BioFuel Energy (Green Brick Partners) Revisited

BioFuel Energy (BIOF) is a shell company with $181MM in net operating losses that I first toyed with in April as Greenlight Capital and developer James Brickman proposed the NOL shell buy JBGL Capital for $275MM in a convoluted transaction that many including myself misjudged.  Combining the star appeal of David Einhorn with the previously sexy BIOF ticker and a small cap float, the company became a favorite of day traders.  I let the price action and the craziness of others skew my view of how the rights offering math worked and the underlying transaction's value.

JBGL Capital is a residential land developer with 4,300 lots spread pretty evenly between the Dallas-Fort Worth and Atlanta markets.  They own a 50% interest in a few different home builders that operate in their communities, this appears to be a point of emphasis going forward as the home building margins are better than just straight land sales, but there is value in the hybrid model.  JBGL was formed in 2008 during the financial crisis and as a result doesn't have the legacy issues of other home builders, also much of the land on the books is likely understated.

To reiterate, the $275MM price tag will be paid as follows:

1. $150 million in debt financing provided by Greenlight, 10% fixed interest rate for a 5 year term with a 1% prepayment penalty during the first two years.
2. A rights offering of at least $70 million at a $5 offering price.  The rights trade under the ticker BIOFR, 2.2445 shares per right, expiring on 10/17/14.
3. Equity issuance to Greenlight/Brickman, this will ensure that Greenlight owns 49.9% of the shares following the rights offering and James Brickman will own 8.4% of the shares.
4. $8 million cash currently held by the company.

Additionally, Third Point agreed to backstop the rights offering and is expected to own 16.7% of the shares.  After the rights offering is completed 75% of the shares will be in the hands of essentially insiders (85% if you look at it on an enterprise value basis), these shares will be relatively restricted due to the NOLs, aligning insider interests with long term shareholders.  Real estate development requires smart capital allocation, and it seems to be a natural fit to have an asset manager like David Einhorn as the Chairman of the Board (see Bill Ackman at Howard Hughes).

Proforma Income Statement
Eventually the market momentum traders will exit and fundamental investors will move in and value the company based on its assets and earnings stream.  Below is the proforma income statement for the first six months of 2014, there are few items included in the proforma that are hiding the true earnings power of the new Green Bricks Partners (it will lose the BioFuel name after the transaction is finalized).

The SG&A at BioFuel Energy is overstated and double counted with JBGL this year as the company evaluates and goes through this reverse merger process, strip out $3MM there.  Additionally, the proformas are including a 40% income tax expense even though taxable income will be shielded by the NOLs for the foreseeable future, add back another $1.6MM.  Lastly, the interest rate on Greenlight's debt is above market and should be refinanced after Green Brick seasons a bit as a credit.  At a 7.5% interest rate, Green Brick would save $1.73MM over the six month time period. Making those adjustments and the proforma Green Brick Partners would have net income of $0.28 per share, or $0.56 per share annualized.  Even putting a 15x market multiple on Green Brick, and the shares could be worth ~$8.40.  Keep in mind that management has projected 50.4% revenue growth in 2015 creating additional potential upside as BioFuel transitions to Green Brick Partners and becomes valued as an operating company versus an NOL shell.

Duff & Phelps Fairness Opinion
Another fun piece of this transaction is the Duff & Phelps fairness opinion of the $275MM price tag for JBGL Capital.  Fairness opinions are used by boards as a CYA tool, almost always the adviser hired by the board will back into the price paid by cherry picking comps and adjusting the discount rates around to achieve the desired result.

I would argue that both the 14-16% discount rate is too high and the 9-10x net income terminal value is too low, using the lower end of both (16% & 9x) Duff & Phelps was able to back into the $275MM number.  Using more reasonable values would result in a much higher value for JBGL.

As I write this, BIOF is trading for $6.21 and BIOFR is trading for $3.03 (implying a $6.34 share price (2.2445*5+3.03)/2.2445)) making BIOF the better bargain, but the relationship has been moving around a lot so double check before making any decisions.  BIOFR also includes the possibility of an over-subscription allocation that could sweeten the pot a bit as well.  I didn't anticipate Greenlight putting such a valuable asset inside of BIOF, but in hindsight it does make sense as it needs to generate a lot of taxable income to monetize the NOLs and make the transaction worthwhile.

Disclosure: I own BIOFR, plan to fully subscribe to the rights offering

Par Petroleum: Zell Controlled + NOLs

Par Petroleum (PARR) was created through the reorganization of Delta Petroleum in 2012.  Sam Zell, via the Zell Credit Opportunity Fund, and Whitebox Advisors held significant stakes in the unsecured debt which were converted to equity in the reorganization preserving the $1.3B in net operating loss carry forwards.  Post reorganization, Par's assets included a minority stake in a natural gas E&P and NOLs, but the company is now focused on downstream assets with the stated strategy to "create ongoing, stable earnings capable of predictable monetization of NOLs."

Will Monteleone is the CEO, 30 years old, and receives a small base salary at Par, he also serves as an associate at Equity Group Investments where he oversaw the initial restructuring of the company and appears to be Sam Zell's main deal guy focused on the energy sector.  The company recently uplisted from the OTC to the NYSE, and the CEO has talked about engaging analysts a bit more to get the story out.  The financial statements are a bit of a mess, the company isn't currently profitable, but the platform is in place for management to make opportunistic acquisitions to where the future business is not going to look a whole lot like the current.  The three main assets currently are Hawaii Independent Energy, Piceance Energy, and then the large tax assets: 

Hawaii Independent Energy
In the summer of 2013, Par purchased a mothballed refinery on the island of Oahu from Tesoro Corporation for $325MM (including the working capital/inventory) plus up to $40MM in earn outs due to Tesoro if the 94,000 bpd refinery meets certain operating performance targets.  Included in the acquisition were some distribution and storage assets, along with a retail channel under the Tesoro brand name.  Par renamed the company Hawaii Independent Energy and has spent the last year or so reestablishing the asset in the marketplace.  Hawaii is a difficult location to compete, their refinery competes with others all across the Pacific and it's expensive to export refined products out of the islands due to its remote location.  Chevron operates the only other refinery in Hawaii, and announced today their plans to divest it due to its "somewhat isolate and finite market".

Due to this isolated market position, it makes sense to find additional ways to sell their product within Hawaii, to that goal they announced the acquisition of Mid Pac Petroleum in June for $107MM.  Mid Pac operates or owns over 80 retail sites and four terminals across Hawaii, and 22 of the retail locations are fee-owned (although partially encumbered by debt), which is a nice added perk in Hawaii.  The Mid-Pac acquisition helps Par internalize the consumption, thus reducing reliance on exports.  Management put the margin improvement at $6-10 barrel on what they sell on island compared to what its exported.  Additionally, Par will receive both the retail and refinery margin for anything sold through Mid Pac's distribution channel.

It takes time to turnaround a business, they've had to re-engage the market there in Hawaii after Tesoro essentially exited the market 2+ years ago.  The company believes it will be profitable in this segment next year which should make it a little easier for the market to value.

Piceance Energy
Par Petroleum's main upstream asset is a 33.34% non-operated equity interest in Piceance Energy, a primarily natural gas focused E&P in western Colorado.  The majority owner/operator is Laramie Energy II, the first Laramie Energy was previously sold to Plains Exploration and Production (now part of Freeport-McMoRan) for $1B in 2007 (peak of the natural gas boom) after being setup for $200 million only a few years earlier.  They currently have a one rig program running, and management has hinted that results have been good, a previously required capital contribution was put off due to strong operating results at Piceance.  Using the NYMEX forward curve as 12/31/12, Par Petroleum interest in Piceance resulted in estimated proved reserves of 433.4 Bcfe with a PV-10 value of $291.6MM (this was the upper end valuation at the time).  In investor calls, Par is optimistic the next reserve report will be even better.

NOLs
The most interesting asset to me is the $1.3B in net operating loss carry forward captive inside Par Petroleum.  This will shield an awful lot of taxable income if they can turn the corner.  The company has large aspirations, the acquisitions they have made so far aren't large enough to move the needle much on their NOLs.  With Sam Zell's team at the helm, I would imagine they'll be pretty selective buyers and apply a value/distressed approach while meeting their target hurdle rate of 15-20% returns.

In order to pursue their rollup strategy and fund these acquisitions Par has been a serial issuer of rights offerings.  Rights offerings create an efficient way for the controlling shareholders to maintain their ownership percentage which is key to the NOL eligibility.  So if you own shares in Par, be prepared to re-up via a rights offering at least once a year for the next several. 

Conclusion
Besides Sam Zell and Whitebox Advisor, respected investors Lee Cooperman of Omega Advisors, Andrew Shapiro of Lawndale Capital, and Horizon Kinetics are also shareholders.  You'll see I haven't really discussed valuation at all, I struggle to put a specific value on Par Petroleum, but I feel its one of those situations where you don't need to guess someone's weight to know they're fat.  Par is setup to be a potential long term compounder as management pursues an ambitious roll-up strategy to monetize the large NOLs.

Disclosure: I own shares of PARR

Paragon Offshore: Cigar Butt Spinoff

Paragon Offshore (PGN) is a 'standard specification' offshore rig business that was spun off of Noble Corporation (NE) and began trading on 8/1/2014, standard specification in the offshore industry means old and shallow water.  Noble initially attempted to conduct an IPO of the unit, but later scrapped that idea in favor of a rushed spinoff that ended up putting $1.6 billion in debt on Paragon, but immediately improved the optics of Noble's fleet.  Noble CEO David Williams said on a conference call to analysts that without the spinoff, Noble's fleet would have an average age of 35 years by 2016, now that it has shed the older equipment, the average age is 13 years.  

Paragon is once again, your classic spinoff of the 'bad asset' business to make the parent company appear more attractive.  In these situations we can often expect investors who receive shares in the spinoff to sell indiscriminately.  Since Paragon began trading it has basically been a falling knife, down more than 50% as it has suffered both from spinoff dump dynamics and poor timing as clouds have formed over the offshore drilling market.  

The offshore drilling market, especially the deepwater market, can be thought of as the marginal oil supply.  As the onshore/fracking market has increased oil supply, the result has been a pullback in the development of more expensive offshore oil and gas plays by the national and independent oil companies.  At the same time, many offshore rigs that were ordered in good times are scheduled to be delivered in the next 1-3 years just as the market softens creating an excess supply of rigs, particularly in the deepwater segment.  Day rates for jack-ups have stayed fairly steady, but there's some concern that oversupply in the deepwater market will force some high-specification floaters to move down market and compete in the standard-specification market (where Paragon primarily operates) driving down utilization and day rates there as well.  There are 139 (or an additional 30%) new build jack-ups scheduled to be delivered through 2017, however some of these might never make it to market as more than half are being built by speculative non-operating buyers.  The bull case rests on shallow water demand being there, and supply being more spread out than it currently appears.

Paragon's strategy is to be a low-cost, efficient provider focused on the shallow market.  Management claims to have the "best of the old rigs out there", a fleet of 34 jack-ups and 8 floaters.  The main concern around Paragon's assets is the age of their rigs, the average is over 35 years old.  However, some context, the majority of their rigs are jack-ups designed for shallow water, the average age of rigs in that market is more than 25 years old.  Yes, Paragon's rigs are on the older end, but it's generally unfair to compare the fleet to a modern deepwater driller like Seadrill (SDRL) whose EV/Rig ratio is many multiples of Paragon's.  Additionally, Noble spent approximately $1.8B on Paragon's fleet since the beginning of 2010, including $900MM on the floaters where much of the backlog is and all of which have been rebuilt since 2009.

There also seems to be some concern around Paragon's $2.3B backlog, much of it rolls off by mid-2015 potentially exposing the company to the worst of the oversupply situation.

However, key markets like Mexico have been opening up their energy markets, thereby potentially increasing drilling activity there (mostly shallow water gulf drilling), and Paragon's management has guided that the 4 jack-up rigs in the Middle East which are idle are expected to be operational in Q1 (which matches up with what other competitors are calling a hot market in the Middle East).  Another concern is around the 4 floaters which are currently contracted out to Petrobras (with 2-3x the typical jack-up day rate), Petrobras has 29 floaters coming online which could force out Paragon's older floater rigs when they come up for renewal.  But as mentioned earlier, Noble rebuilt each one of these in the past few years, and hopefully they'd be able to place them with new clients with only moderate downtime or expense.

Capital allocation is a bit of a question market with Paragon being such a recent spinoff.  In the initial prospectus, Paragon guided to a $80-90MM annual dividend, at the mid-point, the current yield would have been 14-15%.  Today they announced a $0.50 dividend on an annualized basis, which is roughly half the original guided amount, but still a 7% yield that should attract income based investors.  It also gives management more room to maneuver and address some of the market's concerns about their fleet.  Another option for excess free cash flow is buying back some of their debt in the open market, it's currently trading at a fairly significant discount (80-90) making any buybacks immediately accretive to the equity.  Paragon doesn't have any new builds in the pipeline, but they have stated in investor calls they'd be open to being a buyer of distressed rig assets as well if the industry does experience a downturn.

Valuation
Paragon is in deep value territory assuming you believe it can survive the current cycle.  With a current market capitalization of $575MM and net debt of $1.61B, Paragon has an enterprise value of $2.19B, analysts estimate 2015 EBITDA at $767MM giving PGN a EV/EBITDA multiple of just 2.9x which is basically unheard of in today's market.  Hercules Offshore (HERO) is Paragon's closest peer, operating a number of standard-spec jack-ups in the Gulf of Mexico, trades at 4.7x EBITDA even in this depressed market for offshore drillers.  On a P/E basis, Paragon is expected to earn $157MM in 2015, for a forward P/E of 3.66x.

Even if these estimates are too high, if you cut the $827MM in EBITDA for 2014 in half to $413MM it's still trading at just over 5x EBITDA.  So the market is pricing in the worst, half the rigs working and at lower rates.  Liquidity shouldn't be an immediate concern either as their first maturity is a $650MM term loan due in 2021, and then two tranches of senior unsecured debt due in 2022 and 2024.  They also have in place an undrawn $800MM revolving credit facility at LIBOR + 2.00% if needed.

Risks:

• Paragon's rigs are old, even if well maintained, many will likely need to be retired or rebuilt in the next several years; scrap value for jack-ups = $5MM, floaters = $10MM
• High effective tax rate (50%) in 2014 and early 2015 due to poorly executed/rushed spinoff; Noble skimped on a few corporate structure items that would have delayed the spinoff, tax rate should be in the mid-20s by 2016
• Half of Paragon's contracts come up by Q3 '15; modern-high specification rigs may move down market if deep water market is oversupplied and complete with Paragon's standard specification rigs, driving utilization and day rates lower
• Petrobras has 29 floaters coming online, but repeatedly delayed; Paragon's floaters may not get renewed or have significant downtime in the future as they find new projects; 18% of Paragon's EBITDA is to Petrobras
• CEO Randy Stilley was previously at a similar standard-spec spinoff Seahawk Drilling, which went bankrupt and was liquidated (assets were sold to HERO) after the BP Macondo disaster disrupted Gulf of Mexico drilling
• Offshore drilling is extremely cyclical; stocks in cyclical industries look the cheapest at the top

There seems to be a lot of fear and concern around the offshore drilling industry, I'm honestly a relative novice in this sector, only really deep diving into it in the last several weeks, so do your own research here.  It appears to me that Paragon could be a classic "cigar butt" trade, not one that will generate great returns over the long run, but it really needs to only survive long enough for the market to rebalance itself to be a satisfactory investment.  I initiated a starter position yesterday.

Disclosure: I own shares of PGN

Ebates Deal Pushes Comdisco Closer to Liquidation

"Liquidations require an extended investment horizon, and therefore are of little interest to the majority of investors.  The timing of the payout, if any, is unpredictable.  However, if and when it comes, it may handsomely reward the investor's patience." - Horizon Kinetics

The above quote is from Horizon Kinetics' September 2013 research note on liquidations, which everyone should read.  One current liquidation they own, and are the largest shareholder of, is Comdisco Holding Company (OTC:CDCO) which I discussed in May 2013 but didn't purchase until recently.  To give a brief overview, the original Comdisco was a computer leasing and disaster recovery company that invested its free cash into ~900 start-ups during the middle of the dot com bubble, the company went into bankruptcy, and after restructuring the new Comdisco set on a liquidation track.

Fast forward a decade or so and Comdisco assets consist primarily of cash and three remaining stakes in the dot com start up portfolio valued at $8,875,000 as of 9/30/13.  All three investments are private companies awaiting liquidity events for Comdisco to exit and appear to be the primary hurdle remaining before the company can make a final distribution (although they do have a few claims against former customers that they're still pursuing).  During the company's fiscal second quarter, one of the investments was sold for just over $1MM.

The bigger liquidity event happened this week, when Ebates (As of 9/30 93% of the equity portfolio) was sold for $1B in cash to Rakuten.  I haven't been able to determine what percentage of Ebates the company owns (any help here would be appreciated), so it's difficult to determine if the exit price is higher or lower than the ~$8.25 million it was valued at back in September.  The Ebates position is a little hidden in Comdisco's filings, you have to go back to the 2012 10-K where the company mentions they participated in an additional round of financing for Ebates to see the position called out.  Competitors RetailMeNot and Coupons.com both conducted initial public offerings in the past year and have seen their market values cut in half since, so I'd err on the conservative side and view this as a positive news story in terms of bringing the liquidation wrap up timing forward and not a potential windfall.  There's now potentially one other private equity investment that's of insignificant size (hopefully they just dump it), and some other bad debt they're chasing down before all operations are wrapped up, the end looks near.

The company has contingent distribution rights (CDRs) that are entitled to a 37% sharing percentage of the total amount distributed to the CDRs and equity holders.  Comdisco currently estimates their CDR liability at $11.2MM, meaning the equity distribution is estimated at $30.1MM ($7.50/share), the current market cap is $24.2MM ($6/share) representing a 24% upside.  There could be additional upside depending on the amount they net from Ebates and other bad debts, and again the main risk here is the timing of the final payment.  If this situation appeals to you, be careful, it's a very illiquid stock with a large bid/ask spread.

Disclosure: I own shares of CDCO

Newspaper Spinoffs

I did another lunch investment pitch roundtable today, this time the topic was "Impact of Technology on Communication and Stocks".  I was already looking into the recent news/print spinoffs, so I decided to squeeze them into the topic and pitch the whole basket.

Below is my deck with some commentary, outside of News Corp and New Media Investment Group, I've only looked into these spins at a surface level, so some numbers might be completely wrong.  But the sector seems attractive as its bottoming and figuring out the correct corporate structure, digital strategy and industry dynamics to survive.

The first quote from David Carr of the New York Times came from his column "Print Is Down, and Now Out" published on 8/10/14 after the announcement of Gannett's newspaper spin.  His column and this quote sum up the consensus view of the newspaper industry, it's ugly, unwanted, and destined for red ink in the digital age.  However, news and content is still valuable, it just needs to be more tailored to its audience.  A (digital) subscription to The Wall Street Journal is virtually a requirement for anyone in finance or a senior management position in corporate America.  On the other end of the spectrum, community newspapers are the only news source for many small cities and can provide valuable targeted advertising.

As for the spinoff dynamics, most newspapers have been essentially hiding within otherwise growing media conglomerates, by exposing the print business, management will be forced/incentivized to adapt their product to the current marketplace.

There's nothing really new in this slide compared to my post on News Corp nearly a year ago, but REA Group's market value continues to rise, Harlequin was added, and hopefully Amplify is closer to wider acceptance.  One minor complaint, the quarterly conference calls sound like management is telling a story rather than a business update, makes the lack of a clear capital allocation plan even more of a concern.  But it's clearly cheap.

This is another update slide for blog readers, I'm still on the fence about New Media, like the strategy but I remain concerned about the third party management agreement and how that might be bought out or internalized.  Fortress is a savvy shop, and they've executed on the plans they've laid out.  Their quarterly presentations are transparent, a little promotional, but it clearly presents the investment thesis and should net investors high teen returns as they buy local papers cheap and they're rerated in the public markets.

Now we get to recent spins, Tribune Publishing is the riskiest of the bunch, its leveraged and doesn't have the benefit of its real estate assets.  Its papers are primarily large metropolitan newspapers, a segment that's similar to a JCPenney's in the retail space, stuck in the middle without a loyal customer base.  However, its very cheap and has a lot of upside if turned around, parent Tribune Media emerged from bankruptcy about 2 years ago and former creditors (unnatural holders) might be taking advantage of the liquidity of an NYSE listing and selling.

The newspaper spins really picked up in the last two weeks, Gannett announced they were going to spin off the publishing business earlier in the week.  I don't know the exact timing of the filings, but Carl Icahn curiously filed a 13D after the spin was announced, suggesting the spin.  There might be some upside left, but this transaction is well publicized and pretty straightforward.

E.W. Scripps & Journal Communications
The more interesting transaction is the "double spin/double merger" of E.W. Scripps and Journal Communications, where both will combined their TV/radio broadcast divisions and then spinoff their newspaper segments into a new company to be named Journal Media Group.  Both companies would be free of cross-media ownership rules and could therefore pursue acquisitions in markets they were restricted from as combined broadcast and print companies. 

Today the two companies have a combined $1.5B market cap, if you take management's guidance of $200MM EBITDA and use a 9x multiple (low end of comparable broadcast companies due to radio exposure) the "new Scripps" is worth roughly the current market cap and you get the Journal Media Group newspaper business "for free".  It's a complicated transaction that won't close until sometime in 2015, and there are more merger details including a $60MM special dividend to Scripps shareholders, but with more consolidation in both industries likely, it initially appears to be an attractive deal for both future companies.

Each of the recent spins are a little different, but as a group they should outperform the broad market over a 2-3 year time.  I could also see regulations relaxing in this space, newspapers/radio/local TV entities aren't as influential as they once were, encouraging more consolidation.

Disclosure: I own shares of NWSA

Mario Gabelli: "Activism - New Catalyst to Surface Value... Good or Bad?" - Notes

I attended an enjoyable luncheon today titled "Activism - New Catalyst to Surface Value... Good or Bad" with Mario Gabelli, Founder, CEO, and PM for the value strategies at GAMCO (GBL), he's as talented of a speaker as he is a value investor.  Here are some short form notes I took and wanted to document:

• Gabelli manages the Gabelli Asset Fund, a $3.8 billion dollar five star fund with an amazingly low 6% turnover ratio, he mentioned several names that he's held for over 20 years
• He's a believer in "POSP" or Plain Old Stock Picking, he researches one stock, one industry at a time and doesn't spend a lot of time worrying about economic indicators (showed a cartoon of an analyst flipping a coin) or overvalued sectors like biotech or social media - I particularly liked this point and its how I try to approach investing, it's fun to discuss where we are in the economic cycle, but I don't think there are many people smart enough to consistently exploit it
• Shareholders own the company; think like an owner
• In 1988, he posted a "Magna Carta of Shareholder Rights" and still stands by it today:

• He's fiercely against poison pills and actively works to remove them, compared the poison pill to the Berlin Wall and management trying to keep the shareholders out, entrenching themselves
• Wants short sellers to disclose their holdings, same with distressed debt buyers attempting to gain control of a company going through a restructuring
• He looks for companies trading below private market value that have a catalyst in place to close the gap, he's recently added activism to his list of potential catalysts alongside (1) regulatory changes; (2) industry consolidation; (3) death of founder; (4) stock repurchases; (5) sale of a division; and (6) management or capital succession
• Activism is a net benefit to shareholders
• Large inflows in recent years at activist funds, lots of OPM (Other People's Money) to play with
• Be aware of activist fund intentions, the 2&20 fee structure encourages activism, need for a big quick win, good for publicity to raise assets
• Lots of special situations as a result of activism (spinoffs, splitoffs, mergers, and liquidations), went through a few local Chicago examples like Fortune Brands and Kraft
• During the Q&A he dropped a quick stock pitch for GATX Corporation (GATX), a railcar lease company that should earn 12 or 13% CAGR over the next decade
• Also likes content and media companies, been on TV recently discussing Twenty-First Century Fox (FOXA) and others

He's an active alumnus of the Columbia Business School (interviewed in the Fall '11 copy of Graham and Doddsville), good to get a little Dodd/Graham philosophy reminder every now and then.

Exelis and its Spinoff Vectrus

Exelis Inc (XLS) is an aerospace and defense contractor that was originally spun off of ITT Corporation (ITT) on 10/31/2011, and now Exelis is following suit by spinning off its shrinking mission systems business line into a new company called Vectrus (VEC) later this summer or early fall.  This is the classic move to separate the declining business to highlight the attractive remaining business.  Exelis will be more of a pure play aerospace and defense products contractor focused on a few select growth sectors.  Vectrus will be a government services defense contractor with falling revenues, but strong cash generation due to the low capital requirements and a variable cost structure.

Both Exelis and Vectrus will benefit:

• Exelis benefits by shedding the underinvested services business which is experiencing severe declines in revenue due to budget constraints and the draw down of troops in Afghanistan.  The mission systems business is weighting on the rest of the business and masking the improved growth profile of Exelis's C4ISR segment and other growth initiatives, giving the remaining business a higher multiple.
• Vectrus is similar to other recent spins in the government services space (Engility Holdings & SAIC), declining revenues in the near term is less of a problem than it appears due to the low fixed costs, most of their costs are variable and attached to specific contracts.

With increased geopolitical tension defense contractors could once again see their revenues pick up from cyclical lows and Exelis represents an attractive event driven way to invest in that theme.

Vectrus
At the time of the Exelis spinoff from ITT, mission systems was the growth business and the rest of the business was flat or declining, times have certainly changed.  Shortly after the spinoff from ITT, defense spending came under a microscope with budget sequestration and the draw down of troops in Afghanistan.  In 2013 Vectrus had $1.5B in revenue with 100% of that coming from the U.S. Federal government, a full 92% from the U.S. Army, and 34% of 2013 came from Afghanistan which is quickly going away.  Revenues are expected to be down 25% in the mission systems business in 2014, with additional downward pressure in 2015.

Vectrus will operate in three main business lines: base operations (majority of the revenue), logistics, and network communications.

Major contracts include (69% of 2013 revenue):

1. Kuwait Base Operations and Security Support Services (K-BOSSS) contract for Camp Arifjan: Base operations contract for one of the largest bases in the U.S. Military, services include: medical services, postal and maintenance, public works, transportation, and emergency services
2. Operations, Maintenance and Defense of Army Communications in Southwest Asia and Central Asia (OMDAC-SWACA) contract: Network communications contract expiring in 2018 supporting the O&M of the Army's largest network from locations in the Middle East.
3. Logistics Civilian Augmentation Program (LOGCAP): Logistics contract where Vectrus is a subcontractor for certain task orders, the subcontracting agreement ends in 2018
4. Kuwait based Army Prepositioned Stocks-5: Logistics contract storing and supporting a wide range of military equipment and supplies.

Despite the industry headwinds, Vectrus can be an attractive business due to its low working capital requirements, much of their employment base are subcontractors attached to single contracts, as the contracts wind down so does a lot of the expense base.  Operating margins aren't great, at 4.0-4.5%, but with a renewed strategic focus on the business (classic spinoff reasoning) there will likely be some additional restructuring and cost cutting in the months after the spin is completed.

Leading Vectrus will be Ken Hunzeker, he has been the president of the mission systems business going back to the ITT/XLS spin, and is in for a nice raise.  Slightly more interestingly, Lou Giuliano will become the Chairman, he's the former Chairman and CEO of ITT and ran what would become Exelis at ITT for 8 years before becoming the President and COO of ITT in 1998, so he's intimately familiar with the business and the defense industry cycles.

Like many spins, Vectrus will be take out debt in order to pay a dividend back to the parent, here they're targeting 2.5-3.0x EBITDA, or approximately $130-150MM (although that's been a moving target down recently).  Government services businesses generate a lot of cash, I view debt (as long as its reasonable) as a positive here, management will likely be focused on paying down the new term loan and potentially refinancing to a better rate once the company becomes more seasoned.

Vectrus should have EBITDA of $50MM in '15 EBITDA, assuming they max out the debt at the 3x range, and putting a discounted 7x EV/EBITDA multiple on it gives you $200MM in market cap, a small slice of the $3B combined Exelis market cap.  I would imagine there will be some selling once the spin appears in Exelis investor's accounts as it will be a small unwanted orphan (it's worth about $1 per XLS share), so one strategy would be to wait for the spinoff to occur and settle out a bit before snapping up Vectrus shares on the cheap.

Exelis
Exelis has identified four "Strategic Growth Platforms" in which they want to focus and invest going forward: (1) Critical Networks;  (2) Intelligence, Surveillance and Reconnaissance Systems & Analytics; (3) Electronic Warfare; (4) and Composite Aerostructures.  The Vectrus spin allows Exelis to appear more attractive to investors, post-spin it will have higher margins and a diversified revenue base less focused on the Department of Defense.

While top line revenue is down double digits YoY for the combined Exelis, the majority of the decline is the Vectrus business while the rest of Exelis is mostly flat with growth expectations going forward that should deserve a higher multiple.

Pension Liability
When Exelis was spun off of ITT, many called it a pension plan with a defense business attached to it, and that would have been a fair assessment.  Exelis has made significant progress on the pension (~$1.3 billion unfunded position as of the last 10-Q) and will retain and continue to service it after the spin.  The company has also frozen the pension plan of all future benefit accruals effective December 2016 and expects it to stop needing to make additional contributions to the plan after 2017.

Continued low interest rates have plagued companies with large pension plans because it lowers the discount rate at which a defined benefit plan calculates its future liability.  The lower the discount rate, the more current assets the plan needs to meet the future pension liabilities.  Tucked away in a transportation and student loan bill (MAP-21) was a pension funding relief provision that is likely going to get extended, it will reduce the amount Exelis will be required to contribute to its plans in the next several years from $225MM annually to $150MM.  This gives time for interest rates to normalize (bringing the discount rate up) and may reduce the overall contributions necessary by Exelis.

Post-Spin Cash and Capital Allocation
Vectrus will be paying Exelis a dividend of ~$150MM upon the spinoff giving the parent company amply liquidity when you consider the unused commercial paper program and credit facility with very little net debt.  Exelis anticipates maintaining their current quarterly dividend (2.5% yield), and could return additional capital to shareholders with their share repurchase program.  The flexible balance sheet also allows them additional room to invest in their Strategic Growth Programs and bolt on some smaller acquisitions like they recently did with the Orthogon airport management business.

Exelis Valuation

To value a post spin Exelis I added the $1.3B pension liability to the net debt, along with the $150MM dividend from Vectrus, subtracted out the $50MM in EBITDA that Vectrus is expected to earn in 2015 and then added back the pension contribution to EBITDA.  If Exelis were to be valued at 8x this adjusted EBITDA measure, I come up with a ~$24 price target for the remaining business.  Add the additional $1 for Vectrus, and the combined business is worth $25 per share versus $16.41 at today's prices.

Risks

• Greater than expected headwinds in the Vectrus mission systems business, especially in their major Afghanistan and Iraq contracts.
• Continued political pressure to reduce military and defense spending, although temporarily out of the headlines, the budget deficit is still substantial and unsustainable. 
• Exelis has a large unfunded pension liability in comparison to its market cap, if interest rates stay flat or decline it could force Exelis to make additional pension contributions above current projections.  Additionally, Exelis is assuming an 8.25% rate of return (down from 9.00% in 2012) which could turn out high given current elevated asset prices.
• The spinoff was guided earlier in the year for "Summer 2014", but has now slipped into summer/fall, further slippage or cancellation of the spinoff would reduce the attractiveness of Exelis, but it still remains an undervalued company in its current form.

Summary
With the defense industry near a cyclical bottom, the spinoff of the Vectrus mission systems business provides an attractive event driven investment opportunity by creating a higher growth products business and a headwinds facing services business.  I'm initially going with a Joel Greenblatt like call option strategy to enter a postion, the spin will expose value in both the parent and the orphan, but I'm extending it out with a January expiration to allow Vectrus a little time to find a following in the investment community.  Depending on where Vectrus trades after the spinoff, I may pickup some additional shares at that point.

Disclosure: I own XLS calls, anticipate buying VEC shares sometime after the spinoff is completed