ManTech International – A Contrarian Play On Sequestration And Afghanistan Drawdown

ManTech International – A Contrarian Play On Sequestration And Afghanistan Drawdown

Aug 29 2013, 11:15  |  about: MANT

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Editor’s notes: A shift in MANT’s business mix has it well prepared for industry headwinds. The stock has 30% upside and is a potential takeover target.

Business Overview:

ManTech (MANT) is a leading provider of innovative technologies and solutions for mission-critical national security programs for the intelligence community; the departments of Defense, State, Homeland Security, Energy and Justice, including the Federal Bureau of Investigation (FBI); the healthcare and space communities; and other U.S. federal government customers.

Segments:

The firm is defined by three main segments:

A. Mission, Cyber and Intelligence Solutions Group (MCIS) – It hosts the national intelligence community and cyber work. In addition to pursuing opportunities with their existing companies, MCIS is mandated to aggressively build out a commercial cyber solution.

B. Technical Services Group (TSG) – It hosts C4ISR, global logistics, test and evaluation communications and IT.

C. Emerging Markets Group (EMG): EMG will identify markets and rapidly build new businesses; it will initially focus on healthcare IT and federal civilian agencies and then explore new potential growth areas such as energy and environment.

Major segments of the MANT are C4ISR Solutions and Services which include systems engineering, systems integration and software engineering using the latest Agile methodologies; Cyber Security provides comprehensive cyber warfare and cyber defense security solutions and services; Global Logistics Support which maintains critical and life-sustaining operational readiness levels for counter-improvised explosive device (IED) vehicles and systems, including Mine-Resistant Ambush-Protected (MRAP) vehicles and MRAP All-Terrain Vehicles (M-ATV); IT Modernization and Sustainment design, develop, deploy, modernize, operate and maintain IT systems and infrastructure; Intelligence/Counter-Intelligence Solutions and Support; Test and Evaluation and Environmental, Range and Sustainability Services.

According to me, ManTech can be defined in five major segments:

Thesis:

MANT’s share price is still down 33% from its 2011 high. Almost three quarters after President Obama announced the formal withdrawal from Iraq in FY11, MANT’s share price declined from the high of approximately $41 a share to $20 a share in August 2012. Today, similar fears of drawdown in Afghanistan, in addition to the sequestration risk, have plagued the industry. However, what is a curse to many might be boon to some. Sequestration and fear of Afghan drawdown are exactly the risks that I believe will create opportunities to participate in MANT’s future growth prospects. It is true that MANT has 30% revenue exposure to overseas contingency operations (OCO), while 22% of its revenues will come from MRAP and S3 contracts, respectively. It is also a well-known fact that MANT will report lower revenue in the short term from the drawdown and I believe is majorly, if not completely, discounted in the current share price. The recent decline in S3 revenue for example was from a completion of tower contract in Afghanistan. Short of unforeseen reductions, this one-time decline, which is now priced into the stock, will make any further decline in revenue very gradual. Another cause of concern for investors is the decline in margins over the last 1.5 years. Since the debt debates of FY11 and the talk of sequestration started, government agencies have delayed awarding contracts and have moved to awarding lower margins cost reimbursable contracts. MANT’s share of these contracts has increased from 19% of total in FY09 to 51% of total in FY12. However, according to management, low margin contracts as a percentage of total have peaked this year and fear of further margin compression due to higher mix of low margin contracts might be getting overplayed. As we look into the future, it’s important to understand why MANT may have good future prospects and what has changed since the Iraq drawdown.

Firstly, MANT has made some smart acquisitions and changed its business mix. Compared to 1Q12 in which Cyber and Intelligence constituted 15% of total revenue, today these two segments constitute 30% of total. In addition, MANT has made forays into Healthcare IT, Data Analytics and has expressed its intent to explore commercial applications of its Cyber technology. The diversification makes MANT much better prepared today, than it was when the Iraq drawdown was announced. Secondly, despite modeling for a 60% decline in its MRAP revenues (22% of total) and another 15% decline in S3 revenues (22% of total), MANT around its current share prices seems to have mostly discounted for the drawdown and possible sequestration.

Sequestration rules, unless modified, should lead to cuts in the defense budget as has been highlighted in the 2014 budget documents. However, it should be noted that cuts will not be same across all defense establishments. Cyber and Intel still have priority, according to FY14 President’s budget request. Moreover, less boots on the ground due to Afghan drawdown means further investment into Cyber, Intel and reconnaissance operations – a positive for MANT. Another area of growth for the firm is the current policy of more investments in Navy and Air force to expand US presence in Asia-Pacific. In contrast, government has signaled reduction in expenditure in the healthcare field. MANT’s foray into Healthcare IT to reduce spending will also create opportunities for the company, making budget cuts in Healthcare a boon for MANT shareholders. MANT with its existing contracts can help the agencies migrate from or manage legacy systems more effectively. Another effect of sequestration is that it can trigger consolidation in the sector as larger players feel the effect of upcoming budget cuts. MANT, with its strong FCF, strong balance sheet and suite of products that are already used by the government agencies will make for a good takeover target. In addition to Private Equity firms and larger government service firms, MANT’s JV with firms such as Fluor Corporation, make it an attractive target for industrial firms as well. It should be noted that MANT’s co-founder owns 85% voting control of the firm, however, he is already 77 years old, and might be inclined to find a better home for the firm before he retires. Fundamentally, MANT enjoys strong balance sheet with $193M in cash, $200M in debt due in FY18 and TTM FCF of $230m. According to my analysis, most, if not the entire downside from the drawdown is priced in the stock, although price might further decline in the short term. Medium-term shareholders who are willing to wait will find opportunity to participate in MANT’s growth prospects before 1Q14. MANT also throws in a healthy dividend yield of 3.3%.

Major Catalyst:

Overlooked Business Transition Due To Short-Term Focus on FY14 Afghanistan Drawdown:

Most investors that still retain memories of Iraq drawdown in FY11, when MANT’s share price declined approximately 50% from $41 a share in FY11 to USD 20 a share in FY12 are missing the fact this time it’s different. The argument that MANT generates 95%+ revenues from the federal government still stands, but what needs to be noted is that the revenue drivers have changed. The potential sell off due to comparisons currently made between the drawdown in Iraq with that in Afghanistan topped with sequestration risks will create opportunities for investors who are focused on the medium term. Unlike FY10 and FY11, it’s important to notice the change MANT has brought about and its recent forays into the fields of cyber, intelligence, healthcare IT and analytics.

Since the Iraq drawdown in 2012, MANT has successfully changed its business mix by using its strong cash flow and balance sheet to make smart acquisitions. As recently as FY12, MANT acquired Evolvent Technologies a provider of services in clinical IT, clinical business intelligence, imaging cyber security, behavioral health, tele-health, software development and systems integration to the DoD health organizations, the Veterans Administration and the Department of Health and Human Services. Another was HBGary, a provider of software products to detect, analyze and diagnose advance persistent threat and targeted malware to customers for their cyber security needs in the financial services, energy, critical infrastructure and technology sectors. MANT also acquired ALTA systems in FY13, which provides IT and professional services with valuable applications in healthcare systems and capital planning. HBGary is expected to be accretive in 1Q14.

Although contracts such as MRAP and S3 provide MANT over 30% revenue exposure to overseas operations (OCO), MANT has been able to partially hedge the revenue decline with growth in its Cyber & Intelligence operations that have grown from approximately 15% of total in 1Q12 to approximately 30% as of 2Q13. Some recent wins have been a major contract with the National Institute of Health in 2012, its AMBIANCE program which provides cyber, cloud computing and data analytics to its clients, its CJIS program with the FBI to provide operational support to FBI’s large data centers, to name a few .

In addition, MANT’s efforts to provide Healthcare IT solutions to government agencies and its efforts to explore providing cyber security to commercial enterprises stand to generate profits for investors in the future. Service contracts are not only high margin, but less capital intensive and will help MANT improve its operating margins and earnings in the future. What will further help MANT’s bottom line are its technological applications to the private enterprise.

A major decline in its S3 contract, 22% of total revenue, was due to completion of its tower contract – which has come to pass and is priced in the stock. The Afghan drawdown will not be as quick as expected with troops still remaining on the ground. Moreover, while we slowly reduce operations, the US government would still need logistical and ISR support, giving MANT a revenue stream from overseas operations for a sustainable time period providing the firm enough time to diversify and execute on its strategy. Additionally, certain programs within MARP and S3 are expected to generate steady or incremental revenue stream. Thus the fear of drawdown might be overplayed in the current scenario. Even assuming a 60% reduction in MARP revenue and 15% reduction in S3 revenue for FY14, I believe the stock still remains fairly valued and a surprise to the upside in the near future makes this a good investment for medium-term investors.

Sequestration Risk to Create Opportunities:

It is true that the news of the Afghan drawdown and the debate in the congress over deficits has affected the budget allocations. Specifically, as budget cuts are enacted , they will lead to steep cuts in defense budgets resulting in further sell-off in shares of contractors such as MANT. However, this very phenomenon will create an opening for those who wish to take advantage of a possible sell-off and go long MANT.

It is important to understand that although defense budgets are reduced, the reduction varies depending on the agency and concerned branch of the defense establishment. For example – procurement and military construction funding are reduced by 14% and 23% respectively while research, development, test, and evaluation (RDT&E) funding is only reduced by 3%. Similarly, the FBI and the DoD will require more cyber and Intelligence capabilities, instead of less, in the wake of reduction of boots on the ground and reduction in personal budgets. Given the changing nature of wars, where wars have moved from traditional to the ones fought in the cloud, investment in Cyber and Intel has becomes even more pertinent. In fact FY14 Obama budget asks for more investment in these areas. This benefits MANT. In contrast, a reduction in investments from budget cuts for agencies such as Veteran Affairs, Medicaid, and Medicare is a positive for MANT. Healthcare IT spending is expected to increase as the focus shifts to saving costs and providing for better and more accurate medical care. Given growing healthcare expenditure, government is expected to ramp up its investment in healthcare technology to rein in the expenditures and achieve better results. MANT, which is already working with VA and NIH, can capitalize on this trend to help government save costs by not only assisting the government to maintain legacy systems but to help it migrate from legacy systems to more efficient ones. MANT’s recent acquisition of ALTA in FY13 presents the company with such opportunity. ALTA places MANT in a prime position on contracts for the Centers for Medicare and Medicaid Services (CMS) Enterprise Systems Development (ESD) which has a $4bn ceiling and lasts through May 2018.

Another issue that needs to be addressed is the concern of margin reduction over the course of the last 1 to 1.5 years. This has occurred because of the types of contracts the government has recently awarded. Even before the possibility of sequestration became real, government agencies have not only held off on awarding contracts, but they have increasingly awarded low margin cost reimbursable contracts. This has been a major cause of margin reduction for MANT. The firm’s share of total cost reimbursable contracts have increased from 19% of total revenue in FY09 to 51% of total in FY12 and, according to MANT management have peaked this year. As cost reimbursable contracts peak as a percentage of total revenue and MANT moves to higher margin business over the course of next year or two, medium-term shareholders should benefit from the future upside. Last but not the least, are the effects of budget cuts, which I believe, will be a positive for firms such as MANT. Cut in defense spending should lead to sector consolidation where larger players will hunt for mid size firms that possess strong cash flow, ongoing contracts, strong balance sheet and technology. MANT fits the bill. However, if it were to happen, it has to be amicable to the company. Its founder holds 85% voting control and is now 77 years old. This will be a marriage of convenience, where MANT can find a home for itself before its co-founder retires.

Potential M&A:

While MANT looks for smarter acquisitions, the hunter might as well become the hunted. Sequestration might be a boon to some and is a bane to many! While Defense budgets are cut, according to some industry estimates, spending on Cyber Security is expected to increase to $16bn by 2015 from the current $9bn- $10bn. As previously mentioned, to rein in healthcare expenditure, government is expected to ramp up its investment in healthcare technology to reduce expenditures and achieve better results for patients by providing for better care through lower cost and better data analysis. MANT not only intends to use its technology for federal contracts, but is exploring it for potential commercial applications. This makes MANT even more palatable to larger firms. Multinational firms, such as Lockheed Martin (LMT) and Raytheon (RTN) who face larger risks from spending cuts will walk the traditional path of survival by buying firms with steady cash flow, healthy balance sheet and technology in growth areas such as Cyber & Intelligence. In fact Raytheon has made a dozen or more acquisitions in the past 5 years in cyber security and hungers for more.

Other suitors that might fit the bill might be those industrials who may look to diversify their revenue base. One such example in this case might be Fluor Corporation (FLR) with whom MANT has a joint venture. Through this venture MANT received a $23B basic ordering agreement to manage logistics on an installation basis, covering maintenance, supply, and transportation. Both of these contracts expand MANT’s footprint in vital and enduring Army programs. MANT will certainly not leave its suitors disappointed with $193M in cash as of 1H13, approx. $90M in FCF in 1H13, a $500M unused credit facility and a growing high margin business. In addition to strategic buyers, a company with MANT’s cash flow profile will also be suited for a private equity buyer. But there is one catch – if a marriage were to occur, it has to be consensual. MANT’s co-founder George J. Pedersen owns 36% of MANT and has 85% voting control of the firm. This might not sound enticing to suitors, but what might be is that he is 77 years old, and in my opinion, would be more likely to sell or become part of a larger organization in the near future before he retires.

Current Valuation Discounts Majority of Negative News:

MANT has $193M in cash and $200M in debt, which is not due until April 2018. I have used both transaction multiple analysis and comparable analysis to value the company under three different scenarios, a base-case, a medium-case and a best-case scenario. I have used the following competitors to run valuation on the company, for 2014 and beyond.


I have modeled for different scenarios for FY13 & FY14. The scenarios calculate MANT’s revenues, its operating income, EPS, Op. CF and EBITDA for 2013 and 2014. Additionally, I believe that the company will surprise to the upside, as most if not all of the negative news for this and next year has been majorly discounted in the current market price. Most importantly, MANT’s tower contract, a major reduction for a sudden reduction in S3 revenues is now completed and the revenue downside from the contract is now priced in. The drawdown in Afghanistan will have an effect, but at current price, that’s mostly if not completely discounted for. Moreover, MANT’s foray into cyber, Intel and areas of analytics and Healthcare IT, in addition to commercialization of its cyber technology for financial, energy and infrastructure firms will help shareholders with a longer-term perspective earn healthy returns. Those who are willing to wait can enjoy a 3% dividend yield in the interim. After running different scenarios I believe that the worst-case scenario will value MANT at $27 a share. It’s possible that if a huge market sell-off occurs, the stock might trade at $24. In the event the stock surprises on the upside over the next two years or gets taken over, MANT can be valued at $37 to $41 per share.

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