DynCorp: Undervalued Defense Stock with Substantial Upside

| About: DynCorp International (DCP)

DynCorp International (DCP) is a provider of services to the military and government agencies. It provides law enforcement training, security services, foreign language interpretation, aviation services, and special operations support. The company is a competitor of Xe Services (the firm formerly known as Blackwater).

The company's market cap is ~$600Mn and its enterprise value is ~$1000Mn.

The company is estimated to earn $1.56 per share this year (FY ending March 2010) and $1.75 next year. At around $11, the stock is trading at just 7x trailing and forward EPS. The company’s free cash flow has been in line with net income. The company is using its free cash flow to repay debt, make small acquisitions and buy back stock. Revenue has been growing at a steady 10% clip, which is expected to continue with $3.45Bn this year and $3.78Bn next year.

The stock has been trending down over the last few months, with concern over US military operations winding down in Iraq. However, this is offset by an increase in troop levels in Afghanistan. Also, as US operations wind down, the civilian government has a greater need for support from contractors to assure security and provide training to their forces. Defense contractors, including DynCorp, have got some bad press of late, with charges of unclear billing, which I must add is not unusual in a war-time environment. DynCorp generates a 6 to 7% operating margin, so there is little evidence that they are overcharging for their services.

The stock's drop of 20% in the past month seems overdone, and appears to be a large holder getting out of the stock. I would expect the company to aggressively buy back its stock if it stays at this level. It would also make a nice accretive acquisition for a larger defense company looking to diversify into services.

The company is scheduled to report earnings on the morning of Thursday, February 4, with expectations of a 14% YoY rise in revenues and a 17% YoY increase in EPS.

I estimate the fair value for DCP stock at $20, using a conservative 12x multiple on calendar year 2010 EPS of $1.70. That's more than 75% upside – hard to find in many other stocks in a market that is up a lot in the last year.

Disclosure: Portfolios managed by the author have a long position in DCP