EXECUTIVE SUMMARY: I recommend a SHORT position in KEYW with a 12-18 month price target of $9.50/share (-30% expected return). While consensus is unanimously bullish on KEYW, I believe the market overlooks the reality that KEYW is a sub-scale defense contractor with decelerating organic growth, compressing gross margins, and negative tangible book value, and which is fighting major uphill battles in defending its government business and in expanding into commercial customers.

Please refer to the private comment thread below for a cleanly formatted PDF of this report with additional charts.

HISTORICAL FINANCIALS & MY ESTIMATES:

Revenues: $108.0mm (2010A), $190.6mm (2011A), $243.5mm (2012A), $311.9mm (2013E), $348.8mm (2014E)

EPS: $0.51 (2010A), $0.02 (2011A), $0.03 (2012A), -$0.22 (2013E), $0.03 (2014E)

Gross Margin: 29.2% (2010A), 29.7% (2011A), 34.4% (2012A), 31.1% (2013E), 30.8% (2014E)

EBITDA: $7.0mm (2010A), $20.1mm (2011A), $32.0mm (2012A), $27.6mm (2013E), $30.4mm (2014E)

EBIT: -$0.2mm (2010A), $4.7mm (2011A), $6.4mm (2012A), -$2.9mm (2013E), $12.3mm (2014E)

WHY AN INVESTMENT OPPORTUNITY EXISTS: Consensus long investors have been enamored with KEYW’s pure-play presence in government cyber-security, its historical ambitions for 25%+ annual organic growth, and its potential foray into commercial cyber-security with “Project G.” The Street is unanimously bullish, with all seven sell-side analysts (who participated in the IPO or secondary) issuing Buy ratings with a mean price target of $18.17. High-flying growth stocks such as KEYW can trade at valuations that seem absurd based on traditional valuation metrics as long as current shareholders believe in the growth potential.

Thus, in order to short a company like KEYW, it is essential to correctly identify potential inflection points and timing around when the shareholder base might turn over. With KEYW shares having appreciated 35% in the last year despite deteriorating financials and continued delays to “Project G,” I believe a compelling short-selling opportunity exists today. To develop my investment thesis, I carefully reviewed KEYW’s SEC filings and earnings transcripts, conducted extensive primary due diligence interviews, and attended industry conferences

MY BEARISH INVESTMENT THESIS: My variant view is predicated on the following points:

(1)     KEYW faces financial challenges that include deteriorating organic growth to less than 10% (from reported 20%+ in 2011), declining average service revenue per employee from $193K in 2011 to just $156K in 2012 (-19.4% Y/Y), lengthening cash conversion cycle, earnings margin compression, and a paltry $3.1mm of cash on the balance sheet vs. $96.4mm in debt.

(2)     Under the Budget Control Act of 2011, the government could reduce defense spending by up to $1 trillion over the next decade. My talks with defense contacts affirm that cyber-intelligence competition from larger players will intensify due to greater fiscal conservatism, which could drive backlog weakness and fading gross margins due to fewer prime contracts for KEYW.

(3)     KEYW management’s incentive structure, which is based on revenue and EBITDA targets that can be achieved through acquisitions, prioritizes “empire building” instead of value creation and optimal capital allocation for ordinary shareholders.

(4)     KEYW seems to be making a last-ditch effort to save its declining core government business by expanding into the commercial segment through “Project G,” which I believe is a largely undifferentiated data management platform. I believe that if KEYW fails to attract a meaningful number of paying customers by end of 2013, the current shareholder base could turn over.

NEGATIVE CATALYSTS & EVENT PATH: (1) Further declines in organic growth; (2) inability to secure substantial prime contracts in 2013; (3) failure to meaningfully monetize Project G by end of 2013/early 2014; (4) difficulty in raising capital to drive future M&A; (5) continued pressures on defense spending.

UPSIDE RISKS: The greatest upside risk is that KEYW could be acquired, but management has not indicated that KEYW is being shopped and it seems unlikely for a buyout to happen near current valuation. Bulls are also betting that KEYW can expand into the commercial segment, but I believe KEYW faces significant incumbent competition and will not see meaningful commercial revenues until early 2014 at best. A short squeeze is a possibility given the current short interest ratio.

VALUATION: At 14x EV/EBITDA on my 2014 estimates, KEYW appears overvalued on a variety of methodologies. Based on intrinsic value calculations, company comparables, and precedent transactions, I believe KEYW should be worth $9.50/share (~10.6x forward EV/EBITDA on my estimates). My model also shows an upside case of $14.75/share based on a potential takeout scenario. I believe current levels represent an attractive entry point for a short position, given the 3:1 asymmetric downside/upside ratio.

(The text above summarizes my pitch. Please read on for additional details on company background, consensus view, my variant investment thesis, valuation, key risks, and potential mitigants.)

KEYW has primarily used a roll-up strategy to develop a broad suite of cyber-security offerings, having completed 17 acquisitions since its inception for a total enterprise value of about $400mm. KEYW is almost entirely dependent on government business, which accounts for 96% of the company’s revenues. By customer, 54% of KEYW’s revenues are derived from the National Security Agency (NSA), 25% from the Department of Defense (DoD), 17% from other government intelligence agencies, and 4% from commercial entities. KEYW is engaged in over 150 contracts, with the ten largest contracts accounting for over 40% of revenues. Much of KEYW’s management team, including CEO Len Moodispaw, had held leadership roles at Essex Corporation and had grown its market cap from $50mm to $500mm before selling it to Northrop Grumman in January 2007. Moodispaw and his associates later reached an agreement with Northrop Grumman to acquire 60 employees and certain fixed assets, which gave rise to the formation of KEYW in August 2008. KEYW went public in October 2010, offering 9.1mm shares with selling insiders and early investors accounting for 9% of the offering.

CONSENSUS BULLISH VIEW: Sell-side analysts estimate that the cyber-security market is about $10 billion today and could grow to $15-20 billion over the next few years. Bullish investors have been enamored with KEYW’s pure-play story in cyber-security, its historical organic growth target of 25%+ annually, its industry-leading proportion of employees with security clearances (which I believe is frequently mistaken for a competitive moat), and management’s prior acquisitive track record at Essex that they hope to replicate at KEYW. However, I believe today’s economy, political climate, and competitive landscape pose more formidable challenges, which underpin my bearish investment thesis for KEYW. Moreover, although KEYW is attempting to offset the slowdown in its core government business by expanding into the faster-growing commercial segment with “Project G,” I think this initiative will ultimately prove costly and unsuccessful given the large number of entrenched competitors offering equivalent or better products.

MY VARIANT BEARISH VIEW: I believe KEYW’s growth-by-acquisition strategy does not give it a sustainable competitive advantage nor does it optimize shareholder value. Declining company and industry fundamentals will continue to pressure both KEYW’s roll-up model and organic growth. Despite this, shareholders have held their breath for KEYW’s potential expansion into the commercial segment via “Project G,” which I believe will ultimately make negligible top-line contributions. I expect the shareholder base to begin turning over if KEYW fails to enlist at least a handful of fully-paying commercial customers by the end of 2013.

KEYW shares have appreciated ~35% in the last year due largely to management’s optimistic banter about growth prospects and new initiatives. The market has turned somewhat of a blind eye to persistent government efforts to reduce defense spending along with the absence of major contract wins and organic growth re-acceleration for KEYW. Consensus is overwhelmingly bullish, with all seven sell-side coverage analysts issuing Buy ratings with a mean price target of $18.17. Three of the covering banks – SunTrust, Noble Financial, and Merriman – had participated in KEYW’s IPO. The four other banks – RBC Capital Markets, FBR, Dominick & Dominick, and Noble Financial – were co-managers on KEYW’s $87mm secondary offering in September 2012 (7.4mm shares at $11.75/share). My view that KEYW is overvalued is predicated on four key points.

First, several financial data points suggest deteriorating trends in KEYW’s business:

-          Annual organic growth in services, which was historically touted by management and sell-side analysts as being achievable at 20%+ as recently as early 2012, has decelerated to 10% (and potentially less) as of 1Q13. Taking into account the declines in a key air force contract as the government pulls back on its counter-terrorist efforts abroad, organic growth could actually be in the mid-single digits. Given the persistent pressures on defense spending, I do not expect this growth to re-accelerate to anywhere near management’s original goals.

-          Although management has aimed to increase its headcount by about 25 new hires per quarter and cites this statistic as an indicator of potential growth, average service revenue per employee has actually declined from $193K in 2011 to just $156K in 2012, representing a year-over-year regression of 19.4%. This makes me skeptical about the likelihood for operating leverage.

-          Cash conversion cycle has declined from 80 days at the end of 2011 to 88 days at the end of 2012. It appears that government customers have been leveraging their buying power to extend contract payment terms.

-          The company’s free cash flows (before acquisitions) are somewhat unpredictable given the nature of government contracting, but were nonetheless a meager -$2.4mm in 2010, $7.6mm in 2011, and $5.8mm in 2012 (compared to revenues of $108.0mm, $190.6mm, and $243.5mm over the same time frame). Furthermore, if we factor in the cash expenditures on acquisitions (which have been a cornerstone of KEYW’s strategy), free cash flows have been significantly negative in most quarters since the company went public. Operating margins have also never exceeded 2.1% since KEYW was founded. Thus, although the company has demonstrated strong top-line growth due to its roll-up strategy, the company has failed to grow profitably. With increased operating expenses associated with the ramp-up of Project G, it appears that profitability on both an accounting basis and a cash basis could be at further risk.

-          Despite these headwinds, KEYW has stayed afloat due to a successful secondary offering in September 2012. However, now with just $3.1mm of cash on its balance sheet versus $96.4mm in debt and limited draw left on its revolver, KEYW’s ability to “acquire growth” could soon be impeded.

Secondly, my conversations with defense and intelligence experts affirm that the government has become increasingly deliberate in its contract decisions due to the challenging economic and political climate. I believe this could be a long-term overhang that could drive pipeline weakness, greater competition, and lower service margins for KEYW. Overall defense spending could contract meaningfully over the next few years as the U.S. has begun turning over security responsibility to the Afghan government as of 2Q13. Moreover, in August 2011, the President and Congress signed the Budget Control Act, which called for $487 billion in national security spending cuts over the next decade. Under this same law, since the congressional panel failed to identify $1.2 trillion in across-the-board cuts by March 1, 2013, $110 billion in additional cuts to defense and non-defense agency funding (also known as sequestration) will be applied for fiscal 2013 and beyond unless countermanded by Congress.

These headwinds have been reflected in KEYW’s backlog: of the $492mm in backlog at the end of 2012 (versus $452mm in 2011 and $285mm in 2010), $340mm was unfunded (versus $376mm in 2011 and $193mm at the end of 2010). Much of this unfunded backlog remains unstaffed. Ultimately, revenues from unfunded backlog are at risk of not being realized given the uncertain nature of government contracts. Also, these challenges could continue to drive larger defense players to exploit their economies of scale and become more competitive on contract bidding. KEYW has already been relegated to performing more subcontracting jobs, which carry lower gross margins than prime contracts. At the end of 2012, subcontracts accounted for 72% of KEYW’s revenues compared to 69% in 2011 and 61% in 2010. Furthermore, while other defense companies (e.g. CACI, ManTech, SAIC) have disclosed positive outcomes in obtaining sizable ($30mm+) prime contracts in recent press releases, KEYW has not done the same.

Other than the backlog that KEYW inherited through its acquisition of Poole & Associates in October 2012 – for which KEYW probably overpaid at 16.2x EV/trailing EBITDA, and which also holds a prime contract role in a large, albeit low-margin government contract where KEYW ultimately took backseat as a subcontractor – I do not believe there are any major contracts in KEYW’s pipeline. In fact, since KEYW participated in the highly-publicized bidding contest for “Aura” – a $700mm contract bid with the NSA over seven years that KEYW lost to a larger competitor in September 2011 – KEYW management has barely made a peep about any other large contracts (excluding the ones it had acquired through Poole). Perhaps I am being skeptical, but since KEYW had lost “Aura,” there has been a conspicuous absence of commentary about large contracts in its pipeline. This seems unusual given the company’s promotional management team. In fact, according to press releases since the end of 2010, KEYW’s largest organically generated contracts were $16mm (surface mount technology labs) and $11mm (intelligence analytics program).

Thirdly, KEYW’s executive incentive plan rewards “empire building” instead creating value for ordinary shareholders. Bonuses for the CEO and key executives are determined based on a weighted average of 60% target revenue and 40% target EBITDA. Importantly, these targets can be achieved through acquisitions, and there is no stipulation in the annual incentive plan that prohibits management from taking these actions to obtain their bonuses. In fact, KEYW’s most recent proxy statement reveals that the financial targets at the “minimum / 90% level” failed to be met for the legacy company in 2011, but ended up being achieved when taking into account contributions from that year’s acquisitions. The same compensation structure remained in place for 2012.

I do not believe these incentives are aligned with the interests of ordinary shareholders. Metrics that would be more directly measurable to shareholders would include EPS or cash flow to equity; under the current arrangement, management can reward itself by growing KEYW via acquisition at any cost. Further signs of management’s proclivity to overpay for acquisitions are evident in KEYW’s goodwill, which accounts for 63% of total assets. Finally, even if shareholders disapproved of the incentive plan, the next “say on pay” advisory vote will not occur until KEYW’s 2014 board meeting.

In fact, through the KEYW’s secondary offering in September 2012, common shareholders basically forked over cash to management so that management could buy companies such as Poole that had an existing backlog of contracts, recognize this backlog as revenue as services were performed, meet their performance benchmarks, and pay themselves lofty bonuses. If it turns out that KEYW overpaid for Poole (which I believe it did), common investors will ultimately suffer while management still gets their big payday.

Investors that disagree with my assessment might argue that KEYW does not suffer from weak insider ownership. Indeed, KEYW directors and senior officers held 14.6% beneficial ownership of KEYW according to the most recent proxy filing. However, one should also note that 36% of this beneficial ownership is represented through options and warrants rather than actual shares. Investors should consider that many stock option programs incentivize managers for short-term gains rather than long-term value creation for shareholders since the payoff is positive if shares appreciate, yet the downside of options that have already been granted is zero.

Finally, KEYW has aimed to offset pressures on its government business by expanding into the commercial space through “Project G,” which I believe could be mostly hype and result in little incremental top-line contribution. Project G is KEYW’s cyber awareness and response platform that is being developed on top of software created by Sensage, which KEYW had acquired in October 2012. Sensage’s software was initially built to allow users to visualize security information and event data organized in a columnar database. In “Project G,” KEYW essentially uses Sensage’s software as a base and layers on KEYW’s analytics and database of malicious code that had been built over the years through government projects. Ultimately, the goal of Project G is to identify, analyze, and fix malicious cyber threats for commercial customers, while leveraging the knowledge and street credibility that KEYW developed through government work.

Based on this description, it probably sounds like Project G has all the trappings of a potentially disruptive technology. I believe that in reality, Project G is anything but that. My prediction is that in the best case scenario, KEYW will realize some incremental margin in 2014-2015 from Project G; in the worst case scenario, management is simply throwing good money at bad.

I realize this is a bold claim, but KEYW is essentially trying to enter a highly competitive commercial segment with an unproven technology that is based on undifferentiated data management software with a subpar user interface that KEYW gained through its acquisition of Sensage. This does not sound like a recipe for success in my book. Sensage had once been in the Gartner “magic quadrant” several years ago and employed over 250 employees in its heyday. However, according to my conversations with former employees and customers of the company, Sensage failed to keep pace with innovation, saw dwindling capital commitments from its venture capital backers, and ultimately fell behind in the event management arms race due to outdated technology and an interface that was not nearly as user-friendly as key competitors.

Over the past couple years, Sensage continued to lose share to larger competitors such as ArcSight (owned by Hewlett-Packard) and Splunk, as well as smaller private companies such as LogLogic, LogRhythm, and SumoLogic. One former Sensage employee that I had spoken with, who now works at a competitor, said that Sensage was basically “left for dead” before KEYW bought it for $24 million in October 2012, which was 2.8x trailing LTM revenues. At that time, Sensage had just 35 employees, most of which were not cleared at any security level according to KEYW’s SEC filings.

Although the takeout multiple for Sensage was modest compared to the 7.6x EV/LTM revenues that HP had paid for ArcSight in July 2010, it is still meaningfully higher than the median 1.5x for KEYW’s past acquisitions and the 1.3x for precedent transactions referenced in the HP-ArcSight transaction documents. KEYW had been the great beneficiary of a successful secondary offering that was completed just days before the Sensage acquisition was announced, and likely hoped that Sensage would be able to produce a solid fourth quarter as it seasonally has. In actuality, Sensage’s 4Q12 revenues were anemic and the company only qualified for just $78,000 out of a potential earn-out payment of $10.5 million. While this saved KEYW money, I did not think this boded well for the future prospects of Project G.

The top-secret nature of much of KEYW’s work enables management to provide limited visibility and disclosure about what the company actually does. In fact, unless you are a cyber-security professional, it can be difficult to understand what exactly KEYW does and how the company stacks up within the competitive landscape. Consequently, I decided to conduct some primary research by attending a preeminent industry trade show for cyber-security and cryptography this past spring. KEYW management had an elaborate exhibit at this conference. I also met with employees from various big data and event management competitors, network security consultants, and past Sensage customers.

I thought that this conference would be an ideal opportunity for industry professionals to either prove my thesis wrong or for potential competitors to take an easy shot at KEYW. To my surprise, many of the people I had spoken with were totally unfamiliar with Sensage as well as KEYW to a large extent. Others noted that while Sensage had once been a prominent player in the event management space, they no longer had much of a presence due to the emergence of superior competition. Ultimately, my primary research at this industry conference seemed to contradict the optimism and laudatory statements put forth by KEYW management.

KEYW began piloting Project G in 3Q12 with three “early adopters.” In the last 10 months, the number of early adopters has grown from three to four. Not only has this beta testing progressed at a snail’s pace, but the largest of the three early adopters – AT&T – recently dropped out of the trial process, only to be replaced by two smaller companies. Moreover, general availability of Project G was once slated for early 2013, but as of KEYW’s 1Q13 earnings call, its release has been delayed until at least 4Q13. Management insists that the company is being intentionally deliberate to work out the kinks in its platform and “perfect” the product before general release. However, network security professionals I have spoken with, including former employees of Sensage, have said that the length of this “early adopter” review cycle is unusually long. Ordinarily, they would have expected a typical customer to be capable of rendering a confident “go/no go” decision after 2-3 months of product demos.

Putting all of this information together, I estimate that commercial customers will contribute less than $10mm to KEYW’s revenues in 2013 (based on possibly ambitious assumptions of 15 installations at a $500K average selling price according to management, followed by $100K in annual subscription fees for each of five years thereafter). Moreover, before Project G can even be scaled commercially, KEYW will need to invest significantly in SG&A, which will depress earnings for 1H13 and beyond if there are further launch delays. Lastly, given that Project G is only in a few “early adopters” so far, it seems that the best case scenario for any meaningful revenues will be early 2014.

VALUATION: KEYW shares appear overvalued across several valuation methodologies, which reinforces my bearish view with a reasonable margin of safety. My price target of $9.50/share is based roughly on a mid-range of the following methodologies.

Intrinsic value: My intrinsic value calculations and key assumptions are as follows:

(+) Cash on the balance sheet: $3.1mm

(+) PV of service operations (assume each of the ~1,100 employees is full-time instead of being a contractor and generates an optimistic $200K in service revenue per year on average, then apply a 1.5x EV/sales multiple that is in-line with median valuation for precedent transactions): $331mm

(+) PV of Integrated Solutions business (assume this remains essentially flat for perpetuity): $73mm

(+) Net intangible assets (customer- and technology-related intangibles acquired in various acquisitions, comprising mostly of existing contracts and customer relationships; useful lives range from 1-7 years): $48.0mm

(+) Net PP&E (aircraft, buildings, and manufacturing equipment): $26.0mm

(-) Outstanding revolver: $29.0mm

(-) Senior debt: $67.4mm

(-) Deferred tax liabilities: $28.9mm

= Intrinsic value of KEYW equity = $356.0mm.

Based on assumed 36.4mm diluted shares outstanding today, value of KEYW is $9.79/share.

Comparable company analysis: Using a peer-group of small- and mid-cap defense companies offering solutions to the intelligence community (e.g. CACI, DRCO, FLIR, ICFI, MANT, SAI), KEYW appears overvalued based on forward EV/EBITDA and EV/EBIT while offering lower EBIT margin and FCF yield than peers. At 14x forward EV/EBITDA on my estimates, KEYW trades meaningfully higher than its peer group average of 8x. The most tenable explanation for this premium is that bulls are betting that KEYW will be successful with Project G or could get acquired at some point. However, management has told me that they are not presently looking to sell the company. Moreover, I believe EBITDA overstates the earnings power of KEYW by ignoring intangible amortization. In contrast, EBIT seems more appropriate for capturing true economic reality, since KEYW has depended heavily on growth via acquisition such that acquisitions are effectively part of the company’s normal operating activities. As a result, intangible amortization is a very real expense and is captured by EBIT but not by EBITDA.

Precedent transactions: KEYW has paid an average 1.5x EV/LTM sales and 18x EV/LTM EBITDA for its acquisitions, which have ranged from $13mm to $126mm in enterprise value. Management teams of key defense competitors with whom I have spoken have noted that KEYW has a reputation for paying far richer valuations for deals than many of KEYW’s peers, thanks to a successful IPO and secondary as well as cheap debt financing in the past. I believe it is unlikely for KEYW to make further significant acquisitions given its little remaining cash and access to additional debt, unless the company is somehow able to finance these deals primarily with equity. Moreover, transactions undertaken by defense competitors such as Boeing, CACI, DRCO, NCI, and Northrop Grumman have been completed at much lower valuations (e.g. ~1.6x EV/LTM sales and ~10-11x EV/LTM EBITDA). Applying these metrics yields implied valuation for KEYW of $9.00-10.00/share. The last page of this report details KEYW’s acquisition history.

UPSIDE RISKS vs. POTENTIAL MITIGATING FACTORS: The biggest upside risk to my short thesis is that KEYW ends up getting acquired. Applying an 18x LTM EV/EBITDA multiple based on a weighted average of KEYW’s historic acquisitions yields an implied upside case of $14.75/share. However, if my bearish thesis and $9.50 fair valuation are correct, then the downside-upside case is still asymmetric at 3:1. The following are several upside risks and why I believe they can be mitigated.

1.)     KEYW could be acquired --> My view: A strategic acquirer could take out KEYW given that its key assets are its employees and contracts, and this is the greatest risk to a short position. However, I am skeptical that this could happen anywhere near its current valuation. Management has also told me that they are not currently looking to sell the company, and I agree that a bidder is unlikely to emerge until KEYW makes a decision to either fully commit to or wind down “Project G.”

2.)     If KEYW successfully expands into the commercial segment through “Project G,” shares could experience multiple expansion --> My view: In the face of government austerity, bullish KEYW investors are betting that Project G be will KEYW’s next growth engine. Bulls argue that if KEYW can get into the commercial business, shares will be re-rated at a higher multiple given that publicly traded commercial cyber-security and big data companies such as Fortinet, Palo Alto Networks, SourceFire, and Splunk trade at richer multiples than their government-focused counterparts. However, while it can be argued that each of these companies holds a competitive advantage in their particular product area or customer segment (at least for the time being), the same cannot yet be said of “Project G.” As stated in my investment thesis, KEYW is trying to enter a highly competitive commercial segment with an unproven technology that is based on an outdated, undifferentiated platform that KEYW. The fact that the company is still stuck on three “early adopters” suggests that KEYW is either having internal development issues or product demand isn’t ramping up the way that management had expected.

3.)     The cyber-security market is projected to grow at 8-10% annually over the next few years, and KEYW is a pure-play company that could capitalize on this trend --> My view: This is the story that KEYW management often touts to investors. For my bearish thesis to play out, a pessimistic view on cyber-security spending is not critical as there are multiple company-specific risks that I have highlighted in my thesis. Nonetheless, in speaking with other buy-siders that are long the name, I have learned that they are not even necessarily holding their breath on KEYW’s government business to re-accelerate. Instead, they are betting that Project G could become a disruptive technology. As discussed in my investment thesis, I believe this will be an improbable outcome.

I would also argue that the projected growth in cyber-security is bad for KEYW, since it has drawn heightened interest from larger defense companies that will want to compete away excess returns. Specifically, larger players have observed that sequestration cuts are less likely to impact cyber-security than most other areas of defense spending. According to my conversations with industry experts, these companies have been willing to accept contracts at lower rates than what they have historically billed to increase their foothold in cyber-security and secure a prime contract. Fortunately for the big defense players, they can afford to trade pricing to gain share due to greater economies of scale, diversified revenue bases, and broader customer relationships. With prime contracts going to the big players, KEYW has had to settle for lower-margin subcontracts. I do not see this trend abating anytime soon.

4.)     Positive headlines about cyber-security could cause KEYW shares to appreciate --> My view: Despite a share price decline of 10% the morning after KEYW’s 4Q12 earnings call, shares have more than rebounded due to favorable media attention on cyber-security along with President Obama’s executive order to improve “critical infrastructure cyber-security” on February 12, 2013. KEYW is the only publicly-traded cyber-security pure-play, and the entire network security space has had a nice run year-to-date. The executive order is a commitment from the executive branch to implement a superior framework for cyber-security and share information about cyber-threats that could target companies involved with “important national interests.” Certain companies will undoubtedly benefit from the executive order. Many investors seem to think that KEYW is one such company, but in reality, the companies that the executive order specifically referred to as being of “national interest” were those that worked with power grids, refineries, and water systems. None of these projects relate to what KEYW actually does. Shares could still appreciate due to potential investor misperceptions; however, I believe that financial results over the next few quarters, especially in the wake of sequestration, will correct any such misperceptions.

5.)     KEYW has the highest proportion of employees with top-level security clearance among its competitors, creating a barrier to entry in the fast-growing cyber-security space --> My view: I agree that KEYW’s headcount is its most valuable asset, and the company prides itself on developing “agile” and “flexible” solutions. At the same time, my conversation with a former U.S. defense policy advisor revealed that other factors such as price, service quality, and longevity of customer relationships are also important. In my view, larger defense firms hold advantages in these areas, except in occasional areas where KEYW’s personnel holds expertise that is so specialized and unique.

6.)     KEYW could be awarded a major government contract --> My view: If KEYW were to win a large prime contract, the stock could meaningfully appreciate. However, while KEYW has historically spoken about potential major bids during its conference calls, it has not mentioned major contracts in the works since it had lost out on the “Aura” contract to another competitor. This leads me to believe that there are few exciting contracts in the pipeline.

7.)     Modest trading volumes --> My view: As a small-cap stock, KEYW may not have sufficient liquidity for fund managers that have mandates to invest in larger companies.