Description

Perspecta Inc. (PRSP) offers an attractive long-term buying opportunity.  Perspecta is a $3.4B market capitalization, $5.9B enterprise value, information technology and services provider focused on government customers at the U.S. federal, state, and local level.  The company was formed as the result of a spin-off of DXC Technology’s U.S. Public Sector (USPS) unit in conjunction with a merger with privately held Vencore and Keypoint Government Solutions in a Reverse Morris Trust structure in order to preserve the spin’s tax-free status.  The final structure results in 86% ownership by legacy DXC shareholders and 14% ownership by Veritas, the private equity owners of Vencore and Keypoint. The combination of the three businesses creates a full services IT provider to government customers that is able to offer a broad range of capabilities including next-generation services such as digital, cybersecurity, cloud and analytics in addition to application development and maintenance, systems integration, strategic consulting, applied research, and investigative and identity authentication services.  The combination of the three firms will create a top-five pure-play government services provider with industry-leading margins. The combined company will have $4.2B in revenues and 14,000 employees differentiated by a robust IP portfolio consisting of 260 issued and licensed patents with 170 PhDs.

The investment thesis for Perspecta is based on the following points:

1. Perspecta is an attractive absolute and relative value.  Perspecta trades at 10.5x estimated March 2019 adjusted EPS and offers a 9.1% FCF yield.  On my March 2020 estimates, the stock trades at 9.8x earnings and offers a 10.2% FCF yield.  Currently pure-play government services comparables trade at 18x estimated 2018 earnings and 12.6x EBITDA.  Integrated IT services comps trade at 21x EPS and 12.3x on average. Across the board, the discounts are significant with the exception of EV/sales relative to government services comps due to PSRP’s industry leading margins and levered balance sheet.

2. Perspecta has a historically attractive investment profile as an orphaned, levered smid-cap spin-off from a significantly larger parent with a management team having a consistent history of value creation.   Perspecta is a $3.4B company and it was spun-off from DXC, a $22B market cap company.  Since opening at $27, PRSP has fallen to $20.50. This reflects 23% underperformance relative to the S&P 500 and appears to reflect technical, spin-related selling.  Cowen, Wells Fargo and Vertical have initiated coverage but estimates are not well disseminated. Perpecta’s management team has a history of value creation. John Curtis is the CEO of the company, joining from Vencore where he has been CEO.  He has held numerous roles in government services firms and served as the CEO of Vangent, an information management and business processing outsourcing services firm that was sold to General Dynamics in 2011 for 14.5x EBITDA. Prior to this role he was the CEO of Pearson Government Solutions which was sold to Veritas Capital Management and later became Vangent.  The Chairman of the company is Mike Lawrie, the CEO and Chairman of DXC. Since joining CSC in March of 2012, the stock has a total return of 758%. Prior to joining CSC Lawrie was the CEO of Misys PLC from November 2006 to March 2012. He sold the company to Vista. During this period the stock appreciated 65% and outperformed the FTSE by 75%. From 2005 to 2006, Lawrie was a general partner at Value Act and he served as the CEO of Siebel System from 2004 to 2005.  Of note, CSC spun-out their legacy government services business and combined it with SRA in a similar transaction in late 2015. CSRA was taken out by General Dynamics on April 3rd for an EV of $9.7B and at 11.9x EBITDA.  The stock marginally outperformed the S&P 500 as a public company.  The bottom line is that Lawrie and Curtis are value creators and this is a classic spin-off profile with sloppy initial trading likely leading to longer-term outperformance and an eventual sale of the company.  

3. Perspecta has a solid fundamental outlook with increasing government and defense spending in addition to continued consolidation in the industry.  PRSP notes that Deltek expects 1.5-2% growth in public sector spending growth from 2017 to 2022.  Spending for federal cybersecurity, cloud computing and migration and big data analytics is forecasted to grow by rates of 5%, 15% and 13% through 2021, also according to Deltek.  State and local market IT expenditures are expected to grow 3.5%-4%. Publicly traded comps have seen their bookings and backlogs improve and Bernstein expect 6.4% annual growth in the defense budget between FY2017 and FY2022.  

My initial target for Perspecta is $31.50 reflecting 55% upside.  This equates to 15x my fiscal 2020 (March) estimate. My downside target is $16.20 or 9x the “low-end” of 2019 guidance.  This would reflect a 50% PE discount to peers and points to 20% total return downside. This is a 2.7 to 1 risk/reward proposition.

Below is a brief summary of the operations of the different entities have combined to form Perspecta as well as a financial outlook and management summary:

Operations

On a pro-forma basis, Perspecta is expected to have $4.2B in sales and 14,000 employees.  The company will have a diverse group of customers with longstanding relationships with the Intelligence Community, NASA, the National Background Investigations Bureau, multiple federal healthcare agencies, state government agencies and local municipalities.  The company’s Vencore labs unit also has a research heritage with substantial IP and 260 patents. Management has noted that on a pro-forma basis contracts are 52% fixed price, 27% cost-plus and 21% time and materials. Regarding exposures management noted at their analyst day that 32% of business is DOD, 25% is civilian, state and local, 20% is intelligence, 15% is healthcare and 8% is risk-decision.  The company’s top 25 contracts account for 65% of revenues and the top ten are approximately 50%. 70% of their largest contracts are fixed price. Below is a summary of the businesses of USPS and Vencore (which includes Keypoint).

USPS

USPS is a leading provider of end-to-end enterprise IT services and solutions to government customers across U.S. federal, state and local markets.  The company uses market-leading enterprise offerings and solutions to help its government customers implement modern collaborative workplaces, hybrid cloud platforms and integrated digital systems of engagement with their enterprise management systems.  As Computer Sciences spun-out their government services unit in the form of CSRA this business can largely be traced back to EDS, which was founded by Ross Perot in 1962. EDS was purchased by General Motors in 1984 for $2.5B and subsequently spun off at a valuation of $25B in in 1996.  EDS was eventually purchased by HP in March of 2008 for $13.9B and became HP’s services division. This division merged with CSC in April 3rd of 2017 at an implied valuation of $8.5B.  USPS organizes its business across five primary types of services and solutions – cloud platform and ITO solutions; enterprise and cloud applications; enterprise security; mobility and workplace; and analytics.  

• Cloud, Platform & ITO Services – Through its cloud, platforms and infrastructure technology solutions, USPS helps its public sector clients transform to hybrid infrastructure and bridge private and public cloud environments into their legacy infrastructure.  Their offerings help clients securely move the right workload infrastructure to the cloud to support the modernization of their applications.

• Enterprise & Cloud Applications – USPS’s applications services and program excellence solutions for its U.S. government customers focuses on four areas – application modernization and transformation, application development, testing and digital assurance, and application management.

• Enterprise Security – USPS’s enterprise security solutions include building security infrastructure into the fabric of U.S. government agencies’ digital enterprise.  The company believes its industry leading enterprise security services and cybersecurity solutions improve risk mitigation, increase the speed of possible resolutions and enhance existing information assurance programs.

• Mobility & Workplace – USPS offers a full range of services for converged mobility and workplace management through three primary focus areas.  i) Mobile Enterprise Services allows clients to manage their mobile environment as a service with solutions for procurement, provisioning, refresh, proactive Enterprise mobility management, hardware and software support, security and business usage analytics.  ii) Virtual Desktop and Application Services untethers data and desktop applications from physical user devices to give workforces and partners secure access to desktops, applications, and data from any location. iii) Workplace Device Services transforms traditional workplace environments to deliver a comprehensive, secure, flexible and configurable environment that provides management of desktops and mobile devices.

• Analytics – USPS offers a variety of analytics services such as information governance, artificial intelligence and advisory services to rapidly provide insights and accelerate its public sector customers’ digital transformation, improve decision-making and business processes.

USPS has broad, long-standing relationships with the U.S. federal, state and local governments over the last fifty years.  Below are some examples of solutions that the business has delivered in the past.

US Navy – USPS provides the U.S. Navy solutions to secure its intranet, the largest in the world, by implementing a broad range of integrated security solutions to improve depth and secure the network for security and authentication for all devices.  USPS notes that the U.S. Navy’s intranet successfully detects over 300 million threats and prevents over 2.5 billion unauthorized intrusion attempts every year.

CMS – USPS worked with the U.S. government and CMS to develop healthcare.gov.  Management notes that in 2016, over 29MM users were on the site from November 1st to February 1st and despite peak, usage on many dates site reliability and security was consistent.

County of San Diego – USPS worked with San Diego County probation officers to develop the Probation Utility and Mobile Application that enabled the officers to get on-demand access to their case data and enter contact notes in the field.  USPS rationalized and modernized hundreds of different applications across a distributed management structure. The company claims that probation officers were able to increase productivity by 54% in the country and that there was a 25% reduction in applications.  

California Department of Corrections and Rehabilitation (CDCR) – CDCR operates one of the largest correctional systems in the world.  USPS developed the enterprise solution Strategic Offender Management System (SOMS) that streamlines process by consolidating legacy databases and converted inmate records into digital files.  

Defense Information Systems Agency (DISA) – USPS collaborated with DISA to transform key applications and services to drive efficiencies, improve security and save costs across the agency.

U.S. Federal Government – USPS is working with the U.S. Federal government to develop a DevOps environment, providing IT and engineering services for software resulting in the governments’ secure version of AWS.  The scope of the project includes identifying, prioritizing, integrating and testing new and modified software to satisfy the architectural vision of the enterprise.

USPS serves as the prime contractor on 94% of its work.  The company has long-standing relationships with many clients lasting over 50 years and a 90%+ historical recompete win rate.  At year-end 2017, USPS had 7,700 employees. 45% of the company’s employees held some form of security clearance with 27% having Top Secret clearance, which typically requires a polygraph test.  USPS conducted operations in 26 USPS-owned or leased facilities with the company’s headquarters in Herndon, Virginia.

Vencore (includes Keypoint)

Vencore is a leading provider of mission-critical, innovation-driven service and solutions to U.S. government customers.  The foundation of Vencore’ business is the application of SE&I, cybersecurity, big data analytics and applied research on an enterprise-wide scale to assist in Vencore’s customers in evolving information related challenges.  The company is a leader in the architecture and integration of highly engineered mission-critical information solutions across the U.S. government, and provides enterprise-level support to multiple government programs that manage, collect, analyze and disseminate critical mission data to national security agencies and their customers.  Vencore services and solutions span the lifecycle of programs encompassing systems definition, architecture, agile solutions development, test and integration, deployment and operations. Additionally, Vencore’s leading data analytics capabilities for investigative case management and human resources are valuable assets. Vencore asserts that their business is differentiated by significant IP and “Vencore Labs.”  This unit has 260 patents and they employ 170 PhDs. In 2016 external clients invested $71MM in Vencore lab programs.

The Vencore organization dates back to GE’s aerospace division, which in 1972 established the SI organization.  The SI organization was created in response to a request from an Intelligence Community customer for world-class SE&I expertise to help create a comprehensive, space-based national intelligence system.  SI was acquired by Lockheed Martin’s predecessor, the Martin Marietta Corporation in the early 1990s. After this deal, the company broadly expanded its capabilities to include highly classified mission-critical capabilities for multiple intelligence agencies.  In 2010, Lockheed Martin divested the business to Veritas. In 2013, Vencore acquired Applied Communication Sciences and in 2014, Vencore acquired QinetiQ North American Services and Solutions group. This deal doubled the size of the business and added long-standing contracts with the DOD, DHS, NASA, and other civilian agencies.

KeyPoint Government Solutions (KGS) is the largest provider of background information services for the U.S. government.  The company has a legacy as a subsidiary of Kroll, known as Kroll Government Services. The business was founded in 1995 to pioneer the concept to investigative due diligence and independent investigation services to police departments.  In 2001, following the formation of DHS, TSA and CBP, KGS was selected to perform background investigations on its newly hired workforce of federal security and border patrol agents. In 2004, NBIB selected KGS to perform identity authentication services for its newly hired employees as well.  In 2009, Kroll Government Services spun-off from Kroll and was renamed Keypoint following its acquisition by Veritas Capital.

Vencore classifies its business into three types of services and solutions; SE&I, Cybersecurity, and Big Data Analytics.  The company also performs direct applied research conducted by Vencore labs which the company asserts acts as the “R&D engine” of their business.  

Systems Engineering & Integration – SE&I is the core of Vencore’s mission and expertise.  The company’s experience includes the successful design, architecting and operation of the most complex systems supporting the defense market and intelligence community. Vencore’s principal SE&I capabilities include systems engineering, enterprise architecture, program management, software engineering and cloud engineering.

Cybersecurity – Vencore’s offerings in cybersecurity systems engineering and solutions help its customers implement appropriate cybersecurity processes, identify key vulnerabilities, take correct measures to mitigate risks and have the tools they need available to respond to an attack.  Capabilities include continuous network monitoring solutions that assess and monitor vulnerabilities, forensics and analysis to rapidly detect malware and eradicate threats, and advanced research capabilities and agile development to deliver tools required to respond to increasingly complex cyber threats.

Big Data Analytics – Vencore provides innovative and cost effective solutions by applying a deep data analytics methodology.  The company’s solutions combine advanced predictive analytical techniques, cutting-edge algorithms and machine learning techniques to efficiently analyze large amounts of unstructured data and help it customers to make critical decisions.  Vencore maintains the “Vencore Analytics Platform” which is composed of subject matter experts, proprietary tools and techniques managed to address specific customer needs. Vencore is the largest provider by number of cases completed of identity authentication services for the U.S. government.  

Vencore is the prime contractor on 90% of its work.  The company believes that the sensitivity and complexity of its work make it difficult to be displaced on many contracts.  This is reflected in a 97% historical re-compete win rate. Vencore has many long-term relationships. They have supported the National Reconnaissance Office (NRO) and NASA for over 30 years, the NSA, U.S. Army, and DARPA for over 20 years and the NBIB for over 13 years.  Below are some examples of their work:

NASA – Vencore has supported the U.S. national space system, including space-based intelligence platform as an SE&I prime contractor for over forty years.

U.S. Navy – Vencore has been a prime contractor for the Navy’s Tomahawk program, responsible for developing and maintaining mission-critical software deployed across multiple shore and shipboard installations to ensure successful missions.

DHS, DOD – Vencore has served as the prime SE&I contractor responsible for architecting and securing both the federal civilian government (.GOV) and DOD military (.MIL) infrastructures from advanced cyber threats.

DARPA – The company developed technologies for DARPA and commercial customers for the detection of and response to cyberattacks on critical U.S. infrastructure, including the North American power grid.

NBIB – Vencore maintains a high quality, well-trained network of experienced investigators with a culture of integrity to conduct background investigations for NBIB and other agencies with an unrivaled footprint of coverage.  

At year-end 2017, Vencore employed 5,800.  53% of their employees held security clearances.  The company’s headquarters is in Chantilly, Virginia.  In total, they leased 36 commercial facilities with 1.1MM square feet of space.

Financials

The pro-forma data in the Form 10 is messy and does not contain clean trailing numbers.  One of the risks to the story is that management is being aggressive in their margin targets.  Due to the record of accomplishment of Lawrie and Curtis and specifically Lawrie’s history of meeting and exceeding financial targets I am modeling off their forecasts.  On an LTM pro-forma basis, Perspecta had $4.2B in revenues and 15.8% EBITDA margins. The company is guiding to forward EBITDA margins of 16-17%. They assert that this rich mix is due to a high percentage of fixed price contracts, strong execution, and a rich mix of mission critical work that allows them to command higher margins.  Of note, CSRA’s LTM EBITDA margins were 17.6%.

For fiscal 2019 Perspecta is guiding to adjusted EPS of $1.80-$1.95, 16-17% EBITDA margins, revenues of $4.15-$4.25B and FCF of 90%+ of adjusted net income.  Looking forward from FY20-FY22 Perspecta is guiding to 3-5% revenue growth, 16-17% EBITDA margins, 90-100% of adjusted net income to free cash flow and an 8-12% CAGR in adjusted EPS.  

One driver of excess margins appear to be capital lease obligations with HPE’s financial services unit.  The company has had “below the line” payments on lease liabilities in cash flows from financing of $160MM, $147MM, and $136MM in the October 2016, 2015, and 2014 years.  Even deducting this outflow from free cash flow the USPS unit generated $314MM in FCF 2016, -$65MM in 2015 and $321MM in 2014. I believe that normalized FCF for the USPS business is $300MM+.   Vencore generated $51MM, $86MM and $49.3MM of free cash flow in fiscal 2017, 2016, and 2015.  Obviously, these years do not match up on a calendar basis.  I am modeling $310MM in FCF conversion (95% conversion) in 2018.  Looking at the combined historical FCF generation of the two companies points to this being a reasonable target.  Management stated at the analyst day that they expect to generate $1.5B in CFO in the next three years. They are targeting using 35% of the cash for debt repayment, 30% to capex, 19% return to shareholders, 11% acquisitions, and 5% restructuring and integration.  I believe this 30% includes capital lease obligations. The company is targeting $43MM in gross synergies in 2019.

PRSP will be 3.6x levered on a net basis based on my estimates.  The company will have $2.6B in debt and $160MM in cash. The company has a $94MM gross-underfunded pension.  Relevant financial covenants include net debt to EBITDA of 4.5x to 1, stepping down to 3.75x to 1 in one year and EBITDA to interest expense of 3 to 1.

For fiscal years 2019-2021, I am modeling sales of $4.2B, $4.35B, and $4.5B.  I am modeling EBITDA of $693MM, $722MM, and $751.4MM. I estimate FCF of $310MM, $349MM, and $375MM.  

Management

Management strength is a core part of the Perspecta thesis. I believe that John Curtis and Mike Lawrie are value creators.  Both individuals are in their 60s. I believe they are going to follow the CSRA playbook. I think they want to run the business as effectively as possible over the next several years and try to exit through a sale of the business.  John Curtis is 61 and will be the CEO. As noted earlier he has been the CEO of Vencore since July of 2013. Prior to that he served as a senior advisor to Veritas where he served on the boards of several portfolio companies. From 2007 to 2011, he was President and CEO of Vangent, an information management and business processing outsourcing company that was sold to General Dynamics in 2011.  Prior to that role, he served more than six years as CEO of Pearson Government Solutions, which was sold to Veritas in 2007 and later became Vangent. He holds a BA of Science in Civil Engineering from Virginia Military Institute. Mike Lawrie, 64, is the Chairman of the company. He is the Chairman of CEO of DXC. He joined CSC on March 19, 2012 after serving as the CEO of Misys PLC from November 2006 to March 2012 culminating in a sale of the company.  As noted earlier CSC has been a tremendous performer and Misys was a strong performer as well. Lawrie was the initial Chairman of CSRA, which was sold and had a total return marginally in excess of the S&P 500. From 2005 to 2006, Lawrie was a general partner at Value Act Capital and from 2004 to 2005; he was the CEO of Siebel Systems. Prior to Siebel, Lawrie spent 27 years at IBM where he rose to the level of Senior Vice President of Sales and Solutions for all products and services worldwide.  From 1998-2001 Lawrie was the General Manager for IBM’s business in Europe, the Middle East and Africa, which included operations in 124 countries and 90K employees. Prior to that, he served as General Manager of Industries for IBM’s business operations in Asia Pacific out of Tokyo, Japan. Lawrie has a BA in history from Ohio University and an MBA from Drexel University where he serves as a trustee. The CFO of Perspecta is John Kavanaugh, 56. Prior to this position, he was the VP of Finance for the Americas region of DXC.  Prior to that, he served as the VP of Finance for the Americas region of CSC from January 2015 to April 2017, and a VP of Finance, Public Sector at CSC from July 2013 to January 2015. From 2002 to 2013, Kavanaugh was the President of the Federal Solutions Group at Xerox. Before that, he served as Vice President and General Manager of Northrop Grumman’s Public Sector and State and Local Business units. He holds a bachelor’s degree in business administration from Weber State and an MBA from Loyola Marymount University.

There are multiple risks to the Perspecta thesis:

• The company will be levered with 3.6 turns of debt.

• Perspecta is vulnerable to cuts in government spending

• While the timeline is unclear for the recompete, the NGEN contract is believed to represent a material portion of revenues (likely somewhere in the low double digits to the teens)

• Perspecta is pointing to pro-forma EBITDA margins of 16-17%, far above most pure play defense services firms.  If margins are not sustainable then there is meaningful downside to the stock

• Historical disclosure is poor thus many of my modeling assumptions are based off of management guidance

Catalyst

• Index inclusion
• Management communication