After a year of significant changes at KEYW Corp. (NASDAQ:KEYW), we believe yet another opportunity has presented itself to make money shorting the stock. We have written several articles in the past about KEYW and the ripe opportunity provided by the unfounded hype around the company's push into commercial cybersecurity.
Here we are slightly over a year since our last article and the company has turned over nearly all of its management team and unceremoniously exited its disastrous commercial cyber business. The company is now just the government services business, which has seen its EBITDA decline from 2014 to 2015 and is expect to decline again this year. The market is expecting some growth in 2017, but the stock has traded up nearly 175% from its lows on the promise of the new CEO to grow the business to $500M in revenue. We think the current price is 25% above where the stock should trade even if it does miraculously grow to that size. We think the more likely outcome is the well-worn path of underperformance versus expectation. Possibly as early as the second half of this year. We continue to think the fair value of this highly levered government contractor is below $4.00 per share.
KEYW Divests Hexis
After three and a half years and well north of $100M invested in its commercial cyber venture, KEYW pulled the plug and sold Hexis in pieces. In mid-May, the company announced that it had sold Hexis in two separate transactions for a total of $20 million in cash and stock. Then, in early June, KEYW filed an 8-K with additional details of the transaction, which includes $2.725 million of cash at close (net of expenses), retention of $2.2 million of receivables and $1.7 million of payables. A commitment to fund $4 million of Hexis expenses through December 31st, a payment of $3 million in January 2017, private company stock with a GAAP value of $340,000 (KEYW's management estimated value of $10-12 million) and a potential earnout of $4 million. This info is available in this SEC filing.
If we assume the company collects the receivables and pays the payables, KEYW will spend roughly $700,000 through the end of the year to have unloaded Hexis. Next year, it may collect as much as $7M in cash, and we think it is safe to assume the private stock may be less than $10 million. It technically did sell for roughly $20M of gross cash and stock depending on the valuation and the collection of earn-outs, but this is part of the pattern of what we would call "shining to best possible light" on a situation.
Hexis was the disaster we fully expected it to be and worth even less than we had given it credit for. It was worth substantially less than the ridiculous valuations assigned by nearly every publishing analyst. Even so, getting rid of Hexis is clearly positive as the company is no longer destroying capital in a business venture that had very little chance of success.
The Focus Turns to the Government Business
We could start to see KEYW pivot towards the government business with the hiring of Bill Weber in October of last year. This became official when KEYW reported Q4 results in February and announced it would seek to divest the Hexis business. The new pitch for investors is that the government services business is actually a great business and had just been neglected while the company pursued commercial cyber. This may be true, or it may be the case of it is the only story it can tell so it is going with it. What we know for certain is the government segment EBITDA declined from over $40M in 2014 to $38.8M in 2015 and is guided to decline again to approximately $35M this year. There are actually a few acquisitions that offset some of the organic decline in these numbers as well.
With this backdrop, the company decided to host an analyst day in early April to layout the new path for KEYW. This was eerily similar to the Cyberitavilles hosted by the company in Key West, FL, in 2013 and 2014. At those events, the management made predictions of fantastic growth for the commercial cyber business even projecting $75 million of revenue for Hexis in 2015. These predictions were followed by quarter after quarter of excuses and shifting metrics with Hexis finally producing $12 million of revenue in 2015. A similar level to the amount Sensage (renamed Hexis) produced when it was purchased in 2012. Not to be outdone by the former management team, Mr. Weber made his own projection of growing the government services business to $500 million. So the business that has had flat revenue and shrinking EBITDA for the last few years (even with a few acquisitions) is suddenly now going to grow organically by $200 million?
Valued for a doubling of revenue
After years of big promises and disappointing performance, one would think that KEYW's stock probably has a "show me" valuation, which is to say a significant discount to its peers until the company actually proves it is on the path to this promised growth. This, however, is not the case. The stock has rallied 170% from its lows and now trades at a significant premium to almost every company in the group. In fact, if KEYW traded at our comp groups average revenue multiple, it would need to grow revenue to nearly $650 million to justify the current share price!
Below, we have included our comp table to show just how highly valued KEYW is versus similar companies that we believe are higher quality. We use three metrics that produce share prices for KEYW between $3.42 and $5.67, which is a range that we think represents fair value. For KEYW, we use 42 million fully diluted shares, which accounts for warrants, options and RSUs, and $120 million of net debt. Most analysts struggle with using the correct gross debt balance which is $149.5 million. They often use the balance sheet number which is discounted due to the accounting treatment of convertible debt.
The midpoint of the implied range is $4.50, if KEYW traded in line with its peer group. Given the years of disappointing results, we would expect the shares to trade at a slight discount to the group at the very least.
Does Bill Weber's Compensation Package Indicate Huge Potential?
I have had multiple analysts/investors point out the new CEO's compensation package as an indication of his bullish view on the prospect of KEYW's stock. The reason being is he will be granted up to 400,000 shares based on the stock price achieving certain levels. 50,000 shares at $13.00, 50,000 at $16.00, 100,000 at $20.00, 100,000 at $25.00 and 100,000 at $30.00. While we applaud the Board in aligning the CEO with shareholders, after looking at Mr. Weber's employment history, the cash compensation alone at KEYW is likely a big upgrade from his prior positions.
Prior to KEYW, Mr. Weber was president and COO of XLA. It appears this position is the #2 guy at a company that is much smaller than KEYW. XLA was named Contractor of the Year for revenue category $25-75M at the 2013 Greater Washington Government Contractor Awards. We find it unlikely that XLA was paying Mr. Weber a $450,000 base with a potential of a $450,000 bonus. As a side note, it appears Mr. Weber had his own "Hawkeye G" type product at XLA.
Prior to XLA he was president of Kaseman/KS International (OTCPK:KSIH), which is difficult to find information about. We did find one article that mentions Kaseman, but the primary subject is Black Water.
Prior to Kaseman, he was an SVP at GTSI where he was named in a settlement with the SBA for deceptive business practices. Here is an article about the issue.
Here is the settlement (He is named on page 2, paragraph E).
All of this history leads us to believe that a $450,000 base salary, potential for a cash bonus of $450,000, and 100,000 time vesting RSUs were a sweet enough incentive package to lure Mr. Weber to KEYW without that potential for the additional 400,000 RSUs based on share price.
If history is any guide, we think it is unlikely that KEYW will achieve the goals that have once again been reset, but this will take some time to prove out. There are, however, some near-term risks to the business. In previous articles, we highlighted the Buckeye program that produced an outsized amount of EBITDA relative to its revenue. This contract is up for renewal shortly, and we believe there is a reasonable chance it won't be renewed. While KEYW will continue to fly aircraft for what it now calls its ISR business, it may no longer be in the secure position it was for the past three years when it was paid whether planes were flying or not.
Missing full-year projections is a very real possibility. This should not come as a surprise to anyone as it is par for the course for KEYW to underperform expectations. From the Q1 conference call:
At the midpoint of $295 million, we expect approximately 79% of this revenue to come from existing business, 7% from re-compete wins and 14% coming from new awards, mostly product business in the second half of 2016.
This guidance calls for the company to ramp sales of products to an unprecedented level in the second half of the year. We believe management has limited visibility into this ramp and results could disappoint once again. The company did start the year slightly better than expected largely due to the fact that it couldn't unload Hexis a quickly as expected. This allowed it to allocate corporate overhead to a discontinued operation and make continuing operations EBITDA look better. This actually happened.
From the Q1 conference call:
Okay. So, we did project that we would have lower EBITDA performance as a Company in the first several quarters of 2016. Now, Q1 that did not materialize in quite the measure that we had expected. And the reason for that is we held the SETA asset for much of the quarter and we held the Hexis asset for the entire quarter. Now, while the Hexis assets did not produce profit, they did provide a cost basis by which we had corporate overhead allocation. And so, the result of that was a little bit higher EBITDA production relative to the investments that we made than we had initially thought in Q1.
KEYW may once again benefit in Q2 by holding Hexis through at least half of the quarter. Economically, it is a clear net negative, but optically continuing operations may benefit.
The sale of KEYW's Hexis unit and the accompanying upward revision in the company's EPS been a positive development for KEYW and its shareholders, however, we believe the shares have dramatically overreacted, creating an opportunity once again. After years of constant disappointment, we would expect shares to trade at a discount to its peer group until there are at least some signs the new promises made by management aren't as empty as the past promises. Instead, it trades at a massive premium helped by aggressive investor relations, cheerleading by the same group of analysts that had ridiculous valuations for Hexis and a rising tide in defense and government services stocks. For some history, the analyst from SunTrust even claimed at one point that KEYW could be worth $80.00 per share when FireEye (NASDAQ:FEYE) purchased Mandiant! See this headline from Flyonthewall from January 2014 to get a good idea of who recommends buying this stock:
SunTrust notes that cybersecurity firm KEYW is expected to generate $8.30 in sales per share based on 2013 revenue. If the company was acquired at a similar multiple as the one seen in FireEye's deal for Mandiant, a take-out price above $80 per share would be implied for KEYW, the firm added. SunTrust has a Buy rating on KEYW.
To be fair, SunTrust had plenty of company pumping the not-so-hidden value of KEYW. Basically, the same list of analysts that tout the stock today.
We believe the shares have downside of over 50% with the primary risk being an acquirer willing to pay an absurd multiple for the company. In our view, even paying $8.00 to acquire KEYW would be an absurd valuation.
Disclosure: I am/we are short KEYW.
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.