|Shares Out. (in M):||10||P/E||0.0x||0.0x|
|Market Cap (in $M):||100||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||110||EBIT||0||0|
We are recommending a long position in Dynamics Research Corp. (Ticker: DRCO). We see 50%-75% upside potential in the coming twelve months combined with solid downside protection at current valuation levels. There are a number of catalysts (operating, balance sheet, strategic, industry) that will contribute to narrowing the gap between current prices and intrinsic value.
Investment Overview (each bullet is elaborated on more extensively in the body of this write-up)
Note on the Sector: Depending your investing style now is either a terrible time or a great time to own a company with U.S. Government agencies as its customers. Terrible, because shareholders don’t want to invest in a sector with this degree of customer issues. Great, because the sector is out of favor and trading at trough multiples and this is the opportune time to own it. As the issues improve (possibly post-election) industry multiples may recover
Brief Summary of Dynamics Research
Capitalization and Guidance
The stock is cheap by any number of measures:
As part of the company’s $143mm acquisition of HPTI the company took on $40mm of 13% sub debt and $110 of senior debt at 4.2% (this is a blended rate as some portion of the senior was swapped to fixed). They have the right to pay down the sub debt in July of 2013 at a 5% prepayment penalty. But, as alluded to on the most recent call, we think they might try to accelerate this payment and refinance both pieces of debt in 2012. Of course, they will need to pay some additional penalty to the sub debt holder but it is still well worth it from an economics and optics standpoint to do such a deal.
There are a number of benefits from such a transaction:
Possible M&A Take-out
From 2008 through February of this year – there have been host of comparable transactions which provide some guidance as to what DRCO would be worth in a deal.
|Oct-11||Parsons Engineering||Sparta (Cobham carveout)|
|Sep-11||CACI||Paradigm Solutions Holdings, Inc.|
|Sep-11||General Dynamics||Vangent, Inc.|
|Jul-11||Providence Equity Partners LLC||SRA International, Inc.|
|Jun-11||URS Corporation||Apptis Holdings|
|Apr-11||Ares Management||Global Defense Technology Systems|
|Nov-10||Veritas Capital||Enterprise Integration Group (LM carveout)|
|Nov-10||SRA International, Inc.||Platinum Solutions|
|Oct-10||Jacobs Engineering Group||TechTeam Government Solutions|
|Oct-10||Global Defense Technology Systems||Zytel Corporation|
|Aug-10||Aecom Technology||McNeil Technologies|
|Aug-10||CGI||Stanley Associates, Inc.|
|Jan-10||Mantech International||Sensor Technologies|
|Nov-09||Dell, Inc.||Perot Systems Corporation|
|Apr-09||ICF International||Macro International|
|Jan-09||Lockheed Martin||Universal Systems and Technology|
|Dec-08||Odessey Investment Partners||SM&A|
|Aug-08||Hewlett-Packard Company||Electronic Data Systems|
Multiple of LTM Revenues: 0.6x – 2.0x with a Median of about 1.1x
Multiple of LTM EBITDA: 6.5x to 15.0x with a median of about 11x
Note: DRCO bought HPTi for roughly 1.5x revs and 11x EBITDA in mid-2011 (the effective multiple has come down meaningfully since then as HPTi continues to perform well)
Conversations with industry analysts suggest that in this environment multiples of 7.0x to 10.0x EBITDA and north of 1.0x Revenues would be appropriate for DRCO. so, what would DRCO be worth in a deal?
In some sense those prices all seem a bit extravagant given DRCO is trading for under $10 today. But, at the very least the math gives us comfort that management has a put option at much higher values.
So, what is the chance that management and the Board of Directors are willing to sell DRCO? Frankly it is a hard to handicap although we do think that Q&A from long time shareholders on the recent quarterly call suggests that core holders are vocal with management on this front. No doubt the BOD is aware of the large divergence that continues to exist between trading multiples and transaction multiples.
Also, the CEO is 71 and at some point we see him selling DRCO rather than passing the baton. He should be well aware of how much upside there is to selling DRCO and we think that will be his exit scenario. Please note, we are just speculating here.
The Bad News is Priced In
On the year-end conference call management provided a somewhat dour outlook. The 2012 guidance given in February on the 4Q call was different than street expectations:
Management further elaborated:
Facing huge fiscal challenges in 2011, our clients across the spectrum of federal agencies often dealt with these issues by deferring and delaying new initiatives and procurement decisions. As a result, the total contract value of our new business wins for 2011 was $119 million, down 22% compared with 2010. The estimated first year revenue from these contracts was $62 million. Our business win – new business win rate for the fourth quarter was 22%.
Also, we saw additional evidence of aggressive government cost cutting as the revenue for the fourth quarter was short of expectations. We were impacted on several very successful programs which completed in the quarter, where clients deferred follow-on awards due to cost cutting efforts. For DRC, these programs included the Defense Center of Excellence for Traumatic Brain Injury, the NAVAIR Marine Corp AIRSpeed and several Army training efforts.
Also ending in the fourth quarter 2011 were the Air Force Expeditionary Combat Support System and Air Operation Center Systems integration project, which was successfully completed at year-end. Finally, we encountered an unexpected early curtailment of our work supporting the Walter Reed Army Medical Center BRAC. A reduction in annual revenue from all these completed programs totals approximately $30 million, which has impacted our revenue outlook for 2012.
Rightly so, investors responded to this negative sentiment by taking the stock lower by 12% that day. However, we believe that management brought down expectations sufficiently such that the company is set up to meet or exceed expectations for 2012. With this in mind, we think the majority of the bad news is priced into the stock at these levels.
Price Target of $15.00 to $17.50
Our 12-month price target of $15.00 to $17.50 is predicated on:
There are clearly reasons to dislike this sector right now. But, we think that the bad news is baked in and all of this negative sentiment allows in investors to buy a stock:
While we wait for a potential deal – at the very worst we expect the stock to rise commensurate with debt pay down. That would imply $30mm of upside to equity value or about a 30% return in the stock. But, we expect potential multiple upside from deleveraging, clarity on Federal Budgeting, play out of the election cycle.