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An insecure homeland security stock
PEC Solutions has thrived while its comrades have fallen in recent months. But do its numbers add up to a defensible position? Here's why I don't think so.
By Jon D. Markman
In a curious twist of market logic, the closer that Congress has gotten in recent weeks to establishing a federal homeland security office, the worse the shares of most companies expected to benefit from its new spending plans have done.
In the past month and a half, shares of technology systems integrators Northrop Grumman (NOC, news, msgs) and Lockheed Martin (LMT, news, msgs) have plunged 25% and 22%, while shares of smaller rivals SRA International (SRX, news, msgs) and Veridian (VNX, news, msgs) have fallen about 15%. To be sure, waning tensions with Iraq and sector rotation have played a key role in the downplay of defense, but the decline is undeniable when you consider the broad market averages are up about 7% since Oct. 1.
There is one company, though, that has remained impervious to the decline of the homeland security stocks, and that is PEC Solutions (PECS, news, msgs). This seemingly fast-growing Virginia-based defense contractor, which sports an $885 million market cap, has soared about 40% since Oct. 1 of this year and 400% in the past two years.
Are PEC's numbers really that strong?
Does this outfit, which brags in press releases that it specializes in high-end eGovernment solutions, deserve this sort of market-pounding attention? Maybe not.
It does if you believe its latest earnings release, in which PEC claims to have netted 25 cents per share before amortization of intangibles, compared to 13 cents in the comparable quarter a year ago -- a rise of 99% in an otherwise lousy market for most of its peers. It does if you believe its report of revenue growth, which is said to be up 83% in the past year. It does if you believe Chief Financial Officer Stuart Lloyd when he declares that the company is on track for revenue growth of 70% for the full year in 2002 and another 40% next year. And it certainly does if you believe Chief Operating Officer Paul Rice when he states that the company has seen significant acceleration in certain engagements related to the federal governments homeland security mission, and in the application of biometric identification technologies.
But the well-flexed pectorals of PEC's management seem quite a bit flabbier if you dig a little deeper into their recent financial statement, as my new colleagues at Camelback Research Alliance did recently. Then the companys financial picture begins to look a lot more like Electronic Data Systems (EDS, news, msgs) before it got mauled over the summer.
The main problem is that free cash flow at PEC Solutions has trailed net income by a wide margin since the company went public three years ago -- and recently there has been an unusual increase in both normal and unbilled receivables along with a strangely low reserve for bad debt. Additionally, just two customers represent a significant portion of the companys revenues -- and one of them, EDS, has suffered significant operational deterioration lately. Plus, the board of directors is a corporate-governance hawks nightmare, as it is dominated by company insiders and influential shareholders.
In a truly healthy company, cash flow should rise right along with net income. But at PEC, operating and free cash flow have badly trailed net income in every year since 1999. The ratio of operating cash flow to net income was an extremely low 0.27 in 2001, and it is still a very low 0.76 in the nine months ended Sept. 30. Operating cash flow was 24% lower than net income in the last three fiscal quarters. And while free cash flow has improved recently, the company has generated just $6.2 million in free cash flow over its three-year history even as it has reported earnings of $42.3 million.
The messy business of unbilled receivables
Research by both Camelback and academics elsewhere have shown that companies with low free cash flow relative to reported net income have a much higher risk of future underperformance than companies at which cash keeps pace with earnings. One explanation is that cash flow better represents the underlying strength of a company than net income, as cash is real, spendable currency while reported earnings can be less tangible.
Even this wouldnt be so bad if it were not for the fact that unbilled receivables at PEC Solutions jumped 191% in the first six months of 2002, after a 92% rise in 2001. In contrast, revenues advanced by only 83% and 60% in those periods. (The company did not break out unbilled receivables in its third-quarter release.) As I explained in my column on EDS last May, unbilled receivables are the most subjective form of revenue because they only amount to managements guess as to the percentage of completion in a multiyear contract. Not only might the company not actually be done with work, but the customer may decide it unsatisfactory and ultimately decline to pay. Thus companies that report unbilled receivables growth at a higher pace than revenues -- as EDS did -- are often overly aggressive; if customer problems arise they are often forced to restate results. That wouldnt be hard to envision in the case of PEC, as just two clients account for 37% of its business -- EDS, at 26%, and a division of the Drug Enforcement Agency, at 11%. And the project that got EDS in trouble for unbilled revenues is the one that PEC is involved with: a massive new U.S. Navy-Marine intranet.
Unfortunately, no one from PEC Solutions was available to comment.
In a research note to clients Monday, Lehman Brothers said that there is increasing evidence that the Securities and Exchange Commission will propose new rules opposing the use of such percentage-of-completion accounting on long-term outsourcing deals. Lehman said that would have a negative impact on EDS if it were forced to restate revenues. The same could be said for PEC.
Investors should feel as if they can rely on the board of directors to keep an eye on these issues, but at PEC that could be a problem. Just two of the companys seven board members are independent, while the other five are all senior executives of the company, including its chief executive and chief financial officer. Moreover, the companys directors and executive officers own 56% of the outstanding stock, so matters requiring shareholder approval could be rammed through with little impartial debate. That amount is growing smaller every month, however, as insiders have dumped $5 million worth of shares during the recent rally at $30.74 to $33.94 -- right about where the stock is today.
To be sure, there are many positives with this stock. One is that an SEC filing in late September revealed the excellent mutual fund complex Wasatch Advisors has upped its stake in PEC to 9.2%. Another: Most brokerage analysts agree that PEC deserves a premium price-to-earnings multiple relative to other pure-play government information technology services companies because of its high growth rates and high margins. And a third: It continues to announce big contract wins, including one with Unisys (UIS, news, msgs) for a piece of a $1 billion contract for the new Transportation Security Agency, and many with law-enforcement agencies for its fingerprint identification systems.
But considering that the company is trading at a lofty P/E multiple of 47 on the basis of earnings and revenue expectations that may prove too rosy, it may be time for defense investors to rotate into less expensive peers such as Veridian or SRA International or Northrop Grumman, which trade at 27 and 26 and 15 multiples, respectively.
Fine print
The weeks before Thanksgiving are historically two of the most favorable for bulls in the entire year. To learn more about PEC, visit its Web site for investor relations. And read its latest filings with the Securities and Exchange Commission. I wrote extensively about homeland security plays, including SRA International, back in July in this column. . ... My column listing 17 stocks to snag with the insiders has proved timely, as the stocks are up 9% on average versus a 1% advance in the broad market. Best performers since Nov. 1 are Corning (GLW, news, msgs), up 64% through Nov. 15; Western Wireless (WWCA, news, msgs), up 45%; and Amkor Technology (AMKR, news, msgs), up 24%. Four have lost ground; the worst was Corixa (CRXA, news, msgs), slipping 19%.
Jon Markman, former managing editor of MSN Money, is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While Markman cannot provide personalized investment advice to readers, he invites you to send critiques or comments on his column to supermodels@jonmark.com. At the time of publication, he was not long or short any equities mentioned in this column.
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