Each new company will be more nimble and able to build stronger, more intimate customer relationships to accelerate mutual success.

— Steve Loranger, ITT Chairman and CEO 

On Tuesday (Nov. 1^st), conglomerate ITT (NYSE: ITT) completed its plan to split into three separate companies:

• Xylem (NYSE: XYL) – Water infrastructure (e.g., pumps, pipes, and valves)

• Exelis (NYSE: XLS) – Defense and aerospace (night vision goggles, electronic warfare, radios, satellite imaging, air traffic control)

• ITT (NYSE: ITT) – “Highly-engineered” industrial products (don’t ask)

ITT Spinoff History is a Long One

If this sounds like déjà vu, it could be because ITT has spent the past two decades breaking itself up. In 1989 ITT sold its namesake international telecommunications businesses to France’ Alcatel (NYSE: ALU). In 1994, ITT spun off Rayonier (NYSE: RYN), its forest products division, and divested ITT Educational Services (NSYE: ESI) through an initial public offering (IPO).  The following year (1995), ITT split into three companies: ITT (acquired by Starwood Hotels (NYSE: HOT) in1998), Hartford Financial Services (NYSE: HIG), and ITT Industries, which in 2006 changed its name back to ITT (because the name was available after the Starwood merger swallowed up the old ITT).  A confusing corporate history, to be sure, but I think this latest split-up may be its last.

Conglomerates Have Been Out Since the 60s

In the late 1960s, conglomerates were all the rage as they were viewed as a way to diversify revenue streams and make corporate earnings smoother from year-to-year. Since investors hate uncertainty, the thinking was that a conglomerate’s more stable earnings and “synergies” would obtain a higher market valuation. The common wisdom proved wrong as conglomerates ended up becoming unfocused behemoths that were nothing more than a bunch of unrelated, second-rate businesses. If one of the businesses was a high-growth star, its higher-deserved valuation often went unrealized because investors became distracted by the conglomerate’s other slow-growth businesses. Ever since the 60s, investment bankers have convinced corporations to break up into specialized and focused companies so that the higher valuations of the most profitable business units would be recognized by the marketplace.

Splitting up Increases Valuations

As the introductory quotation above demonstrates, when ITT announced its most recent 3-way split in January 2011, nimbleness and increased customer focus were cited as justification for the split. On the day of the spinoff announcement (Jan. 12^th), ITT stock shot up $16.5% from $52.78 to $61.50. If focused companies do a better job, they’ll win more business, make more profits, and command a higher valuation. According Joel Greenblatt’s classic investment book You Can Be a Stock Market Genius, such improved performance often does happen and studies have shown that spinoff companies (as well as their parent corporations) outperform the S&P 500 by an average of 10% per year during their first three years of independence. 

Water is Sexier Than Defense

In ITT’s case, its low-growth defense business – which generated more than half of the company’s revenues and operating income — was weighing down the valuation of its higher-growth water and industrial engineering businesses. Investors currently despise defense companies because of fears that the U.S .defense budget is in a long-term decline. Consequently, defense companies are valued at only 5 to 6 times EBITDA (i.e., cash flow), whereas stand-alone water companies are valued twice as high at 9 to 10 times EBITDA.

ITT Spinoff Companies: Side-By-Side Comparison

You can see this disparate valuation phenomenon in real time with the current prices of the ITT spinoffs:

Comparison of ITT Spinoff Companies

A few other things to consider (p. 4): the new ITT will be debt-free, shifting all of its debt to the other two spin-offs. Xylem will have $1.2 billion of debt and Exelis will have $890 million. The new ITT is also dumping a majority of the company’s pension obligations onto Exelis. Fitch Ratings estimates that Exelis’ pension liabilities are currently $1.7 billion underfunded, so feel free to add that to its debt burden. The one liability being kept by the new ITT is the asbestos liability, which currently is estimated at $707 million. Xylem will be the company that remains in the S&P 500 index, whereas the other two will be sent packing to the S&P MidCap400 index. Old ITT’s chairman and CEO Steve Loranger decided to go with Xylem and become its chairman. Since he had the power to go anywhere, his decision speaks well for Xylem’s future business prospects.

Slow-Growth Exelis a Better Value Than Fast-Growth Xylem?

All things considered, the new ITT looks like the healthiest business and that may explain why its stock has outperformed the other two during the first two days of trading. But I’m keeping an eye on Exelis, because it is incredibly cheap – even taking into account its debt burden and slow-growth defense business. It is so hated right now that I wouldn’t be surprised if investors sell it off until it falls below $10. That’s when I’ll pounce because I’ve never forgotten what Joel Greenblatt wrote about the “stub” stock in a corporate reorganization (what I think of as the “ugly duckling” portion of the reorganization) usually being the best investment:

If the common stock of XYZ after the recap (usually referred to as the stub stock) were to trade at only $6, the price/earnings ratio would be down to 5. That’s usually much too low. It’s no science, but a new price/earnings ratio of 8 or 9 wouldn’t seem unreasonable.

The stub stock is where you can make the big money. Essentially, investing in the stub stock is just like investing in the equity portion of a publicly-traded leveraged buyout. Many leveraged buyouts have returned five or ten times the original equity investment, and several stub stocks have produced similarly spectacular returns.

Irony and contrarian investing are alive and well in the stock market. Everyone is talking about Xylem and the new ITT because of their high projected growth rates, but don’t fall into the “growth trap” and overpay for growth. Often, the best investments are the slow growers that have been excessively dumped at any price by impatient investors.

I Bet You

Here’s a bet: Exelis outperforms both Xylem and the new ITT over the coming year from now until November 2, 2012. Any takers?