June 26, 2007
Research Associate: Priyanka Ghiya, M.Fin.
Editor: Madhurima Majumdar
Sr. Ed.: Ian Madsen, CFA; ; 1-800-767-3771, x9417
111 N. Canal Street, Suite 1101 Chicago, IL60606
DRS Technologies / (DRS–NYSE) / $55.72Note: All new or revised material since the last report is highlighted.
Reason for Report: 10-K Filing Prev. Ed.:May 18, 2007
Zacks Investment ResearchPage 1
Recent Events
On June 18, 2007, DRS announced that it has been selected to participate in the U.S. General Service Administration's $750 Million SATCOM II Contract. Further details are provided below.
On May 31, 2007, DRS announced that it received a $139 million contract, including options, to provide the Defense Supply Center Columbus (DSCC) with a variety of night vision systems and products.
On May 30, 2007, DRS filed its 10-K report with the SEC.
On May 11, 2007, DRS announced that its Board of Directorshas declared a quarterly cash dividend of $0.03 per share payable on June 29, 2007 to stockholders of record on June 15, 2007.
On May 11, 2007, DRS reported its 4Q07 and FY07 earnings. Highlights are as follows:
- Total revenue was $798.9 million in 4Q07 versus $645.7 million in 4Q06, an increase of 24.0%. Total revenue inFY07was $2.82 billion, up 63%from $1.74 billion in FY06.
- DRS reported net income of $45.6 million in 4Q07 versus $28.8 million in 4Q06, an increase of 58%; and $127.3 million in FY07, 56% above the $81.5 million reported inFY06.
- EPS was $1.11 in 4Q07versus $0.79 in 4Q06; and $3.12 in FY07, 17% above EPS of $2.67 recorded in FY06.
Overview
Key investment considerations as identified by analysts are as follows:
Key Positive Arguments / Key Negative Arguments- Compelling fundamentals: After more than 25 acquisitions, DRS has become a well-regarded defense electronics firm with high-growth franchises.
- Growth opportunities: Given DRS's focus on information and surveillance products, it is well positioned to benefit from the thrust to increase the informational awareness capabilities of U.S. forces. Efforts to boost the surveillance of the nation's borders is another area where DRS could find additional domestic markets for its products without having to manage the export restrictions associated with foreign sales.
- Well-positioned business model: DRS is a diversified defense company with strong capabilities in command & control, surveillance, communications, power generation and military logistics.
- Financials: Higher average borrowings outstanding associated with the financing of the Engineered Support Systems, Inc. (ESSI) acquisition.
- Government spending: Curtailment of expenditures by the U.S. government and its allies for defense equipment and supplies could have a negative effect on the Company’s ability to grow its revenue and profits. About 85-90% of its sales are to the U.S. government.
- Others: Integration risks related to an aggressive acquisition strategy worry some investors.
DRS Technologies, Inc. (DRS or the Company), based in Parsippany, New Jersey, is a supplier of defense electronic products and systems. The Company provides products and services to all branches of the United States military, aerospace, and defense prime contractors, government intelligence agencies, international military forces, and industrial markets. DRS focuses on several key areas of importance for the United States Department of Defense, such as intelligence, surveillance, reconnaissance, power management, advanced communications, and network systems. Its productsinclude thermal imaging devices, combat display workstations, electronic sensor systems, power systems, battlefield digitization systems, air combat training systems, mission recorders and deployable flight-incident recorders. The company’s businessconsists offour operating segments: the Command, Control, Communications, the Computers & Intelligence (C4I) segment, the Reconnaissance, Surveillance & Target Acquisition (RSTA) segment, the Sustainment Systems segment, and the Technical Services segment.
More information can be obtained from DRS’s website:
NOTE: Fiscal year ends on March 31; fiscal references differ from the calendar year.
Revenue
CONSENSUS PROJECTED SALES
TOTAL REVENUE($ in millions) / 2006A / 4Q07A / 2007A / 1Q08E / 2Q08E / 3Q08E / 4Q08E / 2008E / 2009E
Digest High / $1,736 / $799 / $2,821 / $736↔ / $782↔ / $815↔ / $895↔ / $3,160↔ / $3,520↔
Digest Low / $1,736 / $799 / $2,821 / $680↔ / $729↔ / $737↔ / $793↔ / $3,004↔ / $3,193↔
Digest Average / $1,736 / $799 / $2,821 / $694↔ / $757↑ / $760↓ / $859↑ / $3,069↓ / $3,319↑
Digest Average YoY Growth / 32.6% / 23.7% / 62.6% / 10.0% / 6.4% / 11.7% / 7.6% / 8.8% / 8.2%
Quarterly growth / 17.4% / -13.2% / 9.2% / 0.3% / 13.1%
DRS posted 4Q07 revenue of $798.9 million, 24% above the 4Q06 revenue of $645.7 million. The increase in the quarter revenue was primarily attributable to ESSI sales (the acquisition of which was completed during 4Q06) as well as to strong organic growth of 12.2%, especially in the Company's ground vehicle sighting and targeting systems, and tactical computer systems product lines. One firm (Bear Stearns) opined that of the defense companies, DRS delivered the strongest growth rate (organic revenue growth of 12.2%) in 4Q07.
Revenue in FY07was $2.82 billion, 63% higher than revenue of $1.74 billion recorded in FY06. The increase was attributed to the benefit of a full year of revenue fromESSI, and organic revenue growth, which accounted for approximately 13.9% of the sales increase.
DRS's initial FY08 revenue guidance of $3.0 billion-$3.05 billion implies an estimated 6-8% increase over FY07 revenues.
CONSENSUS PROJECTED SALES BY SEGMENT
REVENUE($ in millions) / 4Q07A / Q/Q% Change / Y/Y% Change / 1Q08E / 2006A / 2007A / 2008E / 2009E
C41 Group / $328 / 22.3% / 0.1% / $292↔ / $1,123 / $1,140 / $1,231↓ / $1,325↑
RSTA Segment / $169 / 1.5% / 12.6% / $135↔ / $444 / $600 / $692↑ / $765↑
Sustainment Systems Segment / $121 / 25.6% / 73.7% / $95↔ / $69 / $401 / $430↓ / $465↔
Technical Services Segment / $181 / 21.1% / 83.8% / $167↔ / $99 / $681 / $733↓ / $785↓
Total Revenue / $799 / 17.4% / 23.7% / $694↔ / $1,736 / $2,821 / $3,069↓ / $3,319↑
C4I Group: Revenue in 4Q07 increased0.1%YoY to $328 milliondriven by the high demand for intelligence products, partially offset by soft demand for naval displays. One firm (Jefferies) believes the topline at the segment decelerated as low sales of Q-70 naval display systems and electronic warfare products offset the high volumes of tactical computing equipment and naval power systems. During 4Q07, the segment booked $256.3 million in new contracts.
InFY07, the C4I segment posted record revenue of $1.14 billionversus $1.12 billion inFY06, reflecting increases primarily in the segment's tactical computer systems, naval power systems, and vehicle test and diagnostics systems product lines. The segment sales comprised 40.4% to the total revenue in FY07.
One firm (Citigroup) expects the low growth to continue at the segment. Another firm (JSA Res.) forecasts FY08 C4I sales of $1.2 billion (up 5% from FY07).
RSTASegment: 4Q07 salesrose by 12.6%or $19.0 million YoY to $169 million. Increased deliveries ofground vehicle sighting and targeting systems, and uncooled infrared productswere the primary sales drivers. New contracts awarded to the segment during 4Q07 were valued at $126.2 million.
In FY07, the segment set a new record in revenue of $600 million, up 35% from $444 million in FY06. The increase in sales was due primarily to high shipments in the segment's ground vehicle sighting and targeting systems, soldier systems and infrared detector product lines.
One firm (Citigroup) believes the segment is highly exposed to supplemental funding and should continue to grow at a premium due to the Army reset. Another firm (JSA Res.) forecasts FY08 RSTA sales of $653 million.
Sustainment Systems Segment: 4Q07 sales totaled $121 million, up73.7%YoY. The high demand formtransport systems, power systems and vehicle systems, all contributed tothe robust sales growth.
DRS posted FY07revenue of $401 million, an increase of 477.7%YoY as the segment secured new contracts valued at $508.6 million during FY07, and reported funded backlog of $485.5 million asof March 31, 2007, 28% higher than funded backlog of $378.3 million at the same time a year ago.
One firm (JSA Res.) forecasts FY08 segment sales to increase by 6% to $425 million.
Technical Services Segment: 4Q07 sales totaled $181 million, up 83.8% YoY. The high demand for logistics support, engineering services and power generators were the primary sales drivers.
InFY07, the segment recorded revenue of $681 million. New orders received in FY07 were valued at $781.1 million. Funded backlog as of March 31, 2007 was $414.7 million, up 39% from $297.7 million in funded backlog at the end of FY06.
One firm (Citigroup) believes this business is very volatile in terms of its revenue performance. Another firm (JSA Res.) forecasts FY08 segment sales growth of 8.5% to $739 million.
Please see the Zacks Digest spreadsheet on DRS for more details.
Margins
CONSENSUS PROJECTED MARGINS
MARGINS / 4Q07A / Q/Q % Change / Y/Y % Change / 1Q08E / 2006A / 2007A / 2008E / 2009EC41 Group / 12.8% / 2.5% / 0.1% / 10.6%↔ / 11.2% / 11.4% / 11.6%↔ / 11.7%↓
RSTA Segment / 13.2% / 0.8% / 1.2% / 11.2%↔ / 12.3% / 11.5% / 11.8%↔ / 12.0%↔
Sustainment Systems Segment / 14.7% / -3.0% / 2.7% / 13.8%↔ / 12.0% / 14.8% / 14.4%↓ / 13.9%↓
Technical Services Segment / 7.0% / -0.6% / 0.1% / 7.6%↔ / 6.9% / 7.2% / 7.6%↓ / 7.8%↓
Operating / 11.8% / 0.5% / 0.3% / 10.4%↔ / 11.1% / 10.9% / 11.1%↔ / 11.1%↓
Pre Tax / 8.1% / 1.3% / 0.7% / 6.2%↔ / 7.7% / 6.6% / 7.4%↔ / 8.0%↔
Net / 5.7% / 0.6% / 1.2% / 3.8%↔ / 4.7% / 4.5% / 4.6%↔ / 4.9%↓
Operating income in4Q07 was a record $94.1 million, 27% above the $74.2 million recorded in4Q06. The highoperating income was primarily attributed to the increase in sales volume year over year. 4Q07 operating margin was 11.8% versus 11.5% in 4Q06, an increase of 30 basis points. The increase in the4Q07 operating margin was due to improvements at the RSTA and Sustainment Systems segments.
Operating income was $307.6 million at FY07 end, up 60%from $192.7 million recorded inFY06. The increase was attributed to the high overall sales volume. The operating margin inFY07 was 10.9%versus 11.1%inFY06. The decrease was caused by unfavorable sales mix, which included a greater portion of sales generated by typically low-margin services businesses at the company's Technical Services segment.
Management guided $115-$117 million in interest expense, effective tax rate of approximately 38%and 41.8 million in weighted average diluted shares outstanding for FY08
For FY08 management operating margin guidance is approximately 11%.
C41 Group: In 4Q07, theoperating income was flat at $42.0 millionor 12.8% of segment sales versus 12.7% in 4Q06, though it was up sequentially from 3Q07 by 250 basis points. FY07 operating income was $130.0 million versus $125.9 million inFY06, and operating margin was 11.4%versus11.2%a year ago. One firm (JSA Res.) forecasts FY08 C41 operating income $138 million or 11.5% of sales, up 10 basis points.
RSTA Segment: In 4Q07, the operating income was $22.3 million(operating margin of 13.2%), a 24% increase over $18 million recorded in 4Q06. DSR recorded operating income of $68.8 million(operating margin of 11.5%), an increase of 26% over the $54.5 million recorded a year earlier. The increase in operating income was primarily due to high shipments in the segment's ground vehicle sighting and targeting systems, soldier systems and infrared detector product lines. One firm (JSA Res.) forecasts FY08 RSTA operating income of $79 million or 12.1% of sales.
Sustainment Systems Segment: The segmentrecorded operating income of $17.7 million or 14.7% operating marginin 4Q07. In FY07 the segment posted operating income of $59.2 million or14.8% of operating margin. The profitability in FY07 was attributed to the overall increase in sales. The operating margin expansion in FY07 was primarily due to certain military equipment transport systems, vehicle-mounted weapon targeting systems, universal power systems and other defense system product lines. One firm (JSA Res.) forecasts FY08 Sustainment Systems operating income of$60 million or 14.0% of operating margin.
Technical Services Segment: In 4Q07,the operating income was $12.6 million or operating margin of 7%. The segment reported operating income of $49.1 million or7.2% of sales in FY07. The FY07 profitability was attributed to the increase in revenue, and the strong operating margin in the quarter tothe robust performance of the high-margin engineering and logistics support services and deployable power generators product line. One firm (JSA Res.) forecasts FY08 Technical Services operating income of $54 million or operating margin of 7.3%, up 10 basis points.
Please see the Zacks Digest spreadsheet on DRS for more details.
Earnings per Share
The Company reported 4Q07 GAAP EPS of $1.11, 41% higher than the 4Q06 GAAP EPS of $0.79. SFAS 123R accounting requirements negatively impacted the 4Q07 GAAP EPS by $0.01 per share, offset bydiscrete tax benefits of $0.12 per share. Excluding these two adjustments, the Company reported 4Q07 pro forma EPS of $0.99.
GAAP EPS inFY07 was $3.12, 17% above the FY06 GAAP EPS of $2.67. SFAS 123R (which became effective from April 1, 2006) accounting requirements negatively impacted the FY07GAAP EPS by $0.09 per share, offset by discrete tax benefits of $0.28 per share. The FY06 GAAP EPS of $2.67 included a $0.10 per share favorable tax adjustment. Excluding the FAS 123R and discrete tax benefits adjustments to both FY07 and FY06 EPS, the Company would have reported FY07 pro forma EPS of $2.93, 14% higher than the FY06pro forma EPS of $2.57.
The ESSI acquisition is expected to add $0.20 in diluted EPSin DRS’s first full fiscal year of operation.
All analysts, except one analyst(CIBC), provided GAAP EPS figure without any reconciliation.
CONSENSUS PROJECTED EPS
EPS / 4Q07A / 1Q08E / 2006A / 2007A / 2008E / 2009EZacks Consensus / $0.65↓ / $3.32↓ / 3.80↑
Company Guidance / $3.10-$3.20↔
Zacks Digest Model Max. / $0.99 / $0.65↔ / $2.61 / $2.84 / $3.33↔ / $3.92↔
Zacks Digest Model Min. / $0.99 / $0.65↔ / $2.61 / $2.84 / $3.33 ↔ / $3.92↔
Zacks Digest Model Avg. / $0.99 / $0.65↔ / $2.61 / $2.84 / $3.33 ↔ / $3.92↔
Highlights from the EPS chart are as follows:
- 2008 forecast (by1 analyst) is$3.33.
- 2009 forecast(by 1 analyst) is $3.92.
The Company provided FY08 diluted EPS guidance of $3.10–$3.20, reflecting 9-13% growth.
Please see the Zacks Digest spreadsheet on DRS for more details.
Target Price/Valuation
The average Zacks Digest price target is $59.85(6.90%upside from the current price). The price target ranges from $54.00(3.19% downsidefrom the current price)to $65.00 (14.28% upside from the current price)with a median target price at $61.00. Analysts with the estimated highest target price of $65.00 (Stifel Nicolaus; Friedman, Billings) based the valuation on 9.5xEV/FY08 EBITDA, andDCF method, respectively. Analysts with the estimated lowest target price of $54.00 (JSA Res., Jefferies) is based on a 16x forward-4Q P/E multiple, and 16x FY08 estimate of $3.35, respectively. Valuations are primarily based on EBITDA, EV/EBITDA multiples, P/E multiples, and DCF analyses.
Rating DistributionPositive / 53.8%↔
Neutral / 46.2%↔
Negative / 0.0%↔
Avg. Target Price / $59.85↓
Digest High / $65.00↔
Digest Low / $54.00↔
No. of Analysts with Target Price/Total No. / 10/13
Management effectiveness ratios are as follows:
Metric (TTM) / Value / Industry / S&P 500Return on Assets (ROA) / 3.12% / 5.50% / 8.20%
Return on Investments (ROI) / 3.80% / 8.03% / 12.09%
Return on Equity (ROE) / 8.90% / 16.15% / 20.56%
Please see the Zacks Digest spreadsheet on DRS for more details.
Capital Structure/Solvency/Cash Flow/Governance/Other
Cash Flow: Free cash flow (FCF) in4Q07 was a record $115.9 million, 43% higher than FCF of $80.9 million in 4Q06. Net cash from operations was $133.6 million,consisting of earnings ($45.7 million), D&A($19.7 million), augmented by the $65.2 million reduction in working capital.One firm (Bear Stearns) attributed the decrease in working capital to two primary factors: 1) a $66 million increase in accounts payable and 2) a $36.7 million pickup in customer advances. Another firm (Jefferies) stated that the company generated cash ratably during the quarter as interest expense decreased in a similar proportion to the fall in debt balances, which was $1.79 billion (in 4Q07)versus 1.86 billion in 3Q07.
Net cash from operations inFY07 was $193.4 million, up 24% from $156.8 million a year ago. FCF was a record $138.8 million inFY07, 22% higher than the $113.5 million recorded inFY06, and exceeded the company's targeted ratio of 1:1 of free cash flow to net income by 10%. FY07 capital expenditurewas $56 million versus $43.1 million last fiscal year.
Management guided $70-$90 million in capital expenditure and $110-$130 million in FCF for FY08.
One firm (Citigroup) anticipates that the majority of the cash flow will be used to pay down debt relatedto the ESSI acquisition.
Balance Sheet: As of March 31, 2007, the company had $95.8 million in cash and cash equivalents, compared with $1.2 million at the same time last year. Total debt as of March 31, 2007 was $1.79 billion, down $42.3 million year over year and $68.2 million lower sequentially. Net debt (total debt minus cash) was $1.69 billion at the end of the fiscal year, 8% lower than $1.83 billion at the end of FY06. The Company paid the outstanding balance on its $400.0 million revolving credit facility and had no borrowings against it as of March 31, 2007. Stockholders' equity increased to $1.50 billion at the end of FY07, up 11% from $1.35 billion as of the end of FY06. The Company paid down debt by $72 million in 4Q07 and by $135 million in FY07.
One firm (CIBC) believes therelatively high net debt-to-capital ratio appears manageable but will likely restrict thecompany’s acquisition strategy in the near term. On the other hand one firm (Thomas Weisel) stated that the company continues to use free cash flow to pay down debt with the net debt-to-capital ratio decreasing to 53%.
Managementindicated that de-leveraging of the balance sheet remains its toppriority for the next 18 months. FCF is expected to trackclose to net income, which should result in debt reduction of about $100million in FY08.
Other: The Company was recognized as one of "The 25 Fastest Growing Technology Companies in America" by Forbes Magazine, as published in January 2007.
One firm (Kaufman Bros.) stated that after the end of 4Q07, the company was selected for bidding on up to $750 million in equipment contracts for U.S. government satellite communications services.
DRS is one of the 24 companies selected to participate in the U.S. General Service Administration's (GSA) SATCOM (Satellite Communications) II contract. The Indefinite Delivery/Indefinite Quantity (IDIQ) contract has a ceiling value of $750 million. Once selected, DRS will be able to lease its self-designed satellite earth station systems to provide secure military communication networks for command, control and communications initiatives, Internet access, voice telephone service, high speed data transfer, and video conferencing. DRS has established relationships with global and regional satellite organizations and terrestrial network providers to provide GSA's clients with access to these services at the most competitive rates possible.
Potentially Severe Problems
There are none other than those discussed in other sections of this report.
Long-Term Growth
The lowest projected growth rate is 10.0% (Thomas Weisel) and the highest projected long-term growth rate is 15.0% (CIBC, Raymond James); the average is 12.7%.
Management feels that the completion of the integration of the operations of ESSI, acquired in 4Q06, would start accruing considerable benefits for the Company from FY08 onward. Analystsalso confirm that the positive impact from DRS's cost-cutting realignment of operations, undertaken after the acquisition of ESSI would benefit the company over the long term.
Analysts believe the commercial aerospace cycle is well-positioned for a continued up-cycle, with a peak occurring some time after 2011. This suggests substantial upside potential for the group. Consistent strong free cash flow, pricing power and reasonable valuations are other factors thatwould further underpin the growth of defense companies.
Analysts further add that the yet-to-be-passed supplemental defense appropriation bill will provide some additional business, and the continued demand for DRS products and services due to the global geopolitical situation and the high level of activity of U.S.forces in Southwest Asia. Many analysts are of the opinion that the company's dedication to its roleas an innovator and contractor to the primes should raise its standing asa supplier of advanced technologies to all branches of the military andhomeland security communities.