Engility Holding Spin-off

Engility LogoEngility Holding (EGL) was spun-off defense contractor L-3 Communications Holdings (LLL) on July 17, 2012. It “provides government services in engineering, professional support and mission support to customers in the U.S. Department of Defense, numerous Federal civilian agencies as well as allied foreign governments.”

It has two business segments, Professional Support Services (PSS) and Mission Support Services (MSS)

  • “PSS provides SETA (System Engineering and Technical Services) services, program management support, software engineering life cycle sustainment and support services.” 
  • Through MSS, we provide defense-related training, education and support services. MSS also offers law enforcement training, national security infrastructure and international capacity development.

Overhang

Engility has two major overhangs:

  • The large military drawdown in Iraq and Afghanistan is shrinking revenue. However, most of it will be complete by end of fiscal 2012. See figure below.
  • Further defense budget cuts in the future. 

Engility Revenue BreakdownFigure 1: Engility Revenue Breakdown (Source Engility)

Financials

Here are key financials for the company:

  • ~$300 million market capitalization.
  • ~$18.5 stock price
  • ~16 million shares outstanding.
  • Management estimates revenue of $1.6 billion in 2012
  • Management estimates diluted EPS of $2.30 to $2.55 in 2012
  • Management estimates adjusted diluted EPS of $3.40 to $3.65 in 2012. Adjusted excludes one time costs such as spin-off transaction costs.
Positives
 
Investors are fearful of the decreasing revenue, but are missing out a lot of positives about this company:
 
  • Decent recurring revenue. The weighted average remaining period of service on contracts is over 4 years.
  • Funded backlog as of June 29, 2012 was $753 million.
  • Improving margins. The company recently made a huge organizational change that will significantly improve margins. The company is laying up to 4% of its total workforce of 8,000 people. “These reductions will come from the Company’s general and administrative employees, and will not affect the Company’s workforce of over 7,000 employees that provide direct contract services to the Company’s customers.” I estimate this could boost earnings by $1/share.
  • Spin-off benefits: improving margins, opportunity to tap previously constrained markets.
  • Afghan and Iraq drawdown largely complete in 2012.
  • Huge insider buying by hedge fund: Abrams Capital Management. 
  • Cheap on valuation metrics even when compared to others in industry.
Conclusion
 
 I am taking a wait and see approach on this stock. In the near term, I do not see a catalysts to move the stock price higher. However, there could be an opportunity to enter this stock once fiscal 2012 is complete. By then, the Afghan/Iraq drawdown will be complete, the Presidential race will be decided, and the organizational restructuring will be complete. 
 
If revenues stabilize around $1.5 billion, the company will easily be able to achieve operating margins of over 10%, which will result in earnings of over $5/share. 
 
Disclosure: I do not own EGL.
 

ADT Post-Spinoff

Last week, Keith Meister of Corvex Management LP reported a 5.02% stake in the recently spun-off subsidiary of Tyco (TYC), ADT (ADT). Meister and George Soros are urging management to lever up the company on cheap debt and return the proceeds back to shareholders in the form of dividends or share buybacks. Investors quickly sent the stock price up from $38 to $41 and change. 

I went through Corvex’s presentation. Here are there major points.

Steady State Free Cash Flow

ADT has FCF of around $500 million. However, Corvex argues that this is an understatement because it includes money spent on customer growth acquisitions. The company routinely spends almost $500 million a year buying “dealer generated customer accounts.” It contends that “investors have gotten comfortable valuing REITs and other capital intensive industries on the basis of free cash flow after maintenance capex and then applying a multiple based on growth opportunities and return on investment.” It should do the same with ADT.

Corvex makes steady state free cash flow calculation for fiscal year 2013. The estimates are based on assumptions that EBITDA and average revenue per user (ARPU) grow at historical rates. It estimates that based on $1,707 million EBITDA, ADT would only need to spend $683 million to maintain customer revenue. Thus, their steady free cash flow estimation for 2013 would be around $1 billion. At the current market capitalization of almost $10 billon. The company trades at a price/FCF ratio of 10. 

Their calculations make sense, but there are some caveats that investors should know of:

  • The calculation assumes that EBITDA and ARPU will grow in FY 2013. It has grown historically in the past and there is no reason it won’t do so in the future.
  • The calculation is based on constant revenue not constant number of customers. Based on their calculation, customers would actually go down year after year, but ARPU would go up year after year making up the lost revenue.
  • There is no guarantee that other investors are going to value the company this way just because other industries are valued this way.
  • The real FCF will still be around $500 million for fiscal year 2012. ADT is not going to spend less to acquire less dealer generated customers.
Capital Structure
 
Corvex believes that ADT is under leveraged. See Figure 1 below.
 
ADT Leverage Comparison
Figure 1: ADT Leverage Comparison (Source: Corvex Management)

Corvex wants ADT to increase their Debt/EBITDA ratio to around 3 from 1.4 and keep it that way. If it did that, it should be able to borrow more than $2.5 billion, which could be used to:

  • Return money to shareholders through dividends or stock buybacks.
  • Grow through customer acquisition or M&A.
Based on the low interest rates, the cost for the debt would be ~2-4% (after-tax). See figure 2 below.
 
Improve ADT Capital StructureFigure 2: ADT Leverage Comparison (Source: Corvex Management) 
 
If they do a huge buyback, it will significantly lower price/steady state FCF.
 
Other considerations
 
Corvex also mentions other ADT advantages:
  • Expect low tax rates for the coming years. ADT expects to have $1.0 billion to $1.2 billion federal tax loss carry forward at time of separation.
  • Strong business model with recurring revenue.
  • Under-appreciated secular growth tailwinds.

Conclusion

If ADT increases leverage and uses it to buy shares, Corvex believes the price of ADT could go considerably up. Their base case valuation is $55/share and upside case is $63/share based on a debt/EBITDA ratio of 3 and 3.5 respectively. 

I will sit on the sideline for this investment because:

  • Although, management is in talks with Corvex, there is no guarantee they are going to do anything.
  • The stock price has almost gone up almost 10% since the announcement and this will have an effect on the buyback price.
  • The value case is just not compelling enough. The value case is based on adding more debt to take advantage of the low interest rates. A lot of companies could do this to increase shareholder value.
  • ADT is not cheap enough for the buybacks to have a substantial effect. What happens when the cost of funding goes up in the future?
Check out the full Corvex presentation here.
 
Disclosure: I do not own ADT

Murphy Oil Spin-Off

Murphy Oil LogoA couple weeks back, Murphy Oil announced it will spin-off its retail gasoline business, pay a special dividend and buy back shares. The news came after hedge fund manager Dan Loeb, of Third Point, amassed a significant stake in Murphy Oil and urged Murphy to spin-off its retail business. Here is Third Point’s case:

“Murphy Oil is a ~$10.4 billion energy company with three primary business segments: Exploration and Production; Refining, which it is in the process of exiting; and Retail and Marketing. Third Point owns a significant stake in Murphy and recently filed for Hart-Scott-Rodino approval to increase our position should we so desire. If Murphy pursues the steps outlined below, we believe its shares could be worth in excess of $90, an increase of about 60% from current levels.

We initiated our investment following a 3-year period in which Murphy’s share price declined by ~15% while the SPDR S&P Oil and Gas E&P Index appreciated by ~49%. We believe this lagging performance can be explained partially by Murphy’s disparate asset base, which makes the company complex and cumbersome to value. This issue has been exacerbated by management’s decision to repeatedly delay spinning off its retail business. Investors in Murphy have grown frustrated, particularly given the obvious merits of the spin due to the large multiple disparity between the retail business and the core E & P business.

We believe Murphy can take four easy steps to unlock the latent value in its lagging shares, and we have shared these proposals with Murphy’s management team previously:

1) Spin-Off Its Retail Business: Murphy’s retail business consists of a network of over 1,100 fuel stations, the majority of which are located on or near Wal-Mart store sites. The business generated EBITDA of $363 million in 2011 and has relatively low ongoing capital requirements, making it highly cash generative. On the company’s 2011 Third Quarter earnings call, management indicated they were evaluating a separation of the retail business. After 9 months of consideration, management recently said that they were not interested in pursuing a retail spin at this time on account of the unit’s “underperformance”.

We believe forgoing this accretive spin-off would be a major missed opportunity. Both public company comparables like Alimentation Couche-Tard, Casey’s General Stores, and Susser Holdings and a forecasted dividend yield analysis suggest the retail business would be worth $2.3 – $2.8 billion if separated into a standalone public company. A spin-off in this valuation range would be worth $12 – $14 per share.

At this point, it appears sentimental attachment by management and the Murphy family is driving a stubborn desire to hold onto these and other non-strategic assets, creating a significant drag on enterprise value. While we hope that reason and a desire to create shareholder value will prevail over sentimentality and inaction, we have filed HSR to keep our options open should our discussions with the board and management not bear fruit for Murphy’s owners.

2) Sell Its Canadian Natural Gas Assets: Murphy owns ~145,000 net acres in the Montney play in British Columbia. Investors may recall our description of the Montney opportunity in our Second Quarter 2012 Investor Letter’s discussion of our profitable investment in Progress Energy Resources. Western Canadian gas assets have become strategically valuable given the large arbitrage opportunity between LNG prices in Asia in excess of $15/mmbtu, and $1/mmbtu F&D costs in Western Canada. Encana recently sold 164,000 nearby acres in the Montney to Mitsubishi for C$2.9 billion, or ~C$16,000 per acre (adjusting for the present value of drilling carry). Applying this metric to Murphy’s acreage and attributing ~$4k per flowing mcfe/d for existing production would result in a value of ~$3.0 billion, contributing an additional $15 per share. Management has told investors previously that they would require $4.50 gas in order to resume drilling the asset, which may occur in late 2018 based on the current futures curve and assuming a $0.40 AECO/NYMEX basis differential.

3) Sell Its 5% stake in the Syncrude Oil Sands Project: In April 2010, ConocoPhillips sold its 9% stake in Syncrude for $4.65 billion. In April 2010, WTI crude prices were $84/bbl vs. $92/bbl currently. Assuming a similar purchase price, we believe Murphy’s Syncrude stake would be worth $2.6 billion, or an additional $13 per share.

4) Complete UK Refining Business Exit: According to management, this exit is currently tying up about $500 million in working capital.

These four transactions could generate pre-tax proceeds of $8.4 – $8.9 billion. Assuming 20% tax leakage on the two Canadian asset sales, we arrive at $7.3 – $7.8 billion in after-tax proceeds, or roughly $37 – $40 per share. Third Point estimates that the associated EBITDA with the assets sales is $750 million or ~20% of our 2013 EBITDA forecast for Murphy. Based on a current enterprise valuation of $10.4 billion, our analysis suggests investors are paying only $2.6 – 3.1 billion for the balance of Murphy’s assets, which we estimate could generate $2.9 billion in EBITDA in 2013.

This “new”, slimmed-down Murphy has tremendous upside. Based on May 2012 company guidance, new Murphy could grow production at a 14% CAGR from 2012 to 2015, with oil and oil-indexed gas making up over 85% of the production mix. This strong, “oily” growth profile is bolstered by an industry-leading Eagleford shale position, where Murphy has over 220,000 net acres, the majority of which are located in the oil and wet gas windows of Karnes, Dimmitt, McMullen, LaSalle, Atascosa and Webb Counties. Murphy also has a collection of cash-generative Malaysian assets comprised of high-margin oil and oil-linked natural gas production with several development opportunities.

Assuming new Murphy trades at an extremely conservative 3.5x EBITDA multiple, we estimate total value of $91 – $94 per share after these four steps are completed. We hope that management ultimately decides to take up our suggestions, and act on its own to benefit all shareholders. In any event, as mentioned above, HSR approval, once obtained, will provide us maximum flexibility with the position.”

Murphy plans to pay the special dividend of $2.50, or about, December 3, to shareholders of record as of November 16. The dividend is worth $500 million. It also plans to spend $1 billion on buying back shares. At the current market capitalization of almost $12 billion, the company is returning more than 10% to shareholders.

Murphy will spin-off its downstream business, Murphy Oil USA, sometime in 2013 in a tax free transaction.

If anybody has any thoughts on this transaction, feel free to comment. I will have more analysis in the next couple of days. 

Disclosure: I do not own MUR. 

Buy Xerox


Xerox LogoXerox (XRX)
just reported their third quarter results. Due to a challenging macro environment and government budgetary pressures, operating margins decreased 1 percentage to 8.6% and this had a negative impact on profits. Investors were not impressed and sent the stock down 7.8% to $6.48. However, the lower stock price is an opportunity to buy shares at a very cheap level.

Business

Xerox has three business segments that generate almost $23 billion in yearly revenue:

  • ServicesServices has three offerings: Business Process Outsourcing (“BPO”), Information Technology Outsourcing (“ITO”) and Document Outsourcing (“DO”). Services allow customers to run day-to-day business operations. It contributes over 50% of revenue and is the companies revenue growth driver.
  • Technology. Technology “includes the sale of products and supplies, as well as the associated technical service and financing of those products.” It contributes over 40% of revenue, and the company is focused on maintaing revenue while improving margins.
  • Other.The Other segment “primarily includes revenue from paper sales, wide-format systems, and GIS network integration solutions and electronic presentation systems.” It contributes about 6% of revenue is not profitable.

83% of the companies revenue are recurring (“Annuity”). “Annuity includes revenues from services, maintenance, supplies, rentals and financing.” The other 17% come from one time equipment sales. 

Valuation

Bullish case for Xerox:

  • In a challenging year, the company is on traget for $2 to $2.3 billion operating cash flow and $1.5 to $1.8 billion of free cash flow (FCF). The current market capitalization of the company is $8.3 billion. They are trading at around a price/FCF ratio of 5. If they trade at a ratio of 8, there could be 60% upside to the stock.
  • The company is returning money to shareholders. $1 billion will be used to buy back shares in 2012. $300 million be used for dividends. The company has a 2.5% dividend yield.
  • The company can still improve profitability by cutting costs.
  • 83% of revenues are recurring and company is focused on growing the services division which has more of the recurring revenue.
  • The company is targeting 15% earnings growth over the next coming years.

Risks

  • In a very competitive industry. In services division, competition comes from Accenture (ACN), Aon (AON), Computer Sciences Corporation (CSC), Convergys (CVG), Dell (DELL), Genpact (G), Hewlett-Packard (HPQ), IBM (IBM) and Teletech. In technology division, competition comes from Canon (CAJ), Hewlett-Packard (HPQ), Kodak, Konica Minolta, Lexmark (LXK) and Ricoh (RICOY).
  • Revenue and margins are down this year even though the company spent $200 million on acquisitions. This can be partly blamed on the economy. A lot of the aforementioned competitors like IBM have lower revenue, but unlike Xerox they have  been able to make it up by cutting costs. Xerox is not the strongest of the competitors, but in a stable economy they should be able to at least maintain revenue and margins. 
  • $9 billion debt load. However, this debt load should come down to $8 billion by the year end and over $6 billion is backed by finance receivables. 
  • There is no catalysts for a higher stock price. 

David Einhorn

One investor who agrees is David Einhorn of Greenlight Capital. Here are his comments earlier this year. 

“XRX is a document management provider that entered business process outsourcing when it acquired Affiliated Computer Services (ACS) in February 2010. The combination allows XRX to sell more value-added services to its current customers and apply XRX’s technology to deliver ACS’s services more cheaply. This is our second investment in XRX since the acquisition. The first time, we bought with the stock price around $9.35, and sold with a modest gain over concerns about XRX’s Japanese exposure after the earthquake. That issue appeared fully discounted by the market during the fourth quarter when we re-established a position at $7.61 per share, which is less than 8x estimated 2012 earnings. In the first nine months of 2011, XRX signed a significant amount of new multi-year outsourcing services contracts. XRX has been aggressively cutting costs within the legacy ACS organization. Over the long-term, XRX is expecting over 6% revenue growth and 10-15% adjusted EPS growth. XRX expects to spend $1.0-$1.4 billion on share repurchases in 2012, which should make a good dent in the share count given its current equity capitalization of $11 billion. XRX shares ended the year at $7.96 each.”

Since these comments, Greenlight has added to their posistion. As of June 30th, 2012, they held 26 million shares. Greenlight will report their next quarterly holdings in the middle of November. 

Conclusion

Xerox trades at a cheap price/FCF ratio of 5. They should be able to at least maintain that FCF over the coming years. If so, they should trade at least at a price/FCF level of 8. This would mean a 60% upside in the stock price.

Disclosure: I am long XRX

Sears, Genie, and IPOs

Lot of upcoming events and most of them are this week…

Sears

Sears (SHLD) , which owns 95.5% of Sears Canada, will distribute about 44.5% of its interest to its shareholders. The distribution will be made on November 13 to shareholders of record on November 1. For every one share of Sears, investors will receive 0.4283 share of Sears Canada. The current price of Sears Canada is $11. So, investors will receive almost $5/share in distribution. After the distribution, Sears will still maintain 51% ownership in Sears Canada.

Read article on Sears here.

Genie

Genie (GNE) Preferred will start trading tomorrow, Wednesday, October 24th on the NYSE under the symbol GNEPRA. Only 1,604,591 (7.5% of outstanding Class B) shares were validly tendered. It should be interesting to see how these trade.

Read article on Genie here.

Dean, Lehigh

Dean (DF) spin-off, WhiteWave (WWAV) will begin trading this Friday, October 26th. I expect it to price at the high range just because of the interest in the healthy food segment and low float.

Read our full analysis on Dean here

Lehigh Gas Partners LP (LGP) will also start trading this Friday, October 26th.  

Read our full analysis on Lehigh here.

Disclosure: I am long DF.

HypeZero10 up 6.4% last two months

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Since August 15th, it is up 6.4% as compared to 2.8% for the S&P. Check out HypeZero10

Don’t Short Sears Hometown… Yet!

Eddie Lampert of ESL Investments the major holder of SearsSears Holding’s (SHLD) latest spin-off, Sears Hometown and Outlet (SHOS), starts to trade tomorrow. Based on the subscription rights price, it is expected to trade in the high 20s. I originally wrote an article back in September advising investors to stay away from SHOS.

 

However, avoiding does not necessarily mean shorting it. In the short term, SHOS could go higher because:

  • It is profitable.
  • It is cheap by a lot of valuation measures. 
  • It earned $1.80 in the first half of this year. It will trade at less than 10 times this years earnings. A lot of value investors will be fooled by these numbers.
  • There are still 60 company owned stores. Let me explain.
As I mentioned in my original article, SHOS profitability rose due to huge margin improvements. Part of that margin improvement was due to the conversion of company owned stores to franchisee operated stores. The franchisee operated stores have to pay an initial franchisee fee of $25,000 and also have lower occupancy costs.
 
Here is the numbers breakdown for Hometown and Hardware Stores and Home Appliance Showrooms for last 2 quarters:
 
Hometown and Hardware stores and Home Appliance Showrooms
 Figure 1: Number of Hometown and Hardware Stores and Home Appliance Showrooms
 
 The company owned stores went down from 85 to 60 in the last quarter, while the franchisee operated stores went up from 86 to 104. The 941 independently owned and operated stores are all Sears Hometown stores and are not available to be converted to franchisee stores. However, the good news for SHOS is that there are still 60 company owned Hardware Stores and Home Appliance Showrooms which are available to be converted. This will at least keep margins flat in the near term.
 
However, what happens when there are no more stores left to convert? Margins will slide as the negative business fundamentals catch up with the company!
 
My advice is to avoid SHOS in the near term because there are catalysts that will drive the share price higher. However, with every quarterly report watch the number of company owned stores. When it reaches close to 0, think about shorting this stock!
 
Disclosure: I do now own SHLD or SHOS. I am short OSH.

Best Way To Play GM

General MotorsGeneral Motors (GM) is a stock that I am very bullish about. The best way to invest in GM is not the shares, but the warrants that were issued during the creation of the new GM. There are two kinds of warrants, GM Warrant A and GM Warrant B.

 

GM Warrant A

  • Symbol: GM-WTA
  • CUSIP: 37045V118
  • Exercise Price: $10
  • Expiration Date: July 10, 2016
  • Current GM Price: $24.17
  • Current Warrant Price: $15.12
  • Warrant Premium: ~$.95

GM Warrant B

  • Symbol: GM-WTB
  • CUSIP: 37045V126
  • Exercise Price: $18.33
  • Expiration Date: July 10, 2019
  • Current GM Price: $24.17
  • Current Warrant Price: $9.22
  • Warrant Premium: ~$3.38

The exercise price may change if there is a stock dividend or a stock split.

If you are as bullish on GM as I am, the warrants are better way to invest because they give you additional leverage. Obviously, they will go up faster than the shares, but will also go down faster. 

I personally like the GM-WTB because it gives downside protection if GM or the stock market blows up.

Click here to see more information on the warrants.

Disclosure: I own shares of GM and am looking to buy GM warrants.

David Einhorn’s Bullish GM Case Explained

 GM Logo

David Einhorn of Greenlight Capital presented his bullish case for Generate Motors (GM) yesterday. Let’s break down the two major themes of this presentation in more detail.

 

Earnings will increase

GM already trades at a cheap valuation compared to its peers. It trades at over 7 times estimated fiscal 2012 earnings and less than 6 times estimated fiscal 2013 earnings based on yesterday’s closing price of $23.68. Einhorn believes earnings can rise up to $6/share by 2014. 

GM’s earnings will be decided on two factors:

  • How its car models stack up to its competitors.
  • The overall state of the auto industry.

Although, Einhorn called the new Cadillac “outstading”, it is out of our circle of competence to make a judgment on their models.

On the other hand, there are lots of statistics that suggest that the auto industry is in a cyclical upturn. The sagging economy pushed U.S. vehicle sales down to just over 10 million in 2009 from an average of over 17 million from 2000-2006 (See chart below).

Annual U.S. Vehicle SalesFigure 1 U.S. Annual Vehicle Sales (data from Wards Auto)

In 2011, U.S. vehicle sales were around 13 million. This year sales are on target to be over 14 million. If sales reach anywhere near the pre financial crisis of 17 million, GM’s earnings will get a big boost.

Although, U.S. sales are going back up, sales in Europe are plummeting. Revenue in the first 2 quarters of 2012 for General Motors Europe (GME) is down over 20%. This has had a huge impact on overall profitability. According to Einhorn, “it will take time and there will be more losses but GM could expect Europe to break-even within 3 years.” Any type of European recovery will be a big boon to GM.

If the aforementioned things happen, most of the earnings will go straight to the bottom line. At the end of fiscal 2011, GM had over $47 billion of deferred tax assets of which over $21 billion were carryforward tax assets. This means that GM will not pay very much in taxes for a long time.

Earnings could also increase if GM starts buying back the government’s stake with the $33 billion it has in cash and marketable securities.

Pension risks overblown

At the end of fiscal 2011, GM had over $138 billion of pension and other postretirement benefit obligations. The pension and postretirement benefit plans were underfunded by $32.3 billion.

However, GM, with its cash, marketable securities, and abundant cash flow has the means to cover the shortage.

Besides being underfunded, the obligations are scary to investors because their calculations are based on such factors as mortality rates, discount rates and market returns. A slight increase or decrease in any of these rates could increase or decrease the obligations by billions of dollars. For example, a 25 basis point decrease in the discount rate could increase the obligations by $2 billion.

To reduce this risk, GM is getting out of the business of managing pensions. In June of this year, it announced that Prudential would administer and pay $26 billion of the aforementioned obligations. “GM’s anticipated cash contribution to its U.S. salaried pension plans to effect these actions will be in the range of $3.5 to $4.5 billion to help fund the purchase of the group annuity contract and to improve the funded status of the pension plan for active salaried employees.”

GM also ceased the accrual of additional benefits to its U.S salaried pension plans this September.

So, hopefully in a couple of years the pension risks will be mitigated.

Conclusion

David Einhorn’s case for GM makes a lot of sense. We are long GM shares and will look to add to our position. 

If you like this article or any of our articles, please leave a comment or share on any of the social sites below.

Disclosure: I am long GM.