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NCI (NASDAQ:NCIT)

Q2 2013 Earnings Call

July 31, 2013 4:30 pm ET

Executives

Ali Ferguson

Brian J. Clark - President and Director

Lucas J. Narel - Chief Financial Officer, Executive Vice President and Treasurer

Marco F. de Vito - Chief Operating Officer

Analysts

Edward S. Caso - Wells Fargo Securities, LLC, Research Division

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Gautam Khanna - Cowen and Company, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the NCI, Inc. 2013 Second Quarter Earnings Conference Call. Today's call is being recorded.

I would now like to turn the presentation over to your host for today's call, Ali Ferguson, Corporate Communication Manager for NCI. Please go ahead.

Ali Ferguson

Good evening, and thank you for participating in NCI's conference call today. By now, you should have a copy of the press release we issued a short time ago. If not, it is available on our website at www.nciinc.com.

With us are our President, Brian Clark; and our Chief Financial Officer, Lucas Narel, both of whom will deliver prepared remarks. Our Chief Operating Officer, Marco de Vito is also here to participate on the Q&A portion of the call.

Before we begin our discussion, it is important that we remind you that on this call, we will make statements that do not address historical facts and are thus forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to factors that could cause actual results to differ materially from anticipated results and include the risks and uncertainties identified in our earnings press release under the caption Forward-looking Statements. For a full discussion of these factors and other risks and uncertainties, please refer to the section entitled Risk Factors in NCI's Form 10-K and Form 10-Q filed with the Securities and Exchange Commission. Also, we undertake no obligation to update any of the forward-looking statements made on this call.

I will now turn the call over to Brian Clark.

Brian J. Clark

Thanks, Ali, and good evening. I'll start with a review of NCI's results for the second quarter, and Lucas will follow with more color on the numbers and guidance for the remainder of the year. I'll come back with updates on key business development metrics, win strategies and NCI's pipeline in particular.

Second quarter revenue came in at $83 million, close to the high end of the guidance range we issued on last quarter's call. Earnings per share was $0.14, which exceeded the top end of our guidance range by $0.02. As was the case last quarter, earnings per share was higher than forecasted due to the timing of certain items, such as receipt of award fees, as well as better-than-expected contract performance.

Net bookings in the second quarter represented a book-to-bill ratio of approximately 0.4:1. NCI is continuing to meet and/or exceed expectations for revenue, margins and earnings per share. Cash flow and DSO also improved sequentially as prior customer payment issues were resolved in the quarter. Although the second quarter saw an uptick in bookings, we have yet to secure a game-changing new award, although I believe we have significantly better positioned NCI to bid and win these larger programs when they are ultimately adjudicated and awarded.

I'll give more specifics on what we're encountering and how we're responding to the current procurement environment in my final comments after Lucas' remarks. Lucas?

Lucas J. Narel

Thanks, Brian, and good afternoon. For the second quarter ended June 30, 2013, revenue decreased by 9% or $8.2 million from the same period a year ago to $83 million. The decrease resulted primarily from the expiration of task orders and contracts; reductions in scope of work, including $3.8 million from our PEO Soldier contract; and funding shortfalls as a result of customers' budgetary constraints. The year-over-year decrease was partially offset by revenue from new contracts and task orders.

Our PEO Soldier contract accounted for 13.9% of revenue compared with 16.8% of revenue for the same period during 2012. Revenue came in just below the high end of our guidance for the quarter. Contracts where NCI is the prime contractor, accounted for 89% of revenue for the quarter compared with 90% last quarter and 87% in the second quarter of 2012. DoD and Intelligence contracts made up 75% of total revenues, while Federal and Civilian contracts comprised 25%. The portion of Civilian contracts was up 1 percentage point sequentially and unchanged year-over-year. Fixed-price contracts accounted for 29% of revenue, up 1 percentage point from the first quarter in 2013 and up 5 percentage points year-over-year.

Time and material contracts are 23% of revenue, up 2 percentage points sequentially and down 3 percentage points from the second quarter of last year. Cost-plus fee contracts accounted for 48% of revenue, down 3 percentage points, sequentially, and down 3 percentage points year-over-year.

We expect that our percentage of total revenues from cost-plus fee contracts to increase and our percentage of total revenue from time and material contracts to decrease for the remainder of the year.

G&A expenses decreased 3.4% or approximately $200,000 for the 3 months ended June 30, 2013, compared with the same period a year ago. During the second quarter, our continued investment in business development was more than offset by reduced staffing levels in other areas.

Operating income for the second quarter of 2013 was $3.3 million, up from $2.8 million for the second quarter of 2012. Operating margin for the quarter was 4% compared with operating margin of 3.1% in the second quarter of last year. Operating margin increased due to improved contract performance, reduced overhead and G&A expenses and lower depreciation and amortization.

Net interest expense was approximately $200,000 for the quarter as compared to approximately $400,000 for the corresponding quarter last year. The decrease was primarily attributed to lower overall weighted average loan balance offset by a slightly higher weighted average borrowing rate.

Net income for the quarter increased to $1.8 million from $1.5 million in the second quarter of last year. The increase in net income year-over-year is attributable to the factors affecting operating income and lower interest expense offset by an increase in income taxes and a higher effective income tax rate.

Diluted EPS for the quarter was $0.14 compared with $0.11 in the second quarter of last year. Diluted EPS exceeded the top end of our guidance by $0.02. Diluted EPS was higher than previously forecasted primarily due to the receipt of passthrough award fess and better-than-expected contract margins, particularly on fixed-price contracts.

Day sales outstanding or DSO was 69 days as of June 30, 2013, down 9 days from 78 days reported last quarter. Cash provided by operating activities was $8.2 million for the 6 months ended June 30, 2013, and $16.5 million for the current quarter. During the quarter, cash flow from operations was used to pay down outstanding borrowings under our senior revolving credit facility by $16 million, leaving an outstanding debt balance of $10 million at June 30, 2013.

Contract backlog at June 30, 2013, was $570 million, of which $142 million was funded. This compares to total backlog at March 31, 2013, of $623 million, of which $162 million was funded. Net bookings for the quarter were approximately $30 million, equating to a book-to-bill ratio of 0.4x revenue.

And now moving on to guidance. For the third quarter of 2013, we expect revenues to be $70 million to $78 million and diluted earnings per share to be $0.09 to $0.11 on a weighted average diluted share count of 12.8 million shares. We are raising our full year 2013 revenue forecast to $304 million to $320 million and diluted earnings per share to $0.42 to $0.48 on a weighted average diluted share count of 12.8 million shares.

We estimate interest expense will be approximately $200,000 for the third quarter and $900,000 for the full year. Depreciation and amortization is expected to be $1.5 million for the third quarter and $6 million for the full year. Stock comp expense is expected to be approximately $400,000 in the third quarter and about $1.4 million for the full year.

And with that, I'll turn the call back over to Brian.

Brian J. Clark

Okay. We think, with 1 month into the third quarter of 2013, we still foresee fairly ratable revenue declines for the third and fourth quarters. However, we now believe that these declines will be less pronounced than our previous guidance suggested.

As a result of modest new wins, extensions and plus-ups on existing contracts in the first half of the year, we now feel confident in raising the low end of our annual revenue guidance and thus, the midpoint from $300 million up to $312 million. Our guidance continues to factor in the impact of federal budget constraints being the norm going forward. We still do not have a clear indication from our customers regarding the long-term effects of sequestration on our programs.

However, in the first half of this year, we estimate that sequestration-related cutbacks accounted for approximately $5 million of year-over-year revenue declines, concentrated in a few programs. Our full year guidance today assumes up to an additional $5 million of sequestration-related impact to the top line, for a total of approximately $10 million for the full year. The midpoint of our new revenue guidance range is $7 million higher, and earnings per share at the midpoint is $0.13 higher than what we guided to on last quarter's call. The raise of the revenue midpoint includes the factors I just alluded to: the modest revenue from new task orders, extensions and plus-ups to existing contracts and an impact from sequestration and budget-related cuts of approximately $10 million for the full year.

Now I want to turn to our higher EPS range. Although quarterly revenue, thus far, has been at or above the top end of guidance, reported earnings per share has been significantly higher than we expected. The midpoint of 2013 earnings guidance has gone from $0.20 in late February to $0.45 today. Part of this increase has come from purely operational gains. We performed better than expected on certain contracts during the first half of the year and expect that to continue in the second half as those contracts come to completion. We've also cut indirect costs in key areas, and we've succeeded in posting these gains in margins and earnings, while, at the same time, making continued planned investments in business development, particularly with strategic hires and enhanced bidding proposal capabilities. What's been harder to quantify and forecast have been the timing of pickups that boosted earnings during the first half of 2013 and could continue in the second half of the year.

I want to point out several areas that could provide upside to the EPS range we've guided to today. First, we expect to show continued improved performance on certain fixed-price and time and materials contracts, especially from better labor utilization on T&M contracts and more efficient execution on our fixed-price contracts. Second, we expect that award fees from past periods will continue to provide upside to our EPS numbers. Third, in the second half of the year, we may benefit from the resolution of other favorable gain contingencies that we've been working on over the past several quarters.

Although we baked in several pennies of these anticipated pickups into our published guidance, favorable timing could yield earnings beyond the range that we've provided. If we are successful in realizing some of these gains within the next 5 months, we could see approximately $0.05 more EPS above the range that we've provided today. However, we felt that given the variability and the timing of these pickups, it would not be prudent to include these upsides on our published guidance.

Now I'd like to provide an update on our overall business development and pipeline activity during the second quarter. During Q2, we submitted approximately $200 million of additional new proposals. We posted gross bookings of approximately $57 million, consisting of new awards and increases to existing contract ceiling values. Reductions in funding and several de-bookings brought net bookings to approximately $30 million or 0.4x revenue.

While it is certainly possible that we could see higher award activity in the third quarter, we expect that significant new awards will now be adjudicated in the fourth quarter of this year or early next year. However, any new -- any incremental new bookings in the next couple of months will have a slight impact on fiscal 2013 revenue.

As we told you in past quarters, we spent considerable energy and resources over the past 18 months to transform NCI's business development culture and infrastructure. I believe we now have strong prudent business development and capture teams in place and working effectively. Earlier this year, we established aggressive booking targets for fiscal 2013, and we remain focused on achieving those targets. But I also caution that our goals assume no continued material delays in the procurement process or cancellations of entire programs.

NCI, as well as nearly all of our peers, are experiencing significant delays, postponements and outright cancellations of major programs, both at DoD and in federal civilian agencies. A look inside NCI's pipeline of bids submitted and awaiting award illustrates the state of affairs. The time from a bid being submitted to adjudication, for us, is averaging approximately 9 months. On a dollar-weighted basis, this is even more glaring. Larger, needle-moving proposals are taking much longer to be awarded than smaller procurements and much longer than has historically been the case.

We continue to qualify more of our pipeline in the second quarter, and as of today, our pipeline stands at approximately $9 billion, and both the qualified portion and the average bid size of opportunities showed increases from last quarter. Of this approximately $9 billion pipeline, we expect to submit in excess of $1 billion of bids over the remainder of this year, with the majority of this value coming from individual bids of $50 million or greater. I have to emphasize, however, these figures assume RFPs will actually be issued on the currently announced schedules.

As I mentioned in today's press release, we are very encouraged by increasing proposal activity, particularly on several of our major IDIQ vehicles. While still not at the level seen in prior years, the volume is significantly better than earlier in the year. New wins in these areas, as well as one or more needle-moving new business awards, could meaningfully improve the revenue base going into 2014 and provide incremental pickups to this year as well.

And just a brief comment in closing, over the past 18 months, we've made top-to-bottom changes in the way we pursue, capture and bid new business opportunities. We fully expect these efforts will begin to pay off in the coming quarters. And just as important, we have been building a new growth culture in which everyone is encouraged to commit themselves to the collective goal of growing revenues and enhancing profitability and cash flow. I can tell you this new sentiment is palpable at NCI, as clearly evident in our performance to date this year.

With that, operator, we'll open the call up to questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Edward Caso with Wells Fargo.

Edward S. Caso - Wells Fargo Securities, LLC, Research Division

Brian, you mentioned that the -- you thought the awards fees could continue to the end of the year as the contracts ramp up -- ramp down here. Are there other contracts with that sort of upside potential in the queue for 2014? Or is this sort of -- would this -- could this be the end of it?

Brian J. Clark

Yes, there's a couple of things there to keep in mind. So award fees, as you would probably expect, I think we've talked about it in the past and probably in your dealings with other companies. Typically, you make an estimate of what you believe you would -- you'll ultimately realize. And in most cases, that has to be tied to what you can objectively project based on the award fee criteria. So we have had -- so as you would expect, that over time, there's a -- you would have award fees come in, in some lagging fashion. But on an overall basis, they would -- you'll always have some level of award fee in every quarter. You wouldn't expect to have too much lumpiness there. So that piece of it is starting to smooth out a little bit. But some of these pickups have been in certain areas. There were contracts that go back, in some cases, a few years ago that -- where award fees had not been adjudicated, and this is something that we've had our -- this has been a big area of focus in terms of continued cleanups of past activities. And so where we have these surprises, if you will, a lot of them -- we talked about it related to award fees. It has more to do with things that would be out of the norm. So it's not an award fee that relates to last quarter's performance on a contract that has to do with -- in some cases, an award fee that had to do with performance on a contract 3 years ago, okay? So as we kind of get through that backlog of that stuff -- this is just stuff that didn't -- frankly, didn't have adequate attention. And some of that has to do with -- and a big portion of it, frankly, has to do with stuff that we acquired. We're aggressively working through most of that, and so now we expect to have more of, call it, a regular schedule going forward, if that helps.

Edward S. Caso - Wells Fargo Securities, LLC, Research Division

All right. My other question is around furloughs. Are you seeing any impact, I know the defense department just got going about 2 weeks ago, both from an award perspective and from a DSO collections perspective?

Brian J. Clark

So on furloughs, we've had -- I would characterize it as being -- with the exception of a couple of specific cases, it's been somewhat anecdotal. We've had a couple of things where you've got a person here, a person there actually being furloughed. The only place we've had it, it's kind of a combination where you've got tasks that are ending and they -- and get renewed. So we had actually a pretty significant impact in the month of June, and I would characterize it as probably to the tune of about net 150-or-so people being furloughed for the month. And over half of that is -- are back at work again today, and it wasn't -- but it was not in the sense that you're talking about, where we're aligning up with a government customer. It's something that's kind of systematic, where it's a day a week or a day a month or a day a pay period or something like that. It's because tasks were coming to an end and because of kind of the current funding environment, rather than having us -- giving us authorization to proceed or without -- while we still worked out funding. Since there were question marks around that, they said, "Hey, you're going to have to deal with furloughing folks. And then, as we get the funding aligned and can issue the task orders, we'll bring them back." So that has been happening. So we had -- again, characterize it this way, we had probably about an impact of about 100 to about 150 people or so for a month, for the better part of a month, and then over half of them are already back at work today. So that played in the -- in large part, into the $5 million that I referenced in terms of impacts related to sequestration and budget issues.

Operator

And we'll go next to Bill Loomis with Stifel.

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

Brian, can you, first of all, just talk about the NETCENTS award and how that impacts your task orders, remaining ones you have? And then I have a follow-up on that.

Lucas J. Narel

The follow-up on NETCENTS award that was announced earlier this week was not a bid that we pursued as a prime. And we still -- we continue to work under the existing NETCENTS contract, and there's more activity to happen. A significantly larger award is still pending on NETCENTS-2. Frankly, we don't think that's going to hit until next year. So there's no immediate impact or any surprises for us at this point.

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

And that -- your current contract was extended for -- until 2014 some time, is that correct?

Lucas J. Narel

Right, right. And we're continuing to see task orders coming out on that bid. And frankly, we're spending quite a few cycles pursuing opportunities there.

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

On the -- just the decline in the second half, you mentioned the sequestration impact will be roughly the same as you saw in the first half, but we're going to have more periods of sequestration, 2 full quarters, plus kind of get the lag effect from when the cuts are effected. Why wouldn't you think it would be more in the second half versus the first half? What's the customers telling you to come to that conclusion?

Brian J. Clark

Yes, so Bill, we had the lion's share of that $5 million-ish that we referenced kind of happen related to a couple of isolated instances right at the end of the quarter, and we're already seeing them being resolved and funded pretty much through the end of the year. So we're not -- but it is certainly impacting the month of July, and in some cases, some people will not be coming back, we don't anticipate, until later in August and possibly even September. But they're coming back in tranches as funding comes in and new tasks are put out. So clearly, the answer is not 0, because we already knew we felt impact of it in the month of July, and we know that it will -- and some of these instances will continue on. We're not really aware of anything else. The place that I -- as I said when -- in Ed's question around the kind of anecdotal instances, we've had a couple of them where we've had literally a task where we've got 1 or 2 people, and they put us on some sort of furlough for a few cycles, and that's just not -- there's no impact to show up in our financial results as a result of something that small. But we have seen -- we've got T&M, or cost-plus contracts where you have an employee that leaves the company and you typically go and backfill it, see -- work on backfilling that position right away. We have seen it. This is where they've asked us to not backfill or to hold off on it, just to try to save a little bit that way. So when you kind of take into account all of those pieces, that kind of gets you up to those numbers that we're talking about. It's not an exact science, but there's definitely been some impact, but not something that's very definitive, as the customers having committed said, "Well, this is the sequester impact. You're getting dealt the card that says you're going to lose this task order. There's things we can get shut down." So we have not seen that happen to us.

Marco F. de Vito

It's Marco. I would say the other way to look at this is that while funded activity can get defunded to some extent, that happens much more infrequently than work that's not yet funded being at risk. And we're relatively well funded here through the rest of the year, so that improves our confidence.

Operator

And we'll go next to Tobey Sommer with SunTrust.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

I was wondering if you can delineate any kind of subsets of your customers that are performing and able to execute on contract awards any better than others. Is the civil side noticeably different than defense, for example?

Brian J. Clark

I'll let Marco answer as well. I don't think we've seen anything -- certainly, nothing that -- from my standpoint, that would indicate that a trend on either the civil or defense side and even within defense or intelligence, that there's anything, from an -- that's from an agency or a customer standpoint. I think that they are still, in a lot of ways, trying to figure out how to implement some of these reductions. As we've said before, one of the ironies that does exist here is that in the past couple of years, you haven't seen anything that's been bid or re-competed, where the new award has come out at any value close to -- it's certainly not greater than the prior contract. So these delays, it's interesting that everything keeps getting delayed and stretched out because just the sheer active re-competing work would save our customers money. So it's kind of one of the frustration we have with the whole -- with that whole problem. But we're not -- and I think that they're -- on the customer side, they're just trying to -- they're having a lot of strife made at overstating and not the award. But they are just trying to figure out where they really win, and I feel a lot of it has to do with what their-- what they think their expectations are going to be in terms of where their budget is going to be for '14, for government '14 year.

Marco F. de Vito

I think as a generalization, those -- the work that's being bid out of IDIQ vehicles is being awarded more quickly than standalone jobs, and the smaller and midsize job seem to be doing better than the larger jobs. We have a number of larger jobs that were just kind of stuck. They're more likely to be protested also, so I think that we have cautious customers between their funding constraints and the environment in general.

Tobey Sommer - SunTrust Robinson Humphrey, Inc., Research Division

Based on that kind of commentary, just as a follow-up, do you think that takeaways are incrementally more difficult in this environment? Or are you still confident that some of your big order or big bids, I should say, may convert in coming quarters?

Marco F. de Vito

This is Marco. I would say that, first of all, most bids anymore are takeaways or protections of your work. There's not a lot of new starts these days. I think that the cost pressures in the marketplace tend to provide opportunities for more takeaways. And as technical merit and past performance is weighing a little bit less vis-à-vis cost, I think that the big challenge with takeaways right now is those places where contracts are extended unilaterally to incumbents and decisions are postponed. I think that's our challenge with new business. On the other hand, on our existing business, that's been a positive thing that's happened. So that's a general trend in the marketplace that we're seeing.

Operator

[Operator Instructions] We'll go next to Gautam Khanna with Cowen and Company.

Gautam Khanna - Cowen and Company, LLC, Research Division

Wanted to get your opinion on how you can kind of manage costs incrementally, given the price pressure. I mean is there -- are you able to actually reduce wages? Or is that still a negative dynamic, price versus kind of direct labor cost and how you're able to do it?

Brian J. Clark

Gautam, this is Brian. I think we still have a number of levers we can -- we still have to work with. We have things we've talked about over the past 1.5 years or so. We've gone through a number of kind of restructurings, realignments of how we're set up. We've gotten out of facilities. We had -- unfortunately, about 2 years ago, had to do a fairly significant reduction in our staffing here, but that really was tied to the very substantial dropoff in revenue base when all the BRAC stuff dropped -- dried up. So I think we still got things that we can do, we can deal with internally. We have not had to cut salaries or anything. But as an executive thing, if that was something we had to do, we would do it ourselves. But it was not something we believe is necessary. We are very, very -- we're very focused on trying to improve on the results of the contracts that we have in hand. You've seen that occurring. You've also seen, for lack of a better way of putting it, a lack of bad surprises on contracts. We've not had anything go south in the last 2 years. So we continue to work on those things and focusing on continuing to build out and refine our capability around pursuing new business, and that's our #1 priority, is growing the top line.

Marco F. de Vito

This is Marco. I guess I would say that the way we try to look at opportunities and the cost pressures against those opportunities is to try and address cost savings through innovation. It's, frankly, pretty tough to deal with it through tweaking salaries or this and that, and we really have to find ways to do more with fewer people and do that through innovative approaches, technologies. And that's really our focus as we pursue jobs.

Gautam Khanna - Cowen and Company, LLC, Research Division

Okay. And just a follow-up on all the discussion on sequestration impacts. I mean, is there any way you can characterize kind of where you see vulnerability in the portfolio looking out next year? Because it appears that sequestration can actually get incrementally worse, as Bill alluded to in his question. I mean, when you look at the portfolio, what do you -- how big a slice of your portfolio you think is actually vulnerable to sequestration going forward, not just this year but looking out next year?

Get the crystal ball out.

Brian J. Clark

Yes, get out -- exactly, we need a crystal ball to answer. I think that you have to kind of look at the work that we do, and we all say that we do work that supports customer missions. It's the kind of stuff that -- a lot of it is work that needs to be done to keep the lights on. So you can trim around the edges and stuff like that. But it's also a lot of things that just can't be wholesale shutdown or shutoff or downsized significantly without our customers going through a great deal of pain. So I'm not sure, would that -- if that answers your question or not, but there's been no -- not that I'm aware of anyway, there's no -- there's been no specific instances of customers coming back or anything that would certainly be material in nature. So far, we see more the effect has been -- other than a couple of isolated cases, that have, in a lot of ways, kind of resolved themselves, it's kind of working around the fringes, where you've got customers asking us not to replace somebody who's left the company, so you lose that revenue until some future time when they let you bring it back, if at all.

Gautam Khanna - Cowen and Company, LLC, Research Division

Is there any...

Brian J. Clark

So we would see more of those impacts but not kind of wholesale shutdowns or chunks of the business going away.

Gautam Khanna - Cowen and Company, LLC, Research Division

Have you seen any increased incidents of just renegotiating already priced and agreed upon contracts so that they're just saying, "Hey, cut me an extra 2% off the cost" kind of midstream, at a point where you normally wouldn't have that type of discussion on a non-sequestration environment? Do you just see pricing pressure kind of across the board on already priced business? Is there any increase in that kind of dialogue going on with customers?

Marco F. de Vito

I think the only unilateral discussions I've seen have really been in requests to reduce staff and get adjustments as a result of that, but not as you described it.

Operator

And that concludes our question-and-answer session. I would like to turn the conference back to our speakers for any closing remarks.

Brian J. Clark

That's it from us. If you have any follow-up questions, feel free to call or e-mail myself or Lucas, Marco or Larry Delaney and we'll get back to you. Thank you.

Operator

Thank you, everyone. That does conclude today's conference. We thank you for your participation.

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