Description

PAE provides operational solutions and outsourced services primarily to the U.S. and other allied governments in a wide range of areas, including counter-threat advisory services, systems testing, space development and operations, logistics, maintenance, and other essential mission-related services. The company went public in February 2020 through a merger with Gores Holdings. Platinum Equity, the prior private equity owner, continues to remain the largest shareholder with a 23% stake. The company currently has approximately 20,000 employees, over $2.7 billion in 2020 revenue, and operates its business in two segments:

1.     Global Mission Services (GMS) - $2,080M 2020 revenue: This business unit supports global US government missions, primarily in the areas of: 1) logistics operations and humanitarian and stability operations; 2) mission operations support, space development and operations, test and training range operations management; and 3) maintenance and repair of equipment. The segment focuses on DoD, DoS, and NASA customers. The segment comprises ~77% of total sales.

2.     National Security Services (NSS) - $634M 2020 revenue: This business unit supports essential missions of the US government, both domestically and abroad, primarily in the areas of: 1) training support, intelligence mission support, and counter-terrorism solutions; and 2) business process outsourcing services, including citizenship processing and litigation services and systems support. The segment focuses on intelligence, defense and security customers. The segment comprises approximately a quarter of total sales.

We like the business for a number of reasons, including:

1.     At scale player with broad portfolio of contracts: PAE has established significant scale in the GMS market with over $2.0 billion in revenue. The company’s top 5 contracts only account for approximately 27% of pro forma sales after two recent acquisitions. Approximately two thirds of revenue is domestic and one third is international. The business is truly a portfolio of government contracts without significant concentration risk. 

2.     Transformation and end-market growth: PAE has been focusing on growing its higher value-add services. PAE’s legacy GMS business has focused primarily on performing lower-margin support services to the U.S. government. However, the company has been allocating its capital towards higher margin services, enabled by technology or unique skills such as intelligence or cybersecurity work. The company is at the onset of making this transition, and this will remain a priority going forward. PAE is favorably positioned to make this transition given the scale of its existing GMS business, which allows it to spread its indirect costs over a large base and therefore, be a low-cost provider to the intelligence and cybersecurity markets. PAE has grown its presence in the NSS market through organic growth and acquisitions. In 2020 alone, PAE acquired Metis Solutions (intelligence analytics, operational and tactical training, and program management) and CENTRA Technology, Inc. (intelligence support, information analytics, engineering services, and advanced technology solutions) for approximately $300 million cumulatively.

3.     Margin expansion: PAE has stated a goal of achieving 8% Adjusted EBITDA margins. The company achieved margins of 6.0% and 6.6% in 2019 and 2020, respectively. We believe this goal is readily achievable as the company executes on organic contract expansions (and creates operating leverage), shifts its business to higher-margin fixed price and NSS contracts, and executes on synergies from its acquisitions. Based on our experience with other government services companies, higher margin government services companies are rewarded with higher multiples in the public markets. We expect PAE to re-rate as it executes on these initiatives.

4.     Portfolio well positioned for government spending initiatives: PAE has relatively low exposure to the Army, Navy, and Air Force (around 30%) where growth is expected to slow relative to recent years (under the Trump administration) and relatively high exposure to the Department of State, Department of Homeland Security, and NASA (around 40%) where growth is expected to accelerate in the coming years. 

5.     Significant FCF generation: PAE operates an asset light business model with limited capital expenditure requirements, serving an extremely credit worthy client in the U.S. government. Cash conversion rate is approximately 60% of Adjusted EBITDA and as the company grows organically and increases margins, we expect FCF growth over the coming years.

Reason for Mispricing and Valuation

We believe PAE is mispriced for three main reasons. 

1.  PAE has faced many one-time revenue headwinds over 2020 and 1Q21. The combination of COVID-19 related headwinds in the intelligence business, a decision not to bid on some lower margin contracts, and lost business to small businesses (sometimes government services companies reallocate contracts exclusively for small or minority owned businesses) has led investors to question PAE’s growth profile. Furthermore, the latest news in the past quarter (Q1) is that PAE will be winding down a contract in Afghanistan because of Biden’s decision to withdraw US troops in the country. PAE’s contract in Afghanistan accounts for approximately 7% of revenue and 4% of EBITDA on an annualized basis and is called the National Maintenance Strategy program. In its guidance, management assumes this contract will go to zero at the end of the second quarter. So, one half of the runoff will be recognized in the current year and the other half next year. This new development caught shareholders by surprise as this contract was not linked to troop deployment in the country. Despite the loss of this contract, management maintained its 2021 revenue and EBITDA guidance for the year because it says there was some conservatism in its original guidance and it sees activity levels picking up on many contracts in 2H. Achievement of this year’s guidance is therefore more back half weighted and therefore riskier. While these headwinds have delayed a return to the topline growth this business should be experiencing, we believe PAE will eventually return to such growth. PAE has a long history of revenue growth (with a compound annual growth rate of around 13% from 2013 to 2019) and the same business development personnel is currently in place, so we expect the business to be able to return to a growth trajectory once it laps some of these headwinds. PAE also has favorable exposure to the part of Biden’s budget that is growing as mentioned above. Finally, the two recent acquisitions have increased the addressable market of contracts PAE can bid on which should also be favorable to growth. 

2. The second reason is that the company is underfollowed in the public markets. Despite having a market capitalization of around $840 million, the float is only 60% given the considerable private equity and insider ownership. 

3. The third reason pertains to the recent departure of the CEO. On March 16, 2021, John Heller, abruptly resigned as CEO after being at the company for the last eight years. The resignation came as a surprise to investors, the management team, and the board. We have confirmed that the departure had nothing to do with the state of the company, and the company reconfirmed its 2021 guidance. The board has begun a search to find a new CEO. Based on our discussions with the board, we don’t expect a strategic change and expect the company to continue to grow its higher value-added services in the intelligence end markets. 

As a result of these different dynamics, the stock has become significantly undervalued. Given the loss of the Afghan contract, we assume PAE will come in moderately below management’s current guidance range for EBITDA. We have them producing $203 million of EBITDA in 2021 versus management guidance of $205 to $215 million. This EBITDA leads to a free cash flow yield of approximately 13% for 2021. We believe this yield is too high for a company with a broad portfolio of contracts and relatively favorable exposure to the Department of State. We anticipate PAE will grow in the following two years as it takes advantage of the new addressable market afforded by its recent acquisitions and begins new contract awards such as the Department of State’s global support strategy contract award. We further believe PAE will make progress moving towards its 8% adjusted EBITDA margin target. Assuming an 8x EBITDA multiple, $225 million of 2023 EBITDA and the free cash flow generated during that period, we get a price of around $14 per share, representing an upside of around 60% in 2 years. We also believe the company could be an attractive takevoer target. The company has been owned by PE in the past and we would not be surprised if that is the eventual exit for Platinum equity. 

Downside risks:

·       PAE has other contracts in the middle east performing work at US embassies. Management has been in discussions with the government and in light of those discussions, management does not believe any of this revenue is at risk. However, given the suddenness of the lost revenue from the National Maintenance Strategy program, it is possible these contracts could also be at risk. This would amount to a further 4% of revenue.

·       PAE is in the process of integrating two companies it recently bought: Metis Solutions and CENTRA. The business development and operations teams are fully integrated at this point, but if any complications arise during the rest of the integration, it could cause PAE to not realize the full value from these acquisitions.

·       PAE has not lost additional senior personnel after the CEO departed. However, to the extent other people leave following the CEO departure, this could negatively impact the business. 

Catalyst

1. free cash flow generation

2. Top line growth acceletation

3. Sale of the company