Investor Concerns About This Government IT Company Are Overblown

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Perspecta (NYSE: PRSP) delivered a solid fiscal third quarter, producing adjusted earnings per share and revenue that both came in ahead of consensus at 47 cents and $1.08 billion, respectively.

Despite the strong results, the company has struggled to get off the starting block. Shares of Perspecta are down 17% since its IPO last summer due to two huge overhangs concerning the company's largest shareholder and its most important contract.

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There's a strong case to be made that those concerns are overblown and that this under-the-radar government IT firm with a depressed valuation is one of the best bargains in the sector. Let's take a look at some of investor's concerns with this stock, and what management had to say about them on the post-earnings conference call.

A very important shareholder

Perspecta was created in June 2018 via a three-way merger among Vencore, KeyPoint Government Solutions, and the public sector business DXC Technology. As part of the deal, private equity firm Veritas Capital Management, owner of both Vencore and KeyPoint, received a 14% stake in the resulting company.

Investors since the IPO have been waiting for Veritas to liquidate its position, a move that could put pressure on Perspecta shares. Veritas owned 23 million shares of Perspecta at the time of the separation, and investors on average trade only about 1 million shares of Perspecta per day on the New York Stock Exchange.

The shares fell about 10% in November following Perspecta's last quarterly earnings release after the company filed a form S-1 with regulators that some apparently took as a sign a Veritas exit was imminent. On a Feb. 13 investor call, Perspecta CEO Mac Curtis emphasized that the S-1 was a requirement and urged investors not to overreact to any filing: "Veritas is a patient holder with no need for immediate liquidity and I don't expect them to be sellers at anywhere near the current stock price. Just so there's no confusion, we will file a Form 424 tomorrow as required by the SEC to update the S-1 for our latest results, but it should not be taken as a requirement or intention for Veritas to sell any shares."

While it is impossible to know for sure what Veritas is thinking, some perspective is in order. The firm has a reported $9 billion in assets under management and is highly unlikely to have a funding crisis that would require it to quickly liquidate its $480 million stake in Perspecta.

Veritas is also one of the leading investors in the defense, government IT, and national security sectors, and Perspecta is one of its high-profile deals. The firm is unlikely to take any step that would rock the boat at Perspecta or create negative headlines and put its reputation in the defense community at risk.

A very important contract

Perspecta and its predecessors have held a prime position on a massive U.S. Navy and Marine Corps IT contract since the turn of the century, but the navy is in the initial stages of modernizing its so-called Next Generation Enterprise Network (NGEN) via a new round of bids. The current deal represents upwards of 15% of Perspecta sales.

The $3 billion competition, which includes management and maintenance of a range of navy and marine networks, will pit Perspecta against two of the largest government IT vendors, Leidos Holdings (NYSE: LDOS) and the recently bulked-up IT arm of General Dynamics (NYSE: GD). This is a business where scale is vitally important, potentially putting Perspecta in a difficult position.

We won't know who the winner is until late 2019 at the earliest, but I believe Perspecta is well positioned to at least share in the award. For one, the Navy seems pleased with the service it is receiving now and is in no rush to find a replacement: One of Perspecta's largest awards last year was a $485 million NGEN extension to cover IT and network security through May of 2020.

Perspecta has an incumbent advantage at work. The Navy is unlikely to want to dramatically overhaul an operation that touches nearly all personnel, thereby risking disruptions to day-to-day operations. Perspecta can also lean on its existing team to help hold down costs and better compete on price, as new winners would face a massive expense to hire and train the necessary support staff that Perspecta already has in place.

Even in the worst case, where Perspecta is shut out completely, there is likely to be a gradual transition period that would provide at least some revenue well past the May 2020 extension date. Management noted that beyond NGEN, the only major contract it has to recompete for on the horizon is a classified deal worth less than 3% of sales, and Perspecta has a pipeline of about $72 billion worth of potential opportunities comprised of primarily new work and $13 billion of proposals already submitted.

Perspecta had an excellent quarter in terms of new business, with bookings totaling $1.7 billion in the quarter representing a book-to-bill ratio of 1.6x, and the pipeline gives it ample opportunities to offset any revenue loss. Losing NGEN would be a blow, but over time the long-term growth story should persevere.

Buy into the uncertainty

These concerns have made Perspecta cheap relative to its peers. The company trades at an enterprise value less than 10 times EBITDA, compared to Booz Allen Hamilton's 13.6 times and the industry's average of 11 to 12.

The business is healthy, and even if the worst-case scenarios play out, Perspecta can weather the setbacks. I believe the most likely trajectory for this stock is either up sharply over the next year if NGEN goes Perspecta's way, or up more slowly and unevenly if Perspecta is forced to backfill lost revenue from the navy.

Either way Perspecta, as it grows and gains greater name recognition, is well positioned to outperform over the long haul. It's a great time to buy into this underappreciated contractor.

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