Play Defense with This 5-Star Pick
This U.S. government contractor is poised to gain 20%-plus.
Following is a stock 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.
To see more stocks that have recently jumped to 5 stars--as well as our full list of 5-star stocks--including our consider buying and selling prices, risk ratings, and moat ratings--simply take Morningstar Premium Membership for a test spin. Click here to sign up for a free trial.
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.
* 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.