Friday, June 8, 2018

Perspecta: DXC Government Services Spin, CSRA 2.0

On 6/1, DXC Technology (DXC) completed the spinoff of its U.S. government services business and merged it with Vencore and KeyPoint, two PE owned government services businesses, to form Perspecta (PRSP).  There's been a lot of M&A in this industry, DXC was formed in 2017 via the combination of Computer Services (CSC) and Hewlett Packard Enterprise's (HPE) services business, prior to that merger, CSC had spun off its government services business as CSRA in November 2015 only to re-enter the business via the HPE deal.  Then in February, General Dynamics (GD) came in bought CSRA at a rich 12x EBITDA or 18x earnings multiple. Now once again DXC/CSC is returning to the same playbook and spun off its government services business.

Several years ago I profiled and owned several of the government spins (EGL, XLS, VEC, CSRA, LDOS), large defense contractors were dealing with the draw down of troops in the Middle East and sequestration started pinching Federal budgets by spinning off their lower growth and lower margin services businesses.  Now that the Federal budget is in growth mode again, projected at 1.5-2.0% annually through 2022, government services multiples are on the rise and you're seeing the opposite M&A trend taking place with GD buying CSRA.

If anyone in the industry reads this they'll likely cringe, but from an investment standpoint, most of these government services are very similar with nearly indistinguishable strategies making them fairly straight forward to value.  This kind of M&A in any industry would likely be disruptive to clients, but here deal teams work on individual government contracts and have more of an identity with the contract than the cute name currently on their business card.  It's a very competitive business where valuation multiples should converge over time as its nearly impossible for a firm to have a clear competitive advantage.  The nature of the business also makes these firms a bit of black box, many of their contracts are classified and its hard for the average investor to shift through the contract re-compete pipeline.

Perspecta is pitching their margin profile as their differentiating factor due to their heavy weight towards firm-fixed price contracts compared to peers.  This is partially the nature of the IT services business, CSRA featured similar EBITDA margins.
Fixed contracts are where the government and the contracting firm agree upfront on a price/value of a given engagement and its up to the contracting firm to make it profitable.  These types of contracts are potentially more lucrative if a management team can squeeze costs out as those savings don't have to be shared with the government (at least until the next re-compete).  But this can cut both ways, if Perspecta were to run into issues with cost overruns and or just flat out misprice a fixed-price contract in a competitive bid (animal spirits can get the best of anyone) then they could be stuck in a negative margin position unable to get out for several years.  Whereas the cost-plus contracts are safer, but with lower more predictable margins, as the contracting firm and the government agree on a specified margin upfront and the total value fluctuates with expenses (think timeshare resort management or Nacco's coal mining operating agreements).

As mentioned, all these independent government service providers trade in a pretty tight range, Perspecta has moved up a bit this week, but still remains at the bottom of the table on both an EV/EBITDA and P/E basis.
Perspecta has one large contract with the U.S. Navy servicing their intranet and related communication needs ("NGEN") that is coming up for re-compete, its a $3.5B 5-year contract, or roughly 17% of Perspecta's pro-forma $4.1B annual revenue base.  They're the incumbent on the contract through predecessor firms (was DXC, before that HPE, before that EDS) since the program was established in 2000.  The Navy is splitting the contract into two, one will be the services and the other the equipment side of the contract, Perspecta is likely to give up some of this revenue either by adding additional subcontractors to the team, or losing one side or the other, and then just general competitive pressures will decrease the profitability of NGEN through the re-compete process.  They're projecting flat revenue growth over the next year, given the healthy budget backdrop, I'm guessing its less the integration/new public company focus they've stated, and more an acknowledgment that NGEN will be rolled back for them this time around.  In the Form 10, the old DXC government services business ("USPS") had a 90% historical re-compete win rate and Vencore has a 97% historical re-compete win rate.  It's unlikely that the Navy would move completely away from Perspecta, incumbents are hard to beat, but that headline risk is out there and is potentially a reason why the stock is cheap.  I don't think the market is intentionally doing this but if you were to back out the NGEN contract entirely, Perspecta is trading for roughly the same multiple as its peers.

Perspecta has 165.6 million shares (old DXC shareholders own 86% of the company) and net debt of $2.7B, if it were to trade at a peer multiple of 12x EBITDA, the shares are worth $33/share versus the $24.25/share they trade at today.

Other thoughts:
  • DXC is a S&P 500 constituent, I haven't seen an announcement kicking PRSP out, presumably because there's nothing to announce if PRSP is just simply not added to the S&P, but we've likely seen some forced selling by index funds since the 6/1 spinoff.
  • Mike Lawrie is the CEO and Chairman at DXC, he'll be the Chairman at PRSP, since taking over CSC a few years ago he's done a tremendous job for shareholders in both creative M&A and operating performance.  Good manager that is worth following.
  • One thing about NGEN that feels a bit wrong to me, it's barely mentioned in the Form 10, and not in the risk section for concentration risk, despite being a material 17% of revenue.  Could be an intentional oversight because the risk of losing the contract is minimal, or a bit deceptive, I'm not entirely sure which?
  • Perspecta's leverage will be a little higher than peers to begin with which is pretty typical for spinoffs, the company is projecting $1.5B in operating cash flow over the next three years and have slated 35% of that to pay down debt which would get them to the lower end of their target range of 3 to 3.5x EBITDA.
  • Vencore filed an S-1 last year before pulling the IPO, the S-1 is worth reading, Vencore is more of a mission services business versus the IT services at DXC's old USPS business.  KeyPoint, the smallest of the three being merged together, is the leader in background checks and security clearance, good little niche.  Perspecta believes they can go after contracts they previously weren't qualified for now that they've merged the three entities (combining mission and IT services), that's possible, but doubt it moves the needle much.
Disclosure: I own shares of PRSP

35 comments:

  1. I looked at this one as well, and was flummoxed by the sharecount issue.

    Mgmt. says roughly 144mm shares, but the total is, as you mentioned, 165.6mm. My problem is that the value of the entire enterprise, using 12x, is ~$8.2 billion, less net debt of $2.7 billion, I get an equity value of $5.5 billion, or ~$33/share.

    However, $PRSP shareholders only own 86% of the company, so doesn't it reduce the $PRSP valuation to 86% of ~$33/share, so roughly $28.50/share?

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  2. It is a bit confusing, hopefully I get this right and help, but it’s not that PRSP shareholders own 86% of the company, it’s that former DXC shareholders own 86% of the company and Vencore/KeyPoint’s former owners own the remaining 14%. Said another way, DXC distributed the 144 million shares to its owners, and the PE firm behind Vencore/KeyPoint received shares in PRSP to total 165.6 million.

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  3. Ah, ok. Makes sense. Part of me wondered if I was double counting.

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  4. How are you thinking about the ~$300 million of capitalized lease liabilities on the balance sheet?

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    1. It's included in my net debt number, I'm using the pro forma balance sheet as of 3/31. Looks like it all runs off within 5 years, best to consider it real debt.

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  5. Agree with this write up. On NGEN, I believe at the investor day they said it would be extended and then the recompete comes up in 2020. That may be a reason why it was not mentioned more in the form 10?

    My (simple) view is that the stock is where it is just based on spin dynamics. No DXC holders wants this thing, and can easily make excuses (NGEN contract) to dump it. So there are potentially 144mm shares that need to be dumped, and so far 90mm shares have traded hands since the spin. There was a S&P midcap index inclusion as well I believe.

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    1. Good point on the NGEN contract, these big government contracts often get extended for one reason or another, so for now its more of an overhang on the stock than a potential wake up one morning to negative news type catalyst.

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  6. Unrelated to this post but have you looked into ddr yet?

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    1. Still only surface level, it does share a lot of similarities to SRC, but with SRC I like the triple net business model better, still interested in DDR and I know the spin is coming up soon. Feel free to share how you're thinking of DDR too. Thanks.

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    2. I spent a little time on the RVI Form 10, still formalizing some thoughts, but one thing did jump out at me when comparing/contrasting it to SMTA. At RVI, the CMBS debt and preferred shares need to be paid before the common starts receiving asset sale proceeds, so much of the value will be at the end in 2-3 years. They will be dividending out FFO during that time, but I'm assuming that amount will come down as the assets are being sold. In a liquidation you want cash and cash early to improve the IRR, SMTA is talking about distributing Shopko asset sales to shareholders to drive that IRR early, don't think RVI will be in the same position. Plus the longer it goes on, the more likely some bear scenarios happen? Just one thought I had, but I'll continue to come back to DDR/RVI, DDR might be the more interesting piece here after the spinoff.

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  7. Do you have a feel for whether their above average margins will hold up moving forward? Agree the stock looks cheap based on $683M of EBITDA. But if revenue is flat and EBITDA margin drops to 10% ($430M), it doesn't look so cheap at 15.5x EV/EBITDA.

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    1. I would guess that their margins come in over the next decade, but it's not something that will just disappear overnight as you sort of suggest, most contracts are 5 years in duration and its hard to displace an incumbent. But the government is also smarter than you think and every re-compete the margins will shrink a little, but for the next several years I think its reasonable to expect their margin to remain above average.

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  8. Quick heads up : next spin I`ll be looking at is Servicemaster/ American Home Shield, Q3 2018.

    I also missed the Rafael Holdings spin from IDT. It`s been a quick double. Those quirky microcap spins from Howard Jonas are worth having a look at. Was written up on VIC.

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    1. I have that one circled as well, like the longer term growth story at American Home Shield.

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  9. Seems impressive that margins were that high as three separate (standalone) entities. Given that this is IT, I don't think margin compression is necessarily in the cards here...some reduction of redundant costs can certainly be expected as these entities are combined.

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    1. Adding: CSRA is an example of another firm with margins in this area as MDC pointed out. Cognizant is a firm (private clients) with 20% EBITDA over long periods of time. This business (IT services), if done right, can maintain high margins--certainly higher than traditional consulting service firms.

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  10. Can you break out your math on how PRSP is priced right now at a market multiple without the NGEN contract?

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    1. Sure, just very simplistically, $3.5B contract over 5 years, 15% EBITDA margins (assuming mostly variable costs), that's $105MM in EBITDA. Would move EBITDA down to $578MM, making EV/EBITDA about 11.5x or the same as LDOS.

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  11. Bear in mind that PRSP is negotiating for a contract extension of NGEN til (I think) around May of 2020. In 2019 the largest contract up for re-compete is only 2.5% of revenues. Also, companies in this sector are no doubt happy that the 2 year Federal Budget means there are more new start contracts up for bidding . Add in some probable forced selling from index funds depressing the current stock price. All-in-all, PRSP seems like a good bet for the next year or two at least.

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    1. Right, I agree. NGEN seems to be more of an overhang than actual headline risk where we wake up one morning finding out they lost the entire contract. These things take time, its going to be a couple years before the Navy actually makes a decision and then it will take time to transition as well, by the time its reality and hitting the top line, could be a non-issue.

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  12. Any thoughts on DXC being hammered on its stock price? Do you think it will get a rewrite?

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    1. Sorry -- I haven't looked at DXC, but looks cheap

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    2. I'll answer on DXC - having owned the name for over a year, I like it still. It is trading at ~10x on an NTM P/E basis, and should probably be 11-12x if they show top line growth. On top of that, they healthily beat EPS estimates regularly by setting the bar low (consensus is just a touch above midpoint of guidance) so it should be approaching $10 of EPS in FY2020 (march 2020).

      The stock down at these levels in my opinion is because there were a lot of event players in the name hoping for some quick hit, and DXC disappointed them at their most recent earnings. People were hoping for a bump in EPS from incremental synergies, better tax rate, etc. Instead they got a message on how DXC needs to take incremental synergies and reinvest them to grow. Ultimately though that is a positive for a long term player. The next event is going to be earnings plus an investor day in the fall. In the meantime you have event players moving on to other names.

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    3. Makes sense. Yeah I also noticed that that investors might have been scared away with the eps for 2019 being lowered which was a result of post spin eps. Thank you on the take, I also hold long positions I. PRSP and DXC because it seemed relatively cheap still prior to the spin-off being consumated. Hope to hold it for a few years.

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  13. Hi, do you compile these comparable tables yourself by hand or do you use a datasource to pull them in this form?

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    1. Combination of the two, I do have access to a Bloomberg terminal (share with about 100 other people, don't tell BBG), but for the company in question its almost always done by hand. The comps, a mix of the two.

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  14. Unrelated to this name, but since someone mentioned $rfl has any spent time on it? Reading the form 10 on the pharam business is beyond Greek to me.

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    1. I haven't yet but its near the top of my list, hope to get on it soon although I might have same reaction as you.

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  15. Servicemaster/ American Home Shield initial Form 10 filed yesterday. On SEC site as Frontdoor (new name for American Home Shield)

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    1. Thanks, I will be taking a close look at that one.

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    2. Interesting read, but I keep asking myself, why separate these two businesses? I'm not sure what's being accomplished by the spin as these seem like reasonably similar businesses, business models, investor bases, etc.

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  16. Suggest you read on VIC the Rollins (ROL) write-up dated May 30, 2018. It explains recent changes in the competitive dynamics of the pest control business, the SERV/AHS spin rationale, and industry valuation differentials.

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  17. Hello. Rookie question but how are you getting to the $ 683M EBITDA?

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    1. Don't have the precise math, but it's approximately $4.2B revenue and 16-17% EBITDA margins they're guiding to for FY19.

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