Comtech Telecommunications Corp.
Comtech relies on two contracts with the U.S. Army for about 55% of sales, and both have a hazy future. The first, accounting for about 47% of revenue, is to the Army's Mobile Tracking System (MTS) initiative, a system which uses satellite communications for secure two-way text messaging and location data between mobile vehicles. Comtech is the sole supplier under the existing contract. However, the current deal expires in January of 2011 (that's 3 months), and the Army has opened up bidding for a new, more advanced replacement system dubbed MTS III. Proposals will be submitted next year, and Comtech is expecting several competitors to submit competing bids. While the current contract will produce sales for a few years still, losing a significant chunk of future MTS business would be a major blow to the firm.
This risk is exacerbated because Comtech lost its other big military contract in July. The Blue Force Tracking (BFT-1) system is used by Army command-and-control to track GPS location data for deployed forces. Comtech got about 7% of 2010 revenue from BFT-1. However, competitor ViaSat (VSAT) won the bidding for the next generation BFT-2 contract by under-bidding Comtech by 50%. This kind of intense competition should also make prospective investors a bit nervous about MTS III.
Comtech management recently shifted strategy a bit. In May, the firm announced that it was planning to acquire competitor CPI International (CPII) for $472mm in cash and stock, about a 26% premium to the company's stock price at the time. The deal seemed like a decent strategic fit, as CPI fit nicely into the RF Microwave Amplifier business unit. However, possibly due to anti-trust concerns, Comtech severed the deal a few weeks ago, and instead announced a $100 million dollar share repurchase (about 10% of float), as well as a $1.00 annual dividend, which at current prices yields about 3.3%.
The dividend and repurchase seem like judicious uses of Comtech's $600 million dollar cash reserves (the firm has $200 million in long-term debt). Certainly the company is in good shape to cover the dividend, which will represent less than 30% payout of free cash flow. However, I'm not sure this is a good long-term dividend investor's stock. The uncertain nature of the MTS contract creates the risk of dividend cuts in the future. Cash flows are not necessarily reliable here.
Comtech's growth plan revolves around winning more government business, executing strategic acquisitions, and growing sales in wireless and cellular backhaul traffic. The first two, clearly, there has been some problems this year. The last one is an interesting opportunity.
Cellular providers are being buried under the tidal wave of data and video traffic being generated by smart-phones. Backhaul refers to transferring data from localized collection stations to the network's backbone trunks. Satellite is a useful option for accomplishing this where landlines or line-of-sight microwave transmission is not feasible, such as on an island, a boat, or a remote region with little infrastructure. It is also cheaper and faster to build and deploy than landlines. Significant parts of remote, undeveloped terrain in emerging countries such as China and Russia could see satellite backhaul become an important link in wireless networks. However, Comtech has done little to pursue this as of yet - in fact, the percentage of sales to the military has actually risen over the past few years.
Valuing Comtech is difficult because such a large portion of its business is in an expiring contract with a competitive tender. Assuming a 15-20% drop in profits next year (as forecast), followed by modest growth, Comtech is probably worth about $37 - a 23% premium to current prices. However, I'm not sure this is enough of a margin of safety given the risks. Insiders purchased around the $29 mark, and I believe the stock would look much more attractive around $27, with closer to 40% margin of safety and a 3.7% dividend yield.
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Steve does not own CMTL.
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