Vectrus Inc - Noble Capital Marketsnobleresearch.com › reports › VEC_20170816_10009.pdf · A...

Aug 17, 2017

Government Services

NYQ

VEC

Buy

Current Price

$29.00Target Price

$34.00

Market Capitalization 317.84M

Shares Outstanding 10.94M

Float 10.86M

Institutional Holdings 79.70%

12-month Low/High $12.50/$35.58

Average 90-day Volume 101

Fiscal Year End Dec 31

Revenues ($ MIL)

Period 2016A 2017E 2018EQ1 310.7A 290.1A 260.0EQ2 307.9A 259.3A 265.0EQ3 283.8A 250.0E 265.0EQ4 288.2A 255.0E 270.0E 1,190.5A 1,054.4E 1,060.0E

EPS ($)

Period 2016A 2017E 2018EQ1 0.61A 0.60A 0.46EQ2 0.55A 0.49A 0.50EQ3 0.60A 0.41E 0.51EQ4 0.40A 0.44E 0.55E 2.16A 1.94E 2.02E

Vectrus IncBuy Opportunity With Mission Critical Service Provider (Corrected Copy)

End Market Dynamics Provide Long Term Visibility. As a provider of facilities and logistics services for crucial U.S. military operations domestically and overseas, there is a high degree of long term demand visibility for Vectrus services given the need to outsource these services and the long-term nature of military facilities.

Near Term Visibility With Upside Potential. With minimal re-compete risk in the balance of 2017 and 2018, $1 billion in new business bids submitted and $4 billion in new business opportunities to be bid upon in the next twelve months, there is a high degree of revenue visibility in the near term, with meaningful organic growth potential should the pipeline deliver.

Growth And Margin Expansion Strategy Can Drive Meaningful Value. By enhancing IT competencies and integrating technology into current facilities and logistical missions, the company is positioning itself to be a full IT lifecycle provider which can in turn drive both top line and bottom line growth.

Balance Sheet Improvement Provides Flexibility. Management has significantly de-levered the balance sheet, with net debt falling from $98 million to $27 million in less than three years, providing flexibility to deploy future free cash flows towards growth initiatives.

Initiating Coverage With Buy Rating. We believe the market overreacted to the second quarter results, creating a buying opportunity. We are establishing a twelve month price target of $34.00, which corresponds to an EV/EBITDA of 9.5 times our 2018 estimates.

Equity ResearchBen Klieve, CFA, Analyst (561) 997-8947 [email protected]

Noble Capital Markets, Inc.Trading: (561) 998-5489 Sales: (561) 998-5491 www.noblecapitalmarkets.com

Refer to the last two pages for Analyst Certification & Disclosures

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Investment Appraisal

Vectrus has positioned itself as a facility, IT and communications service provider for global U.S. Department of Defense (DoD) infrastructure with opportunities to move up the value chain by incorporating technology solutions. While demand for these services will fluctuate with the degree of U.S. engagement overseas, such as the build-up and draw-down of U.S. operations in Afghanistan, we believe there is a high degree of long term visibility for government outsourcing of Vectrus services. In the near term, we believe the ramping of new awards and management’s ability to control margins will minimize the effects of top line declines from Afghanistan operations and the conclusion of the APS-5 award. With shares falling off following the second quarter earnings report, we believe a buying opportunity has emerged, and are initiating coverage of Vectrus with a Buy rating and twelve month price target of $34.00 per share.

Key Points

Vectrus’ core competencies in facility and logistics services brings meaningful long term demand, driven by the fixed nature of DoD facilities and the high degree of outsourcing of the facilities management and IT/Communication services Vectrus provides.

A top line growth and margin expansion strategy is focused on infusing technologies into their core capabilities within existing facilities and logistics work. We believe this growth strategy brings a high degree of awareness of the value their core capabilities, and is a strategy that can deliver sustainable shareholder value.

While margin expansion potential is modest, even minor improvements could have a meaningful impact on the bottom line given the lower margin nature of the business. A hypothetical 20 basis point operating margin beat would yield a 5.5% improvement to the bottom line of our 2018 model.

Following the spin-off from Exelis in 2014, a net debt position of $98 million needed to be addressed, and has been reduced to $27 million in less than three years with the company on track to be net debt free in the next twelve months.

Over one third of revenues are derived from the K-BOSSS award, which has options that could extend through the first quarter of 2019. The re-compete of this award was initially lost to a joint venture between two competitors, but their successful bid was meaningfully different than the parameters on which Vectrus bid. As such, the award was successfully protested, with the restructured contract to be included in the LOGCAP V program through the Army Contracting Command.

We believe the inclusion of K-BOSSS in the LOGCAP V program will potentially lengthen the existing contract, increasing our confidence in Vectrus keeping this business at a full run rate into the first half of 2019. Furthermore, the successful protest enhances our confidence that the Army values the comprehensive services Vectrus provides, decreasing the re-compete risk.

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Vectrus Inc VEC | CURRENT PRICE $29.00 | Buy | 08/17/2017Ben Klieve, CFA [email protected] (561) 997-8947

Afghanistan related revenues have declined from over $600 million during the peak of U.S. operations in 2012 to an expected total of less than $50 million in 2017. At less than 5% of overall revenues today, any continued wind-down of Afghanistan revenues beyond 2017 only represent a mild headwind for 2018. However, the conclusion of the APS-5 award at the end of the first quarter of 2017 will bring quarterly top line declines of roughly $60 million for the first two quarters of 2018.

With 2017 seeing the wind-down of the APS-5 award and the ramping of the Thule and Keesler awards, we estimate the net impact of these to roughly offset each other on a full year basis in 2018. The Thule and Keesler awards both represent new work for Vectrus and are expected to bring combined annual revenues of roughly $75 million.

Management has consistently controlled costs and delivered operating margins in the 3% to 4% range despite top line challenges. The ability to control these margins and deliver consistent profitability and free cash flows gives us confidence in management’s ability to generate long term value, despite top line fluctuations that may come from a concentrated portfolio or variable levels of U.S. global engagement.

Business development efforts have led to $1 billion of bids for new awards, and a new business pipeline of $4 billion expected to be bid upon over the next twelve months. Importantly, these totals do not include re-compete bids. Delivering on this pipeline would provide enhanced visibility into 2019, and could still provide upside to our estimates for the second half of 2018.

Business History and Operational Overview

Legacy Vectrus dates back to the 1940’s, evolving over time to the 2014 spin-out from Exelis at which point they became an independent, publicly traded company. Upon the spin-out, Vectrus was left with meaningful debt and a portfolio of lower margin work. Since then, management has taken significant efforts to both de-lever the balance sheet, develop margin enhancement strategies within their existing portfolio and engage in business development efforts to grow a higher value-add pipeline of new business opportunities within their two core segments. See below for a description of the two major segments:

Facilities and Logistics Services ($926 million, or 78% of 2016 Revenue) – Vectrus primarily operates as a worldwide operator of large government facilities and military bases with highly diversified capabilities. These capabilities include: airfield management, ammunition management, civil engineering, communications, emergency services, life support services, public works, security, transportation operations and warehouse management. This segment has historically included meaningful revenues related to Afghanistan operations, which have declined from a peak in 2012 in excess of $600 million to less than $100 million in 2016, with less than $50 million expected in 2017.

Information Technology and Network Communication Services ($265 million, or 22% of 2016 Revenue) – Vectrus also operates and manages communication systems, performs network security and systems installation for the U.S. Department of Defense (DoD). Capabilities within this segment include: communication

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system operations/maintenance, system engineering and design, management/service support, cybersecurity and systems installation. While this segment lacks the scope of the Facilities and Logistics Services segment, it has delivered meaningful growth since Vectrus went public in 2014, with growth rates of 26% and 11% in 2015 and 2016, respectively.

Major Awards

Vectrus revenues are derived from a series of roughly 15 programs, with their three largest accounting for 64% of 2016 revenues. All programs scheduled to re-compete in 2017 have been awarded, and those scheduled to re-compete in 2018 expected to do so in the second half of the year, with the possibility of being pushed back into 2019. As such, there is a high degree of revenue visibility through 2018 from the existing contract portfolio. Major awards within their portfolio are described below.

Kuwait-Base Operations and Security Support Services (K-BOSSS) – The K-BOSSS award supports Kuwaiti based U.S. Army installations, and totaled 36.8% of 2016 revenues, or $430 million. A majority of services provided in this award fall within the Facility and Logistics Services segment, including transportation, logistics, public works, security services and facility maintenance. However, there are also IT and Network Communication segment services provided, including network and computer support, web and database development, and communication system management.

The K-BOSSS award commenced in the fourth quarter of 2010, and the initial contract ran through the middle of 2016. In September of 2016, the Army announced Vectrus lost their re-compete bid to a joint venture between KBR and Triple Canopy. However, the five year contract was valued at $115 million for the first year and potentially $800 million over the length of the contract, which was meaningfully below the historic run rate and 2016 rate of $430 million. The KBR/Triple Canopy award was protested, and the Government Accountability Office (GAO) has voided this award and amended the solicitation to clarify contract requirements. Vectrus has obtained options that are currently extended through the first quarter of 2018, and may be extended through the first quarter of 2019.

Operations, Maintenance and Defense of Army Communications in Southwest Asia and Central Asia (ODMAC)– Representing $150 million of 2016 revenues, the OMDAC award is the largest that falls primarily in the IT and Network Communications segment. Headquartered in Kuwait with operations throughout the Middle East, Southwest and Central Asia, this program operates the largest overseas U.S. Army cyber center. With option periods extending through mid-2018, this award represents the next major re-compete in the Vectrus portfolio.

Army Corps of Engineers – Information Technology (ACE-IT) – After the ODMAC program, ACE-IT represents the largest program that falls largely in the IT and Network Communication segment. Within this award, Vectrus provides engineering design, testing, cyber security and enterprise wide management and operations to the U.S. Army Corps of Engineers. Unlike many of Vectrus programs, the ACE-IT program is solely for domestic operations. The award was initially announced in August of 2014 with options that extend through

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August of 2019, with an average annual run rate of approximately $100 million.

Thule Base Maintenance (Thule) – Vectrus was awarded a $411 million, seven year award to perform operations and maintenance at the Thule Air Base, located in Greenland 750 miles north of the Arctic Circle. While this was initially awarded in October of 2014, a multi year protest has stalled the transition towards Vectrus. The protest has been declined, and Vectrus is now beginning the phase-in process, with revenues expected to begin being realized in the fourth quarter of 2017. We believe this contract will be at a full run rate of roughly $60 million annually by early 2018.

Army Pre-Positioned Stocks-5 (APS-5) – The Kuwait based APS-5 contract represented 15.1% of fiscal 2016 revenues, or $180 million, before winding down in the first half of 2017. Vectrus lost the re-compete on this award, and the $60 million of revenue realized in the first half of fiscal 2017 is expected to represent the final period of revenues.

Strategic and Financial Overview

We believe that Vectrus management has effectively leveraged the company’s core capabilities in terms of financial and operational management, and has identified an appropriate growth strategy given these capabilities. As a facilities and logistics provider, the company competes in the lower margin niche of the government services segment, with operating margins in the 3% to 4% range. However, the company has effectively managed their cost structure to consistently deliver margins within this range which has enabled meaningful value creation from this lower margin work. To drive top and bottom line growth, management has targeted the integration of commercially available technology solutions into their existing core capabilities. Importantly, during the second quarter management brought in Sue Deagle as Chief Growth Officer. With a background at IBM, which included developing federal business strategy, we believe she is well suited to identify opportunities for leveraging commercial technologies into new and existing contract vehicles.

Management has targeted margin enhancement within their existing capabilities by incorporating value add capabilities and technologies into existing Facilities and Logistics segment work, and identifying where there are opportunities for higher value IT and Network Communications segment work. Excluding a major shift in demand, such as with the build-up of operations in Afghanistan, margin expansion potential will be modest. However, with operating margins consistently in the 3% to 4% range, modest expansion could drive significant bottom line growth. A hypothetical 20 basis point beat, which we believe is a reasonable annual target, would drive a 5.5% improvement to our bottom line estimates in 2018. While management could have levered up and chased higher margin capabilities or contracts via acquisition, we believe their clear and patient strategy towards margin enhancement is one that can deliver sustainable value.

Given the lower margin nature of their core capabilities, we believe it is especially important for management to deliver an effective financial strategy, which they have done. Upon the spin-out from Exelis, the company had a net debt position of $98 million, or roughly 2.5x forward EBITDA. While this was a reasonable level, it was

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critical to focus on debt reduction given the wind-down of Afghanistan related revenues, which they have done quite effectively. With net debt at $27 million, or 0.7 times forward EBITDA ending the second quarter of 2017, and on track to be net debt breakeven by mid-2018, we believe the company is now well positioned to use their balance sheet to target accretive acquisitions or pursue other growth initiatives that could be meaningful to the top and bottom line without over-levering the balance sheet.

Outlook For Fiscal 2017

The first half of 2017 saw the final revenues from the APS-5 award, which totaled 10.9% of first half sales, or $60 million. With the final $12 million realized in the second quarter, we expect a modest sequential decline in the third quarter. However, this sequential decline is expected to be partially offset as the Thule and Keesler awards begin to ramp. We estimate 2017 revenues of $1,054 million, representing a decline of $136 million, or 11.4% from 2016. However, this decline includes roughly $45 million of Afghanistan related business and a $130 million decline related to the end of the APS-5 programs. With consistent margins, we project diluted earnings of $1.94 per share and free cash flow generation of roughly $2.15 per share.

Outlook For Fiscal 2018 And Beyond

With all re-compete’s scheduled for 2017 behind them and those in 2018 likely occurring late in the year, Vectrus is entering the second half of 2017 with a high degree of revenue visibility into 2018. We project a full year of K-BOSSS revenues from the recently extended options, and the Thule and Keesler awards to begin the year at a full run rate. There will be headwinds from the end of the APS-5 award and potentially from Afghanistan operations, which combined are projected to contribute roughly $100 million to the 2017 top line. In aggregate, we expect the ramping of the Thule and Keesler awards to roughly offset these headwinds, and the year to be roughly flat at $1,060 million. However, we believe modest margin enhancement is possible from ramping awards and continued focus on value creation, which coupled with lower interest from a de-levered balance sheet we believe will contribute to bottom line growth. From these improvements, we expect modest growth in diluted earnings from $1.94 per share in 2017 to $2.02 per share in 2018. Estimates do not assume the potential positive impact of new business awards derived from Vectrus’ active business development activities.

While there is a high degree of visibility in 2018, there is less visibility into 2019. With $1 billion of new business bids already submitted and an additional $4 billion expected in the next twelve months, there is meangingful potential for the pipeline to deliver top line growth in 2019, but awards must follow the bids. Furthermore, management's concentrated efforts to delivering growth, highlighted by the hiring of Sue Deagle, is in its relative infancy but we believe is a critical step towards improving the top line. Yet another source of potential growth comes from management's utilization of free cash flows, which to this point have been used exclusively for de-leveraging efforts. With a very reasonable net debt position currently, management now has the ability to utilize free cash flow for growth initiatives that could provide upside to 2019. While there is meaningful potential for growth in 2019, there are also some headwinds expected, highlighted by the status of K-BOSSS and re-

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competes of the ACE-IT and OMDAC awards.

Investment Thesis and Valuation

We believe long term growth projections for Vectrus will be tied to the degree to which the U.S. remains engaged in global affairs. While there is political risk from pull-back in U.S. engagement, we believe any meaningful political discussion of this lacks substance. With a long-standing degree of U.S. engagement dating back to WWII, we believe there continues to be a high degree of long term visibility of non-combat related engagement and thus demand for Vectrus services. Periodic combat related engagements can provide significant opportunities for Vectrus, as seen recently in Afghanistan. However, we believe Vectrus has the potential to be consistent value creators even in times of minimal levels of combat engagement, and as such we see Vectrus as a long term value generator and an attractive long term investment.

Our twelve month price target of $34.00 reflects an EV/EBITDA multiple of 9.5 times, with shares currently trading at 8.2 times when assuming our 2018 estimates and a flat net debt position by mid-2018. In the near term, we believe that shares are undervalued given the high degree of visibility through 2018 due to the minimal re-compete risk with potential for organic growth from the new business pipeline. In the long term, we believe Vectrus represents an attractive holding as end market dynamics provide a high degree of long term visibility due to the need for outsourcing of Vectrus provided services and the relatively immovable nature of military bases. Additionally, management has a high degree of awareness for where they create value within this end market, and have developed a strategy for moving up the value chain that we believe can generate sustainable shareholder value, enhancing our belief that Vectrus represents an attractive long term holding.

Management Overview

Chuck Prow (President and CEO) - Charles “Chuck” Prow is the President and Chief Executive Officer of Vectrus, Inc. He is also a member of the Vectrus Board of Directors. He was appointed to both positions in December 2016.

Mr. Prow has more than 30 years of information technology and federal services experience, including leadership positions at IBM Corporation, PricewaterhouseCoopers, and Coopers & Lybrand. During his career, he has run large global government services organizations, delivering solutions to a wide array of Department of Defense and other government customers.

He served in multiple roles with IBM Corporation including General Manager, Global Government Industry, IBM’s technology and services competencies, where he had responsibility for global revenues exceeding $9 billion. During his tenure at IBM, Mr Prow was successful in creating market differentiation through the integration of IBM’s technology and service competencies. He established strategies that focused on delivering complex solutions to critical government missions for national security, federal civilian agencies, and state and local entities. These efforts resulted in market share expansion, revenue growth, and margin improvement.

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Mr. Prow has a Bachelor of Science degree in Management and Data Processing from Northwest Missouri State University, Maryville, Mo. He currently serves on the board of directors for the International Research and Exchange Board (IREX), the World Affairs Council-DC, and Wolf Trap Foundation for the Performing Arts.

Matthew Klein (SVP and CFO) - Mr. Klein serves as our Senior Vice President and Chief Financial Officer. He was previously Vice President and Chief Financial Officer of the Exelis Mission Systems business and has served in this position since May 2011. Prior to this position, Mr. Klein was the Assistant Controller for ITT Electronic Systems, Communications Systems located in Fort Wayne, Indiana and was acting Assistant Controller for ITT Electronic Systems, Radar, Reconnaissance and Acoustic Systems in Van Nuys, CA. In addition, Mr. Klein served in the ITT internal audit department leading various audits for units worldwide. He joined ITT Corporation in 1996. He has a Bachelor’s degree from Indiana University in Bloomington, Indiana, and is a CPA.

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Company Profile

Vectrus Inc is a provider of facility, logistics, IT and network communications services for the U.S. Government, with a high degree of concentration with the U.S. Army. With operations that date back to 1945, Vectrus was spun-off from Exelis in September of 2014 as an independent, publicly traded company. The company operates in two segments: Facility and Logistics Services (78%, or $925 million, of 2016 revenue) and IT and Network Communications (22%, or $265 million, of 2016 revenue).

Valuation Summary

We are initiating coverage of Vectrus with a Buy rating and twelve month price target of $34.00 per share. Our valuation is based upon 2018 estimates, which call for EBITDA of $40.1 million and continued deleveraging efforts to result in the company being net debt free by mid-2018. Our price target reflects an EV/EBITDA multiple of 9.5 times, within the range of their government services peers of 9.0 to 11.0 times.

Risks to our valuation include: the company's ability to win re-competes and new business contracts, stable funding from the Department of Defense, the expectation of the government continuing to outsource Vectrus' core capabilities, and the high degree of revenue concentration with the top three contracts.

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GENERAL DISCLAIMERSAll statements or opinions contained herein that include the words "we", "us", or "our" are solely the responsibility of Noble Capital Markets, Inc. ("Noble") and do not necessarily reflect statements or opinions expressed by any person or party affiliated with the company mentioned in this report. Any opinions expressed herein are subject to change without notice. All information provided herein is based on public and non-public information believed to be accurate and reliable, but is not necessarily complete and cannot be guaranteed. No judgment is hereby expressed or should be implied as to the suitability of any security described herein for any specific investor or any specific investment portfolio. The decision to undertake any investment regarding the security mentioned herein should be made by each reader of this publication based on its own appraisal of the implications and risks of such decision.

This publication is intended for information purposes only and shall not constitute an offer to buy/sell or the solicitation of an offer to buy/sell any security mentioned in this report, nor shall there be any sale of the security herein in any state or domicile in which said offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state or domicile. This publication and all information, comments, statements or opinions contained or expressed herein are applicable only as of the date of this publication and subject to change without prior notice. Past performance is not indicative of future results.

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IMPORTANT DISCLOSURESThis publication is confidential for the information of the addressee only and may not be reproduced in whole or in part, copies circulated, or discussed to another party, without the written consent of Noble Capital Markets, Inc. ("Noble"). Noble seeks to update its research as appropriate, but may be unable to do so based upon various regulatory constraints. Research reports are not published at regular intervals; publication times and dates are based upon the analyst's judgement. Noble professionals including traders, salespeople and investment bankers may provide written or oral market commentary, or discuss trading strategies to Noble clients and the Noble proprietary trading desk that reflect opinions that are contrary to the opinions expressed in this research report.

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WARNINGThis report is intended to provide general securities advice, and does not purport to make any recommendation that any securities transaction is appropriate for any recipient particular investment objectives, financial situation or particular needs. Prior to making any investment decision, recipients should assess, or seek advice from their advisors, on whether any relevant part of this report is appropriate to their individual circumstances. If a recipient was referred to Noble Capital Markets, Inc. by an investment advisor, that advisor may receive a benefit in respect of transactions effected on the recipients behalf, details of which will be available on request in regard to a transaction that involves a personalized securities recommendation. Additional risks associated with the security mentioned in this report that might impede achievement of the target can be found in its initial report issued by Noble Capital Markets, Inc.. This report may not be reproduced, distributed or published for any purpose unless authorized by Noble Capital Markets, Inc..

U.S. CLIENTSFor purposes of distribution in the United States, this report is prepared for persons who can be defined as "Institutional Investors" under U.S. regulations. Any U.S. person receiving this report and wishing to effect a transaction in any security discussed herein, must do so through a U.S. registered broker or dealer. Noble Capital Markets, Inc. is a U.S. registered broker dealer.

RESEARCH ANALYST CERTIFICATIONIndependence Of ViewAll views expressed in this report accurately reflect my personal views about the subject securities or issuers.

Receipt of CompensationNo part of my compensation was, is, or will be directly or indirectly related to any specific recommendations or views expressed in the public appearance and/or research report.

Ownership and Material Conflicts of InterestNeither I nor anybody in my household has a financial interest in the securities of the subject company or any other company mentioned in this report.

> NOBLE RATING DEFINITIONS % OF STOCKS COVERED % OF IB CLIENTS

BUY: potential return is >15% above the current price 59% 42%

HOLD: potential return is -15% to 15% of the current price 24% 3%

SELL: potential return is >15% below the current price 0% 0%

Additional information is available upon request. Any recipient of this report that wishes further information regarding the subject company or the disclosure information mentioned herein, should contact Noble Capital Markets, Inc. by mail or phone.

Noble Capital Markets, Inc.225 NE Mizner Blvd. Suite 150Boca Raton, FL 33432561-994-1191

Noble Capital Markets, Inc. is a FINRA registered broker/dealer.Member - SPIC (Securities Investor Protection Corporation)

Report ID: 10009

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