Description

We decided to do a short write-up of our current thoughts since a lot has changed since our write-up in April of 2013 at $44.  In short, we think URS is for sale and the stock remains attractive despite the run-up during the past two weeks.  Our base case take-out price is $65, which is a 28% premium to today’s price though 44% relative to where it was prior to the company filing an 8k on June 30, 2014.  The 8k noted a revision to three executive’s change-in-control provisions in their employment agreements.  Our upside case is $70, which is a 38% return.  If we are wrong, we think the stock could fall back to $46, down 10%, or approximately where it was pre the 8k on June 30.  Our qualitative judgment is the probability of a sale is 90%, up from 75% pre the 8k. 

Our original 2-3 year thesis is playing out but it hit a few road bumps last year and early this year, which has truncated our initial upside target.  Today, our thesis has evolved and we believe the most probable outcome of the BOD’s “Value Creation Committee,” established in March of this year, is a sale of the entire company.  There are several factors that lead us to this conclusion:

1)      The most recent signpost in our mosaic is the 8k filed on June 30, 2014, where amendments were made to the change-in-control provisions in the three most senior executive’s employment contracts with the exception of Chairman and CEO, Martin Koffell.  We provide a link to the document itself below.  Our interpretation is the BOD is playing offense and setting up a broader opportunity set for a CIC to occur.  We believe the former CIC provision was narrower in scope since it required another party to control more than 50% of the stock to trigger.  The revised language requires URS to own less than 50% to trigger.  We think this protects management’s CIC benefits while enabling a strategic to finance an acquisition of URS using cash and stock, leaving URS shareholders with less than 50% of the surviving entity.  Additionally, our understanding is the previous language was limited to 13D and 14D filers whereas the new language encompasses a broader group of external parties such as another company.  It would appear this paves the way for a strategic offer. 
http://services.corporate-ir.net/SEC/Document.Service?id=P3VybD1hSFIwY0RvdkwyRndhUzUwWlc1cmQybDZZWEprTG1OdmJTOWtiM2R1Ykc5aFpDNXdhSEEvWVdOMGFXOXVQVkJFUmlacGNHRm5aVDA1TmpjNU5qRXpKbk4xWW5OcFpEMDFOdz09JnR5cGU9MiZmbj1VUlNfOEtfMjAxNDA2MzAucGRm

2)      As per their press releases back in March/April, a “Value Creation Committee” and a “CEO Search Committee” have been established on the BOD concurrently.  The value creation committee is exploring all alternative strategies to realize more value than the market is currently doing – hypothetically including a sale of the company, a break-up of the company, a leveraged recapitalization, etc.  The CEO search committee is considering external candidates and internal candidates to succeed current Chairman and CEO Martin Koffell.  Importantly, per the company’s Cooperation Agreement with Jana Partners, Martin is required to resign both his Chairman and CEO roles by year end or earlier at his discretion.  We think an internal successor CEO is unlikely since the leading internal candidate was fired earlier this year.  The challenge we see pursuing an external candidate is the company’s uncertain future: what CEO is likely to take a job at a company that is potentially undergoing a sale process where the hypothetical new owner would have the ability to install their own choice of CEO?  As a result, we think the value creation committee is driving the process underway rather than the CEO search committee.

3)      Among competing alternatives available to the value creation committee, it’s important to consider Chairman and CEO Martin Koffell’s incentives and those of the other executives and BOD members.  Martin in particular is mandated to resign both of his posts by year end per the company’s cooperation agreement with Jana.  This leaves him less than six months to determine the fate of the company he assembled over the past 25+ years.  Which outcome is more graceful for his final act?  A sale of the company enables him to create his own destiny and write the next chapter with a positive spin as the capstone of his career.  He is in a position to negotiate a potential deal that could in theory permit him to remain involved.  For example, a lucrative consulting arrangement would be plausible.  There is precedent in this industry for former Chairmen and CEO’s obtaining $1.5m+/year consulting relationships with their former company.  In contrast, in a scenario where a new CEO comes in and URS remains a standalone public company, Martin’s role is over by year end at the latest.  This seems like an abrupt ending to a relationship he’s built over the past 25+ years.  For reputational reasons, it would appear Martin has an incentive to sell the company.

4)      There is a large financial incentive for management to sell the company.  The value of automatic vesting of time and performance based stock options and RSUs is $30.7m for Martin Koffell per the latest proxy and $8m for CFO Tom Hicks.  Moreover, the CICs include tax gross-up payments, a generous feature in today’s governance landscape.  We believe these amounts are material relative to their respective net worths.

5)      The sell side has speculated that private equity is a potential buyer of URS.  We agree but think a PE offer is not the value-maximizing outcome.  First, there would be no synergies and secondly, we think a strategic could more comfortably lever up to finance the deal given a more diverse earnings base from which to de-lever.  In terms of synergies available to a strategic, URS’s corporate expense of $90m would be the low hanging fruit and we have to believe there would be substantially more to follow.  Eliminating corporate expense alone could be worth $11-$13/share if capitalized at 12x-14x after tax savings.

6)      A break-up of the company is possible, but we are unsure how this would create a lot of value and the CFO said as much during his most recent conference attendance as well.  There would be some value to create here by selling their asset intensive rig hauling business, for example, but this doesn’t move the needle enough.  So while a possible outcome, a break-up is not the value maximizing one.

7)      A leveraged recap is also possible, however the question becomes is this prudent when they have no CEO?  The other consideration that makes this less likely, though not impossible, is current management’s expressed desire to maintain their IG rating.  We should note that we disagree with management’s contention that an IG rating is worth its cost relative to the current cost of equity but this is a moot point at this juncture. 

8)      A final factor to consider is the cause of the company’s low trading valuation when expressed as a multiple of FCF.  URS trades at about 10.5x recurring fully taxed FCF today, up from 9.5x pre the 8k filed on June 30.  The reason this discount persists, in part, is because most analysts value the stock based on a P/GAAP EPS multiple.  FCF is sustainably 50% greater than GAAP EPS today due to the $95m non-cash amortization running through the P&L and asset write-ups that make depreciation alone $50m more than capx.  The result is $1.60/share of excess FCF relative to GAAP EPS of $3.20 this year – fully ignoring their NOLs and taxing their amortization add back.  Thus, the true earnings of the company aren’t being evaluated correctly by analysts.  There isn’t a short term fix to this challenge.  In contrast, a buyer of the entire company would likely evaluate the FCF power of the business rather than GAAP EPS enabling a full valuation today.  A transaction of this size provides the opportunity for management to reset the relevant metric for investors to value the business based upon after their previous attempt at disclosing “Cash EPS” a year ago failed due to poor communication.  The value creation committee is likely considering the cause of URS’s historic undervaluation and how it can be remedied.

These are the basic factors that lead us to the conclusion that a sale is the most likely outcome for URS.  Our time horizon is capped at year end but we see no reason a deal announcement should take this long.  3 months is the approximate mid point between now and then. 

Value of URS in a take-out:

Our base case of $65 represents 8.5x our estimate of 2014 EBITDA less minority interest.  We estimate net debt of $1.3B, which is less than reported during Q1 due to seasonal variation in working capital and a few one-off items that should reverse.  Starting with Q4’13’s net debt of $1.4B, we add $270m for buybacks in Q1, $60m for dividends during 2014, $100m for severance and subtract management’s FCF guidance of $580m implied by their CFO guidance of $750m for the year.  The current share count is 70m. 

Our upside case of $70 represents 10x our 2014 estimate of EBITDA less minority interest less the remaining decline in the company’s chem demil contract, which is a $55m headwind to pretax earnings next year.  This would be in line with two large recent E&C transactions of Foster Wheeler and Kentz.  We assume the same net debt and share count as above. 

Additional factors to consider:

1)      Our EBITDA estimates are below the Street and that implied by the company’s guidance.  It is therefore possible that the company’s projections are more optimistic than ours rendering our valuations conservative.  The company’s projections would likely be incorporated in any pitch book.  Management has recently expressed optimism surrounding a pick-up in business prospects.

2)      The median EBITDA multiple of E&C industry transactions over the past 14 years is 9.3x per Dundee Securities.  Our 8.5x multiple looks conservative relative to the historic median.

3)      The aggregate multiple of URS’s own M&A transactions over the past 18 years is 11.2x EBITDA though the median is 8.2x.  Our 8.5x assumption looks reasonable relative to what URS itself has paid historically to buy other companies.

4)      URS’s book value per share after adjusting for the goodwill write down in 2011 is in the low $60 range.  If the Value Creation Committee is going to create any value, they will probably want to sell for more than retained earnings!

Catalyst: Culmination of the Value Creation Committee’s work in process.

Risks: The Value Creation Committee fails to do anything at all and we are left with a broken company.  The stock probably declines back to the mid $40s but its current FCF yield should support it.  For context, URS is slated to generate approximately $750m of FCF during the next three Qs (remainder of 2014) if management meets their own guidance for the year of $750m of CFO given they had negative $130m of CFO in Q1.  At it’s current market cap of $3.5B even at $51, that is a 21% FCF yield over the next 6-9 months.  Should the stock decline to $46, or a $3.2B mkt cap, the resulting FCF yield would be 23%.  The market clearly doesn’t believe URS will generate this amount of FCF and the company is likely to lower full year guidance at some point.  Up until the past week we too believed this.  Given that we haven’t heard about a Q2 shortfall from the company yet and the Q is over, we are less concerned and even somewhat relieved.  Either way, we think the stock price is already compensating for a miss and it will rise materially should they meet their guidance. 

Catalyst