This Defense Stock Just Suffered a Blow to Its Effort to Diversify

The Marine Corps has selected BAE Systems (NASDAQOTH: BAESY) to manufacture its next-generation amphibious combat vehicle, dealing a major setback to the diversification plans of Science Applications International (NYSE: SAIC).

The initial contract, which calls for BAE to manufacture 30 vehicles, is worth $198 million. But if all goes well, the Marines hope to eventually spend more than $1.2 billion replacing more than 200 vehicles designed to transport troops from ship to shore. The deal reconfirms its reputation as a military vehicle powerhouse — the company also manufactures the M2 Bradley Fighting Vehicle and the M109 self-propelled howitzer.

BAE’s winning amphibious combat vehicle entry. Image source: Kaitlin Kelly, US Marine Corps

BAE, the largest U.K.-based defense contractor, gained significant exposure to the U.S. land weapon market via its $4 billion acquisition of United Defense Industries in 2005. BAE and SAIC have been competing for this amphibious vehicle contract since 2015, when both were selected from a five-company bake-off to build 16 prototype vehicles.

The underdog lost

SAIC, a one-time government consulting and IT firm, has been branching out into equipment. During the Iraq War, it established a business upgrading unarmed vehicles to better withstand mines and roadside bombs.

Over time, that business has expanded to handle additional vehicle upgrades, including adding new armor, engines, and sensors to the Marine Corps’ current amphibious vehicles. The new ACV was going to validate SAIC’s effort to compete with the more-traditional prime contractors for new business and open large new revenue opportunities for the $4.45 billion-sales company.

SAIC in a statement said it was disappointed with the decision, but the company still has high hopes for its equipment division. Chief Operating Officer Nazzic Keene on an earnings call earlier this month said SAIC is expanding its operations in South Carolina in hopes of winning more business not just from the Marines, but to help with the Army and Navy’s equipment modernization efforts as well.

“We are committed to growing this new line of business in alignment with the Defense Department’s focus on readiness and modernization,” Keene said.

Stuck in the doldrums

SAIC could have used the boost. The company’s shares dropped 8% in a single day earlier this month after it reported fiscal 2019 first-quarter earnings per share that were up year over year, thanks in part to buybacks, but also declining free cash flow and margins.

The company, like most of its peers in the defense IT and consulting sector, expects to see a wave of new business over the next 12 to 18 months, thanks to the two-year government budget deal reached back in March. SAIC’s management forecast that revenue will rise by 3% to 4% for fiscal 2019, compared to an earlier forecast of 2% growth, and even stronger growth in fiscal 2020.

“With an agreement in place for government fiscal year 2019 budgets and customers looking to modernize their capabilities and operations, we are optimistic for increased demand and quicker contract decisions that will enable our customers to move forward with their mission imperatives,” CEO Tony Moraco said during the earnings call.

One less reason to buy

The bet here is that SAIC is correct, and that government IT orders are set for an upswing thanks to the budget deal, making it a good time to be invested in government contractors. But unlike rivals Leidos Holdings and Booz Allen Hamilton, SAIC doesn’t have an obvious near-term upside, and it’s hard to make an argument as to why it might outperform other contractors. And even after the recent price decline, SAIC is trading at about 18 times forward earnings, in line with Booz Allen and more expensive than Leidos.

The amphibious combat vehicle competition was a chance for SAIC to rewrite its outlook, validate its push into equipment, and offer a new reason for investors to take notice. And a win likely would have attracted interest in SAIC shares from a much broader audience.

All is not lost for SAIC. But the loss of that hoped-for catalyst eliminates the best argument to buy in right now.

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Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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