I love spinoffs. They're the place to find unwanted companies abandoned by the market. It's one of the key places that I find value stocks for my Special Situations portfolio. So this week I'm buying stock in Vectrus (NYSE:VEC), a recent spinoff of Exelis (NYSE:XLS). This defense contractor has seen shrinking revenue as some government contracts wind down, but now trading at less than 8 times earnings, it should make a solid purchase longer term as the company stabilizes its business and pays down debt.
Vectrus provides infrastructure management, logistics and supply chain management, and IT and communications to the U.S. government globally. Operations are spread across 18 countries on four continents, and all revenue come sfrom the U.S. government in one form or another. Vectrus's primary customer is the Department of Defense, with virtually all of its revenue – 92% -- coming from the U.S. Army. Concentrated, yes, but that also provides an opportunity for expansion.
Performance on its contracts has been solid. The company has had some customer relationship for more than 30 years with many successful recompete contracts. Vectrus is often rated at the highest levels for its performance on contracts.
The company has a variable cost structure, meaning it can be more flexible as contracts roll off and on. And ongoing fixed capital investment here is minuscule, much less than 1% of sales over the last three years. That means the company is highly cash generative. Operating margins should end up between 4%-5%, modest levels and one of the reasons that the higher-margin Exelis wanted to jettison Vectrus into its own public listing.
The company's cost flexibility is important, because it's undergoing a massive roll-off of Afghanistan-related contracts, as the U.S. slowly exits the Asian nation by 2016. And those contracts will have to be replaced with new revenue. The company plans to expand its geographic footprint, by focusing on new opportunities in the U.S., Middle East, and North Africa. It's also looking to broaden its customer base, planning to expand service to other military and governmental agencies.
And with the spinoff into a separate company, it's good to have increased management attention to this business, which may have been lost among Exelis's higher-margin businesses. Members of senior management have an average of 28 years of relevant experience. CEO and President Ken Hunzeker joined the company in 2010 and is a retired lieutenant general.
Vectrus currently trades around 7 times this year's earnings. It's cheap because of the uncertainties about the business. But it also means that there's little expectation built into the stock price, so we're getting upside for free. Moreover, if management can simply hold the business steady and pay down debt – one of the key uses for its free cash flow over the next couple years – investors could see decent returns of about 15% annually over that period. That's a low hurdle for a solid return.
Foolish bottom line
My Special Situations portfolio is buying Vectrus while Mr. Market expects little or nothing from it. But even a stable business and debt paydown alone should see us earn decent annual returns. And if business picks up a little, there's even more upside. So I'll be buying $1,000 in Vectrus on the next market day.
Jim Royal has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.