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

Good afternoon. I am Louie DiPalma. I cover aerospace and defense on William Blair's equity research team. This is day 2 of the 40th William Blair Growth Stock Conference. We are pleased to be hosting a 30-minute fireside chat with the management team of Booz Allen Hamilton. Joining me today are CFO, Lloyd Howell, who you can see; and Head of Investor Relations, Nick Veasey. Lloyd and Nick, thank you for joining me.

Thank you, Louie.

I am required to inform the audience that a complete list of research disclosures or potential conflicts of interest is available on our website at williamblair.com. Booz Allen previously presented at our conference in 2011, 2012 and 2013. And a lot has changed since then when the industry was in a downturn.

To start, Lloyd, the pandemic has impacted companies in different ways across our aerospace and defense coverage. How has the pandemic impacted your team and your key service offerings?

Sure. Louie, again, thank you for hosting us, and it's good to talk to everyone, albeit virtually. From a pandemic perspective, needless to say, the impact has been most felt by our workforce in terms of their welfare, anxiety level, the manner in which they are currently supporting our clients. And fortunately, we've been in a position to lessen many of those anxieties by standing up a $100 million resiliency fund to allow folks to feel -- in a meaningful way, not worry about their jobs, to be -- have the time and the resources to take care of their dependents, be it children or aged parents. And so through some cost management initiatives, executive compensation cuts, we were able to fund that amount. And we have spent a lot of time, appropriately so, engaged with our workforce, both in terms of communicating our new policies but also soliciting their input on what does a safe return to work look like and what would their requirements be. So internal to Booz Allen, a lot of time and investment to assure our people. Externally, at the same time, we've been actively engaged with our clients not only to manage as we all went into a telework mode of operating but what does the other side look like from their perspective and how aggressively would they want to return to whatever the new normal is going to be. And what we have heard is that everyone is being very thoughtful about returning, usually in a staged approach, call it, 25% on up to some new level. But they have also been open to a -- let's call it a more diversified way of support that may still include telework. To what degree remains to be seen, but they are certainly talking to us about that. From a service offering and productivity standpoint, we are back to pre-pandemic levels of productivity, which is great to see. Basically, people are not taking PTO. Attrition is at an all-time low, which certainly we don't expect to be the case throughout the year but certainly has facilitated a strong start to this fiscal year. But missions are being supported, nothing has really been significantly disrupted, so we feel good about where we are.

That is helpful. And now to the question that's on many investors' minds, federal stimulus funding for the pandemic has significantly increased the federal deficit. This has created investor concern that there may be like sharp cuts to the defense budget in the future. During the budget sequestration of 2012, Booz Allen fared better than most, but it still took you guys 6 years for revenue to recover from the high watermark that you achieved in your 2012. I'm wondering, your thoughts on the federal budget trajectory and whether Booz Allen is better equipped now versus back in fiscal 2012 to withstand a potential budget downturn.

Sure. Even pre-pandemic, I think it's fair to say a flattening to a decline was anticipated, the timing of which folks debate. By our, call it, guesstimation, we think we would start to see signs of that in government fiscal year '22 and then more evident government fiscal year '23 and beyond. How much further beyond, who knows? But that's where we would see it. To what degree it would decline, I think, is also debatable. There were other events, call it, back in 2011 that were at play, the wind-down of 2 wars. But clearly, with the deficit continuing to grow, latest of which are the stimulus funds that contribute to that, we believe that our government will need to address that. Learning from what happened in 2011 and 2013, we definitely feel we're in a better position to counter that possibility. We are -- today stepped up our communication with all of our clients but in particular the contracting community. We're getting a good sense of what their priorities would be given various scenarios. And we're encouraged by the fact that widespread, there's an understanding, which, quite frankly, COVID-19 has brought to light that if our government is slow in addressing many of the IT infrastructure modernization efforts, there'll be a price to be paid on that front. So we still see the maintenance or the increase of that being a priority, and we like our positioning over the past 7, 8 years in those areas. So we certainly don't want to take 5 years to return to growth should there be a contraction. But we're also optimistic that, albeit an impact hard to quantify now, we're in a better position to address that should the scenario come to pass.

Sounds good. And on this budget topic, there's been a lot of talk about potential increases in health care spending. At your Analyst Day, and I believe it was 2018, Nick, you created a pretty sleek slide deck in which you broke out Booz Allen's health care revenue as roughly $800 million for fiscal 2018. And you indicated that Booz Allen's health care revenue has increased at a 23% CAGR since 2007, which was before you went public. What types of health care services does Booz Allen offer? And like do you have the necessary assets to expand into areas that could receive more funding?

Sure. Today, we support many of VA's critical and high-visibility projects, be it PTSD or other areas that really impact our vets. And we're very proud of that work. Increasingly, our support to VA and other health care-related agencies and departments have pivoted to these higher technical solutions, be it cybersecurity, data analytics and most recently artificial intelligence. We expect the demand for that type of support to continue to grow, particularly, in fact, that many of these agencies have aging IT infrastructure and, up to this point, haven't been able to take advantage of all the technical advances. So not just because it's a hot topic but because we have been making the investment and really understanding how to marry up these technical solutions with the VA's critical missions and programs, we feel that should it come to pass where there is an increase in VA's budget, for example, we'll be able to continue supporting our existing clients and, frankly, expand our presence across VA from what it is today.

Sounds good. And over the past decade, Lloyd, Booz Allen by some measures has been the least acquisitive of its peers. And this has resulted in your financials being very clean with a lot of dividends and share buybacks, which many investors savor. And I was wondering, has this like very conservative M&A strategy been by design? And do you expect this conservative M&A strategy to continue? Or could there be changes in your strategy there?

Sure. Up to this point, it has been by design and, frankly, is very consistent with our corporate strategy where we were becoming more technically oriented, attracting more technical people who have the skills for those offerings, partnering with external vendors that add complementary capability, getting closer to our clients' mission. And we felt that to do that, capability tuck-ins made the most sense, and we're consistent with that strategy. We believe that we're already at scale. And so to make acquisitions solely to get bigger, we felt, was inconsistent with our strategy as well as our culture. It would take, we felt, a considerable amount of time to work through that integration and, at the same time, distract us in doing so, and frankly, didn't feel that we needed to make a transformative acquisition in order to get to where we are today. So the second part of your question is, hey, on a go-forward basis, how might that change? Increasingly or up to this point, we've emphasized organic growth as our primary mechanism to what we do. And it's not so much that we would want to retreat from that, but we also appreciate that in certain areas, be it an adjacent market or adjacent capability, we may need to consider acquisitions either more frequently or a bit larger than what we've done up to this point. I think it's still early to say what the volume of that would be, but we're certainly asking ourselves, challenging ourselves as to how much of an inorganic contribution do we think we need to make in order to better support our clients and to provide opportunities for our people to grow.

Got you. And do you need an acquisition to gain scale for your commercial business? Or are you comfortable growing that organically?

We have been today looking at acquisition opportunities in the commercial space. And in fact, albeit small, our last acquisition of a managed services company was in that vein. Today, we're looking at opportunities in that space. Now clearly, the impact of COVID-19 has had a dampening effect of how many companies are actually up for sale and the circumstances of which they're up to -- up for sale and also the pricing. But we are going to the plate, swinging the bat on opportunities that are indeed in the commercial space. So a little bit different than my response as it pertains to the federal side of our portfolio, we would definitely be open to doing a deal if the economics made sense, it was the right add to what we already have going on, which is a cyber-first stack. But just to get bigger for the sake of getting bigger is still not in our psyche.

And it seems that most of your government IT peers focus almost exclusively on government services. They don't dabble at all into commercial. What do you see that others don't in terms of synergies between government tech services and commercial tech services?

Yes. I mean it's a good question, and it speaks directly to our heritage of originally being a commercial management strategy consulting firm. Invariably, it flipped, but what we experienced when we had both a much larger commercial business than we have today is that on the federal side, our clients expect us to know and to bring to them commercial solutions. Whether they ultimately act on them or not, they want the benefit of knowing, hey, here's how an oil and gas company address cybersecurity or here's how retail is addressing their IT modernization effort. And at the same time, many of our government clients want to know what's happening commercially. "Hey, I read about this firm in Silicon Valley that's providing AI support. What can you tell me about them?" Or the clients that you support, what are the insights and what adversaries are doing. So by being at the nexus of certain finite commercial areas like cybersecurity, we find having benefit on both sides. So we see that as a strategic advantage. Number two, from a workforce standpoint, our people want to continue to grow and want some options as to what their careers may include. And what we find is that when individuals can apply their craft both federally and commercially, a couple of things happen. One is they grow in terms of those experiences. But number two is that they stay at Booz Allen a bit longer than feeling that they need to depart to go elsewhere. So the diversification from our workforce is also an attractive feature.

Got you. And on this topic of commercial services, you mentioned how there's synergy between cyber -- like what are the major differences between the 2 end markets in terms of you selling? I've always found it peculiar how Booz Allen is, in many investors' minds, the best-of-breed government IT service provider and Accenture is widely considered the best-of-breed enterprise IT service provider. And like currently, Booz Allen trades at a decent discount to Accenture on an earnings basis. And it seems, from my perspective, that enterprise IT and government IT have like similar secular growth drivers. You mentioned cyber, and there's data analytics. There's cloud. There's AI. But what are -- Lloyd, what are your thoughts regarding the differences in the growth prospects for the 2 end markets? And since you participate in both, I think you have a unique perspective.

Sure. I think it's a couple of dimensions. First, on the content of the work, particularly in the cyber space, what our colleagues have the opportunity to do is both offensive and defensive things for many of our clients. And they learn and acquire skill sets that are in keeping with why they came to Booz Allen in the first place. When you're on the other side of the coin, where you might have now joined a private or a commercial company, your ability to do offensive things is greatly limited fundamentally by law. You can't have a bank going out there and doing nefarious activity, albeit with the perceived benefit to their customers. That's just against the law. And so what we have seen is from a talent standpoint, it's really that opportunity to learn a new part of their craft. And even if they do leave and go to a private sector company, at least they have that insight and that experience that they can take with them. Number two is the economics between federal and commercial, even though the words are the same, the economics are quite different. We enjoy 2.5 to 3x greater margin contribution from our commercial work than our federal work. There's a lot more, call it, economically attractive opportunities in the commercial space that ultimately flow through the financials than what you would see federal. At the same time, payment on the dollar tends to be negotiated commercially, whereas government is a pretty good customer in terms of -- or client in terms of paying 100% on the dollar. So all of that kind of plays to why I think Accenture's valuation and multiples tend to be higher because their portfolio shifts more toward a commercial portfolio than ours does. And no disrespect at all to Accenture, they're very good at what they do, but that's why I think you see that sort of treatment of Accenture's valuation versus ours.

Got you. Yes, that makes sense to some degree. I would -- some investors might push back and say, just because Accenture has higher margins because of their commercial contracts doesn't necessarily imply that there's greater health and growth potential for their markets and services. And I think you guys generally agree to that as well. But it's an interesting debate in terms of what markets have like more cyclicality versus what have more like fixed and linear demand. I know that there's been cycles in terms of a defense downturn. There was -- there's an enterprise downturn that may take place right now, but it's definitely interesting to hear your perspective on that.

No. I mean I think much to, I guess, the spirit behind your budget question, my experience as a CFO is the financial community has a much tighter linkage of the budget to a company's performance. So if you guys hear, "Hey, there's a possibility of flattening or a cut," there's an immediate assumption that, that somehow is going to directly impact Booz Allen or any one of our peers in the market. The reality is, if you look at certainly Booz Allen's performance, that's not necessarily so for a couple of reasons. One is we work in the seams. We're not tied to budget line items, and there's a great deal of flexibility in our clients to move money. And we have acquired a skill set to help them reallocate, redistribute. So the impact that otherwise would be assumed isn't as great or doesn't happen at all or in some cases, it's accretive because they'll kill the things that are low-hanging fruit and redirect funds to higher-end support, which we like to believe we are supporting. But I think that mindset and the ability to kind of, in some degree, trust that this isn't a 1:1 cause and effect, I think you can only see that when you look back a little bit as opposed to the current next 2 years or 3 years.

That makes sense. And during this pandemic, Lloyd, the DoD recently announced several awards to emerging software, data analytics firms, such as like Palantir and Dataminr, for projects like data analytics-type services that seem to cross into your realm. Do you feel that like pure play, like software firms represent a growing competitive threat? Or do you view like software firms as potential partners similar to what you do with NVIDIA, Microsoft and Dell?

So the government from time to time is always going to reach out for support for any vendor, any company that they think can help them to address an issue or to address an immediate pressing need. Quite frankly, we saw that occur in the Obama administration when they were standing up many of their IT interfaces that were going to directly talk to taxpayers, and they went to an outside vendor to get that type of support. And so we've seen that in our history, and we expect that to occur. What we've also seen, though, is a "outside vendor's sort of commitment or sustainability" to this market doesn't really occur for a variety of reasons. Back to your Accenture questioning, there's an expectation and a valuation set of assumptions that, "Hey, you are truly a commercial vendor. And so we expect your margins to be in this area, and we expect your performance to be consistent with your peer set." And when you add a considerable component to your portfolio that is federal, that's going to bring that down from their perspective. And we have seen companies not really wanting to do that for obvious reasons. To the latter part of your question, we think that these are terrific partners. And in fact, we are partnering with them today, and there is an increasing interest and desire to continue to do that both from their perspective and ours. What we have and other companies in our sector is just a rich history of relationships, understanding the requirements today, understanding the requirements going forward. And for some of these new market entrants, having that translator, having that partner makes it a win-win where they can practice their craft, bring to bear what they really are confident at. And we can do the same, and both companies win. We are not seeing an encroachment or seeing them as a direct competitor. Certainly, things can change in the future. But to this point, it's really been a recognition of, "Hey, I really want a cloud vendor, but I also at the same time want Booz Allen to make sure that my operational and mission requirements don't suffer with that translation."

Right. That makes sense. And another question that a lot of investors have been asking about. On your recent fourth quarter earnings call, you discussed how you are pursuing larger contracts. And I was wondering, is this a function on how -- of how the customer is now awarding larger contracts versus 5 years ago? Or is this like a change in strategy in which you guys feel more confident to pursue larger contracts, and you didn't feel as confident like 5 years ago?

Yes. It's more so the former. Some, not all, clients are wanting to get economies of scale from existing task orders and sort of bundling them up. And that contributes to a larger award opportunity. Some, which we feel JAIC is a reflection of, the nature of the technology support is scalable. Therefore, they're seeking support in a scaled way toward the implementation of their artificial intelligence program. And because in many cases, we have preexisting relationships or an incumbency position, we're naturally including more of these opportunities because that's where the market has gone. We do not feel that that's a pivot or a change to our fundamental strategy. We're still focused on providing high-end technical support, attracting the people that do that. This is more of a reaction to, hey, Client A is sort of bundled task orders or really wants AI support that is much broader than a specific program or a department, and we feel like the right thing to do is to pursue those opportunities.

Got you. And Nick, are you still on?

Yes, I am.

Can you describe the strategy behind the Modzy artificial intelligence platform? And this is a topic with your recent JAIC $800 million contract and your previous eMAPS that investors are excited about. But I don't think many know as much about Modzy. So I'd like to...

Yes, sure. So I'll spend a minute on it. Lloyd will probably -- should be leading point on this. But Modzy is an exciting option value initiative of ours. And as you know, with the option value initiatives, these are ways that we're looking to diversify our business model away from a purely people-based business model. So there are several option value investments that we're making right now. Modzy is exciting because it's a platform that includes the Booz Allen cybersecurity offering wrapped around an AI product that is essentially a commercially available technology that we've helped due to our mission understanding. And it allows the government and other commercial players to access this marketplace and with the comfort knowing that Booz Allen has scrubbed the available algorithms in this system. And Modzy was a part of this JAIC award that we've spoken about. So it's -- the option value investments are all nascent. They're not material by any means. They are small right now, but a couple of these going our way would be an exciting upside to Booz Allen's investment thesis.

Louie, I don't have much to add to that. But to your previous comment on -- or question regarding why commercial, Modzy is the perfect example of why commercial. And in a meaningful way, we saw that play out in the JAIC award where the client said, "Thank you, Booz Allen. Now we have a bridge to commercial vendors and offerings through Booz Allen that otherwise, we'd have to have a separate procurement and a whole set of processes around that. Now we can come to Booz Allen and have the best of both worlds."

Yes. No, it's -- I think it's very strategic, and it aligns you with the commercial vendors. And it definitely makes sense. I think that is all the time that we have right now. Thank you very much, Lloyd and Nick. Good luck with the rest of our conference. And thanks again. Talk to you guys later.

You bet. Thank you, Louie.

Thanks, everyone.

Bye.

Bye.