ArmorGroup International

Baron Rothschild is thought to have said (though I’ve heard it was actually Bernard Baruch) the time to buy is when there is blood in the streets. You could say that an investment in ArmorGroup International (ARG/LN or AMGPF/OTC) is a case of buying WHERE there’s blood in the streets.

You see, ArmorGroup has three business segments: Protective Security Services (PSS), Security Training (ST), and Weapons Reduction & Mine Clearance Services (WR). And it provides these services primarily in what it terms “regions of the world afflicted by diminished law and order or with a high risk of terrorism.”

Companies like ArmorGroup are generally known as PSCs -- Private Security Companies. Detractors deride them as “mercenaries.” But these firms have nothing in common with the legendary Bob Denard or the characters in Fredrick Forsyth’s novel, The Dogs of War.

PSCs play an increasingly important role for the over-stretched American and British militaries. Calling them “over-stretched” is NOT a political statement -- it’s an objective truth. US and UK armed forces simply couldn’t carry out operations in Iraq and Afghanistan without the support of PSCs.

ArmorGroup derives more than half of its revenue from Iraq. The company is working hard to diversify revenues and profits away from that country, though it remains an important market and likely will continue to be one for the foreseeable future.

PSCs are also working for private companies abroad, especially mining and oil and gas firms in places like Africa, Asia, Russia, former Soviet states and the Middle East. ArmorGroup reports increasing demand for its services in Nigeria, Afghanistan and the Middle East apart from Iraq.

PSCs are increasingly seen as a viable option for the United Nations and assorted NGOs. ArmorGroup was awarded a contract this summer by the UN to handle a land mine clearance program in Southern Sudan.

PSCs also provide security in the aftermath of natural disasters in the developed and non-developed world. ArmorGroup handled security, life support and logistical services for an engineering company in New Orleans after Hurricane Katrina hit.

So, I’m bullish on PSCs in general and think the sector will be around for many years to come.

But that’s top down, big picture stuff. What about ArmorGroup?

I like ArmorGroup because I’m convinced it’s undervalued. And I also like it because it is a British PSC.

As posted previously, ArmorGroup was purchased and closed Tuesday at the equivalent of US$1.03 per share. That’s just below the net tangible asset value of $1.06 per share, and well below the stated book value of $1.47. The current ratio is 1.90 and the quick ratio is 1.87. The dividend yield is more than 4%. The market capitalization is more than $50 million. There are more than 50 million shares outstanding -- but only about 30% trade freely. Several institutions, with about 10% held by company officers and employees, hold most of the shares.

ArmorGroup first listed its shares on the London Stock Exchange in late 2004 -- during the height of the “Iraq Bubble” for private security firms in Iraq. The shares went public and skyrocketed to more than 270 pence (over $5) in early 2005. The share price began plunging when some contracts in Iraq were delayed later that year. They have remained down over concerns of the amount of revenues currently stemming from work in Iraq, which is a “mature” market.

The Iraq Bubble has resulted in more than 20 PSCs of note in the UK. The bubble is deflating and, while there will continue to be work in Iraq, the sector will see substantial change and consolidation over the next five years.

I think ArmorGroup is poised to deliver good things for investors in any number of ways:

First, ArmorGroup has room for growth in diversifying its operations geographically (away from Iraq) and in diversifying and broadening its service offerings. Roughly 90% of revenues stem from its PSS segment, the company is looking to increase revenues from its newer ST and WR segments as well.

Second, ArmorGroup may make one or more strategic acquisitions. The company purchased a training firm, Phoenix CP, in late 2005 and it is performing ahead of expectations.

Third, ArmorGroup could be an attractive takeover candidate for another British PSC in the coming sector consolidation inside the UK.

Fourth, ArmorGroup could be an attractive takeover candidate for an American PSC. ArmorGroup has a history of working for the US government and American corporations. It has two bases in the US (Virginia and Texas) operating at full capacity. It may or may not mean anything that Stephen Kappes -- who left his job as Deputy Director of the CIA after a disagreement with then Director Porter Goss only to return to that post under the new director -- had been ArmorGroup’s Chief Operating Officer.

Continuing with this option, British PSCs have an excellent reputation in American government and commercial circles. Some American PSCs have sought to form joint ventures with British firms for certain US government contracts. Rumors are strong in the British PSC sector of American firms already making merger proposals. Whether these rumors are true or in any way relevant to ArmorGroup is unknown. Of course, it could always be that a British PSC acquires an American one.

And fifth, since ArmorGroup went public after an MBO, management could always take it private again if the share price continues to lag. What’s more, the European private equity arm of Baird holds 32% of the stock. Baird is a US-based investment banking and private equity firm. There’s a lot of private equity money sloshing around the globe and there’s always the chance that Baird -- by itself or in a consortium -- could make an offer to buy the shares not already held.

Now for some of the risks that could make this pick a loser:

• The pipeline of projects in Iraq dries up BEFORE the company can diversify enough of its business away from that country.

• New government regulations are enacted in various nations that might limit foreign-owned PSC activity.

• Financial institutions (remember most of the stock is owned by a handful of firms) dump their ArmorGroup stock at once, crushing the share price.

• ArmorGroup personnel engage in “war crime” type behavior that proves damaging to the company’s reputation.

I don’t think any of the above will happen -- but three of those four could easily trash the balance sheet.

That's it. ArmorGroup is an unloved stock right now. In a sector that's misunderstood or hated. And anyone owning it will need a strong stomach. But I think it's positioned to benefit from the coming shakeout in the British PSC sector.

Just make sure you understand that should you decide to take the plunge on this one.

Comments

[Ian]

Agree Armor is pretty cheap - but is there a solid moat for this business - massive increasing competion in iraq + pretty low barriers to entry and high fixed cost base. Still the current market cap of circa £30m looks way below orivate market value.. Great blog!

[John]

Ian: Many of the PSCs in Iraq are operations with a handful of contractors. ArmorGroup operates in the "higher end" of the business, and many of these firms can't match their global footprint. That said, if the company's pipeline were to dry up, or if costs skyrocketed, things could get bloody (no pun intended).

To repeat from my rationale, I think we're in store for a lot of consolidation among PSCs. With ArmorGroup's small market cap and global footprint, I could easily see a larger company -- perhaps an American one -- buying them as a bolt-on acquisition. But that's not a prediction.

Thanks for liking the blog. I'll do my best to make it worthy of your continued readership.

[brett]

Armorgroup shares have been down in price for about the last 7 months, what do you attribute the rise in price over the last 7-8 weeks to, new contracts in Afganistan alone or other factors as well, and if any what are those other factors

[John]

brett: My hunch is that the stock price got so low because of the amount of busines in Iraq, worries that their expenses were rising, and simply that investors -- who loved this stock when it went public in 2004 -- just didn't like it. My take is that investors were just too down on the stock and that its winning some contracts is convincing the investing public the company is going to be around.

But there are still risks.

[Bruce]

i have owned these shares since the IPO. since then the ride has been pretty frustrating. Biggest issue is their inability to increase operating profit. 2007 has been a good year and the share price is finally close to the level at which i purchased. do not know if i should continue my faith in armor. patience is running out and i am hoping there is some condolidation in the industry or some turnaround that reflects in a positive share price movement.

[John]

Bruce: I can understand someone's frustration if they bought at the IPO as you did. Followers of this blog got in at just under net tangible asset value. The shares are up nicely since then but I'm holding, for now, since they are still under book value. You might consider holding, especially if you think the worst is past for the company. Just my two cents.