Science Applications' (SAIC) CEO Anthony Moraco on Q3 2015 Results - Earnings Call Transcript

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Science Applications International Corporation (NYSE:SAIC) Q3 2015 Results Earnings Conference Call December 9, 2014 8:00 AM ET

Executives

Paul Levi - IR

Tony Moraco - CEO

John Hartley - EVP and CFO

Analysts

Jason Kupferberg - Jefferies

Edward Caso - Wells Fargo

Operator

Good day and welcome to the SAIC Fiscal Year 2015 Third Quarter Conference Call. Today’s conference is being recorded.

At this time, I would like to turn the conference over to Paul Levi, Investor Relations. Please go ahead, sir.

Paul Levi

Good morning and thank you for joining us for SAIC’s third quarter fiscal year 2015 earnings call. This morning we issued our earnings release and joining me today to discuss our business and financial results are Tony Moraco, our CEO; and John Hartley, our CFO.

Today’s call is being webcast at investors.saic.com where you'll also find the earnings release and supplemental financial presentation slides to be utilized in conjunction with today’s call. Both of these documents, in addition to our Form 10-Q to be filed soon, should be utilized in evaluating our results and outlook along with information provided on today's call.

Please note we may make forward-looking statements on today’s call that are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from the statements made on this call. I refer you to our SEC filings for a discussion of these risks, including the Risk Factors section of our annual report on Form 10-K and quarterly reports on Form 10-Q.

In addition, the statements represent our views as of today and subsequent events may 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.

It is now my pleasure to introduce Tony Moraco, our CEO.

Tony Moraco

Thank you, Paul and good morning.

SAIC’s third quarter results demonstrate continued performance in our markets and progress in delivering on our shareholder value creation proposition. Revenue of $993 million and operating margin of 6.3% resulted in diluted earnings per share of $0.77.

After several quarters of revenue contraction, we're encouraged by the 2% revenue growth in our third quarter. The statement of our contract and past quarter portfolio increased demand on our logistic and supply chain business, along with growth in Navy C5ISR effort contributed to this growth.

Third quarter operating cash flow was strong at $82 million, a notable increase from the second quarter. John will provide additional details of the financial results in his remarks.

During the third quarter, we celebrated our one-year anniversary as an independent company. A tremendous amount was accomplished during the year, now least of which is a continued excellent performance for our customers during a year of significant change and refinement of our metrics operating model.

Thanks to all SAIC employees for their continued dedication. We're proud of your teamwork and more effective collaboration as we continue to build a pipeline of opportunities to refine our offerings to the marketplace and execute our contracts.

With regard to the market environment, October began a critical governance fiscal year, which is the second year of the buy parts and budget active 2013. This will be a defining year to determine if sequestration will return in government fiscal '16, where our elected officials will find common ground on a more thoughtful approach to our country's financial pressures.

In this environment, our federal government customers continue to develop their strategies and priorities that reduce budget levels, but even with contract scope and funding adjustments, we've not seen a decline in requests for proposals. However, the pace of contract awards has not changed substantially and the award cycle continues to be elongated.

This quarter, SAIC had a large volume of past quarter renewals, but we did not see a significant increase of contract awards in September or acceleration in the face of procurement activity in October, the last month of our third quarter.

Third quarter activity translated for book-to-bill of 1.0 and SAIC total contract backlog at the end of the quarter stood at $6.5 billion. Total backlog is essentially unchanged from the second quarter; however our funded backlog is up 16% from the second quarter, which is typical for the onset of the new government fiscal year.

Our third quarter win rates continue to be in line with our historical performance and process continues to be filed on most large announcements. As is our practice, awards that have been protested are not included in our backlog until the protest is adjudicated in our favor.

The value of our submitted proposals winning an award is $11 billion, down from about $12 billion at the end of the second quarter. This change is driven in large part by the award to SAIC with a few large IDIQ contracts such as the reestablishment to SAIC of the GSA IT Schedule 70 and the new OASIS contract vehicles.

Although these IDIQ awards do not immediately impact bookings, as we only booked backlog when past quarters are awarded on our IDIQ vehicles, these contract vehicles do provide great opportunity and access to our diverse customer set.

When you're removed from the separation, our market strategy remains intact as we're very well aligned with our customer's mission-oriented requirements. The strategy to protect our base, expand with current customers and growing the market adjacencies is the underpinning of how we approach the market and make investment decisions.

Our protect efforts are paramount to our stable revenue base and the launching point for which to leverage our existing capabilities across current and new customers.

In this regard, we've made significant progress and are expanding growth strategies across the breadth of the $11 billion of submitted proposals outstanding.

I'll now turn it over to our CFO, John Hartley, to discuss our financial results.

John Hartley

Thank you, Tony and good morning everyone.

Consistent with my remarks on prior calls, my comments today will exclude the minor amount of revenues and cost performed by our former parent, which generate no profit for us and will decline over time as that work scope is completed.

Our third quarter revenues of $993 million represented 2% growth as compared to the third quarter of last year. After several quarters of revenue contraction it was encouraging to deliver growth as our step change revenue contraction event discussed previously are largely behind us.

As I've previously communicated, our third quarter revenue is typically our strongest of the year, before experiencing reduction in revenue in the fourth quarter, due to the holiday season. Historically the holiday season has resulted in a decrease in revenue from our third quarter to fourth quarter of around 10% and this is likely to be the case this year.

In accordance with this seasonality, third quarter revenues were up 6% from our second quarter, largely due to summer holidays and vacation time taken by our employees during the second quarter. Operating income of $63 million in the third quarter resulted in operating margin of 6.3%. This demonstrated our continued commitment to improve operating margin though our focused initiatives that cover both cost and program execution improvement.

Net income for the third quarter was $37 million and diluted earnings per share were $0.77 for the quarter. Our income tax rate for the quarter was a little over 37%, which is generally in line with our forward expectations.

Moving to cash and cash flows, the third quarter ended with a cash balance of $254 million and cash flow from operations of $82 million. This represented a significant improvement from our previous quarter's cash flow, primarily due to strong cash collection.

Our day sales outstanding were 57 days at the end of the third quarter, which is an improvement from the second quarter of four days or about $40 million of additional cash flow. During the September call, I discussed the impact on our DSOs and cash flows in the second quarter caused by contract novation activities from our former parent, which was the primary reason for the quarter-to-quarter improvement.

We've largely completed these activities and are now on a more normative cash collection cadence. Capital expenditures for the quarter were $5 million, in line with our long-term expectation of about $20 million annually.

Consistent with my previous communications, we continued our cash deployment activities during the quarter. We repurchased one million of our shares in deploying $50 million. This brings our fiscal year-to-date share repurchases to 2.7 million shares for $114 million and we had repurchased 6% of our shares or 3.1 million shares for $127 million since the initiation of our repurchase program in December of 2013.

Additionally today, we announced the approval of our quarterly cash dividend of $0.28 per share payable on January 30. These actions collectively have resulted in deployment of 93% of our year-to-date free cash flow through the third quarter.

Since separation, we've been operating with a target average minimum cash balance of $200 million. One year following separation, we're more comfortable with our operating cash needs and we're adjusting our target average minimum cash balance to $150 million.

We intend to deploy excess cash through dividends, share repurchases or some combination of the two, absent other capital deployment opportunities with expected higher returns.

In addition, given the strength and flexibility of our balance sheet, we anticipate that we will increase our financial leverage over time to further support our capital deployment strategies.

Before I turn the call over for questions, I'd like to reiterate our long-term financial targets that we expect to accomplish on average and over time. First, low single digit organic revenue growth; second, operating margin expansion of 10 to 20 basis points annually; third, return of capital in excess of operating needs, absent expected higher return capital deployment opportunities and finally financial leverage appropriate for a company with SAIC's investment requirements and cash generating characteristics.

Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we'll go first to Jason Kupferberg with Jefferies.

Jason Kupferberg

Hey, good morning, guys. Nice to see the topline back here in positive territory, I guess if we look at the quarter-over-quarter commentary for January not surprising given the seasonality, but it would imply looks like we go back negative again here, year-over-year in Q4, yet you're reiterating the longer term outlook to be in the single digit range.

So can you just help us kind of understand how you see the trajectory going into fiscal '16? It sounds like at minimum there has been some stabilization in the end markets, which is good to see, but still some open questions regarding the future of sequestration for example. So how would you encourage us to kind of think about roughly kind of next 12 months sort of trajectory on the organic growth side?

John Hartley

Sorry, this is John Hartley. I appreciate the question Jason. Looking at the fourth quarter, realize that we did have a bit of a surge in the third quarter. So the drop back down should be in the normative range of about 10%. So you will see a little bit of decline if that was the case. That doesn’t mean that we couldn’t reach flattish if we did indeed exceed what we were expecting.

Looking into next year, with sequestration moving in the other budget headwinds that we're facing, we certainly think that our results will not be inconsistent with our long-term financial targets. Maybe a little more in the flattish range, but may also reach its low single digit.

So we don’t expect any big step changes. I think we have very good visibility into our next 12 months worth of revenue, as we have much of it in backlog and the rest of it identified with very little if any unidentified as that gives us confidence that it will be in line with its long-term financial expectations.

Tony Moraco

Jason, this is Tony. Good morning

Jason Kupferberg

Good morning.

Tony Moraco

Cleary, to John's point I think in the market as the customers are going through their strategic planning, I think we're seeing a little more clarity on what they may begin to invest in. I think our contract vehicles are very well aligned to take advantage of that through the pass quarter volume, a lot of which we saw is indicative in Q3. So the data on the task orders and our constant approach on the pipeline or the contract awards into next year all that's been submitted frankly.

We will just stay aligned on what the customer's fundamental needs are, addressing their award decision and then on transitioning the programs that we've driven into revenue.

So to John's point, I think it's pretty steady. I think the mix of the date will benefit our long-term and will just address the contract awards as they come out through each quarter.

Jason Kupferberg

So as we think through this kind of next 12 months to comment a little bit and trying to translate that into book-to-bill and then we like to look at that matrix kind of on the trailing 12 month basis, just given there is some lumpiness quarter-to-quarter, so on that LTM basis I think the metric has maybe slipped a little bit to around 0.8 or so, though on the quarter it's up.

I think you were right around one. So what I am trying to get a sense of is as you think about doing may be flattish plus organic revenue growth in your fiscal '16, do you need a book-to-bill of around one or can you kind of run where you are about now on an LTM basis?

John Hartley

We can run where we're at. I think we've seen enough before that the sheer numbers themselves keep you close to that nine-to-one based on the shorter revenue booking per task order and I think we've shown this, Q3 is indicative of -- we can do a lot of the task order refresh and stay close to that number and any opportunity to win the full of contract award is how we calculate those bookings, really will create some additional upside on the book-to-bill metric itself.

We continue to submit large proposals and a couple of quarter really gets you above that on a normative range, so one with some change on those contract awards gets you north of that, but we're comfortable that that nine plus or minus as we look at past quarter volumes alone.

Jason Kupferberg

Okay. That’s very helpful. Thank you guys.

John Hartley

Thanks.

Operator

We'll go next to Edward Caso with Wells Fargo.

Edward Caso

Hi. Good morning. Can you talk a little bit about the acquisition environment within the context of the competitive landscape, particularly now with the announced task acquisition? Thank you.

Tony Moraco

Sure Ed. Good morning. I think as well the market generally has been talking about the need for some level of consolidation given the run-ups over the last 10 to 12 years that there is a lot of properties, a lot of companies all kind of jockeying for similar work given the budget environment.

And the competitive landscape I think we will see consolidations over the next two years. Properties will try and assess where they've got growth opportunities and absent growth look for more acquisition markets.

On a competitive basis, I think most of the markets taken out a lot of the cost and the infrastructure has evolved and adjusting through the budget norms, the price pressures. So the cost, I think is pretty well normalized at this point and folks are still flipping their margin opportunities, their pipelines and portfolios.

You still may see some divestiture and some focus going forward in some areas. You might see some of the formal companies themselves consolidate really trying to get to a point of scale. We do think that that $4 billion, that that does give us a lot of scale and leverage to manage the rates with less volatility to be able to continue to pursue the work with its new contract awards for our task quarters.

I think each company as they go through their consolidation, I've to address what cross synergies they can realize, what market synergies on the revenue side, but I don't think that competitive landscape as a whole will change dramatically.

You may see slightly few bidders and you may see some new entrants in some markets based on those consolidations, but in the macro, I don't think you'll see significant change in the competitive landscape based on price pressures and capabilities that people are going to market with.

Edward Caso

Some of your or some of the other publicly traded companies have highlighted the difference between solutions focus and services focus and I believe you guys are pretty much services focused, but they will also in that context talk about severe price pressure within the services side.

So the first part of my question is are you staying services focused and second, are you seeing continued price pressure, thanks?

Tony Moraco

I would say, as we really design the company's portfolios and the spin, the intent is to stay on the services side from a business model perspective, but we've traditionally continued to deliver technology integration solutions.

So it's not just a resume shootout. It is a total solution, rather it's an integrated practical vehicle, whether it's integrated network architectures across the Board, leveraging some of our strategic partners.

So I guess to be clear it's still about providing the capability of solution for that customer need than just staff augmentation, which we tend to stay away from. But in that model, we think on the services side, it does give us system engineering and requirements and planning proximity through the leadership to be able to be better aligned and to take advantage of the contract vehicles that we have.

So I like being on the services side at this time, so we can help the customers navigate their own priorities and do it in such a way that we can manage the risk and the transition to that next generation capability whatever it is.

The price pressures, I think we've seen that reality over the last few years. Again I don't think it's going to be a knowledge step function in price pressures. We've seen in fact a little bit of pull back on the straight low-priced technically acceptable decisions. I think some of our customers have felt they got what they've paid for and wasn’t quite satisfactory.

So I think we've seen some rationalization with the technical staff being engaged with the acquisition community. And so I think although price will still be predominant evaluation criteria, I think we're trying to see a little bit of a balance as they try and be smart of how they spend their money.

Edward Caso

Thank you.

Tony Moraco

You're welcome.

Operator

[Operator Instructions] We'll go next to Joe Nadol with JPMorgan.

Unidentified Analyst

Hi, good morning guys, it's actually [Chris] [ph] on for Joe. Going back to M&A, can you shed some light on in particular areas where you may be focused whether it's customers or capabilities.

Tony Moraco

Chris, it's Tony again. The approach on M&A, which we think we still have access through the balance sheet and the leverage position. So we've got the flexibility. We've wanted to make sure that we have the organic focus and we continue to have that and we will sustain that organic growth.

But, I think it can be complimented by some M&A activity and if I put it maybe in four categories of how we think about it, maybe not necessarily priority order, but market access is predominant in our ability with the eight service lines we have to be able to create and get access to additional markets and if you break that down to specific customer accounts and fundamentally contract vehicles that we don't have today, you have to spin we'll look at technical capabilities that complement our own across our full life cycle to ensure that we continue to do what we do.

And per previous question aligned a lot of services business model, than out-shaping product technologies, which we want to tap some intellectual property, but it doesn’t have to be out on a privatization limb if you will.

And then when we look at the compliance environment, ensure given what's going on with the EPA, the federal regs that the compliance elements fit our own behaviors as part of the reset and then we'll go to culture aspects.

From a fit, the integration we'd expect to move forward with the matrix itself is a differentiator for us and so we would look through a culture environment that would be adapted through that so we can take full advantage of that.

So, with those characteristics there's a number of properties that would be out there. We've talked in the past about places we've underserved and places like the Air Force, the intelligence communities, our health sector, our public health in particular. There's areas where, may be interesting and more timely, to get to markets through M&A, but again the focus is still on the organic side.

Unidentified Analyst

Excellent. Thanks Tony that's helpful. John, one for you, with Q4 sales being down, do you think you'll be able to hold margin in the low 6% range where it's been or could there be some pressure there?

John Hartley

There certainly could be some pressure on the lower volumes. We do still expect to stand by what we had communicated that the 10 to 20 basis points year-over-year coming off of 6% year. So couldn’t go much below 6% and still stay in that range.

Unidentified Analyst

Okay, fair enough. And then last one; is there any update on the program that's forming at NASA human health and performance?

Tony Moraco

Yeah, the portfolios itself, has been issued. We continue our capture activities and strategies, but it totals out and the government has requested to submit sometime in the late January timeframe.

Unidentified Analyst

Great, thanks guys.

Operator

And we'll go next to Cai von Rumohr with Cowen and Company.

Cai von Rumohr

Yes, thanks so much. So, your worst of sales looked like it's a little under 1.96, but your months of funded backlog are up. And Tony, I think you alluded to the fact that the average duration of the task order has been coming down. Can you give us any color or quantification like where it is today versus a couple of months ago?

Tony Moraco

Cai, it's quite similar on a monthly basis, probably comparative to maybe two years ago when you could get a full option year funded on the IDIQ task orders. It's more traditional and typical now for it to be three to six months of funding coming in.

So unfortunately it's created additional transactional churn on the customer side, but it gives them little more flexibility on the commitment of those funds. So nothing substantially changed in the last year, but it is different and we've seen that consistent task order pressures over the last year or so.

Cai von Rumohr

Okay. And then you know, you mentioned a couple of contracts in your press release. Could you comment which of those are new works and which of those may be -- because you only booked the task order have potential for growth next year?

Tony Moraco

Well they would, this is the only form of new contract vehicle that we recently have been ordered. In the past quarter still we have reestablished the Schedule 70, although we have been using the previous schedule under our separation agreement.

So, overall, and with the DLA awards to sustain our activities there, it's important that we carry those contracts forward, the prime vendor program. So this quarter I think it's still characteristic of market access, contract vehicles that we exploit.

We've looked for in the past additional ones, the DHS Eagle, for example, where that's in transition we'll start moving things towards Eagle II. So it's pretty much consistent with what's been going on in the past.

And as I mentioned earlier, there's still substantial amount of non-IDIQ submits that the customer groups, now the team have been really addressing in our ability to go to market faster supported by Doug Wagner still has the services lines on our offering.

Cai von Rumohr

Okay. Great, and then going back to Jason's question about your low single-digit revenue growth target and then if in fact there hasn’t been a change over the past year in terms of duration of task orders, what will it take to kind of get you to couple percent revenue growth next year or up?

Tony Moraco

I think what we'll see is continuing the sell through the IDIQ vehicles that we have. We are working hard to expand our channel with some of our strategic partners. So as we go to market as a technology integrator, one of the strategic components that we've suggested some time in the past year are some of the technology channels, rather capabilities that we need and then turn around and partner with them on some of the market access that they may have through their sales force.

So look it's a combination of take advantage of the strategic partners on the technology side, sell through on the IDIQs working with those broad teams that we have and continue to introduce new services through those same customers that maybe we didn't historically provide and then continue to address the pipeline opportunities on the non IDIQs although we have many opportunities to take the market share and provide the future that we need.

So it's in those three dimensions that I am still confident that we can sustain the revenue base and then to John point, over time build up on that single digit organic growth.

John Hartley

And Cai, just to add to what Tony is saying, on the book-to-bill as it relates to low single-digit revenue growth, if you think about what Tony was saying as far as the funding on task orders being three to six months, which can be new work on those task orders, they don’t necessarily have to be recomplete.

But if you think of those and then you also realize we have a large book of standard contract awards that we're working of that backlog, think about our Department of State and our NASA mix. Very big amounts that we're burning a couple $300 million worth of backlog each year and those only get replaced every 10 years.

So we can run at a 0.9 to a 0.10 and still grow in the low single digits. You certainly wouldn’t want to do that for years and years in a row and we also like to see those big 10-year awards come through in our favor. But that's kind of a way to think about the book-to-bill in the short term.

Cai von Rumohr

That's very helpful. And then you know, Tony, your background with the Air Force, I think the Air Force was one of your key targets given the relaxation, or sorry the avoidance of OCI restrictions that you had in your part of SAIC, how are you doing in terms of penetrating the Air Force?

Tony Moraco

Cai, we have really submitted this against the Air Force requirements that. We've been I think pretty practical on where we can offer solutions and technologies that we've performed well. You know in this market, the past performance weighs heavy.

So our ability to translate what we've done for other customers to the Air Force we've got a good quality pipeline. We've submitted bids there as well as in other areas like the Navy, post OCI environment. So I'm very confident that we've really looked at what we can do on both the enterprise IC side as well as on our mission engineering side.

We have a lot of work in avionics test equipment, and so, it's really still full lifecycle of what we do and we're just being really practical on which ones makes the most sense as we're smart about how we spend our BPM money and maintain a quality pipeline with a high probability to win. We are at the stage where anything is out there, but those are the lines that grow.

Cai von Rumohr

That's great. So last one for John here, last year your Op margin in the fourth quarter was higher than the third quarter despite the revenues having the seasonal down tick. This quarter you know you had a pretty good gross margin. Should we really expect the margin to be down in the fourth quarter versus the third or could it be stable to slightly higher as it was last year?

John Hartley

In looking at last year Cai, you have to keep in mind and maybe you did the separation costs that were heavy in the third quarter not as heavy in the fourth. So you are dealing with…

Cai von Rumohr

I'm excluding them, I'm doing it before them, it was 6.1 versus 6.

John Hartley

Okay great. And so, it's going to be in that range as with any government contract, there are a lot of things true up at the end of the year. So you have all of your truing up. You have all of your fringe benefits truing up.

So there is a little bit of perturbation up or down as a result of those items truing up. So I don’t think it's going to fall off dramatically. I wasn’t saying that at all. It should just be in a generally a smooth range. I don’t expect any big ups or downs.

Cai von Rumohr

Thank you very much.

Tony Moraco

Thank you, Cai.

Operator

And that concludes the question-and-answer session. I would now like to turn the conference back over to Paul Levi for any additional or closing remarks.

Paul Levi

Thank you very much. I'd like to thank you all for your interest in SAIC and participating in today's call. Have a good day.

Operator

And that concludes today's conference. We thank you for your participation.

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