Chain Bridge Investing’s (“CB” or “we” or “our”) evaluation of Computer Sciences Corporation (“CSC”, “Computer Sciences Corp.” or the “company”) is based primarily on fundamental factors such as past, current and potential operating performance, as well as the company’s current competitive environment. There is no guarantee that the market price of the company will eventually reflect its implied value as derived from fundamental factors. This post, along with the others in this series, does not analyze the technical aspects of the company’s stock price and its volume patterns. Furthermore, the reader should note that this post is one of multiple posts by Chain Bridge Investing regarding CSC.
Brief Statement of Interest in CSC
Chain Bridge Investing evaluated CSC as a potential investment due to the following factors:
- Historically, CSC has consistently generated high levels of free cash flow relative to its market value.
- As the company continues to move a significant portion of its operations to Asia, its operating margins will most likely increase, thus improving overall operating results, free cash flow, and providing a possible catalyst for an increase in market value.
- CSC has a strong balance sheet that shows a company with great liquidity and manageable debt levels.
- During the past couple of years the company has demonstrated strong bookings to revenue. The new bookings have been driven by both new customers and existing customers, thus growing and diversifying its revenue stream.
- CSC is well positioned to serve both commercial and public-sector clients, thus providing it with a degree of protection if one sector were to take a hit.
- In recent years, the company has actively repurchased a portion of its outstanding shares.
Strong Balance Sheet and Minimal Financial Risk Positive for the Investor
As of July 13, 2010, CSC’s robust liquidity position and manageable debt levels provide the company a degree of flexibility and safety when confronting unforeseen shocks and obstacles. The company’s balance sheet is sound and is a positive for an investor considering CSC as an investment. In the space that follows, important aspects of CSC’s strong financial position are analyzed and discussed in more detail.
Strong and Improving Liquidity Position
Through improvements in its cash cycle and expense management, Computer Sciences Corporation has managed to significantly strengthen its liquidity position from fiscal year 2006 to fiscal year 2010. As can be seen in both Exhibits 1 and 2, the company’s improvements have occurred both in current assets and current liabilities.
Beginning with current assets in Exhibit 2, one immediately notices that cash increased to 17% of total assets in fiscal year 2010, while receivables declined to 20% of total assets in fiscal year 2010. The reader should note that the company specifies in its footnotes that a certain portion of its receivables will not be collected, due to the nature of several contracts, within the current fiscal year. Consequently, to accurately illustrate the company’s liquidity the specified amount of receivables was removed from the current asset classification. Other than this classification adjustment, we did not find any other items that warranted further adjustment.
Greatly helping CSC’s liquidity position is the more than sufficient cash on its balance sheet, which provides a strong buffer against any future obligations – either current or long term. This cash balance also provides the company the option of financing future acquisitions, which management has stated that it is actively pursuing in the current market environment. Such acquisitions could potentially increase the fundamental appeal of CSC to the market. Augmenting the strength of CSC’s cash position are its operations and fixed assets.
Historically, CSC’s business has been a strong and consistent producer of cash. For instance, from fiscal year 2006 to fiscal year 2010 the company’s cash from operating activities ranged from $1.3 billion to $2.0 billion and averaged $1.6 billion a year. Thus any significant obligation or acquisition that drains cash would likely be mitigated by the company’s operations.
Moreover, CSC owns a large amount of fixed assets for being primarily a services firm. In earnings calls, the management has acknowledged the relatively large amount of fixed assets on its balance sheet. If the company were to experience a cash crunch, there is a possibility – according to management - that these assets may be monetized.
A CSC investor should feel comfortable knowing that not only does the company have a comfortable cash position, but also has the ability to sustain that cash position if the company were to encounter obstacles in the near future. While at the current levels CSC’s cash position is strong, one wants to ensure that its cash balance does not continue to increase. Cash needs to be deployed to earn a return for the shareholders and too much cash is under utilizing an asset. The company recently began issuing a regular dividend, which will give some of this cash to the shareholders.
CSC’s reduction in receivables relative to its operations should please investors since Michael Mancuso, the chief financial officer, and management have stated that their goal has been to improve the quality and turnover of CSC’s receivables. Yet, due to the nature of the contracts in CSC’s business, there is a limit to the degree of additional improvement investors can witness in receivables. Nevertheless, the improvement has been significant and makes management’s word more credible - especially since prepaid assets have remained relatively flat as a percentage of total assets.
Reviewing the company’s current liabilities one quickly sees that the company has significantly reduced its current liabilities from 34% of total assets as of March 31, 2006 to 25% of total assets as of April 2, 2010. With declines in accounts payable, other accrued expenses, and income taxes payable accounting for a significant portion of the decline in overall current liabilities, the company has significantly improved its cash cycle management in both its assets and liabilities, thus decreasing financial risk.
At present, as seen by working capital in Exhibit 3, CSC’s current assets provide a buffer against its current obligations. With the company’s liquidity and its cash flow generation, CSC has a degree of flexibility and protection against unforeseen obstacles and shocks. One should not lose sleep worrying about CSC’s balance sheet.
Long-Term Debt and Solvency Risk Is Minimal
An initial review of leverage ratios, as seen in Exhibit 4, indicates that the company is leveraged within healthy limits and such leverage does not present undue risk to CSC. Currently CSC has approximately $3.7 billion of total debt outstanding with $1.5 billion and $1.0 billion maturing in fiscal years 2012 and 2013, respectively. As seen in Exhibit 5 and 6, these maturities present minimal risk to the company given the company’s: (1) strong cash position; (2) potential to raise additional cash; and (3) average cash flow from operations.
Yet, one would be remiss to conclude the analysis at the magnitude of the outstanding debt. While analyzing the company’s solvency risk its covenants were considered as well as its ability to cover interest and operating lease expense.
CSC’s debt has two covenants that relate to its financial statement results: (1) consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) to consolidated interest cannot be less than 3 times; and (2) consolidated total debt to consolidated EBITDA ratio must not exceed 3 times. As can be seen from Exhibit 6, CSC has never been near violation of either of these covenants from fiscal year 2006 through fiscal year 2010.
Furthermore, as seen in Exhibit 6, historically, the company generates more than adequate earnings and cash flow to meet its interest and operating expense obligations. Due to the nature of CSC’s operations and the relative ease it has displayed in meeting its operating lease expense, it is unnecessary – at this time – to capitalize CSC’s operating leases to show these off-balance sheet liabilities on the balance sheet.
Nevertheless, regarding off-balance sheet liabilities, in a previous post we analyzed the company’s unfunded pension obligation and determined that this obligation does not affect our assessment that CSC has minimal solvency risk.
A Simple Balance Sheet Test: Altman’s Z Score
For an additional test/perspective of the strength and stability of CSC’s balance sheet, an Altman’s Z score was calculated. The Altman’s Z score was developed by Edward Altman in 1968 and was used to predict bankruptcy using the following formula:
Z = 1.2V1 + 1.4V2 + 3.3V3 + 0.6V4 + .999V5
V1 = Working Capital / Total Assets
V2 = Retained Earnings / Total Assets
V3 = Earnings Before Interest and Taxes / Total Assets
V4 = Market Value of Equity / Book Value of Total Liabilities
V5 = Sales / Total Assets
As of July 13, 2010, CSC’s Z score was approximately 3.15, which is above the 2.99 score required to be considered in the safe zone. As with the prior analysis, Altman’s Z score reveals that CSC has minimum balance sheet risk.
Avoided Significantly Diluting Its Shareholders
Since fiscal year 2006, with the exception of fiscal year 2010, the company has repurchased a significant amount of its outstanding shares every year. From fiscal year 2006 to fiscal year 2010, the company reduced its shares outstanding by approximately 17.7%. Nevertheless, in fiscal year 2010, the company’s shareholders experienced a small dilution of approximately 1.4% in their holdings, which we do not consider significant. Considering the company’s recent history regarding its outstanding shares and the fact that it recently announced a quarterly dividend, we believe company management to be shareholder friendly.
CSC may also be pursuing these actions in an effort to increase the attractiveness of its shares to the market. A brief look at the company’s stock price movements during the past five years, reveals that the market does not seem to favor CSC. Despite increasing sales, increasing operating earnings, and decreasing shares outstanding (during the same time period), the company’s stock price has continually met with resistance near the $60.00 level. Such price action, regardless of the fundamentals, seems to justify the deployment of the new quarterly dividend.
While there remains more pieces to the puzzle when analyzing CSC as an investment, having a robust balance sheet, consistent strong cash flow generation, and shareholder friendly management is a very good start.
Disclosure: Author is long CSC