KEYW Holding Corp.: Five Key Challenges Pose Significant Downside Risk

by Sonya Colberg, Senior Editor - 3/3/2016 9:59:43 AM

An embarrassing acquisition and declining gross margins are among the issues poised to kill the stock price of KEYW Holding Corp. (KEYW).

Indeed, while a rally is temporarily holding up the share price for the holding company, massive challenges have set up prime conditions for a dive. These hazards are tied to the company's failed attempt to jump from a declining government contract business into the cyber security business and back out again.

The Hanover, Maryland-based company hasn't responded to TheStreetSweeper's request for comment but investors may find various viewpoints here. Meanwhile, we present the top five reasons KEYW faces big troubles.

*1. KEYW Must Dump Embarrassing Loser

The company had plodded along as a boring government contractor until it captured investors' attention by forming the Hexis Cyber Solutions product line from two rollups and beginning to remake itself into a cyber security company.

Investors bought into KEYW's expectations for Hexis. They were under the impression that the new business was brimming with hope, based on the company's revenue projections:

(Source: Company SEC filing)

But Hexis has fallen far short of those expectations. The segment generated $7 million revenue less than anticipated in 2014. And the expected $40 million contribution to revenue in 2015 turned out to be under $14 million:

(Sources: Company SEC filings and earnings call)

So KEYW wants to put this major misstep behind it by trying to sell all or part of Hexis. In the last earnings call, CEO Bill Weber said:

"KEYW will not continue to invest in the unconstrained way it has in the past. As a public company, we have the utmost obligation to shareholder value. And as such, we initiated a process a few months ago for a strategic alternatives for the Hexis business. Those alternatives include an investment or sale of our Commercial Cyber Solutions business in one or more transactions to buyers."

But dumping Hexis means that KEYW could get dumped, too.

*2. Bye-Bye Hexis; Bye-Bye Investor

We've asked KEYW if managers are worried that selling all or part of the glamorous cyber security segment could give investors a reason to sell the stock. We haven't heard back. But let's consider why we believe looming stock selling is a clear and present risk to current investors.

The situation revolves around KEYW's activities as a risky roll-up - a company that chases after revenue by conducting acquisition after acquisition. KEYW has rolled up 16 companies since beginning operations in 2008.

All too often, roll-ups produce far less revenue than hyped and consume far more money and management attention than expected. We've frequently warned investors about roll-ups such as Revolution Lighting (RVLT, $4.08 on publication day, $0.77 now) and InterCloud Systems (ICLD, $3.15 then, $0.54 now).

In the case of KEYW, the company wanted the Hexis double rollup deal to propel the company into a sector showing some life - cyber security.

So the company's entry into the cyber security field in 2013 must have seemed perfect at the time for a fund called PureFunds ISE Cyber Security ETF (HACK).

PureFunds bought in. KEYW became a tiny 1.24 percent of PureFunds' portfolio (here). For perspective, here's a snapshot of PureFunds' top holdings in cyber security leaders.

(Source: PureFunds)

Indeed, the KEYW holding is small - the fund's third smallest holding. Yet the 1.8 million shares of KEYW means the fund holds a meaningful 4.5 percent of outstanding shares.

But PureFund now has an issue. The former glamour fund is now a bummer carrying homely, if not downright ugly, returns.

(Source: Bloomberg)

With both the impending divestiture of Hexis and PureFunds' quarterly portfolio rebalancing right around the corner, KEYW is likely in trouble. PureFunds may well sell all or at least a massive amount of KEYW stock once KEYW boots its cyber security business.

That poses a screaming threat of stock dilution for today's investors.

*3. Undependable Government Contract Business

With only about 5 percent of last year's revenue from Hexis, KEYW depends almost solely on its legacy business of flying reconnaissance planes for intelligence agencies.

But gross margins for its key airplane services business have been declining for years.

(Source: Company 10-K filings)

Airplane services issues pressure revenue, too. Indeed, the 2014 10-K indicates these revenue and margin issues have developed gradually as reduced use of these planes leads to KEYW having to cut the contract price:

"Revenue decreased by $8.2 million or 3%, for 2014 as compared to 2013. The decrease in revenue in 2014 from 2013 was a result of Government Solutions segment revenue decreasing by $9.7 million ... The main drivers of the reduction in Government Solutions revenue were the reduction in pricing associated with the new contract for our airborne collection services, residual sequestration-related reductions to the certain programs especially during the first half of 2014 and lower run rates on certain government professional services contracts."

Indeed, CEO Weber indicated to analysts during the third quarter earnings call that the number of aircraft deployments were about half of the implied half-dozen anticipated deployments:

Bill Weber: "Yeah, Brian, right now, we have three aircraft operating in deployments for the customer. We have a fourth aircraft that is also deployed overseas that is undergoing maintenance right now."

The reason for this decline is key.

Bill Weber: "So the start-up cost associated with sending an airplane out to a new sight and actually getting that site set up are not trivial. So certainly as we deploy more aircraft its great in terms of the utilization and it’s a great indicator that the program is healthy because the customer is trying – is using those aircraft but we’re more desperate now than we were a couple of years ago when all of those aircraft were operating in Afghanistan."

Management's ensuing discussion on finding new customers and purposes suggests that no one expects the use of these airborne services by the U.S. Army to return to previous levels.

So it's clear why the failure of the cyber securities segment crushed KEYW management.

*4. Analyst Downgrade

RBC Capital just downgraded KEYW to "sector perform" from "outperform," while cutting the price target to $7 per share from $11.

The planned sale of Hexis should remove some risk and drag on cash, but as RBC Capital analyst Robert Stallard said, it will also remove growth and takeout premiums often enjoyed by startup tech businesses.

The stock rallied on Chardan Capital Market's upgrade last week to "buy" from "neutral."  But we'd be careful following this analyst. We noticed his picks haven't been too great lately and following them would have produced a loss over the past year of almost 23 percent.

(Source: Bloomberg)

*5. Heavy Debt Kicks Up Interest Costs

Finally, interest expenses have rocketed for KEYW by a factor greater than 10 since 2011.

(Sources: Company SEC filings)

In fact, interest expenses are a stunning 84 percent of compound annual growth rate (CAGR).

*Conclusion

Losses have dogged KEYW since 2013 and mounting difficulties continue to clobber the company. These include the mistaken Hexis deal, $126 million in debt, key business pressures, declining margins and possible loss of a major investor.

Divesting assets, in our view, is not a great business plan. If that's the best KEYW can do, it certainly deserves a more reasonable valuation of $3 per share.

* Important Disclosure: The owners of TheStreetSweeper hold a short position in KEYW and stand to profit on any future declines in the stock price.

* Editor's Note: As a matter of policy, TheStreetSweeper prohibits members of its editorial team from taking financial positions in the companies that they cover. To contact Sonya Colberg, the author of this story, please send an email to scolberg@thestreetsweeper.org.

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