Defense Players Look Set to Score


By Stephanie Crane Given the increased attention on national security, the defense industry has been a significant focus for many information-technology outsourcing companies, especially CACI International (CAI

: S&P rated buy; $59) and SRA International (SRX

: buy; $34). IT services for U.S. government agencies at the federal, state, and local levels as well as other key areas around the world is projected to be among the fastest growing markets over the next few years.

We believe that governments are outsourcing technology needs mainly because their tight budgets and low wages don't allow them to attract capable IT professionals for in-house projects. We believe IT service providers should benefit from these tighter budgets, as their value-added offerings should help public-sector clients run their operations more efficiently and reduce overall costs.

At the federal level, defense and homeland security are taking a large share of contracts for IT services. In 2003, the Washington awarded more than $115 billion in IT-related contracts, a 91% increase from 2002, according to Input, a market researcher focused on government and public-sector business. The Defense Dept. and the National Aeronautics & Space Administration (NASA) accounted for approximately $90 billion of total government awards in 2003, with the balance from civilian agencies.

CORE EXPANSION. Input forecasts that Uncle Sam's IT spending will grow nearly 30%, from $71 billion in 2005 to $92 billion in 2010, as homeland security and system vulnerabilities continue to drive demand. A focus on cost efficiencies is also a likely factor, as federal agencies streamline business processes.

At S&P, we have a buy recommendation on shares of CACI, a technology holding company with U.S. and European subsidiaries serving clients in major segments of government and commercial markets primarily throughout North America and Western Europe. Its growth strategy includes seeking to expand its core business by winning contracts and by cross-selling to existing clients; targeting opportunities and winning new business in high-growth areas such as managed network services, information assurance, and national intelligence; and continuing to pursue strategic acquisitions to expand service offerings and increase its federal-government client base.

CACI provides system integration, which combines current systems with new technologies or integrates hardware and software from multiple sources to enhance operations; managed network services offerings for total life-cycle support of global networks; information management and tools and enabling technologies, including Internet-based user interfaces, commercial, and workflow-management systems; and engineering services, which enable clients to standardize and improve the way they manage the logistical life cycles of systems, products, and materials.

DEFENSE DOLLARS. At any one time, CACI may have several hundred separate contract obligations. In fiscal 2005, the 10 leading revenue-producing contracts accounted for 36% of revenues. In that year, 94% of revenue came from U.S. government contracts, broken down as follows: 73% from the Defense Dept., 6% from the Justice Dept., and 16% from civilian agency government clients. The remainder came from commercial business, including international operations, and state and local contracts.

We estimate that more than 70% of fiscal year 2006 (ending June) revenue will come from business associated with the Defense Dept., which has an expanding budget. New contract awards to CACI reached $259 million in the fourth quarter of fiscal year 2005, above its $200 million historical level, after dipping to $140 million in the third quarter.

We think a number of major long-term growth trends bode well for CACI, including increased spending on national defense, intelligence, and homeland security; ongoing modernization of federal IT systems; and growing government reliance on outsourcing. In addition, we believe CACI will continue making acquisitions to strengthen its strategic positioning and maintain double-digit earnings growth.

STRONG EARNINGS. For fiscal 2006, we look for revenue to reach $1.8 billion, up 13% following fiscal 2005's strong 45% advance, which was driven by new contracts and retention rates in excess of 90% for existing contracts. We see steady gross margins of 38% in fiscal 2006. Growth of high-margin network-services projects, together with operating leverage and favorable mix, should result in wider operating margins. We forecast earnings per share of $3.19 in fiscal 2006, a growth rate of 14%, vs. the 30% advance achieved in fiscal 2005.

Our 12-month target price for CACI is $76, reflecting a peer-based price-earnings ratio of about 24 times our EPS estimate for fiscal 2006, and our discounted cash flow analysis. Our DCF model assumes 20% compound annual growth of free cash flows in the first five years, a gradual deceleration to 5% over the next 10 years, and a 3% perpetual growth rate. We assume a cost of capital of 10.9%, long-term debt at 2% of capitalization, and an equity risk premium of 6%.

Risks to our recommendation and target price include acquisition integration risk, pricing pressures from the outsourcing arena, changes in government procurement policy, and a slowdown in defense spending.

IT SECURITY. We also have a buy recommendation on shares of SRA. We base this on valuation and on our projections for the company's growth in earnings and revenues, market-share improvements, and growth in demand for IT services from the U.S. federal, state, and local governments, particularly as they seek to leverage cost and productivity efficiencies in the face of tighter budgets. As demand for IT spending geared toward public projects likely grows, coupled with growth in the U.S. economy, we expect solid bookings in coming quarters.

SRA provides IT services to clients in national security, civil government, health care, and public health. As of June, 2004, the company had more than 4,000 employees, of whom 50% had federal government security clearances. Clients include segments of the U.S. federal government; organizations related to national security; civil government agencies, such as treasury, transportation, health care, and public health; and some minor commercial ventures. In fiscal year 2005, 99% of revenue came from the federal government (including 11% from the National Guard), with 1% from commercial ventures.

SRA's services include strategic consulting; systems design, development, and integration; and outsourcing and operations management. SRA has also developed other business areas, including text and data mining; contingency and disaster response planning; critical infrastructure protection; enterprise systems management; network operations and management; and environmental strategies.

HEALTH AND HOME. To achieve growth in the double digits, SRA's strategy is to cross-sell its services to existing clients, particularly among government agencies. It also plans to pursue strategic acquisitions to complement internal growth.

SRA's sales grew 43% in fiscal year 2005 (ended June), to $881 million, after a 37% advance in fiscal year 2004. We expect revenue in 2006 to grow 30%, to $1.15 billion. We expect demand for IT outsourcing to benefit from strength in the public arena as well as the health-care market -- especially in the U.S., where efforts to bolster homeland security and increases in the defense budget are combining with individual state and local government efforts to boost cost efficiencies by leveraging IT services.

We believe SRA's aggressive efforts to boost its share of the Defense Dept. budget should soon begin to see positive results. SRA is participating in the Smart Alliance, a contract awarded to a consortium to secure U.S. borders.

PROFIT ALLIANCE. In June, 2004, the Homeland Security Dept., with a budget of about $40 billion, awarded a 10-year contract to a consortium led by Accenture (ACN

: buy; $25) to track and identify non-U.S. visitors at the nation's points of entry -- more than 400 air, sea, and land ports. This project, called US-VISIT, will incorporate digital fingerprint scanners and photography. Radio frequency identification systems also may be included.

The contract could end up worth approximately $10 billion to Accenture and its partners in the Smart Border Alliance venture -- Raytheon (RTN

: hold; $37), Titan, and SRA. Despite concerns voiced by some groups that Accenture is headquartered in Bermuda, the House of Representatives and the Senate approved the contract, given the national security risks of further delays in awarding the work to another IT service provider.

We expect SRA's operating margins to continue in the low double digits, on more effective efforts to minimize operating expenses and leverage value-added offerings with pricing options. Our operating EPS estimate for fiscal year 2006 is $1.20.

WEIGHTED BOARD? Our 12-month target price of $42 is based on relative multiple and historical valuation methods. We apply a peer-based PEG multiple of 1.18 to our fiscal year 2006 EPS estimate.

The peer group includes comparable IT-services and outsourcing companies that regularly compete with SRA.

Risks to our recommendation and target price include potential pricing pressures that could erode profit margins, due to increased competition in the IT services field aimed at government entities in the U.S. We also are concerned about corporate governance, particularly given that over 50% of SRA's board of directors are insiders and affiliated outsiders.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM") which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS") which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from CACI, Accenture and Raytheon during the past 12 months.

SRA is not customers of S&P or its affiliates.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

Analyst Crane follows technology services stocks for Standard & Poor's Equity Research


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