The Sprott Equity Research

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1 The Sprott Equity Research Reza Syed BCom. Candidate 2016 Finance and Accounting reza_syed@hotmail.com Equity Analyst Peter Tewolde BCom. Candidate 2015 Finance, minor in Economics Peter.tewolde@gmail.com Sector Manager Exelis Inc. (NYSE:XLS) Buy, Current: $17.06, Target: $24.86 July 13, Year Performance Source: Bloomberg, Student Estimates Investment Thesis 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 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. Secure Long-Term Contracts 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 This transaction is subject to SEC approval and is expected to be completed in the summer of Less Reliance on US DoD Spending Exelis post-spin will have less reliance on the Department of (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.

2 E 2015E 2016E 2017E 2018E 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 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 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 United States International Source: Bloomberg, Student Estimates Source: Bloomberg, Student Estimates Page 2

3 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 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 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 nondefense 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 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. Figure 3: Military Expenditure % of GDP Figure 4: Department of Spending Source: Bloomberg Source: Department of, Bloomberg 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. Page 3

4 Growth & Risk Analysis 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 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. 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 Budget Figure 6: World Military Expenditure Source: United States Department of Source: Bloomberg 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. Page 4

5 Financial Statement Analysis 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 subsegments 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 E 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 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 Source: Bloomberg, Student Estimates 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 and debt to total assets of This is a positive as the firm has the financial strength to take on debt and develop its Strategic Growth Platforms. Page 5

6 Figure 8: Balance Sheet Forecast 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 E 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, , Pension Liabilities 2,149 2,203 1,407 1, Long-Term Debt Total Equity 893 1,016 1,652 1,897 2,308 2,757 3,010 3,123 3,147 Source: Bloomberg, Student Estimates Valuation Figure 14: DCF Calculation 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 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 Page 6

7 Figure 9: Relative Valuation Table 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 E Price/Earnings E Price/Earnings E PEG Ratio E EV/EBITDA E EV/EBITDA Figure 10: Forward Multiple Equals Current Multiple 2015E Price/Earnings 2015E EV/EBITDA 2015E EPS $1.75 $28.43 $30.18 $31.92 $1.45 $23.55 $25.00 $26.45 $1.15 $18.67 $19.82 $ E EBITDA $640 $24.50 $27.95 $31.40 $540 $20.13 $23.04 $25.95 $440 $15.76 $18.13 $20.50 Figure 11: Forward Multiple Moves Toward Current Peer Group Average 2015E Price/Earnings 2015E EV/EBITDA 2015E EPS $1.75 $31.29 $33.04 $34.79 $1.45 $25.92 $27.37 $28.82 $1.15 $20.56 $21.71 $ E EBITDA $640 $28.09 $31.54 $34.99 $540 $23.16 $26.07 $28.98 $440 $18.23 $20.60 $22.97 Figure 12: Target Price Calculation Page 7

8 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 GICS_SUB_INDUSTRY_NAME Screening Metrics Machinery Industrial Machinery 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 Pitroski F Score -1FY Pitroski F Score Current Unlevered Free Cash Flow Yield Per Share Margin Analysis 9.58% % 4.13% 6.93% Unable to compute Unable to compute 7.23% 11.43% 3.14% 6.93% 4.40% 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 #N/A Field Not Applicable EV / EBIT(T12M) #N/A N/A EV / EBITDA(T12M) #N/A N/A Price/Sales Ratio #N/A Field Not Applicable Price/Cash Flow Ratio #N/A Field Not Applicable Price/Book Ratio #N/A Field Not Applicable 3.33 #N/A N/A Average 5 year P/E (Aritimatic Average) Forward EPS 5 year growth (CAGR) Basic 5 year EPS growth (Arithmatic) % 15.76% 11.49% 10.85% 17.00% 10.69% 3.58% 18.31% 8.66% 11.49% 12.09% 47.90% 16.14% 1.59% 1.59% 10.00% 2.36% -9.17% 2.36% 10.06% BEST Forward PEG (Year) BEST Forward P/E Short Interest Ratio 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% % 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% % 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 Total Debt/Total Equity Total Debt/Total Capital Current Ratio Quick Ratio Interest Coverage Ratio Page 8

9 Investment Recommendation 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 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 professional. 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. Page 9

10 Figure A1: Income Statement Appendix A Pro-forma Financial Statements Page 10

11 Figure A2: Common Size Income Statement Page 11

12 Figure A3: Balance Sheet Page 12

13 Figure A4: Common Size Balance Sheet Page 13

14 Figure A5: Cash Flow Statement Page 14

15 Appendix B Valuation Charts and Sensitivity Page 15

16 Figure B5: DCF Sensitivities Cost of Equity CV Profit Margin 5% 6% 7% 8% 9% 8.04% $24.76 $27.73 $30.69 $33.66 $ % $22.15 $24.60 $27.05 $29.50 $ % $20.20 $22.27 $24.34 $26.41 $ % $18.70 $20.47 $22.25 $24.03 $ % $17.51 $19.05 $20.60 $22.14 $23.68 Cost of Equity CV CAPEX as % of Operating Cash Flow 44% 47% 50% 53% 56% 8.04% $31.62 $31.16 $30.69 $30.23 $ % $27.82 $27.43 $27.05 $26.67 $ % $24.99 $24.66 $24.34 $24.02 $ % $22.81 $22.53 $22.25 $21.97 $ % $21.08 $20.84 $20.60 $20.35 $20.11 Cost of Equity CV Growth Rate 0.0% 1.0% 2.0% 3.0% 4.0% 8.04% $25.46 $27.70 $30.69 $34.87 $ % $23.20 $24.89 $27.05 $29.93 $ % $21.41 $22.71 $24.34 $26.43 $ % $19.97 $21.00 $22.25 $23.82 $ % $18.78 $19.60 $20.60 $21.81 $23.32 Page 16