Booz Allen Hamilton Holding Corporation (BAH) Earnings Call Transcript & Summary

Okay. All right. Let's get started. So good afternoon. Matt Akers from Aerospace and Defense team here at Barclays. Our next guest is Booz Allen Hamilton. We've got Nick Veasey from Investor Relations. Nick, thank you for joining us.

Yes, thank you.

So maybe just to kick it off kind of high-level thoughts on the budget. I've got the request last week.

Sure.

Obviously, a long way to go before that's finalized. But Just sort of which areas you guys did well, which may be less so?

Yes. So as you said, I think this is an opening political gambit, prone to a lot of revision over the coming months and sets the tone for the administration's priorities, but obviously, coming into an election year, it's not surprising to set administration priorities and have it be a very political budget request. So look, we were pleased to see the uptick in the VA. We do a lot of work for veterans on the health front. It's a key part of that health business we've talked about, and a big grower in our civil group. And we think, overall, it was a good budget request, and it was a budget request, which doesn't really mean all that much at this stage. Yes.

Yes, fair enough. I guess, in terms of the areas like defense versus sort of the civil, do you see that mix shifting with this budget? Or, I guess, still TBD depending on how it kind of shakes out over time?

Yes, I would say, see -- similar answer. It's going to shake out and political wins will have some impact on that over time, I think, but there's a presidential election coming, that will be a lot more impactful than an opening budget requests that, again, is a political document. But I -- our current mix, ballpark, 50% defense, 25% Intel, 25% in the civil world. We've had great growth in civil, to the extent that growth continues. In recent years, it's somewhat outpaced our broader defense and Intel growth, but we've had really strong defense growth this past year. So puts and takes that kind of bring us back to that mix that we've had for the last few years. I don't think we envision that changing dramatically moving forward, but I think one of the strengths of Booz Allen is its ability to pivot to changing political dynamics. So we think this single P&L enables more rapid movements to changing spending priorities. And that's something that we can find to be a differentiator in the business.

Sure. Do you have any thoughts kind of longer term reading the few years, where we are in the budget cycle? Do you think there's more years of growth ahead of us?

I -- so I guess budget growth, again, will also be tied to a presidential election and where those dollars are spent, whether they're domestic spending priorities, whether they're defense spending priorities. I think a lot of that remains to be seen throughout the political process. Notably, unlike prior election, there hasn't been any side of the aisle that's talked about dramatic spending cuts. So it seems like both parties have different spending priorities, but that they are spending priorities. At the more micro level, Booz Allen has done well in budget environments that have been very variable over the last couple of decades. So I guess, again, politically, I think there is a will to spend. We believe we're positioned well against the sort of politically agnostic ends of the spending environment. So areas like cyber, where Booz Allen has been a leader for a long time. We don't envision that going away regardless of who wins the presidential election or how Congress shapes up. So again, we think we're well positioned right now in certain growth areas. AI being another one that's by contrast with cyber, which is a broad, big bucket of spending right now that's growing, AI is a much smaller bucket of spending that's seen an explosive growth because it's off of a much smaller base. So we think we're well positioned in both of those areas. And again, looking at macro budget growth is an indicator for sure of how the companies in our structure will grow, but it's about exposure within the broader budget that will determine who the winners and the losers are.

Sure. I guess kind of thinking back to prior election cycles. I mean do we typically get a weird seasonality to order patterns or any kind of weird movements that we should watch out for the time?

I think people will overreact to that. I think going back, looking at the data over time, there's this sort of, I guess, perception that a Republican administration would necessarily be better for defense. And when you actually parse the numbers, that's not necessarily the case. So no, I'm not aware of any -- like any particular trend that I personally would be comfortable placing a bet on. But I know I'm probably in the minority there.

Yes. Could you touch on sort of fourth estate? So there's been a lot of headlines in the space about just sort of Secretary Esper's focusing on kind of the non-services part of the defense budget as an area to cut costs. Is this scenario that you guys have exposure to? Are you seeing any pressure? Or is it an opportunity maybe to gain some share if you can get -- do things more efficiently than others?

Yes. So I would say that depends on where your exposure is also in the fourth estate. Lower end work, for sure, is going to have a price point that falls if there is dramatic budget cuts there. I think over time, we have done portfolio shaping to the extent that within the fourth estate, lower end work where we don't have a lot of exposure. But there are classified pieces of work in the fourth estate, depending on how you define that term, which is a pretty broad one, where we do have some exposure. I don't think those would come under immediate budget cuts. But again, it's tough to parse that out because of the classified nature of the work.

Got it. I guess, thinking of the space broadly. So then a ton of M&A activity.

Yes, there has.

Definitely. You guys have sort of been one of the sidelines. I think your strategy hasn't been to pursue that as much. Do you feel pressure to do more deals? Why does it still make sense to kind of do your own thing?

Yes. So it's not for a lack of effort. I -- prior to holding the IR role, I'd worked in the M&A team and actually ran our last 2 acquisitions, so Aquilent and Morphick. Morphick fell into our cyber space and was a managed services offering on the commercial side. Aquilent was the largest dollar amount acquisition we've ever done and still very small by comparison with some of the trades that have happened in the sector, especially recently. Look, it's a low-cost of capital environment. I very much understand why the M&A trades have happened the way they've happened. I think some of our peers have had a lot of success. If you don't have customer access, you don't have a particular capability buying into those spaces, makes a lot of sense. We have looked at the landscape, there have been portions of certain assets that we found very appealing. There have been other portions of the assets that we found less appealing and at the multiples that folks are paying right now, I think some of them would cross our strategic hurdle, which is a pretty high one, but then to cross the financial hurdle as well. It's a challenging auction environment to win, if you don't really feel like everything is 100% strategically aligned. So it's not for a lack of effort. It's not a lack of looking. We look at 100-plus opportunities a year. I want to say, Lloyd is on record saying that we probably have submitted 6 to 10 bids per year, and it's been 2 years since we bought anything.

Right. Yes. A good indicator of the market?

Yes. Look, it's -- I understand why the trades are happening. I think some of our peers have had a lot of success with the trades, and we're going to keep doing what we're doing, which is focused on organic growth, and we're pretty proud with our track record there.

Do you think that it helps you to not get distracted on some of these bigger deals?

Yes. And I think there are a couple of our peers that have real strong M&A track records and they have a well-oiled M&A machine. Booz Allen did -- we've done a little bit of M&A, but I can speak firsthand. We are not -- we can do M&A. We are not terribly well versed in M&A. We're not doing 10 deals a year. So yes, I think some of our peers could do the exact same trade and maybe be a little bit less distracted than we would be, but it's certainly a consideration when we think about M&A.

Got it. I guess, kind of the biggest question I get on Booz is just the organic growth. For a very long time, you guys have had outgrown the peer group. What are kind of the key drivers of that and how sustainable is that going into the future?

It's a number of different things. I think that power of the brand, and the 105-year history of the firm allows us to attract top-tier talent. And I think we can get that top-tier talent and put them against challenging pieces of work. When you've got top-tier talent doing really challenging work, you produce good, strong result. That strong result enables you to have a competitive recruiting pool again. So -- we've often said that we don't feel we're demand-constrained right now. We feel the backlog is near all-time highs. We feel demand is fairly binary and that it's very much a 1 right now. Our concern is on the supply side, and can we attract and retain the right top-tier talent and not lower the bar for our recruiting standards to choose our headcount growth in the near term only to see the brands degrade in the longer term. So Horacio and Lloyd would say, and they have said that attracting and retaining top-tier talent is our biggest focus because it feeds that virtuous circle we were talking about a moment ago. So we think that's part of it. And long-term customer relationships and mission understanding, we think, helps differentiate us. Our first piece of federal work was done with the United States Navy, right prior to World War II, that's the long-term relationship. It's one we value. It's not executing a particular contract for the Navy, it's thinking what the next 10 years might look like for the Navy and how to defend a ship at sea from a cyber-attack, which isn't a problem that existed 20 years ago. So we think we're -- we like to think that we're on the leading edge of anticipating our clients' problems and that it's not a collection of contracts. It is truly a longer-term relationship, and that's strategic consulting mindset that has been a part of the firm since its foundation.

Got it. Makes sense. So yes, you touched on hiring and talent. Could you sort of give us an overview of how that's going? I think there was a lot made of kind of Amazon moving to the capital region. How much competition are you seeing from kind of the tech industry?

Yes. Look, hiring's tough. Again, this is one of the areas that we view is the thing that keeps our CEO and CFO up at night. Amazon coming to the DC area, I think, initially, folks probably overreacted to that. We view it as, look, we're already competing for tech talent with big tech players. I wouldn't say the type of work we're going after is the same type of work, if Amazon, AWS is going to provide cloud infrastructure. We don't provide cloud infrastructure. We'll do the strategy work in the cloud migration work, but they're somewhat clearly-defined swim lanes right now for where the companies play. But when it comes to recruiting and getting people in, we very much compete, and we like to think we're holding our own and have been. So them coming to DC maybe intensifies that competition a little bit, but the idea that we've never seen Amazon before, and we've never competed for talent until they announced HQ2 is just not true. So another way to look at that is Amazon is an incredibly well-known company. They are going to bring an ecosystem of tech talent with them. Arguably, the universities in that area are going to be producing more stem graduates because of interests in a major source of jobs after school. So we think there's an environment that comes along with them. We think we have seen them before. We've been successful when competing against them for talent. And it's, again, not an easy area. It's an area we take really seriously, and Horacio's, probably one of his highest priorities.

Got it. Has the security clearance process gotten better? And has that enabled you to hire people more quickly?

The security clearance backlog has come down. Adjudications of that backlog and actually getting the security clearance out the door hasn't maybe come down at the same rate that the backlog has come down. So security clearance process as a whole, we had not gotten a lot better from our perspective. We still very much struggle trying to find top cleared, top technical talent, and again, not trying to lower that bar, is an area that, again, it's not -- it's an area of focus for our CEO and our CFO.

Sure. Could you touch on so what we've called the option value portfolio? Maybe mention what some of these products are? And I don't know if you can talk about generally kind of how much they will contribute this year? And maybe how that could ramp up in the future?

Yes, sure. So we haven't, I'll be the first to admit, given public disclosure for option value investments, their size or growth rates or anything like that. What we have said on all the option value stuff is, it's exciting. And we are sacrificing some EBITDA margin of shareholders' capital by investing in these option value investments, but we haven't quantified it yet. None of them are material. So we're not required to report on any of them. And what we have said is that they're all small. If they all go to 0, we still are confident that we're going to generate 6% to 9% top line growth and a low 10s EBITDA margin. If 1 or 2 of them take off, which we're hopeful, 1 or 2 of them will, there'll be some upside there. So we've talked most recently about Modzy, which is an AI platform that essentially will allow the federal government or commercial entities to use AI algorithms that have been embedded by the Booz Allen cybersecurity offering. So you could take a commercially available algorithm in our platform, the government or a corporate client could use it with the confidence that Booz Allen has vetted the algorithm, that it was trained appropriately and that the information it'll be spitting out is, in fact, not trained by a malicious actor and dummy data. You can see where there's some applicability there. Again, this is not a headcount-based business model and most of our option value investments are designed to look at ways to break -- not break, but to augment the current business model. So this is something that, if it were to scale, would scale without us having a higher additional headcount. And there are a number of other option value investments like that. But Modzy, the AI platform's the most recent one we've talked about.

So if you look at all these in aggregate, I mean, can you talk about how many have actually sort of hidden or growing? And are there any that you've walked away from already? Or how much are sort of getting to that point where they're decoupling kind of growth from headcount?

So we sold the company or a small portion of our business. We divested a financial crimes unit, which could be classified as one of our option value investments that we looked at. We gave it some runway. There were some generations, some interest. And ultimately, we determined that, most likely, they would do better under different ownership or a separate ownership stake. So we divested the asset. I think we probably came close to breaking even on it, but that's option value, right? Like we expect a bunch of these will not be successful. We have high hopes that a couple of them will be very successful, and hence the name option value. As a collective portfolio, again, we haven't given any financial disclosure around it. I -- Horacio and Lloyd have said, like, when the time is right, and we feel confident, then we'll start putting numbers out there so folks can actually ascribe some value to it. But the view today is these are small, very, very early stage and not a contributor at the top or bottom line, such that it would change anyone's model.

Got it. Makes sense. So could you talk about kind of the long-term strategic framework? So we have Vision 2020, it's now 2020.

Yes, it is.

As you look at the next phase, I mean, what range of options are you considering? Could we see something that's dramatically different, or is it likely to be kind of similar, but kind of new targets?

Yes. So we have a strategic review going on right now. It is a major effort inside the firm. The group of 27,000 strategy consultants. You can imagine, this is -- it's a big process. We expect to be briefing the Board later this summer. And Lloyd has started saying that we will have a rollout of that strategic review in our shift and strategy at some point after that. So the timing, as you can imagine, late summer briefing with the Board, you're into early fall, there's presidential election, do you want to -- the timing of the presidential election and the strategic review are TBD at this point. So likely, as Lloyd has said, either late this calendar year or early next calendar year. And he's also said our last strategic review is done In 2013, 2014, Vision 2020, and was done from a position of borderline duress because of sequestration. So this time, the difference is what we talked about then was fairly revolutionary. We had a lot of change. I think where Lloyd's going with this is, we're doing it from a position of strength this time, and they'll be course correcting, but I don't think he's expecting major strategic shift to that age.

Makes sense. Could you talk about sort of recompete risk going into this year? Any major programs we should watch out for just, sort of, the general level compared to normal years?

Yes, nothing stands out. As you know, one of the strengths of the business is that it's a very broadly-distributed base of revenue. So there aren't any 10-plus percent of revenue contracts out there. There aren't any 3-plus percent of revenue contracts out there. So sure, we have the similar level of recompete risk that we've always had. And there's nothing really that stands out this year about it.

Got it. I guess, could you talk about free cash flow conversion percentage of net income? How you sort of see that going into the future? And maybe, I don't know if you could touch on the various components of working capital or CapEx where those could trend?

Yes. So we -- because of tax reform and how that was going to flow into financials and the timing that we thought it would take to get real clarity on that. We started guiding to operating cash flow, and we gave CapEx guidance. So I can reference back to those metrics. We've seen an uptick and partially driven by tax this year in our operating cash flow guidance for the year. And frankly, our CapEx has been fairly elevated over the last couple of years. So Lloyd has said that, that CapEx level, if you think the norm for services is 1% of revenue, we're at 1.6% ballpark of revenue right now. He said he expects that to remain elevated for a little bit of time. So make what you will from that fairly big statement. But yes, I think we've made progress on the working capital side, our collections process has been tightened. It's had Lloyd's attention for over a year now. So there's been some incremental progress there. There's probably still some room for improvement. So that's on the receivables side. On the payables side, I think that's probably an area of focus for Lloyd now.

Got it. And the CapEx is still a little bit above the 1%. Is that option value that's kind of driving that?

So most of the option value investments have been expensed. So as I was talking about the EBITDA margin that we've sort of sacrificed, most of the option value cost has been P&L-driven rather than capitalized. A small portion of some of the option value has been capitalized. But again, it's so immaterial that we're not talking hundreds of millions of dollars by any stretch of the imagination. So yes, I think option value is largely driven by P&L expense at this stage.

Got it. Okay. Maybe now we can do the audience response questions real quick, and then if we get a few minutes left, maybe we can take questions from the audience, if there are any. Question one, do you currently own the stock? No? Okay. So a lot of opportunity in the room.

Yes.

What's your general bias towards the stock right now?

I'd love to have done this pre and post presentation. Didn't really...

Yes, judged the value by our...

Great.

Maybe next year.

She'll just straight up laugh, come on.

Okay. We're mostly positive. Great. Next one. Through-cycle EPS growth for Booz Allen will be? Okay. Above peers. Well said. Next question. In your opinion, what should Booz Allen do with excess cash?

This is a pressing one. I'm curious.

Yes. Yes. So this is going to be my next question.

Okay. So we can talk...

Capital allocation guide.

Yes.

Share repurchase, internal investment. All right. Interesting. Okay. Next question, please. What multiple of 2020 earnings should Booz Allen trade? 19 to 21x. Okay. Great. And then last one. What's the most significant share price headwind facing Booz Allen Hamilton? Execution strategy. Okay. Interesting.

Great.

Yes, if anyone else from the audience has a question, definitely let me know. Feel free to raise a hand. We've got a microphone we can bring around. In the meantime, I guess, yes, maybe you could touch on the capital allocation strategy. So 3 years, you guys have talked about, I think, $1.4 billion of capital deployment. I think it was like a fairly big step-up over the next year. Any thoughts on which of the levers you can use that for?

Yes. So the priorities really haven't changed. And Lloyd and Horacio have reiterated for every quarter since the investment thesis came out that we would reach the $1.4 billion goal. They also have reiterated that we never said divide by 12, and that's your quarterly corporate capital allocation. So there are still 5 quarters remaining in the 12-quarter thesis. Some of the times, I feel like the -- we've maybe forgotten about 4 of those 5 quarters, but we're confident that we'll get there. Lloyd has talked about share repos being the lever that we've pulled in the past. M&A, as we said earlier in this discussion, we certainly look. We'll see what comes along on the M&A front, and we would buy a company if it was a strategic fit for us at the right price. But I don't envision us buying a company to meet the capital allocation target. There are -- Lloyd and Horacio are a lot more thoughtful about shareholder capital on that. Our common dividend, as you've seen, we've grown pretty rapidly over the last 5 years. We've done 2 dividend increases, the first ever off-cycle dividend increase this year and our usual dividend increase. So we felt very confident, I think, in the longer-term cash generation profile of the business, and you see that in the common dividend growth. And then a special dividend is still a tool. We haven't exercised that tool in a number of years, but we have in the past and could certainly be used again in the future.

Got it. Maybe could you touch on the Intel business? So on the earnings call, you highlighted some headwinds there, programs rolling off. Based on what we're seeing, the budget request, again, not final, but how should we think about that business growing kind of once we get past this initial?

I think it's a little too early to tell right now, like when the inflection point will be or when the pivot will be. But we did want to, again, acknowledge from what we thought was a great quarter, an area that, quite frankly, didn't perform to Horacio and Lloyd's expectations. So if you were to look at the business right now, the flat Intel business is not where Horacio and Lloyd want it to be. We saw a little bit of demand softness. So a couple of recompete losses that we think we should have won. And you're seeing some pressure on the supply side as well. So inability, as I was mentioning earlier, to find that highly cleared talent to plug into our Intel work. It's a challenging business. We are confident that in the long run, we'll get there. But in the near term, it's got a lot of attention from Horacio and Lloyd. And in this past quarter, we -- with the recompete loss, we're able to take some of those people, which we still fight very hard to retain and pivot those folks with their functional capability into our defense business because they had the right clearances, and they were doing a functional piece of work on the AR/VR front that our defense clients would very highly value. So you saw some outsized growth in defense this past quarter, which might have even been driven by the softness in the Intel business. And that speaks volumes about the portfolio nature of the business that we have and how -- look, Intel is a significant portion of our business. It's a little soft right now. And we were able to leverage the highly talented people and highly cleared people into our defense market because it's a single P&L. Folks move very seamlessly amongst our markets, and we see at the macro level, a lot of success in the firm. But also want to acknowledge, look, this is an area that has some attention right now.

Got it. That's helpful. I guess, maybe looking at some -- what some of your peers are talking about, the shifts, more sort of a product, still some of their business and those services, I think, some of the option values that we talked about, has a little bit of that, but how do you think it's sort of that mix? And what are the trade-offs of one versus the other?

I think our strategic review has got that on the docket, something that we're exploring, but not anything that we're sending an indication on right now that we're going towards products is the loose term I've heard out in the market now for a couple of our peers. I think you're right. I think option value are all oriented on something that is more solutions-oriented than maybe just pure services. But again, strategic review, we'll answer some of these questions. I don't see a radical departure like inorganically on the M&A front for us at any time in the near future. We've had a lot of success with our Vision 2020 strategy. And that's something we're going to continue to rely on until we make minor course changes.

Got it. Great. So with that, I think we're out of time. So Nick, thanks a lot.

Yes. Thank you. I appreciate it.