|Shares Out. (in M):||18||P/E||0.0x||0.0x|
|Market Cap (in $M):||722||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||438||EBIT||0||0|
Engility Holdings (EGL) is an under-followed government services contractor at an inflection point following its July 2012 spin-out from L-3 Communications (LLL). I recommend buying EGL and estimate that it can return 22-56% over the next 12-18 months. The stock currently trades at a trailing 13% FCF yield and revenue should stabilize and then accelerate with the immediate federal budget issues resolved and the DRC acquisition. VI4Life submitted an excellent write-up of EGL when it was spun-off and I recommend that for a more detailed background on the company.
EGL was spun-off from L-3 in 2012 to separate L-3’s high margin contracting businesses from the low margin services businesses that ended up at EGL. The spin-off has worked beautifully for shareholders. The company is divided into the Professional Support Services and Mission Support Services segments, which encompass IT, supply chain, training and education, engineering, program support, and technical consulting. The attractive aspect of these services is that they have low fixed costs and disciplined cost management enables companies to quickly scale their operations. EGL currently has annual revenue of $1.4BN from its 1,300 active contracts, none of which are more than 10% of revenue.
The federal budget saga, particularly defense spending, is well known, but the recent budget deal and debt ceiling approval provides contractors with clarity into future contract opportunities. Budget certainty and EGL’s streamlined cost structure are the two catalysts which should drive performance. As recently as Q3, EGL had a book-to-bill ratio (funded orders / revenue) running at 0.9x, indicating falling revenue. However, I believe that this will reverse in light of the DRC acquisition and the elimination of indiscriminate sequestration cuts in 2014 (OMB article). This should not be a one-time boost because government services contractors should benefit from budget projections that have federal spending growing after 2015.
The key to understanding EGL’s story is that despite the decline in discretionary federal spending, the available opportunity is huge (~$150BN of federal spending) and the spin-off left EGL very well positioned to expand its contract book. EGL was unshackled by legacy costs and organizational conflicts of interest (OCI) that prevented it from bidding on contracts. It seems that L-3 was ahead of its competitors by identifying the operational and shareholder value that they could unlock. Exelis (XLS) announced in December that they will spin-off their government services segment (story). EGL can gain market share while their competitors rationalize their services operations. This will result in a temporary loss of capacity in the market and will create a favorable bidding environment. EGL is already realizing the benefit of its internal restructuring and has seen its win rate and re-competes increase. These contract renewals are a source of margin expansion because there aren’t ramp-up or exit costs.
EGL acquired Dynamics Research Corporation for $121MM cash and assumed liabilities on December 23rd. DRC booked $275MM in revenue in 2013. The DRC acquisition is significant because its existing customer base diversifies EGL away from the defense contracting and establishes new relationships within the GSA, DOJ, and DHS. This is especially important as EGL’s US Army mission support services contracts roll-off. The announcement surprised me because a close friend of mine who worked on the spin-off while he was at L-3 seemed to think that EGL was preparing itself for a sale based on recent senior management changes.
Outlook and Valuation
It is difficult to estimate 2014 revenue, but organic revenue growth should continue to stabilize and total revenue should range from $1.5-1.75BN. The federal government’s renewed emphasis on fiscal discipline could affect contract structures, with more using cost plus fixed fee (CPFF) instead of firm fixed price (FPP). This would likely mean that contracts would have margins between 5-7%. Based on my assumptions, I believe EGL could trade between $36.50 and $63, with target of $49.50, over the next 12-18 months. I adjust the forward P/E multiples to reflect the accelerating of EPS growth.
EGL has generated over $95MM in FCF as result of its low capex needs and by converting receivables to cash. FCF generation should fall as the receivables balance starts to grow as revenue stabilizes. Management says that it prefers to pay down debt or look to acquire other services businesses. DRC was this management team’s first acquisition, so it is hard to assess their judgment, but they seem keen to diversify away from defense contracts and pay in cash, which is favorable for shareholders.
Sell-side coverage is limited (Stifel, FRB, and CRT) and the stock is off many investors’ radars.
Deccan Value Investors has been accumulating EGL shares and holds almost 9% of the stock. This stake represents 15.6% of Deccan’s reportable equity holdings.
EGL is a constituent of the Russell 2000 and S&P SmallCap 600.
1) Federal government spending is hard to predict: Contract revenue is inherently difficult to forecast and management did not provide guidance at Cowen’s February 5th A&D conference.
2) Management: they have shown they can cut costs and position for growth, but they have not executed a growth strategy without the larger institutional support of L-3.
3) Political uncertainty: Congressional elections in 2014 could result in Democratic or Republican control of Congress. Although I don’t think either scenario is likely at this point, it is unclear how EGL would be affected. Democratic control could turn the federal spigot back on, but probably not to the benefit of the Pentagon. Republicans would love to boost defense spending, but would need Obama’s support and the ideologues who would give the Republicans the Senate probably would not compromise by spending more on social programs.