A Defense Stock on the Rise

09/14/2012 7:45 am EST

Focus: STOCKS

Taesik Yoon

Editor, Forbes Investor and Forbes Special Situation Survey

The defense sector has been hammered for years now, but there are sectors of growth and companies with expertise in niche areas that are benefiting from a leaner military, writes Taesik Yoon of Forbes Investor.

ManTech International Corporation (MANT) provides innovative technologies and solutions for a wide range of federal government customers, focusing on mission-critical national security projects for the Department of Defense (DoD) and the intelligence community.

Other customers include the Homeland Security Department and the Justice Department, which includes the Federal Bureau of Investigation. MANT also serves non-security-related federal agencies such as the Department of Energy and the space community. Collectively, prime contracts and subcontracts for US government projects were responsible for substantially all of MANT’s revenues through the first six months of the year.

The company’s broad set of offerings consist of information technology, systems engineering, technical and other services and solutions, which are generally custom tailored to best address the needs of each specific project over the long term.

Services include command, control, communications, computers, intelligence, surveillance and reconnaissance (C4ISR) lifecycle support; cyber security; global logistics support; intelligence and counter-intelligence support; information technology modernization and sustainment; test and evaluation; and health IT.

Because MANT supports major national missions, such as military readiness, terrorist threat detection, information security and border protection, its operations have been negatively impacted by the reduction in C4ISR work stemming from changing customer mission priorities, including the withdrawal of US troops from Iraq in 2011, reduced demand for field service support, and delays in enhancements to existing ISR systems.

The decline in revenue, coupled with growing expectations that the mounting federal deficit will result in lower government spending on defense programs, has resulted in a sharp sell-off in MANT shares over the past year.

Initial investor reaction to the disappointing second-quarter report resulted in the stock dipping to $19.74 on August 2—its lowest level since February 2005. The fact that this was the third earnings miss in a row for MANT obviously did not sit well with shareholders. It also implies that the decline in government spending programs, especially those that are military and defense-related, has had a greater negative impact on MANT’s operations than many initially assumed.

Given expectations for significant cuts in defense and other federal-agency spending budgets in upcoming years, spurred by the need to rein in the massive budget deficit, business conditions will likely remain challenging for quite some time.

Nevertheless, looking at the company’s current valuation, we find it difficult to believe that this uncertainty is not already priced-in. In fact, since hitting their recent low, shares have gained approximately 12%.

Next: The primary catalyst

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Part of this rebound is likely attributable to the overall strength in the US equity market over the past month. However, we believe the primary catalyst was MANT’s historically low valuation and the growing perception among investors that the stock may have reached a bottom.

Yet despite the recent recovery, shares remain attractively priced, trading at less than eight times the company’s revised full-year earnings guidance of $2.85 per share. Due to the substantial decline in share value over the past year, MANT’s stock also sports a generous dividend yield of close to 4% on an annual basis. Additionally, the company remains financially sound with $124.7 million in cash—up $10 million from the end of 2011—and just $200 million in debt.

Despite the softer level of government order activity in recent periods, the company was able to secure a substantial contract from the US Army’s TACOM Contracting Center in June. Under this award, MANT is expected to continue providing logistics sustainment and support for the US Military’s Mine Resistant Ambush Protected (MRAP) Family of Vehicles (FoV). This contract, which is the largest in the company’s history, has a total value of $2.85 billion over a five-year period if all options are exercised.

With the continuing resolution agreement reached by Congress at the beginning of August, funding of existing federal programs is now secure for the next six months. As such, MANT expects award activity to pickup over the near term. We believe this could help reverse the company’s recent trend of reporting earnings that fall short of expectations.

While business prospects longer out remain less certain due to the aforementioned need to address the federal deficit, MANT is taking steps to become less reliant on defense-related contracts. For example, the company has been focusing on efforts to grow its intelligence, cybersecurity, healthcare IT, and other businesses that are likely to be more resistant to future federal spending cuts.

Additionally, it is also committed to expanding into the commercial cybersecurity and health-care markets. To this end, MANT recently acquired HBGary, a boutique provider of cybersecurity software products designed to detect, analyze, and diagnose threats and targeted malware for customers in the financial services, energy, critical infrastructure, technology, and other commercial sectors.

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