March 26, 2008 - 5:47pm EST by
2008 2009
Price: 4.25 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 85 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Before we get into the write up, we believe this is important to watch this as this should speak to quality of the new leadership and influence General Pace should bring to SM&A. From 2005-2007 General Pete Pace was the Chairman of the Joint Chiefs of Staff and starts his farewell address after the Secretary of Defense around 2:10 seconds in.

General Pace could literally work for any company he chose in the Aerospace and Defense industry, coming to SM&A is a significant win for a $85mn company. (below is transcript of his early impact)

SM&A we think is incredibly undervalued given recent events. We wrote the idea up in June 2006 today the stock is 25% cheaper with a far stronger company: Revenue has grown from $72mn to $98mn in 2007. Over the last few years the company has continued to buy back shares and has repurchased nearly 20% at an average price of $7.21. From 2002-2005 the company averaged 60% ROE and traded at 9x book. We believe that with the current team in place ROE could jump from current 17% to 35-40% in 2009 with significant revenue growth. Currently the company is at record levels of utilization and expanding head count by 30% in 2008. Today the company, has 40% of the market cap in cash and A/R, and total liabilities are around 10% of market cap while the company is trading at a depressed 6X EBITDA with very little capex.

Here is additional progress that the market has ignored:

a) Jan 2008: hired General Peter Pace There is no better single hire the company could have made. On March 20, 2008 General Pace was also named to the Presidential Intelligence Advisory Board.

b) Jan 2008: hired a CFO that came from a software company with $1bn in revenue

c) Positive short and long term business trends: 1) More winner take all contracts (in Aerospace and Defense) 2) 50% of bidding costs reimbursed by the govt 3) 70,000 aerospace and defense workers will retire over next few years and more of the market will be outsourced. 4) reduced spending in Iraq/Afganistan would increase spending on Research, Development, Testing, & Experiments for next generation defense spending. (even without this RDT&E budget should remain relatively stable around $77bn annually). 5) Expanding into new markets outside A&D: Health and Human Services and Education.

d) Dominant market share for outsourced part of the business: 5x their closest private competitor

e) March 24, 2008 the Former CEO and Founder started running competing slate of directors because he feels: "In my view, SM&As stock price is well below its intrinsic value."

So why is the stock mispriced/cheap and what will change this:

a) Investor fatigue: from 2002-2005: WINS averaged 60% ROE and averaged trading at 9x book times book value, Since then ROE's have fallen to the Mid teen's and revenue was flat for years and the company went through Senior Management turnover (CEO changes: Myers>McCarthy>Davis>McCarthy).

b) SG&A as a % of revenue is too high and should be lower in 2008 than 2007

c) Charges from employee turnover (former CEO/CFO/Head of sales) came $1.3mm in 2007

d) Revenue guidance for 2007 was 11% and the company hit 37% (+25% organically), for 2008 revenue guidance is 10%. I do not think they are intentionally sandbagging but they are putting out very conservative numbers that they know they can hit. They are growing their headcount by 168 people on 400 total employees up from 105 growth last year. So I believe there should be significant revenue growth in 2008 and/or 2009.

The issue is revenue growth with operating margin improvement. I think both will be realized in the 2Q08 and improving each quarter thereafter.

Last year Cathy McCarthy (we think she has done fantastic work for this company over time*) resigned as CEO and turned the reigns over to Cynthia Davis. We believe there is no other word to describe this situation than disastrous. Cynthia lasted a whopping 30 days as CEO, shortly thereafter the head of sales and CFO resigned. We put the pieces together that they immediately started looking for a new job with new CEO on board. Long story short, Cynthia Davis was let go, Cathy came back and hired to fill the empty positions with the best she could find, which on paper look like two 10's. General Pete Pace is now CEO of a new Division called SM&A Strategic Advisors and she filled CFO position with a CFO from a software company with over $1bn in annual revenue. Instead of throwing anyone under the bus, the company took their licks and the stock got hit. However, in our opinion the company has never been in a stronger position in terms of management and market opportunity and the stock is near historic lows on a number of metrics.

* Cathy joined the company as a turnaround consultant, sold off non-core businesses (these non-core busineses nearly destroyed the company in 2000), was named CFO then President and finally CEO.

Strategy/Market Opportunity:

Strategy is built on contract lifecycle success: A) Pursuing the right business, B) Competing & Winning the right contracts, and C) Performing and executing against the contract that allows for the company to maximize profitability and recognize revenue as project is completed.

A) Pursuit: based on strategic business intelligence: General Pace: CEO of SM&A Strategic Advisors = Business opportunities (ranging from shorter term up to 2-5 years out)

B) Competition Management: $1.5-2bn annual market

C) Perform Management: $6.8-11bn annual market

Part of the DOD budget SM&A focus's on is the Research Development Testing & Experiments component which is $77bn a year should be fairly flat unless we reduce spending in Iraq/Afghanistan then RDT&E should increase.
The total market opportunity is $8-13-bn a year spent in competition and performance services for government contracts (98% of this market is currently done internally by the companies), the 2% that is not SM&A has 5x the market share of their next closest private competitor. Aerospace/defense engineers are retiring in significant numbers and more and more of this business is being outsourced to companies like SM&A
We believe the hiring of General Pace should only accelerate this trend
General Pace is CEO of SM&A new Strategic Advisory Business. The objective is to build a multiyear pipeline of business which should serve two key functions: an earlier entry point into the bidding process (which should further increase their 85% win rate) and higher visibility into future revenue growth.

More on General Pace from wikipedia:

The Chairman of the Joint Chiefs of Staff is by law the highest ranking military officer of the United States military [2], and the principal military adviser to the President of the United States. He leads the meetings and coordinates the efforts of the Joint Chiefs of Staff, comprising the Chairman, the Vice Chairman of the Joint Chiefs of Staff, the Chiefs of Staff of the United States Army and United States Air Force, the Chief of Naval Operations, and the Commandant of the United States Marine Corps.

CEO McCarthy response on General Pace's arrival at the company and what contributions she expects from him going forward (transcript from earnings call):

Well, that's a very good question, and it is easy to answer because it's so overwhelmingly successful already. What I would tell you is that I can't and won't and couldn't quantify what amount of revenues I expect. I certainly expect revenues to be created by the Strategic Advisors and programs and solutions that they will provide to our clients.

But what's important about this is as we build out this whole lifecycle support for our clients, you are involved in helping them win competition, competitive procurements. So, if you are not involved in the upfront strategy, and you are not involved with very senior executives within company for looking at what is that they're selling today, what is that they're going to need to sell five years from now.

We had companies, very large companies in our top four list, they're looking at what business are they going to be in 40 years from now, what their business can look like 40 years from now. And you have someone who had a view of the world and experiences that General Pace does as part of the organizations, and that means that he is invited into welcomes, and participates in those kinds of strategy and business intelligence discussions about where markets are moving and where the acquisitions are moving, both for this year, for the next five years, for the next 10 and next 40.

We have got an incredible reception from our client base that General Pace is part of the SM&A organization. He has already had numerous meetings with our top clients, senior executives in those clients, and very large clients that we do not have a presence, we're being introduced to, in addition to a whole variety of, what we call, our tier 1 clients who are not the primes but are mostly the subs to the prime.

He is now making aware of SM&A, what we do and our capacity. So, as I walk you through that, I hope you can hear my excitement about what can come out of that, but it's very difficult to quantify right now. We just know that we're moving in a very positive direction, and he is bringing to the company everything that we knew he would, from both an access point of view, from a reputation point view, and certainly our associates here at the company are extremely excited to have him as part of this organization and our board, and certainly I am.

SM&A added 32 new clients in 2007.

Top Customers include: Boeing, Lockheed Martin, Northrop Grumman, Raytheon, Accenture, Deloitte, Fluor, MedImmune, IBM, PRG Schultz

Barriers to Entry:

Scale: 400 people private competitors are much smaller

Reputation/Experience: Average consultant has 25 years Industry experience and very selective in whom they hire.

Track Record of Success: 25 years in business, 85% win rate, $340 billion in contracts won and assisted on close to $1 trillion dollars in proposals since 1983.

We believe there is a great deal of intangible asset value derived from the reputation of being in business for 25 years with over an 85% win rate. This shows in high ROE's in spite of the company having a significant cash position relavtive to its capital structure.

From the 10K:
Supporting Proposals in Response to Federal Procurements.
According to the Government Electronics and Information Technology Association (GEIA), the federal government will obligate approximately $151 billion in fiscal year 2008 to acquire goods and services from large prime contractors, of which approximately two-thirds to three-quarters will be obligated by the DoD. Federal spending of this nature is expected to remain level in 2008 and may continue at this rate for another two to three years due to resources constrained by the global war on terror, current operations in Iraq and Afghanistan, increased percentage of supplementals allocated to procurement, and current federal deficit pressures. A significant portion of these funds will be spent on information technology goods and services. Much of this procurement spending will be awarded competitively. Companies generally spend from $500,000 to $2 million to prepare a proposal for a must-win program. Federal law and policy encourages this spending and allows companies to seek reimbursement for about 50% of these expenses. Some portion of the money spent to bid on a program is often outsourced and it is this outsourcing for proposal services that represents the majority of our traditional source of revenue. Furthermore, the spending cited above is happening during a time of extreme demographic pressures in the defense and aerospace industry. The defense contractor workforce is retiring in record numbers—by 2010, it is projected that approximately 70,000 defense engineers within the aerospace workforce will become eligible for retirement (Source: Aviation Week & Space Technology, February 2007). If current trends hold, the industry will be able to replace only about half the number expected to retire. For this reason alone we can expect continued outsourcing demand from our clients. Finally, as part of our support to clients in leading the development of a competitive proposal, we often provide competitive strategy services and management consulting services.

Customer Concentration: Top 5 customers are 60%. This would usually concern us, but not as much in the case of SM&A. SM&A is really the only scale outsourced provider in the industry and has an unmatched 85% win rate. SM&A has been with Boeing for 20+ years with relationships at 20 different divisions. Outsourcing pressures should only increase which makes it even more unlikely that companies will do less outsourcing. The risk for a company bidding on a contract is that a competitor retains WINS on a multi billion dollar contract with SM&A's 85% win rate.

70,000 Aerospace/Defense Engineers are going eligible for retirement between 2007 and 2010 and it is estimated that only 35,000 new engineers will be able to be hired to fill these vacant positions. SM&A has 270 billable employees, if major Aerospace/Defense companies lose net 35,000 engineers to retirement and 98% of the business is currently done internally a very significant opportunity exists for SM&A. SM&A average hire is in their late 40's to early 50's with 25 years industry experience, a good deal of SM&A work force are recent retiree's from Aerospace/Defense companies. Essentially for every 1% that is outsourced the size of the market grows by $70-90mn annually which we think is currently around $200-300mn per year. So if eventually 12% gets outsourced it should be a $1bn annual market and if WINS holds their estimated 30-50% market share then SM&A has the potential to reach $300-500mn in annual revenue (no idea on timing, but certainly the potential is there).

Comps: It is difficult to find a comparable company, the closest company we can find is Exponent (EXPO) which has similar business model, operating margins, and growth. EXPO trades at 2x EV/SLS and 12.3x EV/EBITDA and 26x EPS.

Here are the non-recurring costs and other interesting datapoints:

- PPI (Project Planning Incorporated) earnout of $1.6mm in 4q’07, about $0.08/sh pretax. The earn-out will reoccur in 2008/2009 and is estimate to be $1.4mm.

- The offsite sales meeting (they are trying to reduce/cancel this event) is $1.4mm of extra costs for 2008. This is done every other year and expect this to be dramatically reduced in 2010.

- The recruiting effort in 2008 will dampen earnings, but still guidance is $0.34EPS for 2008

- Transition expenses for 2007 were $1.3mm (sign on bonuses, severance pay)

- WINS is planning to hire 168 consultants in 2008 (105 were hired in 2007). There is attrition (~10% estimated) but still that is considerable growth. Total head count is current 400. .

For 2008 the company is guiding for $108mn in revenue with .40 in EPS and ex PPI earnout .34 EPS. We think there is upside to both revenue and EPS in 2008.

So overall expenses that will be reduced (probably not fully in 2008 but for in 2009): $3mm, about $0.15/sh

Bottom Line: For a business that should run 30-40% ROE's without debt, have attractive growth opportunities, and 5x the market share of its next closest competitor we think a reasonable valuation is 10-12x ebitda and 2x ev/sls. 2x ev/sls on 2007 numbers at $10. We feel this type of valuation is realistic and traded for significantly higher multiples over time. At the current time a 2x ev/sls is not warranted but should be higher than .65x ev/sls. The downside should be extremely limited given 40% of the market cap in Cash & A/R and total liabilities are around 10% of the market cap. On an EV/NET the company is trading 8.6x. If you take the rest of current assets (90% AR) less total liabilites that is an additional .60 which you could potentially deduct from the EV which would put the company at less than 8x depressed 2008 net income. Extremely low expectations are priced into the stock. Despite turnover and transitions the company put up a record year in 2007 and has strong momentum for 2008. Frankly, in our opinion the focus had been missing due to management transition issues over the last few years. As of today, we are highly confident that Cathy McCarthy/General Pace are the right leader's and are exceedingly focused on taking the company to the next level in growth and earnings per share and that 2008 and 2009 should be great years for the company.

Major Risks: General Pace or Cathy leave the company. I doubt either will happen, but anything is possible.

Disclaimer: This does not constitute a recommendation to buy or sell this stock. We own shares of the company, and we may buy shares or sell shares at any time without updating the board.


Likely upward revenue and earnings guidance in 2008: 2007 Revenue guidance was 11% company hit 25% organic growth while the company added 105 consultants, 2008 guidance was 10% while they are adding to head count by 30% or 168 consultants. The revenue #'s given are extremely conservative. The company is running at record utilization and sees good pipeline of business.

Hiring of General Pace is a very significant development: should expand the pipeline of potential business while building deeper visibility.

4 Insiders bought stock before their window closed in March

March 24, 2008 Former founder of WINS is seeking to replace 4 board members and feels "SM&As stock price is well below its intrinsic value."

Management likely on the road in April due to Proxy contest.

$1/sh in EBIT should be achievable at $125mn in revenue (could be 2008 or more likely 2009)

Expansion into Education and Health and Human Services

Low expectations + Cheap stock: should report record revenues, 40% cash and A/R vs. total liabilities less than 10% of market cap, .65 ev/sls, 7-8x ev/net on depressed EPS with high unlevered ROE


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