Recently, I’ve been highlighting examples of potential risks when evaluating stocks. Potential pitfalls such as customer concentration can be a nasty surprise if you aren’t prepared for it. One risk that I have experience with is in trying to evaluate defense contractors. This industry group can be a good place to search for worthwhile investments. Whether we like it or not, defense is a growth business with the largest buy (The United States Government) having a large pocketbook.
Unfortunately, shareholders of Comtech Telecom have realized this risk. On July 21st
the company’s shares gapped down 30% in heavy trading. We all know that small cap stocks can be volatile, but that’s a pretty big haircut. Comtech sells communication equipment to both the public and private sector, but the public sector represents a pretty good portion of business. On that day of the big drop, the company was informed that it failed to win bid for a significant army contract. It reminded me of the unique risks one might encounter when one invests in this sector.
- Shifts in defense spending priorities:
Defense budgets can vary greatly in duration, by military departments, and most importantly - administrations. A change in political leadership can cause small and large projects to be deferred or cancelled all together. When a defense contractor puts out a press release announcing a big navy contract, don’t assume that it will result in guaranteed revenue. Defense spending can be very trendy. The mid to late nineties saw a prolonged drop in spending only to revive post 9-11.
- Lumpy Orders:
Orders can come in very uneven fashion. Many times they are for a specified project and a specified time period. Once the order is done, the contract is complete – so very little recurring revenue.
This is not a common as it once was in the past, but it was possible that the military would delay payment beyond the usual pay period – extending the contractor’s days sales outstanding. Cash flow will greatly suffer.
- Canceling Contracts:
This is an offset of shifts in spending priorities. Signing contracts doesn’t guarantee that revenue will actually be realized.
- Re-pricing contracts:
This risk is definitely one that will be unexpected. The government will set terms on these contracts, which means they can set margins and profitability. It isn’t unusual for the government to re-price a book of business wreaking havoc on a contractor’s margins.
Investing in defense can be a profitable endeavor, but it helps to understand the unique risks one will face with partnering with the government.
About the author:
William J. DeRosa, Jr., CFAWilliam J. DeRosa, Jr. is the General Partner of Anthem Asset Management, LLC is an independent investment management company. He has also served as Director of Equity Research and Senior Portfolio Manager at various buy-side asset management firms. Mr. DeRosa is a Chartered Financial Analyst and is a member of The CFA Institute.