I think many investors spend too little time thinking about their investing horizons when contemplating new positions. Although "buy and hold until it works out" is probably the default strategy for many investors, it can lead to some tense moments in the short-term. That brings me to Cubic (NYSE:CUB), a company which I think has a very interesting long-term outlook, but may well underperform for the next year or two.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

In a Class by Itself in Training and Simulation
A large part of Cubic is built around defense systems, and more specifically simulators used to train pilots and soldiers. While other defense-related companies such as Lockheed Martin (NYSE:LMT), L3 Communications (NYSE:LLL) and Boeing (NYSE:BA) all have simulation/simulator and training offerings, Cubic has roughly 80% global share for air combat training and similarly significant share in ground combat ranges.

Alas, strong share in a military business is a decidedly mixed blessing today. While training is going to remain significant to the United States and its allies, lower defense budgets and lower enlistment targets aren't likely to help this business in the near-term.

Transportation also a "Tough Today, Good Tomorrow" Market
I see a similar potential challenge in the company's transportation business. Cubic has built a solid business in automated fare systems and smart cards, but municipalities around the world are seeing tighter budgets and less ability/willingness for federal governments to help out. That leaves Cubic to fight it out with Alstom, Thales, Xerox (NYSE:XRX), Siemens (NYSE:SI) and Federal Signal (NYSE:FSS) for more limited transportation budget funding and forces transportation authorities to pick and choose particular projects.

Longer-term, however, it's hard not to feel good about a strong transportation infrastructure business like this. Major cities in North America and Europe need to update aging and overtaxed systems, while emerging markets such as Brazil, China and India are in many cases finding they have to upgrade and expand systems to cope with increased urbanization and pollution.

A Management Transition Changes the Risk Profile
After the passing of founder and CEO Walter Zable in June of this year. Given that Mr. Zable was 97 years old at the time of his passing, I would hope that the company's board had already had discussions of how it would approach an eventual management transition. As such, I would think that the company would look for an internal candidate (CFO William Boyle was named the interim CEO). Nevertheless, even with Mr. Zable's son (Walter C. Zable) as chairman, there are always disruptions when a company sees new leadership - particularly when it has been run by the same person for more than 60 years.

SEE: How To Improve Your Leadership Skills

Adding to the risk profile is a restatement of the financials covering multiple years. The issue revolves around how the company recognized revenue and profits from in-process projects, and while these issues are not uncommon (and it does not appear that the company deliberately overstated results), it adds noise to a situation that is already turbulent because of the change in management and the ongoing worries about national military and transportation budgets.

The Bottom Line
Although Cubic exited the most recent quarter with a pretty healthy-looking backlog, the fear is that orders will dry up over the next couple of years. Many European governments are pursuing more austere budgets (whether voluntary or not), and it seems like the U.S. federal budget is going to see some substantial trimming as well, no matter which party claims the White House in November. Even if the next couple of years are tough on orders at Cubic, I still like the long-term earnings potential. Militaries are not going to abandon advanced simulation-based training, and municipalities cannot ignore their transportation infrastructure needs indefinitely.

So here's the challenge for Cubic investors - the stock may simultaneously be cheap on a cash flow basis and expensive on a P/E or EBITDA basis. I think the company may indeed be hard-pressed to grow earnings or EBITDA enough over the next two or three years to support today's multiples, but I also think that even just 3% forward free cash flow growth supports a low-end fair value in the high $50s, while 5 to 6% growth boosts the target into the high $60s.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  2. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  3. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  4. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  5. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  6. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  7. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  8. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  9. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  10. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  1. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  2. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  3. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  4. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  5. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  6. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>

You May Also Like

Trading Center