Summary
- There are multiple key drivers across all verticals that Parsons is present in.
- PSN's strong customer relationship and industry recognition are barriers to entry.
- I expect growth to decelerate in FY23, for which the market would attach a lower multiple to the business.
Description
I believe Parsons Corp ( PSN ) stock is fairly valued. The earnings reports from CACI International ( CACI ) and Booz Allen Hamilton ( BAH ) indicate continued robust contracting activity, which gives insight into PSN's 4Q22 earnings and suggests that the company is on track for strong performance. That said, I think growth would slow down in FY23/24 back to industry level which would not reflect well.
Company overview
PSN serves the defense, intelligence, and critical infrastructure industries as a provider of technologically-driven solutions. They help customers with their problems by offering technical design and engineering services and software. Given the different segments, I encourage you to read up on PSN here . My writeup will focus more on competitive advantage and what to expect in the near-term.
Multiple key drivers across all verticals that PSN is present in
Rapid societal shifts, geopolitical complexities, an ever-evolving threat landscape, and the globalization of trade are all the result of the rapid development of technology. Customers are looking for technology-enabled solutions to modernize their assets and operations in response to this shifting landscape.
The increase in both the amount and the standard of data that can be utilized online is a direct result of the growing worldwide connectivity and the widespread use of social media. In addition, the rising popularity of BYOD (bring your own device), IoT (Internet of Things), and cloud computing has dramatically expanded the demand for top-grade cybersecurity programs. Considering the dynamic nature of the threats we face today, I anticipate this market expanding further. In addition, reliable intelligence is always required to back up national security and other U.S. priorities. As such, this calls for increased coordination among intelligence agencies. It has become apparent that command and control systems are needed that can operate effectively in a wide variety of environments, rather than just one. Because of this, advanced data analytics are increasingly important for transforming raw data into actionable insights in near real-time.
Finally, the rapid pace of technological change is placing a strain on US aging physical infrastructure. As a result of this stress, the mobility solutions market is expected to reach $815.2 billion by 2030, according to Precedence Research . Airports, bridges, and rail and transit systems—all of which are vital to the national economy and security—are prime examples of critical infrastructure that are especially at risk in the face of this change. Despite the fact that the United States has set aside a sizable sum to invest, I anticipate that older infrastructure will be gradually phased out in favor of smarter infrastructure with a greater emphasis on connectivity.
M&A strategy
PSN's net debt to EBITDA is under 2 right now. I think this company could easily leverage this up to 4x, which would give it an additional $700 million in dry powder to conduct a series of M&As, because of the cashflow generative nature of the business. According to the management, the target leverage for an M&A deal is between 2x and 3x, but a higher ratio is possible if the deal makes sense (Jefferies Virtual IT Services Summit Jun'22). With its strong free cash flow, I expect PSN to be able to easily deploy between 5% to 8% of its market cap each year on M&A without resorting to additional debt financing.
Deep relationship with customers
The quality of PSN's connections with its clientele is a major factor in the company's ability to compete. PSN's relationships with its most important government and commercial clients often span decades. In the Federal Solutions division, for instance, PSN has been supporting the Missile Defence Agency for over 30 years, with 1,000 employees permanently embedded with the organization. In addition, for the past half century, PSN has worked with the U.S. Department of Energy on a wide range of projects and programs. PSN has been assisting the Washington Metropolitan Area Transit Authority within the Critical Infrastructure sector for well over half a century now.
I think PSN is able to better focus its research and development efforts on satisfying its customers because of the longevity of its relationships with those customers. This work has led to PSN's success in securing key contracts for the projects that require deep technical knowledge. PSN is well-liked by its clientele and is also widely respected within its field. When competing for highly complex, technically challenging projects that necessitate flawless execution, these accolades really shine for PSN. Markets like cybersecurity, missile defense, and smart cities, for example, call for highly specialized knowledge and consistent excellence in performance. Simply put, there are two ways in which a large organization, such as the government, can determine whether or not a solution provider can be relied upon: past performance (based on previous contracts), and recognition by credible bodies. To achieve the latter, years or decades of experience in the field are required before a new player has a chance.
As such, I believe both the long-term relationship with customers and industry recognition form a strong barriers to entry in this industry.
Earnings report from CACI and BAH provide insight to PSN 4Q22 earnings
Revenue growth for CACI International in 2FQ23 was 11%, with EBITDA margins at 10.2%, and adjusted diluted EPS coming in at $4.28. Most importantly for PSN, CACI's quarterly gross book-to-bill ratio increased to 2.1x from 1.4x, indicating continued robust contracting activity.
Revenue growth for Booz Allen Hamilton in 2FQ23 was 12%, with EBITDA margin at 10.7%, and adjusted diluted EPS coming in at $1.07. Client staff also increased by 8%, marking the third consecutive quarter of accelerated growth.
In line with CACI and BAH, I anticipate that for 4Q22 PSN will have a strong revenue performance, with margins falling short and earnings roughly in line with consensus. After lapping an easy comp last year, I anticipate FY23 revenue growth to slow to a rate more in line with industry averages. In terms of profit margins, I anticipate that Federal Solutions will benefit from synergies resulting from the acquisition and operating leverage, while Critical Infrastructure will benefit from an upward bias due to the retirement of legacy programs.
Valuation
Based on my model, my price target is around $43, which makes the stock fairly valued. My model is based on FY22 guidance from management, and a regression in growth rates back to industry levels (as mentioned above). As PSN growth is expected to decelerate rate from current levels, I believe the market would attach a lower EBITDA multiple (11.5x is the long-term average).
Key risks
Government budget and priorities can change
PSN's contracts with government agencies are a major source of income. As a result, the company's success is tied to the federal government's willingness to keep investing in programs like defense, intelligence, infrastructure, and engineering. Spending in this area has varied over time, with some periods seeing decreases. For this reason, PSN may experience underwhelming performance at times.
M&A risk
To expand the company, management is considering making one or two merger and acquisition deals per year. A deal always carries some degree of danger, even if the strategy is sound and the management team has a proven track record. The growth forecast and FCF profile could be negatively affected if management overpaid for or failed to successfully integrate the acquired business.
Summary
PSN serves the defense, intelligence, and critical infrastructure industries, providing technologically-driven solutions such as technical design and engineering services, and software. The business has a competitive advantage due to its deep relationships with clients spanning decades, which has led to success in securing prime contract positions for technically challenging projects. The company also has strong cash flow, making it likely to deploy between 5% to 8% of its market cap on M&A each year without additional debt financing.
That said, I expect growth will slow down in FY23/24 back to industry level, which is likely that the market will attach a lower multiple.
For further details see:
Parsons Corp.: Growth Likely To Decelerate