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Investors in Engility Holdings (EGL) applaud the proposed acquisition of Dynamic Research in a deal which will boost annual revenues by a fifth. After year's of declining revenues, the company is buying growth. The deal looks solid on a strategic nature and expected accretion results in enthusiasm among investors.

Despite strong returns so far this year, shares still offer some appeal given the solid profits of the firm despite operational struggles.

The Deal

Engility Holdings announced that it has entered into a definitive agreement to acquire Dynamic Research Company (DRCO) for $11.50 per share.

The deal values the US government services firm at around $120 million. Including the assumption of debt, the price tag will come close to $200 million. The information technology and management consulting company has leading capabilities in Healthcare, Homeland Security, R&D, Intelligence and Defense Readiness operations, among others.

The company has been founded back in 1955 and the company has over 300 active contracts with the government. With over 1,100 employees the company is a prime contractor on 80% of the work being performed.

Engility expects that the deal will be accretive to earnings in 2014 and significantly accretive to earnings in 2015 and further beyond.

CEO Tony Smeraglinolo commented on the rationale behind the deal, "This acquisition is consistent with our strategy to expand and diversify our services offerings and presence with adjacent customers. It positionsEngility within new higher-end markets, supporting enduring customer priority missions, and provides access to key prime contract vehicles."

Revenues for 2013 are seen between $274-$277 million as adjusted EBITDA is seen between $24.3 and $24.7 million.

The deal has been unanimously approved by the board of directors of both companies. Subject to normal closing conditions and regulatory approval, the deal is expected to close in the first quarter of 2014.

Valuation

Back in November, Engility released its third quarter results. The company ended the quarter with $24.3 million in cash and equivalents. Total debt stands at $230 million for a net cash position of little over $205 million.

The firm has found Bank of America/Merrill Lynch (BAC) to finance the deal, providing committed financing.

Reported revenues came in at $1.08 billion for the first nine months of the year, down 14.4% on the year before. Part of this decline is explained by the fact that the company no longer records revenues of affiliated parties, totaling a $100 million in the comparable period last year.

The company posted a $391.3 million loss so far this year on the back of a $426.5 million goodwill impairment charge. Adjusting for this, annual revenues are seen around $1.4 billion as adjusted earnings are seen around $50 million.

Trading around $33 per share, the market values Engility at $570 million. This values the equity in the firm at 0.4 times annual revenues and 11-12 times annual earning.

The firm does not pay a dividend at the moment

Some Historical Perspective

Back in July of 2012, shares of Engility were spun off from L-3 Communications (LLL). Shares commenced trading around $17 per share, but after solid year to date returns of 72% in 2013, are currently trading at $33 per share. This means that shares have roughly doubled in just 18 months time.

Engility is a real value play. Reported revenues declined by a cumulative 38% to $1.65 billion between 2009 and 2012. Earnings have been volatile at best after the company reported a large loss so far this year on impairment charges. Despite these challenges, the company has been posting solid quarterly profits of $10-$15 million per quarter so far this year.

Investment Thesis

Engility's exposure, or better focus on the US government hurts as spending cuts are reducing the budget and amount of work available for the business.

Despite the significant revenue declines in recent years, the 12-month trailing book-to-bill ratio came in at just 0.9, suggesting further pressure on future revenues. As such the $1.4 billion revenue outlook for 2013, implies revenues are close to being cut in half compared to 2009.

The deal with Dynamic Research will add some 20% to total revenues, as Dynamic's revenues have fared better in recent years, but are on the decline as well. What is comforting is the flexibility, knowing that Engility is still being able to report earnings to the tune of $2.96-$3.06 per share, or around $50 million this year.

The company is taking other steps as well, including debt refinancing and a restructuring of the business to reduce costs. Just two weeks ago the company announced a reduction of overhead costs by combining the engineering and program management service into a new business group.

The deal does make some sense on a strategic basis. It gives the company an opportunity in the new "high priority" markets, while diversifying government service offerings. Furthermore accretion is expected, possible on the back of high synergies.

The deal tag at 0.4 times annual revenues is inline with the company's own valuation in terms of equity. The adjusted EBITDA multiple of about 4.9 times represents a small premium compared to Engility's own valuation at 4.4 times annual EBITDA. Note that Dynamic Research operates with a little bit more debt on a relative basis.

Shares have had a good year, and it is easy to see why. Based on the multiples earlier this year, shares have been arguable too cheap following the spin-off. Even after these very solid returns this year, shares still offer appeal. The reported deal could boost earnings towards $60-$70 million per annum which looks very attractive at around 9 times earnings. Note that Engility expects significant accretion resulting from the deal going forward.

While the business is still in decline, with further pain expected seeing from the book-to-bill ratio's, the situation will have to stabilize one day and the cost flexibility is impressive.

I remain cautiously optimistic about this "unknown" contractor, keeping it on my radar for the coming period.

Source: Engility - Growth Ahead Following Acquisition Of Dynamic Research