Play Defense with This 5-Star Pick
This U.S. government contractor is poised to gain 20%-plus.
Following is a roundup of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.
CACI International, Inc.
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.00%
What It Does: CACI (CAI) provides IT and communications solutions primarily to the U.S. federal government. In 2007, the Department of Defense and civilian agency government clients represented 72% and 22% of revenues, respectively. CACI is based in Arlington, Va., and has nearly 12,000 employees in facilities and offices in more than 120 countries around the world. CACI has acquired more than 35 companies in the past 16 years.
What Gives It an Edge: With the U.S. Department of Defense providing more than 70% of CACI's revenue, the firm benefits from steady long-term demand for its services. Morningstar analyst Todd Lukasik credits CACI with a narrow economic moat, owing mainly to its position as an incumbent provider of outsourced services, which puts the firm in a strong position to continually win its contracts again each time they are rebid. In addition, Lukasik believes the existence of security clearances, which are required for workers dealing with sensitive information regarding U.S. national security, confers advantages to existing firms like CACI, as they can provide a barrier to entry for would-be competitors into the marketplace. About two thirds of CACI's nearly 12,000 employees carry security clearances, with almost half of those sporting Top Secret clearances or higher.
What the Risks Are: CACI is exposed to contract risk--the government can generally cancel contracts on short notice or fail to fully fund projects. CACI is also exposed to the risk that actual project expenses exceed those originally contemplated, resulting in lower project profitability. As a strategic consolidator, CACI faces risks related to finding, purchasing, and integrating its acquisitions.
What the Market Is Missing: Lukasik believes the market is incorrectly assuming that CACI's recently depressed margins will continue indefinitely; if Lukasik incorporates no future operating margin expansion into his valuation model, then his fair value estimate falls to CACI's current price in the low $40s. However, along with 6% annual organic revenue growth in both scenarios, Lukasik thinks operating margin improvement of about 140 basis points over the coming years--to 8%--is a more realistic expectation. According to Lukasik, CACI should have opportunities to staff more of its projects in-house (instead of subcontracting), which should improve its profit margin. In addition, absent any future acquisitions--operating margins should automatically expand as acquisition-related amortization charges diminish over time.
Atmos Energy Corporation
Moat: Narrow | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.82 | Three-Year Expected Annual Return*: 17.1%
What It Does: Atmos Energy (ATO) is the largest natural-gas-only distributor in the United States, serving more than 3.1 million utility customers. Its utility operations serve Colorado, Georgia, Illinois, Iowa, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Tennessee, Texas, and Virginia. Its nonutility operations market natural gas across a vast U.S. territory and include one of the largest intrastate natural-gas pipeline systems in Texas.
What Gives It an Edge: Morningstar analyst Mark Barnett assigns Atmos a narrow economic moat rating due to the extensive barriers to entry in its industry, including government regulations and economies of scale. Barnett thinks Atmos has two major points in its favor: its size and its rate structure. Although Atmos has nonexclusive government franchises to supply its customers with natural gas, the massive cost of replicating its pipes and compressor stations precludes serious competition for its services. Also, with 12 different jurisdictions, Atmos has 12 different government regulatory bodies that determine its rates, which insulates it against any one negative ruling. Barnett points out that the company has done a particularly impressive job of managing these relationships and further mitigating its regulatory risk through the implementation of automatic rate mechanisms. For example, an impressive 90% of its rate increases from 2005 to 2007 were achieved without a formal rate case. Barnett believes consistency and stability are the watchwords of a utility investment and that Atmos has positioned itself to provide both.
What the Risks Are: Atmos' past growth has been achieved through aggressive acquisitions. Having purchased 10 companies during the last 20 years, Atmos has so far successfully integrated them into today's goliath. However, acquisitions entail a great risk of overpayment as well as expensive integration. The company's credit ratings are still suffering from its 2004 purchase of TXU's gas utility and Texas pipelines. Its marketing operations are also unpredictable as that business has no moat, many competitors, and razor-thin margins. Lastly, sustained inflation means higher replacement costs for its rate base, which is valued at original cost for purposes of rate-making. While Atmos is more flexible than most utilities, Barnett believes there is bound to be a lag between the increased costs and the company's recovery of them in the future.
What the Market Is Missing: In response to Atmos' recent stock slide, Barnett thinks the market is beginning to fear the inflation monster, which can inflate costs and work to erode the firm's returns. In addition, recent weak results at peers' marketing segments may also be fanning the flames. While Barnett admits that Atmos' nonregulated marketing operations are unlikely to produce the kind of growth achieved during the last five years, he counters that the company has significantly improved its overall regulatory rate structure, with weather-normalization mechanisms in the great majority of its jurisdictions. In total, Barnett believes this will lead to steadier and more predictable cash flows in the future for Atmos. Aside from confidence in its base business, Barnett also feels that the stock is discounted as if its Texas pipelines hardly existed. Atmos purchased this system from TXU in 2004, and it now runs through nine major natural-gas basins in Texas including the Bossier Sands and the Barnett Shale, where production has exploded in recent years. More natural-gas flowing from wells mean more natural-gas flowing through Atmos' pipes. Barnett sees this as a rare growth opportunity for investors in the otherwise stable and hum-drum world of natural-gas utilities.
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, July 18, 2008.
Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.