Science Applications International's CEO Discusses F4Q2014 Results - Earnings Call Transcript

Apr. 8.14 | About: Science Applications (SAIC)

Science Applications International Corporation (NYSE:SAIC)

F4Q2014 Earnings Conference Call

April 08, 2014, 05:00 PM ET

Executives

Paul Levi - IR

Tony J. Moraco - CEO

John R. Hartley - EVP and CFO

Analysts

Cai von Rumohr - Cowen and Company

Amit Singh - Jefferies

Christopher Sands - JPMorgan Securities LLC

Edward S. Caso - Wells Fargo Securities LLC

Operator

Good day ladies and gentlemen and thank you for standing by. Welcome to the SAIC Fiscal Year 2014 Fourth Quarter Conference Call. During today's presentation, all participants will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions) This conference is being recorded today Tuesday, April 8th, 2014.

And I would now like to turn the conference over to Paul Levi. Please go ahead.

Paul Levi

Thank you. Welcome to SAIC fourth quarter and fiscal year end 2014 earnings call. Presenting with me on the call today are Tony Moraco, our Chief Executive Officer; and John Hartley, our CFO.

Today, we issued our earnings release detailing our quarterly and year end results. Additionally, you will find presentation slides on our website. Both of these documents, in addition to our Form 10-K to be filed soon, should be utilized in evaluating our results and outlook along with information provided on today's call.

During this call, we will make forward-looking statements to assist you in understanding the company and our expectations about its future financial and operating performance. These statements are subject to a number of risks that could cause the actual events to differ materially and I refer you to our SEC filings for a discussion of these risks, including the risk factors section of our registration statement on our Form 10 and the quarterly report on our Form 10-Q.

In addition, the statements represent our views as of today. We anticipate that subsequent events and developments will cause our views to change. We may (indiscernible) at some point (indiscernible) disclaim any obligation to do so.

I will now turn the call over to our CEO, Tony Moraco.

Tony J. Moraco

Thank you, Paul, and good afternoon. SAIC's financial results for fiscal year 2014 were in line with our previous communications and John will discuss the financial details later in the call.

We operated the last quarter of fiscal year 2014 as an independent, standalone company following the separation from our former parent, and I'm proud of the transformation of our operations, attributable to the focus of our leadership team, and the dedication of all of our employees supporting our customers during significant year of change.

I'm also pleased with how well we have improved our competitiveness by reducing our cost structure. We're leveraging our newly implemented matrix operational model to provide more of our capabilities to all of our markets and customers.

Regarding the market environment, since our December call, the two-year federal budget deal was passed in the generally favorable environment during this timeframe compared to full sequestration.

We believe customers will have a more stable budget outlook to execute their missions and are now able to prioritize their expenditures over a multi-year period unlike what we have seen recently. However, fiscal challenges still remain for our customers but the challenges may now be addressed by a more rational and deliberate approach.

We continue to see demand for the services and solutions that SAIC provides, new contract opportunities that we can pursue. We also expect some improvement of our customers' contract award decisions as the government fiscal year progresses. To that point, we have noticed slight improvements in the pace of contract decisions so far in our first quarter.

Moving to our business development efforts, we continue to develop a quality pipeline of opportunities aligned with our strategy to protect our revenue base, expand revenues with current customers, and grow into adjacent markets where appropriate.

At the end of fiscal 2014, the value of our submitted proposals awaiting decision totaled $14.8 billion, which represents an increase in buildup through the year and a 26% increase from the end of our third quarter.

SAIC finished fiscal 2014 with total contract backlog of $6.7 billion. The fourth quarter book-to-bill was only 0.3. Our fourth quarter book-to-bill is historically a low bookings quarter. This was below our historical average.

There were three items that significantly impacted our book-to-bill in the quarter. First, our customer award decisions were light as a result of budget uncertainty and government shutdown leading up to the bipartisan budget act. However, uncountered decisions that were made, our win rate was at our historical average.

Second, we had low bookings on our existing Army, Aviation, & Missile Command or AMCOM Task Order 32 caused by the delay of the recompete award and the existing Army Task Order hit the funding sale.

And finally and perhaps the most significant was a much higher amount of de-bookings on existing programs than we previously experienced, which was approximately $200 million higher than our historical average.

These de-bookings were associated with three specific contracts with the majority of the de-bookings related de-scoping of low-fee or non-fee bury material pass-through or subcontract activity.

So, while these de-bookings impacted our fourth quarter book-to-bill, we do not see it will have a negative impact to our operating income. Some of the de-bookings we experienced were indicative of the budget pressures that our customers are facing than their prioritization of their missions.

Without these impacts, we would have delivered a quarterly book-to-bill in line with our historical average for the fourth quarter.

Looking past the end of the quarter, we have signs of increased award activity and several notable wins aligned to our protect, expand, and grow strategy. In the protect category, we were successful in our recompete of our large AMCOM EXPRESS Task Order 32.

Now known as Task Order 37, this very important win of an $836 million, three-year recompete allows us to continue to provide excellent support for the Army's most critical mission in the area of lifecycle systems and software engineering support to provide world-class aviation and missile systems support for the joint war fighter. I'd like to remind you that bookings are only recognized on the AMCOM EXPRESS Task Orders when funding is committed on technical instructions over time.

Progress on our strategies to expand the current customers was evident in the award of a $221 million Task Order with the Army's Human Resources Command for full lifecycle information technology support.

While this Army Command has been an important customer of SAIC for decades, we were the incumbent on a portion of this work. We were successful in expanding our contract scope to provide system maintenance, enhancement, and development support vital to managing their personnel. This is a great example of our ability to expand our relationships and contract revenues with current customers.

With regard to the growth category, we have made qualified opportunities before the spin. In the fourth quarter, we submitted over $200 million in proposals to customers we had not pursued in the past.

Although it will take some time to convert submits to revenue, SAIC was awarded a relatively small Air Force contract that gives us entrée to develop and deliver, change management and communication services as the Air Force integrates many separate financial management systems into one integrated system. This three-year, $5 million win with the Air Force illustrates our newly expanded reach into previously unserved customers.

During the fourth quarter, a longstanding protest for $70 million Navy contract to provide Naval Surface Warfare Center, creating electronic warfare engineering support, was resolved in our favor.

We're still awaiting the government's decision on two other major programs under protest. The DHS EAGLE II contract is still in a re-evaluation process by the customer and the NASA HHPC contact award is under reconsideration by the GAO on behalf of NASA's award of the contract to SAIC but protested by the incumbent.

I'd like to take a moment to talk about our new operating model. Just a bit over a year ago, we designed and have now fully implemented our new matrix structure that is focused in two dimensions; the customer safety groups that manage the contract portfolios and the service lines that aggregate our technical capabilities.

This efficient and effective organization is critical to fully leverage our strong customer mission understanding and our tremendous technical capabilities of our workforce. We're now operating on five customer groups following integration of our Defense and Logistics Agency portfolio with the DoD Agencies and Commands Group.

We continue to align our resources in eight service lines to deliver services and solutions across the full lifecycle of engineering services and enterprise IT disciplines.

We believe that the implementation of a matrix organization is compelling in this government services space. This model will result in a more collaborative organization and one that is more competitive that can drive improved operating margins.

One example is our ability to optimize our proposed solutions to increase our SAIC labor content, reduce dependencies on subcontractors to result in higher contract fees.

We continue to put our words into action with regards to capital deployment as well. Capital deployment in excess of our minimum operating cash flow level, the foundational tenant of SAIC. And during the fourth quarter, we took another step in returning shareholder value.

In addition to our recurring cash dividend payable on April 30, we imitated a share repurchase program. At the beginning of mid-December and through the end of January, we repurchased approximately 363,000 shares, deploying $12.5 million of capital.

Absent higher return on capital deployment opportunities, we expect to continue buying back shares with our cash in excess of our operating needs.

I will now turn over to our CFO, John Hartley to discuss our financial results.

John R. Hartley

Thank you, Tony. In order to provide a better view into SAIC's operating results, my comments on this call will exclude the minor amount of revenues and cost performed by our former parent and will be primarily focused on SAIC's performance for the fourth quarter as opposed to the full year, as it reflects SAIC's first full quarter as an independent company.

Our revenues for the fourth quarter were $931 million and we ended fiscal year 2014 with just over $4 billion in revenue, which aligned with our guidance. As expected, this represented a year-over-year revenue decline for the whole year of 14% and was driven principally by the ramp downs of the DGS program and also by the completion and ramp down of IT and logistics programs related to the drawdown in Afghanistan, the completion of a program to provide technical support to the Army and lower materials and subcontract work on Navy contract vehicles.

While on the subject of year-over-year revenue decline, as we have communicated previously, we expect the first quarter of fiscal 2015 will result in a double-digit year-over-year revenue decline, then reach improved stability in revenue as we exit from the year-over-year revenue decline towards the second half of fiscal 2015.

Moving onto operating income, we had fourth quarter operating income of $56 million, representing 6% of revenue. After several quarters of significant separation expense impact, this was largely behind us in the fourth quarter with only $1 million of separation costs or 10 basis points impact to operating margins for the quarter.

We believe that our fourth quarter profitability is representative of the current state of our business but there is significant room for improvement in this area.

Optimizing our operating margin is a key area of focus for us and we have various levers available to show steady improvement in this operating metric over time. We're committed to enhancing profitability with the objective of 10 to 20 basis points of average annual improvement until we reach a level more reflective of the markets where we operate.

Net income for the fourth quarter was $33 million, which resulted in diluted earnings per share of $0.66 for the quarter or $2.27 for the year. Our tax rate for the quarter was 36.5%, slightly below our expected normative tax rate going forward of around 38%. This considers that the R&D tax credit expired at the end of calendar 2013 and has not yet been extended.

I will now move on to the balance sheet and cash flow statement. Our days sales outstanding or DSOs were 59 days at the end of the quarter, which is an eight-day improvement over the prior quarter.

You will recall that our Q3 DSOs were significantly impacted by the government shutdown and the planned 10-day shutdown of our IT systems related to the separation. We're very pleased to report that we have fully recovered from these adverse effects and are in a more normative DSO range.

Accordingly, we ended the year with $254 million of cash. Our cash flow from operations was $125 million for the quarter and $183 million for the year, well in excess of our guidance of $125 million for the full year.

We also had fourth quarter capital expenditures of $6 million, which is in line with our normative level of approximately $20 million on the annual basis. Important to our operating cash flow is in the coming quarter is our pending contract novation due to the separation. Disruption in this largely government-led process could have a temporary negative impact on operating cash flow, but we do not expect this will have an ongoing impact.

Regarding SAIC's capitalization, we're in active dialogue with our Board of Directors regarding our leverage ratio. Over time, we plan to move toward a capital structure more appropriate for a business of SAIC's steady and substantial cash flow by increasing our debt level over time.

We believe that our cash generation and balanced sheet flexibility allows us to simultaneously invest in growth, return capital to shareholders, and pursue selective acquisitions when compelling opportunities present themselves.

Additionally, for now, we view $200 million as our average minimum cash level for operating purposes, but this will likely come down as we get more comfortable with our financial operations and working capital requirements.

Moving onto our long-term financial targets, at our Investor Day in September and subsequent investor conferences, we provided long-term financial targets for our company. Those targets, which we expect to achieve on average and over time, remain unchanged.

First, low single-digit organic revenue growth; second, operating margin expansion of 10 to 20 basis points annually; third, return of capital in excess of operating needs absent higher return capital deployment opportunities; and fourth, financial leverage appropriate for a company with SAIC's investment requirements and cash generated characteristics.

Going forward, given the longer-term targets that I just reiterated, our commitment to providing transparency into our quarterly results, the greater market and offering alignment of the company post-separation, we do not believe there is added benefit to providing annual estimates of revenue, EPS, and cash flow as it was initiated while we were part of our former parent.

We expect to comment on our long-term targets and update them in our quarterly process should our views change in the future. Our policy on discloser of long-term targets instead of annual estimates of financial metrics should in no way suggest that we have reduced visibility into our future performance.

Rather, this reflects the desire of Management and the Board to align investor expectations more closely with our own and is reflective of how we intend to manage the business. I would like to reiterate that the Board, Tony and I are fully committed to providing appropriate business and financial transparency to help our investors in making informative invested decisions about SAIC.

With that, I will turn the call back over to Tony.

Tony J. Moraco

Thanks, John. We recently announced that France Cordova left our Board of Directors to take on a critical role for our country as the Director of the National Science Foundation. I would like to thank France for many years of service and participation in the separation process as one of the initial Board members of our independent company.

We wish her well as she serves our country in this challenging and important role. Our proxy statement will be distributed soon to shareholders, but I'd like to announce that our annual shareholder meeting will take place on June 4th at our McLean, Virginia offices. I encourage all shareholders to attend this event.

I very much look forward to fiscal 2015. The leadership team and I remain resolute in our primary objectives of sustaining revenues, improving operating margins and further optimizing our operating structure while we effectively deploy our capital.

Before taking your questions, I would like to thank all SAIC employees for their continued dedication and focus on performance during a year of dramatic change. Your efforts have resulted in a very successful year of transition and positioned SAIC for success in fiscal 2015.

Operator, we're now ready to take questions.

Question-and-Answer Session

Operator

Thank you sir. (Operator instructions)

Our first question comes from the line of Cai von Rumohr with Cowen and Company. Please go ahead.

Cai von Rumohr - Cowen and Company

Yes, thanks so much So, Tony, the $200 million of de-booking approximately when might that have hit in fiscal 2015?

Tony J. Moraco

Cai, that will be spread across the rest of the year based on what we saw those come through across all the contract vehicles. So that will be spread across the rest of that of FY 2015.

John R. Hartley

And also I would point out that these are multi-year contracts, so it's actually spread over a number of years. So, the impact to FY 2015 is nowhere near $200 million.

Cai von Rumohr - Cowen and Company

Got it. How big might it be?

John R. Hartley

We don’t see it having a significant impact based on the type of revenue that we had on what we are expecting for FY 2015, it's more in the out years that we see it having a drag.

Cai von Rumohr - Cowen and Company

Terrific. And then just a comment maybe if you could some of the margin issues in the fourth quarter, the gross margin looked pretty good there at 8.5, did it have any award fees or catchups? The SG&A, a little higher than I’d guess, what's the run rate going forward and I assume that’s the last separation expense?

Tony J. Moraco

I think the profitability kind of was in line with what we expected as we came out of the spin. You saw the light separation costs were part of that. The contract performance delivering fees in the normative range of what we would expect. So, since your point, we didn’t see anything unusual coming out of Q4 on the margin side.

Cai von Rumohr - Cowen and Company

Terrific. Thank you very much.

John R. Hartley

Thank you, Cai.

Operator

Thank you. Our next question comes from the line of Jason Kupferberg with Jefferies & Co. Please go ahead.

Amit Singh - Jefferies

Hi. This is Amit Singh for Jason. Just wanted to come again on the overall discretionary spending or the budget -- government spending environment. So, have you actually -- since defining with the budget deal, if you could add a little bit more, have you actually started seeing a pickup in another contracting and awarding activity?

I'm just trying to tie this with recent comments from some of your peers. It seems to indicate that maybe the pickup just never happened and that they were more pessimistic than you if I would put it that way.

Tony J. Moraco

I think what we are seeing coming out of the budget deal, the reassessment by the customers of what their spend profiles are going to look like, building on our prioritization as they had looked at all over the last year.

I think like our peers, we have not seen a lot of activity in the contract award decision in those first two months. We looked at January and February. We're seeing pickups in certain customer sets. We commented on the AMCOM EXPRESS deal and that efforts continue.

But generally, I think we will be in line with overall expectations that it be the end of this calendar year, end of government year, if we start seeing any additional contract award above the levels that we saw in 2013.

Amit Singh - Jefferies

All right. Great. And then you reiterated your long-term margin guidance, but since last few quarters, have you identified any additional cost take-out opportunities?

John R. Hartley

First, I want to make it clear that we're not providing guidance. We have long-term targets. We continue to look at cost take-out activity, so that one, we meet our commitments to our customers and stay on our rates, also monitoring our direct labor base closely.

But we will continue to optimize the organization through FY 2015 and this year of optimization. So, there certainly will be some additional reductions in costs whether that's labor or non-labor, we're still annualizing, but we will be making those throughout the year.

Amit Singh - Jefferies

All right. Thank you very much.

Operator

Thank you. Our next question comes from the line of Joe Nadol with J.P. Morgan. Please go ahead.

Christopher Sands - JPMorgan Securities LLC

Hi good afternoon guys, this is actually Chris Sands on for Joe. John, you had mentioned that there could be a temporary disruption to cash flow this year from contract a novation issue. Can you quantify how big that might be for us?

John R. Hartley

It's difficult to quantify because it would depend on how long it progressed. We're in a very awkward situation where there's a name change to our former parent, and at the same time, we need a novation to occur over to us.

Again, it is largely government-led. We don't project that there is going to be a significant impact. We think it will recover quickly. We haven't seen a large impact to-date. We don’t expect there to be a huge perturbation in Q1, and we would certainly be expecting to be back on target in Q2. Of course, we'll update you in Q1, if that turns anymore bleak, I just wanted to make all of you aware of that situation.

Christopher Sands - JPMorgan Securities LLC

Okay. So, it's not something that would stretch out into 2016 and then disrupt cash flow for the whole year?

John R. Hartley

Absolutely not. We certainly -- it won’t go past the first half of the year or the first three quarters on our belief.

Christopher Sands - JPMorgan Securities LLC

Yeah. And then sticking with cash flow, you started the share repurchase this quarter. You are now $50 million above your kind of target balance and you said you were comfortable with leverage going even higher. Should we expect repurchase activity to increase from this level going forward or how should we think about that?

John R. Hartley

What I will say is we anticipate deploying the capital in a consistent manner of what is in excess of our operating needs. So you have picked up on the fact that we ended the year in excess of our operating needs. We also have the ability to move up the leverage.

So that may very well indicate an acceleration or an increase in the amount of share repurchases we do in the future. That would be required based on what you saw through the end of the year to deploy our available capital and that is of course as since higher return capital deployment opportunity.

So, just consistently expect again if we don't have those higher return capital deployment activities to deploy the excess capital that we have available to us. Right now, share buyback is what we would intend to do.

Christopher Sands - JPMorgan Securities LLC

Got you. And then on few of the discrete revenue items, can you just remind us how much of the headwind will be this year, and then maybe how much Afghanistan will be what it was in fiscal 2014 and what you expect in fiscal 2015?

John R. Hartley

Yeah, I'm so are you asking how much headwind that is for FY 2015 on year-over-year.

Christopher Sands - JPMorgan Securities LLC

Yes, for both this and Afghanistan?

John R. Hartley

Yeah, so you can expect that year-over-year to decline double-digits in the first quarter as you I have said that’s our fourth double-digit decline in the fourth quarter, but we do anticipate that we'll start to hit a steady state.

If you look at our revenues for Q3 and Q4 when adjusting for seasonality which is minor, we do think those are indicative of a more normative run rate trend for looking into FY 2015 and projecting our performance.

Christopher Sands - JPMorgan Securities LLC

Okay, great. Thanks guys.

John R. Hartley

Yeah. Q3 and Q4 of FY 2014.

Christopher Sands - JPMorgan Securities LLC

Right, understood.

John R. Hartley

Thanks Chris.

Operator

Thank you. Our next question comes from the line of Edward Caso with Wells Fargo. Please go ahead.

Edward S. Caso - Wells Fargo Securities LLC

Hi. Can you talk a little bit about the NASA contract and is it still in the protest, is it still with the GAO and any sense of timing?

Tony J. Moraco

Yes, the NASA deal is still under reconsideration by the GAO, based on the actions that NASA took as part of the protest process. They had a 100-day clock that went forward from last quarter or so we would suggest that by the end of April that clock expires no guarantees would it typically hold to that date.

What I was -- we would see for GAO's response back to NASA, and then based on that outcome, NASA would have to make formal decisions and we are awaiting those as well.

Edward S. Caso - Wells Fargo Securities LLC

Right. Can you talk a little about the impact of Afghanistan activities? Several companies have talked about the level of activity, especially with pass-through as being lower than anticipated. That seems to be a common theme in the last few quarters.

Is it running below your expectations, given the election uncertainty and probably a rising probability that the military will be completely out of Afghanistan by year end?

John R. Hartley

Sure. I will answer that. This is John Hartley. We don't have a lot of OCO exposure in Afghanistan remaining. In fact, it's about $50 million in FY 2015 give or take, and so done we expect -- we expect that to come to fruition as we do some of the wind down. There could be a slight underrun but that's kind of what our exposure is.

Edward S. Caso - Wells Fargo Securities LLC

Okay. And if you could talk a little bit about how the senior management is compensated. Obviously, you've provided us a very squishy scorecard here to guide to the score you on. Curious to see how your -- the senior management scorecard works with the Board?

Tony J. Moraco

Yeah, this is Tony. The incentive plans are aligned around these targets and emphasis are on operating margins. It is more awaited than revenue and cash flow, but those are the three dimensions that we measure short-term and long-term.

Post separation, we've also instituted a performance share plan. It also aligns to the similar measures with again emphasis on operating income and cash flows. So, we think it's very well-aligned to the shareholders interest. We have the full Board's support in that and I would expect to deliver on those plans.

Edward S. Caso - Wells Fargo Securities LLC

Great. Thank you.

Tony J. Moraco

Welcome.

Operator

Thank you. Our next question is a follow-up question from Cai von Rumohr with Cowen and Company. Please go ahead.

Cai von Rumohr - Cowen and Company

Yes. So, first question is, normally your first quarter is cash flow negative and you've mentioned that contract -- potential contract novation issue. So, if you kind of run normal negative you could be down toward the $200 million. Would it be fair to assume that you might be a little bit more cautious on cash deployment opportunities early in the year until you're through those two issues?

John R. Hartley

You're likely to see that, although we project our cash flow out so that we don’t mind dipping below $200 million. That's what we would consider an average. We always have the revolver available to us.

So, we want to deploy capital on a consistent basis, so we didn’t project quite far forward in making the decision on what to deploy. You're likely to see Q1 operating cash flows to be negative as we have seen in the past because that's when we paid some of our bonuses and other things that occur. But that won't really dissuade us from looking a little longer term on how much to share repurchase. But it may not accelerate significantly in Q1.

Cai von Rumohr - Cowen and Company

Okay. And then you had mentioned I guess that on AMCOM EXPRESS you only booked the task orders and then you had this Army HR health contract. So, how much with the bookings you've gotten so far from those be in the quarter just so we can kind of gauge where are you starting off in the quarter?

Tony J. Moraco

Yeah, so the healthcare one is a booking. So, with the task order -- we do book task orders for every other contract except AMCOM EXPRESS. When you look at AMCOM EXPRESS, when they issue a task order, it really is an IDIQ vehicle because other customers come and issue what they call technical instructions and that’s truly the tasking audit. And so, AMCOM comes in as funding is committed. But the army one will be booked in the first quarter.

Cai von Rumohr - Cowen and Company

Okay. And then your SG&A was $23 million in the quarter. I've been looking for somewhat less how should we think about your SG&A run rate as you go through the year.

John R. Hartley

Yeah. We think we'd hit back to our more normative level of SG&A. Again, it aligns with the way we disclose our -- in our disclosure statement to the government. So, it includes certain items. You could expect this to be in the neighborhood of between 2% and 3% for FY 2015 is where you'd expect us to be trending.

Cai von Rumohr - Cowen and Company

Terrific. Thank you very much.

John R. Hartley

Thank you.

Tony J. Moraco

Thanks Cai.

Operator

Thank you. And I'd like to turn the conference back over to management for any closing remarks. Please go ahead.

Tony J. Moraco

Thank you very much. I'd like to thank you all for your interest in SAIC and participating in the call today. And we wish you all a good evening.

Operator

Thank you. Ladies and gentlemen this does conclude our conference for today. If you would like to listen to a replay of today's call, please dial 303-590-3030 or 1800-406-7325 with access code 4670471. Thank you for your participation. You may now disconnect.

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