CACI is a government services contractor with 75% of revenues coming from the DoD and 20% coming from US civilian agencies (5% international). The stock is at an all-time high, +33% last year, despite flat earnings estimates (EBITDA multiple expanded from ~5x -> ~6.6x). This is a ~$1.7bn market cap company with ~$600mm of debt that is adding ~$800mm in incremental debt to complete the biggest acquisition in its history (leverage going from ~1.5x -> ~3.5x). Pro-forma for the acquisition, the multiple will be ~7.5X 2014 EBITDA.

While the multiple is optically low, we think the company is overvalued for the following reasons:

• End-markets extremely challenged due sequester and pressures on budgets/defense spending, leading to stiff revenue headwinds:
• From CACI’s own 10K: “Spending by the U.S. government with contractors who provide services to the Department of Defense (DoD), is being negatively impacted by the country's fiscal shortfall. The Budget Control Act of 2011 (the Budget Act) established limits on discretionary spending, which will reduce planned defense spending by a minimum of $487 billion over a 10 year period that began with the government's fiscal year ended September 30, 2012.
• In addition, the Budget Act included a sequester mechanism that imposed additional defense cuts of $500 billion, or approximately 9 percent, over nine years starting in the government's fiscal year ending September 30, 2013, if the Congress did not identify a means to reduce the U.S. deficit by $1.2 trillion. Because these means were not identified, the sequester mechanism took effect on March 1, 2013. In light of the Budget Act and deficit reduction pressures, it is likely that discretionary spending by the federal government will remain constrained for a number of years.”
• CACI’s organic revenue has declined for 7 quarters, with total revenue negative for 5 out of the last 6 – and the decline is accelerating:
• CACI has been buying revenue through acquisitions (more below), but organic revenue trends are very concerning and the decreases are accelerating (-9% in the most recent quarter)
• In response, CACI announced in the most recent quarter that it would no longer report organic revenue growth – the reasons behind this are obvious and raises questions about management’s transparency with investors, as well as indicating that the trends are expected to remain negative for the foreseeable future
• Comparable companies, including MANT and EGL, are seeing 20-30% peak to trough revenue declines
• Until now, CACI has been able to partially offset revenue declines with SG&A cuts – but will start to lap this benefit in fiscal Q314 (calendar Q114)
• EBITDA has declined each of the last 5 quarters (LTM $320mm vs. $356mm in FY2012), but would have been much more severe without SG&A reductions (SG&A down 9% in the last quarter)
• Cuts began in earnest in fiscal Q313 (calendar Q113) – so will begin to lap benefit in 2 quarters
• To some extent, this is a function of the asset-light nature of the business, but at some point the low hanging fruit will be exhausted (and yet revenue will remain under pressure)
• CACI is essentially a roll-up, and a serial acquirer with mediocre return on purchases. The company touts a big “free” cash flow number that is double counting:
• Over the past 8 years, CACI has spent $1.2bn on acquisitions, and EBITDA has grown from $183mm to $320mm – not a great return given the massive boom in spending on contractors by the DoD in the 2000s
• Over this time, the company has actually generated only $200mm in real free cash flow, after acquisition spending
• Despite spending $300mm on acquisitions in FY11-FY13, revenues and EBITDA have actually DECLINED for the past 4 quarters
• ... and the company just levered up for its largest acquisition ever at 11.5x EBITDA!
• CACI is acquiring Six3 Systems from GTRC for $820mm or 11.5x EBITDA – rather than repurchasing its own stock at 7x EBITDA
• Leverage increases from ~1.5x -> ~3.5x
• Deal will be ~5% accretive to EPS – but this is misleading given they expect to pay L+200 on an institutional TL A to finance the acquisition – it is actually massively dilutive from an enterprise perspective
• Integration risk is always an issue, especially with an acquisition of this size

Our recent discussions with defense contracting companies, consultants and government officials in the space give us further confidence:

• Despite the recent fiscal deal reached to keep defense spending flat in FY14 vs. FY13, we believe FY 14 will be a tougher year for the services contracting companies:
• The Pentagon initially reacted to the sequester cuts by instituting one time measures such as military and civilian hiring freezes; these measures cannot be repeated and thus further cuts will have to come from the R&D, procurement and O&M (operations & maintenance) budgets
• There were a number of other tricks used in FY13 (such as using previous years unobligated funds) that will have less of a buffer effect in 2014
• Within this context, long-cycle (procurement/weapons manufacturing) should continue to significantly outperform short-cycle (services)
• Defense primes (Lockheed, Northrup, Raytheon, General Dynamics) should continue to have solid performance as they have multi-year contracts which are difficult to cut and when cuts are made, take longer to show up
• Servicers (CACI, Mantech, Booze, SAIC) will continue to be under much greater pressure as these contracts are much shorter (~1 year) and easier to reduce/modify
• There is also a perception that the servicing side is “where the fat is” – and events like the Snowden case and the Obamacare/healthcare.gov debacles only further the perception that these companies are overpaid and under-delivering
• Price/margin pressure and commoditization of the service side will continue
• Services companies have told us where 5 years ago they were seeing 3-4 bidders per contract, now they see 8-9, as smaller companies get in the mix and try to win based on price
• The average recompete is being renewed at a 20% discount to the previous price!
• Increasing focus on 1) LPTA (lowest price technically acceptable) and 2) small business set asides are further headwinds
• The recent Ryan-Murray budget deal includes a ~50% cut to the per-employee compensation cap – while this will have a modest EPS impact, indicative of the attitude in Congress to contractors and their margins

What are the risks to the short?

• Large institutional investor in Blue Harbour
• Cliff Robbins pitched this at Ira Sohn in May 2013
• Stock was under $60 then (now ~$74) and Robbins said he thought it was worth $75-$85
• They have been in the stock since 2010
• Recent sequestration deal
• Congress recently reached a deal to offset the 2014 sequester and keep FY14 defense spending at constant levels with 2013
• While this is a positive for the space, as indicated above, our research indicates that the long cycle/weapons systems programs will continue to be protected at the expense of short cycle, commodity type services work
• LBO
• Comp SRA was LBO’d in 2011 and CACI is a good size for an LBO (~$2-3bn EV)
• This seems much less likely now given the run in the stock and the fact that a transformational acquisition is underway
• High short interest:
• Short interest is 22% or 19 days to cover
• However, more than 50% of this is against the convert outstanding