Description

Ready for a “You Can be a SM Genius” special situation with great “Little Blue Book” valuation/metrics?  Engility appears to be both with

• Substantial  technical selling pressure from a spinoff last week (SpinCo 1/30^th the size and 55% outstanding shares traded in 6 days)
• FCF yield that appears to be in the mid 20% range
• Rapid deleveraging guidance that the market is ignoring
• Very strong ROICs and business cash flow characteristics
• It even has a terrible name!  Engility!

Engility (EGL) has all the technical factors associated with a small “bad” company being spun off to an entirely disinterested group of large cap shareholders, reflecting a miniscule and irrelevant position that they can dump indiscriminately. 

EGL has a history of very high returns on invested capital (where cash flows can and have been easily taken out of the business) and trades at an extremely low forward multiple of cash flow and earnings.  If what seems to be management’s expectations for the business are correct, earnings and cash flow will continue at levels whereby the stock is dramatically undervalued and is could be worth close to ~2x the current price or potentially more.  Even in more bearish scenarios, the company likely has acceptable downside protection.  Additionally, the business looks set to generate very substantial cash to de-lever over the next 21 months which is seemingly being ignored.

Technicals

Engility was spun off from L-3 Communications and began regular way trading on July 18^th.  Let’s start with the 30,000 foot view of the technicals.

• One share of Engility for every six shares of L-3 common held
• Feeling by holders that this was very much “badco”
• Huge size discrepancy (not good match for L3 owners).  L-3 is a 6.65bn MC company while Engility is now a $232m MC company.  Roughly 1/30^th the size.  This position does not matter to the people who got the stock
• Tremendous trading velocity of distributed shares with ~9.2m shares trading in the first 6 days of regular way trading – over 55% of the outstanding shares (price of all things driven by supply and demand in the short term)

So it certainly seems like something that has the potential to be mispriced.

Background and Opportunities

The traditional professional services components of the L3 government services sector are now Engility.  This is where the government outsources a function to the private sector (training, software support, systems engineering and technical assistance) and EGL provides talent to perform that service.  78% of EGL’s revenue is from the Department of Defense.  

About four years ago, some of these businesses (principally SETA) began causing organization conflict of interest (OCI) issues and prevented what is now EGL from bidding on many profitable contract opportunities.  This was not unique and in this period Northrop Grumman sold TASC to KKR in 2009 and Lockheed Martin sold EIG (now called SI Organization) to Veritas in late 2010.  It is better for these businesses to be removed from their parent so that they can bid on  substantially more contracts and win more of the ones they do bid on. 

Management seems to think that the unshackling of the OCI constraints enables them to compete for substantial amounts of new business enabling them to grow or cushion a large amount of the upcoming slowdown in other areas of business.  According to the Company “we estimate that L-3 ceded or otherwise lost a significant amount of its SETA related revenues due to OCI constraints” and “The Engility businesses that were part of L-3, did not pursue various SETA opportunities in the U.S. Government market for Professional, Administrative and Management Support Services due to OCI-related constraints.” 

Additionally L-3 had a higher cost structure and is thought to have made the Engility businesses less competitive on pricing (which is important since 48% of the contracts are cost-plus and 28% are time and materials).  Following the spin, EGL will consolidate 7 businesses with full overhead into 4 and is targeting further cost cuts. 

This opportunity is significant with the potential to reduce approx. $15-20m of indirect costs by 2013.  Because of the way EGL’s contracts are structured, these cost cuts will not, as in a typical organization, all fall directly to the bottom line.  For example, 48% of their projects are cost-plus and a large percentage of savings will go towards lowering the cost to the customer of providing services.  This can enable them to maintain/grow revenue without necessarily affecting their margins (getting a cost benefit and passing it onto customers).  Some of those cost cuts (maybe $5m) should help to reduce the company’s costs (rather than the customer’s) and can directly help the bottom line which is meaningful.

It is generally thought by people in the sector that EGL’s target market will significantly increase with OCI gone and cost restrictions removed.  In particular, there seems to be a legitimate opportunity to expand the SETA business and this is one of the core strategies for the company going forward.  A banker who was familiar with the L3 acquisition of Titan (http://www.defenseindustrydaily.com/l3-communications-acquires-titan-0663/) thought that the Titan SETA businesses had lost substantial potential revenue after OCI was more toughly enforced.  People generally seem to think that segment can be competitive with other players in the field.

Business Segments

EGL’s “base” businesses are made up of the more stable categories and consist of Engineering and Program Management Support (largely SETA), Training/Mission support, International Development, and Asset Forfeiture Support (through a JV). 

The primary business is SETA/Program Management, making up ~47% of total revenue and 63% of the base businesses in 2011.   A banker I spoke with thought it could one day be an attractive acquisition candidate for another player (but he’s paid to think that). 

Training/Mission Support is the second largest making up 15% and 20% of total and base revenue respectively.  This business is fine although it does contain the Company’s largest contract for Law Enforcement training largely surrounding IEDs ($142m in 2011) that expires in December 2012 and is currently up for re-bid. 

There are also two segments which have been growing rapidly and could become a much more meaningful part of their business going forward.  International development was ~8% of base revenue in 2011 and has grown at ~24% over the past 2 years.  It is listed as the one of the principal opportunities for growth going forward.  Additionally they are the controlling shareholder of a JV that handles their Asset Forfeiture segment which also contributed ~8% of 2011 base revenue and has grown at a 27% rate for the past two years (with a contract until 2018 for the DOJ).  They own just over half of that.

Their Iraq and Afghanistan businesses going forward are relatively small (~13% of 2012 revenue, $212m guidance down from a billion in 2007) and is seen as a quickly running off higher margin business. The alternative viewpoint is that most of this exposure is Afghanistan and not direct troop support but principally nation building services.  Political people I’ve spoken with believe that the U.S. commitment to nation building in Afghanistan will make this business last longer than expected.  But in any case – it is a higher margin runoff business.

Lastly there is $128m of SSES (Software Systems Engineering Systems) work in 2011 (~6%).  This segment constituted a significant portion of the 2011 revenue decline ($192M) as the contract moved from stand-alone (reached a funding ceiling) to a task under an Army SSES contract (which restricts EGL to a subcontractor role).  It is now being re-bid as a separate contract and represents a very large bid opportunity for EGL (apparently a $7bn contract).

Their largest 10 contracts taken together represent 45% of their revenue, and there are only two contracts expiring before 2014.

The business as a whole seems to be good in their core markets and has substantial barriers to entry for anyone not already deeply involved with the DoD.  In 2011 they won 96% of the available performance-based award fees on cost-plus contracts and 74% of their 9,000 contractors have security clearances (DoD focused).  I know a lot of engineers and it was a real pain in the butt for some of them to get the various security clearances necessary to work on DoD projects.

Financials/Valuation

Ok so what are they going to earn and what is this worth?

Likely large near term working capital release

One very important development currently seems to be completely overlooked.  They have said (in their July presentation) that they expect to have Cash Flow from Operations of $122 million and Capex of $10m in 2012 (only 5 months of 2012 left so would think have good visibility).  This is including cash outflows from transaction expense and related charges.

In Q1 12 they had numerous working capital items swing in a counterintuitive way.  Despite revenues being down big (as expected) working capital ate up $19m of cash.  Q1 had $0m of capex.

That means (and don’t believe that we’re misinterpreting this) that the business should generate an additional $117m of cash onto the balance sheet by the end of the year.  $122m CFO for the full year vs. -$5m for Q1 implies $127m CFO in Q2-Q4.  Minus $10m of guided capex.

This substantially de-levers the balance sheet on a net debt basis (almost a full turn) and substantially effects the perceived leverage and valuation metrics of the business going forward.  It is a substantial move for the valuation of the business on an EV basis. 

What does 2013 look like?

They have given guidance for 2012E (in July) which projects adjusted EBITDA of $132m (translation to FCF below).  Projecting 2013 seems difficult and management doesn’t provide that guidance in any of the documents.  But they did essentially give 2013 guidance to S&P when they were considering issuing a bond and S&P wrote up their 2013 projections for the business in late June (http://www.ubs.wallst.com/mkt_story.asp?docKey=1329-WNA9139-1&first=5).

If we can assume that the S&P numbers represent some management base case for the business they imply real upside.

This report was written based on a plan for Engility to issue $300m in senior secured credit facilities ($100 million revolver and $200 million first-lien term loan due in 2017) as well as $250 million senior unsecured notes due 2019.  They ended up pulling the note offering and upsizing the term loan with the result being that they were spun off with a reduced amount of debt. 

According to S&P (hence to some degree management) EBITDA margins were expected to be ~8% in 2013 vs. ~8.3% in 2012.  That’s not bad and approx. what the analysts who have commented are expecting. 

2013 “free operating cash flow” was guided to be $70m – but this was on a substantially more leveraged balance sheet (higher cash interest costs) and thus on the new capital structure it translates into a FOCF of more like $80m. 

Taken together with the cash generation guidance for 2012 this would imply that $190-200m of cash could come into the business in the next 21 months which would substantially reduce the leverage on the business.

Backing into their guidance for revenue requires a number of assumptions (bridging FOCF to EBITDA) but it’s clear that management is not expecting a devastating 2013 at all.  In fact they essentially seem to be guiding to medium term growth, something you may not want to bank on but certainly something which is not priced into the stock.

Couple key quotes from the S&P report:

“The outlook is stable, reflecting our expectations for the company's revenue to decline to the $1.6 billion in 2012, but with an expected modest revenue growth trajectory in the intermediate term as a result of new revenue generation from Iraq and Afghanistan-related contingency operations already at a low level.”

“Cash uses include minimal capital spending, investment in working capital, and debt amortization payments on the company's senior secured term loan” – seems to imply some growth

“We expect sources of liquidity will cover uses by 1.2x or more and that net sources would be positive, even with a 20% drop in EBITDA” – this referred to a much more leveraged/higher cost capital structure and company was expected to have $30m of amortization requirements (currently has $50m)

If S&P (management) is close to correct, this stock will have very rapid deleveraging and an attractive FCF yield to equity immediately.

If revenue stabilized at $1,550 with an 8% margin (2014) after reducing net debt by ~$190m at the end of 2013 – this stock could generate ~$100m pretax cash flow with a nearly 30% free cash flow yield.  So at 9x FCF that is approx. $35/share.  Not saying it’ll happen but this is basically the S&P guidance from a month ago!

Also – in the goodwill segment for the Government Services business for L3 (of which we are only part of to be sure) they have the following note.

“Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 43% in 2012 compared to 2011 levels due to lower expected sales, operating income, and margins resulting from: contract re-compete losses in 2011, the drawdown of U.S. military forces from Iraq that was completed in December 2011 and the impact of DoD efficiency initiatives. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will remain approximately 44% and 45% below 2011 levels in 2013 and 2014, respectively, reflecting continued constraints on the DoD budget. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow 1% annually after 2016.”

Again we are only part of the L3 Government Services segment but if applied to our business this would imply very good FCF generation for 2013 and beyond (flat line at 2012 numbers - in the mid 20% FCF range).

I will be the first to understand if you don’t want to rely entirely on management projections to build your investment thesis.  But even in a very bad business outcome – where EBITDA is down by ½ from 2011 to 2014 - this could still be trading around 6x 2014 EBITDA after reducing net debt and with debt likely covered by government receivables.  The business could still have a FCF yield to equity above 10%.  While an even worse case disaster scenario is conceivable it seems far more likely that this stock is just trading at the wrong price after a spinoff.

On the other hand – even if management is overly optimistic (but not delusional) and revenues decline at a moderate clip, the stock could still be very cheap with a low to mid 20% FCF yield to equity with rapid deleveraging (where the stock would be approximately a double at 9x FCF).

Financials

Base and bear case financials below are both substantially lower than what management seems to be guiding towards.  These revenue numbers (and margin compression) are built up by segment to take into account various rates of decline (definitely not perfect but a lot better than the person selling the stock I think).

Base Case

Bearish Case

Bullish Case

S&P Case (presumably management case)

Home run

Estimates from Analysts

Stifel Nicolaus is projecting revenues in 2013 of $1.5B, down 6% from the 2012 projection. Assuming operating margins of 7.0%, down slightly from the projected 7.3%, as higher competitive pressures (i.e.- lower margins on incremental contracts) are partially offset by Engility’s aggressive cost reduction plan (such as consolidating 7 business units currently, each with full overhead, to 4 in the near-term and eventually fewer than 4).

2013 EBITDA – 122m

2013 EPS - $3.16

Comps

If this traded at the average 2013E PE in the sector of just under 9x this stock would trade substantially higher (just shy of a double).  There are certainly arguments why other players are better and others are worse.  Maybe EGL doesn’t quite deserve the average multiple today but it seems like they certainly don’t deserve ½ of that multiple either.

One knock on EGL is that on an EV/EBITDA basis it looks less cheap because it has more debt.  But this misses the fact that net debt should decline very substantially through 2013 as outlined above (and this could increase projected earnings as well).  As this happens EGL could rapidly move to having very modest net debt in line with its less levered peers.  Arguably the whole space trades at an attractive multiple but there are headwinds. 

If this normalizes its multiple based on what people seem to expect as earnings and cash flow this has a pretty sizeable discount to its peers to narrow.

Sequestration

Won’t go into sequestration here but it is clearly a risk to the whole sector (and reflected in the valuation for some of the comps).  I for one am skeptical of the governments ability to shrink itself but its obviously out there.  The military says that sequestration is an absurdity and doesn’t plan for absurdities.  But if it were to happen, many contractors will get laid off or furloughed. 

If you want to hedge this risk you can short a couple of EGL’s most direct comps.  The President’s February budget calls for a reduction in the DOD base spending of ~1%  in 2013 followed by growth of a couple percent after that (not including OCO which is expected to shrink faster).

Incentives

Incentives appear to be good.  The executive team receives modest base salaries (600k for the CEO), has decent target bonus upside (which have historically been based largely on operating income and FCF), they just received a sizeable number of RSUs (~100k for the CEO) and are likely to get options shortly.  The LTIPs (arranged at these prices) will be worth a substantial amount if they can achieve what their internal FCF targets seem to be.  There is likely real money for these guys in the option pool/RSUs and they should be very motivated by what matters most to anyone reading this.  The options pool could also come along with them talking about the business (their investor presentation page may not just say “coming soon” next month).

Balance Sheet

A particularly important component of the balance sheet is the $405m of receivables.  Obviously this is largely offset by current liabilities and will come down as revenues drop but I bring it up only because it is likely to represent a substantial proportion of the net debt and should give them at least some financing flexibility if things turn south.

Valuation

So what should the business be worth?  If they hit what seems to be their internal targets it seems very possible to see a double or perhaps better but certainly more than the current price.  Even if things go quite poorly they could still substantially de-lever and produce a double digit FCF yield at this price.  The current price seems like it is largely the function of the spinoff.

Conclusion

There are two sides to any trade. In the case of Engility, it seems that current sellers are largely motivated by non-economic reasons, which has led to tremendous selling pressure. This has created an opportunity for current investors to take the other side of the trade and bet on management incentives, management and analyst guidance, and largely ignored deleveraging trends.

Risks

• Sequestration
• World peace
• Too many democrats
• Poor execution by management
• Possibly margins (execution)

DISCLOSURE

We have an ownership interest in Engility at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of Engility without notice for any reason at any time.

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