, this is not the place to be in the DoD's budget as troop levels in Afghanistan and Iraq are expected to decline dramatically from current levels in the near future.  What's worse, much of ITT's business the last few years related to the "surge" in Iraq, which unwinding completely.

Current financial expectations from management take this into account, at least partly, with the expectation of 2% organic revenue declines for 2011.  Going forward, the 30% of Defense revenue that is not tied to the DoD appears to be growing, but will likely not be enough to offset losses in the core "land based" defense products.  The incremental margin on changes in revenue is roughly 30%, which translates into a decline in operating income of ~2.5% for every 1% decline in revenue. 

The current President of the Defense segment will become the CEO of the new Future Defense business, and the Chairman (non-executive) will be Ralph Hake, formerly the Chairman and CEO of Maytag and a current director of ITT.

Historical and Projected Financial Profile:

For 2011, this unit is expected to produce almost $720 million in operating income on $5.8 billion in revenue for an operating margin of 12.4%.  To that estimate, I subtract about $60 million, which is the remainder of shared corporate overhead after allocations to Future ITT and Future Water were made.  According to management, this is the least expensive segment because of the lack of International revenue / emerging market exposure.

The primary reason for the increase in revenue and operating income in 2008 versus 2007 was the $1.8 billion acquisition of EDO Corporation (added ~$1.7 billion of revenue).  Organic growth in 2007, 2008 and 2009 amounted to ~$800 million cumulative.

To the Defense business, I have allocated two-thirds of the interest burden and 75% of the additional cash pension obligation.  Capex has consistently come in around 1.8% of revenue, which I kept consistent.   

For comparative purposes, I used Harris Corp and Alliant Techsystems.  While they do not compete in all product lines (Harris and ITT do have substantial overlap), these two comps have excess exposure to the same "land-based" budget issues, more so than Raytheon, General Dynamics, Lockheed Martin or Northrop Grumman.  However, I'm told that there are several attractive pieces of ITT's Defense business including its exposure to so called defense electronics (versus weapons, which have substantial budget risks) and its new product pipeline, both of which should move this business toward the top of potential targets for strategic acquirers.

The larger players mentioned above are trading in a tight band with respect to EV to EBITDA multiples.  On a trailing basis, the lowest is Northrop Grumman at 5.5x and the highest is General Dynamics at 6.5x (with Raytheon and Lockheed right in the middle).

Asbestos

Prior to 1985, an ITT subsidiary, Goulds Pumps, manufactured and sold a gasket which contained asbestos.  As a result, the company has been named defendant in several tort proceedings with roughly 103,000 open claims at the end of last year.

ITT estimates its gross liability over the next 10 years to be almost $1.7 billion (up from $933 million at the end of 2009).  The company also estimates that insurance policies will cover ~60% of the gross liability creating an asset worth about $1 billion.

In 2010, there were $54 million of cash payments, 100% of which were covered by insurance.  In 2009, there were $62 million of cash payments, 90% of which were covered by insurance.  All payments and charges are deductible from cash taxes.

Historically, the insurance companies which covered ITT for potential losses handled the claims and administration process relating to all asbestos claims.  Since 2000, the company has begun handling the administration of the asbestos claims, and as a result has gained a historical sample size to help estimate the future liability likely to be realized.  To that end, in the third quarter of 2009 the company hired an outside consultant to aggregate and analyze the collected data. 

Ultimately, the company grossed up the estimated liability by $680 million in 2009, of which management assumed 66% would be covered by insurance, thus the company took a $240 million charge.  In 2010 the company again performed a review of the potential liability and increased the amount by ~$700 million, of which management assumed 53% would be covered by insurance, thus the company took a $385 million charge.

Prior to the work done in 2009, the company maintained a small ~$220 million liability and the assumption that insurance would cover almost 100% of the cost.

It is my hope that Goulds Pumps will reside within the newly formed Water segment, which ideally will remove the liability from Future Defense and ITT (and a hurdle to their takeout).  We will know more when the Form 10 is filed as to where this liability will ultimately reside.

Valuation

Base Case

1) Split happens

2) Management guidance is accurate

3) The three pieces all trade toward the low end of comparable company valuations

4) The pension's funded status is reflected in the valuation

1) Split happens

2) Management guidance is accurate

3) Water trades at the midpoint of comparable valuations

4) Future ITT and Future Defense are taken out at slight discounts to comparable deals

5) The pension's funded status is NOT reflected in the valuation

1) Split happens

2) Management guidance is proven too aggressive

3) All segments trade at or below the lowest valuation of comparable companies

4) The pension's funded status is reflected in the valuation

Conclusion

ITT is an attractive long investment due to its favorable risk / reward (almost 2 to 1), near term major catalyst (~7 months), and free call options (trading ranges of the stubs and potential takeout of Defense and/or Industrial business).

Catalyst

1) Late April 2011 - Q1 earnings

2) Late May / Early June 2011 - estimated Form 10 filing

3) Late July 2011 - Q2 earnings

4) Mid October 2011 - estimated split effective date

5) June and October 2011 - 50c combined dividends

6) Unknown - potential takeout of the "stub" industrial and defense assets