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

Business: KBR provides scientific, technology 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 military and other government agencies in the United States, the United Kingdom and Australia. Its Sustainable Technology Solutions (STS) business segment is anchored by process technology that spans ammonia/syngas/fertilizers, chemical/petrochemicals, clean refining and circular process/circular economy solutions.

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

Ownership: >1%

Average Cost: n/a

Activist Commentary: Irenic Capital was founded in October 2021 by Adam Katz, a former portfolio manager at Elliott Investment Management, and Andy Dodge, a former investment partner at Indaba Capital Management. Irenic invests in public companies and works collaboratively with firm leadership. The firm’s activism has thus far focused on strategic activism, recommending spinoffs and sales of businesses.

On Dec. 19, 2024, Irenic announced that it plans to push KBR to separate its Sustainable Technology Solutions segment from its Government Solutions segment.

KBR is a Houston-based science, technology and engineering solutions company that provides services to governments and companies globally. The company is divided into two segments: Government Solutions (GS) and Sustainable Technology Solutions (STS). The GS segment operates as a government contractor providing solutions to defense, intelligence, space, aviation and other missions for militaries and government agencies. The STS segment serves both government and private sector clients with its extensive portfolio of energy and sustainability-focused technology in four primary verticals: ammonia/syngas, chemical/petrochemicals, clean refining and circular process/circular economy solutions. While both units have established a strong foothold in their respective end markets, they are fundamentally different. Government Solutions is a low-margin mature business, while Sustainable Technology Solutions is a high-margin growing business. The GS segment has experienced revenue contraction since FY21 and has adjusted earnings before interest, taxes, depreciation and amortization margins of about 10%. Conversely, STS has grown revenue by an average of 16.7% annually since FY21 and has margins of approximately 20%.

In recent weeks, government contractors, including KBR, have experienced sector-wide de-rating in response to perceived risks associated with the incoming Trump administration. Investors have been speculating that the new Department of Government Efficiency (DOGE), with its mandate to slash federal spending, already pledging to trim $2 trillion from the federal budget, could result in a material decline in government contractors’ profitability. As a result, between Election Day and the report that Irenic had built a position in the company, 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 does account for 75% of KBR’s revenue, it contributed less than half of its operating income in FY23. In addition, 25% of the GS business is international, primarily in the UK, sheltered from the potential effects of DOGE. Looking at the remaining 75% of that segment in the U.S. market, close analysis reveals that only relatively small portions of KBR’s services are expected to face any related estimated cost pressures. While much is currently uncertain, the threats to the GS segment seem, at this moment, overblown. Moreover, 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 several projects were put on hold. The Trump administration plans to reverse this, which could be a tailwind for KBR as the company is well-positioned to win new and existing projects.

Perhaps enticed 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 is urging management to separate its STS segment. These are fundamentally different businesses with distinct support needs, management requirements and end markets. Companies that don’t belong together should be separated for several reasons: (i) each can attract the appropriate shareholder base and be awarded the proper multiple; (ii) each can dedicate management focus and compensation to be more aligned with specific business needs; and (iii) separation can result in a reduction of corporate overhead costs, producing leaner and more efficient entities. KBR currently trades around 11.5 times enterprise value to the last 12 months’ adjusted EBITDA. Looking at peer companies, those of GS typically trade in this range, but those most like STS fetch an average multiple of 14-15 times EBITDA. Separating the two should re-rate the STS business creating value for shareholders before any cost savings from the separation. By separating the two businesses, there would be no need for a lot of the corporate costs the company presently incurs, which could result in a $50 million savings that goes right to the bottom line. Finally, ahead of any value creation, the company could buy back shares to create additional shareholder value. While each value creation 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 a separation makes sense; many other shareholders share this view. To put it differently: Keeping the two companies together makes no sense. A few years ago, it would’ve been fair to argue that a spin-off of STS wasn’t feasible because of the unit’s size and youth. In 2021, the segment delivered an operating loss of $30 million and in the years after, management successfully made this argument saying the segment needed to be bigger to spin off. But STS now generates close to $400 million of EBITDA, and it is time for management to walk the walk. Irenic likes to work behind the scenes with management and use the power of persuasion to win the day. We expect the firm will be doing that here right up to either the announcement by KBR of a strategic review or the company’s nomination deadline on Feb. 14, 2025, whichever comes first. If no satisfactory announcement is made by Feb. 14, we would expect Irenic to do something that it has never had to do before – launch a proxy fight. However, given the shareholder support for a separation and the fact that there is an empty board seat (General Lester L. Lyles recently announced he will retire from the board effective after the 2025 annual meeting) we do not expect it will come to that. If Irenic is given a seat on the board, it will likely be for an independent director with relevant industry experience as opposed to an Irenic principal.

If KBR does pursue a strategic review, we would be remiss if we did not mention a similar and relevant situation. Elliott Investment Management has recently advocated for the separation of Honeywell into two companies, and Honeywell subsequently announced a strategic review of its businesses. Honeywell could be a potential strategic acquirer of parts or the entirety of KBR. Irenic’s co-founder, Adam Katz, was a former employee of Elliott Investment Management, and I am sure he still knows people over 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 activist 13D investments.