Science Applications International Corporation (SAIC) Q3 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the SAIC Fiscal Year 2014 Q3 Conference Call. [Operator Instructions] I would now like to turn the conference over to Paul Levi, Investor Relations. Please go ahead, sir.

Thank you, and welcome to SAIC's Third Quarter Fiscal Year 2014 Earnings Call. This is our first earnings call since our successful separation transaction in late September. With me today are Tony Moraco, our CEO; John Hartley, our CFO; and other members of our leadership team. During this call, we will make forward-looking statements to assist you in understanding the company and our expectations about it's 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 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. I would now like to turn the call over to our CEO, Tony Moraco.

Thank you, Paul, and good afternoon. Thank you for joining us on the call today. Before I discuss our quarterly results, I would like to take a moment to acknowledge what an important time the past months have been. We successfully completed the separation and became an independent, publicly traded company that proudly carries the SAIC name. Although technically a new company, we have a tremendous legacy and are proud to move forward with the reputation of excellent contract performance earned over several decades. For SAIC employees, let me congratulate and thank you for a job well done. The separation process was a tremendous amount of work with many changes over the last year, and our employees handled a wide range of internal organizational and business model changes while continuing our most important work, customer-focused contract performance. Employee commitment enabled a smooth transition and unimpeded continuity of performance for our customers. Third quarter revenue was about $1 billion, with operating income of $37 million. A few items impacted operating income including $23 million of separation transaction and restructuring expenses, which, if excluded, we believe is a better measure of the profitability of the company. Diluted earnings per share were $0.44, and operating cash flow for the quarter was $10 million. John will discuss the financial results in more detail. Our market environment continues to be shaped by budget challenges facing our customers. Sequestration is likely to continue in some form in this government fiscal year, and we believe that our customers will continue to prioritize their mission needs against available fiscal budgets. The government shutdown on October had a relatively minor impact on our third quarter company results that we issued today, with the federal civilian business area incurring the most disruption in the contract efforts. However, it did affect a number of our employees as well, as they were not able to work and create additional strain on performing for our customers. I do believe that a government shutdown will not occur again based on a recent meeting with some of our elected officials when we shared the detrimental impact of not finding the reasonable solutions to budget differences. We continue our business development efforts to increase and align our opportunity pipeline with our capabilities portfolio, while continuing to optimize the organization to maintain a competitive pricing position. Our value of submitted proposals of $10.2 billion demonstrates the breadth and depth of our pipeline. Our book backlog stands at $7.3 billion and represents a book-to-bill of 1.4 for the third quarter. During the quarter, we had several notable wins that demonstrate our customers' continued confidence in our ability to perform. We were successful in winning a $224 million effort with the Federal Retirement Thrift Investment Board to provide a broad range of business process and IT services for this new customer. This is a great example of SAIC reaching out to provide its technical capabilities and solutions to a new customer. We were awarded $100 million prime contract by the Defense Threat Reduction Agency to provide integrated logistics services for worldwide cooperative threat reduction services. And lastly, we were one of the awardees on a $900 million IDIQ vehicle issued by the Space and Naval Warfare Systems Center Atlantic to provide integrated cyber operations support services. Looking across these 3 wins, they reflect early success in our protect, expand, growth strategy as we've won business with some well-known current customers and brought our capabilities to bear with new customers. During our Investor Day in September, we outlined the operating model that will be the underpinning of customer performance and business results. Our matrix organization of customer groups and service lines has been implemented and we have begun executing in this manner. Employee feedback has been tremendous with great optimism for expanded business opportunities in the future. Our customers are beginning to also experience the benefits of this model, which allows for more efficient resource allocations, an increase in quality and reducing the cost of performance. The matrix operational model is aligned with our business strategy, and our protected spend growth strategy is fueled by our organizational alignment to our customers and the services they demand. Business performance will be realized by our ability to protect our business base, expand business with current customers with existing mature capabilities and growing in selective adjacent markets. In the interest of increasing shareholder value in these market conditions, we are dedicated to achieving relative revenue growth, improving operating income and deploying capital in excess of operating cash needs in the form of a recurring dividend, share repurchases and selective M&A. It's our belief that through operational alignment, program execution and prudent deployment of capital, shareholder value will be created. With that, let me turn it over to John.

Thank you, Tony. I would like to echo Tony's appreciation for the efforts involved in launching this great company. Our dedicated team has set us up quite well for future success as a stand-alone company. Before I cover the financial results, I would like to call your attention to the supplemental earnings presentation on our website. Due to the completion of the separation during the quarter, our third quarter results reflect 2 months as part of our former parent and 1 month as a stand-alone company. Additionally, in our financial results, we reflect a minor amount of revenue and cost for work performed by former parent. In order to give you a clear picture of the company's activities, my comments will exclude the revenues and costs performed by former parent. Tony summarized the financial results, but let me provide some additional color. Revenues for the third quarter of $974 million were in line with our expectations and reflect an 18% contraction as compared to the prior year quarter. This reduction is attributable to the $80 million impact of the ramp down of the DISN Global Services program, $40 million from the completion and ramp down of IT and logistics programs related to the drawdown in Afghanistan and another $40 million from lower material and subcontract work on navy contract vehicles. The remainder of the year-over-year decline was driven by slower U.S. government contract funding and awards, resulting from government budget pressures. Third quarter operating profit was $37 million or 3.8% of revenues. Profit was significantly impacted as a result of incurring the expected amount of separation expenses that are typical with the separation transaction of this nature. We do not expect to incur any additional separation or restructuring costs in the future for this transaction. These separation and restructuring expenses were $23 million for the quarter, and if excluded, would have resulted in operating margins of 6.2%. Operating income was also adversely impacted by a few million due to the partial government shutdown. We do anticipate recovering a portion of this impact in the fourth quarter. Net income for the third quarter of $22 million resulted in diluted earnings per share of $0.44. Our Q3 effective tax rate was 35%, which is generally in line with where we expect to finish the full fiscal year at about 36%. Our expected normative tax rate going forward is around 38%, considering that the R&D tax credit has not yet been extended past December 31, 2013. Now on to the balance sheet and cash flow statement. Days sales outstanding, or DSOs, were 67 days at the end of the quarter, which compares to our more normative level of DSOs of less than 60 days. DSOs were negatively impacted at quarter end by payment delays caused by the government shutdown and anticipated billing delays resulting from a 10-day shutdown of our IT systems related to the company's separation. We expect to return to a more normative level of DSOs by fiscal year end. As such, we ended the quarter with about $157 million cash. Cash flow from operations for the quarter was only $10 million, and free cash flow was slightly less after incurring $8 million of capital expenditures related to infrastructure required to operate as a stand-alone company. After we complete this required infrastructure, our normative level of capital expenditures is expected to be less than $20 million annually. During the quarter, a few notable capital deployment items occurred: first, we initiated and paid a quarterly cash dividend on October 30. We also announced today our next quarterly dividend of $0.28 per share, payable on January 30 to shareholders of record on January 15, which is a consistent amount as our last quarterly dividend; finally, as previously announced, our Board of Directors authorized a stock repurchase program under which the company may repurchase up to 5 million shares of the company's common stock. No repurchases were made during the third quarter but as we stated in September, our intention is to deploy capital in excess of our target average cash balance to maximize shareholder return. Let me now turn to fiscal year guidance for our fiscal year ending January 31, 2014. The company, while part of the former parent, provided fiscal year 2014 forward guidance prior to completion of the separation transaction. Based on our financial results through the third quarter and the outlook for the remainder of the fiscal year 2014, our expectations for the company's revenues and cash flows is unchanged from prior guidance. The company is updating the prior guidance for diluted earnings per share to apply a higher effective tax rate and a higher effective share count than was assumed prior to the separation. The former parent's effective tax rate of 31% was used in the prior guidance, and our guidance is based on the company's estimated tax rate of 36% for this fiscal year. That means our guidance for fiscal year 2014 is revenue in the range of $3.85 billion to $4.1 billion; diluted earnings per share in the range of $2.13 to $2.33; and cash flow from operations above $125 million. Consistent with what we stated at our Investor Day in September, our view of future operating results remains unchanged. We anticipate coming out of the separation with revenues of about $4 billion annually with low-single-digit annual revenue growth potential with additional contraction in early FY '15 as we see the final impact of the FY '14 revenue reduction items I discussed earlier come through in the year-over-year results. We intend to drive revenue through protecting our existing contract base, selling more of SAIC's capabilities to customers who know us well and growing with customers that we previously underserved because of organizational conflict of interest or a lack of investment. Also, we continue to expect operating margins to be in the low 6% range. Improving our operating income is a high priority for the company and will be achieved over the next 3 to 5 years through a combination of optimizing our indirect cost structure; expanding our value-added labor base; leveraging our scale by bidding higher contract fee, and finally, executing well for our customers so we realize the fee that we have bid; and finally, of course, continue to drive strong cash flow from operations. Before I conclude my remarks, let me reiterate our commitment to ensuring transparency with our investors in growing shareholder value. I am a firm believer in saying what you do and doing what you say. It is a fairly simple principle, but we have a great amount of conviction to execute in that regard. Our future actions should clearly demonstrate our commitment to achieving our objectives. With that, I will turn it back over to back over to Tony.

Thank you, John. As I look forward to the next few months, I am confident of a productive fiscal year '14 close and momentum into fiscal '15. We wish you and your family best wishes for the holiday season. And with that, we'll now take your questions.

[Operator Instructions] And our first question comes from the line of Joe Nadol.

It's actually Chris Sands on for Joe. Couple of questions about contracts. Could you please update us on the status of the AMCOM EXPRESS Task Order 32 competition?

Sure, Chris. This is Tony. The AMCOM contract is still being executed under the current contract vehicle and the upcoming recompete is yet out for actual formal proposal. So we are still waiting that to be released by our customers. But...

Okay. But no specific expectation for when that could happen?

No, we haven't had any specific date so we been saying it's relatively soon in the process. We would expect it to happen again fairly near term.

And does the extension run to a specific date?

I think it runs -- currently runs through the end of February of next year.

Okay. And then this one may be more challenging to answer, but any insight into EAGLE and what happened there?

Well, there's been a lot of press on the EAGLE contract. We have officially submitted a protest to GAO based on a debrief that we received shortly after Thanksgiving. So we have yet to get a response from that. But with the rest of the industry being attentive to what the customer's intentions were, trying to understand that and put forward what we think is the best case for our ability to sustain our service delivery of that important customer. So wait and see how that plays out with the customer sets.

And do you get the sense that it was primarily based on price?

Price was a factor, as it's been in a lot of the other industries, but there's a number of factors that have played into their award process and that's what we're trying to evaluate.

Okay. And then one for John. Can you just remind us what that minimum cash balance is above what you had returned to shareholders?

Sure, Chris. Right now, we think it's around $200 million. Once we get comfortable with our operating cadence, we may bring that down over time.

Okay. And then one more. The official guidance, does that include the revenue performed by parent?

No, it does not.

Okay. And so same with the long-term, low 6% margin target?

That's correct.

And our next question comes from the line of Edward Caso.

I was wondering if you could opine a little bit on the budget process going on in Washington, if you think the current effort will actually pass here or whether we'll just kick into a continuing resolution.

Not sure about the CR. But from what we've been reading, what you've been looking at the press as well, I think the sequestration debate, if we do in fact get relief on the next 2 years, as evidenced at least by the most recent discussions, that that's actually a favorable element. We've been lobbying with others on the removal of sequestration in the near term as a means for budget reductions. It takes a little bit of pressure off of services, components, their ability to drive their maintenance and training programs, for instance, are areas that we also support. So I think that's one element, that it provides a little more rational budget decisions and prioritization by the armed services and other agencies. I think also with -- if we get to, in fact, a flat budget and some numbers relative to federal budget across the board, both in defense and nondefense, just in and of itself, should create some clarity on the contract community, that they can at least work off of a funding line that allows them to perhaps release the pent-up demand and submits that are out there. So we're hopeful that the sequestration allows them to make more robust decisions and prioritization, and secondly, that the contract offices themselves have a little more confidence in releasing the contracts that have been sitting on their desk for quite a long period of time with more than 12- to 18-month sales cycle that we've all been living with.

Okay. Does the deal ease up some of the line item cuts, across-the-board line item cuts? Does it give the DoD more flexibility or not?

It appears that it would, that the across-the-board cuts would be lessened in quantity so scale may be down. So again, there may be some across the board, but it appears there is at least efforts underfoot to allow much more specific targeted funding changes so that they can take a broader view on where their priorities lie.

During the split process, you provided information about direct labor subcontracting materials as an effort to help us understand your forward margin outlook. Are you going to make that information available for us to track?

Yes, Ed. This is John Hartley. You'll see that in our 10-Q that will be filed, hopefully, shortly after the earnings call. So that is a big initiative for us. We are starting to see some early movement in that percentage as a component of total labor once you remove the materials. And that is top of mind for our management team.

And our next question comes from the line of Jason Kupferberg.

This is Amit Singh for Jason. Just wanted to delve a little bit more into margins. So during the Analyst Day, you had said that you had started around 6.2%, and then over the next 3 to 5 years, go up to mid-7%. Now you guys have already printed, ex separation expenses, margins of 6.2%. So I was trying to wonder if there is any change in your guidance and when do you expect to reach that mid-7% target. And also, while you talk about it, if you can give us a little bit more color on where do you expect, let's say, SG&A to be, because right now you if you remove the separation rate expenses, it's around 2.3%. Is that a normalized level?

Sure. Let me go into that. So we still do believe that over the next 3 to 5 years, we can get to that more normative operating margin level and that is the 7% to 7.5% range. We do have a large component, I'll remind you, of DLA business, which is largely supply chain and have the significant component materials. And so therefore, that does draw the operating margin down. So if you pull that out, that moves us on our labor side by 60 to 80 basis points and that can provide for a better comparison to our competitors. But we think if we can move 20 basis points per year or so over that 3 to 5 years and some of the operating improvement initiatives that we have and levers available to us take a little longer to get to, some are shorter term in nature, but we'll be doing all of those so that after 3 to 5 years, we're looking in the 7% range.

Okay. And then SG&A at mid-2%, is that the right way to think of it going forward?

Yes, mid to low 2% is where we would be.

Okay. And just quickly on operating cash flow. For the quarter, obviously, it was down but you maintained your guidance. And I believe, in the quarter, it was down because there were some delays in payments from the government. So are you expecting to catch up to it in the last quarter? Or the original guidance, that had a little bit of leeway in it anyway to start with?

We probably won't recover completely but we expect to recover the majority of it. So we, as you can tell with our guidance, we do expect to turn the DSOs around fairly significantly. But we think it will leak a little bit into FY '15 by a few days is what we're currently anticipating.

And our last question comes from Bill Loomis.

What is the war-related work that you have now as a total percent of revenue?

Sure. So in FY '14, we have about $150 million in overseas contingency operations. That's primarily supply chain, which would be our POLChem contract, as well as our tires contract, some tactical vehicle integration work. And then also you would see, certainly, the force protection work as well. Going into '15, that's probably going to come down to about $100 million of OCO, again, primarily force protection and supply chain. Supply chain should be -- should follow the OPTEMPO of the military and we'll just move somewhere else if it moves out of OCO. So we don't expect that to be impacted significantly, but the force protection could be impacted a little more.

So on the supply chain, if we look at the DLA work you're doing overall, that it'll just shift someplace else so those revenues won't go down after we pull out of Afghanistan? Did I interpret you right?

Yes. We don't think it'll go to down significantly. There's got to be a certain OPTEMPO and they've been putting off a lot of training that does require supply chain activity as well. So the readiness and sustainment is going to, we believe, going to have to come back. So we think we've largely leveled off in the supply chain.

On the DISN contract loss, what are the comparisons that we have coming up on that over the next couple of quarters?

I'm sorry, could you -- what...

On the DISN contract that cost you $80 million -- when you're comparing year-over-year, was $80 million lower. What are the comps that we're looking at on that over the next couple quarters? How long it's going to be a -- how long is it going to be a drag?

Yes, it'll drag for about 2 more quarters. And so that's why you'll see contraction in -- you'll continue to see the fourth quarter of large contraction in Q1 of FY '15 and then we will have largely troughed at that point and then maybe even see some growth in H2.

So a large -- another large contraction in the fourth quarter. And then did you say another large one in the first quarter and then it's minimal after that or even a growth?

Yes. The first quarter will also have a large decline as well as you would expect. That's the fourth quarter of double-digit decline, and whether it's double-digit or not is yet to be seen. But that's the fourth consecutive quarter, and from that, we will have flattened out and again may even see some growth later in H2 of FY '15.

And how would you see growth if Lockheed has that?

Oh, not -- I'm sorry, I'm sorry. I was just referring to the enterprise as a whole. The DSG work that's still leaking through, it'll be less than $10 million to $15 million for Q1 -- Q4 and Q1. I'm sorry, I was misunderstanding your question.

Okay. So you'll compare against less than $10 million to $15 million in Q4 and in Q1 and then pretty much nothing in the next 2, right?

That's right.

That's right.

Okay. And the other headwinds, lower material and sub work on navy, what's going on there?

Just that's the navy's way of implementing some of the budget pressures. So we don't think it's completely lost in its entirety. Also, some of the vehicles we have, they've been more hesitant to run some of the materials through. Tony, do you have anything to add to that?

Yes, I would say that the navy's probably been, of the armed services, one that's probably held those monies more so than the others. And so from a portfolio basis, we saw probably a larger variance in the navy accounts.

And I'd like to turn the call back over to Paul Levi for closing remarks.

Thank you very much. I'd like to thank you all for your interest in SAIC and participating in the call today. I wish everybody a safe and happy holiday season. Good evening.

Ladies and gentlemen, this concludes the SAIC's Fiscal Year 2014 Q3 Conference Call. Thank you for using ACT Conferencing. You may now disconnect.