Value Play: ManTech International (Nasdaq: MANT)

Back in November 2011, I wrote about the breakup of ITT into three separate publicly-traded companies: (1) Xylem, a high-growth water company; (2) Exelis, a low-growth defense company; and (3) ITT, an uncertain hodge-podge of industrial products. At the time, analysts were showering praise on the Xylem spin-off, saying it was the real “jewel” because water infrastructure was a hot industry. In contrast, Nobody was excited about Exelis because defense spending under Obama was not a priority and faced the risk of automatic budget cuts under a Congressional sequester.

In my article, I predicted that Exelis would outperform Xylem despite the fact that its growth prospects were much lower – in fact, my prediction depended on the growth being lower. My reasoning was human psychology, which typically overpays for high growth and underpays for slow growth. Wharton finance professor Jeremy Siegel calls this phenomenon the “Growth Trap.” As the chart below demonstrates, my prediction has been proven right, with “boring” Exelis outperforming “exciting” Xylem by a 3.6-to-1 margin:

Source: Bloomberg

The outperformance of Exelis wasn’t a fluke; it was indicative of the entire defense-stock universe. Over the past year, the Dow Jones U.S. Defense Index (^DJUSDN) has outperformed the S&P 500 by more than 11 percentage points despite the fact that the sequester – automatic spending cuts that reduce defense spending by $37 billion through the end of the government fiscal year on September 30, 2013 — went into effect on March 1, 2013. If Congress and the President don’t get their act together, an additional $52 billion in defense cuts will occur in 2014 and $500 billion over the next decade.

Source: Bloomberg

Why are defense stocks doing so well? For one thing, their valuations reached unjustified low levels in reaction to the budget crisis in Washington that started in August 2011 and fears of deep defense cuts caused by the sequester. In reality, the world is such a dangerous place, national security is an essential service that the government simply must pay for. Disturbing testimony that the sequester will make the U.S. unable to fight two wars simultaneously should shock Congress into action.

Second, many defense companies have long-term contracts with the government that are appropriated years in advance, so budget cuts on future appropriations have not affected revenues yet. For example, Lockheed Martin recently reported better-than-expected earnings because the sequester had much less effect than feared. There remains a great deal of uncertainty on how defense cuts will play out, although the Defense Department’s non-combat workforce is starting to feel the pain. 

Lastly, defense companies have done a great job cutting costs (which boosts profit margins) and returning cash to shareholders through stock buybacks and dividend increases – all of which boost valuations despite slowing revenue growth.

So, since defense stocks have done so well recently, is it too late to jump on board? The answer depends on which defense stocks one is talking about. For the prime defense contractors (e.g., LMT, NOC, RTN, GD, BA, and UTX), it probably is too late because they have yet to feel the pain from the sequester thanks to their pre-funded long-term contracts. In contrast, the smaller defense contractors – particularly in the information-technology (IT) field – have already felt some pain and have not yet matched the stock-price gains of the larger stocks. As the Washington Business Journal puts it:

As federal budget cuts kick in under sequestration, IT services are getting hit sooner than large weapons programs because of the shorter buying cycle. Agencies often pay for IT services the same year the services are delivered, while weapons programs are appropriated years ahead of time. Services companies need some way to offset those losses with some fast means of growth, and acquisitions are one way to do it.

ManTech: Best Bet is Small-Cap Defense Technology

My pick for the best defense stock to buy now is ManTech International (Nasdaq: MANT) precisely because it is an IT services contractor that has already felt some sequester pain. In its May 1^st conference call, ManTech CEO George Pedersen was surprisingly optimistic, saying that the effects of the sequester were modest:

Our primary defense intelligence customers have received their full-year appropriations for 2013. That funding is subject to sequestration cuts. But we have seen only modest impacts from sequestration up to this point. Also, the President submitted his FY ’14 budget request, which makes explicit the government’s commitment to many core ManTech capabilities such as cybersecurity.

It is too soon to tell the ultimate outcome for next year’s budget, but we are encouraged that a more normal process is underway and that there is support from the administration in both parties and Congress for defense spending at current levels.

A year earlier in May 2012, the stock suffered its biggest one-day decline in years when the company missed Q1 2012 earnings estimates and warned of slower growth throughout fiscal 2012 because of the end of the U.S. combat presence in Afghanistan. Investor expectations are low – having now had more than a year to adjust to the new reality — and further sequester pain is already baked fully into management’s forward guidance and analyst estimates. With a very low enterprise-value-to-EBITDA ratio of 5.5 and price-to-earnings, price-to-book, and price-to-sales ratios all below the company’s own five-year averages, the stock’s risk of surprise is heavily weighted to the upside, not the downside.

ManTech specializes in command, control, communications, computers, intelligence, surveillance and reconnaissance (C4ISR), in-theater logistics (e.g., MRAP vehicles), cyber security, intelligence/counter-intelligence (including terrorist detection and border security), and healthcare IT. Although the C4ISR and logistics businesses face challenges as the U.S. withdraws from the war-fighting theaters of Iraq and Afghanistan, three business segments are exhibiting strong growth: (1) cyber-security, (2) intelligence, and (3) healthcare IT.

In the wake of reports that the Chinese military is engaged in full-scale computer hacking of U.S. computers, President Obama is ramping up plans to engage in a counter-offensive of cyber warfare (Presidential Policy Directive/PPD-20). The massive data-snooping program on U.S. citizens code-named PRISM (uncovered by fugitive Edward Snowden) continues on at the National Security Agency (NSA) as a terrorist-detection tool. Lastly, Secretary of Defense Chuck Hagel noted in a June speech that cyber security is a top priority:

Our nation is dangerously exposed to cyberspace attacks.  And DOD has a responsibility to defend our nation, and that extends to cyberspace.  For this reason, the Department of Defense must continue to increase its cyber capabilities.

The president and I asked for an increase in our cyber capabilities in the 2014 budget that I presented at Congress the last two months.  We will do this even as we pare back force structure in almost all other areas where the military has excess capacity measured against the real world threats of today.

Growth in defense and healthcare technology is the only certainty in the uncertain world of the sequester:

• Cyber security globally is projected to grow 11.3 percent annually and reach $120.1 billion by 2017.
• Cyber security in the U.S. is projected to grow 6.2 percent annually and reach $65.5 billion by 2018.
• Healthcare IT globally is projected to grow 7.0 percent annually and reach $56.7 billion by 2017.

Given that ManTech’s annual revenue is only $2.6 billion, there is plenty of market share it can still gain from these large growth markets.

Besides organic-growth opportunities, ManTech has a history of growing successfully via acquisition. Recent acquisitions immediately accretive to earnings include ALTA Systems (healthcare), HBGary (cyber security), and Evolvent Technologies (healthcare).

CEO George Pedersen is a Defense Industry Legend

I respect tremendously George Pedersen, the CEO of ManTech and winner of the 2011 Eagle Award for outstanding contributions to the federal IT community. Pedersen founded the company back in 1968 and, for the first 34 years of its existence, ManTech remained privately-held, but in February 2002 went public because Pedersen realized that the defense intelligence industry was consolidating and only companies that could grow through acquisition would achieve the economies of scale necessary to compete. A publicly-traded stock gave him the high-priced currency necessary to make meaningful acquisitions. 

Solid Financials and Strong Balance Sheet

ManTech’s “growth by acquisition” strategy has paid off – over the past 10 years, the company’s earnings have grown at a 13.3% annualized rate. Until the recent budget turbulence surrounding defense cuts, Mantech’s financial performance has been solid:

The company’s earnings are of high quality – in the eight years 2005-2012, free cash flow has been higher than earnings in all fiscal years except 2007. Debt level is reasonable at only 17% of shareholder equity (14.5% of total capital).  

Takeover?

In a 2005 interview, Pedersen was aged 70 and said he had no interest in selling ManTech because “the upside potential for our firm is enormous.” According to the 2013 proxy statement (page 47), Pedersen controls the company because he owns 84.7 percent of the company’s voting power. As the controlling shareholder, Pedersen was able to pay himself $1.75 million in discretionary bonuses in 2012 even though the company’s revenues and earnings declined from 2011.

Now that Pedersen has reached the age of 77, he may feel differently about selling the company. According to a May 2013 Grant Thornton review of M&A transactions in the defense industry (page 18):

In keeping with recent trends, businesses offering relevant cybersecurity services with access to growth areas of DoD spending continued to command higher valuations than the industry average. Publicly available valuation multiples for defense technology deals have seen businesses change hands at around 2.5x revenue and 10.5x EBITDA in 2012 while smaller traditional government contractors have recently changed hands at around 0.5x revenue and 7.5x EBITDA.

For the sake of conservatism, let’s take the low end of the range of the EV-to-EBITDA and EV-to-revenue takeover multiples. Applying these takeover multiples to ManTech’s current valuation reveals substantial appreciation potential:

According to page 6 of the Grant Thornton report, the average takeover price in 2012 was at a 25% premium to median company valuations, which confirms that the price-appreciation range between 19.0% and 36.4% calculated in the table above is reasonable. At the current stock price of $28.99, these takeover multiples suggest the stock could — at a minimum — appreciate anywhere from $34.50 to $39.54.

Takeover activity in the defense industry experienced a significant slow down in the first quarter of 2013, as uncertainty surrounding the sequester has made it virtually impossible to estimate a company’s future cash flows with any precision. The result is that buyers and sellers cannot agree on a takeover price. According to brokerage firm Stifel Nicolaus, however, “things “will pick up through 2014 as the true impact of sequestration is known and the budget is better understood.”

Second-quarter earnings are scheduled to be released on Wednesday, July 31st. Given the continued sequester uncertainty, conservative investors may wish to wait until after the earnings release to initiate a position.

ManTech International is a buy up to $32; I’m also adding the stock to my Value Portfolio.

Momentum Play: LeapFrog Enterprises (NYSE: LF)

“The fate of our country won’t be decided on a battlefield.
It will be determined in a classroom.”

— Waiting for Superman

As chronicled in the 2010 documentary Waiting for Superman, the U.S. elementary and secondary education system is a disgrace. According to a 2013 report by the Organization for Economic Co-operation and Development (OECD), the United States spends $15,171 per year on each student, “higher than in any other country” in the 34-member OECD. Yet, 15-year-old U.S. students rank only 31^st in math (below average) and 23^rd in science (average) out of the 65 nations surveyed by OECD’s  Programme for International Student Assessment (PISA).  Put another way, only 32 percent of U.S. students are “proficient” in math compared to 75 percent in China and 50 percent-plus proficiency rates in Korea, Finland, Switzerland, Japan, Canada and the Netherlands.

If you’re children are grown and out of school, you may think that this issue doesn’t affect you. Think again. The quality of children’s education directly impacts the competitiveness of U.S. industry and the country’s economic growth. Ever since the global financial crisis of 2008, U.S. economic growth has been sub-par, averaging less than 1 percent annually – compared to the long-term average of 3.2 percent. In fact, the U.S. growth rate has not been above 3.0 percent since 2005! The U.S. unemployment rate remains stubbornly high, and employment levels have still not recovered to pre-recessionary highs – making the past five years the longest period of time it has ever taken to recover job losses after any economic recession since World War II. According to Harvard University, improving U.S. math scores will have a substantial positive impact on the U.S. economy:

The United States could enjoy a remarkable increment in its annual GDP growth per capita by enhancing the math proficiency of U.S. students. Increasing the percentage of proficient students to the levels attained in Canada and Korea would increase the annual U.S. growth rate by 0.9 percentage points and 1.3 percentage points, respectively. Since long-term average annual growth rates hover between 2 and 3 percentage points, that increment would lift growth rates by between 30 and 50 percent.

When translated into dollar terms, these magnitudes become staggering. If one calculates these percentage increases as national income projections over an 80-year period (providing for a 20-year delay before any school reform is completed and the newly proficient students begin their working careers), a back-of-the-envelope calculation suggests gains of nothing less than $75 trillion over the period. That averages out to around a trillion dollars a year.

U.S. Education Secretary Arne Duncan argued in 2010 that poor education is making the U.S. uncompetitive in the global economy:

Unfortunately, the 2009 PISA results show that American students are poorly prepared to compete in today’s knowledge economy.

President Obama has repeatedly warned that the nation that “out-educates us today will out-compete us tomorrow.” And the PISA results, to be brutally honest, show that a host of developed nations are out-educating us. The hard truth is that other high-performing nations have passed us by during the last two decades.

The OECD study also finds that more resources are not the simple answer for America’s educational shortcomings. The real problem with K-12 spending in the U.S. is our low educational productivity. Unlike high-performing systems, we achieve less per dollar.

Americans need to wake up to this educational reality–instead of napping at the wheel while emerging competitors prepare their students for economic leadership.

At the elementary and secondary school levels, the key to success is switching from a one-size-all lecture model to a computer-aided interactive model tailored to each individual student’s skill level. I encourage you to watch the 60 Minutes profile of Kahn Academy, the online website with interactive video instruction.

Although more overall education spending is not the answer, there is one component of the U.S. education system that is underfunded: early childhood education. According to the OECD,

In the United States, in 2011, only 50% of children were enrolled in early childhood education at the age of 3, compared to 68% on average among OECD countries. In some countries, such as Belgium, Denmark, France, Iceland, Italy, Norway, Spain and Sweden more than 90% of 3-year-olds were enrolled in early childhood education.

The typical age for entering early childhood education in the United States is 4 years old, but in 2011, only 78% of children this age were enrolled, compared with 85% of 4-year-olds across OECD countries.

There is a lot of room for improvement – especially given the findings that 15-year-old students who had attended at least one year of pre-primary education perform better in reading than those who did not, even after accounting for socio-economic background.

The last paragraph of this quote is important, because it confirms that early childhood education really works. Public and private school systems realize this and consequently the pre-K segment of education spending is the best bet. According to 2012 study by GSV Asset Management (pp. 8, 159), of the four education segments (pre-K, K-12, Postsecondary, and Lifelong Learning) global spending on pre-K education  is forecast to experience the fastest annualized growth of 9 percent over the next five years:

Given the $245 billion size of the global Pre-K market, 9% growth provides $22 billion of market opportunity in the next 12 months and $132 billion in the next 5 years.

The absolute fastest-growing global education subcategories in the next five years are K-12 eLearning ($10 billion to $31 billion) and K-12 edu-gaming ($6 billion to $18 billion), both of which are expected to grow at an amazing 25 percent annualized.    

So, the question is which publicly-traded company is best poised to benefit from this mega-trend toward computer-aided interactive education, especially at the pre-K and K-12 levels? The answer is LeapFrog Enterprises (NYSE: LF).

LeapFrog is a Market Leader

In LeapFrog’s 2012 annual letter to shareholders (April 23, 2013), Chairman of the Board William Chiasson noted that NPD Group/Retail Tracking Service ranked LeapFrog as having a #1 market position in several categories of children’s learning toys:

• #1 selling kids’ learning tablet
• #1 selling learning game system
• #1 selling learn-to-read system
• #1 selling preschool electronic learning toy in the U.S.
• #1 selling learning content

You can go to the Amazon.com website and see for yourself under several Best-Selling lists, including “Electronic Learning Products” (top seller and 8 of top 12) and “Electronic Learning and Education Toys” (top seller and 9 of top 15). LeapFrog’s dominance goes way beyond Amazon. In 2012, LeapFrog had four of the ten top-selling toys in the entire United States – including the #1 top seller (Explorer Software Assortment) (slide no. 17).

The explanation for LeapFrog’s dominance is simple: quality. Founder Mike Wood is no longer with the company he started in 1995, but his can-do philosophy of “making learning fun” through high-quality products that entertain as well as teach continues to permeate the corporate culture. According to current Leapfrog CEO John Barbour:

We’ve won more awards than anyone else in this space. We’ve won over 1,200 awards. If you look at the toy industry, awards for top educational toy of the year, we’ve won it eight of 13 years. 

In fact, the company has won the top toy award in multiple categories and possesses a total of 18 “Toy of the Year Awards” in the U.S. (slide no. 15). LeapFrog’s secret is its close relationship with its customers – 13 million connected parents who provide constant feedback on how to make learning toys more effective. Each potential new product undergoes rigorous testing in the company’s “Kid Lab” with hands-on usage by 2,500 families, including more than 1,600 specific kid and parent tests. Testing continues outside of the lab in the homes of actual families, with more than 300 such in-home evaluations planned for 2013 (slide no. 11). The result of all this hard work – besides the numerous awards and best-selling products on Amazon.com – is an extraordinary number of outstanding customer reviews and ratings. More than 90% of all product reviews on retail websites receive four stars or more, including more than 4,000 five-star reviews. (slide no. 16). The toys have been used by teachers in more than 100,000 U.S. classrooms nationwide.

With so much going for LeapFrog, it’s hard to believe that between 2004 and 2009 the company lost money in five of the six years. Even today, its book value per share of $4.84 is lower than the $7.06 it possessed 10 years ago in 2003 and the current stock price sits at $11 – less than a quarter of the $47 price peak it achieved back in October 2003. Part of the problem was the competitive nature of the technology industry, where constant innovation is required to stay on top. As one analyst described it:

In its early years LeapFrog was a technology company which focused on integrated circuit research to build toys. Once LeapFrog had backing from Knowledge Universe (Larry Ellison, Michael Milken), LeapFrog began to purchase technologies that the company would use down the line to build innovative products. The company offered computer-based products and screen-based technology toys such as the LeapPad. Though LeapFrog’s products were successful, a lack of innovation among a competitive field caused consumer interest to fade in LeapFrog’s products.

The turnaround began in February 2010 when a management shakeup saw CFO Bill Chiasson replace Jeffrey Katz as CEO and promote several new managers to top executive positions. Katz was an airline executive and the founder of Internet travel website Orbitz, not a toy guy. The following year with the appointment of toy industry veteran John Barbour to the CEO spot and Chiasson assuming control of the Board of Directors, the management team was complete and ready to take on the world.

The Curse of Larry Ellison is Lifting

The other drag on LeapFrog was its ownership structure. For most of its life, LeapFrog was controlled by Larry Ellison, the founder/CEO of software firm Oracle, and Michael Milken of junk-bond fame. Ellison forced LeapFrog to purchase software from Oracle and enter into joint ventures with Ellison-controlled entities. This stranglehold lessened in December 2011, when Ellison reduced his ownership below the 50% level of absolute control – down to 42.8 percent. Combined with Milken’s ownership stake, however, the dynamic duo still controlled LeapFrog. A year later in December 2012, the combination of both Ellison and Milken’s ownership interests had fallen below 50% to 49.6% (pp. 16-17). Three months later in March 2013, Ellison’s stake had fallen all the way down to 1.1% (page 25), leaving the Milken trio (Michael, brother Lowell, and Lowell’s wife Sandra)  as the largest remaining shareholder block with 41.2% voting control. Still not ideal, but CEO Barbour has much more freedom now that Ellison’s interference has been mostly removed.

As Barbour noted in the company’s 2012 shareholder letter, the company is transforming itself from a capital-intensive hardware business into an asset-light educational content business:

LeapFrog has embarked on a significant transformation. We have grown from being solely an educational toy company to now being an educational entertainment company with a far greater focus on content. Our line-up includes hundreds of pieces of educational content, spanning games, videos, books, eBooks, creativity studios, maps, apps, music and more. We opened our platforms to third parties, and we now distribute content for more than 30 of the best kids’ entertainment companies. Additionally, we are making significant investments to build an online community with parents as well as improve our online tools to provide parents with even richer, more personalized insight about their child’s learning progress.

Our world-class team is making this transformation a reality by developing learning solutions that are helping millions of children achieve their potential while delivering market-leading performance. This extraordinary team of talented and successful professionals comes from a wide range of disciplines, including child development and education experts, platform designers, content creators, game designers, marketing professionals, system engineers and more. We have also brought in new leaders who come with decades of successful track records in both large companies and entrepreneurial environments.  

Content is king in children’s education, whereas the hardware means for delivering the content is becoming commoditized. Management’s decision to open up LeapFrog hardware to third-party content providers will increase the hardware’s popularity, which will broaden the customer base to which LeapFrog can sell its content. LeapFrog now has the best educational entertainment library with nearly 1,000 games, books, eBooks, videos and music. I’m confident LeapFrog’s transformation will make its financial results more stable and profitable in the future.

Two New Products

That said, the second half of 2013 promises to be an exciting time for the company as two blockbuster new products have recently been released that will be blockbusters during the Christmas selling season:

1.      LeapPad Ultra learning tablet for kids 4-9 years old ($149.99)

2.      LeapReader for kids 4-8 years old ($49.99)

Less than a month after introducing the LeapPad Ultra, two of the largest retailers in Great Britain named it a Top 10 “must have” toy for the upcoming holiday season. Similarly, the LeapReader sold out within two weeks of its launch. The company’s business is very seasonal, with its third and fourth fiscal quarters the largest profit-makers by far. In fact, the first and second quarters usually report a loss. In the Q1 2013 financial report, sales were up 15%, but the company trumpeted the fact that its operating loss was 47% less than the year before. Another operating loss will occur in the upcoming Q2 2103 report. Second-quarter “earnings” (ending June 30^th ) are scheduled to be released on Thursday, August 1^st. After the release, investors will start  to focus on the profitable Q3 and Q4 results and the stock could continue its positive price momentum in anticipation.

Over the past two years, LeapFrog has been a true momentum growth stock. Its stock price has destroyed both the Russell 200 and the S&P 500, rising almost six times as much (181% vs. 31%):

Source: Bloomberg

Stock price follows fundamentals and the fundamentals have improved significantly:

Source: Morningstar

LeapFrog’s valuation is very reasonable – cheap, quite frankly! Given the company’s improving fundamentals, its low enterprise value-to-EBITDA multiple of 7.15 may be puzzling, but I believe it is a remnant of the company’s unstable operating past. Investor skepticism is high about the sustainability of the company’s turnaround – as evidenced by a short interest-to-float ratio above 20%. Nevertheless, with Larry Ellison almost completely gone, a top-notch management team (including CEO with toy-industry experience) now in place, and a transformational commitment to content over hardware, the future of LeapFrog is much brighter than its past and investors will soon afford the stock a much higher valuation.

The company can weather any potential economic storm since its debt level is zero. Combine the company’s strong business fundamentals with a macro-backdrop that favors increased government spending on technology-based and interactive childhood education, and LeapFrog Enterprises deserves a place in your equity portfolio.

LeapFrog Enterprises is a buy up to $13; I’m also adding the stock to my Momentum Portfolio.