Dueling Fools: Defense Turnaround?
The Arguments

With the war in Afghanistan, no industry grew hotter than defense. Stocks ballooned if they had anything to do with airport security or chem/bio protection. The Iraq war saw less of a bounce. But are there companies that will outperform for the long term, not just when lifted by war-related investor enthusiasm? Guest Kevin Spellman makes the case for communications defense firm ViaSat, while our own Tom Jacobs (TMF Tom9) thinks it's a sell. Enjoy the Dueling Fools, and please vote at the end.

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The Bull Argument
By Kevin Spellman

ViaSat (Nasdaq: VSAT) is an exciting turnaround opportunity. A small company with annual revenues less than $200 million, it specializes in space-based and terrestrial communications. Main revenue sources include the Department of Defense, other government agencies (think black helicopters), and commercial entities utilizing satellite communications. Current trends in all these sectors point to an explosion of business for ViaSat, leaving behind its dark, crashing-bubble days of the last few years. Simply exploiting the opportunities in their current commercial and military programs could easily triple revenues over the next several years, leading its stock to crush the market averages.

The company originated in the mid-1980s from the same Linkabit nucleus that spawned a long list of tech superstars, including Qualcomm (Nasdaq: QCOM). In the early years, the focus was on defense, with UHF Demand Assigned Multiple Access (DAMA) modems making up the bulk of revenues. These modems are used in the Army's Manpacks, which are used by forces to set up communication links in the field. The UHF DAMA modem remains an important product, with two awards in the last few weeks, but it is no longer the sole revenue source -- far from it! ViaSat has been busy expanding its product lines in the last few years.

Fifty percent of the company is comprised of engineers, and they are a highly respected lot. In my many years of "scuttlebutting" ViaSat, I can't recall a single unkind word about its engineering abilities, and it's that specialized intellectual capital that gives it an increasing edge in these new business areas.

Government business
There is significant growth, and potential for acceleration of that growth, in ViaSat's government business. Its main product today is the Multifunction Information Display System (MIDS) terminal, which is an anti-jam radio being installed in F-16s, F-18s, various other defense and government aircraft, and in ground facilities such as Patriot missile batteries. There are two approved vendors in the U.S., and one in Europe, all vying for the $2 billion that will be spent on this program over the next seven years.

A scaled-down version of this datalink is being flight tested in bombs such as the Joint Direct Attack Munition (JDAM) and Joint Stand Off Weapon (JSOW), heavily used in the liberation of Iraq. The datalink would allow these glide bombs to be steered by radar planes onto moving targets. The same goes for Tactical Tomahawks, where a wideband anti-jam datalink is desired to increase flexibility in targeting.

But Information Security (INFOSEC) will soon surpass MIDS as the company's No. 1 revenue generator. It is not always an area one can follow closely, with such secretive organizations as the National Security Agency as the main customer. The business centers on encrypting classified information and allowing secure communications between two points over public pathways, as well as allowing secure access to stored information and secure exchange of information over networks. ViaSat management took a calculated risk years ago to develop its own encryption engine to compete with the entrenched incumbents such as General Dynamics (NYSE: GD) and L-3 Communications (NYSE: LLL), and it worked. ViaSat is rapidly ramping their involvement in this mysterious area. 

Commercial side
The other half of the business is commercial, which has gone from being an anchor to being an increasingly stiff breeze in their sails. The commercial business is composed of an antenna manufacturing group (with some defense crossover), a commercial broadband group, and the traditional very-small-aperture-terminal (VSAT) business (where ViaSat offers more feature-rich versions of the credit card approval dishes you see atop gas stations). After suffering in the past several years, commercial broadband is now back on its feet, and ViaSat's DOCSIS-based technology appears to be on its way to becoming a standard for satellite broadband.

Once again, those Borg-like engineers assimilated the DOCSIS cable standard and applied it to satellite at an attractive price for service providers. Companies such as WildBlue (a satellite broadband provider launching in early 2004), Intelsat, Telesat, SES, Echostar (Nasdaq: DISH), Eutelsat, and New Skies (NYSE: NSK) are interested in deploying this ViaSat technology. Millions of people desire broadband in areas not served by DSL or cable modems. At around $500 per customer, equipment revenues could be substantial. Inflight broadband Internet delivery, via Boeing's (NYSE: BA) Connexion or ARINC's SKYLink, is another commercial success of the ViaSat engineering group.

The turnaround case
During the early part of FY2003, which began April 1, 2002, revenues were declining, backlog was evaporating, layoffs were occurring, and the short interest was increasing. ViaSat fell victim to the crash of the techno-world, as did many others. The cessation of operations at Astrolink (a satellite broadband venture backed by Lockheed Martin (NYSE: LMT), TRW, and Liberty Media (NYSE: L) alone yanked $113 million from backlog. 

The nimble nature of the company, with the ability to take advantage of both commercial and defense opportunities, allowed them to survive this brutal period. Many of the poor numbers coming out of these previous quarters stemmed from the evaporation of contracts with Astrolink, WildBlue, and Boeing for Connexion, while management tried to hold on to its most important asset -- its engineers -- in the hope that commercial broadband would return. They are loyal to their people, and it has hurt them at times.

It took far longer for commercial broadband to resurface than they expected�but resurface it did! Connexion is back, WildBlue has been given a funding injection, and Astrolink's revival is in the works. Witness the recent payment of a very long-dated Astrolink receivable that amounted to almost 10% of outstanding accounts receivable. In the same period, defense spending has jumped. In a dramatic swing, bookings at ViaSat went from $26 million to $80 million in a single quarter. Backlog, which stood at $139 million at the end of FY2002, jumped to $208 million last quarter. Strong bookings will continue into the foreseeable future. 

What is not apparent in backlog numbers is the "phantom backlog" inherent in Viasat's business. The MIDS program may award them $30 or $40 million that enters backlog, but the program is worth $2 billion to the two or three bidders involved over the next 7 years. There is a blanket approval out there for the government entities to buy up to $300 million in INFOSEC equipment from three companies, ViaSat being one. The company's new KG-250 encryption device, now being developed at great cost to earnings, will be much in demand soon and available under that $300 million umbrella. Long-tail programs dominate defense, and it is not something readily apparent in a backlog number.

The revenue growth has returned with the typical lag after strong new order bookings, with quarterly numbers going from $42 million in Q2 2003 to a projected $56 million in the current quarter. Profitability remains an issue, and it's important to examine quarterly results closely to see that the most recent turnaround in margins continues. Common sense says that as development projects like those in information security or MIDS enter the pure production phase, margins will rise. Today, the highest margin product in the ViaSat stable is its UHF DAMA modem, in production for many years. Several of these defense products can have gross margins in the mid- to upper-40% range when mature. Time will tell.

Beating the big guys
ViaSat has also been successful in wrenching business from entrenched incumbents -- companies that would benefit greatly from taking it out of the competition picture and bringing its stable of talented engineers in-house. Mining the reams of Defense Department data on pending awards and solicitations shows just how many areas the company is penetrating. They hold the keys, literally, to the "network-centric warfare" that is so vividly portrayed currently on CNN. Datalinks, bandwidth-efficient satellite communications, and information security/encryption are what today's military is all about -- ViaSat absolutely excels in these areas.

My own work indicates they could be doing greater than $500 million in annual revenues within the next few years, which is a huge leap from the sub-$200 million level of today. This means a potential for outstanding returns from the April 24th close of $12.45.

Kevin Spellman is a registered investment advisor in St. Charles, Ill. He and his clients own shares of ViaSat.

The Bear Argument
By Tom Jacobs

Now that Kevin's made the bull case for his favorite scrappy communications company, allow me to rain on the parade. It sure is a popular little stock -- zooming 206% from its August 2002 low of $4.07 to yesterday's $12.45 close -- but I'm turning it down as a date to the investing prom. The case to sell and for experienced aggressive investors to short ViaSat is just too strong to ignore. I laid it out in detail in December 2002's issue of The Motley Fool Select, and here will hit the high points.

First, ViaSat may be a fine investment for you -- if you, like Kevin, think you understand the company's technology and its business model well. Too many people lost too much money in the telecommunications meltdown beginning in 2000 because they mistook cool and groovy technology for cool and groovy investments. If you know this is something special, even after you read the financials, great.

I don't know enough to say whether ViaSat is going to change the world of secure, encrypted communications -- whether for Uncle Sam or Captain Industry -- but I find enough to question strongly the CEO's assertion that ViaSat is a "defense-driven growth company." Growth? Sure, if you like increasing accounts receivable and inventory. These are the first of my "sell" signs.   

Receivables and inventory faster than sales
All else being equal, if sales increase, a business' accounts receivable and inventory may grow, too, and it's not abnormal. If receivables typically are outstanding for a certain period, then more sales mean more receivables. As for inventory, a company must stock more of its product to satisfy increased demand. Inventory may also even reasonably grow out of proportion to sales before new product introductions or in anticipation of increased demand. Think any retailer's hot Christmas toy just before the selling season begins.

But when receivables increase faster than sales for very long, this signals that management might be extending too-favorable credit terms, customers are having trouble paying, or, in the worst case, management is channel stuffing (pushing future sales into current periods and sacrificing future revenues). When inventory increases faster than sales consistently, any slackening in demand can mean a fire sale, and with fast-changing technical products, a painful write-off of obsolete goods.

Here is how ViaSat's sales, accounts receivable, and inventory growth look for the last seven quarters through December 2002, compared to the prior-year period:


Ending   Sales   A/R  Inventory

12/02    (2.2%)  9.8%  13.2%    

9/02    (20.2%)  9.0%  (1.0%)

6/02    (12.2%) 30.7%  25.3%

3/02      5.1%  25.2%  31.4%

12/01    16.2%  24.3%  33.9%

9/01     24.7%   2.0%  82.9%

6/01     33.3%   2.5%  76.6%

Wow. With the exception of A/R for the June and September quarters of 2001, A/R and inventory have increased faster or decreased slower than sales every quarter. We are not talking one-time product introductions. There is no way financially to keep this up for very long, and it means trouble if there is any slowing in demand.

If there is to be a turnaround at ViaSat, it will have to happen very soon. Like in the quarter just finished. And big time. 

Free cash flow?
You have to wonder about a company that claims GAAP earnings per share for the last seven fiscal years, but free cash flow only in one. It's one thing if a company is in its early years, plowing money into research and development, with no profits or free cash flow. But this isn't a brand-new company fresh out of an IPO boom. It's been around.

On the other hand, firm order backlog has increased for the last three quarters, and the company has produced free cash flow (net cash from operations minus capital expenditures) in the last two quarters during which it had its lowest gross margins in the eight years I tracked. Isn't that a sure sign of a turnaround?   

Maybe, but it could be a sign that in the best of times, the company can't do that well. The boost in the net cash from operations part of free cash flow has come from a working capital management. One of our favorite measures of this, the Flow Ratio, shows how long a company can put off suppliers vs. collect from customers. Anything over 2.0 is in the danger zone.

ViaSat's Flowie decreased in the most recent quarter from a dangerous 3.74 to a less lousy 3.11. The company can wring more improvement from cash management, but only so much: It hasn't had a Flowie under 2.0 on a full-year basis since 1996. And while pushing out accounts payable may be a sign of strength in a large, powerful company, it's a warning sign from a small company that hasn't produced GAAP profits since 2001.

Remember that ViaSat doesn't have a lot of room to maneuver. It ended year 2002 with $4.4 million in cash and equivalents, and was in violation of covenants on $14.4 million in short-term debt.

By the way... taxes and expenses
And if the funded order backlog, growing for the last three quarters, flowers in technicolor? There are two problems. First, the company will go back to paying taxes, and that will reduce income. At the same time, expenses will increase. For years, ViaSat has been capitalizing certain software development costs -- over $5 million in the first three quarters this year -- instead of expensing them. Management noted recently on a conference call that this cushion is over.

Sooner or later, a company sells for a valuation that's a reasonable multiple to its growth -- whether a multiple to GAAP earnings or free cash flow. Let's say that the sun shines and the company returns to its boom EPS years of $0.46 a share. Are we talking a P/E of 25? Please. That's 60% higher than hot L-3 Communications, growing at an astonishing rate and throwing off $2.63 in free cash flow per share -- more than its EPS. (Pssst... L-3 has problems of its own, but I'm just sayin'.)

Slice it how you want -- P/E, price to free cash flow, a discounted cash flow analysis assuming blue skies ahead, and I still don't see how the shares are worth more than half of their current price. That's enough for me not to buy, and in December, it was enough for me to short. I'm not alone, with 16% of the float short and 34 days to cover.

I think this boat is too big to turn around before it hits the iceberg.

Tom Jacobs is a Motley Fool senior analyst. He is short ViaSat.

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