I hate seeing innocent investors lose money on disastrous investments, so I've made it my mission to unclog America's stock markets - I am, if you will, the plunger for blockages in the stock market. Keyw Corp. (NASDAQ:KEYW) is a particularly large blockage as the company has destroyed a huge amount of capital and put itself into an impossible corner which investors clearly don't understand. KEYW's only options now appear to be bankruptcy or attempt to immediately dilute shareholders by 35-40%+.
This Part 1 of my 3 part series, uncovers the following reality about KEYW:
1. KEYW's looming covenant violations and high probability of bankruptcy. I walk you through the unforgiving math below.
2. KEYW's backlog accounting presents a headline number that appears massively overstated.
3. KEYW is NOT a high-margin cyber-security software company: investors have been misled by promotional research from underwriters who earn huge investment banking fees from KEYW.
4. KEYW's true business is low-margin government contracting and based on true peer comparable valuations, KEYW's fair value is $3.80 -- if the company can avoid bankruptcy.
5. How KEYW got itself into this impossible mess.
1. KEYW Bankruptcy and Covenant Violations:
On a quarterly basis, KEYW has already violated its recently relaxed debt covenants and is teetering on the edge of a trailing 12-month covenant violation. Without an immediate, massively dilutive equity raise, KEYW faces imminent bankruptcy risk.
How did KEYW get here? KEYW is a failing rollup of disparate, apparently unintegrated assets, acquired at very high valuations that used a lot of debt. The vast majority of KEYW revenue is contract based, with the US government, and now faces formidable revenue and cash flow headwinds as the government curtails spending and contracts roll off.
KEYW's business is now in rapid decline and appears to be getting worse. In Q4 2013 KEYW total revenue declined -7% yoy. Then, even though he was nearly halfway through Q1 already, KEYW CEO Len Moodispaw forecasted a "robust year" though it should have been obvious by then that the government business was rolling over. Just weeks later, Len announced horrendous Q1 2014 results, with KEYW's government business rapidly deteriorating as revenue declined -19% year-over-year (yoy).
On the recent Q1 2014 call, KEYW said the business should stabilize sequentially (quarter over quarter) - let's put aside management's history of repeated disappointment on winning contracts and rolling out new products and assume the business stabilizes. Even if revenue stabilizes qoq, I estimate KEYW revenue would still decline approximately -20% yoy again in Q2 (see below) and I expect more of the same in Q3.
The single most important issue for KEYW now is its debt covenant structure and leverage. This is despite the fact KEYW just very recently in 3/2014 amended and relaxed some of the terms on their debt.
Let's look at my estimates and the unforgiving math of what happens when a roll-up unravels: There is a lot going on in the chart below but I want to call your attention to the yellow highlighted row where you can see that EBITDA has been declining and is estimated to continue that trend. In the last quarter KEYW's EBITDA declined -64% relative to the same quarter last year.
The simple math is KEYW has too much debt and not enough cash flow (EBITDA). With EBITDA now imploding, there is a very real chance KEYW's lenders foreclose on the company soon, leaving the equity worthless. You can see below, in the yellow highlighted row and red numbers, that based on the numbers above KEYW will violate the recently amended terms of their debt next quarter.
You can also see below in the yellow row with red numbers that KEYW appears to be on the verge of violating the debt terms about earning enough cash flow to service the debt. My estimates also show KEYW appears to be unable to even make their debt payments next year, unless revenue turns around dramatically.
As you can see, KEYW's hands are tied because if they try to draw down on their revolver or take on more debt, these covenant metrics and the excessive leverage immediately gets much worse. As far as I can tell, KEYW's only hope is to immediately sell an enormous amount of dilutive equity at whatever terms they can get (I expect a huge discount from the current price, if it is possible at all).
"Related to the balance sheet, we've always had a strong balance sheet. It's getting better." - KEYW CEO Len Moodispaw 2/6/2014
On 3/13/2014 KEYW had to amend the terms of its debt and relax the covenants. This 8k included backward looking terms to January of 2014.
Was CEO Len Moodispaw in conversations with nervous lenders while he told the public his balance sheet was strong and getting better?
2. Math of Potentially Imminent Equity Raise: KEYW's Only Way Out
The unfortunate bottom line is that KEYW only has three options at this point that I can see, and all of them could crush the stock:
1. Continue on their current path, default on their debt, and go bankrupt.
2. Immediately raise at least $100m of equity, according to my estimate. Either they can pay down debt to a more reasonable ~2X EBITDA level or attempt to buy more growth. By my calculations, KEYW needs to purchase (minimum) $5m in EBITDA per quarter or $20m of annual EBITDA to avoid default. If they buy another government contracting business, this will cost at least 5-6x EBITDA or $100-120m and will have to be funded with equity (I don't believe any lender would lend more debt to a company violating its current debt covenants and KEYW has virtually no hard assets to borrow against anyway). That equity is nearly certain to be sold at a large discount to the current share price, likely with dilutive warrant coverage. This works out to at least 35%+ dilution to current shareholders. This $100-120m in estimated equity KEYW needs aligns "coincidentally" with the $150m shelf offering KEYW recently filed. This doesn't solve the structural issues KEYW faces but it would help the company avoid near-term bankruptcy.
Also note, when KEYW's financials looked much better with less leverage and some growth back in 2012, KEYW seems to have struggled to raise equity and had to go to Europe to generate investor interest. With their business now rapidly deteriorating I doubt they will be able to convince anyone to give them $100m in cash with their awful track record of capital destruction. (See KEYW option 1 above: bankruptcy).
3. If KEYW can't raise equity, their only viable option that I see is to shut down the failing commercial and cyber business completely and immediately. KEYW would then be a pure play government contractor with declining revenue, with a valuation re-rated to peers at ~0.8x EV/ forward revenue (likely in the $250m ballpark by my estimate). Putting KEYW's market cap at ~$120m or ~$3-3.50 per share, for -65% downside to the stock. Government revenue would likely still be declining so it may trade at a discount, and without organic revenue growth KEYW's balance sheet could just eventually become strained again anyway.
3. Won't KEYW's Backlog save them? KEYW Backlog Massively Overstated
As of January 1st, KEYW states their total backlog is $509 million. This sounds impressive until you read the fine print and realize only $132 million is actually funded - the remaining balance is unfunded, or basically just a placeholder.
For reference, this $132 million funded backlog is a mere 46% of KEYW's LTM revenue of $285mm. KEYW needs to fill the other 54% of revenue in an increasingly difficult government spending environment while its cyber-security products are failing to get traction and appears to actually be declining (much more detail on that in report Part 3). Given KEYW government contracts are already rolling off or re-pricing at lower levels of profitability (described explicitly on recent earnings calls), plus KEYW's large aircraft contract facing headwinds next year and some analysts estimate that contract alone could be approximately half of KEYW's government EBITDA, KEYW's business has no stabilization in sight that I can see.
4. KEYW is a Sell Side Promote, KEYW is NOT a-Cyber Security Technology Business!
Given the ugly reality of KEYW's current financial situation, why are investors valuing KEYW stock incorrectly?
I believe the primary reason for KEYW's absurd overvaluation is directly due to the conflict of interest from KEYW's relationships with Wall Street. As seen below, since KEYW has been addicted to capital to fuel its failed acquisition strategy, KEYW is an extremely profitable client of some of Wall Street's lower tier banks. These banks derived substantial income from KEYW's IPO and 2012 secondary offering.
Note the coverage initiation, upgrade and price target increase right before the equity offering. You can see similar behavior above with multiple price target boosts early this year too. Particularly interesting are the price target increases right after KEYW CFO Korbath's departure when the stock declined rapidly. I think KEYW has likely known for a long time (all the way back to the Chardan initiation in August, 2013) that it would need to raise equity.
This sell side promote cycle began anew on March 24th when the sell side stepped up to defend the stock in the wake of CFO John Korbath's awkward departure and the unforgiving math of imminent covenant breach and debt default.
Before you dismiss short sellers as being financially biased, think about how much research coverage $10.9 million buys on Wall Street!
Note the average underwriting fee on Wall Street is between 5-7% of the capital raised. If KEYW fills its entire $150 million shelf, that would be roughly another $7.5 to 10.5 million of fees for these or similar investment banks. No wonder the sell side is so supportive!
"Holy smokes Batman! This is a huge conflict of interest!"
(source for picture above)
The Wall Street sell-side bank machine explained
As conflicted underwriters seeking multi-million dollar fees, the incentive is to issue the most favorable coverage possible to KEYW, sending the stock price higher and allowing KEYW to issues new shares at a high price.
The promotion effort for KEYW occurred by comparing KEYW to companies that are completely unrelated, with the most common comparison drawn to FireEye's (NASDAQ:FEYE) acquisition of Mandiant. Some sell side analysts have erroneously valued KEYW as high as $3 billion of market cap (10x sales for the entire KEYW business even though only 3% is cyber revenue).
Just how different is Mandiant?
Mandiant was founded in 2004 and backed by Kleiner Perkins, one of the world's premier Venture Capital firms. Mandiant organically grew to over $100 million of revenue before being acquired. Unlike KEYW, it was not a patchwork of disparate, unrelated assets, one of which was sold by a consortium of VC firms at a loss (Sensage). Also unlike KEYW, Mandiant was founded and managed by a team with deep cyber-security experience - it was not a "me too" cyber-security company.
FACT: KEYW's cyber-security revenue accounts for only 3% of the KEYW's total revenue. Clearly, KEYW is not a cyber-security company no matter what anyone says. It is a zero probability event that any strategic acquirer would buy a declining government subcontracting business (what KEYW actually is) for 10x revenue. Using CapIQ data, I looked at literally hundreds of Aerospace & Defense acquisitions going back to 1997 and I couldn't even find one example of a government contractor getting bought out at 10x sales.
This is so obvious that I can only conclude the sell side authors writing about KEYW don't even know what KEYW actually does! If this is how management is pitching KEYW to investors, I'm also not sure management knows what KEYW does!
I could clear up all of this confusion with one simple question to KEYW management:
(source for picture above)
Let's look at the timeline of KEYW's current tailspin:
2/6/2014: KEYW CEO says their balance sheet is strong and getting better.
3/13/2014: KEYW amends their credit facility. I believe math makes it obvious KEYW realizes they could need equity at this point.
3/20/2014: KEYW announces the surprising departure of John Korbath, CFO - clearly related, I believe, to the debt covenant amendment and brutally dilutive shelf offering KEYW is about to file. Note KEYW and the CFO are at the end of Q1 2014 already so they know what earnings are going to look like (i.e., a train wreck).
3/24-26/2014: KEYW's underwriter-analysts promote the stock aggressively by comparing KEYW to unrelated businesses that trade at premium valuations.
4/23/2014: KEYW files a $150mm shelf equity offering.
5/1/2014: KEYW announces and awful quarter with revenue imploding -18% YOY, the stock declines rapidly, KEYW's solvency called into question. I highly recommend you read the Q1 2014 call as it is one of the worst examples of management floundering I have ever seen.
Why does KEYW and the sell side seem so confused? Maybe because KEYW is desperate for equity capital?
The company finished Q1 2014 with a shocking $64,000 of cash on the books - that is sixty-four thousand dollars of cash for a company with net losses of >$11mm LTM, revenue that was down 18% in the most recent quarter, and $85mm of debt.
As a public company, KEYW has lifetime free cash flow of roughly $5 million. This is not a typo. Since 2010, the company has generated a mere $5mm of free cash flow. Even after its recent brutal price decline, KEYW stock is still valued at 99x lifetime FCF on an enterprise value basis. That is somewhere between "horrific" and "unbelievably terrible."
I believe the numbers show, KEYW needs to sell equity NOW if it is to remain a going concern. This is why they filed a massively dilutive shelf registration on April 23rd.
4. KEYW Fair Valuation: <1x Sales and a $4 stock
Let's look at some facts to value KEYW appropriately:
Fact 1: KEYW mentions "Direct Peers" in its own SEC filed proxy statement: both Mandiant and FireEye are absent
This is a direct quote from the 2013 KEYW proxy statement (emphasis mine):
Compensation Consultant's benchmarking analysis was based on two distinct peer groups (Direct and Indirect Peers) which it developed jointly with executive management [who presumably should know what KEYW does, but I am not sure anymore]. We believe Direct Peers should serve as the primary reference point for evaluating the reasonableness of pay levels while practices should be shaped by a broader index including Indirect Peers.
Who are these direct peers exactly?
The Direct Peer Group was as follows:
• AeroVironment, Inc.
• ICF International, Inc.
• American Science & Engineering, Inc.
• Mercury Computer Systems, Inc.
• Dynamics Research Corporation
• NCI, Inc.
• GeoEye, Inc.
• Sourcefire, Inc.
• Globecomm Systems, Inc.
FireEye and Mandiant are nowhere on KEYW's own list of their peers!
Fact 2: KEYW's closest peers in its 10-K competitor section trade at a fraction of KEYW's valuation
In the competitors section of KEYW's 10-K:
"We also face competition from a number of large, well-established government contractors such as Science Applications International Corporation (NYSE:SAIC), CACI International, Inc. (NYSE:CACI) and others."
Here you have KEYW directly comparing itself to government contractors that trade at 0.8x and 0.5x, EV / 2014 sales estimates, respectively. This is a very fair comparison because 97% of KEYW's revenue is government contracting and both SAIC and CACI are in similar if not identical contracting businesses.
Here is KEYW's true comparable public company peer group:
You can see above that peers to KEYW are valued at 0.79x sales and 14x EBITDA. If you exclude the MRCY outlier, that declines to ~8x EBITDA. Amazingly, KEYW still trades at roughly double the peer valuation despite near-term risk of bankruptcy with declining revenue and EBITDA - a rerating to peer valuation on estimated 2014 revenue of $250mm would value KEYW stock at ~$3.00 per share.
More importantly, KEYW trades at 2.5x SAIC's valuation and 1.5x CACI's valuation, which are the closest peers per KEYW's own SEC documents. I think $319mm consensus revenue for 2014 is obviously too high after Q1, with similar declines likely coming in Q2 and Q3 by my estimates, so let's be generous and value it on $285mm of LTM revenue with a similar multiple to CACI.
Valuing KEYW appropriately, as a government subcontractor (per KEYW's own filings) with the same valuation as CACI, produces a fair value of $3.80 for the stock, assuming KEYW doesn't go bankrupt or massively dilute current shareholders. This is a shocking ~65% downside from the current price.
KEYW's valuation premium is very likely to compress in coming quarters - for starters because sell side estimates are still too high. Most of the analysts covering the stock have not yet revised their estimates down after KEYW's Q1 huge miss (is this another indication a conflict of interest exists?).
5. How Did KEYW Get Itself Into This Impossible Mess? KEYW is a failed rollup: This is the home of capital destruction
Even though KEYW has only been public since 2010, (per CapIQ) it ranks as the 20th most aggressive rollup out of 285 (top 9%), and the #1 out of the Aerospace & Defense index of 5 companies.
KEYW has been a forced buyer - the company went public on the premise of winning a large prime contract. That failed and the stock tanked. Management then embarked on an aggressive purchasing campaign, buying 13 businesses, with the hope of one day "finding" a sustainable business model- this day has yet to occur, in my opinion. Why? There is a seller to KEYW for a reason and aggressive buyers make expensive acquisitions.
KEYW Has Generated -3.1% Return on the $393m of Asset growth since inception: This is terrible performance
These numbers are staggeringly bad. Even worse, KEYW has experienced ACCELERATING LOSSES (EBIT declined by $12mm) as a result of the acquisitions the company has made. Basically, KEYW could have made more money by purchasing 0.1% T-Bills.
In my opinion, anyone investing in KEYW through an upcoming secondary offering is signing up for continued capital destruction. The bigger KEYW gets, the worse it does. Given the over leveraged balance sheet and history of terrible performance, this next secondary (if they can even do it) is likely to be KEYW's last, in my opinion.
A quick look at the valuation multiples the company has paid makes it clear why the results are so bad
These are overpriced acquisitions, many paid for with debt, and many of the acquired companies have subsequently performed poorly. I am particularly shocked at the Sensage acquisition, which was acquired for 7.1x EV/Revenue and with a tiny revenue base. My channel check revealed Sensage was "the last girl without a date to the dance" and had been shopped extensively in the consolidating cyber-security industry prior to its sale. The VC investors who sold Sensage were so desperate to find a buyer that they were willing to sell Sensage at a loss just to get out of the asset.
An extremely detailed report on KEYW's impossible battle to penetrate the "cyber" market will be coming very soon.
Token Insider buying
Apparently, in a desperate attempt to put a floor on KEYW's imploding stock price before a potential equity raise, Len Moodispaw recently purchased 10,000 shares of KEYW in the open market at ~$11.00 a share.
The market is not so easily fooled by such tomfoolery, Len! I checked KEYW's historic open market acquisitions vs. open market dispositions, per CapIQ data, in the $10-12 price range. As they say, "the numbers don't lie" - KEYW insiders, including Moodispaw, have purchased a total 35,000 shares in this price range and sold 195,400 shares. This is a staggering divide in dollar terms: I estimate, based on CapIQ data, that KEYW execs have purchased $396,823 and sold $2,233,622 in a similar price range over time, a startling 5.6-fold difference. Clearly, insiders would rather take profits at this level, historically speaking.
Len, let's see an immediate $1,000,000+ open market buy by you and the new CFO with your own money and then we'll talk. Until then, you're not fooling anyone.
I have attempted to contact management several times over the last 2+ months and have been unable to reach anyone through the standard investor relations channels. Given the embarrassing investor Q&A from the last earnings call, I believe KEYW is in "circle the wagons" mode and avoiding public communication.
Ultimately I see no easy way out for KEYW. I've outlined the three options KEYW has at this point and all of them point to enormous downside for the stock. With this in mind, my "bull case" scenario for KEYW involves 35-40%+ dilution (depending on warrants) to KEYW shareholders and my downside case involves near-term bankruptcy and -100% downside. My personal view, based on KEYW's rampant capital destruction and repeated failure, is that the market should decline a capital raise until KEYW flushes its failed strategy down the drain - this would be a positive event for the capital markets so that future capital can be redirected towards companies that are creating value. The simple math is unforgiving here and I wish there were a better outcome.
See Website for Full Disclaimer
 My estimate of required dilution, presented below in more detail
 Only 3% of KEYW revenue is cyber-security
 At $8, a $100mm equity raise would create $12.5mm new shares, not including warrants. This would be ~33% more dilution, a number that is likely too low given the likely need for warrants to sweeten the deal.
 I consider the lack of growth in this business to be a failure and my checks reveals KEYW is unlikely to successfully ramp this business. More details in a future report.
Disclosure: I am short KEYW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.