(FORTUNE Magazine) – ITT is hot. So hot that investors are riding the stock without asking basic questions about whether reality matches perceptions. To date it's been some ride. In late March, ITT shares closed above $100 on the New York Stock Exchange for the first time in the conglomerate's tormented 75-year history. Operating performance has improved, the balance sheet is cleaner, and it's an open secret that ITT may soon break into three pieces: Hartford insurance; a manufacturing unit making antilock brakes, pumps, and defense gear; and a sexed-up leisure-time group consisting of Sheraton hotels plus newly acquired Caesars World casinos and Madison Square Garden, owner of the New York Knicks and Rangers. Enthusiastic Wall Street security analysts, such as Jack Blackstock of Donaldson Lufkin & Jenrette, figure the shares are worth perhaps $130; some ITT insiders are guessing closer to $200. Says CEO Rand V. Araskog: "Almost everybody who has bought our stock has made money."

But ITT's second coming as a go-go stock should inspire caution. Araskog has not publicly committed to break apart the $23.6-billion-a-year enterprise he has held together since 1979. "I don't have to bring it to a decision--not yet," he says. In March, Standard & Poor's downgraded the ratings of the Hartford-which contributes half of ITT's earnings and represents an estimated 30% of its breakup value. That mild rebuke serves as a reminder that widely ignored and sometimes disturbing complexities lie just below ITT's smooth surface. In the end, managers and shareholders alike will probably make a killing in ITT, just as they expect; but while the uncertainty lasts, this is a company that deserves much closer scrutiny than it has been getting.

The long-delayed transformation of ITT is a story of generational change. Araskog, a long, lean, blue-eyed Minnesotan of Swedish stock, is 63 and faces mandatory retirement in a year and a half. A West Point graduate who served the National Security Agency in the late 1950s as an interrogator of Russian defectors, he is a logician and a dominating authority figure of the old school, treated with mincing deference by some subordinates.

Though forceful and opinionated in discourse, Araskog sometimes has been cautious to a fault in action. Like many other corporate leaders of his generation, he was slow to respond to profound changes in the general business environment, including Wall Street's loss of faith in conglomerates and a shift to stricter accountability for chief executives. To his credit, he seems to have maintained and perhaps increased ITT's unrealized worth, while his peers at Westinghouse, IBM, and other blue-chip companies were destroying value.

Araskog has promoted a pair of younger executives who don't seem to like each other much but bring fresh thinking to ITT: Travis Engen, 50, a triathlon athlete and amateur car racer, who oversees insurance and manufacturing; and Robert Bowman, 40, chief financial officer. In a breakup, Bowman is expected to become president or perhaps even chief executive of the leisure-time group, the source of nearly half ITT's market value. Araskog would presumably serve the new leisure unit as CEO or chairman, ducking ITT's retirement rules by moving to the new company. Engen, who looks like the heir apparent so long as the conglomerate remains intact, would likely end up with manufacturing, ITT's least valuable unit. The Hartford would remain under its present management.

Credited by Araskog and others with lighting a fire under ITT, the trim, preppy Bowman is the one to watch. His rasuma includes degrees from Harvard and Wharton; a 1979-81 stint at the Treasury Department, where he worked on the Chrysler bailout; and two years in the municipal finance department of investment bank Goldman Sachs. From there he went to Michigan, where he served two four-year terms as state treasurer, an appointed job that initially paid $58,000 a year. A Detroit TV station tried to hire him as an on-air reporter after he left office in 1991. Instead he joined ITT as CFO of Sheraton, then the only piece of the conglomerate reporting directly to Araskog.

Breaking up ITT is hardly an original idea. Jay Pritzker and Irwin Jacobs proposed it a decade or more ago when both were active corporate raiders. One difference is that Bowman, who wears a tie with a fox-in-the-henhouse motif on deal-closing days, has become Araskog's adviser. And Bowman, equally gifted at politics and finance, understands the importance of pleasing constituents. The combination of his deference to Wall Street and Araskog's clamp-jawed determination is a potential bonanza for investors.

If and when it occurs, the breakup will mark the end of a long, twisting saga. Founded in 1920 as a telephone operating company by brothers Sosthenes and Hernand Behn, naturalized U.S. citizens from the Virgin Islands, the company acquired AT&T's overseas telephone-equipment businesses in 1925 plus a grab bag of overseas manufacturing operations. During World War II one of its holdings, German aircraft maker Focke-Wulf, built planes that bombed Allied troops, according to Anthony Sampson's The Sovereign State of ITT. Sosthenes had visited Hitler at Berchtesgaden in 1933 and later pronounced him a "gentleman."

In the 1960s and 1970s an accounting whiz named Harold Geneen transformed the collection of companies into a fast-growing, world-girdling, but downright wacky collection of assets, ranging from military radars to Wonder Bread. A tireless acquisitor, Geneen also championed a self-righteously bureaucratic style of management now viewed by business schools as a case study of what not to do. For one full week a month, Geneen forced scores of top managers in gray suits, white shirts, black ties, and laced shoes to sit together in New York or a quaintly futuristic Brussels conference room while he sweated them, one by one, on their financial results. Geneen sweated, too, as ITT attracted more than its share of controversy, including antitrust suits and allegations of colluding with the CIA to rig elections in Chile, where the company feared nationalization of its telephone properties.

From Araskog's perspective, the company was buffeted by powerful forces beyond his control--many of them legacies of this tortured past--from the moment he took control in 1979 until the late 1980s. Geneen had burdened ITT with such a load of debt and dividends that in the early years Araskog says he had to sell assets just to meet payments. In effect, the company survived by eating its own liver. Araskog moved to eliminate the silly meetings, along with some 250 businesses, including Avis car rentals and the Rayonier pulp-and-paper company.

At the same time, he fought off attacks from raiders, on the lofty principle that shareholders, not financiers, should get the value in ITT. On a third front, governments from Europe to South America began nationalizing ITT's overseas telecommunications assets. Araskog's response was to transfer the core telecommunications holdings to a French company, ultimately reaping $8 billion. He regards that deal, which closed in 1986, as his greatest achievement.

Although Araskog cherishes a reputation for straight-arrow integrity, he deeply embarrassed himself by accepting too much pay. As the charts above show, Araskog provided substandard returns to investors during most of his long reign. Even by the relatively forgiving measure of earnings-per-share growth, he falls short, having produced declines during seven of his 16 years. Yet he benefited from spectacularly generous compensation. In comparisons that weigh compensation against performance, he has frequently ranked high among America's most overpaid CEOs.

The apparent turning point, both for Araskog and ITT, came in 1990. That's when newly activist institutional stockholders rebelled, making ITT one of their first targets. The California Public Employees' Retirement System, a major pension fund known as Calpers, publicly charged that ITT's executive compensation "lacks a rational relationship to the company's economic performance." The accusation stung. ITT director Paul Kirk Jr. calls it "a bum rap." Araskog explains that it was the board's decision to give him a $5 million bonus in 1990--a long-term reward for years of work on the French telecom deal--that made his pay appear so dramatically out of line that year. Whatever the reason, Calpers figured that Araskog pulled down more than twice as much as CEOs of equivalent enterprises while ITT's shareholder returns lagged in the bottom third of its peer group.

According to Kirk, Araskog, and others, it is a coincidence that the conglomerate has demonstrated a laudable commitment to shareholder value ever since Calpers's attack. Whatever the motivation, the board subsequently approved a new compensation scheme that aligns Araskog's interests more closely with those of ITT's owners. Thanks to a recent 23% raise, Araskog will get a salary of $2 million no matter what, and no one can take away the 423,000 shares of ITT stock--recently worth $43 million--that the board has granted him at no cost. But cash bonuses are now pegged in part to return on equity from continuing operations, widely accepted as an appropriate performance measure. The target return is 16.4%, almost two points more than ITT figures it achieved last year; Araskog's bonus totaled $2.4 million.

The board replaced outright stock grants with options exercisable when the market price reaches certain thresholds, currently set at $105 and $117.60 per share. Araskog seems amply motivated to maximize shareholder returns. Were ITT's stock price to reach $130 per share, his personal profit on ITT stock would total $71 million, 65% more than he'd get at today's prices. At a market price of $200 per share, Araskog's payday nearly doubles, to $124 million.

As we shall see, the performance-based rigor of Araskog's new pay package is far from perfect. Still, the incentives are in place, and ITT's behavior in recent years has indisputably delighted investors. Says Carol Neves, a security analyst at Merrill Lynch who values ITT at about $150 per share: "This company got the faith late, but I definitely think they have it now."

While basking in approval, Araskog denies having had a foxhole conversion. "I don't blame people for the perception, but it's baloney," he said during a 21/2-hour interview in his walnut- paneled conference room overlooking Manhattan's Sixth Avenue. "We have been able to sustain a company's performance and survivability. I wouldn't argue that we always acted as quickly as we could. But I do argue that when we acted, we've done it right. And if we hadn't gone through what we went through [in the 1980s], frankly we would not have had the benefits of the last four years."

The question now is, What's really going on at ITT? None of the people Fortune asked--from ITT directors and executives to security analysts--could give a clear, concise statement of the company's strategy. Secretiveness may be part of the problem, suggests ITT spokesman Jim Gallagher: "Our chairman either decided he doesn't know the answer to some pretty important questions, like how are we doing and where are we going, or he doesn't want to give the answers."

In addition to the uncertainty about a potential breakup, ITT has confused investors by focusing in recent months on entertainment businesses to which it brings no obvious expertise. ITT's market value plunged by $600 million when it announced its $1 billion purchase of Madison Square Garden, along with the Knicks, in partnership with Cablevision Systems. And when the company considered acquiring the CBS or NBC television network, Wall Street's contempt forced a hasty retreat. Bowman, chastened, says the company must prove itself before venturing into new businesses: "We owe it to our shareholders to demonstrate that we can acquire large assets, run them well, and add value." But stay tuned: ITT's quadrennial management conference, held in March at Sheraton's newly acquired Phoenician resort in Scottsdale, Arizona, included a whole day of presentations on pop culture from author Tom Wolfe, film critic Roger Ebert, and others.

Even if its strategy were clear, ITT would be difficult to understand. Conglomerates, by nature, are engaged in more businesses than one person can readily grasp. To make matters worse, valuation methods differ from industry to industry. Insurers trade on multiples of book value, manufacturing operations on various multiples of earnings, and hotels and casinos on multiples of cash flow. The result, crazy but true, is that $1 of earnings from antilock brakes is worth less than $1 produced at craps tables. Moreover, the stock market, which once rewarded diversification, penalizes it now, except for occasional superb operators such as General Electric. That's a compelling reason to break up conglomerates. In ITT's case, security analysts estimate the penalty at $2 billion to $4.5 billion of market value.

ITT's behavior adds to the obfuscation. The company's financial filings are blizzards of one-time charges, credits, acquisitions, and divestitures. "Right now we've got money flying all over the place," says Araskog. ITT's striking improvement in return on equity in the past three years results less from big increases in net income than from a 19-million-share stock repurchase program that has reduced shareholder equity by 40% since year-end 1991.

Adding to the confusion, ITT has a habit of restating its earnings, fuzzing comparisons with past years. And to make the hotel business look better, Sheraton's reported revenues now include those of hotels it manages that are owned by others--even though only a small percentage of that money actually passes through ITT. Marriott International uses the same practice, which is permitted by accounting rules.

Probe deeper to find more cause for concern. ITT tried and failed to sell its Rayonier wood-products subsidiary. Finally, in February 1994, ITT unloaded the business through a so-called spinoff, in which shares of the newly independent company are simply handed out, pro rata, to ITT's existing shareholders. Thereafter the two companies' shares trade independently. Since the spinoff, Rayonier shares have wobbled, closing recently at $30 7/8--up just 12 1/2 cents from last year's initial price. Araskog, for the record, has hung on to his Rayonier shares and added more. But he and other ITT executives benefited in another way. Since the spinoff would reduce ITT's earnings and presumably its value, the board reduced the cost base and strike price of the new, performance-based options by the same percentage--roughly 9%--that the stock dipped after the deal was completed.

The importance of accounting increases when you consider the hotel-and-gambling business. Since 1989, ITT has invested some $3 billion in hotels and casinos, from the Caesars Palace acquisition ($1.7 billion) to the refurbishing of Manhattan's posh St. Regis ($250 million), where a room-service breakfast of coffee and toast costs $21.

Achieving ITT's corporate target return of 16.4% on that $3 billion investment will take some doing. Asked what the rate of return is now, Araskog first estimated it at "around 15% this year." Later, figuring in the dilution from Caesars, he revised his estimate to "around 12%." Then he called in Bowman, who suggested that a number "around 9% to 10%" would be more accurate. At that point, with Bowman still in the room, Araskog dismissed the subject, saying "Okay, 10% to 12%." Attempting a graceful exit, Bowman added, "It depends on how much debt you put into it--you can manufacture the number." (Although executives can affect returns of business units dramatically by shifting debt and equity around within the vessel that is ITT, overall corporate returns are not so easily manipulated.)

Now look at the Hartford insurance business, the overwhelming source of ITT's reported profits and a business widely regarded as benefiting from superior management under ITT. The Hartford sells two kinds of insurance: life, and property and casualty. The P&C business is particularly tough. By writing a policy, an insurer promises to pay all valid claims against it. Yet despite the best efforts of actuaries, it can be difficult or even impossible to accurately estimate those claims in advance. Along with other leading insurers, the Hartford has chronically underestimated future claims. Particularly treacherous have been environmental claims arising from asbestos and toxic materials, which have become more costly as a result of court decisions made long after the policies were written. For that reason, says ITT's 1994 annual report, "ITT finds that conventional reserving techniques cannot estimate the ultimate cost of these claims."

That statement of absolute uncertainty suggests that ITT's reported earnings may not correspond to reality. When policies are written and revenues booked, insurers create a reserve for estimated claims, a non-cash item that is charged against earnings. By definition, an underestimation of claims results in an overstatement of earnings.

According to ITT's filings with the SEC, in each of the past ten years for which data are available, 1984 through 1993, the company has (like many of its competitors) acknowledged errors in the accumulated claims from prior years. During that period, the error, or "deficiency" in official terminology, that the Hartford acknowledged each year averaged $337 million--the equivalent of 58% of ITT's average annual net income for those years.

The precision of that rather shocking percentage assumes, of course, that the Hartford has by now correctly estimated "the ultimate cost of these claims"--an unsafe assumption, if the annual report is to be believed. So long as the Hartford is part of ITT, therefore, it seems prudent at least to wonder whether the company produces any real earnings at all. It also raises unanswerable questions about the value of the Hartford in a breakup.

In fairness, officials at the Hartford and ITT take a different and far more comforting view. "ITT's reported earnings are reality as we know it," says the Hartford's chief actuary, Linda Bell. Over time, she notes, estimates are revised and errors get corrected. Each year, as the Hartford increases its estimates of claims, it takes the proper charges against income. The worst deficiencies are on policies written prior to 1983.

Although accounting rules don't permit the company to report it, she adds, the Hartford benefits from the so-called time value of money. Since the company can earn interest on reserves while waiting for claims, the cash needed today to pay future claims is less than face value. Bell estimates that, assuming a 5% interest rate, the actual value of future claims is some 15% to 20% less than the SEC filings show. In other words, the Hartford's deficiencies, though real, are not as bad as they look. Fair enough.

But when pressed, ITT officials protest too much. In an interview with Fortune, Jon Danski, senior vice president and controller, pointed to the relevant page in ITT's Form 10-K--the official annual report submitted to the SEC--and said, "This document, even though it is perfectly accurate, I find it misleading...To say that we were 'deficient' is a misnomer."

Although Bowman, Danski's boss, similarly refers to deficiencies as "so-called deficiencies," he adopts a more balanced perspective. "We feel pretty comfortable that the reserving at the Hartford over the last four or five years is at the conservative end of insurance companies," he says. "During the 1980s we did the best we could in estimating, and history has shown that we did not do a good job, along with everyone else. One of the reasons this industry has the [relatively low] multiple it does is the long-range nature of these estimates."

None of the foregoing suggests that ITT's management has behaved less than impeccably. What becomes clear upon close examination is simply that ITT's very nature, combined with the prospect of a breakup, gives Araskog, Bowman, and other top executives great leverage over the outcomes that the company's investors will experience. For that reason it seems worthwhile to return one last time to the contentious question of executive compensation.

It turns out that ITT's revised compensation scheme exposes Araskog to no great risk at all. Under the terms of his management contract, the board has the right to fire him only in the event of "willful malfeasance or gross negligence or failure to act involving material malfeasance." By itself, destroying shareholder value would not justify a termination. What about those famous stock options pegged to market prices? Well, it turns out they become exercisable nine years after they are granted, regardless of whether the price targets are reached.

You can't blame Araskog for accepting the generous terms of his employment. One of the criteria by which our capitalist system selects leaders is precisely the sort of red-blooded self-interest that this CEO shows. No, if anyone is to be blamed--and someone certainly should be--it is the members of ITT's board. They voted unanimously for these ill-conceived compensation schemes, which were devised and justified by ITT executives and consultants answerable to management. It is the board that should have been pressing for better performance long, long ago.

Almost certainly, Araskog will break ITT into pieces. He has until his scheduled retirement in October 1996 but probably will move much sooner, perhaps as soon as the money stops flying around. It's up to shareholders to watch ITT closely during the next few months, to make sure that as much money as possible flies their way.