Description

Description

Dynamics Research Corp (DRCO: $11.30) provides mission-critical technology management services to various U.S. government entities.  Services include logistics and readiness, information assurance and cyber-security, homeland security, healthcare, intelligence and space. Customers include the Dept of Defense (55%), Dept of Homeland Security (20%), Federal Civilian Agencies (16%) and State Governments (9%).  The recently-filed 2009 10-K gives an excellent, and rather lengthy, description of the company's various programs and contracts, so I will not repeat them here, although certain key contracts are highlighted in the write-up below. Founded in 1955, and public since 1969, DRCO has more than 25 offices nationwide with major offices in Andover, MA and Washington D.C.  

In 2009, DRCO demonstrated an increase in prime contract wins, showcasing the potential value of the company's portfolio of multiple-award-schedule, agency-wide contracts. Management anticipates "high levels of bid activity, continued growth and strong margin expansion and cash flow generation" in 2010.

The company is profitable (2009 ebita margins: 7.9% and climbing), growing ('09E core revs: $264M, +6%, Q4 and '09 book-to-bill of 1.1X) and has modest debt and solid free cash flow, yet trades at 75% of fair public market value and 55% of strategic value (yes, to a rational buyer).

Investment Thesis

Following a multi-year period of significant investment in internal capabilities and process improvements and including a strategic acquisition, Dynamics Research is beginning to show significantly improved profitability as the company's position as a prime contractor and discipline in targeting higher margin contracts begin to bear fruit.  As these improvements become transparent to even the casual observer, we believe the gap between the public market valuation and the strategic value will compress, either through market appreciation or a sale of the company, or hopefully a combination of both!  DRCO is simply too small to adequately capitalize on the large contracts available. Management is too old, the balance sheet too small and valuations too rich to bulk up quickly enough through truly accretive acquisitions.  We expect continued and even accelerated consolidation in the defense IT sector and consider DRCO a likely candidate.  Fair public market value would be a 50% gain over the next 2 years, while reasonable strategic value over that period is nearly a double from current levels.

Valuation

At $11.30, with 10M f.d. shares and $32M net debt, DRCO has a market cap of $113M and an EV of $145M. This represents 5.8X 2009 EBITDA ($25M) and a 14% free cash flow yield, defined as (EBITDA-Capex)/EV.  On 2010 management guidance, the EBITDA multiple drops to 5.5X and the free cash flow yield climbs to 15.5%.  ($26.5M-$4.0M)/ $145M. Capex (including modest capitalized software development) should be about $3M going forward. 

Company guidance is for 2010 revenue of $277M-$286M (3-6% organic growth), ebit margins between 7.7-7.9% and eps of $1.18-$1.26 (+15-25%). 

With expected 2010 EPS of $1.22 (midpoint), the current $11.30 price implies a P/E of only 9.3X.

On $280M of 2010E revs, DRCO's EV/revs is just over 50%.

DRCO trades at 1.2X estimated yearend '09 stated book value of $9.50.  However, all of the stated BV is goodwill, so tangible book is slightly negative.

Other Notes

A decade-old legacy legal issue of $15M was reserved for in 2008 and paid in 2009 impacting reported results and realized free cash flow, respectively. (I excluded the reserve and subsequent payment from the summary table below)

DRCO bought Kadix, a small, but rapidly growing management consulting firm, in Aug 2008 for about $42M, at close and a $5M earnout.  I was not thrilled with the purchase at the time but management has delivered on the revenue and profit performance indicated at the close.

Q4 reported revenue was flat with the prior year; however excluding small business set asides, known as 8(a) contracts, from both periods, results in organic revenue growth of 4%.

DRCO recently announced the pending sale of Metrigraphics, a small and marginally unprofitable manufacturing subsidiary, which accounted for 2% of revs and which is now on the books for about $2M.  The subsidiary and the sale are not particularly meaningful, except that prior results have been rested for Metrigraphics as a discontinued operation; and at least management continues to sharpen its focus on the core (franchise value) operations.

Strategic Value

These metrics understate just how cheap DRCO really is.  We estimate at least $2M of public company costs and $3-5M of readily attainable cost synergies with a host of industry players. The $3-5M of cost synergies is based on conversations with management and other industry sources and represents only 1.5-2% of DRCO's total cost base of $250M.   A strategic buyer could thus realize $32M of current year EBITDA ('10 ebitda: $27M + $5M above) and consummate a highly accretive deal at 7X ebitda or $20 per DRCO share, 77% above the current $11.30 stock price.

Strategic transactions in defense IT would suggest valuations in the 7-10X range, however DRCO has posted organic growth at the low end of peers and also has prime contract exposure and security clearance mix in the middle of the pack so we'll stay with 7X to remain "conservative"/realistic.

Management

DRCO's management team is regarded as capable, albeit less than dynamic, and in fairness has led a re-engineering of the company with a focus on prime contracts and higher growth, higher margin sustainable revenue sources. Management 101 perhaps, but they have shown some real progress. We believe YTD 2009 results are further evidence that these internal and external investments are beginning to pay off.  This is a much better and more valuable company than the DRCO of 2-3 years ago.

There are 1.4M shares and options, of which 889k options are currently exercisable with a $8.42 avg. exercise price. In total, management and the board own 1.8M shares/options or about 17% of the company, with about 700K of that stake in options and with most of the stake concentrated in the 86-year old fmr chmn/CEO, the current CEO and the current CFO. 

Management appears reasonably compensated relative to the size of the company.  There is a so-called "Special Severance Plan" which terminates on 1/1/2012 or the 2^nd anniversary of a change of control. (more on that later)

The most striking thing about the board is that it is OLD, with ages of 51, 67, 69, 74, 75, 77, 86!   I appreciate Buffet's perspective that a mandatory retirement age makes less and less sense every year, but would a LITTLE new blood be so bad?

Profitability

Several years ago management began positioning DRCO as a higher quality, high-end services provider.  This required an aggressive move away from the legacy advisory and assistance services work which was nearly 50% of revenue and is now down to 13% according to the latest 10K.  Management also reduced indirect costs substantially from '06 to '08.   Over the past few years management has been growing the "good business" substantially even as the legacy business evolved away and the company had to overcome the loss of revenue from small business set asides as it was precluded from re-competes.

Simple Business, Simple Model

Strategic Position

Despite a decent lineup of core service offerings, and a continuing turnaround achieved by a solid management team, Dynamics Research is simply too small to compete long term with the big boys, does not have a full suite of integrated service offerings and can only truly maximize value for shareholders by selling itself to another industry player at what is likely to be a good deal for both buyer and seller.

 Organic growth, especially based on results to date, will not be sufficient as DRCO just can't scale big enough fast enough.  We believe truly accretive acquisitions will be hard to come by and are highly unlikely to create equivalent value versus an organized sale of the company.

From a 2008 presentation, "DRC's position as a leading mid-size company allows us to bring to bear the personnel, technology resources and industry standard practices of a large company with the responsiveness of a small company".  The reality is that small companies have a lock on low-value-add A&AS work, and big prime IDIQ business favors big companies.  This will drive continued consolidation in the industry, particularly as organic top line growth slows (see this week's SAI announcement).  

Other Risk Factors

Despite offsets (see A&AS and certain insourcing references below), increased defense spending, ongoing modernization of Federal IT systems and increased emphasis on intelligence capabilities and homeland security are likely to persist as long term trends and provide a supportive backdrop for DRCO and its peers.

A&AS work is increasingly directed to small businesses. This work is low margin and creates little franchise value.

Several managements have noted an increasing insourcing trend for procurement work (see ppg 8, 16, 19 in the DRCO 10K); this is somewhat offset by increased demand for training.

Move away from General Services Administration (GSA) schedule contracts in favor of so-called agency-wide, multiple-award ID/IQ multi-year contract vehicles.

DRCO does face 2010 re-competes for important DHS Eagle and Air Force DESP II contracts.  They are in good position but these clearly bear watching.

Stock performance has been distant laggard vs. market and peer group over the past 5 years, although last 12 months has improved.  We believe this disconnect between stock and company performance has created an attractive investment opportunity as investors catch on to what DRCO management has achieved.

Mix by Contract Type:

T&M 42% in '09, 49% in '08

Fixed price 40% in '09, 33% in '08, more risk but more upside if well-managed.

Mix By Prime/Sub - 71% of 2009 revs were from Prime contracts (63% in 2008).

67% of employees have Federal security clearance (60% in '08), putting DRCO in the top half of the peer group.

 Catalysts

Continued solid results driven by organic rev growth and margin upside.

Mix shift towards higher growth, higher margin, higher multiple prime contracts.

Strategic process initiated by mgmt, shareholders or larger industry players.

Catalyst

Continued solid results driven by organic rev growth and margin upside.

Mix shift towards higher growth, higher margin, higher multiple prime contracts.

Strategic process initiated by mgmt, shareholders or larger industry players.