Defense stocks have underperformed in 2020 as investors fret about the upcoming U.S. election and the pandemic, and their potential ramifications for defense contractors.

I think those fears are overblown, which has created some buying opportunities. Here's why I'm focused on the defense IT segment in particular, and why I just added ManTech International (MANT) shares to my portfolio.

MANT Chart

MANT vs. S&P 500 data by YCharts

1. Defense IT is a budget survivor

The Pentagon's budget is expected to be flat, at best, in the coming years, and there are concerns that Washington's massive emergency spending in response to the pandemic may require cuts to defense spending down the road. However, those cuts would not be made evenly across the board, so defense investors should focus on areas that are likely to hold up well in any environment.

Defense IT companies like ManTech took it on the chin from 2012 to 2015, the last time the Pentagon's budget was under pressure, and investors have been bracing for the worst this time around. But I believe defense IT will hold up better than some military hardware manufacturers.

Aerial view of the Pentagon.

Image source: Getty Images.

For one thing, neglecting IT spending in the early part of the last decade put the government's digital transformation push behind schedule, and some military officials have asserted that the deemphasis on IT helped contribute to some of the high-profile leaks that occurred during that period. Now, the public is more aware of cybersecurity threats, and further delaying digital upgrades in key areas is unlikely to be viewed as acceptable.

Military priorities have changed as well. During the prior period, the Pentagon was focused on the global war of terror, which required equipment and personnel that consumed a healthy chunk of the defense budget. I expect that in the next period of belt-tightening, spending on equipment will be more selective, with winners and losers chosen between hardware platforms, but for IT to survive.

2. ManTech's impressive transformation

That's the argument for defense IT broadly, but there are a lot of companies serving that market for investors to choose from. I considered CACI International (CACI 0.12%) and Science Applications International (SAIC 0.05%), as well as adding to my position in Leidos Holdings (LDOS 0.75%). I think all are set up well to beat the market, but ManTech offers the most ways to win.

It's fresh off a multiyear shift away from grittier work including providing outsourced logistics and related tasks in the Middle East. Those contracts paid off well in the early 2000s, when ManTech was a go-to vendor for the Pentagon in Afghanistan and elsewhere. But that work dried up, and the company in recent years has been shifting toward higher-margin IT.

Investors are now beginning to see the fruits of that shift. ManTech has weathered the COVID-19 pandemic's disruptions well; in late July, it reported quarterly earnings per share and revenue that topped analyst expectations by 29% and 11%, respectively. It also raised its full-year guidance, and its quarterly bookings came in ahead of what was billed.



Analysts' Consensus Expectation

2Q earnings

$0.84 per share

$0.65 per share

2Q revenue

$632.5 million

$570 million

Source: ManTech International, Yahoo! Finance

More than 40% of ManTech's business today supports the intelligence community. Intelligence work is usually a budget battle survivor, and the contracts tend to be more lucrative than run-of-the-mill IT due to the specialized requirements.

ManTech ended Q2 with a backlog of more than $9 billion in contracts, with new business -- as opposed to contract renewals -- accounting for more than half of its trailing 12-month bookings. The stable book-to-bill ratio in the period set the company up well for the September quarter, which is typically the most active for contract awards because it marks the end of the government's fiscal year.

Due to COVID-19, the decisions on some of those awards could slip into the final months of 2020, but with a pipeline of outstanding bids topping $6 billion, ManTech is set up well to achieve strong revenue growth in 2021 and beyond.

3. There's M&A potential

ManTech's transformation was fueled by M&A, but the company has been relatively quiet on that front of late, despite others in the space being active. That's likely to change.

During the company's post-earnings call in late July, CEO Kevin Phillips noted that deal talk had cooled earlier in the year, but said "we are actively reviewing M&A opportunities as we have seen the market return and we will execute on those that are strategically and financially compelling fits."

Acquisitions come with risks, but ManTech has been a serial acquirer and has an established playbook for how to handle integrations. It has also historically focused on small to mid-sized deals that are unlikely to capsize the overall business even if things go wrong.

There's also a chance ManTech could switch from buyer to seller. Co-founder George Pedersen built ManTech and ran it for 50 years before handing the CEO role to Phillips in 2018. As long as Pedersen was at the helm, a sale of the company seemed unlikely. But Pedersen, 84, is now stepping back further from the tiller; in early September, he transitioned from executive chairman of the board to chairman emeritus.

Scale is vital in defense IT and ManTech, with an enterprise value of $3.19 billion and a well-performing business, would make an attractive target for a range of potential buyers including both the aforementioned CACI ($6.94 billion enterprise value) and SAIC ($6.84 billion).

It's unwise to buy stocks based on takeover speculation, and I see good upside for ManTech as a standalone operation. But I'm also not going to be surprised if it ends up the target of a buyout bid in the next 18 to 24 months. ManTech has a lot of ways to win.