Description
Recommend a long position in TTN, for an upside of $26.00 or 60% (20.0x 2006 EPS of $1.30) over the next six to twelve months and downside of $13.50 or -17% (15x downside ’05 EPS of $0.90) assuming entire loss of largest contract. Currently at 12.5x ’06 EPS (versus comp group at 20.8x) and growing earnings at 25% YOY, I believe that the legal overhang on the stock is overly discounted.
Business description
Titan (TTN) is a provider of IT services and products to the Department of Defense, intelligence agencies, and other federal government customers. Over the past few years, Titan has divested foreign telecommunications and commercial IT businesses, and spun off its Surebeam subsidiary; it is now positioned as the largest, independent pure-play defense IT provider.
LMT's aborted acquisition
In September 2003, Lockheed Martin (LMT) announced the acquisition of TTN at $22/share, or 13.2x 2004E ebitda and 23.4x 2004E EPS. In February 2004, LMT uncovered questionable payments in TTN’s foreign operations, which were potential violations of Foreign Corrupt Practices Act (FCPA). The DOJ and SEC began investigations (still ongoing), the merger price was reduced to $20, and subsequently the merger was terminated by LMT in June 2004. Since termination, TTN stock is down 19%, having dropped as much as 40%, while the peer group has risen 49%. (Peer group includes Anteon, CACI, Mantech, SRA).
Investment positives
• I believe that earnings power should be $1.30 in 2006, assuming 11% annual top line growth and an 8.5% ebit margin. The biz has been growing organically by 16% YOY (11% in Q3), and did a 7.5% ebit margin ex-items in Q3.
• TTN is in the sweet spot of the secular shift in the defense market from large weapon systems procurements to spending on intelligence, homeland security, and security applications. The War on Terror is fueling the trend. Titan is gaining share by providing less costly systems, i.e. the “Affordable Weapon” program which costs $100k vs. a $1m cruise missile. An outsourcing trend in government spending is continuing to grow as aging government workers retire.
• Headlines in the beginning of ’04 proclaimed government budget cuts and a rebound in commercial IT, and the defense IT stocks were forgotten; but over the past few months the market has started to pay attention. The top line of the Defense budget, at first glance, may appear to be slowing by growing at only 7% per year, but the segments which drive TTN’s business are growing much faster. The operations and maintenance budget is growing at 10%/year, the intelligence budget is growing in the upper teens, the department of homeland security budget is growing at 20%/year, and civil agencies spend on homeland security is growing at 15%/year.
• Defense spending as a percentage of GDP stands at less than 4% today and is well below levels that peaked at nearly 10% during the Vietnam war. In constant 2005 dollars, spending during the Cold War was in-line with levels seen today.
• The market is fragmented leaving opportunity for incumbent vendors like Titan to grow by taking market share. The top 10 IT contractors (which includes Titan) account for just fewer than 50% of overall federal IT dollars spent. However, over 31% of the federal IT spend emanates from outside the top 100 companies.
• The business and TTN’s capabilities are scaling such that Titan is able to compete for larger deals. Pre 2002, the company won zero $100m+ bids, in 2002 they bid on 9 and won 7, in 2003 they bid on 11 and won 8, and in 2004 they bid on 24 and won 13 with 7 pending. The book/bill ratio has been greater than 1.0 in all of the last 11 quarters, and was 2.0 in Q3. Backlog is at $6.0 billion, and TTN has good revenue visibility with 80% of next twelve months revenue coming from backlog.
• Margin enhancement (I assume lower than the midpoint of '05 management guidance of 7.75% to 8.5%) is driven by increased scale and cost control. Over the long term, management's goal is 10%. Historically, margins trended between 7 and 11%, but improvement should be easier to achieve going forward as the business grows (TTN is double the size today as it was in 2000). Additionally, management was not focused on managing the business tightly during the LMT merger. Pricing is expected to remain stable as government places value on performance rather than price in awarding contracts, and specialized IT skills are in short supply with 50% of federal IT workers eligible for retirement in 2007. Finally, 83% of contracts are time and materials or cost plus, providing visibility to earnings.
• Street 2005 estimates are conservative. Analysts have not updated models to account for lower interest costs from revised bank agreement ($.02 in EPS), and earnings guidance includes $0.04 of legal costs, i.e. normalized earnings are higher.
• Titan’s NOL of $230m is worth approximately $1.05 per share, and is not included in my valuations.
Valuation and nums
With the defense IT group at 23.2x ’05 EPS and 20.2x '06 EPS, upside could be 20x $1.30 = $26.00 (60%). The Defense IT sector is roughly at its average on a historical basis: median forward P/E is 22.3x, high is 31.5x, low 16.2x. TTN has historically traded at 20.8x forward EPS.
(MM, except per share)
Price $16.29
Shares out 87.40 (includes 6.6m options treasury stocked)
Mkt. Cap 1,424
Debt 565
Cash 30
Ent. Value 1,959
Dividend yield% 0.0%
EV/EBITDA
2004E 168 11.7x
2005E 203 9.7x
2006E 235 8.3x
EPS
2003A $0.74 22.0x
2004E $0.79 20.6x
2005E $1.04 15.7x
2006E $1.30 12.5x
*Above valuations exclude a $230m NOL, estimated at $1.05 per share, assuming a 40% tax rate.
I am modeling an 11.7% revenue growth rate in '05 and 10% in '06, resulting in $2.296B and $2.525B in '05 and '06 revenue respectively. Management is assuming 9-16% rev growth in their '05 guidance. I assume 8%/8.5% EBIT margins in '05/'06, $19m and $20m in '05 and '06 D&A, resulting in $203m and $235m of EBITDA. I assume $34m and $27m in '05/'06 interest expense, and fully taxing at 40% results in $1.04 and $1.30 in '05/'06 EPS. This implies 25% earnings growth, a 12.5x multiple on '06 earnings, and a 40% discount to the comparable group. I believe this stock is therefore both relatively and absolutely cheap.
FCF is better than earnings due to the NOL and should allow TTN to significantly delever over the next two years. Debt/Ebitda should be reduced to 2.1x and 1.3x by end of '05 and '06.
2005E 2006E
EBITDA 202.7 234.7
Interest (34.4) (27.0)
Tax (59.7) (75.1)
Capex (28.0) (25.3)
Working capital change (Assumes DSOs stay at 77days) (17.7) (16.9)
Normalized FCF 62.9 90.5
FCPA settlement (28.5) 0.0
Tax adjustment 59.7 42.8
Free cash available for debt paydown 94.1 133.3
Normalized FCF yield 4.4% 6.4%
FCF yield 6.6% 9.4%
Other positives:
• Visibility on the Street is increasing. Management held an earnings call/gave guidance in August for the first time since October ’03. The team was recently on the road with institutional investors, and completed an analyst day in November.
• Ultimately, this business is likely acquired by one of the large defense co’s (Boeing, Northrop, or Lockheed), so that they can diversify away from large/Cold war weapon system projects.
• TTN is a willing seller because the CEO (who is also the founder of the business) is 66 years old and looking to retire. The Board is actively seeking a successor and has retained an executive search firm.
Primary risks:
1) Allegation of violation of FCPA. The SEC and DOJ have been investigating since February TTN’s alleged violation of FCPA, involving bribes of foreign officials. The company initially accrued a $3m charge, but raised it to $29m in Q2. The nature of the charges are still unclear. Information flow is limited, because the company will not comment due to the ongoing nature of the investigation. Bear arguments:
a) There just has to be something else out there, i.e. why is this taking so long to resolve?
My view is that now that the pressure to settle in order to complete the LMT merger is gone, the company could be wrangling with the government to settle on more favorable terms. $29m is a large amount for a $200m ebitda business and is the largest FCPA settlement ever. It's not surprising that management may be "thinking twice" about readily paying such a high amount now that the deal is definitely off. In addition, TTN gets insurance coverage only if they don’t plead guilty, so they may be negotiating the wording of the settlement carefully.
b) TTN could be prohibited from bidding on new government work for some time (debarred) as part of a settlement.
I would argue that the risk of debarment is very low for several reasons. For one, debarment has almost never happened. Boeing was convicted on more egregious FCPA charges and was only fined. Lockheed had two guilty FCPA pleas, and wasn’t debarred. Secondly, the alleged violations occurred in TTN's foreign, commercial operations (specifically Saudi Arabia) which as a whole represent less than 1% of revenue and have since been discontinued. As a result, it would seem counterintuitive for the government to penalize the domestic federal business.
c) There could be more legal liability than the $29m charge.
I view this as unlikely given $29m is the largest ever settlement for a defense FCPA violation. The Company also assumed no other costs from FCPA in their ’05 guidance, although said they would expense any further legal costs as incurred.
2) Linguist contract recompete and Abu Graib. Titan’s largest contract (14% of revenue or $300m run rate) provides translation services for intelligence operations in the Iraq and Afghanistan war zones. The contract was up for recompete in September ’04, with Northrop, L3, CSC, competing. A small contractor protested the Army’s RFP procedure, and the recompete decision was indefinitely delayed. Subsequently, the Army extended an interim contract to TTN for up to a year, so that the Army can initiate a new RFP, accept bids, select a winner and transition to the new contractor should TTN lose. An announcement is expected by June of 2005.
o EPS impact would be approximately $0.14 in ’05 if lost
o At least one TTN translator was present at Abu Ghraib during prisoner abuse, which increases the political risk of awarding the contract to TTN
o The contract is potentially peaking as most of revenue is dependent on Iraq war effort
o Northrop just won a 3.5 year $97m linguist contract in Balkans (Northrop was incumbent)
However, I believe TTN will win the recompete, based on the following:
o It would be very difficult, if not impossible/dangerous to replace 800 TTN employees and 3,500 translators, mainly in Iraq, in the midst of a war
o TTN's incumbent win rates are generally 90-95%
o Army recently awarded CACI (a TTN comp with personnel also at Abu Ghraib) a six month interim contract for interrogators
o Removing TTN still leaves same subcontractors on the ground (i.e. doesn’t solve anything)
o TTN was recently awarded a linguistic contact from the NSA, indicating the government's continuing confidence in the company
o The Army, not Titan, performs background checks on translator candidates (i.e. the previous issues were a result of Army negligence)
o ’05 revenues would likely include $200m of linguist revenue even if the recompete is lost, because the contract expires midyear plus a 3-month transition period. (i.e., I'm being overly conservative in calling '05 a goose egg if they lose the recompete)
3)The “Why would LMT walk away from a $2.3b deal over a $30m liability?” argument.
o The argument here is that Lockheed uncovered other business issues and used FCPA to walk away, or FCPA is larger than we think.
However, I believe there are several reasonable explanations which mitigate this fear:
• Vance Coffman, the Lockheed CEO and chief proponent of the deal, retired from CEO post in March ’04, allowing other management to kill the deal.
• With so much government work at stake, LMT didn’t need to risk its reputation or future contracts with Abu Ghraib or FCPA issues.
• LMT shareholders had pressured LMT from the beginning about the deal, because of the high multiple paid. In addition, sector valuations had come down 30% from announcement to termination.
• LMT tied up capital/management attention for nine months and gave TTM two chances to resolve with the government – both of which they missed – ultimately it was this fatigue factor and the loss of faith in TTN management that caused them to walk.
There are some very misunderstood fears surrounding this stock, such that at 12.5x earnings growing at 25%/year, the risk/reward profile is quite favorable.
Catalyst
Resolution of alleged FCPA violations.
Recompete win on linguistic contract.
Sale of the business to a large, mature defense contractor within the next six to 18 months.
“Turning of the clock” at year end when analysts release ’06 estimates and investors realize TTN is trading at 12.5x earnings
Replacement of existing CEO.
Management continuing to increase communication with the Street.