This IT Services Provider is as Reliable as They Come
Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The chaos in Washington, D.C. is creating a mountain of uncertainty throughout the United States economy. If Congress ever gets around to it, there will be large spending cuts to the federal budget. Since it is unlikely that any cuts can be made without reducing defense spending, defense contractor CACI International (NYSE: CACI) trades at a low multiple of historical earnings.
High, Steady Returns on Assets
Most of CACI International's value comes from its work with the U.S. federal government. The company's multi-decade relationship with the government has allowed it to earn high and predictable returns on its projects.
The company routinely earns over 25% on tangible invested assets. That is, pre-tax income divided by tangible assets minus cash. The pre-tax return on tangible invested assets shows how much the company earns per dollar it invests. A 25% return is pretty good (think about what you'd consider a good return in your stock portfolio -- you'd probably take 25%).
Competitors Show the Way
What's more, since the majority of CACI's business comes from government contracts, the company has more predictable ROI than competitors like Computer Sciences Corp. (NYSE: CSC), which derives a much less substantial portion of its revenue from the government. On the other hand, SAIC (NYSE: SAI), which derives nearly all of its revenue from the government, earns a similar return on tangible invested assets as CACI.
As an example of the perils of non-government work, consider Computer Science Corp.'s recent results in its non-government segment (2/3 of revenue). The company fell behind its competitors in moving its labor overseas, a misstep which has cost the company significantly in lost profits. It now has a significant overseas presence and is exposed to foreign exchange rate fluctuations. In addition, the company is currently under an SEC investigation into possible accounting errors. Finally, there is no assurance that its contracts with the U.S. or U.K. governments will all be renewed.
SAIC, on the other hand, is doing quite well -- it earns nearly 90% of its revenue from government work. It also has a healthy balance sheet and a long history of working with the U.S. federal government. Margins have fallen off a bit recently as bidding has become more competitive, but a recovering U.S. economy should eliminate that problem. In addition, SAIC's longstanding relationship with the federal government has enabled many of its employees to gain the security clearance necessary to work on sensitive projects. As a result, it has experienced success similar to that of CACI.
Key Relationship with Department of Defense
Defense cuts may actually be beneficial to CACI to an extent. As the government reduces IT headcount, it will need to outsource even more of the work to private companies. CACI has partnered with the government for many decades, which makes it a logical choice to pick up additional government projects.
In addition, there are significant barriers to entry for doing business with the Department of Defense. For one, employees who work on sensitive projects need security clearance. As a long-time service provider, the majority of CACI's employees have some level of security clearance. Since the Pentagon is not in the business of sharing secrets, it is difficult for new entrants to get the clearance necessary to bid for new projects. As a result, there is little threat from new entrants.
Undervalued If Status Quo Remains in Effect
CACI has averaged a 26.65% pre-tax return on tangible invested assets since 2003. If you apply that margin to the company's current tangible invested assets -- $832 million -- then you get normalized pre-tax earnings of $222 million. This means that, in an average year, the company will earn $222 million before tax assuming assets remain at the same level and the ROI trend holds steady.
$222 million in pre-tax earnings seems reasonable; the company earned $228 million and $276 million in fiscal 2011 and 2012, respectively. At a 9x multiple of $222 million, the company would be worth close to $87 per share.
However, there is reason to be concerned about the company's prospects going forward. Cuts in defense spending is one concern. The other is the company's attempt to grow outside of government work. I look at Computer Science Corp.'s margins and then look back at CACI's and wonder why anyone would want to expand outside of government work. CACI has a great advantage as a large government contractor, but I cannot identify a durable competitive advantage outside of government work. Management seems focused more on revenue growth than on profitability.
Bottom Line
Rarely will you find a stock that has everything going for it and nothing against. CACI International looks undervalued at $51 per share despite the looming possibility of budget cuts. But it's up to each individual to decide whether or not it makes a good investment.
Ted Cooper III has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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!
