A reader suggested I check into ManTech International Corp (NASDAQ: MANT), one of the largest technology providers for national security programs for the intelligence community, including the departments of Defense, State and Homeland Security, as well as the Department of Justice, the FBI, NASA and NOAA. The reader pointed to the fact that the company is trading close to book value, generates decent returns, has strong free cash flows, and almost zero net debt. Additionally, the company has experienced strong revenue growth.
Let’s start with the company’s returns:
The company has had acceptable though not really exciting returns over its relatively short history as a public company. CROIC has tended to be higher than income statement based (accruals-based) returns metrics, suggesting a larger portion of non-cash expenses. Impressively, returns have tended to increase throughout the recession.
Here we see the revenue growth that my reader pointed me to. Revenues have grown at a CAGR of 21% for the last ten years! It is important to recognize that this kind of growth cannot occur indefinitely, so any valuation would have to take into account a slowing rate of growth.
Another interesting thing to note is that the company’s gross margins have declined rather dramatically, with about 444bp lost since the 2003 peak. Given that this appears to be a secular trend that has persisted throughout the post-9/11 resurgence in defense and intelligence spending, it would be a mistake to use a long-term average in assessing normalized earnings. It could be that the company has achieved its rapid revenue growth by relatively underbidding on new contracts, or perhaps increased competition in this space has led to pressure on contract prices. What is interesting is that the company has done a good job of trimming operating expenses in response, thus managing to hold its net margin relatively steady (even increase it slightly!). Unfortunately, this only works so far, so unless the company is able to get a handle on its gross margin, this could be a source of problems in the future.
Here we note that the company has managed to grow cash flows roughly in line with revenues (see the chart above). Additionally, the business does not appear to be very capital intensive, as capex is quite low, translating cash flows from operations very closely into free cash flows. The company has managed to grow free cash flows by a CAGR of 24% since 2000, which is quite impressive. The company’s average free cash flow over the last three years amounts to $134 million, or an 11.4% yield.
Unfortunately, this is not the whole story. MANT is a particularly acquisitive company, spending on average $92 million per year on business acquisitions. These acquisitions are a large source of revenue and free cash flow growth, and so we have to consider the company’s free cash flows after acquisitions, which I show in the chart below.
Here we see that the company’s free cash flow after acquisitions (the yellow bar) is significantly lower than free cash flow, and in about half the cases negative.
Given the company’s reliance on acquisitions to fuel its growth, I am far less impressed with the company. Going back to the reader’s email, let’s take stock of the original points. First, the company is indeed trading for close to book value, but 85% of book value is comprised of intangibles as a result of the company’s history of paying a premium for its acquisitions (which results in goodwill on the balance sheet). On a tangible book value basis, the company is trading at a massive premium, so the downside isn’t as protected in liquidation as might be expected based on P/B alone.
Second, the company has indeed enjoyed rapid revenue growth, but this is not the result of organic growth. Anyone can buy another company and show improving revenues; I am interested in organic growth the suggests a capable management with competitive products. Additionally, the company is almost completely reliable on government spending, and there are many reasons to believe that governmental budgets will contract in the years to come, which will surely have an effect on MANT’s ability to generate organic growth. In this light, the revenue story is not nearly as attractive as first appears.