The Virginian-Pilot May 29, 2011
IPO for Virginia Beach company assessed
By Robert McCabe
ADS Tactical Inc. became a billion-dollar business in one decade, serving as a one-stop-shop for the Pentagon and other agencies in the defense buildup that followed the 9/11 attacks.
From its modest start in a Lynnhaven dive shop where Navy SEALs would buy gear off the shelf, ADS has morphed into a super middle-man for the Pentagon. It rang up $1.3 billion in sales last year, purveying the things troops need in the field – everything from boots, gloves and parkas to knives, sunglasses and hydration packs.
It connects 4,000 active customers, mostly in the departments of Defense and Homeland Security, with about 1,400 vendors offering more than 160,000 items. It packages related items into “kits” – cold-weather gear for soldiers or flame retardant gear for firefighters, for example – to be shipped together.
Having built a successful defense contracting business, the owners of ADS now plan to take the company public, selling some of their stock to investors.
ADS first filed paperwork with the Securities and Exchange Commission on Feb. 8 to make an initial public offering for as much as $100 million. The date of the sale or other details such as the price or the number of shares to be sold has not been announced. The deal is being underwritten by Wall Street powerhouses J.P. Morgan and Morgan Stanley.
But the details disclosed in the filing, which has been amended twice, most recently after ADS took on substantial debt in March, raise questions about the nature of the deal.
Part of the proceeds will go to its three shareholders, as did much of the proceeds from the March debt offering.
Initial public offerings typically are done to raise money for young companies with a lot of ideas and opportunities for growth but without the cash to pursue them, said Susan Chaplinsky, a business professor at the University of Virginia.
Because of the way ADS’ IPO is structured, with proceeds going to the existing shareholders rather than to the company to fuel growth, it’s going to raise red flags, Chaplinsky said.
“It’s going to take a very robust IPO market to get this IPO through,” she said.
Officials at ADS Tactical declined to comment, citing the SEC’s “quiet period” prohibition on firms saying anything more than what’s stated in their prospectus.
In its SEC filing, ADS said it is well positioned for growth. It has about 1 percent of its “addressable market” of about $100 billion.
Over the past 10 years, both “the needs of the U.S. military and the nature of modern warfare have evolved significantly,” the company stated.
The Pentagon’s focus has shifted from large-scale weapons systems for air, land and sea conflicts toward making sure that individual soldiers have the best equipment possible for engaging in “ground-based irregular warfare against asymmetric threats.”
During World War II, the Defense Department spent about $2,000 equipping the average soldier; today, in the“Global War on Terror,” the cost per soldier has risen to $19,000, in adjusted 2009 dollars, ADS said.
“We believe these trends will continue for the foreseeable future,” it stated. Some defense-industry analysts agree.
“When you look at the kinds of products that ADS is in, you can’t really predict that a general downturn in defense is going to have some particular outcome for their business, because they make essential items that are relatively inexpensive compared with things like aircraft carriers,” said Loren Thompson, with the Arlington-based Lexington Institute.
“The key thing that differentiates a company like ADS from one of the better-known defense suppliers is that its products are not expensive,” he said. “They’re things that are affordable compared with the high technology that the Pentagon often buys. So I wouldn’t jump to the conclusion that less overseas fighting automatically translates into less demand for their goods.”
The three men who own ADS stand to reap a bonanza from the proposed $100 million stock offering. Luke Hillier, ADS’ president and CEO and one of four directors, owns 58.4 percent of the company; R. Scott LaRose, a director, has a 25 percent stake; and Daniel Clarkson, the chief operating officer, vice president, treasurer, secretary and a director, holds 16.6 percent.
Hillier’s father ran Lynnhaven Dive Center, out of which ADS grew. Luke Hillier and LaRose are veterans of Oracle Corp., where LaRose worked as the regional manager in its state and local government division and Hillier was a lead sales rep in the sales division. Clarkson came from Sunbelt Rentals, a South Carolina-based equipment-rental company.
Hillier spun ADS off from his father’s shop in 1997 as Atlantic Diving Supply Inc. That firm is now the main subsidiary of ADS Tactical.
Hillier also founded Mythics Inc. with LaRose in 2000. The Virginia Beach-based information-systems firm supports Oracle products.
ADS, with about 420 employees, leases three warehouses and an office. A “kitting facility” in Virginia Beach and its corporate headquarters on Lynnhaven Parkway are owned by related entities that Hillier, LaRose and Clarkson control and are consolidated financially with ADS.
The three men have been on the hook for paying taxes on ADS’ income. ADS earned a profit of $78.2 million last year, up 86.5 percent from 2008.
ADS is organized as an “S corporation.” Rather than paying taxes, the company passes profits directly to its shareholders who must report it as income and pay the taxes.
Hillier, LaRose and Clarkson received $191.1 million in distributions from ADS between 2007 and 2010, according to its SEC filing. So far this year, the trio have received $227.7 million in distributions from ADS, including $10.6 million in January related to estimated taxes for 2010’s fourth quarter and $217.1 million in March.
The latest payment primarily came from ADS’ sale of $275 million of “senior secured notes” on March 25. The company is paying an interest rate of 11 percent on the seven-year notes.
The remainder of the cash from that offering went to pay down some debt as well as to pay bonuses to some senior managers.
In its SEC filings, ADS said that some of the IPO proceeds will be used to pay off up to 35 percent of those notes, in addition to making a payment to the three shareholders related to the end of its S-corporation status.
But the size of the debt offering could hinder a stock sale.
Both ADS Tactical and its debt earned non-investment grade ratings from Standard & Poor’s and Moody’s Investors Service in mid-March.
In a March 14 report, Moody’s said it was the highest debt level in the company’s history.
“Moody’s is concerned that the fact that the company has undertaken this offering to fund a large distribution to shareholders, rather than for investment in operations or to bolster liquidity, as indicative of an aggressive financial policy,” Moody’s said in its report. “Moreover, Moody’s expects that substantially all of ADS’ free cash flow generated over the near term will be distributed to shareholders for tax payments.”
Standard & Poor’s reported the same day that ADS historically has “operated with modest debt,” but the debt offering would leave it “highly leveraged.”
“However, the company’s positive cash generation, limited competition, favorable demand outlook, and modest cash needs provide important mitigating factors,” S&P stated.
ADS acknowledges in its SEC filing that it incurred “significant indebtedness” in the March transaction. “As a result, our annual interest expense will increase significantly from prior years’ interest expense,” it reported.
“Where’s the money going to come from to fund growth if we’re already over-leveraged?” asked U.Va.’s Chaplinsky. “You’re paying 11 percent interest. Unless you have a very healthy cash flow, you’re going to have to pay interest first. What’s left to fund growth for the company?”
Companies with a lot of debt can be a tough sell unless they have major private-equity backers and very high brand awareness, such as Dunkin’ Donuts, said Scott Sweet, senior managing partner at Tampa-based IPOBoutique.com, which tracks IPOs.
“High-debt, debt-laden companies are toxic right now,” Sweet said. “High-debt companies are not first and foremost on IPO buyers’ lists.”
There are other risks as well: ADS lists nearly 30 “risk factors” in its SEC filing.
Chief among them is its heavy dependence on federal spending, particularly the Defense Department. Defense spending could take a hit as the nation wrestles with its own rising debt.
Two contracts accounted for 63 percent of ADS’ sales last year. One for providing equipment to special-operations forces generated 44 percent of its revenue. That contract recently was renewed for a year and is up for another option-year renewal next March. The other, for cold-weather clothing systems, is in its final year and accounted for 19 percent of ADS’ sales.
If the company loses either contract, those sales dollars would go with them, the company warned. Still, John E. Pike, director of GlobalSecurity.org, a military information website, believes the kind of defense spending ADS thrives on is secure. Funding for special-operations-type forces will be the most resistant to budget-cutting, he said.
“If you had to think about defense stocks, you know, and what their business prospects were over the next several years, well, I think this company’s got a good story,” Pike said of ADS. “It’s in part of the defense budget that’s going to be the last to get cut.”
While ADS has filed its SEC paperwork, putting it in the IPO pipeline, its executives have yet to go on a customary nationwide “road show,” to cities such as New York and San Francisco, to make their pitch to investors. Chaplinsky wondered if there might not be another reason for the ADS filing.
“It can set up a dual-track process where you’re indicating, ‘I’m open to discussion,’ ” she said. “Many of these IPO filings are not followed by an IPO but a sale to another company. The IPO becomes a fall-back if you don’t find a strategic buyer.”
Only time will tell.
“At this point, there is nobody – I’ve been doing this for 38 years – who can predict, unless they have inside information, when ADS Tactical is going to make their next move,” Sweet said.
© Copyright 2011, The Virginian-Pilot