Irenic takes a position at KBR. How the activist may improve shareholder value

Business: KBR provides scientific, technological and engineering solutions to governments and companies around the world. The company operates through two segments: Government Solutions and Sustainable Technology Solutions. Its Government Solutions (GS) business segment provides full life-cycle support solutions to defense, intelligence, space, aviation and other programs and missions for the military and other agencies of government in the United States, the United Kingdom and ​​Australia. Its Sustainable Technology Solutions (STS) business segment is anchored by process technology that includes ammonia/syngas/fertilizers, chemical/petrochemical, clean refining and circular process/circular economy solutions.

Stock Market Value: $7.91B ($59.36 per share)

In recent weeks, government contractors, including KBR, have experienced a declassification in the sector in response to perceived risks associated with the incoming Trump administration. Investors have speculated that the new Department of Government Efficiency (DOGE), with its mandate to reduce federal spending, has already promised to cut $2 trillion from the federal budget, could result in a material decrease in the profitability of government contractors. As a result, between the day of the election and the report that Irenic had built a position in the company, the shares of KBR fell more than 18%. However, KBR may have been unduly punished by DOGE speculation. In reality, KBR appears to be more insulated from these threats than the market currently perceives. First, while the company’s GS business accounts for 75% of KBR’s revenue, it contributed less than half of its operating income in FY23. In addition, 25% of GS business is international, mainly in the UK, sheltered from the potential effects of DOGE. Looking at the remaining 75% of that segment in the US market, a close analysis reveals that only relatively small portions of KBR’s services are expected to face any estimated cost pressures. While much is currently uncertain, the threats to the GS segment appear, at this time, to be overwhelming. Additionally, the STS segment may be a beneficiary of the incoming administration’s plans. Under the Biden administration, there was a moratorium on export permits for LNG plants and many projects were put on hold. The Trump administration plans to announce this, which could be a tailwind for KBR as the company is well-positioned to win new and existing projects.

Perhaps prompted by KBR’s discounted valuation following the recent exogenous share price shock, Irenic has now entered the picture. Irenic has accumulated a position of more than 1% in the company and urges management to separate its STS segment. These are fundamentally different businesses with distinct support needs, management requirements and end markets. Companies that do not belong together should be separated for several reasons: (i) each can attract the appropriate shareholder base and be allocated the proper multiple; (ii) each can dedicate management focus and compensation to be more aligned with the specific needs of the business; and (iii) the separation may result in a reduction of the company’s overhead costs, producing leaner and more efficient entities. KBR currently trades at about 11.5 times enterprise value to trailing 12-month adjusted EBITDA. Looking at peer companies, those of GS typically trade in this range, but those more like STS take an average multiple of 14-15 times EBITDA. Separating the two should revalue the STS company that creates shareholder value before any cost savings from the separation. By separating the two businesses, there would be no need for a large portion of the corporate costs that the company currently incurs, which could be a savings of $50 million that goes right to the bottom line. Finally, before any value creation, the company could buy shares to create additional value for the shareholder. While each value-creating lever on its own might not be incredibly compelling, the combination could result in a 50% increase in shareholder value.

Irenic is not the only shareholder who thinks that a separation makes sense; many other shareholders share this view. To put it another way: Keeping the two companies together makes no sense. A few years ago, it would have been fair to argue that a spin-off of STS was not feasible due to the size and youth of the unit. In 2021, the segment made an operating loss of $ 30 million and in the following years, management successfully made this argument saying that the segment had to be bigger to spin off. But STS now generates close to $400 million of EBITDA, and it’s time for management to walk away. Irenic likes to work behind the scenes with management and use the power of persuasion to win the day. We expect the company to do this until KBR’s announcement of a strategic review or the company’s nomination deadline on February 14, 2025, whichever comes first. If there is no satisfactory announcement by February 14, we expect Irenic to do something he has never had to do before – launch a proxy fight. However, given shareholder support for a separation and the fact that there is a vacancy on the board (General Lester L. Lyles recently announced will retire from the board effective after the 2025 annual meeting) we don’t expect it to come to that. If Irenic is given a seat on the board, it will probably be for an independent director with experience in the relevant industry as opposed to an Irenic principal.

If KBR is pursuing a strategic review, we would be remiss if we did not mention a similar and relevant situation. Elliott Investment Management has recently favored for the separation of Honeywell into two companies, and Honeywell announced later a strategic review of their businesses. Honeywell could be a potential strategic buyer of part or all of KBR. Irenic’s co-founder, Adam Katz, was a former employee of Elliott Investment Management, and I’m sure he still knows people there.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of investments 13D activists.