Focus Article: ITT Corporation (ITT)

  • July 21, 2012

Portfolio Update Regarding GeoEye (GEOY):

Earlier this week, satellite imaging company DigitalGlobe (DGI) made a bid for our portfolio holding company GeoEye (GEOY) for approximately $900 million. Under the terms of the agreement, shareholders of GEOY can choose to receive either $20.27 in cash, 1.425 shares of DigitalGlobe stock, or a combination of 1.137 shares of stock and $4.10 per share in cash. The aggregate consideration mix will reflect 1.137 shares of DGI and $4.10 per share in cash. This values GeoEye at a little over $24 per share and the stock is trading just below $23. Both GeoEye’s management and its largest shareholder Cerberus Capital Management have agreed to vote in favor of the deal.

This has been an interesting turn of events. When we wrote about GeoEye in our weekly focus article in January, it clearly appeared to be a stronger company and Cerberus was accumulating shares. GeoEye even made a hostile bid for DigitalGlobe in May, which was spurned by the company. In an unexpected turn of events, GeoEye lost a key government contract and the stock dropped sharply. The current deal by DigitalGlobe, when announced, helped the stock get back to the levels we purchased it at. Following the appreciation of both DigitalGlobe and GeoEye this week, we are actually posting a small profit in the position.

As you can see from our merger arbitrage tool there is a nearly 5% spread on the deal or about 7% annualized. Since the deal can be considered a stock plus cash deal and capturing the spread would require shorting DigitalGlobe stock, I am going to take profits by selling the position both in my personal portfolio and the model portfolio. The closing price on July 25th will be used as the selling price for the model portfolio.

This was an important lesson learnt about the perils of investing in a company that relies heavily on one government contract but thankfully it was learnt without any loss of capital.

ITT Corporation (ITT) $18.45

The Company:

We decided to pick ITT for this week’s focus article following an insider purchase by the President of its Motion Technologies division. ITT was once a huge conglomerate with hundreds of subsidiary companies covering everything from hotels to insurance. The company started the process of splitting up into smaller independent companies in 1995. Its latest split occurred last October when the company split into three companies. ITT’s former defense unit, ‘ITT Exelis’ now trades under the ticker symbol (XLS) and its water management unit is now called ‘Xylem’ and trades as (XYL). The surviving former parent retained the ITT name and provides it services to the industrial, aerospace, transportation and oil and gas markets.

The company, created in 1920 was originally known as the International Telephone and Telegraph. Through a number of strategic acquisitions it became an international provider of telephone switching equipment and telecommunications services. From 1960 to 1977, under the leadership of Harold Geneen, ITT acquired more than 350 companies and grew from a medium-sized business with $760 million in sales to a global corporation with $17 billion in sales. From 1979 to 1995, the company continued restructuring through strategic divestitures and acquisitions till it split into three separate companies in 1995: ITT Corporation focused on the hotel and gaming businesses, ITT Hartford, a stand-alone insurance operation and ITT Industries, a collection of manufacturing companies. A decade later, ITT Corporation was acquired, ITT Hartford changed its name and ITT industries continued its transformation and changed its name back to ITT Corporation in 2006.

The new independent ITT operates in four main segments:

  1. Industrial Process: Manufatures industrial pumps, valves, monitoring and control systems and aftermarket services for the chemical, oil and gas, mining, pulp and paper, power, and biopharmaceutical markets. This business is the company’s largest segment by revenue, generating $226 million in Q1 2012 revenue or 39% of total revenue of $577 million.
  2. Motion Technologies: Manufactures friction technology, durable brake pads, shock absorbers and damping technologies for the automotive and rail markets. This is the second largest segment in the company’s business.
  3. Interconnect Solutions: Manufactures highly engineered connectors for harsh environments in aerospace, industrial, oil and gas, medical, military and transportation markets.
  4. Control Technologies: Specializes in highly engineered aerospace components and industrial products in the energy absorption and motion control markets.

Why did the company split? Beyond financial independence and greater operational focus, I did not see much in the CEO’s letter explaining the reasons for the split. If unlocking value in each of the newly created companies was the goal, it was temporarily achieved for ITT post split, when the stock soared from $18.50 on November 1st to $24.95 in less than four months. However with the general market decline since May, the stock has given back those gains and is back at the post split levels.

ITT has a large global presence. Following the spin-off in 2011, the company’s business has delivered key strategic wins in the first quarter of 2012, which include industrial pump wins in the Middle East, automotive and rail gains in emerging markets and successes in energy absorption. The company continues to see success in emerging markets and has also seen growth through aftermarket sales. 60% of their revenue comes from outside the United States and a quarter of their revenue comes from emerging markets. The company is also spending 30% above industry average in research and development, bringing new products like its advanced drilling pump.

Business Statistics & Financials:

In the first quarter of 2012, the company saw organic revenue growth of 9% to $577 million and reported adjusted earnings of 39 cents per share, a drop of 13% from Q1 2011. Their US pension plan was 85% funded at the end of Q1 2012, up from 66% funded at the end of 2011. For the full year 2012, the company expects earnings of $1.62 to $1.72 per share, giving it a forward P/E of 11 at the mid-point of that range.

By the end of March 2012, ITT had approximately $728 million in cash and $23 million in short term debt.

Competitors:

On account of the split last October, I would not pay much heed to the numbers reported on most financial sites as they include earnings before the reorganization. Our source for the numbers below is Yahoo Finance but we have recalculated EV/EBITDA (extrapolating Q1 EBITDA to the next three quarters as operating margins are projected to be similar in Q2), Price/Book and Operating Margins for ITT based on Q1 results.

StockSymbolMkt CapEV/EBIDTAP/BOperating Margin
ITT CorporationITT1.74B4.622.356.41%
Dana Holding CorporationDAN1.76B2.491.65.74%
Ampco-Pittsburgh Corp.AP179.54M2.950.918.72%
Colfax CorporationCFX2.60B22.21.327.31%
The Boeing CompanyBA55.35B7.2211.018.37%
United Technologies Corp.UTX67.65B7.313.0114.47%
Honeywell International Inc.HON45.07B12.723.767.64%

Insider Buying:

Only one insider purchased stock on the open market over the last six months as listed below. You can view a list of all insider transactions for ITT Corporation here.

OwnerRelationshipDateCost# SharesValue($)Total Shares
Luca SaviSVP & President Motion TechnologiesJul-17$17.628,5001,49,7818,500

Conclusion:

One of our goals in exploring ITT this week was to see if the market was undervaluing the company post-split especially since the valuation ratios reported on most financial websites are inaccurate. The stock does appear cheap but the company is facing higher costs post-split as it spends more on building its sales teams and infrastructure. The company is buying back stock but most of those purchases are simply offsetting dilution from options awarded to management and employees.

The balance sheet is not as strong as management would have us believe on account of over $1.5 billion in long-term asbestos related liabilities. Operating margins of 6.41% are on the low end for their industry and organic growth is expected to remain in the single digits. With a lot of cash on hand, the company plans to make strategic acquisitions. I would rather wait and see how the company executes over the next quarter or two instead of starting a position.