NCI Is An Undervalued Defense Contractor With Multiple Catalysts

| About: NCI, Inc. (NCIT)
This article is now exclusive for PRO subscribers.

Key takeaways

  • NCI (NASDAQ:NCIT) trades at a low single-digit EBITDA multiple due to fears of lower defense spending.
  • However, these fears are unwarranted given its focus on niche and high priority programs.
  • Strong cash flow and a lower debt load allow NCIT to survive the current challenging environment while a "hidden value" in the form of its fast growing healthcare division provides the potential for significant value extraction.

Company overview

NCIT provides enterprise services and solutions to defense, intelligence, healthcare and civilian government agencies. NCIT operates in more than 100 locations globally and generates a majority of its revenue from contracts with the U.S. federal government.

The eight core service offerings are below:

Source: Company website

Lack of differentiation between defense contractors creates opportunity

The market is applying a blanket valuation discount to all defense contractors (see Valuation section below) due to fears of lower government spending, especially in light of sequestration and the recent shutdown and near default on government debt. However, current and expected cuts will not affect all government programs (especially defense) equally.

Despite what some may think, the DoD doesn't have an unlimited budget. Going forward, spending growth will be even more restrained due to the increasing pressure to reduce spending across all levels of government. The result is a reallocation of resources away from marginal programs to those most "in demand".

NCIT should benefit from the change in how wars are fought as well as the growing number of global threats. For example, in January 2012 the DoD cited intelligence, surveillance/reconnaissance and cybersecurity as priorities in its ten-year strategic guidance.

The war on terror will continue even after the troop withdrawal from Afghanistan and the U.S. will, for all intents and purposes, always be "at war" even if war is not officially declared by Congress. The lack of a major domestic terrorist attack since 9/11 does not mean there is no risk. Rather it means the men and women serving in the defense and intelligence communities have done an outstanding job protecting the country (and world) by responding to these risks, many of which don't make the front page.

The critical nature of the services provided by NCIT effectively shields them from sequestration related cuts. For example, on the most recent conference call management said that its work "supports customer missions" and is "work that needs to be done to keep the lights on".

NCIT helps its defense customers meet two objectives, which should only grow in importance in the coming years given the focus on cost cutting and the ability to quickly respond to global threats. For example, NCIT has long experience in reducing diminishing manufacturing sources and material shortages (DMSMS) and recently was part of a team that received a multiple-year contract from the U.S. Air Force to provide logistics and engineering support services (e.g. improved supply chain management, asset readiness, lower cost of ownership for weapons systems).

NCIT is at the intersection of multiple secular trends (not just in the defense world) of reducing energy demand, centrally managed technology infrastructure and fighting an increased number of security threats.

NCIT is the systems integration contractor for the Fort Huachuca project, which will provide infrastructure modernization for the U.S. Army using gigabit passive optical network (GPON) technology. This technology was originally used to deliver bundled services (e.g. phone, internet, video) to the consumer market and is now being used to replace existing copper wire with fiber-optic cabling and network switches with GPON solutions.

There are four key benefits. First, there are lower personnel requirements, which provides significant labor savings. Second, the equipment footprint is smaller than a switch-based inventory, which results in reduced space requirements (up to 90% less) and reduced energy consumption* (up to 80% less). Third, the expected life cycle of 8-10 years is double the current copper life cycle. Fourth (and extremely important for classified operations), security is increased given that services can be remotely monitored as well as the fact that fibers are less vulnerable to tampering.

This program (and those like it) provide the DoD with "low hanging fruit" in terms of spending cuts. For example, deploying a more efficient IT system that saves energy and money while increasing security doesn't hurt anyone (other than the companies providing the inefficient solution) the way reduced spending for those forward deployed (e.g. body armor) or cuts to the VA would.

Moreover, there is a significant valuation disparity given that many IT services companies receive much higher multiples even though they provide similar services but to corporate America.

*The military in general is starting to reduce its energy consumption not just to "be green" (which is not the primary concern for obvious reasons) but to save lives.

Consistent "beat and raise" performance does not translate into higher multiple

Although revenue declined 9% in the mrq due to expiring task orders/contracts and funding shortfalls, it exceeded the guidance midpoint while EPS exceeded the high end of guidance by $0.02. Operating income rose 18% to $3.3 million and the operating margin rose 90 basis points to 4%. NCIT expects to submit more than $1 billion of bids on its ~$9 billion pipeline in the remainder of 2013.

NCIT continues to generate strong cash flow (e.g. ~$26.5 million of ttm FCF), which it is using to significantly reduce its debt load as shown in the chart below.

NCIT has a history of "beating and raising". For example, actual EPS beat estimates by 66% in the last four quarters. NCIT raised the 2013 revenue guidance midpoint from $300 million to $312 million due to new contract wins while the EPS guidance midpoint more than doubled from $0.20 in February to $0.45 currently. Moreover, this guidance includes ~$10 million of sequestration related cuts and does not include the potential for even more award fees that could add another ~$0.05 per share. This "underpromise/overdeliver" approach deserves a higher multiple.

Healthcare division is a hidden asset with the potential for significant value extraction

In April 2011, NCIT completed the acquisition of AdvanceMed from an affiliate of Computer Sciences for $63.3 million. AdvanceMed helps U.S. federal agencies reduce improper payments by fighting fraud, waste and abuse in entitlement programs. This area will only grow in importance. For example, the upcoming budget and debt ceiling fight puts the issue of entitlement spending front and center again. Moreover, there are few ways to cut this spending without committing political suicide. However, there is a bi-partisan commitment to eliminating fraud, waste and abuse.

In addition to AdvanceMed, the healthcare division provides fast growing IT services to the healthcare industry including cybersecurity and HIPPA compliance solutions. This division is being undervalued for three reasons. First, the microcap status effectively limits its visibility (with the notable exception of Seeking Alpha readers and subscribers). Second, the previously mentioned spending cuts leaves investors preoccupied on the defense side of the business, which is doing better than expected. The third point is "hidden in plain sight". For example, although the founder and CEO effectively controls the company through his 100% ownership of Class B shares (and their 10x voting rights), there is an important exception. With respect to a going private transaction, both share classes only have one vote. This means that a financial or strategic acquirer (see Valuation section below) could buy the company and spin off or sell the healthcare division and significantly reduce the effective cost for the defense side of the business.

High insider ownership, institutional support and a shrinking share count

Insiders own 41% of the total shares outstanding while two institutional holders (Fidelity and Invesco) own ~23% of the Class A shares.

Since 3Q11, NCIT repurchased 916,717 shares or ~10% of the outstanding Class A shares (after accounting for the conversion of 500,000 Class B shares in 2011). Furthermore, NCIT reduced future compensation expense by repurchasing outstanding out of the money options.

Valuation

As previously mentioned, the industry as a whole and especially NCIT trades at a low multiple over fears of spending cuts as shown in the charts below.

Six3 acquisition highlights valuation disparity

The below chart builds on the excellent research by Aronson Capital Partners on the recent $820 million acquisition of Six3 Systems by CACI International.

Risks

NCIT expects revenue to decline this year due to the expiration of task orders/contracts as well as the reduction in scope of certain contracts and lost contract recompetes. However management said that revenue declines for 3Q13 and 4Q13 will be less than suggested in previous guidance and that it is relatively well funded for the rest of the year.

NCIT is dependent on the federal government (and Congress to authorize the appropriations) for substantially all of its revenue.

NCIT faces intense competition from mid-tier contractors with specialized capabilities and large defense and IT services providers. Furthermore, the increasing use of low-price, technically acceptable, indefinite delivery/indefinite quantity and multiple-award contracts has resulted in increased pricing pressure.

NCIT may not realize its full backlog, especially the unfunded portion.

The industry is facing increasing procurement delays and the possibility of major program cancellations.

Conclusion

The target price of $7.27 is based on a 5x EBITDA multiple.

The pullback to the 200 DMA provides a low-risk entry point and an excellent place for a stop loss. The time frame is 12-24 months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.