DynCorp vs KBR on Strategy

Here is a rather sober analysis on DynCorp's latest quarterly results. Reasons for concern and "negative" outlook:

• 75% of revenues derive from US operations in Iraq and Afghanistan
• Delays in approving the FY13 defense budget which could hold up orders on current and new contracts
• Further potential cuts to DoD budgets under sequestration 

Although contract win rates have increase over the past couple years, operating margins sit at around 5%, suggesting that DynCorp may be cutting costs on its bids to maintain a healthy backlog during tighter times.

This raises a fundamental question about diversification for defense contractors, particularly for those in the Defense & Government Services and Logistics sector. Is it better to be a USG or DoD specialist or to diversify those programs with commercial work? The market has a habit of punishing diversification -- ITT and L3 both spun off businesses that had successfully grown into emerging industrial sectors. The former Chairman of Lockheed Martin once commented that "the record of diversification in the defense industry is unblemished by success." So why is DynCorp getting a negative outlook for specializing?

In a vote for diversification, consider DynCorp's close competitor, KBR. In Q3 KBR had revenue on the LOGCAP contract of just $156M, compared to DynCorp's $438M. Clearly, KBR has been on the losing side of many recent DynCorp advances on market share, and they are fighting to stay relevant in a shrinking, crowded environment for USG logistics & infrastructure services.

However, looking at the bottom lines of both companies, we find operating profits (for 9 months through Sep 2012) of $126M derived from KBR's two Government units (North American Government & Logistics, and International Defense & Support Services), compared to $114M for all of DynCorp for the same period. At KBR the defense business is probably less than 20% of the total, most of which comes from a Hydrocarbons business that produced over half KBR's turnover for Q3. 

I think KBR benefits in their Government work by having a diversified portfolio of related commercial work. They’ve protected margins better by making resources compete for returns across many different markets. DynCorp, on the other hand, with its concentration in DoD and State, has to cut its margins and low-bid everything in order to drive revenues/backlog. 

News in Defense Private Equity

Finding it hard to keep up lately, but here is some recent news in defense-related PE activity:

Ranger Aerospace is in the news after being involved in a recent capital markets conference. From the press release, Steve Townes is quoted:

"Key leaders in the capital markets and aerospace services industry recognize the strong niche brand we have built with Ranger over the years. We are middle market operators and business-builders, specialists in positive transformations. This newest Ranger platform is developing excellent velocity for 2011 and beyond."

Xe Services (formerly Blackwater) has been acquired by USTC Holdings, fully divesting founder Erik Prince's equity stake. USTC is an investor consortium led by Forté Capital Advisors and Manhattan Partners. More from the press release here.

ExecutiveBiz's list of the Top 20 People to Watch in 2011 includes the former CEO of DynCorp, Bill Ballhaus, as well as his successor, Steve Gaffney. Ballhaus remains on the board of DynCorp and serves as strategic advisor to parent Cerberus Capital Management.

Admiralty Partners will sell Trident Space & Defense to TeleCommunication Systems (TCS). Admiralty founder Jon Kutler will join the board at TCS. More here.

Former DynCorp CEO Joins Kaseman Board

Herb Lanese, former CEO of DynCorp International, has joined the board at Kaseman LLC. Kaseman, owned by DC Capital, provides engineering & technical services to U.S. Government customers.

DynCorp Goes Private

There are a couple of good articles out there on the sale of DynCorp International to Cerberus Capital Management. One from Forbes outlines the deal's financial gain for deal originator and Veritas founder Robert McKeon, who picks up around $320M+ in the end (after a $47M investment back in 2005, which he immediately recovered through a dividend). The other, from The Street, discusses the bigger picture, including deal details that price the shares at a 49% premium to the market price just before the deal was announced. It also mentions the difficulty DynCorp had as a public stock, with a controversial business and a couple incidents that may have weighed down the share price (not to mention those "pesky regulatory filings").

The Forbes article also implies that Veritas' success with this deal has drawn Cerberus into the sector. Insiders know better, that Cerberus has been trying to do a high-level acquisition in this space for several years, backing IAP's acquisition spree en route to its (unsuccessful) bid on LOGCAP, as well as some aborted attempts in the security services sector. 

IBM Buys NISC from DC Capital

Forbes reports that IBM has purchased the National Interest Security Company (NISC) from DC Capital Partners. NISC specializes in mostly classified contracts helping intelligence organizations manage and secure data and information systems. When the deal closes during Q1 this year, DC Capital will realize $180M on its original investment of $19.6M less than 3 years ago.

The same article describes the NISC sale as particularly important win for former Veritas Capital founder Thomas Campbell, who left Veritas to found DC Capital after being squeezed out by then partner Robert McKeon. Campbell and McKeon led the 2005 buyout and subsequent IPO of DynCorp International. The former partners separated after Campbell was forced off the DynCorp board. See prior Defense Ventures article here.

More on DynCorp, LOGCAP

Forbes continues its positive coverage of DynCorp International with an article providing a basic overview of their position on the LOGCAP IV contract and recent award of the Afghanistan-South task orders on that contract.

"DynCorp has emerged as one of the big winners of the wars in Iraq and Afghanistan, which now generate 53% of DynCorp's $3.1 billion of annual revenue. The company's revenue grew 45% last year thanks to a 51%-owned joint venture that has a multiyear $4.6 billion contract to supply 9,100 linguists to translate for U.S. soldiers in Iraq."

Certainly, DynCorp is doing quite well and finds themselves in a strong position in Afghanistan with a strong partner in CH2MHill. At the same time, the southern task orders will be a highly challenging environment to work in, on some high visibility construction projects. Overall the boom years for LOGCAP have temporarily passed, so investors should look another phase ahead to see how DynCorp can continue its diversification across the Defense & Government Services sector with this latest win.

Also mentioned in the article is the recent announcement that KBR will not protest either of the Afghanistan awards, even though one of its bids was lower than its winning competitor. KBR discussed this further during their Q209 earnings call, for which you can find a transcript here. Pages 2-3 discuss their stark prospects for Government Services (more commentary to come on that).

Forbes Article about Veritas, DynCorp: Part II Commentary

Back to the article in Forbes discussed yesterday about Veritas founders Robert McKeon and Thomas Campbell. We’re going to skip over the discussion about the supposed origins of strife between McKeon and Campbell over the DynCorp deal and subsequent departure of the latter from DynCorp’s board. Instead we’ll focus today’s post in part on what the Forbes article fails to mention about Campbell’s new firm DC Capital Partners, which has been profiled here on this site.

In the end perhaps it will be Campbell who achieves the most from his unique investment perch within the defense industry. We have remarked previously about the difficulty of 3rd party investors – Veritas among them – to maintain persistent returns from simply doing deals. Defense is a narrow industry, after all. When deal flow is strong, or when a big deal like DynCorp comes along, returns will tend to concentrate for a specialist firm like Veritas. However, when credit tightens and deal flow contracts sharply, Veritas may struggle to compete for quality against cash rich defense firms looking to integrate struggling mid-market firms.

One way to counter such a trend may be exactly the model that Campbell has developed at DC Capital, namely the integrated platform that focuses on rolling up companies around a particular market sector. DC Capital has pursued this strategy so far with its National Interest Security Company (NISC), which the Forbes article mentions is already profitable at around $200M revenue. More than just a concept, Campbell has recruited top management talent into NISC, led by Andrew Maner, former CFO for the Department of Homeland Security.

However, the Forbes article overlooks one of the principle strengths of DC Capital in addition to its platform strategy. In 2007 DC Capital acquired a controlling interest in The Spectrum Group, a consulting group with “over 100 associates – half of which are Admirals and Generals, the remainder are former Political Appointees, former Hill staffers, Corporate officers and lobbyists, and U.S. Government officials.” This is the reason NISC can deploy a deep advisory board for NISC that includes Ambassador Henry Crumpton, General Hagee, Chuck Hagel, General Michael Hayden, Admiral Joseph Lopez… and others, as well as access to the dozens of other brand names at Spectrum.

Tomorrow we’ll do another post of Part III commentary, in which we’ll provide some direct feedback on specific points within the Forbes article, particularly about the DynCorp deal and their current outlook in general.

Forbes article about Veritas, DynCorp

The August edition of Forbes Magazine features an outstanding article about Thomas Campbell and Robert McKeon, one-time partners and founders of Veritas Capital. The article gives us a detailed timeline on the start-up of Veritas Capital Management and the subsequent acquisition in 2005 of DynCorp International.

Worth reading in its entirety, but here are some highlights:

• Neither McKeon nor Campbell had a background in defense related deals when they started Veritas in 1996 (with $175 million for its first fund). McKeon was apparently more well known at Wasserstein Perella & co for a deal with Maybelline in the cosmetics industry.
• Computer Sciences Corp. bought DynCorp for $622 million in 2003. Veritas buys it in 2005 for $850M with a $100M of equity from Veritas. A year later after going public DynCorp pays off equity sponsors with a $100M dividend. DynCorp shares are today worth over $1B, of which McKeon personally is estimated to own/control around $270M worth through his sole ownership of DIV Holding.
• The DynCorp deal almost did not happen. Although Veritas only had to put up $100M, they were limited to a $38M investment. Some support came from Northwestern Mutual Life Insurance and from various Veritas investors, but ultimately McKeon put up $48M of his own money in the deal. 

The article also covers the story of McKeon's and Campbell's eventual falling out a couple years ago, when Campbell was forced off the DynCorp board. In part II of our commentary on this article, we'll cover more details of Campbell's launch of DC Capital and some hints to Forbes writer Nathan Vardi for following up on this piece.

Look for Part II tomorrow. In the meantime bone up by checking out this site's profiles of both Veritas and DC Capital.