Summary

Mantech is a prime US defense contractor.  The investment opportunity presented itself after the stocks massive sell-off in May 2012 which accentuated a decline that began at the start of the year.  From high to low in 2012 the company’s value has been cut by about 45%.  Most of the negative sentiment surrounds the US government budget cuts and involvement with “in-theatre” operations in Iraq and Afghanistan.  Revenue from overseas operations amounted to 30% of the total in 2011 and will decline to just less than 10% over the next three years (although not in a straight line).  Sell side analysts are having a difficult time reconciling the company’s ongoing growth claim while defense budgets are being cut and the US is withdrawing from conflict areas.  The current sequester in place and delay’s in funding any contracts for the first two quarters of 2012 has so far supported the skeptical outlook.  In fact most analysts feel the company is likely to shrink in coming years – presenting a very interesting dichotomy.  After reviewing their prospects we felt it presented an excellent opportunity, where sentiment has pushed the company’s valuation to such an extreme that it provides good upside with a healthy margin for error.

Mantech provides systems engineering and IT solutions for a number of government agencies including:  the Defense Department, Homeland Security, and the FBI.  The company was founded 40 years ago by George Pedersen, who still owns over one-third of the company.  Since going public in 2002 revenue has grown from $400mln to $2.9bln, evenly split between organic and acquisitions.

Metrics Summary

Investment Thesis

Our investment thesis is based on: 1) management’s ability to grow other parts of the business, offsetting the revenue lost from overseas operations and 2) owning it at a price that provides us with a margin for error should management fail and enough upside to make it worthwhile.

To prove this out we examined the past track record of the company and the extent of the budget cuts on Mantech’s business.  Starting with the US withdrawal from Iraq in 2010 – 2011; in-theatre operations fell from 10% of revenue to 1%, yet overall revenue increased by 10% (overall defense budget increased 1%).  So far, so good.  Looking further back to the early 90’s (before the company was public) and a similar type of adaptability is evident.  They successfully ramped up government operations going into the Gulf war and found alternative niches when funding for those operations dried up.  The nature of Mantech’s business means that broad based defense cuts have only a limited effect on their prospects.  Our research suggests  that even with the worst outcome in budget agreements (sequester) the defense industry broadly would be cut by a maximum of 9.6% over 9 years (just over 1%/year) and MANT’s revenue impact would be significantly less (analysts are predicting a 7% revenue decline for 2012 followed by another 5% drop in 2013) . In speaking with management they feel confident there are enough new business proposals in areas like cyber security and federal healthcare IT to more than offset the decline.  Based on the value of proposals they are bidding on this seems accurate ($29bln pipeline as of Q2).  To date Mantech has submitted bids for almost $9bln, up from $5bln last year. 

They were recently awarded a $2.85bln contract, their largest in company history, (reducing the bids to $6bln for the balance of the year).  Unfortunately the award is being reviewed which only allows them to book the forward portion or 10% in the funded back-log.  Their back-log (booked business) at the start of 2012 was $4.7bln which was essentially flat from 2011 while overall US defense backlog fell about 7%.  Backlog is important because it hints at what is bankable in the coming year.  Mantech has historically been able to convert half the backlog to revenue, so normally $2.3bln would be expected in 2012 but due to funding delays this has extended the conversion period and the company is unsure how much will fall in this calendar year. 

Are we being properly compensated?  Over the past five years after tax cash flows have grown about 11%/year from $78mln to $133mln (peaking at $144mln before the overseas run-down).  The current after tax run rate is around $130mln but we prefer to be even more conservative and use the five year average of $115mln suggesting the company currently trades  around 7.78x after tax cash and under 5x EV/EBIT.  In the event the consensus is right and the company is unable to grow, cash flows are likely to decrease at about 2% a year which still provides an after tax return of about 10% for the next five years.  The company has very little net debt, is valued at a 26% discount to their book value, pay’s out a 3.75% dividend and has shown a knack for well-priced acquisitions.  A line often heard from CEO Pedersen is they don’t pay for revenue growth and there is a unique reason for this.  Mantech is a prime contractor to the US government which enables them to buy companies without the same access and immediately multiply their revenue prospects by dropping them into the defense procurement. 

We believe Mantech is a well-run quality company that has demonstrated it can adapt and grow through the defense cycles.  Cuts in government spending and delays in actual funding have created an extremely bearish tone over the entire defense industry and while there is a risk to further cuts we feel it’s more than built in to the current value.

• Budget agreements other than sequester
• Management execution transitioning out of in-theatre operations