Description

Overview

• High quality government services business is (unfairly) penalized by the market due to its legacy as an E&C-heavy energy services business; 2020 earnings have been largely derisked; backlog provides a high degree of visibility in the current uncertain environment; trades at a meaningful discount to the most appropriate comps; potential double in share price over the next 2-3 years

Business

• Government Services (70% 2019 revs, 70% 2019 EBITDA): Professional services spanning defense, space, and government; services include outsourced R&D, test and evaluation, program management, consulting, mission planning, logistics and facilities, operational support, training, and security
• Funding sources: 30% UK + Australia, 25% US government logistics, 25% US government higher value-add technical/engineering oriented, 20% NASA; overall 50% reliant on DoD
• Technology Solutions (6% 2019 revs, 17% 2019 EBITDA): Front-end services and solutions, technology licensing, engineering and design, plant automation services, remote monitoring of plant operations for hydrocarbons/petrochemicals/chemicals
• Energy Solutions (24% 2019 revs, 13% 2019 EBITDA): Project planning delivery solutions; conceptual design, engineering design + execution planning; development, construction, commissioning of projects across offshore, onshore, LNG, refining, petrochemical; maintenance services

Thesis

• KBR has transformed itself over past five years from a volatile provider of energy-related E&C services to a much more predictable, diversified provider of primarily government services
• Current CEO Stuart Bradie (hired in mid-2014) has aggressively repositioned KBR over the past five years
• Government Services has grown from 10% of revenues in 2014 to 70% of revenues and EBITDA in 2019
• Energy Solutions revenue has dropped from ~85% of revenues in 2015 to 24% of revenues (and just 13% of EBITDA) in 2019; this year (2020) Energy Solutions will represent an even lower percentage of EBITDA
• 2020 earnings have a high degree of visibility, a rarity in the current environment
• Concurrent with the 1Q earnings release, KBR reduced its 2020 earnings guidance from a range of $1.80-$1.92/shr to $1.50-$1.80/shr
• In an environment where most companies are withdrawing guidance completely, KBR has an impressive level of visibility
• The new guidance range assumes that Energy Services makes zero contribution for the full year to profitability; this despite
• Management confidence that the Energy Services business should remain profitable for the year
• Only minimal deterioration to-date in the 70% of the business that is opex-driven
• Cost takeouts currently underway to reduce capacity in the business and protect profitability
• An ongoing more fulsome assessment of the business’ scope going forward
• By way of comparison, Energy Services last year (2019) contributed ~$0.30/shr in EPS to the consolidated total of $1.69/shr; thus, at the midpoint of the current guide momentum in both Government Services and Technology Solutions are expected to largely offset headwinds in Energy Solutions
• 90% of current 2020 EPS is already fully covered by existing backlog
• Long-term tailwinds for US government contractors
• The US government continues to move increasing amounts of non-core functionality to contractors; this is driven in large part by lower total cost (for outsourcing) as the government can avoid the high pension and benefit expenses incurred by public employees
• In addition, recent years have provided additional tailwinds for large, global diversified contractors like KBR
• Average contract sizes have increased materially; the Trump administration has moved away from the Obama administration focus on small- and minority-owned business preferences; this shift favors diversified providers like KBR
• LOGCAP, the DoD’s primary global outsourcing contract for logistics support and base operations, is a good example; prior iterations may have consisted of as many as 50 individual subcontracts; LOGCAP V (the most recent) consists of just seven regions which aggregate to cover the entire globe
• US government (and DoD by extension) has moved away from historical focus on lowest-price-technically-available ("LPTA") bid awards to "best value" model, which is more of a TCO-focused approach; this has benefited large multifaceted organizations like KBR who have an enhanced ability to execute successfully on complex projects
• Thru multiple acquisitions KBR has built a diversified government contracting business that ranges from lower value-added logistics business to higher-end technical and engineering capabilities; this positions it well in the current environment
• KBR has a high rate of contract wins: 90% recompete win rate in government services, 80% in energy services; 2020-21 has a lower-than-typical number of recompetes for KBR, further lower earnings risk; the largest 2020-21 recompete (NASA Ames ISRDS) has already been won by KBR
• The Energy Services business that remains is much higher quality than in the past
• In 2015 70% of overall revenues were categorized as engineering and construction (E&C), a notoriously boom-bust business that typically carries high risk for providers who are often on the hook for contract overages
• Today, 70% of the energy revenue is tied to services/production (i.e. driven by OpEx instead of CapEx), which delivers a higher level of predictability due to more consistent demand
• Energy Services is now focused on consultancy, high-end engineering services, and reimbursable construction services
• KBR has effectively purged its order book of fixed price contracts; today, all Energy Services contracts are cost-reimbursable with a largely variable workforce
• Strong backlog
• Firm backlog currently sits at $13.9bn, covering roughly 2.5 years of revenue
• Another $2.7bn of backlog is possible under existing options
• Backlog trends and book:bill have largely been trending favorably; 1Q saw book:bill of 1.3x in Government Services, with all subsegment business units posting book:bill > 1.0x
• Backlog does not currently include LOGCAP V wins
• KBR won 3 of 7 primary regions for LOGCAP V, this represents a material (although unspecified) expansion of its current responsibilities under LOGCAP IV (2 regions)
• In addition, LOGCAP V covers much broader training and readiness components, which will also increase potential revenue for KBR
• Dyncorp and other losers on the LOGCAP V bids have filed court challenges; these are likely to be decided w/in the next few months; should the LOGCAP V contract grants hold, backlog for KBR could grow meaningfully
• Strong financial position and solid cash flow
• KBR is currently levered 2.4x on a gross basis, 1.2x on a net basis
• The company has an untapped $500mm revolver
• An additional $500mm could come in the door over the coming 12 mos from settlement of outstanding arbitration/litigation related to a legacy project (“Ichthys”)
• KBR was part of a JV/consortium that had been responsible for building the Ichthys Onshore LNG export facility in Australia
• There were multiple historical issues with the project, including unapproved change orders from the client (resulting in cost overruns), as well as subcontractor productivity and underperformance issues
• These issues led to material out-of-pocket costs for KBR which negatively impacted FCF over the last few years to the tune of ~$500mm
• The project has now been completed and turned over to the client; this has capped/terminated the fear of additional out-of-pocket expenses for KBR
• KBR, meanwhile, is pursuing arbitration for recovery from both subcontractors and the client; KBR is reportedly on firm legal ground and stands a strong chance of completely recovering the $500mm, if not materially more
• Reflecting the company’s solid financial position, it received an upgrade from Moody’s last week on its senior secured to Baa
• Completion of the Ichthys projected has materially improved KBR’s cash flow profile, with free cash flow accelerating from ~$150mm in 2018 to $230mm in 2019
• In 2020, a down year for Energy Services, free cash flow should approximate $185mm (~$1.30/shr)
• This FCF excludes ~$50mm in favorable timing-related operating cash flow from CARES Act related tax deferrals into future years
• Despite the meaningful transformation of the business over the past five years, KBR continues to trade at a meaningful discount to government services comps
• 7.8x 2020E EBITDA vs. Government Services comps (BAH, LDOS, SAIC, PSN, MANT, CACI) @ 12.5x
• Conservatism may argue for a lower blended multiple, given KBR is not a pure play; however, with management effectively assuming no contribution to profitability this year from Energy Solutions, Government Services will account for ~85% of overall EBITDA, with Technology Solutions making up the balance
• Technology Solutions is itself arguably deserving of a healthy multiple, with its focus on proprietary technology, license fees, and associated high (25%+) EBITDA margins

Financials and Target

• Value accretion approach
• Multiple revaluation
• Comp multiple (12.5x) on 2020E EBITDA of $450mm = $5.6bn EV
• ~$500mm net debt
• Equity value = $5.1bn on 142mm shrs = $36/shr
• So, 65% aggregate upside from multiple revaluation
• 8% annual EBITDA growth + 6% FCF accretion = addl 14% annual upside
• Assuming 2-year holding period implies total upside of ~115%, or 47% CAGR
• Additional potential upside of $3.50/shr with settlement of Ichthys litigation/arbitration

Risks

• Returned US government focus on small- and minority-owned businesses; disaggregation of large contracts
• Government bidding price compression; return to LPTA bid methodology
• Democratic administration reverses and/or slows growth rate of DoD funding
• Succssful LOGCAP V challenge from Dyncorp

Catalyst

• Multiple expansion as business revalues in-line with government services comps
• End of LOGCAP V protests
• Improvement in energy markets
• Sale/spin of Energy business(es)