AMM Dividend Letter Vol. 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.

Chart Courtesy of The Falkenblog.
Chart Courtesy of The Falkenblog.

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.

Exelis Business Divisions

The Missions Systems division is set to spin-off from Exelis this summer under the name Vectrus.

Dividend History:

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.

Data from S&P Capital IQ.
Data from S&P Capital IQ.

Catalysts for Dividend Growth and Price Appreciation

Vectrus Spin-Off

“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).

New Exelis

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.

Conclusion:

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.

 Chart courtesy of Stockcharts.com.
Chart courtesy of Stockcharts.com.

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

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

AMM Dividend Letter Vol. 5 ~ Growing Wealth Like Grace Groner With Abbvie (ABBV)

This is from the AMM Dividend Letter released February 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.

You’ve probably never heard the story of Grace Groner but it’s an important one.

Grace lived in Michigan, worked as a secretary, wore secondhand clothes, never owned a car, and lived in a modest one bedroom house. Upon her death, this woman of modest means left Lake Forest College an estate of over $7 million to establish internships and study abroad programs. The donation is expected to generate over $300,000 a year for the college.

How was a woman of such modest means able to give away over $7 million upon her death?

After graduating from Lake Forest College in 1931, Grace started working for Abbott Labs (ABT) as a secretary. She worked at Abbott Labs for 43 years. The key to her wealth was a simple decision she made early in her career. At age 26 she took her savings, about $180, and bought 3 shares of Abbott Labs at $60 per share and then never sold.

Along its way to becoming a global pharmaceutical/medical device behemoth Abbott split its shares a dozen times, paid dividends, and grew its dividend year-in and year-out. Living below her means Grace didn’t have a need for the dividends, instead she reinvested them. Her initial $180 investment compounded into $7 million, 39,000 times her original investment, a compound annual growth rate slightly over 15%.

Yes, Grace was very fortunate in making an early investment in one of the great health-care and dividend growth companies of the 20th century. While Grace’s wealth may be considered a happy accident her investment strategy, dividend growth and reinvestment, is a proven way to build wealth over a long period of time.

According to Longrundata.com, a nifty website with a dividend reinvestment calculator, if you had bought $1,000 worth of Abbott Labs 20 years ago (January 1, 1994), well after Grace Groner’s initial purchase, you would now have $10,667 as of February 27, 2014. That’s over 10x you’re original investment and an annualized return of 12.46%. Because of Abbott Labs commitment to growing its dividend, the yield on your original purchase would now be around 24%.

Spending less than you earn, investing in dividend growth companies, and reinvesting those dividends is a tried and true path to building wealth over the long-term. Just like Grace Groner.

Sincerely,
Your Portfolio Management Team

Dividend Stock in Focus

AbbVie (ABBV): $50.91*

*price as of the close February 28, 2014

In late 2012 Abbott Labs, in an effort for investors to better evaluate its two distinct business lines, spun-off its biopharmaceutical division, Abbvie, to existing shareholders in a tax-free corporate restructuring. Abbvie is an example of a “Restructuring/Special Situation” (as described in the last letter) that we feel has an opportunity to eventually become a dividend stalwart.

Following the spinoff, shares of ABBV declined in to the low $30 range on fears of Abbvie’s largest drug Humira losing its patent in 2017. Our opinion at this time was that these fears were overblown and that the market was mis-pricing the risk of the patent loss. The essence of this mis-pricing is related to the difference between a chemically synthesized drug (which is easier for generic manufacturers to develop and bring to market) vs. a biologic like Humira which is more complicated and costly to develop in generic form. More on this below.

Our initial time frame for an investment in a spin-off is at least one year. This allows us time to evaluate the new stand alone business as it pertains to management, strategy execution, and dividend policy. Additionally, research has shown that corporate spin-offs in general continue to outperform the broader stock market for 2-3 years following the spin-off. During our initial holding period if our outlook for the new stand alone company improves and our valuation estimate continues to increase we may continue to buy shares in the new company.

The strong growth and cash flow from Humira, the continued development of their drug pipeline, and management’s commitment to returning capital to shareholders through dividends has increased our estimate of fair value for the company and changed our holding period from one year to multiple years.

Catalysts for Dividend Growth and Price Appreciation:

Biologic vs. Chemical Compound:

Abbvie’s near term fortunes are heavily dependent on the blockbuster drug Humira. Over 50% of Abbvie’s sales and over 70% of their profits come from Humira. The main concern surrounding Abbvie is the loss of Humira’s patent in 2017 in the U.S. followed by the loss of its European patent in 2018. Once “off patent” there is a risk that generic drug makers will start selling their own form of Humira for much less than Abbvie, stealing market share and hurting Abbvie’s profitability. As discussed above, however, the fact that Humira is a biologic rather than a chemically synthesized drug provides a layer of protection or “moat” to help protect it from would be generic competition.

Chemically synthesized drugs are produced through a combination of chemical processes that can be repeated in a predictable and highly dependable way. Well known examples of these kinds of drugs include Tylenol, Lipitor and Viagra.

When a chemically synthesized drug goes off patent it is easier for a generic drug maker to get FDA approval for its version. The generic drug maker does not have to put its generic drug through clinical trials, it only has to prove that their drug is equivalent to the name brand drug and therefore will produce the same data as when the name brand drug went through its trials.

Unlike these drugs, biologics are proteins currently too large and complex to be created chemically. Instead, scientists enroll the help of microorganisms (plant or animal cells) by splicing the necessary DNA sequence coding the protein/biologic into the microorganisms’ DNA. Then the microorganisms produce the targeted biologic.

In contrast to chemically synthesized drugs it is difficult, and sometimes impossible, to characterize a complex biologic by testing methods available in the laboratory. Some of the components of a finished biologic may even be unknown.

In short, for biologics the product is the process. Manufacturers must ensure product consistency, quality, and purity by ensuring that the manufacturing process remains substantially the same over time. In contrast, a chemical drug manufacturer can change the manufacturing process extensively and analyze the finished product to establish that it is the same as before the manufacturing change.

The trouble with creating generic or “follow-on” biologics is that any deviation from the process in producing the original pioneering biologic, whether it be different cell lines, purification techniques, etc., can cause vast differences between the original biologic and the follow-on biologic. This can have dangerous consequences.

For example, Epogen and Eprex are both proteins of identical structure, Epotein, focused on treating anemia due to Kidney failure. However, they are each produced by two slightly different methods. The slight difference in productions leads to a dangerous reaction in patients taking Eprex. Patients taking Eprex began producing antibodies at a much higher rate than patients taking Epogen. Eprex patients experienced an allergic reaction to Epotein so severe that they also became allergic to the Epotein produced naturally by their own body. Instead of improving medically, Eprex patients became more ill.

As discussed above in the case of Epogen and Eprex, the potential differences between the original biologic and the follow-on biologic means the follow-on must undergo testing for efficacy and safety too. Per new regulations, the potential follow-on biologic must have animal toxicity tests performed and possibly animal immunogenicity tests if there are elevated concerns about impurities and excipients.

It is more than likely that follow-on biologics will be required to undergo clinical studies. The scope of these clinical trials will depend upon the uncertainty surrounding the biosimilarity after structural and functional characterization and animal studies.

More tests mean more time and more costs to develop a generic biologic. Humira is way too profitable a drug to not have potential competition but the complexity of production and the costs associated with bringing a generic competitor to market make it that much harder for generic drug makers to immediately cut into Abbvie’s Humira profits.

Pipeline:

Hepatitis C: Abbvie has an extremely effective HCV combo being developed to treat Hepatitis C. The SVR12 rates (the undetectable amounts of virus RNA at 12 weeks after stopping treatment) in the early phase III trials are around 96%. While they will face strong competition from both Merck and Gilead, Abbvie is still looking to grab $2-3 billion in peak sales in the very attractive HCV market.

Leukemia: Abbvie is in partnership with Roche to develop ABT-199, a treatment for Chronic Lymphocytic Leukemia (CLL), one of the most common forms of Leukemia. It targets the Bcl-2 protein that prevents the CLL cell from dying. ABT-199 switches off the Bcl-2 protein allowing CLL cells to die naturally and making them more susceptible to chemotherapy.

In a recent Australian clinical trial people with an extremely poor prognosis achieved an 84% response rate and the bone marrow cancer was cleared in 23% of the people. From Anthony Steele the Head of Support Services for the Leukemia Foundation of Australia.

This drug means people with an incurable cancer, who undergo many periods of intensive treatment, periods of remission and with an expectation that the disease will relapse, now have hope that a treatment will be made available to end this life-long cycle.

Endometriosis: Elagolix is focused on the treatment of endometriosis and is currently in phase III trials. Compared to the standard care for endometriosis, Elagolix is as effective with less side effects, goes into effect quicker, and easily reversed. Ovulation returns after the first month of cessation, a key aspect for women who want to get pregnant. It is also a once day oral tablet versus an injection for the current methods. Elagolix is also in phase II trials for uterine fibroids, an indication that could be larger than endometriosis. JP Morgan Equity Research potentially sees a $1 billion combined market for Elagolix.

Conclusion:

Abbvie is a company whose story is still lead by Humira but the narrative is turning into one about its pipeline. However, when calculating fair value we can’t base it on potential. We have to calculate fair value on what we can currently account for. Our estimate of fair value has risen over the year and currently sits at $58 per share.

Chart courtesy of Stockcharts.com
Chart courtesy of Stockcharts.com
The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.

SLM Corp: Upcoming Spinoff To Unlock Value

This is from the AMM Dividend Letter released October 31, 2013. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

SLM Corporation (SLM): $25.37**

Profile:

SLM Corp. (also known as Sallie Mae) operates two distinct businesses related to the student loan industry: 1) Consumer Lending: originates, acquires, finances and services private student loans, and 2) Government Guaranteed Loans: manages a portfolio of private loans guaranteed by the government through the Federal Family Education Loan Program (FFELP). While the FFELP program was terminated in 2010, SLM Corp. continues to manage a FFELP loan portfolio of more than $118 billion on its balance sheet. Additionally, the company services loans owned by the Department of Education, and other guarantors of Federal Family Education Loan Program (FFELP) loans.

Dividend History:

From 1988 through 2006 SLM Corp. grew their dividend at a compound annual rate of 22% with only one annual reduction of the payout during the 2001 recession. However they reduced the dividend in 2007 and then eliminated the dividend completely from 2008 through 2010 as a result of the financial crisis. In 2011 they reinitiated a dividend of 30 cents per share and increased this amount by 66% to 50 cents per share in 2012.

Catalyst for dividend growth and price appreciation:

Earlier this year SLM Corp. announced that it will be spinning off its high growth, high return on equity private education loan business while the parent company will retain and manage its large student loan portfolio. The private bank, the spin off, will be named Sallie Mae Bank. The parent company will change its name to Education Loan Management. Splitting the company in two via a spinoff is a classic value creating strategy. Conceptually, the parts should be worth more than the whole, since investors can now value the high growth business independently of the operating performance of the slower growth business. The spinoff is expected to occur sometime in calendar year 2014. We outline the attributes of each post spinoff business below:

Education Loan Management (predictable cash flows, consistent return of capital to shareholders):

This entity will manage the cash flow from a student loan book that will amortize in 20 years and will remain the largest education loan servicer in the country. After accounting for operational expenses and discounting back the expected and reliable cash flows for the next 20 years we arrive at a value of $25 per share for Sallie Mae’s student loan portfolio. Ultimately, we expect Education Loan Management to return more capital to shareholders via share buybacks and dividends after the spinoff is completed. The potential exists for the value of Education Loan Management to increase if they are able to acquire more blocks of federally guaranteed student loans.

Sallie Mae Bank (high growth, high return on equity):

Sallie Mae Bank will retain the most recognized brand in the education loan industry, along with a leading market share (~47%) in private loan originations. We estimate the private bank business (the spinoff) is worth between $5-7 per share based on a comparison to similar publicly traded companies.

Based on our valuation analysis, the combined value of the two entities following the spinoff could be as high as $32 per share. Our 1 year total return target for this holding at time of our purchase was 25-30%***.

** Price as of October 31, 2013
*** Represents average price paid for clients invested in our Dividend Strategy. Depending on when a client joined the strategy they may have received a different price.

Image courtesy of Stockcharts.com.
Image courtesy of StockCharts.com.