Friday, August 8, 2014

Exelis and its Spinoff Vectrus

Exelis Inc (XLS) is an aerospace and defense contractor that was originally spun off of ITT Corporation (ITT) on 10/31/2011, and now Exelis is following suit by spinning off its shrinking mission systems business line into a new company called Vectrus (VEC) later this summer or early fall.  This is the classic move to separate the declining business to highlight the attractive remaining business.  Exelis will be more of a pure play aerospace and defense products contractor focused on a few select growth sectors.  Vectrus will be a government services defense contractor with falling revenues, but strong cash generation due to the low capital requirements and a variable cost structure.

Both Exelis and Vectrus will benefit:
  • Exelis benefits by shedding the underinvested services business which is experiencing severe declines in revenue due to budget constraints and the draw down of troops in Afghanistan.  The mission systems business is weighting on the rest of the business and masking the improved growth profile of Exelis's C4ISR segment and other growth initiatives, giving the remaining business a higher multiple.
  • Vectrus is similar to other recent spins in the government services space (Engility Holdings & SAIC), declining revenues in the near term is less of a problem than it appears due to the low fixed costs, most of their costs are variable and attached to specific contracts.
With increased geopolitical tension defense contractors could once again see their revenues pick up from cyclical lows and Exelis represents an attractive event driven way to invest in that theme.
At the time of the Exelis spinoff from ITT, mission systems was the growth business and the rest of the business was flat or declining, times have certainly changed.  Shortly after the spinoff from ITT, defense spending came under a microscope with budget sequestration and the draw down of troops in Afghanistan.  In 2013 Vectrus had $1.5B in revenue with 100% of that coming from the U.S. Federal government, a full 92% from the U.S. Army, and 34% of 2013 came from Afghanistan which is quickly going away.  Revenues are expected to be down 25% in the mission systems business in 2014, with additional downward pressure in 2015.

Vectrus will operate in three main business lines: base operations (majority of the revenue), logistics, and network communications.

Major contracts include (69% of 2013 revenue):
  1. Kuwait Base Operations and Security Support Services (K-BOSSS) contract for Camp Arifjan: Base operations contract for one of the largest bases in the U.S. Military, services include: medical services, postal and maintenance, public works, transportation, and emergency services
  2. Operations, Maintenance and Defense of Army Communications in Southwest Asia and Central Asia (OMDAC-SWACA) contract: Network communications contract expiring in 2018 supporting the O&M of the Army's largest network from locations in the Middle East.
  3. Logistics Civilian Augmentation Program (LOGCAP): Logistics contract where Vectrus is a subcontractor for certain task orders, the subcontracting agreement ends in 2018
  4. Kuwait based Army Prepositioned Stocks-5: Logistics contract storing and supporting a wide range of military equipment and supplies.
Despite the industry headwinds, Vectrus can be an attractive business due to its low working capital requirements, much of their employment base are subcontractors attached to single contracts, as the contracts wind down so does a lot of the expense base.  Operating margins aren't great, at 4.0-4.5%, but with a renewed strategic focus on the business (classic spinoff reasoning) there will likely be some additional restructuring and cost cutting in the months after the spin is completed.

Leading Vectrus will be Ken Hunzeker, he has been the president of the mission systems business going back to the ITT/XLS spin, and is in for a nice raise.  Slightly more interestingly, Lou Giuliano will become the Chairman, he's the former Chairman and CEO of ITT and ran what would become Exelis at ITT for 8 years before becoming the President and COO of ITT in 1998, so he's intimately familiar with the business and the defense industry cycles.

Like many spins, Vectrus will be take out debt in order to pay a dividend back to the parent, here they're targeting 2.5-3.0x EBITDA, or approximately $130-150MM (although that's been a moving target down recently).  Government services businesses generate a lot of cash, I view debt (as long as its reasonable) as a positive here, management will likely be focused on paying down the new term loan and potentially refinancing to a better rate once the company becomes more seasoned.

Vectrus should have EBITDA of $50MM in '15 EBITDA, assuming they max out the debt at the 3x range, and putting a discounted 7x EV/EBITDA multiple on it gives you $200MM in market cap, a small slice of the $3B combined Exelis market cap.  I would imagine there will be some selling once the spin appears in Exelis investor's accounts as it will be a small unwanted orphan (it's worth about $1 per XLS share), so one strategy would be to wait for the spinoff to occur and settle out a bit before snapping up Vectrus shares on the cheap.

Exelis has identified four "Strategic Growth Platforms" in which they want to focus and invest going forward: (1) Critical Networks;  (2) Intelligence, Surveillance and Reconnaissance Systems & Analytics; (3) Electronic Warfare; (4) and Composite Aerostructures.  The Vectrus spin allows Exelis to appear more attractive to investors, post-spin it will have higher margins and a diversified revenue base less focused on the Department of Defense.
While top line revenue is down double digits YoY for the combined Exelis, the majority of the decline is the Vectrus business while the rest of Exelis is mostly flat with growth expectations going forward that should deserve a higher multiple.

Pension Liability
When Exelis was spun off of ITT, many called it a pension plan with a defense business attached to it, and that would have been a fair assessment.  Exelis has made significant progress on the pension (~$1.3 billion unfunded position as of the last 10-Q) and will retain and continue to service it after the spin.  The company has also frozen the pension plan of all future benefit accruals effective December 2016 and expects it to stop needing to make additional contributions to the plan after 2017.

Continued low interest rates have plagued companies with large pension plans because it lowers the discount rate at which a defined benefit plan calculates its future liability.  The lower the discount rate, the more current assets the plan needs to meet the future pension liabilities.  Tucked away in a transportation and student loan bill (MAP-21) was a pension funding relief provision that is likely going to get extended, it will reduce the amount Exelis will be required to contribute to its plans in the next several years from $225MM annually to $150MM.  This gives time for interest rates to normalize (bringing the discount rate up) and may reduce the overall contributions necessary by Exelis.

Post-Spin Cash and Capital Allocation
Vectrus will be paying Exelis a dividend of ~$150MM upon the spinoff giving the parent company amply liquidity when you consider the unused commercial paper program and credit facility with very little net debt.  Exelis anticipates maintaining their current quarterly dividend (2.5% yield), and could return additional capital to shareholders with their share repurchase program.  The flexible balance sheet also allows them additional room to invest in their Strategic Growth Programs and bolt on some smaller acquisitions like they recently did with the Orthogon airport management business.

Exelis Valuation
To value a post spin Exelis I added the $1.3B pension liability to the net debt, along with the $150MM dividend from Vectrus, subtracted out the $50MM in EBITDA that Vectrus is expected to earn in 2015 and then added back the pension contribution to EBITDA.  If Exelis were to be valued at 8x this adjusted EBITDA measure, I come up with a ~$24 price target for the remaining business.  Add the additional $1 for Vectrus, and the combined business is worth $25 per share versus $16.41 at today's prices.

  • Greater than expected headwinds in the Vectrus mission systems business, especially in their major Afghanistan and Iraq contracts.
  • Continued political pressure to reduce military and defense spending, although temporarily out of the headlines, the budget deficit is still substantial and unsustainable. 
  • Exelis has a large unfunded pension liability in comparison to its market cap, if interest rates stay flat or decline it could force Exelis to make additional pension contributions above current projections.  Additionally, Exelis is assuming an 8.25% rate of return (down from 9.00% in 2012) which could turn out high given current elevated asset prices.
  • The spinoff was guided earlier in the year for "Summer 2014", but has now slipped into summer/fall, further slippage or cancellation of the spinoff would reduce the attractiveness of Exelis, but it still remains an undervalued company in its current form.
With the defense industry near a cyclical bottom, the spinoff of the Vectrus mission systems business provides an attractive event driven investment opportunity by creating a higher growth products business and a headwinds facing services business.  I'm initially going with a Joel Greenblatt like call option strategy to enter a postion, the spin will expose value in both the parent and the orphan, but I'm extending it out with a January expiration to allow Vectrus a little time to find a following in the investment community.  Depending on where Vectrus trades after the spinoff, I may pickup some additional shares at that point.

Disclosure: I own XLS calls, anticipate buying VEC shares sometime after the spinoff is completed


  1. Curious, how are you arriving at the $751 of post-spin Exelis EBITDA? I struggle to arrive at a similar number - not even $600. I saw your note re: pension add back...

    1. Fair question, my notes are a little disorganized, but I was trying to add back the additional pension contributions. Straight estimated '15 EBITDA for the combined company is ~$600MM, take out $50MM for Vectrus, that nets about $550MM for post-spin Exelis. If I remove the pension liability from EV, and put a 8x multiple on $550MM in EBITDA, I come up with ~$23 per share for XLS post spin, close to my estimate in the post. Accounting for the pension liability is a little tricky, and I'm open to better ways to value it.

  2. Great article. Came to similar conclusions, albeit a bit later. What's your price target for VEC? I imagine it will fall quite a bit, considering declining revenue projections.

    1. At ~$19.70 its market cap is almost exactly $200MM, so it looks fairly valued to me if you give it a 7x EBITDA multiple. You're right that falling revenue isn't initially going to attract buyers, and given its odd 18-1 spin ratio, I'm guessing there are a lot of small odd lots in brokerage accounts that will look to sell. I like the business model as almost all of net income converts to free cash flow that will be used to pay down debt, but I would wait for a cheaper price in the next month or two.

      Exelis is likely the better the value now, they're going to be hosting an analyst event to go over capital allocation which should highlight some of the different levers they can pull to create value, plus the revenue guidance will now look more attractive without Vectrus. Thanks for reading.

    2. Hi, I love your blog, I just wanted some help understanding how you calculated the value of the VEC shares, do You have a simple math formula you can show? I understand all the EV/EBITDA but how to you manage to get to $19.70 how do you multiply the 7x by the EBITDA ? I don't understand that part. thanks/

    3. Sure, $50MM EBITDA x 7 = $350MM for the enterprise value. I wrote this post before they determined the final debt amount, Exelis put $140MM on Vectrus versus $150 that I assumed in the post, so the market cap should be $210MM ($350MM - $140MM), or $21 per share assuming about 10 million shares. Hope that helps, and thanks for reading.

    4. Yes that does help... But where did you get the 10 million shares from? the form 10?

    5. I'm sure its in one of the form 10 amendments, but I just took the spinoff ratio of 1 share of Vectrus for every 18 shares of Exelis. Exelis has about 188 million shares outstanding, so Vectrus should have a little more than 10 million shares outstanding.

  3. MDC, I enjoyed reading your blog. How did the XLS calls turn out post spin-off? Never managed to figure that conversion out.
    Happy Thanksgiving.

    1. I bought the January calls, so I still have almost another two months for this trade to work out a little more in my favor. My thesis was Exelis would be the primary beneficiary of the split, but in the months since the spin took place, Vectrus has significantly outperformed. Unfortunately, Vectrus is such a small piece of the overall trade, in hindsight I probably could have structured this better.

      The conversion for the options is a little lower than if you just owned the common due to fractional shares, but it works out to be 1 XLS share plus 1/20th of a VEC share, so the combined value is $19.37. I bought the $17.50 strike for ~$1, so far it's worked out alright, but still another two months to go. I'm actively looking for another spinoff situation to play in a similar way. Thanks for the comment, and Happy Thanksgiving too.