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

Hi, good afternoon, everybody. My name is Gavin Parsons. I'm the Government IT & Services analyst at Goldman. We've got Booz Allen Hamilton today. Typically, my coverage would follow industrials but these guys do a lot of tech, and there's a lot of overlap. So I'd love to introduce Lloyd Howell, the CFO; and Rubun Dey, Head of Investor Relations. Thanks for joining, guys.

Pleasure to be here. And thanks, Gavin.

So maybe just since not everybody is as familiar with you guys as might be at an industrial conference, do you mind just giving a high-level overview of who Booz Allen is and what you do?

Sure. We are a government services contractor supporting U.S. federal, international and commercial clients in the areas of consulting, analytics, digital solutions, engineering, cyber. We were founded in 1914, and we're headquartered in McLean, Virginia. We went public in 2010. And for the latest 12 months ended in December, we had just under $6 billion in revenue. We're pure-play services with 97% of our portfolio focused on the U.S. government, the balance being commercial clients. We're built on collaboration. We've got a very diverse leadership team, where the majority of our business leaders are women. We have a single P&L, and that's supported with a bonus pool for partners, vice presidents, principals and senior associates. To give you a little bit of more detail, we've got a broad customer base. A little over half of our portfolio is aimed at defense clients, namely in the services and the Joint Combatant Commands, roughly 25% are aimed at civil federal clients, specifically Homeland Security, HHS, Veterans Affairs, Treasury and Justice, and the balance is aimed at the intelligence community, namely the U.S. intelligence agencies as well as military intelligence. I mentioned global commercial. That's roughly 3% of our portfolio, focused on aerospace, financial services, health and life sciences. And internationally, we have a presence, primarily in the Middle East and parts of Western Europe. Our primary service offering across that is really in cybersecurity. And we've been doing that, as I mentioned earlier, since our IPO. We've got a variety of offerings that are really -- stem from our consulting heritage. But over the years, we've learned to integrate analytics and engineering toward things such as digital solutions and cyber. Our growth strategy, which we put in place roughly 8 years ago, was really to move closer to our clients' core missions. we've increased the technical content of our work. Hand-in-hand with that is competing in a very tough labor market for candidates that have those skills. We instituted an innovative group that really is aimed at delivering complex and differentiated end-to-end solutions. We've consistently increased our network of external partners and alliances, and we've also expanded beyond the U.S. federal government into international and commercial markets. A few comments on the financials. We've had a history of strong earnings growth and finished our third quarter at $646 million and ADEPS of just over $3. We've also consistently performed organically and finished at the end of Q3 up 7% and what we call revenue ex billable expenses at 9%. Our backlog has really been an indication of strong demand, and we saw a 6% growth in our backlog at the end of Q3, coming in at $23.3 billion, and we are aimed at continuing to increase that. We've got a history of high-quality and diversified contracts. We've got over 4,600 total contracts, not any one of which is greater than 2.3%. So it's also -- presented, it's also very diverse. From a contract type mix, we've got 3: Cost reimbursables coming in at 56% thereabouts; time and materials, roughly 25%; and fixed price in the high-teens. We've consistently had strong win rates. When we are the incumbent on a recompete basis, we win around 90% of the time. And for new business, we come in around 60%. And about 90% of the time we're a prime versus the sub. A few more demographic points, and then I'll turn it back over to you, Gavin. We're located in over 500 locations in 25 countries. We have a little over 27,000 employees, a 1/3 of which are veterans and about 2/3 of our staff have security clearances. And so with that, let me stop, Gavin, and see what other questions you have.

Perfect. That's great. And I'll just dive right in. And if anybody has any questions, feel free to submit them on the webcast, and we'll get to them. Now just jumping right in on cyber, that's obviously a huge area of priority for the government, given some recent high-profile breaches, nation-state sponsored activity. Budgets have grown a good deal over the last few years, but I mean, it certainly seems like the threat hasn't fully been mitigated. So what do you think cyber investment for the federal government grows at over the next few years? And then within that context, how big is cyber for you today? And then, where are you positioned or what do you do that would allow you to benefit from increased investment in cyber from the federal government?

Sure. Cyber is such a big catch-all descriptor. And we have learned that over the years, it's really the integration of lots of different capabilities to provide that type of support. That being said, it also presents a challenge to kind of size the overall market. I think what we see in the most recent stimulus bill is about $9 billion, which certainly, I think, indicates the demand signals that many of our clients are reaching out to us for support and that we are also shaping those opportunities. If I tried to quantify it 8 years ago, roughly 1/3 of our business would be aimed at high-technology solution type of work, which cyber clearly is a part of, and today, more than half of our portfolio is in these spaces that also include cyber. We have, as my previous comments indicated, about 1/4 of our portfolio focused on the intelligence community. And much of that is cybersecurity related as well. And that extends into our defense-related work. For as far as we can see, the addressability of the market's going to continue to grow. The aftermath of SolarWinds is just our most recent example of adversaries, many of which are enemy-state backed. And so we are working with our clients to protect not only them but the country, and we see lots of demand signals for that going forward.

You've got a commercial cyber business, too. And one thing that's always kind of surprised me is that there hasn't been more commercial demand for cyber services from a provider such as yourself, that actually does cyber for the U.S. government, for the Department of Defense. So I mean, how competitive are commercial players in your cyber for the federal government? And how competitive are you in the commercial market? And are there teaming opportunities in both directions there? If you could talk about that a little bit, it would be great.

Sure. Well, the commercial market certainly has been evolving. I think it's fair to say that many commercial clients, their first foray into cyber was to buy many tools that they felt would bring them the necessary protections against hacks and things of that sort. As the intrusions began to increase, and they found that, hey, we've got all these tools. I think the demand signal shifted to what are the tools that will give us more security? How do we knit that together? And then on top of that, what are the governance and crisis management and responses that we need to do? And I think that is -- plays more into our sweet spot. So what we've seen with our commercial business is increasing demand, not only on the intrusion side but also on continuous monitoring, penetration testing and other aspects that we feel are relevant to being secure. And when it comes to why not more, I think maybe a couple of reasons. One is that the limiting factor to meeting this demand is talent. So everyone is seeking cyber professionals, and there's just a dearth of supply. These are candidates that have high demand skills. The recruitment and onboarding of them is a challenge as an employer. We certainly have been successful, we continue to feel that we will, but to meet the growing demand is a function of bringing on more people. Increasingly, partnerships and alliances to meet this challenge is growing. We have many companies and the other vendors that we partner with, just given the scope and breadth of this type of work. And we don't see that in any way lessening going forward. I think it's fair to say everyone brings something to the game. And so we like to feel that we have a really good understanding of motivations, who the adversaries are, what their approaches typically are. And so we counsel our clients to the best that we can on those topics and then work with other vendors to address the risk.

So cyber, a little bit more mature but still growing. AI, I think you guys said last earnings call that you're the largest provider of AI to the federal government and you size that as like 60% year-over-year in the last period. But now a lot of companies like to talk about some of these buzz-wordy subjects, but you guys have won hundreds of millions, if not into the billions of dollars' worth of specific AI awards. So I was hoping you could talk a little bit about exactly what the major applications are, if that's more DoD or if that's federal? And then any sort of sizing today versus where you think that could be in 10 years, kind of like you did with cyber today versus a number of years ago?

Yes. In many aspects, artificial intelligence is also sort of the inclusion and integration of not only cyber but data analytics and other offerings that we've been building out over the years. And where we think we've been successful is cross walking the technology with a real understanding of what our clients' core mission requirements are and how to help them from an operational standpoint to meet those requirements. So I'll give you an example. Back in the 2000s, while we were engaged in many conflicts around the world, drone technology came into light. And many of our military clients saw the advantages of increased information, increased data that needed to be synthesized and then draw intelligence out of that. If you can imagine, banks and banks of screens with soldiers behind them, trying to interpret a millimeter move of a truck or a rock and then feed that to decision-makers to make operational decisions. Clearly not efficient, clearly prone to error. And so there was a need to not only streamline that, but to get more accurate. We saw that as a need of our clients and began to propose solutions that, at the time, were sort of deemed machine learning. And then if you carry it forward into the next decade, began to appear more like artificial intelligence. That's just a small, high-level example, but that sort of history and relationships have allowed us to position ourselves as really understanding what our clients need to do, then proposing technical solutions to meet those needs. And so our early successes in artificial intelligence really stem from that. And the size of the opportunities are more enterprise-wide than program-specific, because our clients are looking to get greater economies of scale and have those insights rain down across an entire department or agency, not just captured in one specific program. With that being said, it's been primarily defense and intelligence in nature. But increasingly, our civilian federal clients are learning what's the art of the possible? How can it be applied to them? Take the IRS and the processing of tax returns, are there some potential applications there? And given that the IRS is one of our long-standing clients, we're working with them and other treasury boroughs to help out. Again, much like my commentary around cyber, we see this as a growing, large addressable market. Increasingly, our clients are challenged with growing requirements, but a reduction in resources. And so technologies, such as artificial intelligence and cyber, are looked at as ways to do more with less, and we're helping them to see that to fruition.

And you mentioned enterprise-wide, I mean there's a lot of this expertise or IP that you've developed yourselves and then can leverage across multiple offerings rather than just simply being tied to a specific government contract?

To the extent we get the approvals, to the extent that the translation will still be relevant, the short answer is yes. So there are a variety of gates that we need to make sure that confidentiality and other sensitivities are maintained. But what we frequently do is we connect government to government clients. And in many ways, the government then begins the sort of education and learning process themselves. And to the extent that we're seen as a significant honest partner broker, we're engaged then to help that newer client with whatever challenges that they're facing. And sometimes, that includes IP, IC that we developed elsewhere. And other times, it's new and really relevant to whatever the specifics are of the newer client.

How about Modzy specifically? I mean, obviously, the call option opportunity right now, and you've talked about a number of those investments. But what's the potential path to monetizing that? And maybe also, if you could explain for people just what Modzy is?

Yes. Basically, it's an application resource for commercial AI apps that either a commercial or a federal client can access to construct or put together their artificial intelligence programs. And in the eyes of the federal market, it's seen as essentially a gateway to get the best of both worlds, not only federal insight and support, but also commercial innovations and new things that they think may be relevant as to what they're trying to do. Early days for us with Modzy. I think largely in the development phase. And I also would say growing demand and interest by potential customers. We have been successful including Modzy on proposals for our federal clients. And in some cases, our federal clients have seen that as a key differentiator, largely because, their words, they get the best of both worlds. So we remain optimistic, as Modzy matures, that it'll have even more impact, but it's still very much early days with Modzy.

And talent is something you've mentioned a number of times so far. And obviously, I assume a lot of these companies -- other companies at the conference today are ones you compete with for talent, many of which are either bigger at the start-up angle. So I mean, what's your approach to attracting talent? And does the government appreciate the need to be wage competitive?

Yes. So the labor market, not only with the capabilities that we talked about so far, but other areas, be it software, systems engineers, digital, analytic experts, are all hotly demanded. And to your point, fierce competition to attract those candidates. And for Booz Allen, we lead with a couple of things. One is the content of our work. So in certain parts of our portfolio, for example, we offer the opportunity to not only do defensive things in the area of cyber, but also offensive things. And you can't always do that in the broader market. And we found that, that sort of flexibility, that sort of breadth of art of the possible, is of interest to candidates, and they would like to have that experience, whether they stay with us for years or they're just passing through and return to or go to another employer. So the first is the content of the work. The second is really sort of our core values and our culture. We're very team- and collaborative-oriented and, as such, provides flexibility to work on lots of different projects across our portfolio. So that sort of optionality appeals to these professionals. They don't want to be pigeonholed. They want to have a variety of experiences and continue with their learning, and we're able to provide that. And then we feel that we fairly compensate these individuals, to your point. They certainly could get more in terms of compensation. So compensation, nature of the work, flexibility to work on different things, the total package, is really what we lead with. And we found that, that's effective in attracting the types of folks that we want. In terms of the wage, certainly, these professionals garner higher compensation than others, but the nature of our contracts are such that the government has been willing to pay for these professionals to support their programs, whether it's a cost reimbursable or a time and materials type of contract. Once these folks are slotted into the right labor categories and bid successfully, the government has been willing to pay for that type of support.

Has government made it harder to hire or harder to onboard?

It's certainly a challenge. Everything now is being done virtually. And so what for us is a pretty intensive, high-touch process, we've had to learn how to do that virtually. And the candidate pool has been more hesitant to switch employers, given all that's going on, balancing, dependent care, other life pressures and then on the professional side, doing it from home. So we have been successful in attracting talent, albeit at a lower volume than what we've seen in years past. And we're working on ways to increase the candidate pool, so that we can continue to onboard and add to our workforce going forward. But I think it's very fair to say that it has been a challenge to bring on talent in the midst of the pandemic.

Makes sense. And I want to come back to that process in a little bit. But maybe on margins, high level. You've talked about investing in more R&D, retaining more [Technical Difficulty], adopting a commercial selling model [indiscernible] others as well. But is there a natural margin ceiling for you, given that the governments your customer? Or can you continue to expand margins based on the things I said or other drivers that could allow you to continue to expand margins over a multiyear period?

Yes. So it all starts with the nature of the contracts that we support the government on. And I mentioned 3, cost reimbursable, time and materials and fixed price. Both cost reimbursable and time and materials are really capped in a range of mid- to high single digits. And so you're already facing a restriction when it comes to margin, just given the nature of the contract type. With fixed price, it can be well north of that. And typically, for the federal work, it's somewhere in the teens. There are occasions when it can be even higher than that, if it's a high level study or something of that sort. But by and large, in the mid-teens. What we have consistently been able to do over the years is operate our business increasingly efficiently, where we've been able to have solid contract performance. We've also put in a variety of cost management initiatives over the years that have really led us to be at the higher end of that range, let's call it, in the low 10s. In addition to -- just on the federal side, even though our global commercial business is the smallest part of the portfolio, we see 2.5 to 3.0x better margin performance than we would federal. And so that even at a small top line really falls to the bottom line and contributes to margin enhancement. I always get this question, like what's the art of the possible? I can certainly do some things in the near term where I'm maybe taking out our most highly compensated, less utilized folks in the near term, margins could jump well north of where we are today. But I probably would be hurting ourselves in terms of long-term growth prospects. So it's always a balancing act. Now what we have done is really focused on bottom line growth, and we've been able to really achieve some remarkable bottom line growth over the past 3 years from when we began. And to do that, we need a solid mid- to high single-digit top line performance. And we feel that being in the 10%, be it the low 10% range, has allowed us to do that. This year, we're guiding to mid- to high 10s, in large part because of some of the COVID impacts. They'll dissipate going forward, we suspect, but we feel that this is sort of a good range for us to be in, certainly over the years and certainly in the near term.

That makes sense. I think that's a perfect segue to tie it back into maybe some of the more specifics of financial planning and the outlook. And you mentioned your prior 3-year plan, and I think you're on track to exceed almost all of those targets. So what do the next 3 years look like compared to the past 3? And then what kind of context should we keep in mind for the starting point today relative to the starting point 3 years ago?

Yes, that's a great and timely question. We are in the midst of updating our strategic plan and, at the same time, what's the financial underpinnings of that. Just so as a point of reference, for those of you who may not be aware, our original investment thesis had us being somewhere between 6% and 9% at the top line, 9.5% with margins and then tried shooting for 50% bottom line growth with $1.4 billion of capital to be deployed. We did very well over the past 3 years and consistently raised that, and we're -- looks like we're coming in, in the 8%-ish range over that period of time. We increased our margins to be in the low 10s. And we're looking at an increase of over 80% at the ADEPS line. At the end of Q3, we're a little bit shy of the $1.4 billion target, but remain optimistic that we'll be able to close that gap by the end of this fiscal year, which ends in March. And with an eye toward the future, I think, Gavin, it's going to come down to a couple of things. What are we currently doing in our portfolio that we want to continue? And we talked about some of them, be it cyber or artificial intelligence. What are those areas within our portfolio we'd like to diminish or have less exposure to, and we're working our way through that. And across all of it, what are the adjacent markets and capabilities that we would like to expand into? We expect that to become a lot clearer later in the calendar year. And we also expect to be in a position to share that more broadly sometime in the fall. And then hand-in-hand with that would be sort of the financial underpinnings to that. We haven't settled on what that time period will be, whether it'll be 3 or even longer, but that's certainly the work that's underway at the moment.

Got it. It makes a lot of sense. That's helpful. I mean -- and obviously, it's a little bit more difficult for us to take the bottoms-up kind of viewpoint on growth. So I mean, what's the most important kind of financial or quantitative metric then, if I think about -- is it your book-to-bill? Is it how much backlog has grown over the past few years? Obviously, you've pointed out that you're pursuing some larger awards or contracts, book-to-bill may be lumpier, so that it'll slow down to 1.2 from 1.4. This may just be timing related, but your backlog has really outgrown revenue. So what's the most important kind of financial indicator that we should look to as an indicator of forward growth?

Yes. For us, it's really -- on the supply side. It's at what rate are we adding to our workforce. If you look at the demand side and you look at sort of our total backlog growth, that's been terrific over the -- certainly, the last 3 years and beyond. And so as Horacio had said on many calls, we never feel that we're demand-constrained. It's always been a supply constraint. So if we bring on the talent that we talked about in this call at a sufficient growth rate, we feel pretty confident that we'll be able to convert what's in our backlog to achieve top line and bottom line performance. So we're -- we typically, going into any fiscal year, target mid-single digits. We exited FY '20 at 4.2, which really translated into a nice growth rate for FY '20. We had a run rate of 3% in the first half of this year. And when you consider the fact that people were not taking vacation, attrition was at an all-time low. And our available labor was through the roof. We had a highly productive workforce that also translated into some very strong top line growth. Productivity snapped back on us in November. And at the same time, we did not bring on the number of folks that we needed to do. So we're doubling and emphasizing even more the recruiting side of things. But it gets back to your question, Gavin, which is, what's the key thing to look at? And so our ability to attract, onboard and deploy the talent to convert the backlog that's been pretty high for quite some time.

Right. And to your point, growth slowed a little bit in 3Q, but it sounds like you've got a good handle on why that is, and then you're taking steps already to right that and -- but if I look at guidance, it implies a bit of a slowdown in 4Q and obviously, in the front half of next year, I think you do have some difficult comps on that headcount utilization dynamic. A second ago, you just made a comment towards the end of this calendar year, we should start to see kind of a -- maybe a return to a more normal Booz Allen growth trajectory, if I'm interpreting that correctly. So what is the slowdown in 4Q? And what gives you the confidence that you can kind of make sure that these headwinds are short term in nature?

Yes. I mean, there are really 3 dynamics that we saw increase in magnitude in the third quarter. One was some programmatic shifts in our portfolio in light of the challenging transition, in light of the new administration team needing to come into place, and our clients essentially hitting the pause button and saying, hey, let's let things settle down before we move out with the issuance of RFPs and making awards. From our experience, that's pretty unusual. Usually, there is a rhythm even through a transition to the issuance of work and getting things going as the new team comes into place, largely because the type of things we do are politically agnostic. But in this last transition, there was more disruption than I think we certainly anticipated. Hand-in-hand with that, billable expenses, which are really tied to equipment purchases, business travel, things of that sort, also has come down in the midst of COVID. So with the shift in contracts, the drop in billable expenses, you certainly saw the top line impacts. And then on the supply side, as I mentioned in my previous response, we saw a shift in productivity levels to a more normal pre-COVID level of performance. And that was largely due to us encouraging our people to take a break, take some time off, and they did that certainly in November as we went into the holiday season. So of the 3 dynamics, we expect that 2 of them will start to reverse in the ensuing quarters. The work and the opportunities did not go away. There weren't any cancellations or anything of that sort. It's really just a timing delay. And then as we -- on the supply side, picked up the pace on recruiting, taking into account a more normal productivity level, we expect that to kind of play out into the next fiscal year. And that's why we remain confident and optimistic about getting back to where we are, the timing of which, Gavin, I think, is a challenge. It's really a function of when the government issues this work and works its way through any potential protests. But we have all indications by our clients that they do indeed intend to move out on these opportunities. And we like our competitive positioning going into it.

Got it. That's helpful, especially on the top line side. And on margins, in 3Q, even with some of the growth disruption, you grew margins very nicely year-over-year. But -- and while I imagine it might be somewhat difficult to quantify, there was obviously a COVID headwind to margins and a profit on loss revenue in the first half. But then also you had the benefit of the higher utilization. So what does that mean for margins in either the first half of next year or next year? Can you actually grow margins next year? Or was there a large net tailwind from that headcount utilization dynamic this year?

Again, a bit too early to pinpoint exactly where it will be. But things that are tailwinds now largely due to COVID impacts will subside. But at the same time, the fundamentals of the business are strong that we don't anticipate any serious deterioration in what we've been able to do going into the last year or pre-COVID, if you will. We typically have very strong margin performance in the first half of any fiscal year, and it trails off a bit in the second, largely due to -- that's where we're rewarding our people, we're making infrastructure improvements, we're investing in capabilities. When I say investing, we're asking folks to devote more of their time toward IC, IP generation to shape future opportunities. And we're also ramping up hiring going into the following fiscal year, so we can really hit the ground running. And I would expect a similar pattern. I think the choppiness that we'll see at the top line is really a function of the new team getting in place, the issuance of recompetes and new work. And as I mentioned, we feel we're pretty well positioned to compete for that. And given our historic win rates, we're pretty optimistic that we'll do well.

What exactly does ramping up hiring entail? And how do you put the government, put pedal for that? And how long does it take from hiring somebody day 1 to having them deployed on a project?

Yes. I mean, pre-COVID, it really is a function of us filling sold and funded requisitions versus pure capabilities. Said another way, work we already have in hand, the minute we find an individual we're able to onboard and deploy that person within 30 days, 30, 45 days. And then for a capability hire, it's more forward-leaning in terms of maybe the work's not necessarily in hand, but we feel that it's got a high probability of being one. And so we'll pull the trigger on those candidates. The process itself is pretty intensive. As I mentioned, our culture is very important. So a candidate will talk to a number of people before we think it's the right fit culturally and capability wise. In some cases, our clients will also want to review resumes and have a say on who ultimately will work on their job. So it's not unusual that we'll make contingent hires depending upon when the work is won and comes in. And naturally, to my previous comment, as things shifted, those contingent offers also shifted. Once we interview the candidate, we have a sold and funded position for them. And then they move into their team with the right supervisor and career manager and are able to become a fully integrated member of the team going forward. So that was sort of pre-COVID. In the midst of COVID, we do all that virtually. And so the challenge is ensuring that the candidate themselves are comfortable getting traction and also that the client is seeing value in the person. I'd also offer that the process is a bit elongated, just given that the timing, the sense of urgency, the processes, the decision making, you could argue it could be more efficient virtually, but what we found is it takes a little bit longer to do that. So in the ramp-up, it's a function of increasing the volume of candidates going through the process, and then on our side, speeding up the decision-making and maybe collapsing what is otherwise a pretty intensive interview process to be even more efficient, so we can bring on and get a higher yield of folks joining our workforce. It takes a bit to get that flywheel going. We certainly feel that we'll be able to do that in large part because the candidate pools, 1/3 of it comes from referrals from our existing workforce. Other sources include the government themselves, competitors, folks looking to make a transition from a commercial environment to more of a federal environment. And given that dynamic, familiarity with the firm, the content of the work, we're always trying to communicate as best we can to that potential candidate to join Booz Allen.

Great. That makes sense. Well, with that, I think we are out of time. But thank you so much, Lloyd. Really appreciate the time. Rubun, thank you.

Our pleasure.