Description
Thesis:
Dyncorp is a key service provider to two main divisions of the U.S. government – the Department of State (DOS) and Department of Defense (DOD). It primarily does business in areas to be described below that are unappealing to most large competitors and yet the government needs to staff these mission critical projects – with a secularly declining work force size.
Despite a recent run up, the company still trades at an attractive valuation relative to the value being created by management under the leadership of Herb Lanese – the key orchestrator of the revival and sale of McDonnell Douglas to Boeing. Catalysts are new contracts and the retention of old key contracts that should drive cash flow north of $3 per annum within 2-3 years. If the company can continue to win contracts, it should trade at a 12x multiple to FCF and perhaps higher. Thus, the stock has a minimum 40% upside within the next two years – from its current $25 stock price. Should the company succeed in materially growing its non U.S. government business, then cash flows could well exceed that figure and thus create more upside.
The key features of this company are the following:
- Herb Lanese is building a great team that will win business and provide a very high service level.
- The company has great long-term contracts and they are in a strong position to retain them, which should provide earnings stability and an expanded multiple
- A position of being a needed outsourced provider of mission critical services to the federal government and increasingly governments around the world. This includes excellence in civilian police training, logistics, vehicle servicing and other areas. In other words, it is well situated in a less competitive area of government work
- Government employee secular trends wherein the government is directly employing fewer and fewer people
- Secular trends toward assigning contracts toward bigger companies
Valuation:
Current guidance for F08 – ending March 31, 2008
- $2.3 to 2.4B in revenue
- $190 to 200MM in EBITDA
- $1.00 to $1.10 in diluted earnings per share
- Currently there is just under $40mm in excess deprecation and amortization
- 57mm shares outstanding
- Stock is at $25
- Market cap is $1.4B
- Debt = $594MM
- Cash = $127MM ($17MM in restricted cash)
- Roughly 10x EV/EBITDA
- Free cash flow per share – before working capital additions for new contracts = minimum of $1.80 in F2008 – though there is some risk with the recent protest of the INSCOM contract.
- If you assume the company has 10% growth in its core business (excluding the Logcap and INSCOM contracts) for F2009 and assume a 3.5% after tax FCF margin, then this would add 35c to earnings
- There are two big contracts (INSCOM and Logcap) that they have been awarded but are currently under protest. Combined these contracts should add 55c to 60c on an annualized basis
- It is conceivable that in F2009 – or at least by mid F09 and late calendar 2009, the company could be on a run rate to earn $2.60 to 2.80 per share, a figure which could increase to over $3.00 in F2010
- Putting a 12 to 14x multiple on the F2009 figure yields $31 to $39 stock
- Note that net debt has come down from $687MM in 2005 to $485MM this year and that Net debt to EBITDA has come down from 6.0 to 2.5X during the same period.
Company background
DCP provides everything from servicing aircraft for the Air Force and Army to training civilian police officers in Iraq and Afghanistan to translators in those same war regions to drug eradication in Columbia and Afghanistan. .
The single biggest factor to this story is the turnaround that Herb Lanese has implemented. When he joined the board less than two years ago, the company was not functioning well – with a high level of debt and a lack of structure that prevented growth. Mr. Lanese decided this past year to take a larger role taking over as CEO and has restructured the company and created a high performance culture with a high level of discipline, consistency and pride in craftsmanship. This comes through in the way they talk, the quality of service that they demand of their personnel and even the pride they take in submitting the highest quality proposals to the government.
To effectuate the plan, Mr. Lanese changed the reporting structure and compensation and brought in new management. He further brought financial discipline, which included brigning down debt, as mentioned above, to a more manageable level. He also brought in new management as discussed below. The company is now winning more business and getting better margins than before. Yet it appears that we still are in the early stages of a turnaround.
Management:
Management is excellent and is led by Herb Lanese and now Anthoney Zinni – a former lifer in the U.S. Marine Corps. See his biography below. Mr. Lanese is adeptly playing the Washington, DC game of stacking his board and management team with people that have inside connections in the Departments of Defense and State. This is key to getting an inside track on new contracts with the federal government. He is also bringing in the expertise to expand the commercial side of the business which includes working with foreign governments – as shown by his appointment of Anthony Zinni – moving him from board member to an executive position working out of the same office as Mr. Lanese.
Herb Lanese was formerly CFO and President of McDonnell Douglas after a bout at Tenneco. His contacts in Washington, DC are extensive and he is widely credited with turning around McDonnell Douglas and engineering the sale to Boeing. His reputation is stellar and I cannot emphasize enough the importance of his stature, his work quality and his work ethic to the company. He is very well respected in both the business arena as well as in the inner circles of Washington, DC and its environs. Mr. Lanese is the company’s greatest asset and the single biggest key to making this company a success.
Anthoney Zinni served as US Special Envoy to the Middle East since November 2001. During his military career, Gen. Zinni served as the Commanding General, the First Marine Expeditionary Force from 1994 to 1996 and as Commander-in-Chief, US Central Command from 1997 to 2000. Gen. Zinni's staff assignments included service on battalion, regimental, division, base and service staffs in operations, training, special operations, counterterrorism, and manpower billets. Gen. Zinni has participated in numerous humanitarian operations and presidential diplomatic missions. In November 2001, Gen. Zinni was appointed senior adviser and U.S. envoy to the Middle East by Secretary of State Colin Powell. Gen. Zinni retired from the US Marine Corps after 39 years of service in September 2000.
Strategic Positioning
As mentioned above, the company performs tasks for the government that require expertise that many other companies do not have and do not wish to pursue given their risks and high profile nature. While KBR is the only other major competitor of size, the rest of the competition is comprised of smaller companies that are increasingly at a disadvantage (or are otherwise partnered with). We view the company as a strategic asset to the U.S. and other foreign governments – particularly as they all go toward outsourcing more and more of their service requirements. A few interesting facts: Total U.S. military personnel has continued to decline from over 3MM in 1970 to 2MM in 1991 to under 1.5MM in 2006. Yet, since 2001, DOD spending has gone up from $311MM to $623MM. With the supplemental war bills, this figure is much higher. From personnel to trucks to planes to all associated services and equipment needs, DCP is well positioned.
Customer Breakdown
- DOS – 54%
- Army – 20%
- Air Force – 13%
- Navy – 8%
- DOD – 2%
- Other – 3%
Revenue by Region
- U.S. – 32%
- Iraq – 21%
- Afghanistan – 18%
- Other Middle East – 7%
- Other Americas – 11%
- Africa – 4%
- Europe – 3%
- Other – 4%
Main Projects
The company has a few major current contracts and two major pending ones. While the business can be lumpy due to these major contracts – and the fact that they can be re-competed (and thus are at risk of loss) – the long-term trends remain quite favorable and this high quality management team will go a long way to ensuring that the company retains its major contracts and secures new ones.
The largest projects currently under management are:
- Contract Field Teams – is the most significant program in the maintenance business. The company has provided this service for over 55 consecutive years. This program deploys highly mobile, quick-response field teams to primarily to service aircraft for the US DOD both domestically and abroad. The main contract is up for re-competition in September 2008. This contract has a $2.6 billion estimated value over a ten and one-half year term through September 2008. It is estimated to be worth roughly $240 to 260MM per year. We expect DCP to hold on to the vast majority if not all of this contract going forward.
- Civilian Police Contract – (CIVPOL): The most significant contract in government services is the Civilian Police contract, awarded by the DoS in February 2004. This contract has an estimated value of $2.45 billion over the five-year term of this program, through February 2009. The firm has deployed civilian police officers from the U.S. to 12 countries to train and offer logistics support to the local police and assist them with infrastructure reconstruction. Most of the business currently is in Iraq and Afghanistan. Should the U.S. begin to pull out, the company anticipates an increased need for police trainers. This occurred in Kosovo post the U.N. pull out.
- INSCOM – otherwise known as the linguist contract. This contract primarily resides with the DoS to provide translation services in Iraq, Afghanistan and in other locations. This contract should grow materially. The company was recently awarded the contract. It was protested by L3, the incumbent and the protest was upheld. It was won again by DCP and then protested again. That too was upheld the other day and thus the weakness in the stock. Having won the contract two times, we expect that the protest by L3 stands on weak ground – as previously protested issues cannot be re-protested and were the crux of the issue. To L3, it makes sense as they hold on to revenues for as long as possible. March 28 is the cutoff date for a final decision.
- LOGCAP – This is the major logistics contract with the DOD responsible for moving materials around the world. The contract has a ceiling value of $150B over 10 years but the probably value is closer to $50B or $5B per year. With its partners, DCP will have at least 1/3 of this contract and perhaps more. It too is currently being protested but should be resolved in the first quarter of 2008. We have spoken to one of the protesting companies and the big problem was with the other two awardees. Regardless, consensus is that it would be too costly and time consuming to start over again. Therefore, the odds are highly favorable that DCP will retain the bulk of the business.
Future Business
Herb Lanese sees major business coming from the U.S. government, Iraq, Afghanistan and in various parts of Africa. The company views Africa as a vibrant source of new business. The Middle East is another great area as well – primarily providing support for aircraft and vehicles – most of which are made by U.S. manufacturers. The company also has involvement in the MRAP – the new armored troop transport vehicle which is expected to grow into a large fleet of over 50,000 vehicles in the next few years. There are, of course, many other areas to grow as well.
Funding Environment
The funding environment in the defense department recently has become much better and funding the warfighter is particularly high on the list. Current funding will run through April 2008 and we expect that to continue.
Veritas Overhang
Veritas has worked to either sell the company or sell some shares. A secondary for their shares was shelved this summer due to the market blowup but there has been no formal filing since. At $20, Veritas was not willing to sell and the value of the company has only gone up since then. From a long-term perspective, I view this as a non-issue.
Use of Cash
- the company will use cash to fund working capital for new big projects and to repay debt
- in the near term, the company will use a considerable amount of cash to staff and train personnel for the INSCOM contract and in the near future for logcap
Risk
- The company does not win new major U.S. government contracts and backlog and ultimately revenues decrease
- The company does not win other business – primarily in the Middle East and elsewhere
- Bad things happen in places like Iraq and Afghanistan and any association with unlawful killings as described above could hurt their chances of getting future contracts in those countries and beyond
- The company loses one of the four major contracts mentioned above. It is quite conceivable that the company will lose some of the Contract Field Teams business.
Catalyst
- award of the Logcap deal
- future awards – expected to kick in to full swing in the next year