I am recommending a long position in URS equity.  I believe the equity has material upside potential and limited downside with reward/risk of 2.2x, with my base case at $63 or 40%, and my downside case at $37 or -18%.  (Bonds trade by appointment; thus not included in this analysis).

This is a value oriented free cash flow thesis with support from the release of excess working capital.  While the business is a cyclical industry, URS has a more diverse revenue stream than most competitors and a stable defensible core in its main Federal segment.  Therefore, the company should not trade at a steep FCF yield discount to peers.  The three core parts of the thesis are:

1.)   Balance sheet release of approximately ~495mm of about $1.5bn in working capital including a couple long-term receivables/payables.  The combination of large incentive payments, running ahead of schedule on the chemical demilitarization contract and the recent sizable acquisition of Flint have pushed working capital to ~13.5% of revenue versus historical norm of 7-10%.  The quick ramp down of the chemical demilitarization contract and the post-merger normalization of accounts should release a significant portion of this $495mm.  Current guidance implies $100 to $150mm release in 2014.  I believe a similar sized release is likely for 2015 based on the ramp down in the chemical demilitarization contract.

2.)   URS has been a significant beneficiary of the US chemical de-militarization efforts; however, as the project comes to a close the federal services segment will revert to normalized margins (5-7% but running at what appears to be low 4’s now ex this contract; low double digits with it) with a significant revenue headwind.  A 2011 DoD report (excerpt below) identifies aggregate contract revenue by year (primarily retained by URS).  While management guides to being 3-4 years ahead, the revenue drop appears to map better to one year ahead.  This highly profitable contract had base payments with a total margin possibility of 12% plus sizeable incentive payments.  Because of the back-ended nature of incentive earnings milestones, the current margin is 30%+.  This contract run-off along with general government spending paints a picture of a melting ice cube.  Looking at the remaining ~75% of the federal business, the bulk is higher value-add work (via consultant and company discussions).  My work suggests 25% of federal is lower-end generic work.  Thus, the majority of remaining revenue should be quite sticky.  In addition, the revenue diversification of URS should further add to the stability of the overall business.

3.)   Expectations for the Oil & Gas segment are extremely low.  The Q4 pre-release highlights continued issues at Flint with a ~$40mm reversal of prior recognized earnings (an additional ~$15mm related to tax accruals due to expected earnings contribution from Flint).  The Flint CEO also departed the firm due to risk management issues.  Typically, operational missteps in this space have extended impacts on the business; however, I believe these issues are shorter term.  The restatement was on contracts that are 90+% complete and initially delayed due to weather related issues (see 100-year flood back in the summer).  At the 2.5% adjusted EBIT margin the business has been running at is half the 4-6% normalized margin.  Part of the struggle has been this segment was originally ~50% Canada and heavily gas focused.  Now it is about 1/3^rd Canada.  One additional positive is that Canadian E&P capex has been down two years in a row but is expected to increase in 2014 by ~3%.

In my upside case, I assume the rest of the business (ex-Chemical Demilitarization) grows at ~1.5% and Oil & Gas returns to a 5% normalized margin.  Industry expectations have the peer group growing at high single to low double digits on the top line.  In addition, I assume the announced $350mm share buyback happens in 2014, a subsequent buyback of $150mm in 2015, and ~550mm of aggregate debt pay down.  This leaves excess cash of ~$180mm and possible excess working capital release of ~370mm.  The rating agencies have URS listed as stable but expect it to delever to 3.0x or lower.  The capital allocation above will keep lease adjust leverage in the low 3’s, which I think will allow the URS to keep its rating (which is important for future projects).  On the valuations side, I apply a 12.5% free cash flow yield on free cash flow pre working capital then adjust the market cap by any remaining working capital release expected.  The closest comparable trades at a 10% free cash flow yield, while the widest comps (more energy focused) trade at nearly 11%.

In my downside case, I assume no growth ex Chemical Demilitarization, Oil & Gas EBIT margins flat at 2.5%, $350mm buyback in 2014, and no buyback in 2015.  Based on the continued downward trajectory in this case, I used a 20% free cash flow yield then adjust for excess working capital.  Even a fairly draconian DCF cases where the business unwinds to roughly 2/3rds its size yields a share price in the low 30’s.  It is worth noting that the 10%+ buyback and rapidly declining D&A (post Flint acquisition) provide significant support of the reported GAAP EPS.

Risks:

1)    Rating agencies take a harder line on leverage and push capital allocation towards debt pay down.  For procuring new long-term contracts, an IG rating is very important to URS.

2)    Oil & Gas issues are the tip of the iceberg and the underperformance further deteriorates and hurts growth prospects

3)    Acquisitions… company loses focus on capital allocation.  I think having Jana in the name helps prevent this (to the extent they stay in the name).

General:

URS is an Engineering and Construction (E&C) service company.  Typically, E&C companies will have varying degrees of technical expertise and staffing capabilities that allow them maintain, build or operate certain facilities or projects more economically than the final owner.  Contracts can span fairly large time periods and will generally be cost plus or fixed price.  URS was built in large part through a series of acquisitions but was founded in the 1950’s.  Now, nearly 40% of the business is from Federal Services and the latest acquisition was in 2012 when Oil & Gas was added to the portfolio (Flint).