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The following segment was excerpted from this fund letter.
ICF International (NASDAQ:ICFI)
ICF International: Investing in the “-Ologists” for Government IT Modernization and Complex Program Implementation
Thesis
- Government advisory and service provider leveraged to secular growth areas of the civilian budget, civilian budget less cyclical than defense budget.
- Civilian agency focus combined with decades of institutional knowledge serves as a competitive advantage relative to commercial consulting firms and defense focused government services firms.
- Highly visible and recurring revenue given long-term nature of government contracts and high win-rate on re-compete bids.
- M&A tailwind to organic growth: portfolio of services that are well suited for complementary acquisitions, strong cash flow to fund M&A.
- Improved mix of durable, higher growth segments combined with stabilization of low growth businesses is under-appreciated by the market.
Company Overview
ICF International, headquartered in Washington, DC, is a government consulting and services firm focused primarily on civilian agencies within federal, state and local governments (75% of revenue). ICF was founded in 1969 and originally provided front-end advisory services to government agencies. Given the nature of advisory work, these engagements tended to be lumpy and contract values were a fraction of the value of the implementation work that followed. Around the turn of the century, the company realized that it could leverage this advisory expertise into providing the back-end project implementation work, which came with larger value contracts and longer-term engagements. The company began building out its contract bidding and implementation services teams at this time and implementation work now comprises most of its government related revenue. As an example of the process flow, the original ICF might be engaged by a government agency to advise on how to modernize a technology stack, which the agency would then use as a blueprint for the implementation work. ICF can now provide the upfront advisory work and capitalize on its domain expertise to win the back-end implementation services. While ICF has capabilities that span hundreds of different domains, examples of major government programs where ICF has participated include Energy Star, Smokefree.gov and Head Start.
ICF primarily focuses on civilian agencies, which are less exposed to budget cycles than defense agencies. Key areas of focus within the civilian agencies include digital transformation/IT modernization, federal health, disaster management and climate. All of these domains have secular growth tailwinds and generally strong bipartisan support (climate being an exception), which provides exposure to higher growth areas of the budget. Climate policies have more risk around election cycles, however the recently enacted Infrastructure Investment and Jobs Act (IIJA) and in the Inflation Reduction Act (IRA) provide some insulation around this cycle over the next few years. Additionally, broader citizen awareness and support for positive climate initiatives partially mitigates some of the budget risk longer term.
ICF competes with commercial consulting firms (Deloitte, Accenture, EY, etc) as well as smaller segments of government consulting firms, which are almost exclusively focused on the defense sector. ICF differentiates itself through its civilian agency focus, subject matter expertise via its deep talent pool and longstanding relationships with government agencies. As management has commented, ICF becomes institutional memory for these agencies given multi-decade engagements that often outlast many of the government employees in these departments. HHS is ICF’s largest client at 22% of revenue, however no single contract accounts for more than 4% of revenue.
ICF provides a broad array of consulting services in many different parts of the government, which adds some complexity to the story given the broad budget exposure. The key thread weaving all of these areas together is personnel expertise (the “-ologists”) with long-standing relationships in each of their respective government agencies. As one of the senior executives at ICF joked during their most recent investor day, the company employs almost every “-ologist” in existence. This speaks to the unique capabilities and talent within ICF and, when combined with the tenure at ICF, serves as a clear differentiator versus competitors. A summary of the key areas of domain expertise within ICF are outlined below.
- Digital Transformation and IT Modernization
- Focused on Low Code/No Code development and migration from on-prem to cloud.
- Contracts with almost all civilian agencies (HHS, FDA, CDC, USDA, DOT, FDIC, SEC, FCC, NASA, etc)
- While this business was a small part of ICF in 2019, new CEO John Wasson identified this as a long-term, critical growth area within the federal government. The majority of this business has been built through a series of acquisitions beginning in early 2020.
- Given the outdated nature of government IT systems, this segment represents a multi-year opportunity with growth rates exceeding +10%. Note that governments have been slower to adopt the technology upgrades seen in the private sector, so it is early innings of this upgrade cycle.
- Federal Health
- Data management and analysis, research, training, and health communications programs.
- Over 2,000 health professionals including toxicologists, psychologists, microbiologists, epidemiologists.
- Levered to critical areas within health such as public health and social services, IT and scientific support, health care services.
- Climate, Environment and Infrastructure
- This segment provides consulting services related to policy and planning, risk assessments, permitting, monitoring, etc.
- Tailwind from Infrastructure Investment and Jobs Act over the next 5 years as funds begin flowing in 2023. Inflation Reduction Act provides additional funding for climate related work.
- Disaster Management
- 65% of this business is related to state and local disaster recovery programs. ICF oversees disbursement of funds related to these contracts. Current major programs include Puerto Rico following Hurricane Irma and State of Texas following Hurricane Harvey. Potential for Hurricane Ian and Fiona related work in 2023+. These revenues have some lumpiness around the initial event, but have a long tail of project work (e.g. Puerto Rico work is expected to last for another 8 years).
- 35% of this business is related to disaster mitigation efforts, which are seeing increased attention as governments look to improve infrastructure resiliency ahead of storm activity.
On the commercial side of the business (25% of revs), ICF provides similar advisory and consulting services to utility customers (70% of commercial revenue). Given the regulated nature of this industry and the long-term nature of these contracts, I view this as an extension of their government practice. Consulting work here primarily relates to energy efficiency initiatives and grid modernization, both of which have sustainable growth opportunities. Management believes this is another high growth segment, likely growing at least high single digit for many years.
The other 30% of this segment is a hodge podge of other commercial marketing services and loyalty programs for a variety of industries, but primarily hospitality and travel (they bizarrely run the loyalty program for Skittles). This part of the business is left over from the acquisition of Olson commercial marketing in 2014. ICF acquired this business at a time when government spending was depressed, which provided diversification of revs into the faster growing commercial sector. Strategically, it allowed ICF to bolster its marketing expertise, which was increasingly valued in contract bids as the government sought to improve citizen engagement via marketing outreach. The remaining commercial marketing services are profitable, but don’t have a strategic purpose in the business, which could represent an opportunity for portfolio rationalization in the future (note they sold a small business from this segment in Q3, so I believe this could be a near term opportunity).
Acquisitions
ICF is a business that lends itself well to acquisitions given that acquired companies can provide complementary domain expertise and/or provide deeper penetration into certain government agencies. The result of this consistent M&A program is that ICF steadily builds a more comprehensive portfolio of consulting expertise and gradually expands into more agencies. The network effects that come with broader domain expertise and increased government reach support both broader contract scope and increasing win rates on bids.
ICF has completed 22 acquisitions since 2002 demonstrating an ability to successfully execute both programmatic M&A as well as larger, more transformational type deals. Over the last 3 years, ICF has focused its M&A activities on building a leading IT modernization practice as management identified this as a long-term high growth area for the government. The IT modernization focus began with the acquisition of ITG in January 2020 and was followed by 2 additional acquisitions, Creative Systems (2022) and Semantic Bits (2022), to build out its expertise and scale in the IT space.
Management
CEO John Wasson started his career at ICF 35 years ago and was promoted to CEO in October 2019. Mr. Wasson has overseen the portfolio repositioning, specifically the push into IT modernization beginning with the acquisition of ITG in 2020. His experience with the company gives me confidence that he will continue to operate the business in much the same way it has been run for the last 20 years.
Financial Model
ICF’s presentation of its financials doesn’t do investors any favors. While they talk about their 5 key growth areas by vertical (IT modernization, health, etc), they disclose financial information at the government agency level. The easiest way to look at ICF is by segmenting their high growth businesses and their low growth businesses, which we can back into using management comments and investor presentations.
ICF’s high growth businesses now account for ~85% of revenue and collectively are expected to grow at least 10%. The low growth businesses are likely to grow low single digit at best as international revenues stabilize following the roll-off of a significant contract and the commercial businesses tread water following the recent portfolio rationalization. At a consolidated level, ICF should be able to sustain high single digit organic revenue growth as a result of the portfolio repositioning into higher growth areas of the budget.
As described above, this revenue growth will be supplemented with complementary M&A, bringing total revenue growth into the low double digit range. Management has targeted 10-20bps of annual margin improvement from efficiency gains and scale, which supports ~10-15% EBITDA growth.
From a balance sheet perspective, ICF has appropriate financial leverage for the consistent nature of its business. The company should end the year at 2.5x of leverage and will de-lever by ~0.5x annually through free cash flow and EBITDA growth.
Summary Thesis
ICF likely sounds like a sleepy and complicated business, so why is the stock positioned well to outperform the market? The market has yet to appreciate the portfolio transformation that ICF has undergone under the new CEO. ICF now has 5 distinct areas of domain expertise that are leveraged to higher growth areas of the federal budget, areas that have broad bipartisan support and years of investment opportunity. Decades of government consulting experience and deep institutional knowledge within many of these agencies position the company well to capitalize on these growth opportunities. These 5 growth domains have additional near-term tailwinds from the recently passed IIJA and IRA, which should materialize in 2023 as allocated funds begin to flow. Furthermore, the low growth part of ICF’s portfolio is not only a smaller piece of ICF’s business entering 2023, but also on the cusp of reaching revenue stabilization after years of revenue declines.
The net result is that ICF now looks like a company that can steadily grow revenue in the high single digit range, which will be supplemented with M&A to bring total revenue growth above 10%. Slight margin expansion supports EBITDA growth of 10-15% depending on the pace of M&A. While the ~15% earnings growth is attractive by itself, there is additional upside from multiple expansion as the market comes to appreciate the higher growth profile of the current ICF business along with the durability of this growth.
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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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