In the Sweet Spot of Defense Spending

10/11/2010 11:28 am EST

Focus: STOCKS

Taesik Yoon

Editor, Forbes Investor and Forbes Special Situation Survey

Taesik Yoon, editor of Forbes Growth Investor, finds a rapidly growing defense contractor that is focusing on areas that are likely to be spared the budget cutters’ ax.

SAIC (NYSE: SAI) provides scientific, engineering, systems integration, and technical services to the US military, the Department of Defense (DoD), the intelligence community, the Department of Homeland Security, other civil and government agencies, and foreign governments.

The company’s broad offering of services include system engineering and implementation of complex information technology (IT) networks; software development; IT outsourcing; solutions that protect against cyber security threats; solutions that allow for information sharing and collaboration; logistics and product support, and data processing and analysis services that enable more effective collection and interpretation of intelligence data.

Shares of firms that provide IT services to government agencies have not fared well this year. SAI is no exception, with the stock down about 16% so far [at Friday’s close just below $16—Editor].

A key reason for the weakness is delays in the US government’s procurement process across the intelligence and defense sectors, which have resulted in revenue growth from new contract starts below historical levels.

Investors may also be concerned that the growing budget deficit will force the government to cut defense spending and postpone or cancel programs, which could result in a shrinking pipeline of business opportunities and greater competition for existing contracts.

For example, Defense Secretary Robert Gates recently outlined a strategy to save the DoD $100 billion over the next five years through efficiency enhancements and the elimination of unnecessary programs.

[SAI’s] second-quarter revenues grew by a disappointing 1.5% year over year in [the second quarter] to $2.79 billion. They fell one percent on an organic basis. This overshadowed strong bottom-line performance, with net income from continuing operations climbing 26.4% to $189 million and earnings per share rising to 42 cents per share, nine cents above estimates.

To its credit, SAI has taken a proactive approach to addressing these challenging industry conditions. The company has focused more on higher growth opportunities. It is also bidding on larger contracts.

As a result, [submissions] on definitive delivery contracts rose by $3.3 billion, or 32%, through the first half of the year. SAI also booked 12 contracts valued in excess of $100 million each. This has allowed order activity to remain solid, with $5.9 billion in new bookings in the first half of fiscal 2010, up 20.4% from the prior year.

The company also had $18.8 billion in submitted proposals awaiting decisions at the end of [the second quarter], up 9% sequentially and 45% from a year ago. [For these reasons,] SAI’s current full-year organic revenue growth guidance of 3% to 6% implies accelerating top- line growth in the second half.

The company also expects adjusted earnings from continuing operations to grow 14% to 18% [this year,] versus the 8% to 14% estimate provided three months earlier.

Financially, the company is sound: SAI has $604 million in cash and total debt of just $1.1 billion, or 21.4% of total assets.

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