Description

1. Recommendation. I recommend a long position in KBR, Inc. (KBR) with a near term price target of $38.88 (+25%). My thesis is based on KBR’s attractive valuation, limited downside risk, strong FCF dynamics and optionality from its acquisition of Centauri and high-growth technology services business. 

2. Company Overview. Since 2014, KBR has transformed itself from an E&C business focused on the petroleum refining and LNG industries to a stable, high-end government services provider. The Government Solutions (GS) business represents ~70% of revenue and ~90% of EBITDA. KBR has replaced its legacy Energy Solutions (ES) business (low-margin, fixed price EPC work) with a Technology Solutions (TS) segment that provides proprietary technologies, catalysts, digital solutions and consulting services to the refining, petrochemicals, and specialty chemicals end markets. This business has an attractive financial profile (~20% 20-22E revenue CAGR, ~27% EBITDA margin), minimal reinvestment needs and attractive cyclical exposure to clean energy and global GDP growth. For FY2020, KBR reported revenue and Adj. EBITDA of $5.7bn and $478m, respectively.

3. Investment Thesis.

1. KBR remains undervalued. Even after outperforming its peers over the last six months, KBR still trades at a discount of over two turns of 2021E EBITDA relative to its industry peers (e.g., SAIC, ManTech, CACI). This discount is unsupported by its margin profile (9.5% 21E EBITDA margins vs. 9.7% peer median), FCF yield (6.1% vs. 5.8% peer median) or comparable high-end capability set (e.g., space superiority, IS&R, hypersonics, engineering).

At KBR’s current valuation, investors essentially pay full price for the GS business and get a free call option on clean energy and global reflation in the form of the Technology Solutions business. Interestingly, McDermott recently sold Lummus Technology (a nearly identical business to TS) to a financial sponsor for ~11.7x LTM EBITDA. Applying this multiple to TS, a 12x multiple to GS and allocating corporate overhead costs across both segments yields an implied share price of $44.70 (a +44% premium to the current price). A SOTP analysis with multiples even below peer medians yields a 13%-40% premium to the current share price (see below).

2. KBR has derisked near term performance. Management has significantly limited the risk of near-term underperformance by eliminating ~$1.2bn of lump sum EPC backlog (and the associated risk of losses/delays) at a cost of only ~$5-8m to 21E EBITDA. GS now represents ~83% of total backlog with a 1.2x book-to-bill ratio, providing clear earnings visibility. Moreover, within GS, capabilities with broad bipartisan support (e.g., space superiority, hypersonics, engineering) now represent ~50% of sales (+7% from 2019) while less reliable contingency logistics work represents ~9% of the business (-7% from 2019).

3. Centauri may prove transformative. Investors may have failed to appreciate the likely contribution of Centauri (acquired in Oct. 2020) to KBR’s portfolio. My review of public data on over 1,500 KBR federal contracts indicated virtually no overlap with Centauri based on customers or work type. Centauri’s entrenched presence across space superiority, directed energy, missile defense and intelligence appear to strongly complement KBR’s portfolio of engineering, civilian space and logistics work. I view Jacobs Engineering’s 5x NTM P/E re-rating following its acquisition of KeyW in 2019 as a useful case study for the potential impact of Centauri. 

4. Strong FCF profile offers additional upside. KBR’s minimal capital intensity and working capital requirements give it a strong FCF profile that represents further upside for investors. My math indicates that KBR could have well over $1 billion to deploy for dividends, share buybacks or additional M&A between excess cash on balance sheet, free cash flow and debt capacity based on management’s target net leverage of 2.5x-3.0x.

5. Valuation/Projections. My $38.88 (+25%) target price reflects the median valuation across my various analyses (see below). Though my base case revenues are only slightly above consensus (driven by ~12% and 15% y/y organic growth in space and engineering, respectively), I expect 2021E EBITDA margins to exceed broker consensus and guidance by ~50-100bps due (i) the addition of Centauri (~$700m of incremental revenue with >10-11% margins and a higher % of fixed-price contracts than KBR) and (ii) favorable mix shift given KBR's wind down of low-margin EPC work.

   

4. Key Risks/Considerations: Key risks include (1) a material reduction or change in U.S. defense spending priorities following this year and (2) various tail risks facing all contractors (e.g., contractual disputes, data leak, recompete risk). Risk (1) is mitigated by the GS segment’s international revenues (~22% of segment) and its growing focus on critical defense priorities with broad bipartisan support (such as missile defense, space superiority and hypersonic missiles). KBR has addressed risk (2) by exiting lump sum EPC contracts and winding down the ES segment, the principal drivers of recent cost overruns and margin volatility. 

Catalyst

(1) KBR could deploy over $1 billion via buybacks, dividends or M&A to address valuation over the next 12 months; (2) a gradual re-rating as the market appreciates KBR's focus on stable, relatively high margin government services work; and (3) a potential decision to spin-off or sell the TS segment and become a pure play government services business.