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

Good day, and welcome to the Unisys Corporation Investor Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Courtney Holben, Vice President of Investor Relations. Please go ahead.

Thank you, Alison. Good morning, everyone, and thank you for joining us this morning to discuss our announced sale of our U.S. Federal business to SAIC. I am joined this morning by Peter Altabef, Chairman and CEO of Unisys; as well as Mike Thomson, Senior Vice President and CFO of Unisys. I will turn the call over momentarily to both of them, but first, I will cover some disclaimers and logistics. First, today's conference call and the Q&A session are being webcast via the Unisys investor website. Second, you can find the presentation slides that we will be using today to guide our discussion on the same investor website, which we encourage you to visit. For more information regarding our financials and non-GAAP information referenced in these materials, please see the press release associated with this transaction, our earnings releases and our Form 10-Qs and 10-Ks. I would also like to refer you to the press release associated with this transaction for details on a tax asset protection plan that was adopted in conjunction with the deal. I would also like to remind you that all forward-looking statements made during this conference call are subject to various risks and uncertainties that could cause the actual results to differ materially from our expectations. These factors are discussed more fully in the company's earnings releases and SEC filings. Copies of those SEC reports are available from the SEC, and along with other materials I mentioned earlier, on the Unisys investor website. In terms of logistics for today's discussion, we will spend the first portion of the call going through the presentation with some prepared remarks. Following this, we will allow time for Q&A. [Operator Instructions] We will monitor incoming questions and we'll take as many as we can from the web as well as from our analysts participating in the call. With that, I will ask you all to turn to Slide 3 in the presentation, and I will turn it over to Peter to begin our prepared remarks.

Good morning, everyone, and thank you for joining us to discuss what we view to be a very exciting development for our company. This morning, we announced that we had entered into a definitive agreement to sell our U.S. Federal business to SAIC for $1.2 billion, which represents a 13x last 12 months from 9/30/19 adjusted EBITDA multiple. This is a significant premium to the Unisys trading multiple and is a tribute to the unique and attractive business that our U.S. Federal colleagues, led by Venkatapathi PV Puvvada, have built over many years. Unisys' performance in recent periods has benefited from the strength of our U.S. Federal business, and we believe this transaction creates another exciting opportunity for the company to continue its evolution. We intend to use the proceeds from the transaction, which is targeted to close in the first half of 2020, largely to pay down debt and reduce U.S. pension obligations. This will allow us to significantly improve our balance sheet and effectively remove the requirements to make any cash contributions to the U.S. pension plans out of operating cash in 2020, 2021 and 2022. Before providing additional detail on the transaction, I would note that in our press release, we also provided some commentary regarding Unisys' preliminary financial results for 2019, which indicates that the company is expected to achieve guidance for all provided metrics. Specifically, we expect full year 2019 non-GAAP adjusted revenue growth and non-GAAP operating profit margin to be towards the upper end of the full 2019 guidance ranges of 3% to 7% and 8.25% and 9.25%, respectively. And we expect full year 2019 adjusted EBITDA to be at the low end of guidance of 14.4% to 16%. We intend to provide full detail on our fourth quarter and full year results in conjunction with our earnings release scheduled for February 25. So I'll now turn back to focus on the rest of my comments regarding the sale of U.S. Federal. Pro forma for the transaction, we expect much of what we have discussed regarding strategy, opportunities and financial goals to remain largely consistent but with a sharpened focus on the portion of the business that today represents Enterprise Solutions from a P&L perspective. The company will maintain significant scale as Enterprise Solutions generated $2.3 billion in revenue of non -- on a non-GAAP adjusted basis on an LTM basis through September 30. We will continue to serve non-U.S. Federal government clients, along with clients in the commercial and financial services sectors in over 90 countries, with a team of approximately 19,300 associates around the globe. I would also note that in contemplation of this transaction, we have adopted a tax asset protection plan designed to protect Unisys' tax assets by reducing the likelihood of an ownership change through actions involving Unisys' securities. As Courtney noted, we would refer you to the press release associated with this transaction for further detail on this. We believe this transaction benefits all of our stakeholders, as you can see as you turn to Slide 4. First, our goal is to use our increased financial flexibility pro forma for the transaction to position ourselves to better serve our clients. We expect to be able to invest more in new solutions that address our clients' needs, both independently and with our partners, and to have more ability to pursue larger deals as a result of the improvements to our capital structure and cash flow requirements. We will continue to balance these efforts with a sharp focus on profitability and cash flow, with the goal of continuing to optimize financial performance. Secondly, we believe that both current U.S. Federal and Enterprise Solutions associates have the potential to benefit from this transaction. With respect to the associates remaining with Unisys, we believe that they will see increased opportunity associated with improved operational flexibility. And for the U.S. Federal associates moving to SAIC, we believe that they stand to benefit from being associated with the company with a larger U.S. Federal footprint. We also believe that our investors should benefit from the transaction. We were able to capitalize on the recent strength of the U.S. Federal business as well as strong market conditions to achieve a multiple well above the trading multiple for Unisys. We believe that the deleveraging, reduction of required pension contributions and improvement to the U.S. pension-funded status meaningfully derisk the balance sheet, which should remove a significant element of overhang with respect to how our stock currently trades. Additionally, all of these improvements accelerate the company's path to becoming free cash flow positive. Reflecting on all of that, as we look forward to what Unisys will look like pro forma for the transaction, you can see an overview of our perspective on Slide 5 and on subsequent slides. Moving to Slide 6. The pro forma business has a solid foundation built on strong recent performance and innovative solutions. The company overall has seen a significant improvement in its financial results over recent quarters and years. U.S. Federal has had extremely strong results recently, and Enterprise Solutions has also made significant contributions to our improved financial performance. On a year-to-date basis, as of September 30, 2019, Enterprise Solutions had seen over 4% year-on-year growth in non-GAAP adjusted revenue. As we have discussed, those recent improvements to financial performance have been driven in part by security as a differentiator in our go-to-market efforts as well as our IP-led solutions, both of which are used to serve clients across all of our sectors. This will be the case going forward as well as we will continue to leverage offerings, such as Stealth, InteliServe, CloudForte and ClearPath Forward. Next-generation technologies, such as artificial intelligence and IoT represent key opportunities for us in the future, both in terms of improving profitability and developing new solutions. We believe this transaction will position us to better accelerate our integration of these technologies into our offerings based on the increased financial flexibility this transaction will create. In addition to solid financial performance, Enterprise Solutions is also built on strong client relationships, which you can see on Slide 7. Some of these relationships date back many decades, while others represent recent wins. This indicates both a solid foundation with long-standing clients as well as the ability to broaden our reach to new clients. We believe this transaction will position us to further expand the list of Enterprise Solutions clients that we can serve. Turning to Slide 8. We believe that the markets that we will continue to serve remain very attractive, with solid growth potential that we can leverage to continue driving the business forward on a pro forma basis. As you can see, Gartner estimates the global IT services market to be approximately $1.268 trillion in size, with a projected growth rate of about 5% between 2018 and 2024. This provides ample opportunity for us to cultivate the levels of growth we have been targeting for the company in the medium term. In addition, the key market drivers are generally consistent across all sectors that we serve today, and so we don't foresee a meaningful change in macro dynamics going forward. For instance, clients across all sectors we serve have increasing digital and cloud transformation needs and a heightened focus on security in -- and in these transactions and in all of their IT requirements. Likewise, increased regulatory and compliance requirements are impacting most sectors and creating the need for an increasingly sophisticated analytics. Emerging technologies, some of which we have already discussed, also create demand across the market, and the tight labor market and increasing importance of contract labor drive further opportunities for IT services firms. To provide some more color on the financial benefits of the transaction which helped create the opportunities I've been discussing. I'll now turn the call over to Mike.

Thank you, Peter, and thank you all for joining us today. As Peter has noted, we're very excited about the transaction and how it positions us for the future. If you turn to Slide 9, I'll spend a few minutes discussing the capital structure benefits in a bit more detail. As Peter stated, it's our intention that the net proceeds from the transaction will largely be used to reduce debt and pension obligations. This will effectively be done in two ways: first, we intend to fully redeem the $440 million of senior secured notes that we have outstanding in accordance with the terms of those notes; second, we intend to contribute the bulk of the remaining proceeds, which will be approximately $600 million to our U.S.-defined benefit pension plans and to apply this amount towards the required contributions in 2020, 2021 and 2022. Doing so will reduce our aggregate unfunded pension deficit to approximately $1.14 billion relative to $1.74 billion as of the year-end 2019. Our net debt, inclusive of pension deficit, is expected to be approximately $860 million relative to $1.9 billion pre-transaction, which will result in a net leverage decrease to approximately 2.4x on a pro forma basis relative to 4.2x as of September 30, 2019. Our intended contribution of the net proceeds to the U.S. pension plans will also effectively eliminate requirement to make cash contributions out of ongoing operations to those plans for the next 3 years and significantly accelerates our path to being free cash flow positive. Overall, cumulative required contributions to worldwide pension plans from 2020 through 2025 are expected to reduce to $775 million relative to $1.375 billion prior to the transaction, and the U.S. plans are still targeted to be fully funded by 2025. Given our improved cash position, we may choose to opportunistically make discretionary contributions during the coming years to help smooth the future funding requirements beyond 2022. We've spoken recently about the fact that due to our current funded status being below 80%, that there were barriers to opportunistically remove liability. This transaction removes those barriers and gives us the ability to pursue bulk lump sum and annuity programs where they make economic sense. As Peter noted, while this transaction enables increased solution innovation and broader deal pursuit, we'll retain our sharp focus on profitability and cash flow to continue optimizing financial results where possible and making additional working capital improvement. I would also note that even though we expect the proceeds of the deal to effectively prefund our pension contribution requirements for the next 3 years, we've asked the IRS and the PBGC to continue their efforts on granting our waiver request as a backstop in case the sale does not close or the closing is delayed. We're appreciative of all the good efforts made with the service and the PBGC on this front over the last few months, and we'd like to bring that process to a favorable conclusion. Lastly, as a clarification, throughout this discussion and the materials that we've posted in connection with the transaction, we've made numerous references to reducing pension obligations. We mean this in the way I've just described relating to the unfunded pension deficit and demands on operational cash flow. Nothing that we've said, discussed in any way, changes our commitment to the pension beneficiaries nor has any impact on the benefits they're entitled to receive. Stepping back now to consider everything we've discussed this morning. While this transaction creates a number of opportunities for us, it does not fundamentally change our approach to running the business. Turning to Slide 10. As we think about strategy going forward, we envision continuity of what you have seen in recent periods. Importantly, we'll continue our IP-led industry go-to-market approach with an intense focus on our security offerings, and over time, we'll have more potential to pursue both organic and inorganic growth. One of the key areas of upside for us recently has been improving margins in the Enterprise Solutions business, and this will continue to be one of our top priorities going forward, as will cash flow generation. We're pleased that the transaction allows us to reduce our pension obligations, but cash flow is a critical element to running the business successfully in the long term, so we do not intend to reduce our focus on this effort as we consider additional investments, both organic and inorganic. One area where our strategy will change, to potentially state the obvious, will be in the U.S. Federal market. As part of the transaction, we've agreed not to enter the U.S. Federal market over the 2 years post-closing. Further, we'll refrain for 5 years post-closing from soliciting business from U.S. Federal clients who are clients of Unisys at closing or who were in the pipeline with bid submission deadlines through December 2021. Given the consistency and strategy and market dynamics going forward, our financial performance goals will remain largely consistent with what we've stated in the past, as you can see when you turn to Slide 11. We believe, on a pro forma basis, significant upside still remains in the financial results that we've seen in recent periods. I will note that we intend to host an Investor Day following the closing of the transaction to provide more insight into what the company will look like going forward, including with respect to financial performance. However, we wanted to provide some perspective ahead of it. In November 2017, we hosted an Investor Day, during which, we laid out our targets for the near and medium term. These included a 3- to 5-year business model that called for 2% to 4% revenue growth and a non-GAAP operating profit margin of 9% to 12%. Pro forma for the transaction, our goals for the remaining portion of this time horizon remained in line with what we stated in 2017. Market growth for the sectors we'll continue to serve remains in a similar range to what we've seen in recent years. And additionally, U.S. Federal has largely been operating at or above its target margins, and Enterprise Solution has always represented the biggest opportunity for margin improvement in recent years. The team has made progress on this in recent periods, and there is still significant room to build on this with further margin expansion over time. So at a high level, we believe these are still good working assumptions to use for the remaining portion of the highlighted time frame. With respect to cash flows. As we have noted, we expect the transaction to significantly accelerate our path to being free cash flow positive. As with most sales of a business, there will be some stranded costs that remain with Unisys post transaction, and we intend to work to eliminate or mitigate those costs over the course of the coming months, though there's likely to be some modest impact to profitability in the short term. There may be minor additional disruptions in the year following closing as we make the necessary adjustments, which means we may result in a time frame that would slightly vary from the medium-term targets laid out here, and that we'd likely take a modest restructuring charge in conjunction with these efforts. However, that does not impact our broader expectations over time. Regarding our near-term expectations. Peter noted preliminary view on 2019 results relative to guidance ranges that we provided previously. I also want to give some preliminary color on a few onetime items that are expected to impact 2019 net income as I believe most of these are not currently reflected in analyst consensus numbers. As we've discussed, we were anticipating a limited restructuring charge in the fourth quarter of 2019. The amount of this charge is expected to be approximately $24 million based on preliminary indications, which brings the total restructuring charges for the full year 2019 to approximately $30 million. Additionally, our pension expense for 2019 is expected to be approximately $13 million higher year-over-year, which would put us at approximately $94 million. We expect a few additional onetime charges that aggregate to approximately $14 million. The majority of these relate to some cost closeouts for the remediation of a site that the company no longer operate. Lastly, we had a charge of approximately $10 million related to unfavorable FX for the fourth quarter of '19. As a result of these charges, we expect net loss of approximately $20 million for the full year 2019, though on a non-GAAP basis, these charges would be added back. And to confirm, none of these charges that I've noted relate to the transaction we announced today. They're reflective of the business through the year ended 2019. So with that, I'll turn the call back over to Peter.

Thank you, Mike. I would just like to say again that we're extremely positive about the transaction and the path that puts Unisys on going forward. We believe the significant premium to the Unisys trading multiple that we were able to obtain is a fair value to our investors. The increased financial flexibility that comes as a result of the transaction positions us better to be able to continue driving increased value for investors over time while also improving our ability to serve our clients. We look forward to discussing all of this with you in more detail over the coming months. And now we'll open the call for questions.

[Operator Instructions] Our first question today will come from Joseph Vafi of Canaccord.

Big news, and congratulations to all the new and existing stakeholders here in this transaction. I think the key question I think I may have for Mike and for Peter here is obviously, I mean there's some information in some of those slides on the pro forma business. Obviously, probably a very strong free cash flow generator in the Federal business, and I know what you do here is then reduce cash obligations. And so I think you're looking at potentially accretive to the trajectory of cash flow. Just like to dig into that a little bit more on some of those cash flow levers over the next couple of years with this sale, and a little more thought on where those levers are and how we get to kind of that sustainable free cash flow?

Joe, it's Mike. Thanks for the question. As I indicated in the prepared remarks, we are intending to have an Investor Day right after close here, and we will get into the specifics of the business, the modeling of those cash flows, we'll look at a 5-year projection and kind of where we're at, at that point in time. And obviously, we have earnings in a couple of weeks, so we'll give additional guidance at that point as to what the 2020 looks like and maybe a little bit of insight into how it shifts based on this sale. So I don't think at this point, we want to get into that level of specifics on this, but certainly coming up shortly, we will. And you're exactly right. I mean the delevering of the balance sheet and the position it puts us in from an obligation perspective is significantly curtailed. Our balance sheet strengthening in the context of what would be left on a pro forma basis will be just convertible notes, which sit at about $85 million, which is relatively nothing out there. So I think we'll be positioned pretty strongly from a cash perspective. And I guess also as I've noted, most of the expected growth from a margin perspective was coming out of the Enterprise Solutions business anyway. The Federal business, as we've talked about for quite a while now, has been operating at the target margin already. So we expect to see that operating profit improvement come out of the ES business, and obviously, that's going to generate free cash flow for us as well, so -- but a lot more to come on that in the very near future.

Okay. That's helpful. And then on just the IRS deferral request, I guess, with the sale, does it just kind of mean that you're really no longer eligible for that deferral request? Would that be the way to look at it? Or do you think you could still potentially get the deferral, even with the sale?

Yes. Look, I mean -- yes, again, thanks, Joe, for the question. It's not necessarily that we're not eligible, right? We have spoken with the service and the PBGC and we are going to push forward with the waiver process. You're right that it's kind of a move point after you prepay the proceeds to have the waiver, but we think it's a good backstop just in case there's a delay in the close or anything like that, right? So it's kind of a belt and suspender-type thing. We've done a lot of work with those parties, as you know, and we've made some great progress. And I think we're kind of at the end of that cycle, and we'd like to bring it to a favorable resolution. And worst-case scenario, we have a nice backstop for the proceeds from the sale.

And our next question will come from Rod Bourgeois of DeepDive Equity Research.

Good -- congratulations on this deal. I wanted to focus on your intellectual property, particularly in the area of Stealth. I'm wondering, do you see any encumbrances being added to Stealth or other IP other than the noncompete that you now have in the U.S. Federal market? And I guess more specifically, I'm wondering how will your IP work in cases where you own IP that's now attached to deals that will be taken over by SAIC?

Yes. Rod, this is Peter. Thanks for the question, and thank you for being on the call. With respect to IP, we see this as only positive. So obviously, we are not going to be active in the U.S. Federal business, so we won't be directly selling into that Federal market, but we expect SAIC to be selling into that Federal market. And given that they have a larger footprint than we do in U.S. Federal, it will include our prior U.S. Federal and their new stuff. So we actually expect, in the U.S. Federal marketplace, an expansion of use of Stealth, and that we'll continue to get licensing fees from that expanded use of Stealth. So we see this as really only positive. Outside of the U.S. market, we're retaining full control of Stealth and CloudForte and InteliServe and obviously, ClearPath Forward. So we really see this from an IP standpoint as only a positive.

Got it, great. And then you alluded to this a little bit. I'm assuming there would be some level of SG&A impact because you'll have a smaller business to allocate your overhead onto. But it sounds like you've got a plan to address that. Can you just give a little more color? Would you feel like you'll be able to essentially inoculate all of the impact of the -- the overhead impact of this deal as your revenue base gets smaller?

Well, one of the -- that's also a great question. Obviously, this is a sale of a division as opposed to the sale of an entire company, so there has to be an allocation of associates, which is the term we use for the people who work at Unisys. And we have done that allocation with SAIC. So people in SG&A slots that were directly and primarily supporting the Federal team are moving over as part of this transaction. So some of that, if you will, SG&A overhead will be moving over with SAIC, where we expect them to be very, very important for SAIC. That leaves a team here that, as Mike indicated, probably is still, from a percentage basis, slightly larger than we need, and we will continue over the course of the next 12 months to really look carefully over those costs. One advantage is we've turned the corner and the company has been growing, but we will still look at how do we make sure that we're operating at a very, very specific and tight way. Now we did refer to a potential future onetime charge, and that may be associated with some of those activities. But at this point, we don't expect that to be overwhelming because of the way we set up this deal.

Got it. And with the increased financial flexibility and a business that's now streamlined to focus on Enterprise Solutions, are there investments and initiatives that you will now likely apply in the Enterprise Solutions business that you were not planning to do before selling off the Federal business?

Yes, Rod. That's also a good question. The answer is yes. And they're really across a range of different parts affecting our business. So with respect to IP, we will have more cash to invest in some of our next-generation solutions, such as CloudForte and such as InteliServe, both of which use AI pretty significantly. With respect to InteliServe, which is -- which really covers the gamut of global workspace, we can now take some of this financial flexibility and accelerate the process that is already underway to say there is a world of IoT out there for especially large expensive IoT devices that we can be supporting through InteliServe and our global workspace capabilities that we just didn't have reached to before. So we expect to actually expand into service of large-scale IoT devices because of this transaction. And then finally, when we get to Stealth, this gives us the ability to really enhance the marketing of Stealth. We have been working to enhance certainly our third-party providers, if you will, our partners to get market share in Stealth. It's one thing to do deals with those third-party partners, another to really support them with the kind of support they need to be successful. And this transaction is going to give us the ability to provide that support, and we think will accelerate Stealth revenues as well.

Our next question today will come from Jon Tanwanteng of CJS Securities.

Congratulations. Really great news. If you could start, could you talk about the remaining cash flow -- or free cash flow conversion from EBITDA pro forma for the sale? What do you expect it to be given: one, the Federal business, it has a very nice cash flow and lower CapEx intensity; and two, you do have that flexibility to go after more investments and more cash-intensive deals? Is there a number that we can look to a ballpark as a percentage? Just how are you thinking about that pro forma for the close?

Yes. Thanks, Jon. As I mentioned to Joe, I think as we get a little deeper into this and get through our regular earnings cycle, we'll have some more color at that point. And certainly, post-close and Investor Day, we'll have even a deeper dive into what that looks like. But Peter gave you some good color here on some of the investments in IP and how that ultimately will convert to cash. I mean clearly, it opens up opportunities as well for additional deal pursuit, right, going after some things that we probably would have had to pass on in the future. So that's helpful. And from just a perspective of being unencumbered here gives us an opportunity, both from organic and an inorganic perspective, right? We've been growing this business in a organic way, as you know, really since 2015. So not only growing top line, growing bottom line, all of that being organic. So this really gives us, I think, a wealth of opportunities, both in investing in our partners, investing in our IP, going after larger deals and potentially looking at some other opportunities out there. All of which should generate additional cash flow. So again, I think we're pretty excited about the transaction right now.

Jon, let me just take a step back from Mike's answer, 100% I agree with, and just kind of look at where we have been over the last couple of years. So if we look at 2017 and 2018, we used some cash in those years to accelerate our growth. And we think we did that wisely. We think that was a good move. But the consequence of that was when we got to 2019 and we saw the cash requirements of 2021 and '22, in particular, we no longer had the freedom to do that. So while we made some investments in some deals in '17 and '18 that we consider really good deals, we were hamstrung in '19 to make those deals. As a result, we didn't make those deals. And so you saw some of our TCV, you saw some of our sales, our new sales go down in '19, largely because of not making those large deals, which tend to be more cash-invasive. One of the other problems with us historically -- and my problem, I mean kind of a challenge to overcome, has been our cost of capital. So when we are running on a net leverage basis, including debt at 4.2x and the industry is at 3.5x, our cost of capital simply has been higher than the industry. So even where we can use capital in deals, it's more expensive. The result of that is, over the past 15 months, the team has done an extraordinary job of developing relationships with third-party capital providers so that we can kind of do some of this capital directly with third-party providers. That's a good solution, but it's not a complete solution. We'll continue to use that solution. But we will now, as Mike said, on a post-transaction basis, our net leverage, including pension has gone from 4.2 to 2.4, substantially below the industry average. So we're not going to walk or will walk back into a world of high-debt or high-cash deals. But there is a world of medium capital deals that we really were restricted from doing that we can go back into, which we think are really good deals for this company.