The Intelligence Report on ManTech International
A large percentage of Magic Formula Investing (MFI) at current is composed of defense contracting firms, from the huge "big 5" players like Northrup Grumman (NOC) and General Dynamics (GD) to smaller, more focused firms such as Cubic (CUB) and today's stock in focus, ManTech (MANT).
ManTech is a smaller, more specialized contractor. The firm focuses on a few areas. Command, Control, Computers, Communications, Intelligence, Surveillance and Reconnaissance, known as "C4ISR" to the acronym-obsessed Department of Defense (DoD, natch), is a wide-ranging set of services from developing technology plans, to training, to maintenance and beyond. Cyber Security involves protecting military, law enforcement, health, and other critical and classified networks from security threats. Global Logistics is just what it sounds like - supply chain management, maintenance of vehicles and equipment, and operations support. Intelligence Solutions comprises of services including secure information sharing, network engineering, and data mining and analysis. Information Technology services and Systems Engineering round out the portfolio.
When reviewing ManTech, it was striking to me that its portfolio of services are exactly where nearly all of the big 5 are trying to expand into. This is both positive and negative. On the plus side, it lends credence to management's assertions that ManTech's line of work is isolated from the primary focus of upcoming DoD cuts (namely large weapon systems and active duty force size). There seems to be wide consensus in the defense contracting industry that C4ISR, Cyber-security, and Logistics in particular are ripe areas for budget increases. Indeed, the intelligence budget has increased at a 10% compound annual rate since 1998, including 7% last year, and the government has increased IT spending every year since 1980, with another 30% total increase expected by 2015.
The financial picture is also a positive. ManTech's balance sheet is minimally levered, with just a 19% debt-to-equity ratio (anything under 50% is great), and operating earnings covering interest 15 times over. The company this year just started paying a dividend that yields 2.3%, and represents less than 20% of free cash flow. With a stable business and steady cash flows, the dividend is well supported and has room to grow.
On the negative side, ManTech is going to face increasing competition from some very big players going forward. Northrup, for example, specifically has called out the above 3 areas as their key focuses for growth. With large weapons programs clearly under the knife, the big 5 will turn their attentions to ManTech's specialties. This will either hurt the firm's growth and margin potential... or lead to a nice premium buyout of the company. It is going to be a key factor in this investment going forward.
Despite being well-positioned, ManTech's growth prospects are still average at best. There seems to be little room for margin expansion - operating margins have been steady at 8% for years. The company has grown by acquisition, including 4 sizable ones in the past year alone. This is not usually a very efficient way to grow, however. ManTech is a clear example of MFI's bias towards growth by acquisition. Without goodwill, ManTech's return on capital looks great. With it, however, after-tax return on capital is ony about 12% - not bad, but not that good, either.
Finally, there is no diversification here. While General Dynamics has its Gulfstream business jet division, and Cubic has its mass transit fare system business, ManTech is wed to the defense and security segments of the federal government, where over 98% of revenues originate from.
In all, like pretty much all the defense contractors, ManTech looks oversold. Even assuming well below historic 3% growth rates going forward (trailing 5-year growth rate is 15%), and below historic P/E and P/S (price-to-sales) multiples, ManTech looks worth $60 to me - a massive discount to current sub-$40 share prices. That said, I like the larger contractors in this space more right now, as many pay over 4% yields, trade at decades-low valuations, and have more potential for margin upside.
Disclosure: Steve owns NOC, CUB