Description

Maximus (NYSE: MMS), founded in 1975 and based in Virginia, is the largest provider of program management, consulting and information technology services exclusively to state and local governments. Despite the drop-off in tax receipts due to the slowdown in consumer spending and the real estate markets, Maximus’ business has a very low beta to the general economy; 70% of Maximus’ revenue comes through federally funded programs, i.e., states must spend on these programs or lose federal dollars. In the last several years, there have been a number of legislative reforms which have effectively transferred authority for program management from the federal government to state and local agencies. These agencies have in turn relied on the private sector for assistance in managing these programs and Maximus has been well positioned to capitalize on this trend.

 

The company participates in a large market with substantial growth opportunities. Maximus estimates health and human service entitlement spending at more than $300 billion annually, with state-operated program administration costs well in excess of $20 billion. In addition, outsourcing, which currently has a penetration rate of approximately 20%, will become increasingly important given trends in the federal and state workforces. According to the Department of Labor, 60% of the federal workforce is eligible for retirement in the next ten years and we estimate the figure is around 35-40% at the state level.

 

Maximus presents a low-risk, value opportunity due to the fallout from the credit markets. On July 23, 2007, Maximus’ management team announced that they were seeking strategic alternatives for the company. Although the company received over 70 indications of interest, ultimately no financial buyer was able to get financial backing after August. Our understanding is that certain strategic buyers, like Unisys, had internal issues and other strategic buyers, like CGI, were hesitant because of the uncertainty surrounding the litigation in Texas (discussed later in write-up). As a result, the share price has fallen from $47.92 to the current price $38.72.

 

Maximus has historically commanded greater than a 17x P/E multiple. We believe that Maximus can earn $2.88 next year, 15c above consensus, which would justify a price of $48.96, 26% higher than the current price. However, there is additional upside in Maximus: we believe a segment of the Systems’ division is generating an after tax loss of in excess of 20c. Our understanding is that management received a bid for this segment during the strategic review but felt that they could maximize shareholder value by turning around the operating results of this segment and then returning to the market. If Maximus receives nothing for this division, EPS for FY08 would be in excess of $3.08 which at a 17x multiple would justify a share price over $52.36, 35% higher than the current price.

 

Description of the Business

 

Maximus operates through three segments: Operations, Consulting and Systems.

 

·         Operations, Maximus’ largest business segment, represents approximately 68% of revenues. The Operations group provides business process outsourcing for health and human services programs, including welfare-to-work and job readiness, child support enforcement, and children’s health insurance.

As an example, Maximus manages the New York State Medicaid contract which provides a full range of services including outreach, education, enrollment and customer service. Through this program, Maximus leverages its systems capability to create and mail millions of enrollment packets and program notices in multiple languages to identified populations in a timely manner. Maximus also engages local communities in New York to educate consumers about Medicaid benefits and eligibility. The company operates toll-free call centers in 17 different languages to facilitate eligibility determination and enrollment application processing and to provide a helpline to answer customer queries.

Maximus differentiates itself through its expertise in working through the technical details of these programs. Because Maximus administers these types of programs in multiple locales, Maximus offers state and local governments economies of scale and economies of knowledge that could not be obtained in-house. The company has strong credibility with state and local governments given its successful track record of implementing such contracts as well its solid performance metrics (e.g. raising enrollment rates and lowering costs).

·         Consulting contributes approximately 13% of Maximus’ revenue and provides a wide range of services to government agencies including planning and management, information technology consulting and revenue maximization. This division includes a business called RevenueMax that works with on a contingency basis with state and local agencies to obtain federal funding reimbursements for health and human services program expenditures.

·         Systems contributes approximately 19% of revenues and provides both custom and proprietary software tools for government agencies to be more effective and efficient. For example, Maximus supplies its Courtview and JuryView software to hundreds of court systems to improve the management and operations of courts. The company is also a significant PeopleSoft ERP integrator for governments, schools and universities.

 

History

 

Maximus was founded by David Mastran, who retired as CEO in 2004. Under Mastran’s leadership, the business grew rapidly, from $173 million in revenues at the time of its IPO in 1997 to $604 million in fiscal 2004, or a compound annual growth rate of 19.5%. However, during the tail end of the Mastran era, earnings stopped growing as certain businesses suffered from margin compression.

 

When Mastran retired, Lynn Davenport, formerly Maximus’ Chief Operating Officer, was promoted to CEO. Davenport’s driving focus was to obtain revenue growth via larger contracts, with little regard for profitability. This is apparent in Maximus’ EBIT margins which contracted from a peak of 14.9% in fiscal 2001 to 9.8% in fiscal 2005. Although some of the decline in profitability was due to product maturation, Davenport presided over a period of poor risk management in bidding and execution of work and this depressed financial returns. The biggest example of this mismanagement came in June 2005 when Maximus bid as a subcontractor to Accenture (NYSE: ACN) for a $370 million contract in Texas that would ultimately prove costly to the company. Davenport would not be around to address the problems he created, however, as he

was fired for an unrelated indiscretion.

 

Following Davenport’s departure in April 2006, the company appointed its former CFO, Richard Montoni, as the new CEO. Montoni, who had left Maximus only weeks before to become CFO of Towers Perrin, inherited a company with a leading market position and strong brand but with several problems. First, Maximus had a number of troubled legacy contracts in its portfolio, many of which were losing money and consuming management time and attention. Second, several of Maximus’ products, most notably RevenueMax, had matured leading to a compression in profit margins. Third, there were problems with the large contract in Texas.

 

Montoni addressed most of these issues and Maximus is now a “fixed” company.

·         Montoni led an operational review of all contracts in order to determine the best way to address current legacy contract problems and avert these problems in the future. Montoni’s focus was to drive accountability lower into the organizational ranks, improve bidding on contract terms and conditions, focus the scope of contracts, and better customer management. As a result, EBIT margins in the Operations Segment have gone from 6% in 2q07 to 17% in 4q07.

·         Montoni has wound down or divested low margin businesses or businesses that are outside of Maximus’ core competency. Montoni’s focus is on growing the bottom line rather than growing the topline as had been the focus of prior management. As a result, Maximus is no longer bidding on mega-projects but, rather, is focusing on smaller, less competitive contracts where the company can manage its risks and rewards better.

·         In June 2005 MAXIMUS was selected to serve as a subcontractor in support of the Texas Health and Human Services Commission’s (THHSC’s) Integrated Eligibility and Enrollment Services Program. The contract was designed to modernize the process that more than 2.6 million Texans use to apply for services such as Medicaid and Food Stamps by providing a single, integrated system for applications over the phone, via the internet, or by fax or mail. The benefits from this new service delivery model were to include improved customer service, expanded access to services, greater efficiency for state employees and stronger protections against fraud.

Soon after Montoni rejoined Maximus, it became public knowledge that the Texas subcontract was in trouble. In short, the state had underestimated the complexity of the project and the Accenture/Maximus partnership had similarly underestimated the implementation risk involved. The root issue for Maximus was the company was responsible for writing the front end of a database to a back end database Texas Integrated Eligibility Redesign System (TIERS). The state had hired Deloitte in 2001 to create a new back end database to tie together the states antiquated systems for various eligibility programs. Deloitte never got the system properly functioning. As part of the Integrated Eligibility contract with the state, Accenture was to make TIERS operational. Accenture never fully finished the project. So, Maximus was responsible for the front end of a database when the back end never functioned.

In June 2006, Maximus announced that (i) it was incurring significant cost overruns on the Integrated Eligibility component of the program due to increased staffing levels to compensate for a database that was not working, i.e., st, (ii) the project would cause it to incur $45-50 million of pre-tax losses in the second half of fiscal 2006, reducing full year profit to $0.57-0.67 per share from its recently affirmed guidance of $1.87-1.92 per share and that (iii) it had negotiated a smaller role under its subcontract with Accenture going forward.

In December 2006, Accenture and the State negotiated a new prime contract to address the underlying problems in the original contract. The negotiations resulted in a reduction of scope of the prime contract from $899 million to $543 million, Accenture providing the state with $30 million in vendor rebates and discounts for new work, and a redistribution of more work to state employees.  However, Accenture did not include Maximus in these renegotiations, which dramatically altered Maximus’ fiscal position and ability to deliver work to the state. Because of this, Maximus initiated arbitration with Accenture. We evaluated Maximus claims and found them to have merit within the framework of Maximus’ subcontract with Accenture.

On January 24, 2007, Maximus notified Accenture of its intention to nullify the subcontract if Accenture did not cure the contract defaults by February 16, 2007. Accenture did not cure these defaults, so Maximus began transitioning the contract work to Accenture in late February.

Although Accenture and THHSC had negotiated a new contract, neither party signed the amended agreement. By mid-March, Accenture and the THHSC mutually agreed to terminate the contract due to an inability to reach an agreement on some of the amended terms. As a result, THHSC announced on March 13, 2007 that it would cancel its contract with Accenture. THHSC then approached Maximus to continue to provide interim work to the state, affirming Maximus’ brand value and domain expertise. Management has since signed contracts with the state.

While the company is still in arbitration proceedings with Accenture, we believe there is a strong likelihood of a favorable resolution in the near term. Our research indicates that THHSC does not have the appetite to pursue liquidated damages from Accenture which increases Accenture’s incentive to settle its arbitration with Maximus. Many of the problems were the result of Accenture’s inability to get the TIERS database operational. We believe the fact that the THHSC has given new work to Maximus further bolsters Maximus’ case.

 

 

After having addressed these issues, management hired UBS on July 23, 2007 to begin a review of strategic alternatives. Maximus is a niche provider of key ITO and BPO services and has real franchise value. At the onset of the review, the company received over 70 indications of interest from a mix of strategic and financial players. However, the deterioration of the credit markets resulted in financial buyers being unable to secure lines of credit to bid on Maximus. The strategic buyers, after the financial buyers had left, did not offer a price that management believed fully value Maximus’ franchise.

 

After the strategic review, management engaged UBS to begin an accelerated stock repurchase program for $150 million which has reduced the diluted share count by 17%. Management has stated their intentions to use the remaining $47 million in net cash to repurchase additional shares once UBS has completed the ASR.

 

Current Valuation

Maximus currently trades $38.61 and has $2.52 in net cash per share. The company can earn $2.88 including the loss making Education and Justice Systems or $3.09 if we exclude the operating losses from these divisions. We believe Maximus is worth at least 17x the $2.88 in earnings or $48.96 and that there is potentially upside over $52.36 if and when the loss making segments are divested.

 

Catalysts

·         Continued delivery of earnings story.

·         Divestiture / Sale of the Education & Justice Systems operations from the Systems segment.

·         An additional $50 million buyback once the current accelerated share repurchase program is completed by UBS.

·         Management bringing the company back to auction when the credit markets normalize.

·         Settlement of the Accenture arbitration.

 

Risks

·         Execution risk on the existing book of contracts.

·         Potential negative outcome in the arbitration with Accenture.

 

 

Catalyst

Continued delivery of earnings story.
Divestiture / Sale of the Education & Justice Systems operations from the Systems segment.
An additional $50 million buyback once the current accelerated share repurchase program is completed by UBS.
Management bringing the company back to auction when the credit markets normalize.
Settlement of the Accenture arbitration.