Valuations for 3 Smallcap Defense Contractors

I recently reviewed the second quarter results and offered valuations for three small defense contractors: ManTech International  (MANT), VSE Corporation  (VSEC), and CPI Aerostructures (CVU).

The valuation approach I have taken is based on owner earnings, which is a variation on free cash flow. Basically, owner earnings is free cash flow with working capital removed from consideration. It is computed as net income plus depreciation and amortization minus capital expenditures, and adjusted for one-time items if necessary. An argument could be made for only subtracting off the portion of capex required for maintenance, thereby including growth capex in owner earnings. However, I generally take the more conservative approach and subtract out total capex.

Also, I have to choose whether to use a trailing-twelve month figure or to use a run rate for the current fiscal year. Once I have a figure for owner earnings, I then use a DCF calculation to determine the growth expectation which is built into the current price. This will give us some idea as so whether or not the market has mispriced the stock, and if so, in what direction.

I tend to be wary of overly complicated and intricate valuation analyses. Don’t get me wrong – I like numbers as much as the next guy (maybe even a tad more than the next guy given my professional calling), but I think it’s easy to go overboard and attempt to achieve a level of precision which is simply not attainable given all of the subjective assumptions which must be made in any valuation argument. I’m not looking for precision, which I think is a meaningless quest in any case, but rather for a sense of the direction in which the stock price will likely move. I am comfortable with this approach because in the long run (though definitely not in the short-run), price follows earnings, or, if you will, owner earnings.

That said, I’d like to revisit my recent valuations of the companies mentioned above. In those valuations, the DCF calculation I used was based on an 11% discount rate, a 5-year growth period, and no terminal growth. While I try to be as conservative in my assumptions as is reasonable, I think the assumption of no terminal growth goes a bit too far. A more reasonable model is provided by the assumption of 3% terminal growth, and this is what I will use in the DCF calculations which follow.

ManTech has a market cap of 2.08B corresponding to a stock price of 59.29. Based on the owner earnings for the first half of 2008, and on the company’s projection for its 2008 net income, I estimate 2008 owner earnings as 98.3M. With 10M in cash and 98M in debt, the company has an enterprise value of 2.17B and therefore is trading at an EV/OE multiple of 22. A DCF calculation shows that the current price is based on the assumption of 16% growth.

Taking into account the company’s recent level of 20% organic growth and the guidance it has provided, it appears that the stock is reasonably priced, but not a screaming bargain. If the growth assumption of the trading price falls to the range 13%-15%, we will have a very attractive buy-in point. This would occur when the price is in the range $52 – $56.

VSE Corporation has a market cap of 190.3M corresponding to a stock price of 37.57. The company has generated 7M in owner earnings in the first half of this year which implies a run rate of 14M for the year. With 1.5M in cash and no debt, the company has an enterprise value of 188.8M and therefore is trading at an EV/OE multiple of 13. A DCF calculation shows that the current price is based on the assumption of 5% growth.

Given the growth rates this company has been experiencing as well as its funded backlog which is substantial and growing as well, it appears that the market has seriously undervalued this stock. The current price is quite attractive.

CPI Aero has a market cap of 46M corresponding to a stock price of 7.70. Based on the owner earnings for the first half of 2008 and on the company's projection for its 2008 net income, I estimate 2008 owner earnings as $2.5M. With 207K in cash and 67K in long-term debt, the company has an enterprise value of 45.9M and therefore is trading at an EV/OE multiple of 18. A DCF calculation shows that the current price is based on the assumption of 12% growth.

This company has been clicking on all cylinders, and based on its growth rate over the last two years as well as on the long-term outlook provided in the recent earnings release, the company seems well-poised to handily exceed the growth assumption which is built into the current price. Therefore, the current price represents a good buy-in point.

Disclosure: I own shares of all three companies discussed in this article. I recently purchased additional shares of VSEC and CVU.

Comments

[buyitcheap:]

Your analysis presupposes that life will go on nicely as if these firms had lots of customers - they don't. Typically, they have 2-3 "real" ones. The defense sector is very different from others where one contract cancellation, delay, or award protest (witness Boeing's tanker fiasco) can ruin your whole quarter/year/call on a stock. Items you should consider are the quality of their backlogs, how the contract funding spread over the defense priority allocation system (DPAS). That will give you a sense of how serious the government considers the contracts - meaning, if the Dems get in and say "cut cut cut" the higher up on the DPAS their contracts are, the more likely the revenues will continue to flow. DCF is nice, but you need to put probabilities around every one of their major contracts and know where the funding is coming from to do a serious analysis.

2008 Aug 25 07:37 AM

[liegh aulper:]

Buyit,
you do have a valid point when speaking in general terms. However, personally I can speak about VSEC and CVU, your points don't carry a lot of wieght because of the type of contracts these companies have and the programs they are involved in. Short of us going back to reducing our military (like in the Clinton days) you are way off base. Matter of fact, as the war winds down these companies will benifit as they will also be involved in helping the military rebuild our worn torn equipment. And in the case of CVU they have major upcoming work with Commerical programs.

2008 Aug 25 02:13 PM

[buyitcheap:]

Leigh, you make some fair points but first I welcome the discussion because you sound like you know the industry too. Personally I love the sector especially as you note those with commercial business interest as well. And VSEC has trailed down nicely so its definitely worth consideration.

So in terms of my general statement, which true, that's what it was, in looking at their 10-Q, I actually think you're making my point. One contract for VSEC appears to have generated 75% of its total revenue. And that's where the "risk". From VSEC's latest 10-Q:

from page 13-14 of the 6/30 10Q filing:
"CECOM Contract: This contract generated revenues of
approximately $302 million in the first six months of 2008 and approximately$145 million in the first six months of 2007. The CED Army Equipment Support Program and the CED Assured Mobility Systems Program are performed through this contract. CED Army Equipment Support Program - In December 2005, our CED division was awarded a task order on the Rapid Response support contract to provide maintenance and logistics services in support of U.S. Army equipment in Iraq and Afghanistan. Services provided under this program include deployed sustainment management, deployed logistics and repairs management, unique system training and curriculum support, resource management and acquisition and administrative support. Most of the services on this program is provided by CED's subcontractor. Profit margins on subcontract work are generally significantly lower than on work performed by our own personnel." - This one concerns me. A) it's subk work b) it's generating a lot of low margin revenue. (now on the flip side, that could be disguising some nice higher margin biz, but the proportion is overwhelming right now).

And that's all I'm saying...when the revenue is concentrated like that, you've got to know how the customer views the contract, is it "strategic" or is it, "eh- take it or leave it."

I love to throw around ideas in this space - so please I welcome your comments and look forward to the discussion! :-) Best to you!

2008 Aug 26 07:34 AM