Aug 16, 2012

ENGILITY (EGL): What About this Spinoff Makes a Baupost Alum Buy 11%?

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[youtube http://www.youtube.com/watch?v=01-2pNCZiNk&w=420&h=315]


Overview:

On July 28th 2011 L3 communications (LLL), a major military contractor announced its intention to spinoff a number of its business units into a new company, Engility Holdings Inc. (EGL). On July 17th 2012 the spinoff was completed and Engility and began trading as a separate entity.

The company faces significant headwinds going forward including:

  • Revenues, and margins have been on the decline due to the draw-down in Afghanistan and Iraq as well as the near certainty of a decline in defense spending over the near to medium term.
  • At the spinoff L3 saddled the company with 350mm worth of debt they used to payout L3 shareholders / retire debt.
  • Roughly 60% of the company’s assets are goodwill and they have only 14mm of cash on the balance sheet as of January 1st 2012.

All this negativity begs the question; why did this guy buy 11% of the stock?

David Abrams is the managing member of Abrams Capital, a Boston-based investment firm that began operations in 1999. He currently serves on the board of Crown Castle, Inc. and CC Media Holdings as well as several private companies. Prior to forming Abrams Capital, Mr. Abrams was employed by The Baupost Group, Inc. for ten years. He graduated from the University of Pennsylvania in 1983 with a Bachelor of Arts.

On July 27th Abrams Capital Partners filed a form 13-G stating that they had purchased control of 9.7% of the company. Then on August 2nd they filed an amendment stating they now controlled 11.6% of the outstanding shares. There has been no filing by Abrams since.

In light of this I decided the stock merited a closer look. Even though I know little to nothing about the industry, if this hedge fund manager was seeing value, I wanted to see if I could too. Plus I think this kind of investigation has an element of deliberate practice which is always good.

Valuation:

Ownership Structure

According the Yahoo finance the single largest non-institutional shareholder behind Abrams Capital is Engility’s CEO, Anthony Smeragliolo with 127,028 shares as of this writing. With a fully diluted float of 16.2mm shares Mr. Smeragliolo owns roughly 7/10ths of 1% of the company. Mr. Smeragliolo’s stake and those of other executives amount to almost 2% of the company, so while management is reasonably incentivized this ownership structure doesn’t merit special consideration.

Past And Present Financials

At first glance Engility’s balance sheet appears something of a disaster. With only 14mm in cash and $904mil of Goodwill accounting for roughly 60% of the firms total assets and $350mil of debt about to be tacked onto the liabilities – this doesn’t look like a stock that would show up on your value screeners.

The income statement is not much better, since 2009 earning have been lumpy as a result of significant goodwill write-downs in 2010 and 2011. In addition revenue has been declining by about 6% per year and management expects that due to probability of additional cuts in defense spending FY revenue for 2012 will be approximately 1600, a 26.6% Y/Y decline.

The only bright spot in the financials was the cash flow statement. Since 2009 free cash flow to the firm as a percentage of revenue has averaged 8.2% declining from 9.3% in 2009 to 7.5% in 2011.

I should point out though that cash flow to the firm percentages accounts for capital expenditures. This is where all that goodwill comes into play, since the company doesn’t actually make any stuff, they don’t have to spend capex on plants or much equipment. In fact, capital expenditure never exceeded $7mil in any of the last 3 years. Putting it simply, if they make money they can afford to throw it off it as cash to shareholders. Whether or not they plan to do so is another question.

Using what we know about Q1 and assuming that cash flow’s as a percentage of operating profit are near their historical average of 92% thereafter, I came up with FCFF to the firm of $76mil in 2012 and FCFE of 54mil. Assuming the stock is trading around $15.00 (where I believe Mr. Abrams was buying) he was paying for roughly $3.3 dollars a share in cash flow a 4.5x CF multiple, or a 6.05x EBITDA/EV valuation on the firm.

Looking at competitors this doesn’t seem to be any great bargain, many trade at or around these EBITDA / EV levels with better balance sheets than Engility.

Valuing the Future

That the stock not trading at a spectacular relative-value to its peer or at a significant discount to its competitors or at an absolute level relative to the liquidation value of its current assets, leads me to conclude that the matter of value lies in Mr. Abrams expectations for the company future prospects.

In my opinion the best way to think about the future of this enterprise is to ask two questions that though fundamentally interrelated are for the sake of clarity best evaluated separately:

  1. What is a reasonable expectation of future revenue?

Because the department of defense is Engility’s largest customer, accounting for 79% of revenue in 2011, it is reasonable to expect the primary diver of revenue will be the timing and severity of the reduction in defense spending.

The present consensus is that there will be cuts until 2014 and then the budget will again slowly increase. The looming question here is whether and how the mandatory sequestration tied to the spending cuts laid out in the budget control act of 2011 will go through or not.

Personally, I don’t think there will be a resolution that stops mandatory sequestration from being enacted until at least the middle of Q1 2013 but that doesn’t mean there won’t be one at all (more on this in another post).

The other potential revenue driver is the termination of Organizational Conflicts of Interest (OCI) as a result of no longer being affiliated with other business segments in L3.

OCI is a regulation that prohibits firms who make products for the government from providing the services and support surround said products. For instance, if you contract to build a cell-phone tower for the US government, you cannot bid to be the person who provides the networking software. The net affect of this regulation is to limit the spectrum of services a single firm or entity can provide for the government and thereby limit conflicts of interest between the government and the firm itself (no one is allowed a monopoly on the US government). Now that Engility is separated from L3 communications it will be able to bid for all the business that it missed due to being previously constrained by the OCI regulation.

Without knowing more about the specifics of each of L3’s business its difficult to determine what if any impact this will have on revenue. Pulling some number out of thin air lets say services surrounding L3’s products accounted for up to 10% of potential business that was not bid on as a result of OCI regulations. That means using FY’11 revenue there is potential for 1.5 billion in revenue that Engility can now bid for. Assuming they win just 25% of that potential business we can tack on another 375mil in potential new revenue for the firm.

2. What is a reasonable expectation of future profitability as defined by free cash flow to the firm?

Operating margins and more importantly free cash flow as a % of operating income have been declining over the last several years largely due to the decrease in Mission Support revenue, which is generally a higher margin business and increased competition among contractors for what business remains.

How low can margins go as remaining contractors compete to maintain their share of a shrinking pie? This is difficult to answer, but I think it’s safe to say that we shouldn’t expect to see a positive trend in margins while the defense budget is contracting.

Mean Value

Using some conservative assumptions here’s my attempt to value the firm:

Assuming that the budget DoD budget contracts for the next two years then stabilizes and no incremental business resulting from lack of OCI constraints, I came up with the below revenue projections. In addition, I assume that free cash flow to the firm drops from its 7% historical average to 5%.

Using a 15% discount rate, not deducting the tax shield from interest expense and assuming no growth in cash flows after 2014, I get a NPV of $198 mil or a roughly 20% discount to where the shares were trading when Mr. Abrams was buying.

Obviously these are fairly pessimistic assumptions but given the uncertain future of the DoD budget and my limited ability to forecast gains from the termination of OIC, necessary nonetheless. (All my CFA’s out there feel free to take me to task in the comments section)

Conclusion

I think any thesis on Engility turns on ones expectations for future DoD budgets and OCI related incremental revenue generation. If either of these things works out moderately positively then you have good upside potential at a sub $300mil market capitalization. But that’s far from a screaming endorsement or what I set out looking for when trying to identify the thesis Mr. Abrams would be using for his investment. Perhaps / probably Mr. Abrams has a better handle on these issues than I do and that depth of understanding allows him to see a margin of safety I cant. Nevertheless i’m going to buy a little because i’m speculating on what these OCI regulations might be worth in terms of revenue. I wouldn’t call this a fat a fat pitch for me, but maybe is it for you?

Meta Sum

The reality is unless Mr. Abrams tells the world I’ll never be sure what he was thinking or what he saw in Engility but it should prove insightful to see 1. whether or not the investment plays out and 2. whether or not it plays out for reasons i suspected.

In any case, I think it’s very interesting to note that this famous value investor is betting on a company without any obvious margin of safety in the balance sheet. More than that, he’s buying into a business with a ton of goodwill, very little cash and long-term debt that the firm’s not even getting the benefit of! In my opinion, the takeaway has to be that a margin of safety isn’t always sitting in cash or PP&E on the balance sheet and that’s something that a lot of value investors struggle to wrap their heads around.

Good Luck,

– No Mean Sum

Disclosure: Long EGL

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