NCI's (NCIT) CEO Brian Clark on Q2 2016 Results - Earnings Call Transcript

| About: NCI, Inc. (NCIT)

NCI, Inc. (NASDAQ:NCIT)

Q2 2016 Results Earnings Conference Call

July 27, 2016, 04:30 PM ET

Executives

Joelle Shreves - Director of Marketing and Corporate Communications

Brian Clark - President and CEO

Lucas Narel - CFO

Marco de Vito - COO

Larry Delaney - IR Counsel

Analysts

Tobey Sommer - SunTrust

Bill Loomis - Stifel.

Mark Jordan - Noble Financial.

Edward Caso - Wells Fargo

Operator

Good day, ladies and gentlemen and welcome to the NCI Incorporated Second Quarter 2016 Earnings Conference Call. My name is Catherine and I'll be your conference operator today. This call is being recorded.

I would like to turn the presentation now over to your host for today's call, Joelle Shreves, Vice President of Marketing and Corporate Communications for NCI. Please go ahead Ms. Shreves.

Joelle Shreves

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 and CEO Brian Clark and our Chief Financial Officer Lucas Narel, both of whom will deliver prepared remarks. Our Chief Operating Officer Marco de Vito and Investor Relations Adviser Larry Delaney are here to participate on the Q&A portion of the call.

Before we begin our discussion, it is important 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 titled Risk Factors in NCI's Form 10-K and Form 10-Qs 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 turn the call over now to Brian Clark.

Brian Clark

Okay, thanks, Joelle. I'll begin with an overview of second-quarter results and then turn the call over to Lucas, who will provide more detail on the numbers and issue our updated guidance. I'll then return to provide additional color around our outlook, trends we're seeing in the sector, and how our business development team is responding to the current climate.

Second-quarter revenue was near the midpoint of our guidance range at $81.9 million, down 4.5% or $3.9 million compared to the same period last year. The decrease was due mostly to completed contracts, work that was set aside for small businesses, and reductions in staffing and scope of work on certain contracts.

Higher revenues derived under our expanded PEO Soldier program, growth in our Cyber Network Operations and Security Support, or CNOSS, program, and other new awards partially offset the decrease.

NCI's PEO Solider program accounted for $13.6 million or 16.6% of revenue in the second quarter. That's up from $8.2 million or 9.6% of revenue in Q2 of last year. NCI's CNOSS program accounted for $9.3 million or 11.4% of revenue in the second quarter. That's up from $5.7 million or 6.6% of revenue in Q2 of last year.

Operating and EBITDA margins were also strong at 6.7% and 8.8% respectively. Q2 earnings per share was $0.23, which was at the midpoint of the guidance we issued on last quarter's call. Q2 bookings were solid at $88 million or 1.1 times revenue, and trailing 12-month bookings were 1.5 times revenue.

A majority of the second quarter's bookings were attributed to a task order under the $2.5 billion Unified Program Integrity Contractor, or UPIC, IDIQ vehicle for the Centers for Medicare and Medicaid Services. The remainder of Q2 bookings consisted of several smaller new business and recompete wins as well as plus-ups to existing contracts.

Several $50-plus million bids have been pushed out to the latter part of this year through mid 2017, causing us to reduce the anticipated new business component of our revenue guidance. I'll talk more about our updated guidance, our pipeline, and bids submitted and awaiting award shortly. And with that, I'll turn the call over to Lucas.

Lucas Narel

Okay. Thanks, Brian, and good evening. In the second quarter of 2016, NCI reported revenue of $81.9 million compared with $85.8 million in the second quarter of last year, a decrease of 4.5%. Brian outlined the factors behind the year-over-year decline in second quarter 2016 revenue.

Contracts where NCI is the prime contractor accounted for 94% of revenue, up sequentially and up 3 percentage point’s year over year. DoD and Intel contracts made up 64% of revenue in the second quarter, while federal civilian contracts comprised 36%.

Share of DoD and Intel contracts was up 1 percentage point sequentially and up 4 percentage point’s year over year. The DoD and Intel share increased year over year because of the growth in our PEO Soldier program and additional task orders awarded under our CNOSS contract.

The express contracts accounted for 22% of revenue, down 2 percentage points sequentially and down 7 percentage point’s year over year. Time and material contracts were 17% of revenue, unchanged sequentially and down 5 percentage points from the second quarter of last year.

Cost plus fee contracts accounted for 61% of revenue, up 2 percentage points sequentially and up 12 percentage point’s year-over-year. The increase in cost plus fee contract percentage is primarily a result of the new larger PEO Soldier program and a growth in our CNOSS contract, both which are cost plus vehicles.

EBITDA for the second quarter was $7.2 million or 8.8% of revenue, compared with $7.2 million or 8.4% of revenue for the same period in 2015. EBITDA margin for the second quarter of 2016 improved primarily as a result of the greater contribution of direct labor and more efficient absorption of indirect costs in the period.

Operating income for the second quarter of 2016 was $5.5 million compared with $5.3 million for the same quarter last year. Operating margin was 6.7% compared with 6.2% for the second quarter of 2015.

Operating income and margin increased as a result of the factors affecting EBITDA and EBITDA margin and lower depreciation and amortization and lower acquisition-related costs compared with the same period last year.

Net income for the second quarter of 2016 was $3.2 million compared with $3 million for the second quarter last year. Net income increased due to the factors affecting operating income and lower interest expense in the quarter.

Diluted EPS for the second quarter of 2016 was $0.23 compared with $0.22 from the second quarter last year. Daily sales outstanding, or DSO, was 60 days at June 30, 2016, down sequentially from 75 days last quarter. The decrease in DSO was mostly attributable to the resolution of certain invoice issues that affected first-quarter results.

Cash flow provided by operating activities for the three months ended June 30 was $13.7 million. Capital expenditures were $500,000 for the quarter, resulting in free cash flow of approximately $13.2 million.

With the $88 million in net bookings this quarter, NCI reported total backlog at June 30 of $507 million of which $120 million is funded. This compares with total backlog at March 31 of $501 million of which $147 million was funded.

And now moving on to guidance. For the third quarter of 2016, we expect revenues to be approximately $76 million to $82 million, and diluted earnings per share to be $0.22 to $0.24 on a weighted average diluted share count of 13.9 million shares.

We now expect full-year 2016 revenues to be in the range of $320 million to $332 million. Brian will detail the reasons for a reduction in the guidance range. We've also revised the earnings guidance as well, and now expect full-year diluted EPS to be $0.91 to $0.97 on a weighted average diluted share count of 13.9 million shares.

We expect interest expense for the third quarter to be approximately $150,000 and $600,000 for the full year. Depreciation and amortization is expected to be $1.7 million for the third quarter and $7 million for the full year.

Stock comp expense is expected to be approximately $200,000 in the third quarter and about $1 million for the full year. And we're forecasting an annual effective income tax rate of approximately 39%.

And as usual, we'll provide updates as events and circumstances warrant, and I'll now turn the call back over to Brian.

Brian Clark

Okay. I want to start with some more detail on our fiscal 2016 guidance. As Lucas said, we have lowered the range of our guidance to produce a new midpoint of $326 million, which is down $16 million from our topline midpoint forecasts last quarter of $342 million.

A combination of slippage and award timeframes, including protests, certain lost contracts, and opportunities not bid in the second quarter, and lower expectations on revenue for materials for the remainder of the fiscal year have made the realization of revenue in 2016 more challenging. As such, we're lowering our guidance range for the full fiscal year to align to our revenue expectations in the second half of the year.

As of today, our full-year revenue midpoint assumes approximately 92% coming from existing contracts, 6% from recompetes, and 2% from new business awards. As for EPS, the midpoint of our annual guidance is now $0.94, which is $0.02 lower than the previous guidance midpoint of $0.96. Our new fiscal 2016 EPS midpoint number implies EBITDA margins of 8.8% to 9.0%.

Our lower expectations on revenue for materials for the remainder of the fiscal year as well as our expectations for profitability on existing contracts and indirect cost spending yields only a slight paring of EPS guidance for the full year.

The lower end of the revenue and EPS ranges assume we maintain our existing contract base including recompetes with virtually no meaningful new business revenue contribution. The higher end of the ranges assume some level of new award activity that would begin to generate revenue and earnings in the fourth quarter.

This could occur if we see greater motivation to make awards prior to the end of the government fiscal year and ahead of any disruption that may occur as a result of the election cycle and a change in administration that will take place throughout the fourth quarter.

As we announced earlier this month, we were an awardee on CMS' UPIC IDIQ vehicle. This award not only positions us to continue our significant program integrity efforts in combating Medicare fraud, waste, and abuse for CMS, but also expands the scope of work to include Medicaid program integrity among other things.

We will shortly announce our award of the first UPIC task order for the Midwestern jurisdiction. Two additional jurisdiction proposals are due this month, and the remaining two RFPs should be released later this year.

NCI is very competitive within this marketplace as we currently hold task orders on the predecessor contract performing work in three of the seven geographic zones, which covers 31 states.

We are targeting several enterprise IT and infrastructure management opportunities across the Department of Defense later this year and into 2017, providing new avenues for growth. This represents one of NCI's core competencies in an area that's grown in the past year.

We're also seeing robust task order proposal requests on our Total Engineering and Information Systems, or TEIS, contract and expect this trend to continue. Under this contract vehicle, NCI provides engineering, information assurance, and systems integration services primarily to DoD customers.

As of today's call, we have over $400 million of bids submitted and awaiting award. We continue to be encouraged by RFPs we're expecting across all of our business areas, and we're still on track to submit bids aggregating approximately $1.5 billion during 2016. While we're seeing incremental improvements in the overall procurement climate, customer delays and bid protests continue to be the norm.

Our overall pipeline stands at nearly $10 billion. And while we have many large enterprise jobs in various stages of our pipeline, we're also seeing a greater number of opportunities for agile application development with a number of new as well as existing customers.

And although we continue to experience delays and other challenges to faster revenue generation, we remain optimistic that NCI is well positioned and has the capability to compete effectively in the coming quarters.

In addition, our profitability continues to be strong and we expect additional opportunities for margin expansion, especially on fixed price contracts.

Finally, we're also very active in M&A pursuits of both smaller opportunistic acquisitions and potentially transformational strategic transactions. We'll keep you posted on these activities as inorganic growth is going to be a key at building scale and differentiated capabilities that allow us to compete in more areas on a greater number of procurements.

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

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we'll go to Tobey Sommer with SunTrust.

Tobey Sommer

Thanks. Brian, maybe start off on the last comment that you had about acquisitions. How would you characterize the likelihood of sort of the smaller opportunistic acquisitions versus the transformative ones? And could you refresh us on what the Company's liquidity position is now to consummate transactions?

Brian Clark

Sure. Yes, so starting with your last question there, I mean, at this point, we're effectively unlevered. We've got, I think, $7 million of net debt at the end of the quarter, so we'll be presumably close to $0 here in the next couple of months.

So in terms of what I think that means with a new -- we'll also be undergoing a renewal of our credit facility that otherwise expires in January of next year. So I think a reasonable expectation in terms of what we can do on a larger side with debt financing would be.

I'd say comfortably, $150 million in either a single deal, or aggregate number of deals could be as high as $200 million. And that obviously takes into account the characteristics of a target. But that's kind of the range that we could do either in a single transaction or multiple ones, I think, with relative ease from a financing standpoint.

In terms of the targets out there, I mean, our focus has been on larger opportunities for a couple reasons. One, obviously you're going to move the needle more rapidly, bring us more capability quickly, and there's not a whole lot of difference in the level of effort it takes to close a larger transaction versus a smaller one.

The other major factor that comes into play here when you look at smaller, tuck-in deals, is the amount of small business revenue or exposure that those companies generally have. It's pretty rare to find -- and our experience has been looking at things even up in the $100 million range, it's not unusual to find companies that still have 20% to 25% of their revenue exposure to small business. And that makes it really, really tough.

Obviously, there's opportunities to structure around those things, but it can be pretty disruptive even if you're bringing a company on and there's a significant component of revenue that's going to inherently go away.

So we're looking at both. None of those statements are absolutes, but I would say, overall, the things that are $100 million and down generally have quite a bit of small business components, which are problematic from an acquisition standpoint.

Tobey Sommer

Thank you very much. The 6% of guidance from recompetes and 2% from new revenue, how does that compare to the prior quarter in your guidance?

Lucas Narel

I think last year we had about 8% in each of those -- recompete and 8% in new.

Tobey Sommer

So is it fair that even from the previous sequential quarter that the biggest change in guidance is the percentage change from new?

Lucas Narel

That's correct, yes.

Tobey Sommer

Okay. Maybe could you comment on the cash flow and the impact of DSOs? I'm just trying to get a sense for what sort of ongoing operating cash flow as opposed to DSO catch-up is likely to be this year.

Lucas Narel

Yes, sure. This is Lucas. I think we did a lot of the catch-up, as you can tell, this quarter. I do expect the DSO to remain in the low to mid 60s. And then overall, for the course of the year, I'd expect cash flow from operations to probably end up around 1.5 time’s net income. So I think we're on our way to normalizing to where we want to be for the full year, but still a little bit of a ways to go.

Tobey Sommer

Okay. And just kind of a little housekeeping. What was the percentage of sales in the quarter from prime contracts?

Lucas Narel

94%.

Tobey Sommer

Last question from me. Do you have an outlook in the back half of the year for PEO Soldier to contribute a like percentage as of 2Q, or is there some variability in the guidance there?

Lucas Narel

I'd say that's a good assumption. We think it'll be better than 15% as we look at the whole year, but I think we're kind of in the range.

Tobey Sommer

Okay. Thank you very much for the time.

Lucas Narel

Sure.

Operator

Thank you. We'll continue on to Bill Loomis with Stifel.

Bill Loomis

Hi, thank you. Good evening. Of the UPIC task order, how much was that?

Brian Clark

Which one, Bill? The one that we were awarded?

Bill Loomis

Yes, the Midwest one that you were awarded that made up, you said, a good part of the awards in the quarter.

Brian Clark

That was $77 million.

Bill Loomis

Was that a recompete?

Brian Clark

Yes, we consider it a recompete, Bill. I mean, it's under a new contract vehicle. But what's interesting about it is that it's a -- I guess the way that we look at it internally here is that it's a recompete of a portion of the work that we do. It actually crosses on the old contract that had seven zones -- the ZPIC contract had seven zones. And this new jurisdiction, Midwest jurisdiction, under the new UPIC vehicle takes states out of two of the existing zones that we work in, if that makes sense.

So there's an overlap there in terms of the work that we're doing in the locations. But then, as I said, there's an expansion of the scope of work, so there's an opportunity for the level of effort and, there for the revenue and earnings coming from those programs to be larger because the scope of work is larger going forward.

Bill Loomis

Okay. And then the pipeline, last quarter I think you had -- it was $11 billion; now it's $10 billion. What was the big delta for that change?

Brian Clark

Most of that, Bill -- so the way I look at it or what we focus on is really our qualified pipeline that was relatively static, may have been up a little bit in the last quarter. So what you're seeing there is things that we were kicking out as we went through the qualification process.

So that billion dollars that went down, it isn't something that we get concerned about. We look at that and say that's a good -- well, we say it's a good thing from the standpoint we're identifying it early on before we really apply any resources to it. So it's very early stage stuff that hasn't really had any investment or anything put on to it. And that's typical for us to go through that on an ongoing basis.

Bill Loomis

Okay. And in discussions with customers, is there any concern that the awards for the September quarter won't be as seasonally strong as they typically are because of the election cycle? Do you see any play there, or do you think it's going to be kind of normal seasonality on strong awards next quarter?

Brian Clark

We're not seeing or hearing anything specific to that. I think that as we -- I think it really depends on who you are in terms of who your company is and what you're doing in terms of how much you may or may not benefit from the year-end budget flushes. I think in general we all do.

I think in NCI's case, we usually see awards that might not otherwise get made till early in the fourth quarter, sometimes you'll see things kind of pull forward and get done. So it wouldn't surprise us if maybe some of those kinds of things happen.

But I think also, as I said in my comments, that part of what we're hopeful for here as well is that we'll see some anticipation on the customer side of disruption coming in the latter part of the year.

And so maybe that'll prompt them to try to push things out a little bit sooner ahead of that. But there's nothing specific. We're not getting specific guidance from customers or anything like that on that front.

Bill Loomis

Okay. And just one last quick one. You had mentioned that you expect fixed-price contracts to go up in the future, but we have CNOSS and PEO still growing, AdvanceMed. That UPIC work, is that cost plus, right?

Brian Clark

Yes, UPIC work is cost plus. PEO Soldier and CNOSS are both cost plus as well. What we're talking about there is that a great portion of -- as we look at the pipeline of things that are qualified that we expect to bid, we're seeing more things there coming out as fixed price versus cost plus in most cases.

Bill Loomis

Got it. So that's the future bucket that you could see that down the road?

Brian Clark

Yes.

Bill Loomis

Okay, thank you.

Brian Clark

Sure.

Operator

Thank you. Our next question will come from Mark Jordan with Noble Financial.

Mark Jordan

Good afternoon, gentlemen. Two questions. First of all, SG&A sequentially picked up about $700,000 versus the first quarter. Was there any specific one-time events in there? Were you doing some M&A expenses that hit the quarter?

Lucas Narel

Yes, I mean, if you look to prior quarters, we always have some fluctuations from period to period. So there was some specific consulting fees and costs that increased our expense sequentially from the last quarter. Some of those related to some of the activities we talked about, related to strategic transactions. So yes, that is attributable a little bit to the sequential uplift.

Mark Jordan

Okay. Could you also say what you are expecting when you re-establish your bank lines? What type of rate do you think you'll be able to obtain?

Lucas Narel

I think the market is pretty competitive right now. I would assume that we would get rates that are similar to what we have currently. Interest is still very low. Obviously, we'll be looking for a long-term deal, and some of the nuances with the covenants will be more important to what we're looking at to allow for some more freedom with what we're doing on the M&A side.

Brian Clark

And Mark, this is Brian. I think that the other thing that's a factor in that is it depends on how much leverage we would ultimately take on. So if we take into account our current EBITDA level and some reasonable expectations on potential targets.

If we're looking at doing things that would be a combination of things where a singular transaction may be closer to $100 million to $120 million, we'd probably do that inside of a senior secured credit facility, which is what we had typically done in the past, and that's going to be at a pretty low leverage point.

If we look at something that's going to be up more like $200 million, at that point, you're going to be at probably closer to four times leverage. You're going to be probably taking on institutional debt that's going to have a different pricing structure associated with it. But I think it's all very doable. But there'll be fluctuations in what those rates would be depending on what the debt level is.

Mark Jordan

Okay, thank you very much.

Operator

Thank you. [Operator Instructions] And Edward Caso with Wells Fargo. Please go ahead.

Edward Caso

Thanks. Hey, Brian. Curious, you had made a comment that you were seeing the pass-throughs running at a lower level. We sort of heard that elsewhere. Is there some nervousness maybe about spending existing money before year end? Or I mean, why are you sensing sort of a lower rate of pass-throughs?

Marco de Vito

This is Marco. We're seeing this across a number of contracts, although we're not hearing specific reasons for them. It may be caution that, at the end of the year, may free up, but it's hard to tell.

But so far, our clients are just playing it a little close to the vest on these procurements. But they are lower on a number places that we anticipated seeing more flow-through.

Edward Caso

So we've been hearing pockets of tight labor markets and difficulty in getting people to actually execute on one business. Is your mix, both of contracts and geographies that they're being fulfilled in, is that a challenge for you as far as getting people, or less so than your competitors?

Marco de Vito

I think, overall, our staffing ability has been pretty good. We've had a number of contracts where we had to staff up in the last six months. CNOSS and PEO Soldier are two good examples of that. Both those contracts are doing very well in terms of staffing levels and our ability to get the resources at competitive rates. So we're feeling okay about the marketplace right now.

Edward Caso

And just housekeeping. Can you repeat the guide breakdown between existing, recompete, and new?

Brian Clark

Sure. This is at the midpoint, Ed, so its $326 million. So at the midpoint, it's 92% from existing, 6% from recompetes, and 2% from new business contribution.

Edward Caso

Great, thank you.

Brian Clark

Sure.

Operator

Thank you. Our next question comes from Gautam Khanna with Cowen and Company.

Unidentified Analyst

Hi, it's Lucy on for Guatam. Just a couple follow-ups on the Q3 book-to-bill, which was better than expected. And were there any, sorry, Q3 book-to-bill, which is the next quarter, were there any large awards anticipated? You talked about the CMS that was anticipated for Q2.

And also, what sort of work that's fixed price in the pipeline? Because another peer of yours also talked about sort of higher mix of fixed price, time and material going forward. Just wondering if that's a trend across the industry?

Marco de Vito

I'll take that. This is Marco. So in terms of awards, we mentioned that we have over $400 million in submitted right now. I anticipate that a third to a half of that probably get awarded in this next quarter. We've been pretty consistently wrong in our predictions in that, but that's what it looks like right now.

In terms of the fixed-price work, we talked a little bit about UPIC contracts still being cost plus, so that's one area that hasn't changed. However, some of these larger enterprise jobs are going fixed price right now.

Some of CMS' other work has been moved to a fixed-price structure. And a lot of these agile development jobs are coming out as fixed price. So there seems to be a real trend towards fixed price. T&M is very rare anymore.

Unidentified Analyst

That's helpful. And then secondly, maybe if you can provide anymore granularity on the $16 million guide down at the midpoint in terms of revenues. You talked about a number of reasons. Was there one that's more than the other? And it sounds like you may be able to catch up more on Q4. Just any granularity on the $16 million would be helpful.

Brian Clark

It's probably about equally split in three parts with the things I indicated with things that are slipping to the right, some things that we were not successful on in terms of award decisions that were made in the second quarter, and things that we ended up no-bidding or made no-bid decisions on. And as we were just talking about, the revenue that comes from materials contribution that we really are not seeing in the second half of the year.

Unidentified Analyst

Got it. And…

Brian Clark

Yes, so that's right. So as Marco said, and that's what I said in my remarks earlier, when you look at all those factors, considering particularly the fact that you don't see a lot of margin on the materials at all, that's why there's a lesser impact on the earnings guidance.

Unidentified Analyst

Right, so that was actually my next question. Your EBITDA margin guidance is now 8.8% to 9%. It's not up. How come it's not up more given that you have better mix and lower pass-through? It seems like you also have higher direct labor content.

Lucas Narel

Yes, Lucy. This is Lucas. So obviously, the materials are going to draw less profit than other work that's more labor-driven. Our DL is definitely up year over year, and we expect it to continue to be up as we progress through this year as compared to last year.

But really, the other component of this is just the scale. Obviously, with the revenue expectation going down, there's certain fixed costs that we have that's not going to be able to maintain an even higher margin than what we're projecting. But we do feel very confident in the 8.8% to 9% EBITDA for this year and for the remaining quarters.

Unidentified Analyst

That's helpful. Thank you.

Operator

Thank you. And with no additional questions in the queue, I'd like to turn the call back over the Brian Clark for any addition or closing remarks.

Brian Clark

Okay, thanks, everybody, for taking the time to join us this afternoon. If you have any unanswered questions or follow-ups, please feel free to get in touch with Larry Delaney, and we'll get back to you right away. Thanks again.

Operator

Thank you. Ladies and gentlemen, again, that does conclude today's conference. Thank you all again for your participation.

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