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Summary

  • KEYW is dangerously close to breaching debt covenants and will likely sell stock to fund its nascent cyber security business.
  • Despite reporting robust bookings the government services business is declining and more red flags remain.
  • We believe there is over 60% downside in the stock if a reasonable valuation is applied.

We believe KEYW Holding (NASDAQ:KEYW) has been viewed as a relatively safe way to play the rapid growth in cyber security with its government business providing both funding for its Hexis project as well as a valuation floor for the stock. We believe this has changed as the fundamentals of the government business have deteriorated while the spend for Hexis has ramped leaving the company dangerously close to breaching even its recently loosened debt covenants. KEYW Holding is looking much more like a third-tier government contractor that is spending to chase a dream that has been realized by so few small government contractors: Successfully enter the commercial market. The company is chasing this dream on a shoestring budget compared to the resource rich companies that are growing rapidly in the markets KEYW is trying to enter. Rather than being cash rich and well funded, KEYW has $85.25 million in debt and $64,000 in cash as of their latest reported balance sheet. With declining EBITDA, we believe the company will have difficulty remaining within its debt covenants without either an equity issuance or a drastic cut in Hexis spending. We don't expect management to fire all the people they just hired at Hexis, but rather to utilize the S-3 that was filed recently to raise money through a stock sale. With that expectation we look at the downside protection in the stock price and take a hard look at what is a reasonably valued KEYW share price and come to the conclusion of under $4.00, down over 60% from yesterday's closing price of $10.95.

Examining the debt

KEYW Holding amended its debt covenants in mid-March to provide more room with the leverage ratio. The company increased the allowed leverage ratio to 4x EBITDA for the March quarter with a stair step down of 25 basis points for the next few quarters and then back to an ongoing leverage ratio of 3x (which is where it was before the amendment). It's worth noting the company would have violated its previous leverage ratio covenant if it had not received the amendment in mid-March. For the June quarter, the required leverage ratio is 3.75x. The company had $85.25 million of total debt at the end of March, which means they will need roughly $22.75 million of trailing twelve month EBITDA through the June quarter to remain in compliance if the debt level remains the same. (We think debt will creep up some but we will assume it is flat for this analysis). KEYW's adjusted EBITDA for Q3 '13, Q4 '13 and Q1 '14 totals approximately $17 million, which leaves $5.75 million needed in the June quarter to remain within the new covenants. We view this as highly unlikely given the $2.4 million of EBITDA in Q1 and management's loose and confusing guidance (we address this later) implies Q2 to be slightly up. This could leave an EBITDA shortfall of nearly $3.5 million. Without a significant improvement in the business during the second half this shortfall only continues to grow. If KEYW remains on a $10M annual EBITDA run rate, we project the company will exit 2014 with a leverage ratio of over 9x EBITDA. Their bank may give them waivers if they do violate covenants, but EBITDA generation will need to improve or their creditors may begin to lose patience.

KEYW's overall balance sheet provides little comfort or downside protection. At the end of Q1 the company had net working capital of only $12.9 million. If Q2 EBITDA is similar to Q1 we expect the company to burn over $4 million when considering interest payments, debt principal payments, a legal settlement payment and capital expenditures similar to Q1. The company has a tangible book value of NEGATIVE $0.66 per share.

The government business is struggling

In Q1, KEYW reported government revenues down 19% versus Q1 of last year. Management blames the decline on sequestration and inclement weather during the quarter, but made comments on their conference call that indicated money is starting to flow again. Then, the new CFO guided that the government business would be slightly up in Q2, which we estimate would still be a 15% decline versus last year. Somehow there is not much correlation between the positive comments about money flowing again and the CFO's guidance. Management claims that the company missed out on $4MM in revenue during Q1 due to inclement weather so one would think that it should be to at least generate a $4MM sequential revenue increase in Q2. When questioned about this on the conference call a fairly odd exchange happened where the CEO, Len Moodispaw, implied they were low-balling the number so analysts didn't get carried away with their projections. The VP of Corporate Communications then steps in to reiterate the guidance the CFO gave of flat to slightly up. Moodispaw then finally states that he thinks they will be up double digits sequentially. Probably one of the strangest things we have heard on a conference call:

Phil Calamia - KEYW Holding Corp. - CFO

We expect Q2 revenue from our Government Solutions segment to be slightly up sequentially and both gross margin and adjusted EBITDA margin to be consistent with Q1.

Brian Kinstlinger - Sidoti & Company - Analyst

Got it. Great. And then on the government side, you said the first quarter was hurt by the weather which meant less billable hours or days, however you want to look at it. And I guess I'm wondering -- then you mentioned the second quarter is a slight sequential uptick. But with the more billable hours and 150 open positions, why is that just a modest sequential uptick (inaudible) so depressed.

Len Moodispaw - KEYW Holding Corp. - Chairman & CEO

Len here, Brian. Because if I said more than that, you'd go crazy with projections. So we expect it to be a nice increase, but by saying slight, we're trying to tamper your expectations.

Brian Kinstlinger - Sidoti & Company - Analyst

Instead of worrying about my projections, maybe tell us what you think slight -- maybe quantify slight.

Len Moodispaw - KEYW Holding Corp. - Chairman & CEO

You're a persistent guy, you know that?

Chris Donaghey - KEYW Holding Corp. - VP of Corporate Development and Communications

Yes, I think that we're going to stick to slight. While we're impacted by the weather in the first quarter, there's a finite amount of work that can be done. And as to the hiring, while we're certainly glad and fortunate to have the ability to fill these positions, we do have to get after and fill them.

Len Moodispaw - KEYW Holding Corp. - Chairman & CEO

Brian, it's Len again. Could I be a little more helpful and say you could think about the government growth as double digit. Does that help you any?

We will see in August who is right, but given the recent track record we will place our bet on the CFO's guidance. While this is strange, we are more troubled by the lack of correlation between bookings and revenue over the past year. In five out of the last six quarters KEYW has reported a book to bill above 1.0, sometimes significantly above 1.0 (1.7 in Q4 '12 and 1.6 in Q4 '13) and the only quarter below 1.0 came in at .98. Despite this the company saw its revenue decline 18% in Q1. When we look through the company's most recent 10-K it appears the correlation problem is due to aggressive bookings/backlog policies. KEYW reported backlog at the end of 2012 of $492 million and $509 million at the end of 2013. During 2013 the company reported bookings of $358 million and revenue of $298 million. Simple math would say backlog at the end of the 2013 should be $492 million (beginning backlog) + $358 million (new bookings) - $298 million (revenue) = $552 million (ending backlog). But ending backlog was $509 million or $43 million less than expected. We assume this is due to cancellations. We think this is especially worth noting since management recently shifted focus in the Hexis business from revenue to bookings as a way to measure success.

What is happening at Flight Landata (FLD)?

During its analyst day presentation in March KEYW management stated that all of its FLD planes had been taken out of Afghanistan, which was somewhat of a surprise. The planes are now in the US and are being fitted with other sensor technologies. The company is hopeful they will be redeployed later this year, but the timing is unclear. The program is funded through March of 2015, but again, it is unclear to us what level of guaranteed payment KEYW receives if the planes are not deployed. We believe this also clearly raises the risk that Buckeye may not become a program of record and may not remain the highly profitable business it has been over the past two years. We estimate FLD has been generating approximately $19M of EBITDA per year, which makes the business critical to KEYW. To put this in perspective, the government business generated $38M of EBITDA in 2013. Without FLD we estimate it would have generated $19M. At this level, even without the drag of Hexis, KEYW would be levered at 4.7x EBITDA. This is a full turn above their recently renegotiated leverage covenant with RBC. While disappointment in the progress of Hexis may pose a significant risk to the stock valuation, we believe the uncertainty at FLD poses the most significant risk to the financial viability of KEYW and should be watched closely.

What is the appropriate valuation?

In our previous article, we examined the value of the business excluding Hawkeye G. In our valuation, we assigned high "take-out" multiples to each of the company's business to reach this valuation. Now, when examining downside protection we must take a more realistic view of the company's business. We will use trailing EBITDA for some of the businesses even though the business trends have been weakening. For the government business we split it between FLD and non-FLD. We view this as more appropriate than ever given the uncertainty around the Buckeye program with all of KEYW's planes now out of Afghanistan. FY '13 EBITDA for the government business was $38 million. We estimate that half of that is from FLD, leaving $19 million for the other business. In our last article, we valued the remainder at 13x EBITDA based on a takeout. Since that time the environment has started changing and we are also looking at a trading multiple, which should be at least a 30% discount to a buyout. For a little to no growth government services business we think 8x is very fair and maybe a little high (e.g. MANT, which has successfully competed head-to-head with KEYW for government contracts, trades at < 7x trailing EBITDA). We previously valued FLD at $50 million, which was a 67% premium to what KEYW paid a few years ago. Now that the planes are out of Afghanistan and the future is much less certain we are trimming that valuation to $40 million. Sensage, which has actually shrunk since KEYW purchased it, we now value at the purchase price of $24 million. Now to Hawkeye G. Management has set a goal of $30 million of bookings for Hexis this year. We think at least $10 million is Sensage. That leaves up to $20 million for Hawkeye G. This is the call option that we usually like to get for free when we buy a stock, but we will attempt a valuation. $20 million of bookings likely translates to about $7M of annual revenue if customers opt for a three-year payment plan or subscription. Most of these will be booked in the second half so let's look to 2015 and assume 50% bookings growth in 2015 ($30 million of bookings). That would be an additional $10 million in annual revenue but the company would get about half of that in 2015 if bookings were linear. That gives us a total of $12 million in revenue for Hawkeye G in 2015. A rapidly compressing comparable multiple environment makes it a little harder to determine an appropriate multiple, but we are using 5x, which is FEYE's current 2015 revenue multiple. This gives us a valuation of $60 million for Hawkeye G, but viewed as a call option, we (and most people) want to buy the stocks where we get this for free or very discounted. At a 50% discount we would pay $30 million for the call option of Hawkeye G. Adding all this together we get a share price for KEYW of $3.89. Again, this is a discount to what we view as a buyout valuation we presented previously.

KEYW Valuation

Current Valuation

Share Price

$ 10.95

Shares Outstanding **

41,330

Market Cap

452,564

Net Debt

85,250

Total Enterprise Value

537,814

Our Fair Value Estimate

Sum of the parts

Government Business

152,000

Flight Landata

40,000

Sensage

24,000

Hawkeye G

30,000

Implied Enterprise Value

246,000

Less Debt

85,250

Implied Market Cap

160,750

Per Share Valuation

$ 3.89

Potential Downside

-64.5%

** Shares Outstanding is our fully diluted estimate using Treasury Method

Now to watch the Wall Street machine at work

We expect to see a stock offering from KEYW shortly after their S-3 becomes effective. Not that it matters that much, but our guess is that RBC will lead the offering. RBC is the lead bank in the lending group for KEYW, but also has an analyst that rates the stock a "Buy." We can't help but wonder if the commercial bank has been extra flexible with KEYW with the prospect of a nice investment banking fee hanging in the balance. We will be interested to see the demand from investors given the recent lackluster performance of many secondaries. Rubicon (NASDAQ:RBCN) is down 42%, Veeva (NYSE:VEEV) down 28%, and Plug Power (NASDAQ:PLUG) down 29%, just to name a few. We are measuring these declines from the deal price, which was at a discount to where the stocks were trading the day the offerings were priced. FireEye (NASDAQ:FEYE) sold stock recently at $82.50. This turned out to be a great deal for the company and the selling shareholders with the stock promptly dropping to $26 after the deal. A decline of 70%. While this deal was bad for the buyers it was also bad for KEYW. FEYE now has nearly $600 million of cash and is ramping expenses, which only increases competition. If KEYW raises $50 million in an equity offering they will still have $35 million of net debt and a small fraction of the resources to spend on R&D and Marketing compared to FEYE, Cisco (NASDAQ:CSCO), Palo Alto Networks (NYSE:PANW), etc. We continue to believe KEYW's commercial aspirations are long shot.

Additional Disclosure: The fund I manage continues to have a short position in KEYW.

Source: Risks Continue To Outweigh The Potential Reward In KEYW Holding