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

Leidos Holdings: Reverse Morris Trust with Lockheed Martin

Following the draw-down of U.S. troops in Iraq/Afghanistan and the 2013 budget sequestration we've seen many defense and consulting firms spinoff their headwinds facing government services businesses (EGL, VEC, CSRA to name a few) as a way to continue to show growth.  In 2013, Science Applications International Corporation or "SAIC" spunoff it's slower growth technical services and IT divisions, the parent company changed it's name to Leidos Holdings (LDOS) and the slower growth government services division kept the name SAIC.  The reason for that spinoff wasn't entirely clear to me at the time, and still isn't, especially now that Leidos Holdings is acquiring the Information Systems & Global Solutions business of Lockheed Martin (LMT) in a Reverse Morris Trust transaction that will close in mid-August.

However after the transaction closes, Leidos will be the largest pure-play IT and government services contractor in the U.S., about twice as big as CSC's government services business CSRA.  They will be broadly diversified across government agencies, and internationally, in fact they'll be one of the few businesses to touch all seven continents as Lockheed's contract to run the U.S. research base in Antarctica will move to Leidos.  This is an industry where scale matters, in today's budget environment more and more contracts are being put out to bid as "Lowest Price Technically Acceptable".  Prior to sequestration, agencies used the "Best Value" method for determining a winning bid, allowing agencies to balance the trade-off between quality and cost, greater value for a higher cost was still okay.  Now the award goes to the lowest price as long as the bid meets all the technical requirements of the contract, there's less judgment on the contracting agency's part.  By being able to spread your corporate overhead over a larger contracting base, those with significant scale will be in a better position to compete on price.

Once a contract is won, it's often difficult to unseat the incumbent in future re-competes as the incumbent has the advantage of not needing to shoulder start-up and implementation costs, putting them in an advantage on price.  If a contract is lost, many of the employees working on the contract end up with the new contractor, the cost model for these firms is more variable than other industries allowing them to experience revenue declines but maintain acceptable margins.

Reverse Morris Trust Transaction
Below is an Leidos investor relations' slide outlining the transaction.  Lockheed Martin's IS&GS business generates about $500MM in EBITDA, at the $5B headline price, LDOS paid 10x EBITDA.

Leidos will be making a special dividend prior to the transaction closing to effectively true up the ownership bases of the two firms, in order for it to qualify as a Reverse Morris Trust and be tax free, Lockheed Martin shareholders need to own more than 50% of the combined company.  RMTs have been interesting to me recently because they pair the effects of a spinoff, but with immediate/improved scale and an in-place management team.

Valuation
There will be approximately 151 million diluted shares outstanding after the transaction is complete, the Leidos special dividend will be $13.64 adjusting the pro-forma stock price down to $34.95 for a $5.3B market cap company.  Per the prospectus, the combined pro-forma EBITDA is $1.05B without any cost synergies which are expected to equal $120MM by 2018.

I have pro-forma Leidos trading for 8.2x EBITDA, 1-3 turns below most of their peers despite the company's new scale which should make them more competitive and lead to an increased win rate.  While 8x EBITDA might not be absolutely cheap for a business like Leidos, consider the U.S. Federal government has a budget for the first time in years with all sectors of government including the Department of Defense seeing increased appropriations.  The economy is still sluggish and treasury rates are near record lows, fiscal spending is likely to increase in an attempt to spur growth as deficit concerns and the risk of sequestration lessen.

Exchange Offer
There's a cheaper way to buy LDOS shares being offered right now.  Instead of spinning off LDOS shares directly to shareholders, Lockheed Martin is conducting an exchange offer where LMT shareholders can select to exchange their LMT shares for LDOS shares at a 10% discount rate (subject to an upper limit).  Even without the exchange offer this is an attractive deal and LDOS should be worth ~$44 per share (adjusted for the $13.64 special dividend) or 9.5x EBITDA.

Disclosure: I own shares of LMT (will be exchanging for LDOS) and CSRA

Computer Sciences: Gov Services Spinoff, Commercial Business For Sale?

Computer Sciences Corporation (CSC) is primarily an IT services firm that is spinning off its U.S. government services business (targeted by the end of November) and immediately merging the spinoff with SRA International which is another contractor in an industry that's seen a lot of spinoffs and consolidation activity.  The spinoff will be recapitalized and paying out a special dividend to shareholders (versus the typical scenario where the spinoff dividend goes to the parent) of $10.50 per share.  There's been a lot of takeover speculation regarding both the parent and spinoff, that along with the dividend to shareholders leads me to believe the parent might be sold thus completing a breakup of the company.

Overview

CSC was founded in 1959 and today it is a $9B market cap global IT services company, they partner with various hardware/software providers (including some in-house) to provide clients with customized outsourcing and IT solutions.  This is a highly competitive business, CSC is in the midst of a turnaround similar to competitors IBM, HP, Xerox, among others.  Revenues continue to fall at a double digit pace and have each year since 2012 as the company changes their mix and moves towards the hot buzzwords - big data, cloud computing and cyber security. The company does have rocky recent past highlighted by the nearly $200MM fine the SEC imposed on them in June (that really muddies up backward looking earnings) for accounting fraud charges as the former management inflated earnings starting in 2011 and generally hid a troubled contract with the U.K's National Health Service.  In early 2012, Michael Lawrie joined the board and became CEO replacing disgraced management, he has both an IT services background (Misys PLC, IBM) and was also briefly a managing director at the hedge fund ValueAct.

CSC reports in three segments, each contribute roughly the same amount of revenue:

Global Business Services is the consulting and services piece of the business, it has respectable 10% operating margins; Global Infrastructure Services provides data center management, cloud, infrastructure as a service type offerings, its more product/hardware intensive and has the lowest operating margins of the three at 6%; North American Public Sector is the U.S. government contractor business, almost entirely IT services offerings and has the highest operating margin at 14%.  There's been speculation that the company has been looking to sell itself; In September 2014, Bloomberg reported that CSC had contacted private-equity firms to gauge interest in an LBO and then this past February DealReporter said CSC is in talks to sell itself in a two-part deal to a foreign strategic buyer and a private equity firm.  It seems like the two-part deal might be in play as in May, the company announced plans to spinoff the North American Public Sector unit as Computer Sciences Government Services (many government contracts have restrictions against foreign contractors), leaving the two commercial/international business behind to potentially be taken out.

Computer Sciences GS + SRA
I tend to like government services businesses, they have low capital requirements, fairly consistent and predictable revenues as once you win a contract it's hard to be unseated as the incumbent.  As a service provider, most of their expenses are personnel and many government contractor personnel are more tied to the individual contract versus the actual employer.  If you lose a contract rebid, the staff either gets reassigned, moved to the new contractor, or are laid off.  So given the predictable revenue steam and low capital requirements, the business can sustain a high debt load and use the free cash flow to delever, ultimately accruing more value to shareholders.

Along with the spinoff, CSC is immediately merging their government services business with competitor SRA International which is owned by private equity and management.  I like these multi-step spinoff and merger transactions (think ATK/ORB and SSP/JRN) as it shows a little more foresight and thoughtfulness to the corporate action, rather than just doing a "garbage barge" spinoff, management is putting together a company that's setup to succeed.

Notably the spinoff is assuming SRA's debt adding even more leverage to the company, although still at reasonable 3.75-4x EBITDA levels.  The company will be roughly split 50-50 between defense/intelligence contracts and civil agencies, SRA's book of business is a little more diversified than legacy CSC further reducing concentration risk to losing any one large contract.  When announcing the SRA merger, management provided some expense synergy and EBITDA numbers for the combined entity along with some easy public comparables of very similar businesses.

CSC Government Services will have $2.7B in net debt, plus they're taking the $400MM pension liability with them in the spinoff, for a total adjusted net debt of $3.1B.  For EBITDA, I'm taking out the expected synergies for now and using proxy/estimates swags for earnings and FCF.  Their competitors are all of relative similar size, similar debt levels, and trade within a tight range of 9.5-11x EBITDA.

Sorry if that's a bit small, but I wanted to try and show the industry's valuation using a series of multiples and give a fairly conservative valuation to CSC Government Services, using a 9.5x EBITDA value I'm coming up with a market cap for the spinoff at $5.08B.  Current CSC shareholders are going to own 84.68% of the spinoff, so net to CSC shareholders the spinoff should be worth approximately $30.55 per share, add in the $10.50 special dividend for a total of $41.05 per share in value.

Computer Sciences Commercial Business
I feel pretty comfortable valuing the government services business, much less so with the remaining commercial business, but if you net out the government business using the above comparables, the remaining parent looks very cheap despite the industry headwinds.  The purple row in the table below is showing just that, netting out the $41.05 and holding the current price constant at $64.62 (went up more today) the stub is trading at: 9.1 P/E, 3x EBITDA, and a 14% FCF yield, all very cheap metrics that would be enticing to any potential financial or strategic buyer.

In yellow, I put the remaining CSC at 6x EBITDA and come up with a $7B market cap, or $50.09 per share, in purple (netting GS out of the current price) it's $23.57 per share, so a lot of the value creation could come from this gap closing.  In the meantime, CSC continues to make bolt-on acquisitions (UXC Limited, Furition Partners, Fixnetix) in the commercial business as they continue to move towards higher margin offerings.  The company will be hosting an investor day on November 5th, hopefully they provide a little more clarity on what the plans are for the remaining business, but at today's prices I think you're paying a cheap price for a fair business that's likely an acquisition target.  Sum of the parts gets me to $91.14 pre-spin for a ~40% upside, although I'll probably sell for something close to $80 per share.

Disclosure: I own shares of CSC