SRA International F2Q08 (Qtr End 12/31/07) Earnings Call Transcript

SRA International Inc. (SRX)

F2Q08 (Qtr End 12/31/07) Earnings Call

February 05, 2008 5:00 pm ET

Executives

Dave Keffer - VP of IR

Stan Sloane - President and CEO

Steve Hughes - CFO and EVP for Operations

Barry Landew - EVP for Strategic Development

Analysts

Bill Loomis - Stifel Nicolaus

Tim Quillin - Stephens Incorporated

Joseph Vafi - Jefferies

Jeff Houston - William Blair

Edward Caso - Wachovia

Greg Wowkun - Bank of America Securities

Michael Lewis - BB&T Capital Markets

Alex Hamilton - Jesup and Lamont

Jason Kupferberg - UBS

Presentation

Operator

Good afternoon. My name is Marcello, and I will be your conference operator today. At this time, I would like to welcome everyone to the SRA International fiscal year '08 Q2 earnings call. (Operator Instructions).

Now I would like to turn the call over to Mr. Dave Keffer. Mr. Keffer, you may begin your conference.

Dave Keffer

Thank you, Marcello, and welcome, everyone. On the call today are Stan Sloane, our President and CEO; Steve Hughes, our CFO and Executive Vice President for Operations; and Barry Landew, our Executive Vice President for Strategic Development.

During this conference 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 actual events to differ materially, and I refer you to our SEC filings for a discussion of these risks.

In addition, the statements made during this earnings call represent our views as of today. We anticipate that subsequent events and developments will cause our views to change. We may elect to update the forward-looking statements at some point in the future, but we specifically disclaim any obligation to do so.

During this call, we will also refer to non-GAAP financial measures. A reconciliation of any non-GAAP financial measures to the most directly comparable GAAP measures is available in the IR section of our website at www.sra.com.

Stan Sloane

Thanks, Dave, and good afternoon, everyone. We appreciate your interest in SRA and look forward to updating you on our second quarter results and business outlook.

For the December quarter, revenue was $382 million, a year-over-year increase of 19%. Operating income was $29.7 million, an increase of 35%. Diluted earnings per share were $0.30, $0.05 above last year's second quarter, which included a gain on the sale of Mantas Incorporated.

Excluding that one-time gain, EPS increased $0.05 this quarter as a result of strong contract execution and more profitable mix of business. We received $328 million of contract awards in Q2, including several programs with significant expansion potential. Demand created by these new contracts and the $829 million of awards we received in Q1 enabled us to increase our headcount by about a 100 in the December quarter.

We also continued to invest in the marketing and sales function offsetting that investment with further efficiencies in G&A. Q2 operating margin of 7.8% improved 90 basis points year-over-year. To provide a more detailed business update, I would like to offer a perspective of the current industry environment.

Fiscal year 2008 civilian agency appropriations were passed in late December as part of the omnibus budget bill. The portion of the Iraq's supplement was also included in that bill and the remainder will be debated in the coming months. The passage of both civilian and supplemental appropriations occurred earlier than we had anticipated and had alleviated some of the growing budget pressure across our customers set.

With about half of our business in civil government arena, we are pleased to have new budgets in place for those agencies first time in over a year. But Iraq spending and deficit concerns continue to limit IT budget growth among many of our customers, and protest activity continues to delay many procurements.

Released yesterday, the President's fiscal year 2009 budget request calls for 4% growth in federal IT spending, with defense growth in the 2% range and civilian agencies more than 5%.

As the 2008 election approaches, we are mindful of a likelihood that agency leadership and spending priorities will continue to evolve. But we are confident that our diversified customer portfolio and leading-edge capabilities will position us well for the new administration. Having captured less than 1% of the market to-date, we have plenty of room to grow and prosper in the coming years.

Let me shift to new business, we won $328 million of business in Q2 including all of our significant recompetes. The December quarter is typically slow period for new contract awards, but we are pleased to win 17% more business than the December quarter last year. Our contract backlog stands at $3.9 billion, up $500 million for the fiscal year to-date.

I'd now like to highlight a few of the key contracts we won in the quarter. Our largest award was a $67 million task order in support of a new civil agency customer. We've already begun work on this program and we are enthusiastic about its potential to drive high quality labor services revenue growth.

Next, the company won a four-year $48 million contract to provide network support services for the Center for Information Technology at the National Institutes of Health. Since 1997, SRA has delivered an effective and reliable network infrastructure for NIH and supported network base services that empowered its researchers and administrators.

Third, SRA was awarded a three-year $18 million contract to provide law enforcement analysis and IT support services to the Office of Investigations at the U.S. Immigration and Customs Enforcement Agency. Services include a combination of analytical and technical support to make efficient use of available Homeland Security Data and identifying trust to national security.

Fourth, the company won three programs totaling $39 million for the U.S. Agency for International Development. The work involves HIV and AIDS policy development and that reach for nations on three different continents.

Our August acquisition of Constella dramatically enhanced SRA's international footprint, and programs like these enable us to play a vital role in the increasingly global health market.

We also won a prime position on a five-year multiple award vehicle with the $1billion ceiling which was support intelligence customer with the variety of IT services. As always, we do not include any value for ID/IQ and GWAC vehicles in our award totals of backlog, but they do provide significant opportunity for future growth.

As of December 31^st, we had about $1.4 billion in pending bids. Net figure has since increased to about $1.8 billion, the highest [best] pending awards we've ever had. We also have several key opportunities coming up in the next quarter and we are expecting proposed leverage to remain vigorous through the remainder of fiscal year.

Our total pipeline has nearly doubled in the last twelve months from $12.5 billion to $23.7 billion as we've added number of large opportunities for fiscal year '09 and beyond. We now have over 60 opportunities in the pipeline worth more than $100million.

Capturing more and larger, new contracts is a vital element of our strategic plan as we seek to accelerate organic growth into the double digits. We are also focused on enhancing the labor services component of our pipeline in order to drive margin improvement and recent wins demonstrate progress in these areas.

The National Guard AITS program is our largest single award contract. It is currently up for re-compete. Our bid was submitted under the Millennia contract vehicle in January. Customers anticipate making an award this quarter.

The AITS currently represents about 5% of our revenue and we are focused intently in the effort to retain it.

Before handing over to Steve, I would like to touch on the improvement or [hiring/retention] results over the last few months.

The abundance of new contract wins in September bolstered Q2 hiring, as we brought 441 employees on board, the strong total from seasonally slowest quarter. Voluntary attrition was 14% below the first quarter level of 17% and in line with historical averages.

Total headcount increased by 94 and net billable hires of well over 100 should lead to robust growth and labor services revenue in the second half of fiscal year '08.

Mary Good, our new Senior Vice President of Human Resources, joined us in mid-December with an extensive background in leading HR organizations for technology and government services companies. We welcome Mary aboard and look forward to supporting her in her efforts to enhance the company's recruiting training and employee development functions. Steve?

Steve Hughes

Thanks, Stan, and good afternoon, every one. We are pleased to have delivered a strong first half of fiscal year 2008. For the six months, revenues and earnings per share both increased by more than 19% and operating margins increased 80 basis points. For the second quarter, revenue was $382 million or $2 million above the high end of our previous guidance.

Total revenue grew by 19% year-over-year while labor services revenue grew 26%. Of the 19% year-over-year growth, the Constella and RABA acquisitions contributed 16 points of growth. Organic growth was 3% reflecting lower year-over-year rebillable revenues.

Operating income for the quarter was $29.7 million, up 35% year-over-year. Operating margin was 7.8%, 90 basis points better than last year given the richer mix of labor services revenue. Higher gross profits were offset by an increase in SG&A spending from marketing and sales, recruiting, training and product development efforts.

I'd like to highlight a few specific items that affected profitability in the second quarter. First, as we noted last quarter, we've been carefully examining our indirect cost structures to identify efficiencies. In Q2, we consolidated some facilities and wrote-off about $3 million of unrealized office space net of subleases.

This $3 million charge, which reduced our rent expense over the next five years, is included in SG&A for the second quarter. Going forward, we'll continue to look for further efficiencies and will keep you posted on our progress.

Offsetting the Space charge in the second quarter were two contract related games. We settled a claim for pick up of $1.8 million and we recognized a $1.9 million gain upon completion of milestones on a fixed price contract. These benefits slightly more than offset the Space write-off in the December quarter.

Stock-based compensation expense was $2.7 million in the second quarter on track with our expectations going forward.

The effective tax rate was 39.7%. Net income for the quarter was $18 million and diluted earnings per share were $0.30. Excluding the $0.04 gain from the sale of our interest in Mantas in Q2 last year, diluted EPS increased by $0.05 or 20% year-over-year.

Now turning to the balance sheet. As of December 31, we had about $105 million in cash and $50 million in debt for a net cash position of $55million. Accounts receivable were $345 million, up from $322 million last quarter. We had approximately $990 million of total assets and shareholders' equity of $681 million.

Now on to the statement of cash flows. Q2 operating cash flows were approximately flat and day sales outstanding were 75. Both metrics were influenced by the seasonally slow December holiday season for collections as well as a brief delay in contract payments from our customer and implemented a new payment system. We expect DSOs and cash flows to improve in the March quarter.

Q2 capital expenditures were $4.9 million. We did not repurchase any shares in the December quarter. Our mergers and acquisitions program remains our top program for capital deployment, but we will continue to consider opportunistic use of our repurchase authorities.

Before discussing forward guidance, I would like to update you on other key metrics. First, contracts business mix. As a percentage of Q2 revenues, cost plus business was 42%. Time and materials was 42% and fixed price was 16% essentially unchanged from last quarter.

Next national security contracts accounted for 53% of our Q2 revenue, civil government 28% and healthcare and other 19%. The health component increased from Q1 given the full quarter of Constella.

Next we were the prime contractor for 88% of our revenue in the quarter.

Finally, directly labor utilization was just over 80% in Q2. We finished the quarter with 6400 employees.

Looking forward we are providing initial Q3 and Q4 guidance and updating our guidance for fiscal year 2008. This guidance anticipates lower pass-through content than we have had historically given current budget pressures.

For the March quarter, we expect revenues of $380 million to $395 million and diluted EPS of $0.30 to $0.31.This implies revenue growth of about 22% at midpoint with an operating margin in the high 7% range, again reflecting a richer mix of labor services business than the third quarter one year ago.

For the June quarter, we expect revenues of $385 million to $400 million and diluted EPS of $0.31 to $0.33. This implies revenue growth of about 20% at the midpoint with an operating margin in the 8% range.

For fiscal year 2008, we expect revenues of about $1.511 billion to $1.541 billion. At the midpoint, that will represent year-over-year growth of 20%. The mid point is slightly lower than it had been previously given our increased focus on high quality labor services revenue and the recent budget pressures leading to lower rebillable revenues.

Our diluted EPS guidance for fiscal year '08 is $1.22 to $1.25. The midpoint of this range is slightly higher than our previous guidance given the strong second quarter results and improving gross margins. This implied full year operating margin is in the 8% range. The year-over-year diluted EPS growth midpoint would be 18% excluding the non-recurring 4% Mantis gain in the fiscal year 2007. Stan?

Stan Sloane

Thanks Steve. Last summer, we set forth upon a path to reach $5 billion in revenue with 10% operating margins by fiscal year 2012. I am pleased with our progress thus far. On the M&A front, Constella was a large strategic acquisition in a growing market and we're continuing to look for sizable acquisitions in other key areas. While larger deals often take longer to analyze and execute, we're currently pursuing several high potential candidates.

Turning to profitability metrics our 8% operating margin in the first half of fiscal year '08 was about 80 basis points better than the same period a year ago, indicative of our increasing focus on profitability.

We're pursuing more opportunities to deliver differentiated solutions and healthy margins and we're streamlining the SG&A functions in order to generate additional efficiencies. We're also making some changes to the organization in order to support future growth.

In addition to Mary Goods' appointment to lead the HR function, we recently redeployed Tim Atkin, former Director of our Civil business to become the Director of our Global Health business. We're confident that Tim's leadership will enable and [start] to integrate efficiently and productively in to SRA and we're enthusiastic about the growth potential of that business.

In January, we added a valuable member to our Board of Directors retired Navy Admiral Edmund Giambastiani, brings a wealth of experience in leadership roles throughout the armed forces. And we're very fortunate to have his perspective on evolving defense marketplace.

Finally, we were selected last month by Fortune Magazines one of the 100 best companies to work for in America for the ninth consecutive year. Employee satisfaction and motivation are vital to the cultivation of creative solutions and customer loyalty. We're proud to see that SRA's cultural values have remained an enduring hallmark to the company as we've grown and matured in recent years.

We are now ready to take your questions. To ensure that we can get to as many people as possible, please restrict yourself to one question, and Marcello will explain how you can phone in your questions.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question is from the line of Bill Loomis with Stifel Nicolaus. Please go ahead.

Bill Loomis - Stifel Nicolaus

Hi, thank you. Good quarter. Can you just talk about the seasonality in the business? Usually I would expect more than $5 million or so revenue sequential change, and a penny on EPS from March to June. Are you concerned about the budget outlook in June as far as the supplemental, or what are some of the other factors outside of the lower re-billables, just looking at the direct labor that would result in the June quarter looking a little bit closure to the March than historical?

Steve Hughes

Bill, it’s Steve. There are a couple of factors here. First, we've decided that we want to pursue more a richer labor services mix and a revenue component. In fact, we have elected not to bid on some contracts that hit a low-margin, direct-materials component. So there is a determination that we will head in that direction try to boost our margin and try to increase the high level component by work.

Secondly, there are budget pressures existing right now, and typically what we have seen is a big Spike in Q2, the December quarter materials with that that kind of rate kind of dropping a little bit in Q3, and Q4 but continuing very strong. But as you look at this year, we are basically looking at about $10 million less of direct materials purchase of hardware and software in both Q3 and Q4. At the same time, our labor services revenue would grow probably about twice the rate of total revenue growth for those two quarters.

Operator

Our next question comes from the line of Tim Quillin with Stephens Incorporated. Please go ahead.

Tim Quillin - Stephens Incorporated

Steve, good afternoon. On the President’s budget request and the IT component there, it looks like the budget for USA. It is going up quite a bit -- doubling year-to-year. I wonder if there is any implications for us, and if you can talk just generally about what you are seeing in terms of trends there where it’s been -- maybe a headwind of growth maybe or turn into a tailwind? Thanks.

Stan Sloane

Well, if you looked at the IT budget overall, I think it's probably better than what most of us were thinking. I don’t know that I would point to anyone particular agency. So AID is up from the '08 enacted was 88, and '09 request is it was figure to 176, sorry.

First of all, I don't know what we'll get through in terms of what passes. I think as everybody recognizes this is likely to be controversial budget request. So I don’t know where it will end up. Assuming that there are significant increases, AIT is a particular focus for us, as you know we have a lot of business with AIT and in the developing world healthcare related infrastructure kinds of things. And so certainly, we would view that as very attractive for the kinds of things we are doing with that agency.

There are some other places where the IT budget is less-robust obviously, but that one is a good story. I think generally a 5.2% civil-agency budget total for the federal government budget flow of 3.8, the 5.2 to the civil agencies. If you look at our mix of business, we're about half-and-half. So, I would be optimistic about the budget -- it's better than what I would have anticipated. I don't know if that answers your question.

Operator

Our next question is from the line of Joseph Vafi with Jeffries. Please go ahead

Joseph Vafi - Jefferies

Hi, gentlemen. Good afternoon. On the margin front, Stan I kind of if you look at your longer term plan getting to a 10% operating margin is there anything we should be looking at here shorter term as the kind of keys to progress on the margin fron,t say over the next few quarters?

Stan Sloane

Well, I think the key is consistent, incremental improvement. I mean that is probably the most indicative metric for ability to achieve the end state. I think we have ways to go with the current business in terms of ability to further improve our margin performance, and we're going to pursue those pretty aggressively, but I think we're going to also reach a point – which, I have said in the last couple of calls -- where the mix business, and the type of work we do is going to have to change a little bit to achieve that 10% vision. So I don't think we're not facing that next quarter, but we're starting to think about positioning the company to achieve that 10%, which would entail products and other types of things that to a larger extent than what we have in business today.

Operator

Our next question is from the line of Jeff Houston with William Blair. Please go ahead.

Jeff Houston - William Blair

Hi, guys. Jeff Houston for Laura Lederman. I had a question on the recompetes You touched on the AITS contract. Just wondering if we get an update on the CR2 project and also any other major recompetes coming up in the next year or so?

Stan Sloane

We are not pursuing the recompete on CR2. And then to dig up a lister, but we haven’t. In terms of recompete, let’s see the big one, of course, is AITS -- that's in front of us today. We have our Intel agency one also in adjudication, and we're waiting customer decision on that. I would expect that next month or so, that's about $150 million program. And then we have a program out on the West Coast in the JTRS, Joint Tactical Radio System program office, which will be coming up next few months -- that's probably $100 million, those are kind of the big ones.

Operator

Our next question comes from the line of Edward Caso with Wachovia. Please go ahead.

Edward Caso - Wachovia

Great, thank you. I was just wondering, Steve, if you could just sort of help us out with what the implied organic growth rate is in third and fourth quarter?

Steve Hughes

Yeah, sure. At the top line, I guess the mid-point would be in the Q3 about 6% and about 3% in Q4, but that's the total revenue growth. If you were to strip out the materials piece and look at the labor services growth, you'd find that's a couple clicks higher in both cases. But for the half in total revenue it's about 4%, and if you normalize direct materials, it would be 6% to 7% probably.

Operator

Our next question is from line of Greg Wowkun with Bank of America Securities. Please go ahead.

Greg Wowkun - Bank of America Securities

Good afternoon, gentlemen. Last quarter, you mentioned state and local as a new area of focus for you. Can you provide any update on any trash maintenance market and also just as a quick follow-up if you plan to do it organically or through acquisition?

Steve Hughes

We are -- first of all we have a fairly robust business in West Coast. We do fair amount of work with the State of California, which continues to execute well. We are in the throes of pursuing a couple of different geographical areas where we have presence. The easiest place for us to expand is where we have people and have facilities and capabilities, so places like Texas, San Antonio , Georgia where we have worked in and went on, (inaudible) of course here in Virginia ,Maryland, -- places where we have businesses, we will start considering to pursue.

It's probably going to take a few quarters for us to give you what I would characterize is concrete steps in that direction. It's pretty early for us. That would address the organic piece. We also are looking at -- and will continue to look at -- acquisition targets that service state local markets where they make sense for us. In other words, they are closely aligned kind of business, IT or systems integration. But you know we'll have to get back to what's new news hopefully in the next few months.

Greg Wowkun - Bank of America Securities

Stan if I can just add on the state local issue, the M&A targets that are most appealing to us are those that also have a repeatable solutions at the plight of the states. So not just labor services companies but they further are goals around products and technology and therefore margins as well as having a presence in our business base in several states.

Operator

Our next question is from the line of Michael Lewis with BB&T Capital Markets, please go ahead.

Michael Lewis - BB&T Capital Markets

Good evening. Nice reports --especially with the EBIT margins, they look great. Dr. Sloane, you have been at the helm here for about a year now. Have you taken a look at the portfolio made any determinations about areas that you think are no longer considered core to the business, and I guess, in other words, should we anticipate divestitures in ’08 that could further solidify the strategy here that we last see the improving internal growth longer term?

Stan Sloane

I don’t anticipate any divestitures. I think the way they characterize, I think what I would say to you is and you have seen it from Steve's comments here about our decision to forego low margin work and focus more on the value added work or labor services type of things. That I think is going to be the direction as opposed to divestures. The portfolio that we have today, I am pretty happy with -- and where I sit right now, I am not looking to shed any particular businesses. I think they are all where we want to be, and I think everything we have in portfolio today is worthy of continued focus and investment and growth other than the quality of the revenue stream holding low-margin work.

Operator

(Operator Instructions) Our next question is from the line of Alex Hamilton of Jesup and Lamont. Please go ahead.

Alex Hamilton - Jesup and Lamont

Hi, gentlemen. Most of my questions have been answered. Your new guidance does that still imply your old organic growth guidance in the range of 5% to 6%?

Steve Hughes

The new guidance at the midpoint has total growth of 20%. The organic rate would be about 4% for total revenue, but if you were to sort of normalize take out the (inaudible), you find that to be a couple of two or three clicks higher maybe 6% or 7% will be a rough estimate. Did that answer your question Alex?

Alex Hamilton - Jesup and Lamont

Yes, it does, thank you.

Steve Hughes

Okay.

Operator

Our next question is from the line of Jason Kupferberg of UBS. Please go ahead.

Jason Kupferberg - UBS

Hey, thanks guys. Just what to come back to the comments earlier: I think in the prepared remarks about the fiscal '08 appropriations getting done a little bit sooner than you guys had anticipated as of the time of the last call. So that would have seem to have been a bit of an upside surprise, but guidance here is essentially unchanged a little bit of a tick down in the midpoint of revenues. How do we reconcile those two facts? I know you guys are maybe changing the strategy in terms of going after or being more selective in the businesses that you pursue. But then, wouldn’t that imply that your margins should be higher than what was contemplated last quarter? If you can help us think through that I would appreciate it?

Steve Hughes

Well, let me try couple questions. I guess the first thing I would say is we were I think what we said last with respect to budget and trying to the get budgets passed. We anticipated them happening in next month or two, but if it went past there, then we start to think about potential impacts to the business. And I think that was a good call, because in fact they got past little bit ahead of what we were talking about. So it was in avoidance of a problem I think if I remember what I said. Second part, with respect to -- give me the second part of question Jason again please. Are you there?

Operator

One moment sir, at this point your line is open again.

Jason Kupferberg - UBS

Thanks, I wanted to get a sense of in terms of your avoidance of low-margin contract pursuits to the extent that's been a material change in your price to market over the last quarter. I might have thought that would yield a higher operating-margin outlook for the year than what was contemplated last quarter. I think we are still talking about the range of 8%, which if I am not mistake is the same thing we talked about last quarter. So I can understand if you are saying let's go after more profitable revenue, but one is the pull through going to come in the margin is the second part.

Steve Hughes

Well, I think Jason, this is Steve. I think you -- at the midpoint you would see that the margins are up actually about 220 basis points for the Q3 and Q4 periods. And I also point out that compared with '07 we are up about 70 basis points. I think, for '08, if we get about 8% and then we'll go from there for '09. So I think you have seen improvement margins.

Jason Kupferberg - UBS

Right but the guidance is unchanged versus last quarter to this quarter, am I not mistaken?

Steve Hughes

Well, the revenue is, the revenue guidance is down.

Jason Kupferberg - UBS

The margin guidance, the upper margin guidance is up.

Steve Hughes

No, the margin guidance is up.

Jason Kupferberg - UBS

What did you guys say last quarter? I think you said in the range of 8% last quarter, and this quarter is that now right?

Steve Hughes

For both periods, we said we'll be in the range of 8%, but if I actually look at the details in front of me, I would see that there will be a slight improvement in Q3 and Q4 compared with last time. So, it's the detail I think but the margins are improved for this quarter compared to for the fiscal year compared. This call compared to last quarter call. Is that your question?

Jason Kupferberg - UBS

Yeah. Okay, I’ll follow up him or I am falling back?

Steve Hughes

Will be around.

Operator

And at this time, there are no other questions. Mr. Keffer, do you have any finally remarks you would like to thank?

David Keffer

Thanks, Michele. I would like to thank everyone for joining us this evening, and you all are more than welcome to contact us with any follow-up questions. So that concludes tonight's call.

Operator

And this does conclude today’s SRA International fiscal year '08 Q2 earnings call. You may now disconnect.

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