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 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.
