ICF International: An Opportunity Created By Concerns Over Lower Government Spending

Key takeaways

ICF International (ICFI) trades at an attractive multiple due to concerns that lower government spending (~three quarters of its business) will negatively affect results.However recent contract wins and an expected strong 2H mitigate these concerns.Moreover, a successful acquisition strategy reduced its dependence on government spending and resulted in significant EBITDA growth, high free cash flow and an almost 50% debt reduction.

Company overview

ICFI provides consulting services and technology solutions to U.S. and non-U.S. based government and commercial clients. Its government clients include federal, state, local and non-U.S. governments. Its commercial clients include airlines, airports, utilities, financial institutions, healthcare organizations, law firms, non-profit organizations, oil companies and retail firms.

The key markets are:

Energy, environment and infrastructure.Health, social programs and consumer/financial.Public safety and defense.

Why does this opportunity exist?

ICFI is caught in the perfect storm of the effects of sequestration, the continuing government shutdown and the increasing possibility of the U.S. defaulting on its debt. In the mrq, revenue only rose 0.8% to $241.6 million as strong commercial and non-U.S. government business offset weaker state and local government business. EBITDA declined 8.2% to $22.4 million and the margin declined 90 basis points to 9.3% due to increased subcontract activity.

As a result, ICFI trades at a low EBITDA multiple (especially relative to its closest peers) despite the positive fundamentals mentioned below.

However this creates an asymmetric opportunity as ICFI is effectively responding to the first fear and the second and third fears should eventually recede.*

For example, management said on the most recent conference call that federal government revenue remained stable due to its strong reputation and long-term client relationships in fast-growing niche markets such as healthcare, energy and infrastructure. ICFI won almost 100 new federal government contracts and awards as well as hundreds of awards from state/local and non-U.S. governments.

Management even reported strong proposal activity in the federal market, which is evident by the recent $189 million contract win from the U.S. Agency for International Development's Bureau for Global Health. This superior company-specific performance despite challenging overall industry conditions should be rewarded with a higher multiple.

Management expects 2H sales to be significantly ahead of 1H13 and raised the revenue guidance midpoint (to $955-975 million from $935-975 million) due to continued growth in the commercial business and an expected ramp-up in government contracts.

The book-to-bill ratio rose to 1.0 from 0.85 in the year ago period due to broad-based strength while the total pipeline rose $600 million sequentially to $3.6 billion with almost half of the increase from the commercial business. Moreover the dollar value of proposals submitted rose by more than 70% at the end of July 2013. Some of these contracts are 2-3 years in duration with the possibility of an extension. If awarded these contracts would provide a steady revenue stream.

*If the government remains shut indefinitely and the U.S. defaults on its debt later this month, no stock will be spared.

ICFI has domain expertise in fast-growing niche markets

ICFI can effectively compete against much larger peers ! such as B! ooz Allen due to its focus on a small number of markets and its proprietary analytics/methods. The latter provides a key competitive advantage (e.g. the ability to deliver a cost-competitive and customized solution). Moreover these intangible assets are not property valued on the balance sheet however they should eventually be reflected in the income and cash flow statements.

Moreover, ICFI should benefit from the increasing secular and global demand for its services that address critical issues such as energy efficiency, clean energy, health care cost containment and homeland security.

The ability to leverage its strong reputation as a prime contractor for advisory work into full lifecycle solutions (e.g. implementation, evaluation and improvement) and larger and longer contracts is a significant growth opportunity. Being the prime contractor is becoming increasingly important for federal clients and ICFI is positioned to take advantage of this as ~87% of 2012 revenue was from prime contracts.

Another growth driver is helping state and local governments adapt to the reality of lower budgets. ICFI should be able to capture this "low hanging fruit" by selling more services such as cybersecurity, program management and strategic communications to existing clients.

Moreover, its performance measurement and program evaluation services help these governments increase efficiency and save money. In this instance, lower government spending should be viewed as a blessing in disguise as any near-term weakness can be more than offset by increased sales to new and existing clients.

Growth through acquisitions strategy results in a more diverse revenue stream and growing cash flow

At first glance, ICFI does not appear to be diversified given that 68% of revenue is from the U.S. government.

H! owever, t! here are two significant mitigating factors.

First, ICFI is diversified within these markets as the chart below shows. Moreover, in 2012 no single contract accounted for more than 4% of revenue and the top 10 contracts only accounted for ~16%.

Second, ICFI has successfully implemented a growth through acquisitions strategy over the past eight years. This reduced its dependence on U.S. government spending and significantly diversified the revenue stream (e.g. by client, business and geography).

Source: Company presentation

However all growth through acquisitions strategies are not the same, nor should the companies that employ them receive the same multiple. For example, debt-fueled growth should not be given a higher multiple as there is little management skill required (especially if overpaying) and more importantly the risk is significantly increased.

However as the charts below show, EBITDA rose (as expected from acquisitions) yet management used the growing free cash flow to pay down debt. In addition to its much lower debt load, ICFI has access to $290.6 million under its credit facility.

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Moreover, this is a margin expansion story as the growing commercial business has higher margins than the government business. For example, the energy segment should experience secular growth and higher margins due to the increasing need to control rising energy costs and reduce the environmental impact through the use of cleaner energy sources. In the mrq, revenue from commercial energy efficiency programs rose 21.3% and accounted for 37.5% of total commercial revenue. ICFI believes it is the market leader in residential energy efficiency programs and reported increased market share in the commercial industrial sector.

Risks

Dependent on government spending. ICFI still receives a majority of its revenue from various U.S. governments and is dependent on congressional appropriations/agency allocations. This risk is mitigated by the continued expansion of its commercial client base however this presents new challenges as many of these clients operate in cyclical industries.

Total backlog may not be realized. ICFI may not receive revenue for the total amount of its backlog (especially if a client does not renew a contract or an award is protested) or may receive the money later than expected.

Contract cost overruns. ICFI is exposed to the risk of underestimating the cost of fulfilling contracts. This risk is mitigated by employing three types of contracts (time-and-materials, cost-based and fixed-price).

Conclusion

The target price of $42.38 is based on a 10x EBITDA multiple, which is conservative given the discount to the peer group average multiple and the fact that it is based on the low end of management guidance."

The pullback to the 50 DMA provides a perfect place for a tight 5% stop loss. The time frame is 12-24 months given the current uncertainty surrounding government spending and ongoing expansion of the commercial business.

*2013 revenue guidance of $955-975 million and EBITDA margin of 9.5-10%

Source: ICF International: An Opportunity Created By Concerns Over Lower Government Spending

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. (More...)