AMM Dividend Letter Issue 9: Investing in Exelis Spin-Off
This is from the AMM Dividend Letter released June 28, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
We focus on three types of dividend payers when building your portfolio.
1) Dividend Stalwarts: Companies that have strong dependable market positions, that pay a reasonable dividend (~2-3%), and have shown an ability to grow their dividends over a long period of time at a pace far faster than inflation. While the current yield is modest, we expect the growth in the dividend payout to provide a more robust yield (on original cost) in the future. Qualcomm (QCOM) is a recent example.
2) New Dividend Payers: Companies that have recently initiated a dividend policy. While these companies do not have the long history of paying and growing their dividend like the stalwarts, they do have a strong market position and the cash flow to become a stalwart in the future. Anheuser-Busch Inbev (BUD) and Apple (AAPL) are two examples.
3) Restructuring/Special Situations: Companies undergoing a restructuring, spin-off, or other special situation. Volume 1 of the AMM Dividend Letter highlighted such an investment, the spin-off of SLM Corporation (SLM) into two companies, Navient (NAVI) and SLM Corp. (SLM). If we see value in the restructuring and the parent company pays a reasonable dividend we will invest. Our initial time frame for these investments is one year but if, after the restructuring, one of the companies’ appears to offer good odds of becoming a dividend stalwart we may hold our investment for a longer time frame.
The subject of this letter, Exelis (XLS), is a good example of a company undergoing a restructuring.
Why We Like Spin-Offs
While building a future income stream is the primary goal of our dividend strategy, capital appreciation is a very close second goal. Investing in dividend paying companies undergoing a spin-off can help us achieve both of these goals.
The chart below highlights the capital appreciation potential of investing in spin-offs. The blue line is the Bloomberg Spin-Off Index and the red line is the S&P 500.
According to a paper written by John McConnell and Alexei Ovtchinnikov, since 1965 spin-offs have outperformed the broad market, on average, by over 20% in the first three years following the spin-off. The excess returns tend to be the highest during the first 12 months of trading.
Over time we expect the majority of your portfolio to be filled with dividend stalwarts. However, we will continue to proactively look for special situations, including dividend paying spin-offs, where we see good value and opportunity for capital appreciation.
Dividend Stock in Focus
Exelis (XLS): $16.94*
*price as of the close June 27, 2014
Exelis is well versed in spin-offs. The company used to be a part of ITT Corporation (ITT) but was spun-off along with Xylem (XYL) in 2011. It was then that we first added Exelis, trading around $10 per share, to the dividend portfolio. At the time the dividend yield was over 3% and was trading at multiples well below comparable companies. After more than a year when the company reached $16 per share we sold our position.
We’ve added Exelis back to your portfolio because it is about to undergo a spin-off transaction of its own.
Exelis is a defense contractor that has two main business divisions, C4ISR and Informational & Technical Services. C4ISR includes Exelis’ Electronic systems, Geospatial Systems, Night Vision & Tactical Communications Systems, and their Aero structures divisions. Their Informational & Technical Services business includes Exelis’ Information Systems and Mission Systems divisions.
The Missions Systems division is set to spin-off from Exelis this summer under the name Vectrus.
Exelis has only operated as a standalone company since late 2011. Exelis immediately started paying a quarterly dividend of $0.103 per share and the dividend hasn’t changed. The current yield is over 2.4%. Exelis’ current investment appeal is less about its dividend growth but more about its upcoming corporate restructuring.
Catalysts for Dividend Growth and Price Appreciation
“The line between disorder and order lies in logistics.” – Sun Tzu from The Art of War
Tactics win battles, logistics win wars. Exelis’ Mission Systems focuses on logistic solutions for the U.S. Military. Logistics support is a vital business to our military as it keeps our military forces operating at their best. However the business of logistics no longer fits in with the rest of Exelis.
Mission Systems is a lower growth and lower margin business compared to the rest of Exelis’ business divisions. The division is also heavily exposed to our military operations in the Middle East. As operations in the middle East wind down, this should create a drag on overall revenue growth at Exelis. It is a good time to spin-off Mission Systems and for Exelis to exit the logistics business.
Vectrus will be a pure play military logistics company. While the publicly traded Vectrus is new its business has been in operation for over 50 years as part of ITT and recently as a part of Exelis. The troop draw downs in the Middle East are affecting Vectrus’ revenue but it is still a solid business. Vectrus requires minimal excess capital to operate and generates a good amount of free cash flow.
Vectrus will be a small company when spun-off but a leader in military logistics. Vectrus should also be a good acquisition target for a larger company involved in military logistics like KBR, inc. (KBR).
After spinning off Vectrus, Exelis will focus on the higher margin and faster growing defense electronics business. Exelis’ current operating margin is 11%. After spinning off the lower margin logistics business (Vectrus), Exelis’ margins should reach 13-14%. Post spin-off, Exelis’ revenue base shifts from 30% international to around 50%. International revenue is expected to grow faster than U.S. revenue boosting the new Exelis’ growth profile.
Exelis will receive a special dividend from Vectrus too. As part of the spin-off process Vectrus will take on debt and use the proceeds to pay around a $150 million dividend to Exelis. The extra cash allows Exelis to buy back more shares or helps Exelis acquire another company.
Exelis will continue its current dividend policy post spin-off. Better growth and better margins also allow the new Exelis to raise its dividend but we don’t expect that to happen right away.
Higher margins and higher growth profile should push a re-valuing of a post spin-off Exelis. Industry peers currently trade at an Enterprise to EBITDA multiple at 8x or higher. Right now Exelis trades at 6x Enterprise Value to EBITDA because of its Mission systems business and exposure to current Middle East operations. A post spin-off Exelis is expected to have revenue around $3.4 Billion and EBITDA of $442 using a 13% operating margin. If Exelis traded in-line with its peers of 8x EV/EBITDA then the new Exelis will have a value of $3.5 Billion.
This doesn’t seem like much of a difference compared to Exelis’ current Enterprise value of $3.6 Billion. However, the new value doesn’t include Vectrus. At Exelis’ current per share price we are getting Vectrus for free.
In an ideal world we would be 100% invested in high-quality, high return on capital, dividend growth blue chip companies. Unfortunately these companies aren’t always trading at a price we’re willing to pay. Special situations, including spin-offs and corporate restructurings, can provide an opportunity to increase your income and overall capital when fewer opportunities exist elsewhere.
Exelis’ dividend provides a good short-term income stream. The upcoming spin-off of Vectrus should unlock the hidden value in this company and provide a return on your capital. Combining the two expected values of a post spin-off Exelis and Vectrus gives us an estimated current value of $20 per share for Exelis, providing 17% upside potential from the current price.
Books of Interest
You Can Be a Stock Market Geniusby Joel Greenblatt for more on investing in spin-offs and other special situations. It’s a bright yellow book with a title that is sure to embarrass you when reading in public but it is the authority on investing in special situations.
The Art of War by Sun Tzu