DynCorp derives almost all of its revenue from the U.S. Defense and State departments, which face significant uncertainty in their budgets. For starters, the government is currently operating under a continuing resolution (CR) because the fiscal 2013 (beginning Oct. 1, 2012) budget has yet to be signed into law. A CR limits spending to prior-year levels and restricts the start of new programs until the budget is passed, which could delay orders for DynCorp’s services and disrupt earnings and cash flow generation. In addition, the fiscal 2013 budget proposal, which includes roughly $500 billion in cuts to previously planned defense spending levels over the next decade, does not take into account the potential impact of sequestration. If the sequestration process is triggered, roughly $500 billion in additional cuts over the next decade will occur, beginning in March 2013. Although we do not believe Congress will implement the full amount of these cuts, we believe further spending reductions are likely, which could shrink funding for DynCorp’s services.
We believe DynCorp will experience modest revenue growth over the next 12 months, but demand may fall in the longer term. DynCorp has significant exposure to the Middle East, as roughly 75% of the company’s sales are related to operations in Iraq and Afghanistan. In the near term, we believe DynCorp will continue to benefit in the next year from base consolidations in Afghanistan, as the Army focuses on larger, enduring bases. However, long-term demand for DynCorp’s services could decline with the wind-down of the wars in Iraq and Afghanistan because DynCorp generates the most revenue during conflicts. While DynCorp does provide training and judicial support to local governments, as well as transportation and protection to the State Department during peacetime, we believe demand could decline, as it is now not clear how large the U.S. presence in Afghanistan will be after all combat troops are withdrawn in 2014.
EBITDA margins have stabilized at about 5% for the past 12 months ended Sept. 28, 2012, from 7%-8% from 2007 through early 2010. The deterioration was due to lower margins on new contracts (especially the LOGCAP contract, which accounts for about 45% of sales), increased price competition, and the U.S. government’s efforts to reduce costs and problems in the security business. To improve efficiency and increase the number of contracts it wins in a more price-competitive market, DynCorp re-aligned its business development functions at the end of 2011 and has taken actions to lower costs in the supply chain. The effort has proved successful thus far, as DynCorp’s win rate has increased and award-fee scores have improved on the LOGCAP IV contract in 2012. Better bidding practices may lead to a modest improvement in EBITDA margins over the next year, although challenging market dynamics will likely keep margins below levels in prior years.
We expect DynCorp International’s liquidity to be “adequate” for its near-term operational and financial obligations. We believe sources of liquidity will exceed uses by at least 1.2x over the next 12 months and that sources would exceed uses even if EBITDA were to decline by 15%.
As of Sept. 28, 2012, cash was $87 million and the company had $110 million of availability remaining under a $150 million revolving credit facility (net of letters of credit) that matures in July 2014. We expect free cash flow to be between $75 million and $100 million over the next 12 months and we believe DynCorp will use these proceeds for a combination of debt reduction and acquisitions.
The company has no debt maturities until 2016 and minimal capital spending requirements. We expect the company to maintain adequate cushion in the maximum leverage (which steps down to 5x in June 2013 from 5.25x) and minimum interest coverage covenants--which use different definitions of debt and EBITDA than we use in our credit ratios--in the credit facility.
We rate the company’s secured debt (which consists of a $417 million term loan and a $150 million revolver) ‘BB-’ with a recovery rating of ‘2’, indicating expectations of substantial recovery (70%-90%) in a payment default. We also rate the $455 million unsecured notes ‘B-’ with a recovery rating of ‘6’, indicating expectations of negligible recovery (0-10%). Please see our recovery report published on RatingsDirect on June 22, 2012, for a complete analysis.
The outlook is negative. While credit metrics have improved to levels more appropriate for the rating in recent months, we believe budget pressures at the U.S. Defense and State departments or a change in U.S. foreign policy could hurt demand. We could lower the rating if a reduction in funding for DynCorp’s services, weaker margins, or contract losses result in debt to EBITDA greater than 5.5x or FFO to debt less than 10% for a sustained period. We could revise the outlook to stable if new contract wins, better award fee scores on LOGCAP IV, and debt reduction, as well increased clarity on U.S. spending for defense and foreign policy, enable the company to maintain debt to EBITDA of 4.5x-5x for a sustained period.
Related Criteria And Research
-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Key Credit Factors: Methodology And Assumptions On Risks In The Aerospace And Defense Industries, June 24, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008