September 06, 2019 - 11:02pm EST by
2019 2020
Price: 34.67 EPS 0 0
Shares Out. (in M): 100 P/E 0 0
Market Cap (in $M): 3,467 P/FCF 0 0
Net Debt (in $M): 264 EBIT 0 0
TEV ($): 3,731 TEV/EBIT 0 0

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Summary:  Parsons Corporation (NYSE:  PSN) is recently public government IT & services contractor/engineering & construction company.  We believe the company’s limited capital needs and growing end markets will allow it to continue to earn significant returns on capital while also growing its topline and expanding its margins.  We expect it will continue to generate excess cash that should be recycled into high-return acquisitions or distributed to shareholders in the coming years.  

Business Overview:  Parsons is a 75-year old company based in Virginia with 14,000 employees.  Of the company’s $4b in annual revenue, half comes from the lower-growth Critical Infrastructure E&C segment. The other half is in the faster growing, higher margin Federal Solutions segment (which provide technical design, engineering services, and software for customers).   Parsons recently went public since having gone private in an ESOP-funded LBO in 1985.  

Key Pillars of the Thesis:

1.       Mix shift to higher margin contracts.  We believe that Parsons can ultimately get to 10% or higher EBITDA margins over time.

2.       An uptick in demand from their key government end-markets.  Public construction spending and the Federal budget both show several years of strong demand. 

3.       Opportunistic M&A through tuck-in acquisitions. Parsons explicitly targets acquisitions as a driver for growth.  We believe the company has significant opportunity to pursue accretive acquisitions. 

4.       Significant Free Cash Flow and Returns on Capital.  The company has minimal capital requirements, leading to balance sheet flexibility for acquisitions, and ROIC in excess of 20%.

5.       Attractive Valuation. 

#1.  Mix to higher margin contracts.  In 2018, Parsons generated an EBITDA margin of approximately 7%.  We believe there are multiple drivers that can get them to 10% or better over time: 

Mix shift to government IT & services segment

The company has focused heavily in recent years on growing the IT side of the business.  It now represents the majority of EBITDA. This business is faster growing, higher margin (7+% EBITDA margin) than E&C side (4-5%).  Within this segment, we expect margins could improve as Parson attempts to improve the mix to more fixed-price work.    

Improvement in margins at construction segment

The company is focused on moving away from lower margin, higher capital requirement (through longer A/R days) construction segment.  The company has estimated that it could potentially exit 20-30% of the critical infrastructure business if they cannot get acceptable margins there.

Recent Acquisitions

In the last several years, the two big acquisitions made by Parsons are Polaris Alpha (bought for $489mm) and OGSystems (bought for $300mm).  Combined, these two companies contribute $700mm in revenue, at higher margins than the rest of the company. 

#2. Uptick in demand from their key government end-markets.   We believe Parsons will benefit from strong and growing budgets in both the public construction and defense/intel sectors.   Current book to bill in the TTM is 1.2x, and the company’s total backlog is currently $8.5b. 

While our data on this is more anecdotal, based on reports from some of the other E&C companies tied to public infrastructure budgets (e.g. ORN), we believe that the public construction markets are growing fairly significantly. 

The Defense Department is on pace for approximately $700b in outlays this year, up from a recently cyclical bottom below $600b in 2014-2016.  The current budget request shows growth for next 5 years. Parsons is particularly focused on the intelligence and cybersecurity budgets, where growth is greater than 20%.      

#3.  Opportunistic M&A.  The government IT/services business is highly fragmented.  An explicit leg of the company’s growth strategy is to pursue acquisitions for the Federal Solutions segment.  In recent years, they have been doing 1-2 acquisitions per year. The company currently has a pipeline of 30+ candidates.  As a general matter, management looks for 10+% topline growers with 10+% EBITDA margins. 

A good example is their recently announced acquisition of QRC Technologies, which has revenue growth in the mid-20% range with EBITDA margins of 30%.  The $185mm price ($215mm gross less tax benefit) was at 10x EBITDA.   

#5.  Solid Balance Sheet and Returns on Capital.  The only significant capital requirements in this business is an investment in Accounts Receivable, which tends to run around 125 days (and they are looking at ways to reduce this).  There is generally no inventory and minimal capex required (approximately 1% of revenues). The ROIC on this business can run above 20%. This year, we estimate Parsons can generate in excess $200mm in free cash flow, approximately 5% of the company’s enterprise value. 

Proforma for the QRC acquisition, the company has $264mm in net debt on the balance sheet, under 1x EBITDA.  The company has said it is willing to go to 2.0-3.0x leverage for the right M&A opportunity. We expect that Parsons will lever up to fund acquisitions, then use its cash flow to pay down debt to a low level, then rinse and repeat. 

#6.  Attractive Valuation.  The stock currently trades for 15x 2020 estimated cash flow per share of $2.40.  If the company can continue to grow revenue at 5% per year the next several years and increase its margins slightly, they should be able to generate approximately $3.00-3.20 in cash flow.  At 15x EPS, this yields a $45-48 stock, up 35% from here.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


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