In a recent edition of Value Investor Insight, Edward McAree, of Williamson McAree Investment Partners, explained what he thinks the market is missing in SAIC (SAI).
Let’s talk about some specific ideas. Describe your interest in the big but not very well-known SAIC (SAI).
EM: SAIC was founded in 1969 and in many ways enables the United States to actually have a modern military. If a modern military force is about command, control and intelligence, then SAIC helps build the systems that allow all of that to function well and in real-time. Just looking at recent contract wins gives you a sense of the breadth of what they do: working with the Army to enhance nightvision capabilities, working with the Air Force to remotely train units around the world, being the provider of the Navy’s ship-to-shore communications system, setting up and managing vehicle cargo inspection systems.
One of the things we like most about the company is that it’s very difficult for us to find other companies that have the same technological capability. Out of 44,000 employees, 28% hold advanced degrees and more than 50% have high-level national security clearances. The company is the prime contractor for 90% of its contracts and wins well over 90% of its re-competes. Retention rates have been 100% in recent quarters, which is a level of customer satisfaction that’s unprecedented. Based on all our fieldwork, SAIC has a distinctive reputation for accomplishing what they say they are going to do, on time and on budget.
How dependent is the company on ever higher military spending?
EM: Roughly 75% of total revenues are linked to national security, whether related to the military or homeland security. But the company has grown organically every year since its founding – through various cycles of military spending – because the focus is on using resources more efficiently and making programs more effective through connectivity and timely information. We have not seen those types of initiatives be cut back. SAIC’s largest single contract, accounting for 5-6% of revenues, is related to the Army’s Future Combat Systems initiative, which involves creating a family of remote-controlled weapons, robots and combat vehicles connected by a wireless network. Everyone wants to see that happen because it removes personnel from harm’s way, so we can see an effort like that going on for at least the next decade.
What kind of growth are you expecting?
EM: We believe the company can grow internal revenues 8% annually. (They did better than that last quarter, up 14%, but we don’t believe that’s sustainable.) On top of that, we expect 2-4% in annual revenue growth over time from add-on acquisitions. They have walked away from some recent deals due to price – which we like – yet we imagine some potential targets (both public and private) could get more affordable in the near term.
One particularly interesting area of growth is to go after the larger and more complex projects that companies like General Dynamics or Lockheed Martin typically win. SAIC has historically been run in such a decentralized way that it was difficult for them to bring all of their assets to bear on the largest and most-integrated programs. Having realigned and slimmed down the number of business units, that’s starting to change and we expect bigger projects to be an attractive avenue for new business.
Margins aren’t particularly high. Do you see upside there?
EM: As a government contractor SAIC is never going to have blow-out margins, but we do think they can improve operating margins 20-30 basis points per year. That will come from things like continuing to simplify the organizational structure, addressing redundant costs like those for real estate, and a mix shift to higher-margin businesses. Port security projects, for example, which currently represent 2% of revenues but 7% of profits, are growing rapidly not just in the United States, but also in the Middle East and Asia.
With SAIC shares recently at $20, how are you looking at valuation?
EM: From revenue growth and margin improvement, we expect the company to be able to increase cash earnings 15%-plus per year. But the stock trades at less than 17x this year’s estimated cash earnings of $1.20 per share and only 14x next year’s expected earnings of $1.40.
At just 18x the $1.60 in earnings we estimate for 2010, the stock would trade close to $29. Even that wouldn’t be particularly expensive for a company of this unique quality.
One additional area of comfort for us here is that the head of the board’s finance committee is Lou Simpson of Geico. The company has been smart about buying in its own shares, and we expect to be well represented as shareholders in all capital-allocation decisions.
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