Description

We are recommending a long position in Dynamics Research Corp. (Ticker: DRCO).  We see 50%-75% upside potential in the coming twelve months combined with solid downside protection at current valuation levels.  There are a number of catalysts (operating, balance sheet, strategic, industry) that will contribute to narrowing the gap between current prices and intrinsic value.

Investment Overview (each bullet is elaborated on more extensively in the body of this write-up)

• The valuation is highly compelling
  • 30% FCF yield to equity – all of which will go to debt reduction
  • Under 9.0x 2012 EPS and probably closer to 7.5x 2013 EPS
  • Deep discount to recent transaction multiples
• Near term refinancing catalyst which will meaningfully lower interest expense and provide a tailwind to EPS (will add more than $0.20 to 2013 EPS)
• There is reasonable potential for a buyout by a strategic or financial buyer in the coming 24 months (DRCO stock would be a 2x or better if they are acquired using comp multiples)
• Stock has already priced in a difficult 2012 as management recently provided tepid guidance for the year

The Bad

• Investors are rightly wary of companies with the U.S. Government as large customer
  • There has been no federal budget since early 2009
  • Slowdown / delays in Federal contracting persist
  • Increasing competition for awards may lead to industry margin pressures
  • 2013 Sequestration - expected across-the-board spending cuts that would first take effect in January 2013.  (Note: politicians are looking at workarounds because many see sequestration as political suicide for incumbents in both parties.  For instance Secretary of Defense, Leon Panetta was recently quoted, “We are more than prepared to work with Congress on approach to de-trigger sequestration”)
• For all of the above reasons – the government contracting sector is out of favor

Note on the Sector:  Depending your investing style now is either a terrible time or a great time to own a company with U.S. Government agencies as its customers.  Terrible, because shareholders don’t want to invest in a sector with this degree of customer issues.  Great, because the sector is out of favor and trading at trough multiples and this is the opportune time to own it.  As the issues improve (possibly post-election) industry multiples may recover

Brief Summary of Dynamics Research

• Provider of management consulting, science, engineering, and IT solutions to  government customers
• Highly credentialed employees (40% w/graduate degrees, 75% with clearances).  Not a commodity ‘bodies’ business
• Leading operating margins in the 8%+ range
• Mid-2011 acquired HPTi for $143mm (took on $150mm in debt at the time).  HPTi is focused on IT consulting related to healthcare (mostly to Federal agencies)
• Low capital intensity  (recurring Capex roughly 1% of sales)

Capitalization and Guidance

• At the current stock price of $9.50 – the market capitalization is just under $100mm and with net debt roughly $110mm – the EV is about $210mm
• This mid-point of guidance implies $358mm in revenues, $38mm in EBITDA, and $35mm of EBITDA less Capex, and $1.10 of EPS
• Management also guided to $30mm of debt reduction in 2012

Valuation

The stock is cheap by any number of measures:

• First, debt will be reduced by $30mm against a market cap of $100 = 30% FCF yield to equity.  If multiples hold through the end of the year then the stock price should increase by the amount of debt reduction = $30mm / 10mm shares out = $3.00 increase per share.  If nothing else transpires this would result in an increase in the stock price of 30%.
• 5.5x 2012 EBITDA.  If EBITDA is the same in 2013 but going-in debt is lower by $30mm – this would imply 4.7x 2013 EBITDA. 
• The stock is trading at 9.0x 2012 EPS guidance.  If nothing else changes, a refinancing of current debt and lower overall debt levels will add 20+ cents to 2013 earnings suggesting an 7.5x multiple

Refinancing Catalyst

As part of the company’s $143mm acquisition of HPTI the company took on $40mm of 13% sub debt and $110 of senior debt at 4.2% (this is a blended rate as some portion of the senior was swapped to fixed).  They have the right to pay down the sub debt in July of 2013 at a 5% prepayment penalty.  But, as alluded to on the most recent call, we think they might try to accelerate this payment and refinance both pieces of debt in 2012. Of course, they will need to pay some additional penalty to the sub debt holder but it is still well worth it from an economics and optics standpoint to do such a deal.

 There are a number of benefits from such a transaction:

• Benefit #1 – Big EPS benefit for 2013 compared to 2012: 
  • Average senior debt in 2012 will be about $65mm at 4.2% = $2.5mm of interest.  Plus, $40mm of sub debt at 13% $5.2mm of interest.  So, total 2012 interest should be $8.7mm. 
  • Looking forward to 2013, if they refi at year-end 2012, they should have about $95mm in average debt with an interest rate of 4.25%.  This = $4.03mm in interest expense.
  • The difference in year-over-year interest implies a savings of $4.67mm.  Tax effected at 40% = $2.8mm of after tax savings = $0.27 per share
• Benefit #2 – Costs Contained to 2012:  There are costs of effecting such a transaction but they can all be crammed into 2012 and investors will likely just look past these ‘one-time’ costs
• Benefit #3 – Balance Sheet Optics:  The 13% sub debt was a necessary evil to getting their acquisition deal done.  However, it is also optically ugly and perhaps off-putting to some investors.  Paying that level of interest makes DRCO look like a much lower credit and they actually are.  Note that by year-end 2012 they should be at about 2.5x total debt to EBITDA which is well within senior debt range

Possible M&A Take-out

From 2008 through February of this year – there have been host of comparable transactions which provide some guidance as to what DRCO would be worth in a deal.

Multiple of LTM Revenues:         0.6x – 2.0x with a Median of about 1.1x

Multiple of LTM EBITDA:             6.5x to 15.0x with a median of about 11x

Note:  DRCO bought HPTi for roughly 1.5x revs and 11x EBITDA in mid-2011 (the effective multiple has come down meaningfully since then as HPTi continues to perform well)

Conversations with industry analysts suggest that in this environment multiples of 7.0x to 10.0x EBITDA and north of 1.0x Revenues would be appropriate for DRCO.  so, what would DRCO be worth in a deal?

• A 2012 year-end deal at 7.0x EBITDA with $90mm net debt levels would imply a share price of $17.25
• 10.0x EBITDA would equate to a $30 share price
• 1.0x Revs of $360mm – less $90mm of year end net debt = $27 per share

In some sense those prices all seem a bit extravagant given DRCO is trading for under $10 today.  But, at the very least the math gives us comfort that management has a put option at much higher values.

So, what is the chance that management and the Board of Directors are willing to sell DRCO?  Frankly it is a hard to handicap although we do think that Q&A from long time shareholders on the recent quarterly call suggests that core holders are vocal with management on this front.  No doubt the BOD is aware of the large divergence that continues to exist between trading multiples and transaction multiples. 

Also, the CEO is 71 and at some point we see him selling DRCO rather than passing the baton.  He should be well aware of how much upside there is to selling DRCO and we think that will be his exit scenario.  Please note, we are just speculating here. 

The Bad News is Priced In

On the year-end conference call management provided a somewhat dour outlook.  The 2012 guidance given in February on the 4Q call was different than street expectations:

• Expectation:  2012 revenues of more than $380mm and EBITDA of roughly $45mm
• Management Guidance:  2012 revenues in the $353 to $363 range and EBITDA of $37mm to $39mm

Management further elaborated:

Facing huge fiscal challenges in 2011, our clients across the spectrum of federal agencies often dealt with these issues by deferring and delaying new initiatives and procurement decisions. As a result, the total contract value of our new business wins for 2011 was $119 million, down 22% compared with 2010. The estimated first year revenue from these contracts was $62 million. Our business win – new business win rate for the fourth quarter was 22%.

Also, we saw additional evidence of aggressive government cost cutting as the revenue for the fourth quarter was short of expectations. We were impacted on several very successful programs which completed in the quarter, where clients deferred follow-on awards due to cost cutting efforts. For DRC, these programs included the Defense Center of Excellence for Traumatic Brain Injury, the NAVAIR Marine Corp AIRSpeed and several Army training efforts.

Also ending in the fourth quarter 2011 were the Air Force Expeditionary Combat Support System and Air Operation Center Systems integration project, which was successfully completed at year-end. Finally, we encountered an unexpected early curtailment of our work supporting the Walter Reed Army Medical Center BRAC. A reduction in annual revenue from all these completed programs totals approximately $30 million, which has impacted our revenue outlook for 2012.

Rightly so, investors responded to this negative sentiment by taking the stock lower by 12% that day.  However, we believe that management brought down expectations sufficiently such that the company is set up to meet or exceed expectations for 2012.  With this in mind, we think the majority of the bad news is priced into the stock at these levels.

Price Target of $15.00 to $17.50

Our 12-month price target of $15.00 to $17.50 is predicated on:

• 12x 2013 EPS of $1.30 = $15.60 (12x is the 5-year average forward multiple – over longer periods of time the forward multiple is closer to 15x)
• The low end of where we think a deal would go off at 7.0x EBITDA = $17.25 share price

Summary

There are clearly reasons to dislike this sector right now.  But, we think that the bad news is baked in and all of this negative sentiment allows in investors to buy a stock:

• Trading at a 30% FCF yield to equity
• Trading at 7.5x 2013 EPS
• With a refinancing catalyst which could materially add to EPS in 2013
• With meaningful downside protection to intrinsic value as management essentially has an M&A put option at much higher value
• And, a company that is highly cognizant of the multiple arbitrage between where they trade currently and what they would get in a deal.  We think at some point in the not-too-distant future they may seek to close this gap and sell the company

While we wait for a potential deal – at the very worst we expect the stock to rise commensurate with debt pay down.  That would imply $30mm of upside to equity value or about a 30% return in the stock.  But, we expect potential multiple upside from deleveraging, clarity on Federal Budgeting, play out of the election cycle.

Catalyst