Value Investors Club / CSRA INC (CSRA)

Description

largest independent providers of IT services to the US federal government. These services include growth areas such as cybersecurity,

cloud computing, IT infrastructure, and software development (examples such as transition to cloud, 24x7x365 IT services support for

organizations, SAP implementation, setting up backend infrastructure, integrating next-generation tech offerings). The Company has more

than 5 decades of government partnership and long standing relationships with its customers (20-30 years in many cases). The Company

provides outsourced contractor services work to government entities such as the DoD and State Department. CSRA has thousands of

contracts with the largest being only 7% of revenue. Medium contracts ($10-100MM) are the largest contributors to revenue at 44% vs.

large contracts (>$100MM) at 32% and small contracts (<$10MM) comprise 23%. The Company is focused in highly differentiated

services in IT (75-80% of revenue) rather than its peers who participate heavily in lower quality SETA work.

CSRA is a public LBO trading at an inexpensive HSD/LDD entry levered FCF yield. CSRA believes it can maintain its market leading

margins and leverage its LSD organic revenue growth into HSD EPS growth through deleveraging and capital returns, driving an all-in

mid-teens equity return. Given the strong and relatively stable recurring FCF generation of the business, CSRA could financially engineer

value over the long term by levering up at cheap rates and returning capital to shareholders through debt repayment, dividends, and share

repurchases. There is a long runway for bolt-on M&A where CSRA would be buying sticky customer contracts/relationship and niche

technical capabilities which can help build scale and leverage its fixed cost structure. This is an industry where indirect wrap rates and

overhead absorption are helpful in establishing cost advantage and winning business (scale begets scale). Management plans to return 90%

of its FCF to shareholders through debt repayment and share repurchases/dividends (currently 1.6% yield). Therefore, the downside from

poor capital allocation (overpay for M&A) is somewhat limited in the medium term.

Revenue growth of 2-3% CAGR is driven by retaining/successfully recompeting existing business while more aggressively pursuing new

business. Currently, there are $16Bn submitted bids. Assuming a 25% win rate, CSRA could win $4Bn of new revenue which translates

into $800MM annual run-rate vs. current revenue base of $5Bn. CSRA also claims that it has $6Bn of pending adjudications, $15Bn+

contract backlog, and $50Bn pipeline of qualified business. CSRA will stay in the high end, complex, and sticky IT modernization work,

which is in very early innings of adoption by government agencies. In fact, IT budget lines are growing for the government, not shrinking.

The 2-3% revenue CAGR assumes very little share gain despite the market being very fragmented and the current environment lending

itself to natural consolidation to scaled players. EBITDA margins should be maintained/expand marginally due to fixed cost absorption,

synergies from its SRA merger, mix shift to higher fixed price IT contracts where investment is already sunk, and continued efficiencies.

CSRA believes it can keep SG&A flat/down as % of revenue over the next few years. FCF conversion is well over 100% of adjusted net

income given working capital improvement (better DSOs) and D&A > capex mismatch. Per share FCF should grow 8-10% based on debt

pay down (>3x net financial leverage but 4x including pension and capital leases) and share repurchases.

Government services have proven to be relatively stable through history and countercyclical. Because there will always be wars and threats

to national security, the private sector is needed as outsourced labor and for its specific expertise. This allows the government to be

flexible with its labor so that it is not overly burdened with pensions/benefits while allowing it to retain needed technical services. For

these reasons, it is not in the government’s best interest to squeeze margins despite its monopsony status. Not to mention that numerous

contractors that we have spoken with all confirm that the government is a mess, disorganized, and individually silo-ed. Margins have been

relatively stable through history and are largely in equilibrium. The fear is that CSRA’s margins are much higher than its peers (430 bps

differential) and, therefore, not sustainable. However, taking this view would miss the fact that CSRA’s business skews to higher end, more

technical capabilities rather than lower quality “butts in seats” type work of its peers. The Company argues that 75-80% of its revenue is

derived from better than average growth and more “differentiated” IT solutions (think Accenture but strictly in government vertical;

margins are comparable between ACN and CSRA). Also, it is worth noting that CSRA has superior contract mix due to its relative

overweight to T&M and fixed price contracts. 45% of revenue is from fixed price, more than double that of peers. These contracts have

EBIT margins that are high-teens and vastly superior to the single digit margins of cost-plus. While the contractor is exposed to cost

overruns, a good operator such as CSRA can manage its projects well and earn above normal margins with better processes, technology,

infrastructure, and program managers. Of the 430 bps differential, CSRA states that 200 bps is due to higher end services while 230 bps is

due to contract type. The Company has in a disciplined fashion culled and restructured bad contracts from its portfolio. Over time, the

business is shifting towards next-generation IT which should driver higher fixed price content.

The business has proven to be relatively stable holding EBITDA flat over the last three years despite big budget resets due to

sequestration, continuing resolution, and Iraq/Afghanistan ending. CSRA has recurring 5 year average contracts and 85-90% recompete

win rates (top 25 contracts actually have average tenure of 10 years) across a highly diversified contract base. The biggest single contract is

only 7% of revenue. This is a customer relationship business where CSC has been doing business with these customers going back 20-30

years. They’re embedded within the organization and work alongside the government employees on a daily basis. CSRA has high level

officers (think 2-3 star generals) who have contacts and strong relationships throughout the government, including key decision makers.

CSRA does a superb job of extending contracts, expanding the ceiling, and adding work to improve margins. Also, government

contracting officers are generally risk-averse and are going to stick with incumbents or market leaders with good reputations when

awarding work, absent significant price differences (we already know that CSRA competes well on price given drastically reduced overhead

over the last few years). It’s similar to “nobody gets fired for going with CSRA.” This is what makes it sticky despite it seemingly

providing a relatively simple service. I also believe that defense services revenue should be somewhat stable over time (defense spend has

been 4-6% of GDP over last 20 years; much higher prior) especially after the defense budget has recently been rebased and is not at a

cyclical peak.

The biggest risk would be the ability to renew highly profitable contracts. Based on diligence, I understand that six of its top 25 contracts

are up for recompete over the next few years. A few of these contracts have supernormal economics where margins are in the 20%+

range. The concern is that either the project terminates or margins are competed away. Unfortunately, we will never have an edge given

the black box nature of the business. However, I would note that the biggest contract is only 7% of revenue with the next 4 contracts each

being only 3-6% of revenue. Therefore, some of the margin degradation is mitigated based on contract diversity. I’d also note that the

high margin contracts compensated CSRA for its higher than normal capex investment to serve the customer’s needs on this specific long

dated projects. Therefore, I would expect that these infrastructure investments have been either been recouped through the life of the

contract (and can possibly be repurposed for other investors) and/or its higher cost-to-serve burden can be reduced if business is lost.

Lastly, the Company has a good track record of retaining business, upselling customers, and consistently winning contracts with very

attractive economics.

Another significant risk would be the ability for CSRA to retain the margin benefits and not have to share the savings upon renewal. The

government audits the contractors’ books and cost efficiencies are generally passed through, especially in cost-plus contracts. The margin

improvement has been a result of portfolio pruning and significant cost-out (e.g. low cost delivery, reduced overhead/SG&A, etc). The

fear is that CSRA’s EBIT margins have improved from 6.4% in FY12 to 15% in FY15 (well above its initial 8-9% FY17 target) and there is

a lag between when they need to be given back to the customer. In other words, FCF is at a cyclical peak and not sustainable. The offset

would be that the lower cost structure enables the business to win more share and grow revenue given its ability to bid more aggressively

and competitively. Therefore, the aggregate profit $ may offset the margin % impact.

Important Disclosure

The provision of this report does not constitute a recommendation to buy or sell the security discussed herein. The report is an

example of the author’s company write-ups / research process; its breadth and coverage may differ materially from other such

reports. Certain statements reflect the opinions of the author as of the date written, are forward-looking and/or based on current

expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any

obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a

result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The

views are those of the author acting in his individual capacity and not as a representative of the firm; in no way does this report

constitute investment advice on behalf of the firm.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

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			2016	2017
Price:	23.80	EPS	0	0
Shares Out. (in M):	163	P/E	0	0
Market Cap (in $M):	3,887	P/FCF	0	0
Net Debt (in $M):	2,805	EBIT	0	0
TEV (in $M):	6,718	TEV/EBIT	0	0