Description

MTC Technologies (“MTCT”) is a leading Defense IT Services company now trading below its 2002 IPO price.  We believe the recent sell-off provides a very compelling entry point for what we believe is the best pure-play on the wind down of the Iraq War.  Having changed management and rebuilt the business development pipeline, we believe the company has at least $1.60 of cash earnings power under current contracts, which we believe could be achieved as early as 2008.   This places the Cash PE multiple (EPS excluding amortization from acquired intangibles) at 10x.  On more conventional 2008E metrics, MTCT trades at 6.0x EV/EBITDA and a 9% FCF yield.  This neglected stock now trades at a 40+% discount to its peers.  We believe that there is potentially 85% upside from current levels as earnings accelerate through a combination of accelerating revenue growth, margin expansion and a normalization of its valuation multiple.

 

Company Description

MTCT is a leading provider of specialized engineering and IT services to the U.S. military and intelligence agencies.  The business is segmented into two roughly equal parts:  Modernization & Sustainment (“M&S”) and IT Services.   

 

Within Modernization & Sustainment, MTCT designs, re-engineers and manages the implementation of aircraft and vehicle parts upgrades and maintenance principally on behalf of the Air Force, Army and Special Operations Forces.  They do not do metal bending but rather provide the critical engineering, product management and procurement tasks that the military can no longer provide itself.  This segment is poised for a boom in funding as 6 years of high tempo war operations have created significant pent-up demand for these services.

 

Within IT Services, MTCT’s capabilities include designing and implementing mission critical IT networks for NASA and various defense and intelligence agencies, training/equipping/deploying troops and managing over 50 Air Force logistics offices.  This segment benefits from typical outsourcing trends driven by 50% of Defense Department employees eligible to retire during the next five years as well as the growing need for more sophisticated IT-based solutions to fight the Global War on Terror.

 

The Best Public Way to Play a Troop Pullout from Iraq

• Significant Pent-Up Demand:  When wars wind down, the military goes through a “reset”.  This multi-year process is meant to fix, upgrade and reposition aircraft and land vehicles to be ready for the next war.  To give you some perspective for how dire the current maintenance and upgrade issue is for the military, the first Gulf War’s ground war lasted 40 hours and created nearly a decade of “reset” work.  By some accounts, the Army has at one time or another deployed nearly all of its vehicles to Iraq.  The Air Force has been flying at high tempo since operations began in Afghanistan in 2001.  Given the massive per copy cost to replace a vehicle or an aircraft, the military is preparing to maintain and upgrade the vast majority of the current fleet.  Current cost estimates for the upcoming reset are in the hundreds of billions of dollars over the next decade.  MTCT has been doing this type of work since its founding in the mid-1980s.

 

• Positioned on all the Right Funding Vehicles:  MTCT is well-positioned to earn their fair share of the reset money given their historical performance/reputation, capacity and prime contractor status on the key contracts:  FAST (for aircraft) and FIRST (for land vehicles).  MTCT has enjoyed approximately 25% market share on the FAST contract during the last six years competing against Boeing, Lockheed Martin, SAIC and L3.  MTCT’s legacy position on a prior Army reset contract places it in an excellent position with the customer to win ample work on the $9bn FIRST contract, which only recently began issuing task awards.

 

• Sustained Wave of Funding Ahead:  Modernization & Sustainment work is viewed by most industry participants as one of the most important waves of new funding for the next decade.  IT Services work will also benefit as important IT projects were delayed as dollars were re-directed to the war during the last two years.  A change in the White House will not likely impact these trends.  In fact, the leading Democratic presidential candidates have all backed increases in the size of the military.

 

Attractive Business Model

• Recurring Revenues:  MTCT has a very attractive business model with impressive cash flow characteristics.  Revenues are recurring in nature as they are generated via contract-based task awards that run 4-5 years in length.  As a result, they generally enter a year with visibility on at least 75% of existing revenues. 

 

• Diversified Contract Base:  These revenues are diversified across 550+ discrete task awards with no single award greater than 5% of revenues. 

 

• Strong Free Cash Flow Generation:  MTCT generates approximately 9+% EBITDA margins, has minimal working capital and capex needs (maintenance capex is 2-2.5% of revenues) and has approximately $15mm of PV deferred tax assets via 338(h)10 elections on their historical acquisitions.  In sum, MTCT generally converts at least 80-85% of net income into free cash flow.

 

New Management Team’s Turnaround Plan Nearing Completion

• Recent Step Function Improvement in Leadership Talent:   One year ago, MTCT hired Mark Brown as COO from CSC to install much needed “big business” processes and thinking.   The second half of 2006 was a critical period that saw a number of senior managers “retire” and the founder step back in as CEO.  By the beginning of 2007, Brown had revitalized business development, reorganized the company and was effectively running the business.  Many of these changes were not radical but simply the type of “professionalization” one often finds that small businesses need in order to someday become big businesses.

 

• Revitalized Business Development Indicates Future Reacceleration of Organic Revenues:  Changes in the business development group have led to a significant reacceleration in critical leading indicators despite the overall challenging industry contracting environment.  For example, ytd bookings growth has accelerated to 45% y/y and ytd funded backlog has accelerated to 13% y/y.  These growth rates and the absolute levels are the best levels MTCT has seen in years and provide a solid foundation for re-accelerating organic revenue growth beyond the currently forecasted 1% for 2007 and the 6% consensus estimate for 2008.  Should the war wind down, MTCT should see a surge in contracts as monies are refocused but as we mention later we not assuming any of these monies hit in our numbers.

 

• Significant Cost Reduction Program:  For whatever reason, the market seems to have forgotten about MTCT’s recently completed business realignment that enabled a headcount reduction of nearly 15% of the workforce.  The total annualized cash costs savings of this program is nearly $6mm and management has been frank about letting this drop to the bottom line.  That’s $0.24 of EPS of which approximately $0.16 hits incrementally in 2008.

 

True Earnings Power Reveals a Cheap Stock

• As with the rest of its industry peers the last two years have been difficult as award activity slowed dramatically to help fund the growing cost of the Iraq War.  As the “surge-related” troops come home over the next 6 months with others to follow later, earnings power should return.

 

• 2008 Base Case Earnings Power:  $1.62 Cash EPS, $51mm EBITDA

• In 2008, we should see organic revenue growth reaccelerate from 1% in 2007 to 13% as the recent backlog momentum converts into revenues.
• We believe the contracting environment should begin to normalize but we are not counting on material upside largely because we don’t need that to happen. 
• Underlying our 13% organic growth assumption are three supporting drivers:

 

1. MTCT’s AIC subsidiary (7.5% of revenues), which does modernization & sustainment work, re-accelerates.   This subsidiary has been the primary culprit for the stock underperformance this year.  This business has shrunk from $17mm of revenues in 4Q06 to $7mm in 3Q07.   The principal reason for the decline was a government rule change voiding “small business” contracts after MTCT bought AIC, which were not offset by enough new wins.    This contracting snafu led to some personnel changes.  The business now appears to be re-accelerating with $34mm in backlog now and $12mm in new bookings in September.  We believe it is reasonably conservative to expect this business to deliver a modest 10% growth in 2008.  The normalization of these revenues will also help margins as this business is a slight loss-maker and has a significant fixed cost base to leverage.

 

2. For the remaining business, we are assuming 8% organic growth, which is consistent with 2007 and probably conservative given the recent improvement in backlogs and as key new contracts, such as PEO Soldier and FIRST ramp up.

 

3. MTCT is scheduled to open in 1Q08 a new hangar in Alabama to expand their ability to service Special Forces and Army aircraft.  Management has stated in the past the hangar could likely generate $25mm of revenues in 2008.    

 

• Upside to our numbers could come from a higher win rate on the record high $500mm of bids waiting to be adjudicated, a production contract for their Unmanned Aerial Vehicle that could be worth up to $90mm and the ramp up of work under the Army’s principal reset contract (FIRST) and its Alliant contract.
• Margins will benefit principally from the cost savings program and to a lesser extent AIC’s return to slight profitability.  We have baked in slight gross margin compression to account for potentially adverse product mix shifts.
• The combination of these earnings drivers could drive EPS 40% higher than 2007 levels. 

 

• On these numbers, we believe valuation is quite attractive at less than 10x Cash EPS, 6.0x EV/EBITDA (including $15mm of PV deferred tax assets); 9% FCF Yield.  Even if we are wrong and we only get 20% earnings growth because of funding delays, these multiples are still quite attractive.

 

• Looking out to 2009 as the military aggressively ramps up its reset process and as more troops come home, MTCT should be able to sustain 10% organic growth and flat EBITDA margins (although we would expect margin expansion is possible).  At these levels, MTCT is trading at 8x Cash EPS and 5.4x EV/EBITDA.

 

• On a relative basis, MTCT trades at a 40% discount to its Defense IT Services peers despite better growth and margin upside than any of its peers in our opinion.  Such a discount is unsustainable and also inconsistent with historical trading ranges.  Were MTCT valued inline with its peers at 9x 2008E EBITDA, the stock would be worth $29 (85% upside).  

 

 

Founder is Highly Motivated to Increase Shareholder Value

• The founder, Raj Soin, owns approximately 42% of the shares and is acutely focused on boosting the stock price.  Unhappy with the stock’s performance, Raj became actively re-engaged in the business during the latter part of 2006.  He has since re-assumed the CEO role, made some key senior management changes, instituted two buybacks, restructured the business, aggressively cut costs and key metrics are showing early signs of reacceleration.  Furthermore, Raj received 70k options in lieu of a salary for 2007.

 

A Ripe Take-Out Target in a Consolidating Industry

• In a recent conversation, a senior executive of Lockheed Martin’s Information Systems & Global Services stated what many in the defense community believe:  that Modernization & Sustainment work will be one of the fastest growing areas of Defense spending over the coming decade.  Stan Sloane, CEO of SRA International has echoed this view in recent conference calls. 

 

• MTCT is the only public small cap with significant exposure and expertise in M&S.  It also has sufficient capacity and infrastructure to permit companies with limited or no exposure to M&S to instantly gain significant exposure to this spending trend.    There is a fairly long list of potential acquirers – mostly large defense companies – that includes BAE, L3, DCP, BA, NOC and SAI.  It should be noted that nearly all of the potential acquirers could easily finance the acquisition with cash on hand.

 

Key Risk

·        MTCT will recompete its largest contract (FAST), which accounts for approximately 20% of revenues from over 100 small contracts, during 2Q08.  MTCT has been a significant prime contractor to FAST since 2001.  We believe that MTCT’s ~25% historical market share on this contract plus its new Special Forces capabilities through AIC and the new hangar make this event more of an opportunity than a risk, as FAST2 is likely to be significantly larger in both scope and size.

 

Conclusion

In summary, MTCT is a classic misunderstood asset flying under the radar (pardon the pun).  Given its huge upside earnings potential as the war winds down and its significant discount to its peers, we believe the stock has potentially 85% upside over the next 6-12 months, as the market properly recognizes the acceleration in fundamentals.

 

Catalysts

1) Macro:  Returning troops, which begins this Christmas; Any political actions, change in administration or funding changes that accelerate the return of troops.

2) Company:  4Q earnings, which should exceed consensus estimates; new contract award announcements.

 

 

 

Catalyst

1) Macro: Returning troops, which begins this Christmas; Any political actions, change in administration or funding changes that accelerate the return of troops.

2) Company: 4Q earnings, which should exceed consensus estimates; new contract award announcements.