Exelis XLS

Spin off from ITT. Hands down the worst of the three companies both with debt and business prospects. Ripe with opportunity. Insiders have started to buy decent sized lots on the open market. It is loaded up with all the pension liabilities of ITT, Fitch estimates them to be in excess of 1.7B, but with the belief that the cash flows will adequately support them.

Business: Defense contractor with a wide array of products. About 73% of their sales (as of their 10-12B) was DoD related. International sales were 11%, the remainder went to corporations and private based business.
Geospatial systems, night vision, IED jammers, US SINCARS etc. I'm somewhat familiar with their work thanks to the research on EMAN. The night vision products are held as high quality and I think this will be a product long into the future capable of driving revenue.

Financials: They generated 5.8B in revenue for 2010 and 430M in net income from operations. For the next five years or so they expect to push 200-300 million towards their pension liabilities to get back to fully funded. According to the investor day conference this assumes no change in discount rate (historical low) or a temporary government relief (which has happened before).  Management has made it clear they don't expect either to happen.
This year they are expected to generate (calculated annualized previous 9 months which will likely discount) a little over 340M in net income.

Cuts to Defense Spending: There will be cuts to defense spending, how much is slowly becoming clear. Right now the running rumor is 450B over the next decade. How this will actually be done is the million dollar question but lets just call it an even 45B/year. With defense spending estimated to total 650B in the US this means there will be a 7% drop.
With this quick and dirty calculation we can now find some sort of reference point for revenue drops at XLS.

Scenario 1: 20% revenue drop next year: 4500M in revenue for XLS. Gross margins have averaged around 22%...Gross profit of 990M. SG&A is 600M/year R&D is 100M/year and interest expense is 32M/year. Operating income of $258M a year. All of their FCF will go towards pension payments.

Scenario 2: 10% drop in revenue, same parameters: 400M in operating income. 250M to pension payments. 150M in income before tax, 100 if a 33% rate is applied. ~75M in dividend payments are adequately covered.

Both of these scenarios assume a much greater than expected average cut to defense spending. With rates at historical lows there's little room for them to go lower and any push up would only help XLS. I think what is important to note is that this is generating substantial FCF relative to it's MC of 1700M as of 1/7/2012. 

None of their debt has to be rolled over for awhile (2016 I believe), giving them time to pay down their pension before worrying about the tranche of debt coming up. 

Investment decision: I'm still trolling through their products. I've got some leads and preliminary indications that their products are better and stickier than the market is giving it credit for. A lot of bad news is written into this and the game theorist in me says this is an opportunity, at a lower price. Under $8.50/share (a MC of ~1600M) I believe one is compensated for the risk. If cuts are imminent (they've already been downsized by 10% from initial CBO estimates) I would like to believe that a larger defense contractor would take a look at XLS (LMT, RTN NOC etc). No position.

2/6/2012: Kept on reviewing. I basically compared this to a recent investment in a highly levered company. We know they have 9B plus of backlog. While this isn't guaranteed it likely will flow through the pipeline. This would give us 2 years of scenario 1.  This assumes no new contracts and a rugged drop in revenue.

The more information that comes out about the defense cuts the more I believe they won't be as severe as stated. Most of the savings is from withdrawing from Iraq and Afghanistan. They then hope to save more money through technological advances, essentially just cutting troops and enabling lots of UAV's. This is a space XLS has a presence in already. When everything is all said and done DoD funding will actually rise 1.5% annually over the next five years. So this is essentially a bet XLS won't receive the worst of the worst cuts. Considering their exposure to over budget stealth fighters (none) I'm one to believe revenue will not drop ridiculously. Management seems capable and smart. The pension liability, while quite high, is well covered and once it is fully funded there will be ample cash for shareholders.

This is a beaten down sector but a company that has good management, good products and some growth kickers in their air traffic divisions and exposure to the Middle East. Forced use of FCF,while not ideal, certainly prevents disaster acquisitions or squandering of cash. I judge FCF to be roughly 300M in Scenario 1 (adding back in certain non-cash items found in MRQ's 10Q). Small position for now. Plenty of potential to be wrong. Long XLS.

3/2/2012: Quarterly results released. Nothing particularly surprising here. They hit their 2011 numbers in line with what they have stated previously. For 2012 they expect revenues to be  5.4-5.8B, a slight decline from 2011 but no deleterious fall. They expect FCF to be around 125M for 2012, AFTER pension contributions of 320-370M and dividends of 75M. They have a funded backlog of 3.6B relative to a total backlog of 11.7B.

They spelled out their pension contributions, namely what they are going to do, very well. This is still the scariest thing about the company in my opinion. They have a high return rate of 9% (~40% of pension assets are in fixed income, not getting 9% there!) that likely will be readjusted. While the future is unknown at least I, the investor, know where the companies cash is going.

The CEO mentioned that he wanted to do some acquisitions and would prefer to be "a bit more active than not." This is not what I wanted to hear but until action is taken and the impact is assessed I will stand still.

Due to the shifting capital structure, higher I&T segment revenues and lower C4ISR revenues, depreciation will begin to outpace CapEx. The effect will be stronger free cash flows relative to declining net income. With this shift also comes lower margins, but management expects this shift to stabilize soon.

I still think this company remains undervalued, and as such remains an investment.