On August 11, 2010, Computer Sciences Corporation (NYSE:CSC) reported its operating results for the first quarter of its fiscal year 2011. Chain Bridge Investing (CBI), after reviewing these results, still maintains that CSC is an attractive long-term investment opportunity. In this article, we briefly discuss CSC’s transparency efforts, backlog, pipeline, book-to-revenue ratio, and operating margins. While there are many other topics that could be discussed following the company’s recent earnings release (see conference call transcript here), we believe that – at this time – these topics are pertinent to understanding/monitoring the company’s long-term potential.
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Increased Transparency for Shareholders
During the earnings call, CSC’s management – for the first time – publicly disclosed the magnitude of the company’s backlog and the company’s revenue exposure to foreign currencies. Since Michael Mancuso joined CSC as chief financial officer, management has made various attempts to increase CSC’s transparency and appeal to investors. This increased transparency may be motivated by management’s desire to drive CSC’s stock price higher. Such moves are most definitely appreciated by Chain Bridge Investing as it helps us to better understand the company and could serve as part of the catalyst that increases the company’s market value.
Backlog Grows to $41.8 Billion and Provides a Base for Future Revenue
In the company’s most recent 10-Q, total backlog was stated at $41.8 billion, which is an increase of $1.6 billion from the prior year. The backlog is approximately 2.6 times CSC’s fiscal year 2010 revenue. At present, $33.3 billion of the company’s backlog is expected to be realized in fiscal year 2012 and beyond, while $8.5 billion is expected to be realized during the remainder of fiscal year 2011. One should note that CSC has quite a few active indefinite delivery, indefinite quantity (“IDIQ”) awards, which are not included in the company’s backlog. The company only records the value of the task orders of the IDIQ that it wins, and CSC had a win rate of 70% (including re-competes) in fiscal year 2010.
Furthermore, CSC has a $34 billion pipeline of potential contracts this fiscal year, compared to $28 billion from last fiscal year. Considering CSC’s backlog, historical win rate, and pipeline, one can see that CSC continues to gain business and has a solid base of contracts upon which to build out revenue for the next two to three years. These factors should make any long-term investor happy.
Nevertheless, we believe it would be helpful if the company would disclose how much of the backlog is to be realized in the next three years and the amount that is to be realized beyond the next three years.
Book-to-Revenue Ratio Drops below 1.0 Times
A metric that we closely watch is CSC’s book-to-revenue ratio, which declined from .90 times for the first quarter of fiscal year 2010, to .81 times for the first quarter of fiscal year 2011. As a general rule, we do not like to see this ratio drop below 1.0 times for an extended period of time. Such an extended drop would most likely imply a future decline in CSC’s revenue. Yet, CSC’s book-to-revenue ratio, historically, has been very volatile and there does not appear to be a sustained pattern of seasonality to the ratio.
In the last four quarters, this is the first where the company’s book-to-revenue ratio dropped below 1.0 times. Yet, we recognize that this does not represent an extended decline. In fact, as fiscal year 2011 continues, this quarter’s book-to-revenue ratio may not matter much, especially if CSC records the $18 billion plus in bookings that it has issued as guidance. Such bookings would most likely put CSC’s book-to-revenue ratio above 1.0 times. At this time, we do not have a reason to be concerned about the decline in the book-to-revenue ratio, but we will continue to monitor it in the future.
Margin Improvements Continue to Be Driven by Reduced Depreciation and Amortization Expense
CSC continues to draw attention to its increased operating margins; however, as seen in the exhibit, most of the margin improvement continues to come from decreased depreciation and amortization expenses. The first quarter earnings before interest, taxes, depreciation and amortization (“EBITDA”) margin remains flat at 12.7% compared to the margin from the prior year. The earnings before interest and taxes (“EBIT”) margin is when the majority of the year-over-year increase margin occurs and the only change from the previously mentioned margin metric is the inclusion of depreciation and amortization expense.
Company management believes these increases are sustainable due to its recent focus on eschewing growth that is dependent on large capital expenditures. Nevertheless, as discussed earlier, we would like to see more of the increases in margin to come from a reduction in other expenses, than from the reduction in depreciation and amortization expense. If margins were to improve as a result of a reduction in other expenses besides depreciation and amortization, then we believe that could be a possible catalyst for increases in the company’s stock price. Similar to the book-to-revenue ratio, this is another factor that we will continue to monitor closely as time progresses.
Disclosure: Author is long CSC