GMP: Politics killed $1 billion DND contract

It isn’t every day that a Bay Street equity research department strays into the political minefield, so it is worth noting that GMP Securities has done just that regarding the Federal government’s decision to cancel, for the second time in less than two years, a large defence procurement. The tender in question was the 20 year Contracted Airborne Training Services (CATS), which has previously been said to be worth up to $1 billion of revenue to the winning bidder. The current incumbent is Top Aces, one of our Fund II portfolio companies, which was acquired by TSX-listed Discovery Air in August 2007 (see prior post “Congrats to the Top Aces team” Aug 25-07).

According to a GMP note published yesterday, the firm believes that “this decision [to delay] was largely political”, which is quite the statement given the accolades that the government recently received for going out of its way to avoid politics when it came to the award of $35 billion of shipbuilding contracts to yards in B.C. and Atlantic Canada, at the expense of a Quebec-based firm.

According to GMP, the Top Aces team “was the only bidder on the contract”. One has to assume that would-be competitors based in Newfoundland and British Columbia intentionally sat on their hands and chose not to bid, in the hopes that the government would get frightened by a single bid dynamic and cancel the procurement. In theory, this would give the private sector time to lobby DND to lower its current bid standards and make it possible for firms with no suitable aircraft or staff to somehow win a contract to provide aircraft and pilot training to our armed forces. A few months ago, the Feds retendered this very same contract after 2010-era complaints that firms hadn’t had enough time to bid. Having responded to those complaints by reopening and extending the procurement period, the private sector appears no closer to providing Top Aces with competition.

As is the case sometimes with government contracting all over the western world, the folks who lose a bid feel no qualms about throwing mud at the “process” in the hopes they’ll shame the government agency into giving them another shot on goal. What’s remarkable about this CATS contract is that, if GMP is right, and political influence played a role, why has the government so quickly forgotten the success of the pristine shipbuilding procurement and allowed pressure from Western or Atlantic political interests to upend a CATS contract award to a Montreal-based bidder?

As for sole-sourcing, the same government is very comfortable defending the requirement to sole source the massive procurement of the new F-35 fighter, and rightly so, which means that can’t be a reason to hold up the relatively small $1B CATS file. Particularly when a Canadian-based firm has already been providing the government with a cost-effective service for the past six years.

Here is yesterday’s note from GMP:

Canadian Government delays long-term CATS contract; Top Aces continues interim services

Government intends to re-issue solicitation at later date

Today (November 17), Discovery Air announced that Public Works and Government Services Canada (PWGSC) has cancelled the existing Contracted Airborne Training Services (CATS) solicitation. However, the Government has stated its intention to re-issue a solicitation for the CATS requirement at a later date.

Top Aces will continue to provide services under the current ICATS standing offer arrangements until June 2012. We also believe that the Government will exercise its option to extend ICATS for an additional 12 months to June 2013. Therefore, this announcement does not impact our forecasts for Discovery Air. If the CATS contract is delayed for an extended period of time, we believe the ICATS standing offers could be extended beyond 2013.

Impact: Neutral – We believe that Top Aces was the only bidder on the contract

While this announcement delays the award of the CATS contract, we believe this decision was largely political and will not change the ultimate outcome of the award. This decision by the Government comes several months after it retendered the CATS solicitation (earlier this year) stating that the period for submitting proposals was insufficient. Given this announcement, we believe that Top Aces was the only bidder in the retendered CATS solicitation and that the Government was reluctant to grant this award unless there were competing bids.

Top Aces remains well positioned on CATS contract

While the next course of action by the Government is uncertain, we believe that Top Aces will continue to provide interim services until the CATS contract is awarded. Top Aces is the incumbent supplier and it remains well positioned to win the long-term CATS contract in our view. Given that Top Aces is the incumbent provider, has highly experienced pilots and cost-efficient equipment, we believe the company would be a compliant bidder on any future procurement processes. Top Aces has held standing offers to provide these services since February 2005 and operates a fleet that includes 16 Alpha Jets to support training services for the Canadian DND.

Maintain BUY rating and $8.00 target price

We are maintaining our BUY rating and target price of $8.00 (unchanged) on Discovery Air. Our valuation is based on 5.0x F13 EV/EBITDA. Our target multiple remains discounted to the industry peer group as DA continues to face risks associated with the renewal of Top Aces’ contract with the Canadian DND.

Hopefully, cooler heads will prevail within the government and the apolitical foundation that made for the success of the $35B shipbuilding procurement will be applied to DND’s CATS contract. That’s what this Conservative government stands for, after all, when you look at its efforts to bring transparency to the world of lobbying, for example. No monkey business. Maybe someone “didn’t get the memo”, and thought we were living in a prior age….

MRM
(disclosure – our Fund II owns Discovery shares as a result of the 2007 Top Aces acquisition; this post, like all blogs, reflects a personal Opinion and should not be seen as reflecting the views or perspective of Discovery Air, its Board/management or any other party)