Is This Defense Stock Preparing to Tank?


At first glance, defense contractor SAIC (NYS: SAI) looks like a promising pick-up. Media pundits are quick to harp on the company's exposure to overblown fears of draconian budget cuts. However, SAIC has a solid history of providing intelligence and technology systems to the Department of Defense. These are strong sectors for a future moving away from traditional conflicts fought with bombers and tanks.

However, SAIC looks like a long shot to power the gears of war in this new era. Let's take a look at where this company falls short.

One big financial mess
One look at SAIC's financials should be enough to strike fear into an investor's heart. Its margins underperform the industry averages considerably, with gross margins of 12% last quarter falling below its competitors on average. The company barely squeaks out a profit, clinging to net margins of 0.4% over the last 12 months. Even in an industry that averages a mere 4% net margins, SAIC's lack of performance bodes poorly for its financial future.

Granted, SAIC doesn't play on the same field as most public companies. It secured more than 10,000 government contracts in the past year, putting it on par with fellow defense contractors General Dynamics (NYS: GD) and Northrop-Grumman (NYS: NOC) . SAIC derived over 90% of its sales from the U.S. government last year, and revenues have stabilized around $10.5 billion between 2010 and 2012. While this may look secure if not promising, SAIC's five-year sales growth rate of 5% actually underperforms the industry average by around 6%.

For a company with such shaky numbers, SAIC could soon find its larger and stronger rivals assuming control of its niches.

The competition bares its teeth
Larger defense contractors such as Lockheed Martin (NYS: LMT) and Raytheon (NYS: RTN) have recently moved more into SAIC's traditional territory. The latter especially has positioned itself well for the future of war, bolstering its position in areas such as communications and radar systems. While these moves don't threaten SAIC directly, Raytheon's growing focus on information and intelligence systems will put it more in competition with SAIC's own divisions.

Lockheed has bolstered its position in developing electronics and IT systems, threatening a domain serviced heavily by SAIC. Most investors know Lockheed primarily for its high-profile aircraft and weapons. However, electronics and information technology sales have jumped to the forefront of the company's profile, combining to fill out more than 50% of sales in 2011.

Lockheed directly beat out SAIC over a $4.6 billion Defense Department contract for a communications network in June. While this alone a tough blow for SAIC's future revenues, the success of larger rivals such as Lockheed in head-to-head competitions sheds worrisome light on the company's ability to compete for major projects in the future.

Wait for signs of life before jumping in
SAIC will have to evolve to survive in the changing defense industry. With competitors breathing down its throat, the company can't afford continued lackluster results. If it doesn't change its business model soon, SAIC could see its niche dominated by its larger industry rivals.

The company has taken a few first steps in adapting, recently expanding its position in health care IT systems and securing non-defense government contracts from the General Services Administration. Potential shareholders must take a long, careful look at the future, however. With its competition and current financials, SAIC doesn't look like a winner. I've gone ahead and made an underperform call on CAPS to reflect my sentiment.

SAIC's numerous question marks make it a hard stock to recommend. Investors don't have to settle for poor performance, however. If you want to see a company poised to succeed, check out The Motley Fool's free report, "The Motley Fool's Top Stock for 2012." Inject a spark into your portfolio and get your free copy by clicking here.

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Fool contributorDan Carrollholds no positions in the stocks mentioned in this article.The Motley Fool owns shares of Raytheon, L-3 Communications, Northrop Grumman, and General Dynamics.The Motley Fool has adisclosure policy.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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