Recommendation: I recommend refraining from the purchase of Booz Allen Hamilton (BAH) common stock. The business has historically generated ample excess cash flows and could achieve strong growth in the future. However, the business depends on the federal government for 98% of its revenue and profits. Predicting government demand ultimately proves futile and demonstrates BAH's weak pricing power. Consequently, the stock is unsuitable for investment.
Revenue and Profits (in thousands):
- Revenue: $5,859,000
- Op.Costs: 5,472,000
- Taxes: 104,000
- Net Income: 240,000
After adjusting for restructuring charges, amortization of debt, other depreciation and amortization, deferred income taxes, tax benefits utilized, and capital expenditures, it is more accurate to say that profit, or rather free cash flow, was $295,000 in FY2012. Looking forward, adjusting for increased interest expense, free cash flow for FY2013 will be $275,000. Consequently, the equity value represented in the open market suggests a forward free cash flow multiple of 7.3.
Government Consulting Industry Dynamics
The market prices the business with the hostility it might similarly hold toward a cyclical commodities operation. Yet, sustained economic advantages abound in the form of minimal capital investment, high returns on capital, and high barriers to entry distinguish the business from a highly competitive commodities operation.
Investment in property, plant, and equipment is minimal; compare Alcoa's (AA) 6% depreciation and amortization as a percentage of revenue compared with just 1% in the instant case. Return on assets is 17%, with virtually all of the profits available for distribution to shareholders. The largest cost is workforce, a variable cost that can be adjusted according to business conditions.
Unlike competitors, growth has come naturally, not as a result of aggressive acquisition strategies. Competitors have consistently spent up to four times investment in property, plant, and equipment on acquisitions, whereas Booz Allen Hamilton has rarely made acquisitions.
The company's long-standing relationship with its client, the United States Government, raises high the barriers to entry for potential market entrants. It is the eighth leading defense contractor by revenue. It is the leading technology consultant, along with IBM, in the world by revenue. And it started consulting to the government in 1941, when it assisted the Secretary of the Navy in preparations for the Second World War.
For the government, hiring new market entrants carries an unnecessary risk of loss. Booz Allen Hamilton has knowledge of, and experience with, government systems, which often they have helped to manage and engineer. They have a broad scope of expertise spanning a 24,000 headcount, 76% of whom hold government security clearances.
Thus, a persuasive reasoning approach to the company's historical business dynamics demonstrate that it is does not operate similarly to a perfectly competitive commodities operation.
As further proof of economic advantages, bidding figures on government contracts contribute additional support. The company has a win rate of 53% on first-time competed contracts. However, re-competed contracts, which had previously been won are re-won 91% of the time. This figure strengthens the conclusion that significant incumbent advantages exist.
Promising Additions to Earnings Power
The company is strategically focused on areas where the federal budget is expected to grow. Such areas as cyber security, conversion to cloud computing, healthcare IT, and energy infrastructure IT are all areas where the government is almost certain to increase spending over the next generation. Early indications of the company's success at transitioning toward new business include the "Cyber War" simulation, the Cyber Solutions Network, and the recent consulting and services partnership with RSA for cyber attack preparedness and response.
A non-compete agreement blocking the company from the private sector, established when it was split-off from a larger corporate structure in 2008, was lifted in mid-2011. Combined with newly quartered operations in Abu Dhabi, non-U.S. government business has since passed the 2% threshold as a percentage of overall revenue. The revenue from this line of business is potentially enormous, considering that the global cyber market is set to reach $80 billion by 2017.
In summation of the points so far discussed: a) the business operates in a high-barrier to entry industry, b) returns on capital are high, c) capital investment is low, d) strategic positioning toward growth areas is optimal, and e) a potentially massive line of business in the private sector is in its very early stages of development.
Government Demand and Pricing Power
If the operation is a fine-tuned engine, then government demand is the fuel. The issue is whether and to what extent an investor in common shares can rely on the federal government to allocate funds to management and technology consultation. The usefulness of predictions is largely a function of how certain we are about those predictions, and to predict government expenditure is an endeavor fraught with uncertainty.
The possibilities for how the federal government allocates capital over a generation or more are nearly endless. The baseline budget for defense, for example, could grow at a compounded annual rate of 2.5% in nominal terms from 2013 to 2021 as currently set forth by the Department of Defense. The stagnation, and potentially negative real growth, could put downward pressure on the company's operating margins so that historical margins of 6%-8% are reduced to 4%-6%. Fewer contracts on which to bid, in conjunction with a strict application of low-price, technologically acceptable (LPTA) could, foreseeably, result in such a scenario.
Alternatively, a large-scale proxy war could break out in Syria and spending on contractors could grow at the high rates of the 2000s. Yet another alternative is that sequestration takes effect and creates a slew of unforeseeable outcomes.
On a larger scale, post World War II outlays by the federal government have historically been about 21.5% of GDP, yet in the past few years we have seen outlays at up to 24% while government revenue declines and a greater part of income is made through the sale of debt as revenue collected from taxes is historically low. In what way this historical shift will resolve itself is anyone's guess. The wide range of outcomes combined with the lack of certainty, takes this valuation of demand for Booz Allen Hamilton's services into the realm of speculation.
The Carlyle Group LP (CG) holds 75% of the company's common stock. The group could reduce its stake in the company by issuing additional shares by as much as, if not more than, 25% of those now outstanding while retaining its majority control. Meanwhile, management, in large part, is compensated through the issuance of stock options.
While the risk of dilution is not certain, there is little, if any, protection against it occurring. In order to value the equity raise positively, it would have to be assumed that Carlyle was putting the money to good use. However, one of the attractions of BAH is that organic growth has been the general rule, and, therefore, reliance on rational deal making would have been unnecessary.
Because there is no protection against dilution, and because Carlyle is an active dealmaker with, arguably, more to gain than to lose by raising equity, the possibility of dilution poses a significant risk to the current value of the shares by as much as 30% or more.
The issue rests, finally, on whether demand for services can be relied on with confidence. In any worthwhile investment, positive results should be a near certainty. Predicting government expenditures, especially given current fiscal and political conditions, falls well outside the boundaries of arithmetic or logical reasoning. Statistical data of government expenditure may prove to be useless, or, worse yet, misleading. Available historical performance for industry peers going back to 1994 may very well represent data in which subnormal business conditions never occurred. Untouched in this analysis, but adding uncertainty, is the leveraged capital structure arranged by Carlyle.
As such, calculating either value or an adjoining margin of safety to protect against future adverse events becomes overwhelmingly difficult, and the security, therefore, seems unsuitable for analysis, and, consequently, for investment.