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On May 1st, Bill Simpson wrote an analysis of DynCorp International (DCP). DCP's shares priced at $15 a share on May 3rd for a total raise of $375 million. The text of Simpson's original writeup follows.

DCP is offering 25 million shares at a range of $15- $17. Credit Suisse and Goldman Sachs are lead managing the deal, Bear Stearns co-managing. Post-offering DCP will have 57 million shares outstanding for a market cap mid-range of $912 million. 2/3 of the IPO proceeds will be used to purchase preferred shares, 1/3 will be paid as a dividend to insiders, predominantly Veritas Capital Management.

Pre-IPO DCP has been controlled by Veritas Capital Management, in the form of an entity named DIV Holding. Veritas owns 86% of DIV Holding. In 2/05 DIV Holding acquired DCP for $937 million from Computer Sciences Corporation. As is customary these days, the acquisition was funded by laying hefty debt onto the back DCP. Pre-acquisition DCP had no debt, post-IPO DCP will have $602 million in debt. As near as I can decipher DIV Holding paid roughly $100 million in cash for DCP in 2/05, the rest was leveraged debt.

DCP (Veritas Capital) will be repaying themselves that $100 million on offering as a dividend. They will own 55% of DCP post-offering, which will essentially be free shares for them as they've already recouped their $100 million investment. This has been standard operating procedure with these leveraged buyout IPOs. DCP's balance sheet was clean as a whistle until Veritas Capital saw an opportunity for a quick turnaround. Now debt servicing eats up over 50% of operating profits. DCP is yet another IPO that would be quite attractive were it not for someone else (in this case Veritas Capital) having already gotten there first and taken the best looking fruit.

From the prospectus:

We are a leading provider of specialized mission-critical outsourced technical services to civilian and military government agencies...Our specific global expertise is in law enforcement training and support, security services, base operations, and aviation services and operations.

Main customers are the US Department of State and the US Department of Defense with roughly 50% of annual revenue derived from each. In the past decade the US government has stepped up outsourcing across a wide range of services. That coupled with a burgeoning US defense budget has been the revenue growth driver for DCP. As of 12/05 DCP had over 14,000 employees in 35 countries, 45 active contracts ranging in duration from three to ten years and over 100 task orders.

DCP has 2 main operating divisions, International Technical Services and Field Technical Services. They've their hands in a lot of cookie jars. Following is a brief summary of the different niches DCP engages.

International Technical Services [ITS] - This area includes: 1) Law enforcement training, specifically international police training and immigrant support; 2) Narcotics, specifically foreign crew and pilot training; 3) Contingency Services, including peace-keeping support, humanitarian relief, and de-mining; 4) Logistics including inventory tracking, property and inventory control; 5) Security including diplomat protection, security systems and personal protection; 6) Military Facility, facility management, administration and maintenance; 7) Marine Services, ship logistics and hazard clean-up; 8) Security Technology, biometrics, smartcards, security systems.

Field Technical Services [FTS]
- 1) Aviation services and engineering, including aircraft fleet maintenance, aircraft design specifically cockpit and avionics upgrades; 2) Ground vehicle maintenance, pretty self explanatory; and 3) Range services.

ITS division accounted for 2/3's pf 2005 revenue, FTS 1/3. DCP has a pretty hefty backlog of $2.7 billion. Historically their entire backlog has been converted into revenue. In addition the past 3 years DCP has won 83% of new and/or renewed bid contracts. New contract wins themselves were 70% in FY 2006 (ending 3/06). On re-competing contracts, DCP has a 100% rate past 2 years.

Contracts are usually for a period of 3-10 years with one year guaranteed and multiple annual renewal options at the discretion of the US government. Contracts are reported at a total dollar value assuming all options are exercised. DCP sub-contracts out roughly 10% of their business.

International Civilian Policing accounted for 27% of FY '06 revenues. This has been DCP's revenue driver for a decade and should continue to be same into future. Since the original contract win in 1994, DCP has deployed civilian police officers from the United States to 12 countries to train and offer logistics support to the local police and assist them with infrastructure reconstruction. DCP currently has over 250 civilian police liaison officers in Iraq and Afghanistan.

So we've a pretty large stable operation it appears. One that has its fingers in many different niches of outsourced Department of Defense contracts.

DCP sees their business going forward propelled by:

1 - The transformation of military forces, leading to increases in outsourcing of non-combat functions.

2 - Increased level and frequency of overseas deployment and peace-keeping operations.

3 - Growth in U.S. military budget driven by operations and maintenance spending.

4 - Increased maintenance, overhaul and upgrade needs to support aging military platforms.

Financials

DCP does not expect to pay dividends. Due to the debt, book value will be negative post-offering.

Debt is the story here. As well see just below DCP has a large slowly growing revenue base. Margins are fairly thin as well. When you take a slim margin company that is not ramping revenues appreciably and lay hundreds of million of debt on its back it is bound to destroy net margins. That is what has occurred here. Debt post-offering is roughly $602 million.

Due to the transactions concluding 2/05, revenues are comparable here for just FY 2005 ending 3/05 and FY 2006 ending 3/06. DCP breaks out both years as if the Veritas leveraged buyout happened pre-FY 2005. In addition DCP breaks out numbers for FY '06 as if the IPO had happened before the fiscal year -- These are two things I normally have to break out and model myself, nice that they broke things out for me here.

Revenues for FY '05 were $1.92 billion. Gross margins were 9%, net margins after factoring in debt servicing and depreciation & amortization were a just 1%. Earnings per share for FY '05 were 26 cents a share.

For the just completed FY '06, revenues increased just 2% to $1.956 billion. Revenue was boosted by the growth in International police liaison officers deployed in Iraq and Afghanistan. Growth there was offset by DCP's decision to exit a series of contracts to provide security and protection for a number of US construction projects in Iraq. Appears as if DCP felt the civilian situation on the ground in Iraq was too dangerous for their personnel and they've gotten many of them out.

Gross margins in FY '06 were 10%. Net margins still in the 1% range. Earnings per share were 40-45 cents. At $16 share price DCP will be trading 37 X's trailing earnings.

Let's briefly look at the impact of debt servicing here. Yes depreciation and amortization related directly to the transaction has hurt the bottom line. This is not too much of a concern as it is more an accounting issue than cash flow. Cash flows pro forma in FY '06 were a bit stronger than actual earnings due to that hefty depreciation & amortization number. Pro forma flows for FY '06 (folding out 1 time charges) were approximately 50-55 cents per share. Debt servicing however does harm cash flows here. The margins are simply too slim here for hefty debt payments. Even if depreciation and amortization is completely folded out here, debt servicing still ate up close to 40% of operating earnings. DCP is going to be stuck with this debt for the foreseeable future as it appears they will not be able to pay off via cash flows more than 3%-5% of principal annually.

Looking into FY '07 (ending 3/07) I would expect DCP to show mid to high single digit growth. I don't foresee gross margins altering all that much, although net margins should improve a bit. I would not expect net margins to reach 2% in FY 2007. I believe DCP could earn 55-60 cents on the bottom line in FY '07 with cash flows being 15 cents or so stronger. At a share price of $16, DCP would be trading 26 X's current earnings estimates.

There really is not a good public pure play comparison here. Companies such as Halliburton (NYSE:HAL), ITT, Lockheed Martin (NYSE:LMT), Boeing (NYSE:BA) and Geo Group all have overlapping segments. However all of those also have key revenue drivers in segments not matching up with DCP.

That brings us to the big risk here. DCP would be an attractive offering at this valuation if not for the debt placed here by Veritas et al. The gross and operating margins are just too slim for this hefty amount of debt. DCP saw a stagnant revenue year sequentially in FY '06. If they experience any significant declines, they'll be forced to make significant operating expense cuts to maintain debt servicing. Do I think that is likely? Shorter term no, I do not as I expect a solid high single digit revenue gain in FY '07.

However, we've seen many surprising events the past few years and DCP's slim margins and thick debt servicing payments leave them vulnerable to any negative revenue event. Factor in that they're not coming public at enough of a cash flow discount really to compensate for the debt risk. Without the debt-load I would recommend this offering even with the flat sequential revenue year just ended. I like the backlog and the contract win rate. I like the strong policing contract, a contract that should generate significant future revenues in an unstable world. However the debt pushed up the risk factor here and I've got to pass in range. This is one to keep an eye on and possibly revisit if they're able to push revenue growth into double digits, which would assist them in paying down principle.

Source: DynCorp International IPO: Beware the Debt (DCP)