Description

We recommend purchase of newly public PAE Incorporated (PAE - $10.75).

PAE is a government services contractor with a multi-decade history of serving a number of different U.S. government agencies.  This is a simple, easy to understand, well managed, growing, free cash compounder with long-term contracted revenues trading well below comps at only 8.3x EBITDA and 8.2x FCF on the company’s own 2021 targets; PAE has a shareholder-oriented ownership base and an experienced management team that should continue growing PAE both organically and via M&A.  PAE recently came public via the Gores Holdings III SPAC. The seller of PAE, Platinum Equity, has retained a 23% stake while the SPAC sponsor Gores Group owns 8%. For the record, this is Gores Group’s third SPAC. Gores’ first SPAC brought Hostess Brands (TWNK - $12.68) public in 2016, Gores’ second SPAC brought Verra Mobility (VRRM-$14.91) public in 2018.  Both have done reasonably well, particularly Verra.

Investor Presentation: https://www.sec.gov/Archives/edgar/data/1720821/000119312520002841/d781342dex991.htm

From the merger proxy: “PAE’s long-tenured contracts have created a sticky base business with its top contracts having a weighted average contract length of over 7 years as of September 29, 2019. Revenue from these long-running contracts is steady as PAE’s contracts are predominantly funded from stable portions of the DoD budget with little dependence on wartime or emergency overseas contingency operations funding.……………PAE’s customer diversity, backlog, multi-year contract terms, leading track record of winning re-competitions and new business opportunities, and limited reliance on DoD-directed Overseas Contingency Operation funding provides PAE with visible and predictable future revenues bolstered by free cash flow generation.”

We note the following:

• Average contract length 7.3 years with no one contract representing more than 7% of revenue
• Geographic revenue breakout: USA - 53%, Middle East - 23%, Asia/Pacific - 8%, Africa - 6%, Other 10%
• Customer revenue: State Department 26%, Navy 14%, Homeland Security 13%, Army 10%, NASA 9%, Air Force 9%, Other 19%
• PAE’s workforce totals approximately 20,000 across 60 countries (70% in the USA)

The government services space has done quite well in recent years; there are no China issues or technological disruption fears, these are long term contract businesses with relatively low margins, and these companies have thousands of security cleared employees along with deep expertise in government related bid and proposal efforts. The “better” more tech project focused companies like Leidos, CACI, Booz Allen have about 10% EBITDA margins with about 1.0% - 1.5% capex/revenue, so about 8.5% - 9.0% EBITDA minus capex margins and they trade at full EBITDA multiples of 12x - 15x.  Lower tech PAE on the other hand has a 6.0% EBITDA margin with virtually zero capex and a goal to reach 8% EBITDA margins in time organically and via M&A. 

PAE capitalization is as follows:

Source: PAE merger proxy projections, historical numbers are pro forma for completed acquisitions and a number of other items listed out in the presentation above

The organic plan is for the GMS segment to grow low single digits, while the NSS segment grows revenue and EBITDA by 10% and 15% annually (driven by significant new contract wins off a fairly low revenue base), the combination of which would drive consolidated revenue / EBITDA growth in the mid-single digit range annually. On top of this, PAE is almost certain to be an active acquirer, particularly in the faster growing higher margin NSS segment. PAE’s 2021 projections are organic and take into account the expected contribution of contracts already won (and expected to be won) in the NSS segment that will begin generating revenue in 2021.  

From 2013 through 2020E, actual revenue will have grown at a 12% CAGR including acquisitions.  For what its worth, PAE’s bid submits increased from $4.6 billion in 2017 to $15.4 billion in 2018.  In NSS alone, bid submits have increased from $600 million in 2017 to $6.6 billion in 2018!     

The model above taken from the company’s presentation assumes no M&A and therefore substantially lower cash interest as FCF is used to reduce debt. 

PAE operates in two different business segments:

The Global Mission Services (GMS) segment should do $2.1 billion revenue and $115 million EBITDA in 2020 (5.5% EBITDA margin) operating in the three business units below.  Top customers are Department of State, U.S. Navy and NASA.

• Logistics & Stability Operations ($545m revenue)
  • Logistics/support services on bases outside the United States
• Infrastructure Management ($880m revenue)
  • Manages/supports overseas embassies, NASA facilities, DOD test equipment ranges
• Force Readiness ($670m revenue)
  • Afghan military logistics/vehicle maintenance, aircraft support/maintenance for AMCOM/CBP/Navy

GMS has delivered low single digit growth in revenue and EBITDA over the last few years.  This is a stable low growth business that has been around for many years (https://www.youtube.com/watch?v=XKzbA6__J4k), offering “blue collar” type services, largely cost plus work with lowish margins, very cash generative.  These are enduring revenue streams with no planned closings of any of the major assets that PAE operates/manages. Think embassy operations/maintenance especially in higher risk location like Iraq, management of 76 different camps and facilities in Africa/Middle East with work that might include anything from security to catering to waste pickup – PAE is basically a city manager in these contracts.  PAE is also the number one provider of test and training range services to the U.S. Navy and the largest facility contractor to NASA. Force Readiness includes a long-time expertise in managing large fleets of aircraft for numerous government agencies across 50 different locations.

The National Security Solutions (NSS) segment should do $700 million in revenue and $59 million in EBITDA in 2020 (8.4% EBITDA margin) operating in the two business units below with the top customers being Department Homeland Security, Department of Justice and the intelligence agencies.

• Counter-Threat Solutions/Intelligence Solutions ($344 million revenue) 
  • Training services support / services related to implementation of homeland security
  • Intelligence mission support: operational support for classified missions/facilities, security services and training
• Information Optimization ($358 million revenue)
  • BPO services related to visa/passport applications, immigration benefits, litigation support

NSS is the faster growing higher margin “white collar” type services segment that has been created by acquisitions, which have been funded by GMS cash flows (and debt).  This segment is largely a mix of four different businesses acquired over the last seven years and shows pro forma revenue and EBITDA growth (as if all acquisitions were owned during the entire period) of 10% and 15% annually.  This segment has a much higher percentage of fixed price and T&M contracts and far less cost plus (12% of revenue) which results in higher EBITDA margins. The segment has grown rapidly as PAE has done an excellent job of winning new contracts.  Each acquisition adds new “white space” for PAE to go after. As noted above, bidding activity in the NSS segment has ramped up considerably.

PAE is in a great spot to continue acquiring higher-margin NSS type businesses.  Larger players like Leidos and CACI need to acquire very large 10%+ EBITDA margin companies to accrete their own margins higher.  PAE on the other hand is thrilled to do mid-size tuck-ins in the 7% - 9% EBITDA margin range which are highly accretive to the company’s own margins.  While M&A has been on the backburner for the last year or two as PAE prepared for an ownership change, we think that as a newly public company, PAE will be aggressive in going after accretive acquisitions.

One very important thing to note is that M&A generally works quite well in this industry; the buyer is acquiring ongoing long-term cash flowing contracts, which will remain in place while eliminating duplicative corporate expenses, and gaining expertise and additional white space with which to increase bidding activity. For PAE specifically, in buying smaller companies, there is also the benefit of managing the target’s existing contracts more efficiently as well, leading to greater profitability and/or freeing up more dollars for the government to spend as an add on to existing contracts.  We think PAE will do a healthy number of tuck-ins, creating more EBITDA in the 7x - 9x range while PAE should trade at least in the 10x EBITDA range. In time, PAE’s margins should expand in turn warranting a higher multiple.

In summary, this seems like a very compelling situation to us.  PAE will continue growing organically and through accretive M&A, while generating significant amounts of free cash flow and the current valuation of 8.2x 2021 FCF is very modest.  We are happy to own the lower margin player in this consolidating sector as it grows its margins closer to industry comps with the valuation gap likely to shrink over the next few years.

Catalyst

Accretive M&A. Stable growth in free cash flow.