|Shares Out. (in M):||37||P/E||0||0|
|Market Cap (in $M):||800||P/FCF||0||6.7|
|Net Debt (in $M):||1,150||EBIT||0||0|
Engility offers the opportunity to enter into an equity position in a KKR-led LBO at under 7x 2016 free cash flow, anticipating a 100% return over the next 2-3 years. The business is a competitively well-positioned government services provider, offering a diversified range of consulting, technical support, IT, engineering and logistics services to defense, intelligence and civilian agencies. Engility shares have traded off following the completion of its merger/recapitalization, offering a compelling entry point at current levels.
Engility has been written up twice before, so we provide a brief overview of the past few years (which give us confidence in management and in their strategy) and focus on the transformational TASC acquisition that has occurred since the last writeup.
Engility is a government services business that was spun out from L-3 Communications in July 2012. The company provides technical consulting, IT implementation and development, engineering and technology, logistics and other support services to the Department of Defense, intelligence agencies, the Department of Justice, the State Department, USAID and other government customers.
Engility was ostensibly spun out because the company was increasingly constrained by organizational conflict of interest issues—where Engility was restricted from bidding on services contracts associated with L-3’s prime contracting business. However, L-3 was at least partly motivated to separate itself from the rapidly shrinking revenues associated with Engility’s services contracts in Iraq and Afghanistan. This revenue drag, coupled with Engility’s small size (1/16th L-3’s size based on net income), set the stage for a deeply undervalued share price in the wake of the spin off, followed by several years of significant outperformance: a 45% IRR from spinoff through recapitalization, including a cash dividend of more than 60% of the spin basis.
Engility’s success as a public company has had a few key drivers:
In late October 2014, Engility announced a merger with fellow government contractor TASC, whereby: (1) pre-deal EGL shareholders received an $11.43/share dividend; (2) TASC owner Birch Parners (JV of KKR and General Atlantic) received EGL shares representing 51% of the pro forma equity; and (3) Engility CEO Tony Smeraglinolo remained CEO of the combined company.
The TASC acquisition is very large for Engility—increasing revenues and EBITDA by over 70%--and it brings significant additional benefits:
The deal allows Engility to extend its low cost, capital efficient strategies into new end markets. Their government agency customers are increasingly awarding contracts based on lowest price, technically acceptable (LPTA) standards. Engility’s ability to cuts costs and pass those savings on to the customer provides them with a competitive advantage. In the near term, management can leverage corporate functions across the expanded base of business. Longer-term, they see opportunities to reduce their facilities footprint—a cost legacy from L-3 and from Northrop Grumman (TASC) ownership.
Put more simply, both Engility and TASC were spun out from their parent companies with inefficient cost structures—too much real estate under lease, too little scale against corporate fixed costs, etc. Engility management will continue to attack these costs and use the savings to make their bids for future contracts even more cost competitive. In a market that is experiencing some commoditization, they are positioning to be the low cost provider.
This merger repeats the basic strategy employed in Engility’s spinoff from L3 and its subsequent purchase of DRC in early 2014: (1) leverage up to facilitate the transaction; (2) cut costs and gain efficiencies; and (3) channel cash flows toward paying down debt. Even with zero growth in EBITDA and EV (which is not the expectation), this model can result in a significant transfer of value from debt holder to equity holders.
Why is it undervalued?
What is it worth?
Pro forma capitalization:
Pro forma valuation ‘16E:
At 11x fully-taxed 2018 FCF (no top-line growth), plus the value of the tax shield, the shares would be worth $44 per share—100% upside or 26% IRR over 3 years. The FCF number can go higher if we assume a successful re-fi of the debt in May 2016 (as suggested by the company) or if we assume they can hit the revenue projections included in the TASC merger proxy.
When Engility was first spun out of L3, it was not well followed and not well understood; it traded at 5 to 6x forward free cash flow. Over the next two years the shares doubled. We think that the stage is set for a similar performance.