Tuesday, May 28, 2013

Engility Holdings

Spinoffs can take many shapes, often times a company has a hidden gem or assets the market can't readily value inside of their current structure (HHC's assets within GGP comes to mind), other times its management trying to lose a business that is perceived to have a difficult operating environment going forward and is a drag on the core.  In some fashion, the value of the parts is greater than the sum.

In July 2012, defense contractor L-3 Communications spun off most of their government services business, Engility Holdings (EGL), in what many described to be a "dump transaction".  It sure looked that way as L-3 kept the most lucrative areas of government services (cybersecurity, intelligence and security solutions business lines), and saddled the newly formed company with $335 million in debt, $325 million of which was paid to L-3 in order to pay down debt and repurchase shares.  With L-3 holders receiving only 1 share of Engility for every 6 shares of L-3, it probably also caused a small amount of forced selling as some L-3 investors might not have wanted to hold the less profitable business lines or be restricted due to market cap minimums.  Whatever is the case, it was almost structured to be ignored by the broader market and as a result there's very little press/analyst coverage.

Engility provides systems engineering services, training, program management and operational support to the U.S. government.  99% of their revenues are service based (no tangible products) to the U.S. government and its agencies.  With decifits and sequester talk in the headlines, the defense industry has been a particularly easy target for politicians wishing to reduce government spending.  Engility's response to the current environment has been to slash costs, underbid competitors, and reposition the itself as the "low-cost, technically-acceptable" provider to its customers.  Even so, Engility's revenues will decrease with the company's contract work in Afghanistan and Iraq rolling off as the troops come home.  On the positive side, some revenue might be recovered now that Engility is a separate public company allowing them to bid on contracts that were otherwise restricted from them due to conflicts of interest with L-3 Communications.

With little history to go off of, the best place to gain an idea of what the business might be worth is management's guidance for 2013 (which was reaffirmed on the Q1 call).
Using the low end of their earnings guidance, Engility is trading for roughly 7.5x earnings (about half the current market multiple) or about a 6.3x EV/EBITDA ratio.  Engility is trading for a slight discount to its peers as well in Booz Allen, CACI, and ManTech, which are in the 8-9x earnings range.  Besides the revenue run off, what else is not to like?  Oh yeah, the $335 million in debt.  Starting with the end of this past quarter, Engility will have to pay $12.6 million toward principal each quarter.  With only $80 million in cash flow from operations (at the low end), it doesn't leave a lot of room for error after taking into account their principal and interest payments.  Luckily the government services business doesn't require much in terms of capital expenditures (~$5 million in 2013), a service business with their employees usually working onsite or close to their clients, very capital efficient.  I also tend to side with the camp that believes some debt can be beneficial to a business as it ties management's hands and keeps them from making poor capital allocation decisions; the next several years are pretty much set at Engility, free cash flow will be used to pay down debt.

And with Engility facing no major contracts remaining for recompete in 2013, the initial concerns over revenue declines might be overblown?  Not to get political (but hard in the government services business), will the government actually follow through and cut spending drastically?  With the overall economy improving and the deficit shrinking, budget issues might get kicked down the road a little longer.  Seems like the politically easiest answer.  The defense industry is often called the biggest government jobs program for a reason.  Plus with tensions around the world seemingly always escalated these days, never know when the next conflict could erupt.  The low expectations seem pretty priced in at this point.

With spinoffs, you always have to pay attention to how the incentives are aligned.  With Howard Hughes, management literally dipped into their personal savings to buy long dated warrants before taking the job.  Engility seems to have the more typical options and RSUs structure, not necessarily a negative, but not a screaming positive like if they bought equity out of pocket.  But I do like Engility's ownership profile, several hedge funds with concentrated positions, plus I always like to see Pzena Investment Management (PZN) up there as they're another one of my favorite value investors.

I'm pretty much fully invested at this point, I tend to think the individual investor managing their own account should be able to find enough names to fill out a portfolio in any environment, even a potentially fully valued one.  But I'm adding Engility to my shopping list and will likely start a position if we get another self created budget deadline in Washington that causes more uncertainty in the defense and government services sector.

A similar spinoff that also interests me is Exelis (XLS), which has been described as a pension fund with a defense business attached.   It probably deserves its own post, but with interest rates, and as a result discount rates so low, pension fund liabilities are likely overstated, could be an interesting place to look for value in a rising rate environment.

Disclosure: No position in EGL or XLS

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