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Dyncorp International Inc


Positive Review

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Stock Review

DynCorp is a government contractor that operates in three business segments. Global Stabilization and Development Solutions (GSDS, 36% of revenues, 30% of operating profits) provides policing and police training, security and personal protection for government officials and diplomats, and military base logistics such as electricity, water, sewage, and laundry under the recently awarded Logistics Civil Augmentation Program (LOGCAP) IV program. Global Platform Support Solutions (GPSS, 39% of revenues, 49% of operating profits) provides aircraft maintenance services, air traffic control, pilot training, and some land vehicle maintenance. Global Linguist Solutions (GLS, 25%; 20%) is a joint venture with McNeil Technologies providing interpreters and translators to the military for a variety of languages. GLS has grown from practically nothing over the past year after DynCorp won the INSCOM contract from former holder (and recent Magic Formula stock) L-3 Communications (LLL). 96% of revenue comes from U.S. government contracts. DynCorp recently went public in 2006 after being carved out of former parent Computer Sciences (CSC), but the company has a 60-year history of government contracting.

The most attractive aspect of DynCorp as an investment is the company's near-term growth potential. Winning a piece of LOGCAP IV was huge, as it could be worth tens of billions of dollars over the next decade or so. Under this contract, the company won a piece of providing services in southern Afghanistan, and there is a lot of potential for more wins there if military presence is expanded as recommended by U.S. command. LOGCAP will also provide service opportunities in Iraq, as the military transitions from LOGCAP III which was sole-sourced to competitor KBR (KBR). Also in Iraq, DynCorp is winning security service opportunities from the country's banning of former provider Xe Services (better known as Blackwater). For fiscal 2010, revenues are forecast to be up 14%, earnings per share over 25%, and 2011 is forecast to be even better. Forward earnings yield for 2010 is over 15% - a very cheap price to pay for that potential.

Service contracting to the military is a quite competitive business. DynCorp competes in some way with a wide array of firms including KBR, Fluor (FLR), L-3 Communications (LLL), ITT Corp (ITT), Lockheed Martin (LMT), and others. DynCorp is considerably smaller than its competitors, and with much weaker financial flexibility. However, this has not stopped the company from maintaining an impressive record of winning and maintaining contracts. The aviation support contract is over 55 years old, they wrested the linguistics contract from L-3, won a part of the lucrative LOGCAP IV, and continue to consistently get a piece of important overseas services opportunities. This is a testament to the company's executive level management, who have an average of a decade or more of experience and established political connections - which helps immensely in this kind of business.

Of course there are significant risks and concerns. As mentioned, DynCorp does not have the rock solid balance sheet that many of its competitors have. The balance sheet shows about $160 million of cash vs. a debt burden of over $560 million (largely from the spin-off). Interest coverage ratio is tight - operating earnings cover interest only 3.5 times over, less than the 5 times or more I like to see. While there are no near-term debt maturities, the nature of contracting is that the government can change terms at any time, putting revenues at risk. A serious unforeseen development, like a major pullback in overseas operations, could make the interest burden a real problem here. 50% of DynCorp's business comes from the Middle East, and the political momentum is certainly towards drawing down operations there. So, financial health is a bit of a concern.

Also, government contracting is quite unpredictable. First, the availability of contracts is hard to predict - it depends a lot on the political environment towards overseas operations, as well as the threat level. Second, the process for awarding contracts is muddled. The current administration has focused on improving the contracting process to bring costs down, and this is leading to more competition and multi-sourced contracts. There has been some indication of a move towards more government-provided services, or "in-sourcing". Any of these things could negatively effect DynCorp. Projecting accurate sales and profit numbers, particularly several years out, is virtually impossible. One thing is for certain: the 2001-2008 period was a boon to military contractors, one that is unlikely to be replicated over the next few years.

DynCorp is a quality play in the government contracting field, with good momentum and a proven ability to successfully compete with bigger players. MagicDiligence has a positive opinion of it. The inherent unpredictability and questionable financial health hold this back from being a Top Buy recommendation, however.

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Steve does not own DCP.

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