Science Applications International Corporation (SAIC) Q4 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the SAIC Fiscal Year 2014 Fourth Quarter Conference Call. [Operator Instructions] This conference is being recorded today, Tuesday, April 8, 2014. And I would now like to turn the conference over to Paul Levi. Please go ahead.

Thank you, and welcome to SAIC's fourth quarter and fiscal year end 2014 earnings call. Presenting with me on the call today are Tony Moraco, our CEO; and John Hartley, our CFO. Today, we issued our earnings release detailing our quarterly and year-end results. Additionally, you will find presentation slides on our website. Both of these documents, in addition to our Form 10-K to be filed soon, should be utilized in evaluating our results and outlook, along with information provided on today's call. During this call, we will make forward-looking statements to assist you in understanding the company and our expectations about the future financial and operating performance. These statements are subject to a number of risks that could cause the actual events to differ materially, and I refer you to our SEC filings for a discussion of these risks, including the Risk Factors section of our Registration Statement on our Form 10 and the quarterly reports on our Form 10-Q. 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 will now turn the call over to our CEO, Tony Moraco.

Thank you, Paul, and good afternoon. SAIC's financial results for fiscal year 2014 were in line with our previous communications, and John will discuss the financial details later in the call. We operated the last quarter of fiscal year '14 as an independent standalone company following the separation from our former parent, and I'm proud of the transformation of our operations, attributable to the focus of our leadership team and the dedication of all of our employees supporting our customers during a significant year of change. I'm also pleased with how well we have improved our competitiveness by reducing our cost structure. We're leveraging our newly implemented matrix operational model to provide more of our capabilities to all of our markets and customers. Regarding the market environment, since our December call, the 2-year federal budget deal was passed and is generally favorable to the environment during this timeframe compared to full sequestration. We believe customers will have a more stable budget outlook to execute their missions. They are now able to prioritize their expenditures over a multiyear period, unlike what we have seen recently. However, fiscal challenges still remain for our customers, but these challenges may now be addressed by a more rational and deliberate approach. We continue to see demand for the services and solutions that SAIC provides and new contract opportunities that pursue. We also expect some improvement of our customers' contact award decisions as the government fiscal year progresses. To that point, we have noted slight improvements in the pace of contract decisions so far in our first quarter. Moving to our business development efforts, we continue to develop a quality pipeline of opportunities, aligned with our strategy to protect our revenue base, expand revenues with current customers and grow into adjacent markets where appropriate. At the end of fiscal '14, the value of our submitted proposals awaiting decision totaled $14.8 billion, which represents an increasing buildup through the year and a 26% increase from the end of our third quarter. SAIC finished fiscal '14 with total contract backlog of $6.7 billion. The fourth quarter book-to-bill was only 0.3. While our fourth quarter book-to-bill is historically a low bookings quarter, this was below our historical average. There were 3 items that significantly impacted our book-to-bill in the quarter: First, our customer award decisions were light as a result of budget uncertainty, the government shut down, leading up to the Bipartisan Budget Act. However, [indiscernible] decisions that were made, our win rate was in our historical average. Second, we had low bookings on our existing Army Aviation and Missile Command or AMCOM task order 32 caused by the delay of the recompete award and the existing Army task order [indiscernible] funding [indiscernible]. And finally and perhaps the most significant, the much higher amount of de-bookings on existing programs than we previously experienced, which was approximately $200 million higher than our historical average. These de-bookings were associated with 3 specific contracts, with the majority of de-bookings related to the scoping of low fee or non-fee very material pass-through for subcontract activity. So while these de-bookings impacted our fourth quarter book-to-bill, we do not see it will have a negative impact to our operating income. Some of the de-bookings we experienced were indicative of the budget pressures that our customers are facing and their prioritization of their missions. Without these impacts, we would have delivered a quarterly book-to-bill in line with our historical average for the fourth quarter. Looking past the end of the quarter, we had signs of increased award activity and had several notable wins aligned to our protect, expand and growth strategy. In the protect category, we were successful in our recompete of our large AMCOM EXPRESS task order 32. Now known as task order 37, this very important win of an $836 million 3-year recompete allows us to continue to provide excellent support for the Army's most critical missions. In the area of lifecycle systems and software engineering support to provide world-class aviation and missile system support to the joint warfighter. I would like to remind you that bookings are only recognized on the AMCOM EXPRESS task orders when funding is committed on technical instructions over time. The progress on our strategy to expand the current customers was evident in the award of a $221 million task order for the Army's Human Resources Command for full lifecycle information technology support. While this Army command has been an important customer of SAIC for decades, we were the incumbent on a portion of this work. We were successful in expanding our contract scope to provide system maintenance, enhancement and development support vital to managing their personnel. This is a great example of our ability to expand our relationships and contract revenues with current customers. With regard to the growth category, we have been qualifying opportunities before the spin. In the fourth quarter, we submitted over $200 million in proposals to customers we had not pursued in the past. Although it will take some time to convert submits to revenue, SAIC was awarded a relatively small Air Force contract that gives us [indiscernible] to develop and deliver change management and communication services as the Air Force integrates many separate financial management systems into one integrated system. This 3-year $5 million win with the Air Force illustrates our newly-expanded region to previously underserved customers. During the fourth quarter, a long-standing protest for a $70 million Navy contract to provide Naval Surface Warfare Center, create an air electronic warfare engineering support was resolved in our favor. We are still waiting the government's decision on 2 other major programs under protest. The DHS EAGLE II contract is still in a reevaluation process by the customer, and the NASA HHPC contract award is under reconsideration by the GAO on behalf of NASA's award for the contract that SAIC, the protest abiding company. I would like to take a moment to talk about our new operating model. Just a bit over a year ago, we designed and have now fully implemented our new matrix structure that is focused on 2 dimensions: the customer-facing groups that manage the contract portfolio and the service lines that aggregate our technical capabilities. This efficient and effective organization is critical to fully leverage our strong customer mission understanding and our tremendous technical capabilities of our workforce. We are now operating in 5 customer groups, following integration of our Defense Logistics Agency portfolio with the DoD Agencies and Commands Group. We continue to align our resources in 8 service lines to deliver services and solutions across equal lifecycle of engineering services and enterprise IT disciplines. We believe that this implementation of a matrix organization is compelling to the government services space. This model will result in a more collaborative organization and one that is more competitive that can drive improved operating margins. One example is our ability to optimize our proposed solutions, to increase our SAIC labor content, reduce dependencies on subcontractors, to result in higher contract fees. We continue to put our words into action with regards to capital deployment as well. Capital deployment in excess of our minimum operating cash level, the foundational tenet of SAIC, and during the fourth quarter, we took another step to returning shareholder value. In addition to our recurring cash dividend payable on April 30, we initiated a share repurchase program. Beginning in mid-December and through the end of January, we repurchased approximately 363,000 shares, deploying $12.5 million of capital. Absent higher returns on capital deployment opportunities, we expect to continue buying back shares with our cash in excess of our operating needs. I will now turn it over to our CFO, John Hartley, to discuss our financial results.

Thank you, Tony. In order to provide a better view into SAIC's operating results, my comments on this call will exclude the minor amount of revenues and costs performed by our former parent and will be primarily focused on SAIC's performance for the fourth quarter as opposed to the full year, as it reflects SAIC's first full quarter as an independent company. Our revenues for the fourth quarter were $931 million. And we ended fiscal year 2014 with just over $4 billion in revenue, which aligned with our guidance. As expected, this represented a year-over-year revenue decline for the whole year of 14% and was driven principally by the ramp down of the DGS program and also by the completion and ramp down of IT and logistics programs related to the draw down in Afghanistan, the completion of a program to provide technical support to the Army, and lower material and subcontract work on Navy contract vehicles. While on the subject of year-over-year revenue decline, as we have communicated previously, we expect the first quarter of fiscal '15 will result in a double-digit year-over-year revenue decline, then reach improved stability in revenue as we exit from the year-over-year revenue decline towards the second half of fiscal '15. Moving on to operating income, we had fourth quarter operating income of $56 million, representing 6% of revenue. After several quarters of significant separation expense impact, this was largely behind us in the fourth quarter, with only $1 million of separation cost or 10 basis points impact to operating margins for the quarter. We believe that our fourth quarter profitability is representative of the current state of our business, but there is significant room for improvement in this area. Optimizing our operating margin is a key area of focus for us, and we have various levers available to show steady improvement in this operating metric over time. We are committed to enhancing profitability with the objective of 10 to 20 basis points of average annual improvement until we reach a level more reflective of the markets where we operate. Net income for the fourth quarter was $33 million, which resulted in diluted earnings per share of $0.66 for the quarter or $2.27 for the year. Our tax rate for the quarter was 36.5%, slightly below our expected normative tax rate going forward of around 38%. This considers that the R&D tax credit expired at the end of calendar '13, and has not yet been extended. I will now move on to the balance sheet and cash flow statement. Our days sales outstanding or DSOs were 59 days at the end of the quarter, which is an 8-day improvement over the prior quarter. You will recall that our Q3 DSOs were significantly impacted by the government shutdown and the planned 10-day shutdown of our IT systems related to the separation. We are very pleased to report that we have fully recovered from these adverse effects and are in a more normative DSO range. Accordingly, we ended the year with $254 million of cash. Our cash flow from operations was $125 million for the quarter and $183 million for the year, well in excess of our guidance of $125 million for the full year. We also had fourth quarter capital expenditures of $6 million, which is in line with our normative level of approximately $20 million on an annual basis. Important to our operating cash flow in the coming quarters is our pending contract novation due to the separation. Disruption in this largely government-led process could have a temporary negative impact on operating cash flow, but we do not expect this will have an ongoing impact. Regarding SAIC's capitalization, we are in active dialogue with our Board of Directors regarding our leverage ratio. Over time, we plan to move toward a capital structure more appropriate for a business of SAIC's steady and substantial cash flow by increasing our debt level over time. We believe that our cash generation and balance sheet flexibility allows us to simultaneously invest in growth, return capital to shareholders, and pursue selective acquisitions when compelling opportunities present themselves. Additionally, for now, we view $200 million as our average minimum cash level for operating purposes, but this will likely come down as we get more comfortable with our financial operations and working capital requirements. Moving on to our long-term financial targets. At our Investor Day in September and subsequent investor conferences, we provided long-term financial targets for our company. Those targets, which we expect to achieve on average and over time, remain unchanged. 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 higher return capital deployment opportunities. And fourth, financial leverage appropriate for a company with SAIC's investment requirement and cash generating characteristics. Going forward, given the longer-term targets that I just reiterated, our commitment to providing transparency into our quarterly results, the greater market and operating alignment of the company post separation, we do not believe there is added benefit to providing annual estimates of revenue, EPS and cash flow as was initiated while we were part of our former parent. We expect to comment on our long-term targets and update them in our quarterly process should our views change in the future. Our policy on disclosure of long-term targets instead of annual estimates of financial metrics should in no way suggest that we have reduced visibility into our future performance. Rather, this reflects the desire of management and the board to align investor expectations more closely with our own and is reflective of how we intend to manage the business. I would like to reiterate that the board, Tony and I are fully committed to providing appropriate business and financial transparency to help our investors in making informed investment decisions about SAIC. With that, I will turn the call back over to Tony.

Thanks, John. We recently announced that France Cordova left our Board of Directors to take on a critical role for our country as the Director of the National Science Foundation. I would like to thank France for many years of service and participation in the separation process as one of the initial board members of our independent company. We wish her well as she serves our country in this challenging and important role. Our proxy statement will be distributed soon to shareholders, but I would like to announce that our annual shareholder meeting will take place on June 4, at our McLean, Virginia offices. I encourage all shareholders to attend this event. I very much look forward to fiscal year '15. The leadership team and I remain resolute in our primary objectives of sustaining revenues, improving operating margins, further optimizing our operating structure, while we effectively deploy our capital. Before taking your questions, I would like to thank all SAIC employees for their continued dedication and focus on performance during a year of dramatic change. Your efforts have resulted in a very successful year of transition and position SAIC for success in fiscal year '15. Operator, we are now ready to take questions.

[Operator Instructions] Our first question comes from the line of Cai Von Rumohr with Cowen and Company.

So Tony, the $200 million of de-booking, approximately when might that have hit in fiscal '15?

Cai, that will be spread across the rest of the year. Based on what we saw, those come through across all the contract vehicles. So that will be spread across the rest of FY '15.

And also, I would point out that these are multiyear contracts. So it's actually spread over a number of years. So the impact to FY' 15 is nowhere near $200 million.

Got it. How big might it be?

We don't see it having a significant impact based on the type of revenue that we had on what we are expecting for FY '15. It's more in the out years that we see it having a drag.

Terrific. And then, just a comment maybe if you could, some of the margin issues in the fourth quarter. The gross margin looked pretty good there at 8.5%, didn't have any award fees or catch ups. The SG&A, a little higher than I'd guess. What's the run rate going forward? And I assume that that's the last separation expense.

I think the profitability, Cai, was in line with what we expected, as we came out of the spin. You saw the light separation costs were part of that. The contract performance delivering fees in the normative range of what we would expect. So I think to your point, we didn't see anything unusual come out of Q4 on the margin side.

Our next question comes from the line of Jason Kupferberg with Jefferies & Company.

This is Amit Singh for Jason. Just wanted to come again on the overall discretionary spending or the budget -- the government spending environment. So have you actually -- since the signing of the budget deal, if you could add a little bit more, have you actually started seeing a pickup in the contracting and awarding activity? I'm just trying to tie this with recent comments from some of your peers which seem to indicate that maybe the pickup just never happened, and they were more pessimistic than you, if I would put it that way.

I think what we've seen coming out of the budget deal, the reassessment by the customers of what their spend profiles are going to look like, building on the prioritization that they had looked at over the last year. Like our peers, we have not seen a lot of activity in the contract award decision in those first 2 months as we looked at January and February. We're seeing pickups in certain customer sets. We commented on the AMCOM EXPRESS deal and as efforts continue. But generally, I think, we would be aligned with overall expectations that it would be the end of this calendar year, end of government year, is you'd start seeing any additional contract awards above the levels that we saw in 2013.

All right. Great. And then you reiterated your long-term margin guidance. But since the last few quarters, have you identified any additional cost take out opportunities?

So first, I want to make it clear that we're not providing guidance. We have long-term targets. We continue to look at cost take out activities. So that, one, we meet our commitments to our customers and stay on our rates, also monitoring our direct labor base closely. But we'll continue to optimize the organization through FY '15 and this year of optimization. So there certainly will be some additional reductions in costs, whether that's labor or nonlabor, we're still analyzing, but we'll be making those throughout the year.

Our next question comes from the line of Joe Nadol with JPMorgan.

This is actually Chris Sands on for Joe. John, you had mentioned that there could be a temporary disruption to cash flow this year from the contract novation issue. Can you quantify how big that might be for us?

It's difficult to quantify because it would depend on how long it progressed. We are in a very awkward situation where there is a name change to our former parent, and at the same time, we need a novation to occur over to us. Again, it is largely government-led. We don't project that there is going to be a significant impact. We think it will recover quickly. We haven't seen a large impact to date. We don't expect there to be a huge perturbation in Q1, and we would certainly be expecting to be back on target in Q2. Of course, we'll update you in Q1 if that turns any more bleak. I just wanted to make all of you aware of that situation.

Okay. So it's not something that would stretch out into 2016 and then disrupt the cash flow for the whole year?

Actually not. We certainly won't go past the first half of the year or the first 3 quarters. It's our belief.

And then sticking with cash flow, you started the share repurchase this quarter. You're now $50 million above your kind of target balance, and you said you're comfortable with leverage going even higher. Should we expect repurchase activity to increase from this level going forward or how should we think about that?

Well, what I will say is, we anticipate deploying the capital in a consistent manner of what is in excess of our operating needs. So you've picked up on the fact that we ended the year in excess of our operating needs. We also have the ability to move up the leverage. So that may very well indicate an acceleration or an increase in the amount of share repurchases we'd do in the future that would be required based on what you saw through the end of the year, to deploy our available capital. And that is, of course, absent higher return capital deployment opportunities. So just consistently expect again, if we don't have those higher return capital deployment activities to deploy the excess capital that we have available to us. Right now, share buyback is what we would intend to do.

Got you. And then on a few of the discreet revenue items, can you just remind us how much of a headwind DISN will be this year and then maybe how much Afghanistan will be? What it was in fiscal '14 and what you expect in fiscal '15?

Yes, I'm sorry, so were you asking how much headwind that is for FY '15 on a year-over-year?

Yes, for both DISN and Afghanistan.

Yes. So you can expect the year-over-year to decline double digits in the first quarter. As I have said, that's our fourth double-digit decline in the fourth quarter. But we do anticipate that we'll start to hit a steady-state. If you look at our revenues for Q3 and Q4, when adjusting for seasonality, which is minor, we do think those are indicative of a more normative run rate trend for looking into FY' 15 and projecting our performance. Q3 and Q4 of FY' 14.

Our next question comes from the line of Edward Caso with Wells Fargo Securities.

Can you talk a little bit about the NASA contract? And is it still in the protest? Is it still with the GAO and any sense on timing?

Yes. The NASA deal is still under reconsideration by the GAO based on the actions that NASA took as part of the protest process. They had a 100-day clock that went forward from last quarter. So we would suggest that by the end of April that clock expires, no guarantees, but they typically hold to that date. Without it, we would see for GAO's response back to NASA, and then based on that outcome, NASA would have to make formal decisions and we're awaiting those as well.

Right. Can you talk a little bit about the impact of Afghanistan activities. Several companies have talked about the level of activity, especially with pass-throughs being lower than anticipated. That seems to be a common theme the last few quarters. Is it running below your expectations, given the election uncertainty and probably a rising probability that the military will be completely out of Afghanistan by year end?

Sure, I'll answer that. This is John Hartley. We don't have a lot of OCO exposure in Afghanistan remaining. In fact, we -- it's about $50 million in FY '15 give or take. And so we don't expect -- we expect that to come to fruition as we do some of the wind down. There could be some slight underrun, but that's kind of what our exposure is.

Okay. And if you could talk a little bit about how the senior management is compensated. Obviously, you provided us a very squishy scorecard here to guide you, to score you on. Curious to see how your -- the senior management scorecard works with the board.

This is Tony. The incentive plans are aligned around these targets and emphasis are on operating margins, is more weighted than revenue and cash flow. But those are the 3 dimensions that we measure short term and long term. Post separation, we've also instituted a performance share plan that also aligns to those same similar measures with, again, emphasis on operating income and cash flows. So we think it is very well aligned to the shareholders' interest. We have full board support in that, and I would expect to deliver on those plans.

Our next question is a follow-up question from Cai Von Rumohr with Cowen and Company.

Yes. So first question is, normally, your first quarter is cash flow negative. And you've mentioned this contract -- potential contract novation issue. So if you kind of run normal negative, you could be down toward the $200 million. Would it be fair to assume that you might be a little bit more cautious on cash deployment opportunities early in the year until you're through those 2 issues?

You're likely to see that, although, we project our cash flow out so that we don't mind dipping below $200 million. That's what we would consider an average. We always have the revolver available to us. So we want to deploy capital on a consistent basis. So we do project quite far forward in making the decision on what to deploy. You're likely to see Q1 operating cash flows to be negative, as we've seen in the past, because that's when we pay some of our bonuses and other things that occur. But that won't really dissuade us from looking a little longer term on how much to share repurchase. But it may not accelerate significantly in Q1.

Okay. And then, you had mentioned, I guess, that on AMCOM EXPRESS, you only book the task orders, and then you had this is Army HR health contract. So how much with the bookings you've gotten so far from those be in the quarter just so we can kind of gauge where you're starting off in the quarter?

Yes. So the health care one is a booking. So it's a task order. We do book task orders for every other contract except AMCOM EXPRESS. When you look at AMCOM EXPRESS, when they issue a task order, it really is an IDIQ vehicle, because other customers come and issue what they call technical instructions, and that's truly the tasking on it. And so AMCOM comes in as funding is committed, but the Army one will be booked in the first quarter.

Okay. And then, your SG&A was $23 million in the quarter. I've been looking for somewhat less. How should we think about your SG&A run rate as you go through the year?

We think we've hit back to our more normative level of SG&A. Again, it aligns with the way we disclose our -- in our disclosure statement to the government. So it includes certain items. You could expect it to be in the neighborhood of between 2% and 3% for FY '15 is where you'd expect us to be trending.

And I'd like to turn the conference back over to management for any closing remarks. Please go ahead.

Thank you very much. I'd like to thank you all for your interest in SAIC, and participating in the call today, and we wish you all a good evening.

Thank you. Ladies and gentlemen, this does conclude our conference for today. If you would like to listen to a replay of today's call, please dial (303) 590-3030 or 1 (800) 406-7325, with access code 4670471. Thank you for your participation. You may now disconnect.