Description

SM&A is a simple business that has 21% of the market cap in cash, announced 4 buybacks last 2 years, bought back 10% of the company at $7.95 average over the last 18 months (34% above today’s price), has a dominant market position and history of success which is reflected in the business being able to reach 20% operating margins. The downside is $5+/- which would be 5x EV/EBIT averaging the last three years EBIT, while the upside could be $10-11 over the next year. If the company hits their objectives in 2007 the company could get to $105mn with $17-19mn in EBIT or nearly $1 a share on current ev of $4.60.

SM&A helps companies in Aerospace & Defense, Electronics, Engineering & Construction, Financial & Audit services, IT, and Telecom win and manage Federal government contracts by providing two services Competition Management (winning contracts) and Program Services (profitability executing contracts). WINS has 5x market share of its next closest competitor who is private, a 24 year history of an 85% win rate, and total of $340 billion dollars in contract wins. This track record of success makes the barriers to entry high on a national scale.

WINS business requires little capital and should be able to reach 25%+ ROE over time. The company’s business model is driven by hiring the best talent which is reflected in bill rates averaging $177 an hour. More interestingly the company’s unconventional business model where a consultant who is not working makes essentially $12 an hour which caps at 2 months, and when they resume work they have to pay back what they got when they were on the bench. This unique model is atypical in the industry. Given the average consultants profile they like working at SM&A for several reasons: flexibility in work schedule, getting paid when not working, working on top projects, and making a very good salary (heard $200K+ for 9 months +/-).

The business:
SM&A competitive advantage are its people and proprietary services. The typical consultant that works at WINS is early 50’s in age and has worked in the industry for 20 years+ (60% have more than 30 years experience). SM&A corporate culture is built on winning which is pretty obvious: Ticker: WINS, Website: www.SMAWINS.com, and a motto of “SM&A: When You Must Win.” In meeting with the company, came away feeling the company is highly motivated to create value and is beginning to significantly improve its operations.

Here are some comments from an interview Steve Myers gave on his business:

“getting a winning strategy right is absolutely critical. But to my way of thinking it kind of like a scientific hypothesis. If done right, the win strategy will describe a set of conditions, such that, if you make then true, you win.”
“You’re (SM&A) not going to come in as a facilitator, as an administrator, as a writer, and do more than document what they tell you to document. If you are going to influence a client’s behavior, first you are going to have to command their respect and earn their trust.”
SM&A does not accept a proposal engagement unless it comes with full management responsibility and all client staff report to SM&A personnel.

Risks: Customer Concentration: Boeing, Accenture, and Northrop are 62.5% of revenues.

A couple of important points here:

First, the hire/fire decision is made at the regional/division level inside of Boeing this is 20+ separate decisions when SMA is selected. Second, these are long time customers and the alternative is to do it in house* (which I will touch on as less likely scenario). Third, SMA is like a law firm on retainer, if a big contract comes that Boeing and Northrop are both bidding on its first come first serve at SMA. With SMA win rate of 85% and industry track record of success these are compelling arguments, especially when you consider, that the Government reimburses 50% of bid costs for winning bid to spur competition. When a contract comes up for bid, the company bidding typically spends 50-200bps of the total project value. WINS has a highly detailed and proprietary process that they walk the client through (you can see at their website). After the business is won, WINS has a project management business that helps companies focus on maximizing margins and executing contract. Finally, given that WINS non-aerospace and defense business is growing 30%+ customer concentration is dropping at a good clip.

*Annual Report 2005 “As previously mentioned, our client base is under demographic pressures. Increased demand for goods and services for defense and homeland security purposes factored in with the accelerating pace of retirements in the industry indicates a shortfall of some 255,000 knowledge workers from 2003 through 2007. About half of this shortfall is due to retirements and half is due to increased demand. We primarily recruit new workers from the ranks of the best and brightest of the newly retired aerospace and information technology community”

Negatives: Management sold stock in late 2005, not directly into the buyback but same quarter as company bought back. They still own 25% of the company and it was about 6-7% of the total holding sold. They also sold at 45% higher prices. Steve Myers sold a little this year at $6.80.


The company has proven to be flexible: “From 1989 to 1993 the Aerospace & Defense business was reduced by a factor of 2 and while this was occurring SM&A tripled its size, and from 1993 to 1997 more than tripled again.”-CEO interview 1999. “…our goal is not to be the high volume provider of journey men technical support, but rather the premium provider of high-value strategic support services. Our focus is on delivering very high quality, something that is very difficult for high volume providers to deliver.” –Annual Report 2005.

Shareholder base:
Management owns 24%
Lord Abbott owns 13%
Wasatch owns 10%
Royce owns 8%
JP Morgan 6%
Top 5 own: 60% +/-

Targeted Business Model
42% GM +/-
22% SG&A +/-
20% Operating margin +/-

Buyback history:

May 2004 announced $7mn buyback,

April 2005 announced additional $5mn,

October 2005 announced additional $8mn,

Jan 2006 announced additional $10mn buyback:

Total shares repurchased: 2.1mn shares about 10% of the equity for $16.1mn $7.95 a share today the stock is $5.92. WINS cost in the buyback is 36% higher than where the share price currently is!!
Given the company’s action and my recent meeting with management I think the company willv continue to aggressively buy back meaningful amounts of equity at current prices. We think upside is $10-11 (+85%) and downside should be around $5 (-12%).


Downside: aggressive active buyback with another 8% of company open to buy, management team that owns 25%, if the stock were to hit $5 it would be trading at 5x ev/ebit of last 3 years average ebit, good cash flow dynamics: maintenance capex about 15% CFO, strong b-sheet $24mn in cash and no debt.

Upside: SM&A currently has 15 sales people that should be $7mn run rate by 4Q06, last quarter they got to $1.7mn or $6.8mn. If the company reaches this goal should be on pace for $105mn in 2007 with $17-19mn in EBIT.

10x on ’07E EBIT of $18 = $185 + 24mn= $209mn/20mn S/o= 10.45 a share
With a 25%+ ROE a 10x multiple should be reasonable. (the ROE could be significantly higher if company buys back the other $14mn of buyback open would take SHE down to low $20’s, I think they would given their average cost is 34% higher than stock)

Customers: Oracle, Cisco, Boeing, Northrop, Accenture, Amgen, IBM, and 3M

Catalyst

Business improving: Pipeline up 21% since year end, just guided up revenues 10% for 2006

Diversifying business: Non-A&D business +39% year/year now 33% of total revenue, reducing customer concentration

High quality business: should be able to reach 20% OM and 25%+ ROE and has 5x market share of next competitor

Aggressive buyback 10% already bought back @ $7.95 avg cost. MGT will likely continue to aggr. Repurchase shares at current prices.
2007: think the company could reach $105mn and $20mn EBIT or $1 in EBIT

Limited downside: $5 which would equate to 5x ev/ebit if you averaged last 3 yrs EBIT