(Copyright (c) 2005 The Wall Street Transcript Corporation. Allrights reserved.) MICHAEL LEWIS joined BB&T Capital Markets' Government Information Technology Services Equity Research team in 2002. Prior to joining the firm, he served in various other capacities, including consulting, private equity, equity research and regulatory compliance. He is a Chartered Financial Analyst in good standing and a member of the CFA Institute, Washington Society of Investment Analysts, and The National Defense Industrial Association. Mr. Lewis earned a Bachelor of Business Administration in Finance from the University of Georgia.
TWST: Michael, what's been happening in your coverage area at BB&T over the past 12 months?
Mr. Lewis: Our coverage area includes government information technology (IT) companies providing services to the federal government. Most of the companies we cover tend to derive a majority of their revenue from the Department of Defense (DoD), the intelligence community, federal civilian agencies and the Department of Homeland Security (DHS). From the beginning of 2004 through early August 2004, our coverage underperformed in relation to the Russell 2000, S&P 500, and Nasdaq Composite Indices. We attributed this underperformance to two issues. First was the overhang due to uncertainty surrounding the presidential elections. Second was investors' expectations of a turnaround in the commercial IT sector, which we believe caused a rotation into commercial IT shares. Once it was apparent that the commercial sector would continue to disappoint, we again began to see renewed interest in government services firms beginning in early August. Over the last two quarters, we have seen a noticeable increase in valuations following strong financial reports from many of the companies within the government services area.
TWST: Was that move justified by the results? Has money finally started to flow in a significant way?
Mr. Lewis: In our opinion, the increases in valuations discussed above are justified by recent results. Many of the companies we follow have shown strong year-over-year revenue increases, continued operational leverage, margin accretion, and reported earnings at or slightly above consensus estimates. We would also highlight that most of the companies within this segment have indicated that they anticipate 10%-15% growth from internal operations as well as another 5%-10% from strategic acquisitions. In our opinion, most of these companies should continue to show robust growth.
TWST: Is that growth coming because government spending is increasing that much, or is there shifting of market share taking place?
Mr. Lewis: We believe both scenarios are at play here. First, with regard to overall defense spending, the defense budget is growing in the low- to mid-single-digit range in FY 2005 and is anticipated to reach about $420 billion, not including supplemental spending for operations in Iraq and Afghanistan.
However, if you dig deeper and review the individual segments of the budget, it infers that information technology spending should continue to grow at a higher clip versus the overall defense budget. We estimate IT spending growth in the high-single to low-teen range over the next few years. Additionally, we believe there is a shift in market share taking place. In our opinion, as the government IT firms continue to grow and improve operations, they should prove successful in taking some market share from other aerospace and defense companies with information services components as well as some commercial oriented firms operating within the sector. We would note, however, that with such large expenditures coming from the DoD there is plenty of money to go around.
TWST: What's driving that?
Mr. Lewis: There are a few catalysts driving this anticipated growth. We believe the most important issues driving the government IT services sector continue to hinge on the War on Terrorism, a refocus on our joint warfare capabilities, and the transformational initiatives currently under way within all the military services. Additionally, we believe some mechanisms that should continue to accelerate the fundamentals within the government IT services sector include increased demand for outsourcing IT services in response to demographic shifts within the federal government's workforce, i.e., retirements; continued government procurement reforms; increased budget procurements for national defense initiatives; the Bush administration's focus on realigning federal agencies into more efficient organizations; the modernization of legacy IT and communications infrastructure; and a continued robust merger and acquisition environment.
TWST: As we look out at 2005 and 2006, can that continue with the pressure on defense spending that we're seeing?
Mr. Lewis: We believe so. Considering the mission-critical nature of the work most of these companies engage in, these services are more likely to be insulated from budget cuts. We think any pressures on defense spending may be directed at larger weapons platforms, as supported by recent news articles related to potential cutbacks on Lockheed Martin's F/A-22 fighter program. We would note that we do not cover that company. With that said, we believe some of the proceeds from those cuts could potentially be reallocated to other areas including critical IT services (like the modernization of legacy IT systems, for example), something that we would consider a positive for our coverage universe.
TWST: So we may see some cutbacks in big-ticket hardware and continued spending on your segments.
Mr. Lewis: One aspect of our investment thesis is our belief that some larger weapons platforms are at risk. Over the past few years, we have seen the following programs cut: the $11 billion Crusader artillery system; the $9 billion Navy Area Missile Defense Program; and, most recently, the $38 billion Comanche recon/surveillance helicopter. The F/A-22 is now facing potential unit cuts. We also believe another high profile system that may be at risk to be pushed out a few more years includes the Future Combat Systems. As we stated above, some of the proceeds from additional cuts or cancellations could move to critical infrastructure investment, including network security, communications, command and control systems, surveillance and reconnaissance systems, and training/ education and simulations systems. To counter these potential spending shifts, we believe one way the larger aerospace and defense companies may insulate themselves may be to further emphasize and grow their IT services segments internally as well as through strategic acquisitions. This should serve to diversify their revenue streams away from large platform concentration risks.
TWST: How important is spending by Homeland Security in your space?
Mr. Lewis: It's becoming a bigger piece of the pie. On October 18, President Bush signed the DHS (Department of Homeland Security) Appropriations Act of 2005, which outlined much of the nation's investment in homeland security. Since taking office, Bush has increased DHS funding by nearly 3 times. In FY 2005, the discretionary funding portion of the Department of Homeland Security Appropriations Act is expected to be about $29 billion. This is almost $15 billion above FY 2001 levels, so we've seen a huge increase in spending on national security following 9/11.
TWST: But there seems to be a slip between appropriations and actual spending. The appropriations are one thing, but the money doesn't seem to be getting spent.
Mr. Lewis: We have to remember that the DHS is a consolidation of 22 disparate agencies into one entity, which also brought together over 180,000 government employees. Of course, there were bumps in the road, but the first two years served as a time of major integration for that agency. We agree, there appear to be issues with fundings moving through the system; however, we believe going forward these problems will be resolved. Last year, we heard rumblings that, at the state and local level, allocated fundings never got to the intended first responders. Fundings from DHS to the states seemed to be held up, which caused bickering between the states and their respective localities.
In 2005, we don't anticipate as many of these problems since the funding process has become much more fluid. With regard to federal DHS awards, we would note that the US-VISIT contract was awarded in May 2004. US-VISIT is the DHS' automated system for entry/exit tracking of foreign visitors to the United States. The VISIT contract is a multibillion-dollar contract that was awarded to Accenture, a company we do not cover. We continue to anticipate new contract awards off this contract in the near term.
TWST: Is that getting resolved?
Mr. Lewis: With regard to those issues surrounding state and local fundings, we think the issues are getting resolved. FY 2005 includes about $4 billion for state and local assistance, which we believe will move down to those recommended areas.
TWST: You said the stocks did very well in 2004. As you talk to investors at this point, what's the interest level?
Mr. Lewis: The level of interest by investors appears to remain positive. Investors understand the favorable drivers within the government IT sector, in our opinion, and continue to seek opportunities to enter the shares. As I stated before, the catalysts to investment in these companies are compelling, and investors understand those points. What's also important here is we have a robust merger and acquisition environment, which is driving some of the upside in the market right now. We're going to continue to see strategic acquisitions that should add new customer relationships and access to other contracts and/or agencies.
TWST: It sounds like a very positive backdrop.
Mr. Lewis: It is. We continue to consider the government IT sector a good place for clients to invest.
TWST: It doesn't sound like there's a whole lot of risk unless you screw up internally.
Mr. Lewis: There is risk in any investment opportunity; however, one of the keys here is the longer-term visibility into revenue, cash flows and earnings. Also, when contracting with the US government, companies are confident in their ability to collect receivables from the government. We typically don't see many issues regarding delinquent accounts since the government normally pays on time. For example, if you look at a company like Anteon International (ANT), which is a buy-rated stock we cover, they derive 92% of their revenue from their DoD, DHS and intelligence community clients. We believe that these revenue sources are much more stable in comparison to other IT sectors such as commercial IT. This adds visibility for investors over the long term.
TWST: Am I correct that the government contracts tend to be longer-term or project-length commitments?
Mr. Lewis: Most of the contracts in this sector are typically awarded on a multi-year basis with option years available at the end of the award term.
We typically see awards between one to five years, not including option years. As I discussed previously, these contracting schedules help with the increased visibility in the sector. There are companies that do more project-oriented work, where you would typically see the term of the contracts running from three months to 12 months. One firm within our coverage universe that conducts a lot of this project- oriented work is PEC Solutions (PECS). We currently have a hold rating on this company but would note that PEC has the highest EBITDA and EBIT margins in the sector based on last quarter's results. The company currently runs a 15.8% EBITDA margin versus our universe average of 10% and a 13.4% EBIT margin versus the universe average of 8.8%. We anticipate PEC's margin profile may move down over time as it appears to be repositioning its core operations to include more multi-year engagements through increased exposure to the defense and intelligence sectors.
TWST: We were talking earlier about this positive backdrop. Is there anything on the horizon that could interfere with that or change it, or will we have this positive environment going forward?
Mr. Lewis: Of course, there are always risks involved. Some of the risks in this sector would include changes in overall government spending policies of additional appropriation delays. We've seen appropriation delays in some of the federal-civilian agencies over the last few years, which forced those agencies to work under continuing resolutions until new appropriations were enacted by Congress. In a few instances, those continuing resolutions served to push out contract awards to some companies focused in that segment. Also, if the government comes back and tries to renegotiate or cancel a contract, that would be a risk as well. However, we haven't seen this scenario come into play over the past few years. With that said, probably the biggest issue here is whether or not the government's spending policy will change over the next few years. In our opinion, the services that these IT firms provide are mission critical. For example, some of these companies are building secure communications networks, secure infrastructure, and identification and entry/exit systems for the US government. We think these types of businesses are more insulated from budget cuts in the near to intermediate term and, hence, should provide a positive operating environment going forward.
TWST: So anything that does come along is going to be more in the form of a bump in the road rather than a detour at this point.
Mr. Lewis: I would agree with that statement.
TWST: You also mentioned that M&A activity has been a factor and will continue to be.
Is it being driven because people need to broaden their product lines or they're looking for new lines of business?
Mr. Lewis: There are two things at play here. There are literally thousands of companies that contract with the federal government, and in our opinion, it will continue to be a consolidating industry. There are many private companies that have revenue under $100 million operating in this area. At some point they may hit a ceiling in their ability to grow into larger organizations, and that's when they either make the decision to sell or perhaps enter the public markets for access to capital. In addition, many of these companies are run by their original founders who may be seeking an exit strategy. In our opinion, a good exit strategy for management teams is being purchased by another company within the segment. We would note that the majority of these transactions are in cash and accretive to the acquiror. With regard to the consolidators, there are a few things that these companies are looking for, including the ability to bring on strategic acquisitions that open the company to new markets and/or customers. It is normally easier for a company to purchase its way into a new client relationship or agency than to build a new segment over time to gain access into a strategic market. Because of this, we continue to believe the M&A outlook within our coverage universe will remain robust.
TWST: So you're anticipating that this M&A activity is going to continue in 2005 and beyond.
Mr. Lewis: Absolutely.
TWST: How about from a valuation point of view? Where do these stocks stand at this point?
Mr. Lewis: With regard to valuation, our universe of coverage hit its peak valuation in early January 2002. Over the next year, it trended lower, reaching its trough valuation in March 2003. We have seen a gradual increase in valuation since the low point in 2003 and would note our coverage is currently trading at its highest level since late March 2002 based on share price appreciation. We typically value these companies utilizing an enterprise-value (EV) to EBITDA approach. Reviewing trailing 12 months results would imply a current EV/EBITDA multiple of 15 times. In comparison, in December 2002 and 2003, we calculated that multiple at approximately 13.0 times and 14.4 times, respectively, so we have seen multiple expansion there. With regard to forward 12-month price to earnings multiples, our universe is currently trading at about 21 times our forward estimates; this is in comparison to 22 times for the comparable period last year.
TWST: Is that multiple scaring off institutional investors at this point?
Mr. Lewis: Not that we've seen.
We continue to see a lot of interest in our core government IT services coverage area.
TWST: What are your two or three favorite names at this point?
Mr. Lewis: With regard to the overall universe, we like ManTech (MANT) based on valuation. Another company we like right now is SI International (SINT). We rate both companies a buy at this time.
TWST: What is it about ManTech that appeals to you at this juncture?
Mr. Lewis: We believe the market discounted the company too much as a result of an issue that came about in 2004 within a recent acquisition called MSM Security Services. The company was providing personnel security clearances for national security customers. Cost overruns on a fixed-price contract caused the company to sustain some losses in mid-2004 and, consequently, a lot of the analyst community pulled back estimates too much in 2005, in our opinion. We believe this is exclusively a 2004 issue, with the ManTech story now tied to 2005 operating results. We believe the security clearance contract issue will be resolved in 2005, and the shares may move back in line with their normal trading range, which is typically at about a 10% discount to the universe. ManTech currently trades slightly above 15 times our FY 2005 EPS estimate. Its comparative universe is currently around 21 times. We believe the shares deserve a multiple between 17 and 18 times, which implies good upside in our opinion.
TWST: Are there signs that they've addressed and cleaned up the problem?
Mr. Lewis: It has been addressed, and they began negotiations in November with the client to obtain payment on outstanding account receivables.
TWST: What's ManTech's basic business, and what kind of growth can they generate?
Mr. Lewis: ManTech provides services for mission-critical national security programs to the intelligence community, DoD and other federal customers. It provides IT services, software development, enterprise security architecture, information assurance, intelligence operations support, network and infrastructure protection and communications and engineering support.
TWST: What kind of growth can they generate as they broaden out with acquisitions and other things?
Mr. Lewis: As I stated earlier, most of these companies have indicated 10%-15% internal growth, with an additional 5%-10% through acquisitions. We currently expect ManTech to grow internally about 13%-14% in 2005.
TWST: Do they have an appropriate management team in place at this point to do a better job of folding in acquisitions and making sure they don't stumble again?
Mr. Lewis: Some accounts have questioned management's credibility; however, we believe management did a good job identifying the issue and minimizing additional large losses on the fixed-price contract.
Management is diligently working to move past the MSM security clearance debacle from 2004. We believe senior management remains focused and engaged in this process and consider it a high priority in early 2005.
TWST: Where is the stock today and what's your target on it?
Mr. Lewis: Our target price is $27, and the stock currently trades at $23.71.
TWST: What's the appeal at SI International?
Mr. Lewis: We think that management has done a good job of selectively identifying and executing on new opportunities through its strategic acquisition program. We believe investors should applaud management's prudent acquisition approach in identifying, purchasing, integrating and growing companies that have filled a void in its core operations or have opened the company to new business engagements.
TWST: What are some of the areas where they've looked for opportunities?
Mr. Lewis: The company seeks to acquire companies that either fill a void in core business or opens new business opportunities. Case in point, in early 2004, SI purchased MATCOM International Corporation. We believe MATCOM strengthened SI's IT and systems engineering solutions offerings to the government in areas like homeland defense engineering and software development with the DoD and DHS. More recently, SI acquired Bridge Technology, an intelligence community focused company. Bridge should increase SI's exposure to new opportunities within the highly coveted intelligence community and may lead to new business relationships and cross- selling opportunities. We believe Bridge should better position the company for opportunities with defense intelligence community customers in critical areas like systems engineering.
TWST: What kind of growth do you expect out of SI?
Mr. Lewis: In 2005, we expect the company to grow revenue above 20% year over year. We also anticipate more acquisitions as well, but we don't model them until they are closed. This company is growing a bit faster than ManTech. However, we would note that SI has a lower revenue base. We think the management team has done a good job executing its business plan. SI has also identified and successfully bid on larger contract opportunities. What's important here is that we believe SI has proven its ability to compete against the larger aerospace and defense and government IT firms within the sector. We think that's something that the investment community has not taken into consideration when reviewing the company. We've seen some recent large contracts awarded to SI, and we anticipate that SI's bid and proposal pipeline will continue to afford the company additional opportunities in the near and intermediate term.
TWST: Where is the stock today, and where do you see it going?
Mr. Lewis: We currently have a price target of $33 on the stock. Right now the stock is trading at $31.68.
TWST: If we look at the homeland security side, what would be your top pick?
Mr. Lewis: Within homeland security, we have a few companies well positioned for growth opportunities. One company we'll discuss today is The Titan Corp. (TTN), which we have a hold rating on. Titan's homeland security business is its fastest-growing segment currently. It focuses its reach within homeland security with the Coast Guard, state and local government coordination, border and transportation security and emergency preparedness. Out of the entire Department of Homeland Security budget discussed earlier, Titan's addressable market is about $11 billion. The company currently has over 60 contracts with the DHS as well. They have a strong presence in border control and are a subcontractor to Accenture on the US-VISIT contract. Additionally, they assist in cargo screening of material entering the country and also conduct some airspace surveillance. Within emergency preparedness, they have emergency support vehicles called MOCs (mobile operations centers). Titan also conducts emergency training and exercises. Within infrastructure protection, a high profile area they work in has to do with weapons of mass destruction analysis.
TWST: They're involved very broadly.
Mr. Lewis: Yes. Across the entire national security spectrum, in our opinion.
TWST: Why is there a hold rating on Titan? Is it valuation?
Mr. Lewis: Our hold rating is based on two issues. First is due to its ongoing Foreign Corrupt Practices Act investigation with the Department of Justice. In addition, there is also uncertainty surrounding the company's Army linguist services contract recompete, which makes up about 12% of their revenue. Until we have more visibility into how to quantify these two issues, we believe it's prudent to remain on the sidelines at this time with the hold rating.
TWST: When are these issues likely to be resolved?
Mr. Lewis: Both issues should be resolved in 2005, in our opinion. Regarding the Foreign Corrupt Practices Act, we anticipated hearing a resolution at the end of 2004, but it looks like it's going to be pushed into the first quarter of 2005. The Army linguist services contract should most likely be awarded by mid-2005. If not, we anticipate additional options to be awarded to Titan so linguist services remain uninterrupted.
TWST: Thank you. (TJM)
Note: Opinions and recommendations are as of 1/4/05.
MICHAEL LEWIS
BB&T Capital Markets
8133 Leesburg Pike
Suite 460
Tyson's Corner
Vienna, VA 22182
(703) 245-0903
BB&T Disclosure:
BB&T Capital Markets makes a market in PEC Solutions; SI International,
Inc.; and ManTech International Corp.
BB&T Capital Markets expects to receive or intends to seek compensation
for investment banking services from Anteon International Corp.; ManTech
International Corp.; PEC Solutions; SI International, Inc.; and Titan
Corporation in the next three months.
An affiliate of BB&T Capital Markets received compensation from Anteon
International Corp.; ManTech International Corp.; SI International,
Inc.; and Titan Corporation for products or services other than
investment banking services during the past 12 months. The analyst or
employees of BB&T Capital Markets with the ability to influence the
substance of this interview know or have reason to know the foregoing
facts.
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