Description

Summary Thesis

Engility offers the opportunity to enter into an equity position in a KKR-led LBO at under 7x 2016 free cash flow, anticipating a 100% return over the next 2-3 years.  The business is a competitively well-positioned government services provider, offering a diversified range of consulting, technical support, IT, engineering and logistics services to defense, intelligence and civilian agencies.  Engility shares have traded off following the completion of its merger/recapitalization, offering a compelling entry point at current levels.

Engility has been written up twice before, so we provide a brief overview of the past few years (which give us confidence in management and in their strategy) and focus on the transformational TASC acquisition that has occurred since the last writeup.

Business Overview

Engility is a government services business that was spun out from L-3 Communications in July 2012.  The company provides technical consulting, IT implementation and development, engineering and technology, logistics and other support services to the Department of Defense, intelligence agencies, the Department of Justice, the State Department, USAID and other government customers.

Engility was ostensibly spun out because the company was increasingly constrained by organizational conflict of interest issues—where Engility was restricted from bidding on services contracts associated with L-3’s prime contracting business.  However, L-3 was at least partly motivated to separate itself from the rapidly shrinking revenues associated with Engility’s services contracts in Iraq and Afghanistan.  This revenue drag, coupled with Engility’s small size (1/16^th L-3’s size based on net income), set the stage for a deeply undervalued share price in the wake of the spin off, followed by several years of significant outperformance: a 45% IRR from spinoff through recapitalization, including a cash dividend of more than 60% of the spin basis.

Engility’s success as a public company has had a few key drivers:

• First, management has attacked the cost structure they inherited from L-3, cutting SG&A from $142mm (9% revenues) in 2012 to $85mm (6% of revenues) in 2013 and an adjusted 7.0% of revenues in 2014.  [large in the context of a 8-9% operating margin business.] 
• Second, Engility has done a better job than expected in managing the revenue headwinds associated with troop drawdowns in Iraq and Afghanistan—largely through success in winning new business outside those theaters. 
• Third, EGL management has focused on maximizing free cash flow, particularly through working capital management.  (Of the $151mm in cash from operations generated in 2013, $70mm came from reducing DSOs as well as releasing capital tied up in Iraq/Afghanistan projects.)
• Finally, this cash flow has been used to aggressively pay down debt, resulting in a gross transfer of nearly $250mn from debt to equity since the spin (versus a $300mn market cap post-spin).

TASC Acquisition

In late October 2014, Engility announced a merger with fellow government contractor TASC, whereby: (1) pre-deal EGL shareholders received an $11.43/share dividend; (2) TASC owner Birch Parners (JV of KKR and General Atlantic) received EGL shares representing 51% of the pro forma equity; and (3) Engility CEO Tony Smeraglinolo remained CEO of the combined company.

The TASC acquisition is very large for Engility—increasing revenues and EBITDA by over 70%--and it brings significant additional benefits:

• A more balanced customer base across defense, intelligence and federal civilian
• Ability to realize economies of scale across central functions (accounting, IT, etc)
• Revenue synergies from bringing EGL’s low cost model to TASC’s higher-end consulting markets
• Tax Shield—the deal was structured to preserve TASC’s $1.4bn tax attributes ($370mm tax shield NPV). As a result, KKR and General Atlantic are prohibited from selling any shares for three years.  

The deal allows Engility to extend its low cost, capital efficient strategies into new end markets.  Their government agency customers are increasingly awarding contracts based on lowest price, technically acceptable (LPTA) standards.  Engility’s ability to cuts costs and pass those savings on to the customer provides them with a competitive advantage.  In the near term, management can leverage corporate functions across the expanded base of business.  Longer-term, they see opportunities to reduce their facilities footprint—a cost legacy from L-3 and from Northrop Grumman (TASC) ownership.

Put more simply, both Engility and TASC were spun out from their parent companies with inefficient cost structures—too much real estate under lease, too little scale against corporate fixed costs, etc.  Engility management will continue to attack these costs and use the savings to make their bids for future contracts even more cost competitive.  In a market that is experiencing some commoditization, they are positioning to be the low cost provider. 

This merger repeats the basic strategy employed in Engility’s spinoff from L3 and its subsequent purchase of DRC in early 2014: (1) leverage up to facilitate the transaction; (2) cut costs and gain efficiencies; and (3) channel cash flows toward paying down debt.  Even with zero growth in EBITDA and EV (which is not the expectation), this model can result in a significant transfer of value from debt holder to equity holders.

Why is it undervalued?

• Pro forma financials obscured—the costs of the transaction are front end loaded, while the benefits begin to accrue in 2016 and after.  Company guidance for 2015 free cash flow includes all of the costs of the deal, but no cost savings or synergies.  Also it only includes ten months of TASC.  So a quick look at forecasts only shows FCF of $50-$60mm in 2015, and doesn’t indicate that the business is expected to generate roughly $120mm in free cash flow in 2016 as deal costs go away and synergies phase in. [$50mm in deal costs.  $50mm in run rate synergies; $35mm in 2016.]  In other words, guidance doesn’t show the path to higher FCF and is a mishmash of adjusted and unadjusted items. (e.g. On the guidance page of their slide deck they show actual expected revenues in 2015 and adjusted revenues as if the TASC deal had closed Jan 1; but they also show cash flow from ops actual and adjusted—except this adjusts only for deal costs and is a 10 month pro forma rather than a 12 month number.  Confused?  Exactly.)
• Organic revenue declines—revenues have been shrinking, primarily as a result of drawdowns in Iraq and Afghanistan, but also reflecting the challenging defense budget environment.  The company has been able to preserve its cash flow margins, and management is projecting organic revenue growth in 2016.
• Liquidity—Liquidity is adequate for most funds ($1-10mn/day); however, it has been stretched at times. For example, the declines in the spring were exacerbated by traders playing the recap dividend that have struggled to exit.

What is it worth?

Pro forma capitalization:

• $22.21  x 36.5mm shares =                    $810mm Mkt Cap
•                                                            + $1,150mm Net Debt
•                                                               $1,960mm Ent Value

Pro forma valuation ‘16E:

• $810mm Mkt Cap/$120mm free cash flow = 6.75x FCF (14.8% FCF yield)
• $1,960mm EV/ $234 EBITDA = 8.4x EV/EBITDA (6.8x adj. for tax assets)
• The company will only pay ~$5mm in cash taxes for the next several years.

At 11x fully-taxed 2018 FCF (no top-line growth), plus the value of the tax shield, the shares would be worth $44 per share—100% upside or 26% IRR over 3 years. The FCF number can go higher if we assume a successful re-fi of the debt in May 2016 (as suggested by the company) or if we assume they can hit the revenue projections included in the TASC merger proxy.

When Engility was first spun out of L3, it was not well followed and not well understood; it traded at 5 to 6x forward free cash flow.  Over the next two years the shares doubled.  We think that the stage is set for a similar performance. 

Key Risks

• Defense/Intelligence budget cuts—Forecasts are for a flat to upward trajectory, but with the government, you can’t rule this risk out.
• Unsuccessful refinancing
• Deterioration of the competitive environment/pricing pressure

Catalyst

• Rapid debt paydown, leading to accelerated FCF growth
• Refinancing of high cost debt, leading to higher FCF
• Organic revenue growth inflection point