Share tips: No ordinary defence stock

published 18 May 2012

Exelis (NYSE: XLS), rated BUY by EVA Dimensions

Exelis is in the doghouse. The mid-sized defence business was spun out of ITT last October. Since then, it has been largely discarded by investors, fearful of the US government's military belt-tightening. Yet Exelis is no ordinary defence stock. It specialises in advanced electronics and communications, used for operations such as cyber warfare and battlefield support.

Its turnover is split as follows: 69% comes from the US Department of Defence; 9% from international sources (eg, Middle East and Europe); and 22% from commercial aerospace. For the first quarter, the company saw sales rise 6% to $1.4bn, delivering an operating margin of 10.6% and underlying earnings per share (EPS) of 47 cents beating Wall Street hopes.

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For the rest of 2012, the board reconfirmed that it expected to achieve $5.45bn in revenues and EPS of $1.83. This makes the forward p/e of 6.2 look ludicrous, given that there is an $11.3bn order book, equivalent to twice sales. The management team is also very well connected within the Pentagon. Chief executive David Melcher has many military contacts, having spent 32 years in the army, reaching the rank of general.

There are some possible stumbling blocks. Cutbacks by the US government could hit performance, particularly in its higher-margin hardware unit. But President Obama says he remains committed to maintaining "force readiness", which he describes as having immediate access to ships, aircraft and aerial drones. He also wants to be able to knock out enemy communications through electronic warfare and precision-targeted missiles, all areas where Exelis specialises.

Another key factor is that many of the firm's products can be deployed across numerous platforms or used to upgrade existing systems. This means that no single programme accounts for more than 7% of sales. A great example is the ongoing debate over whether to expand the F-35 Joint Strike Fighter programme or upgrade the F-18s jets. Irrespective of the political debate, Exelis can install its systems on either of the planes.

Given this flexibility, along with the organisation's exposure to the few key areas that might benefit from more of the US military's huge annual budget of $550bn, then I would rate the stock on a ten times EBITA multiple. Adjusting for $851m of net borrowings and a $1,938m pension deficit delivers an intrinsic worth of roughly $16 a share. Second-quarter numbers are due out in July.

Rating: Buy at $11.50

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments. See www.moneyweek.com/PGI or phone 020-7633 3634 for more.

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.