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Can This Small-Cap Government Contractor Weather the Storm?

Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Cubic Corporation (NYSE: CUB) had a summer full of foul weather.  The dark clouds formed in June with the death of their founder and CEO, Walter J. Zable at the age of 97.  The heavy rain swept in as accounting problems surfaced in August.  Still, the sun is peeking out this fall and the company's share price is up slightly since the start of 2012, as the federal and local contract awards have kept rolling in.  Is Cubic a good investment despite the stormy weather surrounding them?  Let's take an overall look at the company's competitive position through SWOT analysis: Strengths, Weaknesses, Opportunities, and Threats.

Strengths

  • Transportation Business Moat: The other third of Cubic's business is automated fare collection for transportation systems in major cities around the world.  Cubic Transportation Systems owns 80% of the market for transit smart card payment systems in the U.S. Plus, Cubic offers cities the full out-sourcing of service for their fare systems, leading to recurring revenue instead of one-time, up-front software and equipment purchases.  Once cities are contracted for fare equipment, smartcards, and service with Cubic, it is very expensive to replace the system, which helps lock Cubic in with that transit network for years to come. 
  • International Exposure: Altogether, including defense and transportation, Cubic does business in over 50 different countries, hedging against declines in revenue from the U.S. government. 
  • Long-Tenured Leadership: After Walter J. Zable's death, there was no leadership void.  His son, Walter C. Zable, who has been with the company since 1976, took over as chairman.  William Boyle, Cubic's CFO since 1983, took over as interim CEO.
  • Dividend: Cubic pays a semi-annual dividend.  It's currently a small 0.5% yield, but the company did increase it by 33% in 2012.  The payout ratio is 6% of their earnings, and they have paid a dividend consistently since 1971.
  • Strong Balance Sheet: Cubic has $239 million in cash versus only $11 million in debt, but these numbers are over 6 months out of date, as we will discuss next.


Weaknesses

  • Restating Financials: In August, Cubic announced that auditors had found problems with the company's method for recording revenue from certain types of long-term, fixed-price government contracts. Cubic said that they would be restating their financials going back to 2009.  Since then, Cubic has failed to file their 3rd quarter earnings statements with the SEC, earning them a reprimand from the New York Stock Exchange, and there is no announced date for releasing the 4th quarter or year end numbers either.  Nobody believes there is fraud or deception going on here; Cubic just has to get things recorded the right way in their books.  In the meantime though, the often cited financial measures cannot be relied on for estimating the company's value, since all of the publicly available numbers are over six months out of date.
  • Reliance on One Customer: Cubic has many customers, national and local, around the world, but the U.S. Defense Department is their largest customer by far, and there are always risks in being too reliant on one customer
  • Small Fish in a Big Pond: While Cubic has carved out a niche as the leader in military training systems, in other realms of the defense industry they are at a disadvantage to the money and staff that the bigger defense companies could bring to bear if they chose to.


Opportunities

  • Re-selling Military Concepts to Civilian Customers: Because of their dual background in defense and transportation, Cubic has opportunities to re-purpose defense logistics and security products for civilian transportation, like freight rail and air cargo, and re-sell the same technology to a new customer base.
  • New Weapons Means New Training Opportunities: Military technology is always moving ahead, and newer weapons, vehicles, and aircraft coming from other defense contractors gives Cubic the opportunity for newer training systems and simulators to sell.
  • Open Payment Systems for Public Transit: The newest technology in public transportation is open payment systems: passengers use smartphones or a major credit card they already own instead of buying dedicated smart cards or paper tickets.  Chicago is already trying this out; Cubic was recently awarded a contract to implement open payment on the city's PACE buses. Cubic should gain more business as transportation systems around the world upgrade their fare collection systems in the coming years. 
  • NextCity: All of Cubic's transportation technology comes together in what the company calls its NextCity vision, which would allow regional transportation networks to manage fares over all modes of transportation, let customers use open payment systems to pay for their fares, and give customers and system managers real-time travel and operations information about the transit system.  Selling regional transportation systems on this high-tech, full end-to-end management system for their networks could be a huge opportunity for Cubic.


Threats

  • The Fiscal Cliff and Defense Cuts: As I mentioned earlier, the U.S. Defense Department is Cubic's biggest customer, and across the board cuts would hurt, even in the normally safe areas of training and logistics.  Also, if new weapons systems or vehicles are cut from the budget, that also wipes out the need for Cubic to create and sell the training systems to go along with them.
  • Could Cubic be an Acquisition Target?  Ever since their founder died, there has been speculation that Cubic could be acquired by a larger defense contractor.  In particular, defense giants Lockheed Martin (NYSE: LMT) and Raytheon (NYSE: RTN) both already have transportation sectors within their companies, but do not yet specialize in fare collection, so either company could digest both sides of Cubic's business without needing to sell off the transit side.  Other companies like SAIC (NYSE: SAI) or L-3 Communications (NYSE: LLL), which already do national security work and have civilian government business fields related to transit like public infrastructure and communications, could also find value in absorbing both parts of Cubic.  So far, the Zable family has said they don't intend to sell, but one never knows what might happen if the right offer came along.


The Bottom Line

I think the long-term opportunities in defense and transportation that Cubic can attain in the future outweighs the short-term problems they're facing today.  I wouldn't want to see Cubic sold to a larger rival because I see long-term potential in the company, but in the event that a sale happened, shareholders could expect a premium price.  I'm personally holding on to my Cubic shares, but not buying more until the company gets back on track with releasing their earnings statements.  The rain may not have stopped falling over Cubic yet, but I think I can see the rainbow forming on the horizon.


Gordogato owns shares of Cubic. The Motley Fool owns shares of L-3 Communications Holdings, Lockheed Martin, and Raytheon Company. Motley Fool newsletter services recommend Cubic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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