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