The Efficient Market Hypothesis ascertains that the price of a stock reflects its intrinsic value at any given time. While I concur that most of the time the market efficiently (correctly) prices equities, there are rare opportunities emerging when market's mood swings are extreme.
In this article, I'd like to bring an example in which the market turned from radical optimism to radical pessimism, allowing us to take advantage of the mood swings.
The company I'd like to discuss is VSE Corporation (VSEC), which provides services and products to the various US government branches. The services are diversified across anything from navy battleship maintenance and overhaul, through USPS inventory management, to various specialized IT services for the Treasury.
The following graph depicts the company's profitability (EPS) and cash earnings multiple assigned by the market over the past business cycle:
As illustrated in the above graph, the market-assigned valuation to VSE may be divided into two periods - marked I & II in the graph and separated by a vertical dotted green line. The earnings multiples assigned earlier in the previous decade reflected the optimism towards defense contractors on defense budget growth following the 9/11 events. In the latter part of the decade, the assigned multiples were dramatically reduced, with the great recession pessimism followed by the budget reductions and the Sequestration. Amazingly, the same company that used to garner multiples in the 25-50 range, dropped to well under 10. All that while the Earnings Per Share remained stable (against a major revenue drop).
In fact, the company's profitability can be nicely correlated to the US defense spending trends:
The graph shows a consistent annual growth that started immediately following the 9/11, ending in 2008 (over a 100% total increase over the period). Then, starting 2011, we've seen a budget reduction all the way through 2013, with an expectation for a minor rise in 2014.
The expected budget rise starting from 2014 is the first path for the company's growth. When an industry grows double-digit year after year for the better part of a decade, the industry participants often prepare through expanding capacity/hiring/etc. Then, when the industry suddenly moves to a halt and then to contraction, the excess capacity causes not only a reduction in revenues, but also of margins. The company had been facing a highly competitive environment in the last 5 years, as companies were competing for a smaller budget. As the budget stops contracting and possibly starts expanding, the downtrend would hopefully come to an end.
Additionally, the company has been actively sizing its operations and diversifying its business to accommodate the new reality. Besides downsizing 15% of the headcount, it had dramatically diversified its revenue. In 2005, 90% of the revenue came from military services (DOD), against 80% in 2008, 56% in 2012, and only 45% in Q3 of 2013. As a matter of fact, its largest customer presently is the USPS, with a self-funding contract that is not dependent on an outside budget and which has been displaying annual growth in its activity level.
Following discussions with management, I believe that the business diversification would continue both organically and through acquisitions.
The latest acquisition took place in mid-2011. The acquired company, WBI, is the USPS service provider that was discussed above. It was acquired for $180M, which was raised through low-cost debt. Since the acquisition, the company paid down over a $100M of its debt, and with the current level of cash generation, the debt will be fully repaid in two to three years. The acquired company earns $30M pre-tax, which can demonstrate the attractive multiple it was acquired for (especially when considering the segment's growth).
Management confirmed that they intend to reduce the debt to a lower level and then try to execute an acquisition, but only if one can be made at 6-7 times pre-tax earnings. Last time they turned to an acquisition was when debt level reached $20M, so with the debt at around a $100M, we are definitely getting closer to the point where management feels comfortable with the level of debt.
The company has earned $24M over the past 12 months. The earnings were burdened with two expenses, which I believe could be added back for a total of $16M. The first expense is the goodwill amortization (part of the acquisition accounting) for a total of $10M, and the second would be the $6M difference between the Depreciation and the Capital Expenditure. Normally, I do consider Depreciation to be a real expense, and hence, would use it to evaluate the true earnings power. However, the depreciation has been unduly high as the company left its 40-year old office building for a new one which it heavily invested in, and does not expect to repeat such an expense over the coming decade or two. This puts us at $40M of earnings power.
Hence, right off the bat, at current share price, the company is trading for 6 times earnings, which is both a low absolute multiple as well as low when compared against peers or against the S&P 500 (SPY).
Additionally, within three years the company will become debt-free, and so if we add back the $6M of interest expense that would free up, we would get to $44M of net income, or a PE of just under 5.5.
As discussed above, the company has several paths for growth - increase in government spending, and improved competitive landscape (from the smaller number of participants due to the M&A activity of recent years). Additional and major source for growth would be an acquisition. If we take the acquisition path as an example, we can assume a similar acquisition to the last one, which added $30M of pre-tax earnings. Debt would be re-introduced to the balance sheet and consequently higher interest expense, but after adding the $30M of pre-tax income and deducting the interest expense from the newly-taken debt at prevailing interest rates, we would be left with $60M in net earnings, which would put current valuation at 4 times earnings.
Another valuation metric could be its value for a private owner. In a recent transaction, Engility Holdings (EGL) acquired Dynamics Research Corporation (DRCO), a company in adjacent verticals (though admittedly not overlapping). The acquired company had minimal profits, so the best comparison would be of sales. The price paid reflected EV/Sales of 0.74, and a similar valuation would put VSE's stock price at $70 PS, or over 50% upside. I believe it to be an extremely conservative valuation, as DRC had shrinking earnings and was highly indebted (same level of debt as VSE, with roughly a sixth the operating earnings - putting it under liquidity risks). Additionally, if the debt is repaid within three years, the same 0.74 EV/Sales ratio would imply an $87 PS of VSE, or 90% of upside.
To summarize, the company boasts an ROE of 15% for over two decades and is trading at anywhere between 4 and 5.5 times near future earnings (4 times earnings in case of acquisition, 5.5 times earnings if EPS stagnates and it just repays debt). Current valuation should give us at least a double from here (remember that in good times market assigned 20-50 times earnings multiples).
The risks we are seeing are:
1) A huge contract with the USPS, which is in a well-known dire financial position. The contract goes to the core of the USPS operation, so as long as the USPS is in operational mode, the service needs to be rendered.
2) Continual decline in the competitive landscape and an additional decrease of the federal budget. It is important to remember that the company has debt to repay over the coming years, so strong cash flow would be of essence.
The reason I feel comfortable with the risk is that the USPS contract of $30M of annual pre-tax earnings would be enough to service the debt and repay most of it on its amortized schedule, even if the rest of the business continues to deteriorate.
Additionally, while we believe that revenues and margins would continue to deteriorate in the short term, we can't imagine the government not raising its spending level at some point in order to maintain services at a reasonable level.
Having said that, it is important to understand that the change in the industry will not happen overnight, and it will require patience, as most likely margins would still be under pressure for some time.
Liron Manor and his partners at Capra Capital own shares of VSE Corp.