Science Applications International Corporation (SAIC) Earnings Call Transcript & Summary

Good evening, and welcome, everybody, to Morgan Stanley's Virtual Laguna Conference. My name is Matt Sharpe. I'm the firm's government services and technologies analyst. Before we begin today, I do need to read some disclosures. For important disclosures, please see the Morgan Stanley research disclosures website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. With that, it's my pleasure to be joined this morning by the SAIC team, specifically the CFO and Vice President of Investor Relations. Prabu, Joe, welcome. Pleasure to have you guys this morning.

Thank you, Matt.

Thanks for having us, Matt.

Joe, I believe you also, on your end, have some disclosures to share with our audience before we kick things off?

I do. I'll be brief. And yes, thank you again for having us. Before we begin our discussions today, we'll refer to our recently disclosed Q2 results and our outlook provided on our September 2 call. I refer you to our second quarter earnings release and recently filed 10-Q. And with that, I'll turn it back over to you, Matt.

Fantastic. Thank you. So Prabu, maybe we can start high level here at the top line. You've done a very nice job of executing over the first half of your year. And as we look into the back half, there's probably some building blocks or some moving pieces here that represent risks and opportunities. What can you share with us? What context can you share to help us think through the back half of the year? And what might move around, what risks, what opportunities specifically are there?

Thank you, Matt. And first of all, thank you again for having us here this morning. Our guidance implies low single-digit growth in the second half of the year, and we ran through some of the puts and takes that can influence that. Clearly, COVID introduces some uncertainty. And as you know, our supply chain business has been fairly sensitive to trends there. So we're trying to capture some of that in the updated guidance. But really for today's conversation, I'm going to try and take us up 1 level and say that the bottom line for us as a management team is this. We want to profitably grow the business and manage this business as a shareholder of the business. As you've seen, we made some changes to senior leadership, and we've changed some leadership in the ranks, and we've also made some changes to what I'm going to call at-risk compensation to better incentivize profitable growth around here. And we've taken both a relative peer review performance, but also a TSR modifier for our Vice Presidents. These are really important changes. As for sort of growth rates and such, we've got plenty of opportunity in the pipeline. And I think I'd step back and say, is the pipeline getting better qualitatively? And I think the teams are continuing to do a lot of work to improve that. We do believe that with the changes we've made, the increased investments we're continuing to make and the at-risk changes to our comp plan, all of these underpin our strategy. And those are some of the reasons, candidly, why we're more confident in our ability to grow. But again, that we have work to do and go execute every quarter like we've done in the first half of the year with intensity and, frankly, consistently. We understand, finally, the market's focus on organic growth, and we're mindful of what we've not produced in the recent past. So with that, I'd say we recognize that driving sort of sustained top quartile organic growth and expanding margins can drive significant value for our shareholders, and that's what we're focused on.

To that point, I think we're likely seeing some of the first indications of those investments you've made, right? Trailing 12-month book-to-bill is now at about 1.6x. Backlog is at near record levels, $24 billion. I think that's up 25% year-over-year. How should we think about these forward indicators? And what else should we maybe consider? And given the levels that we're at today, should we think that sometime in the near or medium term, there might be an acceleration of your organic growth?

Yes. So as I think we've mentioned, we've done a fair amount of work around pipeline. And clearly, I think one of the focus areas for us is to make sure that the work is in areas that we aspire to be -- to be in a few years. So there's obviously a fair amount of focus on NASA AEGIS or NASA NEX, which represents over 2% of the revenues for the company. But it's clearly meaningfully less than that as a percentage of EBITDA on an annual basis. On the other hand, we do expect the Army business to ramp on the back of the S3I portfolio. Now we're pleased with our book-to-bill performance, and it provides for us, I think, the foundation to grow the business over time. To be clear, I think while our book-to-bill is top tier, that alone, we know this business does not secure top gear organic growth over the next few years. So we still have work to do here, but that's our focus. So we're not going to be specific about sort of growth rates in the near term or even the medium term. I will continue to share progress on our journey to creating long-term shareholder value. The foundation is there. We've got to go execute day in and day out and book-to-bill is obviously strong enough for us to grow off of.

Fair enough. Fair enough. Maybe we just sort of pivot here to a related subject, your end markets, right? The past 12 to 18 months have seen a lot of changes, whether it's COVID-19 or the administration change or what's going on right now in Afghanistan. There's just been a lot of fluidity. How do you see your end markets in terms of health right now? Are they holding up through this environment? Or what can you share with us to help us get comfortable with continued growth and spend from the U.S. government?

That's a really good question. Our end markets, I'd say, notwithstanding COVID, have actually held up reasonably well through the recent administration change, but also the disruptive dynamics, I think, you mentioned. Customers are planning for the future. They are making contract awards and executing their missions. There is actually pent-up demand for the adoption of what I'm going to term newer and innovative technology. Our customers are looking to modernize the infrastructure and adopt technology to accomplish mission objectives. With regard to intel specifically, we've heard the buzz in the commentary around contract award dynamics. We've candidly not seen that dynamic or at least not more so than, I'd say, normal contract delays. I think creatively, there's been some backlog here in terms of the COVID impacts sort of working its way through the pipeline here. And so there's a backlog here that they're trying to catch up on. Our supply chain clearly has taken the brunt of the impact from COVID. So I'd say from an end market perspective, that's probably where we've seen the most impact. I think while it's really hard to predict on the ops tempo side of this, which is really what impacts our supply chain business, I suspect that impact will be here with us for the next few quarters. The current administration has placed a larger priority on FedCiv and that's reflected in the President's budget request. Now with about 1/3 of our portfolio sort of squarely in that FedCiv market, we really do have, I think, opportunity even within sort of this very dynamic environment to place emphasis in areas, but it's all going to come down to winning -- winnable work and executing well. But I think the end markets have actually held up reasonably well.

Maybe thinking a little bit more near term and less big picture, Q3 is obviously the high watermark annually for the U.S. government obligating getting dollars on contract as they head into the end of their fiscal year. Maybe care to share any thoughts around what you guys are seeing through this quarter in real time as they close out?

Yes. So I think we feel good about the pipeline, both in terms of the quality and the magnitude of the pipeline. We shared some of that data on the Q2 call. A significant portion of the pipeline is for new business. Clearly, those will be competitive, but we believe we're in a good position because of the changes I described earlier to capture, I'd say, our fair share or hopefully more than our fair share of this work. Our trailing 12-month book-to-bill is 1.6. So we're confident in our team's ability to capture both recompete work as well as new work. Our recompete profile, just we're talking about it, it becomes a little more normalized in FY '23. We've got 3 notable recompetes, as we've signaled earlier, the Vanguard recompete contract; the PVMRO within our supply chain business, but also enterprise IT as a service, ITaaS, contract for the U.S. Air Force. So I'd say Q2 does tend to be a high watermark. We're comfortable about our prognosis to delivering good book-to-bill in the year. I'd step away always because book-to-bill does tend to be lumpy in a quarter, but comfortable about the ability for SAIC to deliver good book-to-bill over the course of the year.

Fantastic. Maybe shifting gears here a bit and walking down the P&L with the profitability in your EBITDA margins. It's been a somewhat complicated story, as it has been for the entire group, with the COVID-19 backdrop and what that can potentially do to numbers. Maybe unpack the bridge from '21 to '22. And then just help us think about what normalized margins are here and what you're expecting going forward? What is sort of COVID-19 and what is performance for SAIC and margin expansion?

Yes, great question. So underlying, I'd say, strong year-to-date performance is really strong execution by the team. What we've also realized, I think we've signaled on the call, some nonrecurring favorable items so far this year. So I think if you adjust for the nonrecurring sort of favorable items, our first half margins are roughly 9%. Now our guidance implies lower margins in the second half based on some planned investments we're making to drive growth as well as some additional indirect costs, which we expect will come back into the system. Now whether we expand margins in FY '23 versus calendar '22 effectively is a function of how strong sort of FY '22, calendar '21 comes in for us. I don't think we're alone in facing some noise when it comes to year-on-year comparisons. But I think -- I'd say relative to that high 8% margin baseline, we do see opportunities to expand margin over time. So I think even if you adjust for the relative sort of noise in the first half of the year, if you sort of step back and you said this business is fundamentally generating kind of high margins, we do, over time, see potential to expect margins from that.

From a structural standpoint, as SAIC is built today, can you give us a sense of what that potential is? I mean is it still 9%? Is it something north of there now that you've done several deals that are clearly accretive to margin levels? How are you thinking about it as it's constructed today and the potential into the future?

Yes. So margin expansion is obviously a journey, and I think we've made good progress, I'd say, primarily, inorganically over the last few years. There's an opportunity for us to organically do that. I'd say sort of a more comprehensive discussion of the levers that we have to drive margin over the next few years. I'd say, let's just say, it's best saved for a later day. It is a priority for this team. As a shareholder of this business, we believe we can accomplish both stronger organic growth and expand margins from that approximately, let's call it, high 8% baseline over time as the portfolio is constructed today. Plus, we're always going to manage the business for the benefit of our shareholders. So as we continue to make tweaks to the portfolio, it will provide us some room to continue to expand margin share over time.

So maybe staying on those deals that I just alluded to. You're coming off the heels of a few of them. You did the Halfaker, you did Koverse. And prior to that, you did Unisys. Can you maybe talk a little bit about why you did each of them or some of them and how they performed thus far?

Yes. So over the past couple of years, we've executed 3 deals. And all those deals were aligned with our long-term kind of strategy accretive to our financial metrics and gave us incremental access to customers across key capability areas. Our most recent acquisition in the Halfaker deal is off to a good start, but we're only 2 months in. We're encouraged, I'd say, by the early returns, particularly vis-a-vis the market opportunities we see as we go to market with that health customer as one team. Now on the other hand, this Koverse deal, which is a smaller deal in terms of financial impact, but it's really important to our AI portfolio development and our AI capabilities. Since acquiring Koverse, and I'm going to double-click a little bit here, we've seen that the technology that they bring to the table is, in fact, a differentiator in several contract opportunities, particularly in the intel customer. And so to me, that's what's playing well here for us. On Unisys Federal, they've performed as we thought they would, and they've been a great addition to the portfolio. Their IT modernization capability, particularly in cloud, combined with customer access such as DHS has been a real contributor to the portfolio. And the proprietary technology that we gained from Unisys Federal is the underpinning of our recent CloudScend, our end-to-end suite of cloud solutions. So to me, I think we're thinking about M&A in the context of capability and in the context of customer access. And these last 3 deals have sort of either hit 1 or both of those important criteria for us.

Maybe talking a little bit about your M&A pipeline today and what you might want to do forward. What can you sort of share about the composition of the pipeline as well as your thoughts on the portfolio, gaps that you want to fill and just help us understand where things might be trending?

Yes. So our focus in the near term, I'd say, is just making sure we integrate Koverse and Halfaker and capitalizing on the capabilities that they provide us. Our pipeline is pretty healthy for M&A. I understand the focus on M&A as a way to add capability to the portfolio. But candidly, we spend more time internally focused on improving cash generation that makes a fuller set of capital deployment options for us. And as with margins, we'll face some noise year-over-year on cash, as most companies do, but we're really challenging the teams to improve cash generation via improving DSOs and push that focus on execution down to the program level. That's a relatively recent strategic effort, but we're optimistic it will bear fruit over the next 12 or 18 months. So while we're focused internally on continuous improvement of cash, there are opportunities, we then want to deploy the cash in ways that maximize shareholder value. And finally, on M&A, we understand the dynamics -- the price dynamics in the M&A market for buyers, especially. So we'd be sensitive to valuations to ensure that it makes economic sense for us to do these deals. Halfaker is a great example of that discipline. So we will always be mindful of that, I think, in this market.

On Halfaker, squarely focused on the FedCiv market, specifically health, given the composition of both the White House and Congress politically, does the FedCiv market now get elevated in terms of priority in investment in how you deploy that capital, whether it's organic or inorganic?

We are spending a fair amount of time looking at the broad spectrum, I'm going to say, of FedCiv opportunities. That includes ensuring that we remain relevant on an increasing market share basis over time. That means just keenly focused on the opportunities ahead of us and candidly building some long-term plans into the way we think we have to go get to those customer sets with some differentiation. Lots and lots of players in that market. It's a hypercompetitive market. So challenging the teams internally to figure out why is it that we want to be in this market, what is our specific differentiation that we will bring to that customer. Price will always remain an important consideration for customers. But I think for us, total cost of operating the business should be similar. And therefore, we are forcing the teams to kind of go through -- work through the pipeline, figure out what's truly unique about our offering and working overtime to ensure we build the offering into the pipeline that we have ahead of us. So lots of focus, lots of energy being put in the area. The margins in that business tend to be very healthy. So we're making sure that we're prudently thinking about reinvestment rates in that business, recognizing that's where significant opportunity lies for us.

Got it. Fantastic. Shifting gears again. COVID-19 seems to -- we can't get away without at least touching on it to some extent. We're probably, what, 18 months into the pandemic at this point. At some juncture in the year, you'll come to the point where you need to start doing your annual operating plan for next year or refreshing your long-range strategic plan or otherwise just thinking about that medium term. Given those 2 dynamics where we've got a decent amount of time under our belt now with COVID-19 and the nature of sort of refreshing long-term plans, you'll likely start to bake in some of the changes that we've observed over the last period of time, 18 months. What stays or what do you believe stays for the long term here? And what sort of normalizes, if you will, or reverts back to what we knew as normal? Are there things such as real estate or the work from home dynamic or otherwise that you believe might change the economics of the business?

Yes. So a couple of comments. One, I think if you thought about this structurally, we are clearly thinking about sort of our next cycle of plan. That's a 1-year plan, but it's also a 3-year look and a 5-year strategic look of the business to say, to what extent are the COVID-related dynamics going to stay with us. And I think we are assuming for planning purposes that there is some element of COVID that's going to be here with us and we're challenging the teams to ensure that we continue to deliver growth in spite of whatever COVID dynamics we might have. So we're sort of presuming that some form or fashion of COVID is going to be with us over the next few years. So we're all, having said that, looking to getting to the other side of the pandemic and returning to what a new normal might look like. And we're starting to define what that looks like. And some of that will actually be for some customers and maybe for some within SAIC look familiar to a pre-COVID environment. And for a lot of folks, it would actually be more similar and resemble sort of the last 18 months. And so let me double click here. Some of the changes were related to our workplace of the future, how our employees work partially or fully remote going forward, that will certainly dictate our facilities footprint for sure. So while we're thinking about facilities footprint, we're not quite ready to, I'd say, talk about potential reductions or savings. And in a predominantly cost plus business, it may actually give us an opportunity to reinvest in some other differentiators. The reality is, we'll probably have less footprint 5 years from now than we have today. And so to me, I think we sort of understand the cost dynamics. There is, obviously, a competitive element to the cost dynamics we have to think about. But in our case, since the business is predominantly cost plus, we also have to think about what a dollar cost savings would do for reinvestment ratios and the like. So we're sort of working our way through a multiyear dynamics around COVID, recognizing it's going to be here with us for a long time. Having said that, our supply chain business, I'd say, is most impacted by the pandemic. And while this year appears to be better than last year, we still expect about $125 million of impact this year. So we are presuming that there will be some impact likely into FY '23, calendar '22, and hopefully, it will be less. But we do fully expect, as we plan for this, that there will be some impact in fiscal '23 for us.

Great. And then maybe related, but a subject that has always been important is human capital, right? You're a services company. They're key to your success. We're in a very tight labor market. What are you seeing out there? What observations can you share with respect to the labor market? And is it a gating factor at this juncture to growth?

Yes. So the market is tight. The dynamics are no different than most of our peers have talked about. It is a competitive job market out there. I think part of the inflection for us is obviously a focus on head count and making sure we have folks on programs when we need them, but it's also becoming a little more solution-based. A little more solution based in the sense that you can make up for revenue and margin with more solutions down the road. But in the near term, I'd say, I think it will probably be a constraint. We're out there just like everybody else, offering good terms for people to come on. I'd say a little more challenging in the intel-restricted market for people with clearances. That dynamic is here with us. Our attrition rate is probably a little bit higher than it was last year when we were in the middle of the pandemic, but not unusually. So I'd say, if you step back and thought about this business in a growth environment. So I'd say we're seeing some of the challenges to that growth -- sort of organic growth rates from having to have folks on staff at customer sites, et cetera. So -- but it's a dynamic we're sort of managing through with the rest of our peers, I'd say, in the market. But again, focused on being more solution-based and generating value over time and sort of managing as best we can through the staffing challenges in the near term.

Got it. I want to take a moment here just to turn to the portal, and we've got some questions coming in. The first one, Prabu, you mentioned NASA AEGIS earlier in the conversation. What can you share with us about its current status and NASA's path forward for re-awarding that contract?

Yes. So I'd say, as a matter of principle, we generally don't comment on things that are in actively with the customer. What we do know is they are going to take corrective action. We do not know what form that corrective action will take. So we're sort of executing as we are the incumbents on the program as effectively. The team is doing a phenomenal job delivering the mission for the customer. So our focus is to keep doing what we're doing and things will play themselves out over the next 3 to 6 months. So not a whole lot to share other than we know they're taking corrective action, and we don't know what it is [indiscernible].

Sure. Another one here from the portal. The question is President Biden recently signed some executive orders that related to COVID-19. There's been some chatter in the media about a mandate for all contractors doing federal work to be vaccinated. Has anything been communicated to SAIC at this point in time with respect to a mandate and how might that impact the employee base?

We are actively communicating with our employee base, including our expectations for vaccination. And so that's an ongoing conversation we're having even before we get communication directly over. And so that's -- we understand what we have to do to create a safe working environment for folks that are required to be on site somewhere, either a customer side or in a SAIC facility. So we're actively sort of navigating this just like everybody else.

Right. And then maybe 1 last one for me before I let you guys get going here because we're almost up against our stops. If you had 1 more dollar of IR&D or M&A funding, what technology would you place it on?

I would say AI, continue to make the right bets there. And AI and cloud, including Secure Cloud.

Great. Fantastic, Prabu. We really appreciate your time. Same, Joe, it's been good catching up. Hopefully, we can do this again in another year, and it will be in a sunny Laguna Beach. So thank you very much, and thanks, everybody, for dialing in.

Thanks so much for having us, Matt.

Thanks, Matt.