SAIC goes through an odd sentiment cycle and is currently near the bottom of this cycle. Investors and sell-side analysts will the company to HSD organic revenue growth and strong margin expansion and all in a straight line. They assume recently-won contracts will ramp up quickly and assume away the phasing out of other contracts. Earnings call are odd as analysts ask leading questions with optimism baked in. They then get disappointed and the stock languishes.

 

Q4 FY'21 earnings were disappointing and obviated optimistic revenue growth/margin forecasts and even after an improved Q1 report, the stock has been dragging near its lows for 6 months.

 

The market also over-estimates the transformative effects of its acquisitions and struggles with the positive but more mundane reality over time. Its acquisitions have added value (increased organic growth; higher margins) vs the price paid but have not been transformative, and I do not expect this to change.

 

The total return of the stock over the past 4.5 years is less that 1% per year, but over the same time period, the stock has grown significantly cheaper as TEV/EBITDA has dropped from 14.2x to 9.6x.

 

The reality is that the same characteristics that make this company utility-like are the same characteristics that make a transformative acquisition or consistent organic HSD growth or a quick jump in margins unlikely. There is going to be quarter-to-quarter lumpiness as contracts roll in and out, but over a 1-2 year timeframe, SAIC's performance is steady. As well, the company has delivered margin expansion as it has become more efficient internally and slowly transitioned its focus to higher margin contracts. But this is a slow process and management has been consistent in its messaging on this point. SAIC is not going to deliver 10% EBITDA margins in the next year or two, but it will probably get there in 5 or 6 years. Further, there is a delicate tradeoff between margin expansion and revenue growth that the market does not seem to appreciate. Mgmt can drive a jump in revenue or a jump in margins but not both.

 

That is the bad news, but the good news (in addition to its cheapness) is that the demand for its services will steadily increase over time (see backlog data although not perfect indicator), and management has balanced revenue growth with seeking out higher margin contracts. As well, the industry is rational and oligopolistic, and I do not expect this to change unless there is a strong drop in demand the industry is over supplied. So I expect a 4-5% organic EBITDA growth from: (i) personnel inflation costs as contracts roll; (ii) more contracts; personnel; and (iii) continued glacial-paced transition to higher margin contracts. This does not include higher EBITDA margins (and slightly higher EBITDA - capex margins) from contracts with higher capex requirements. Aside: This is an important factor in comparing comps in this sector, and management discusses this.

 

Through the FY 19 10-K, management stated its long-term financial goals as:

  - low single digit annual internal revenue growth percentage

  - margin expansion of 10 to 20 basis points annually, and

  - return of capital in excess of operating needs

 

With the Engility acquisition and then the Unisys acquisition, these goals were confusing so they took them out of the 10-K, but mgmt has essentially repeated that these remain the long-term financial targets although they expect higher organic growth due to faster growing acquisitions. And these translate to about 4-5% FCF-to-Equity growth.

 

In terms of returning capital to shareholders, mgmt has actively repurchased shares and has stated that they are actively buying back shares currently although they are limited as they need to reduce debt until they achieve 3x EBITDA leverage. We should see about $50mm of share buybacks per quarter through Q2 FY'23 (next 4 quarters). At that point, they should be a <3x EBITDA net debt and be able to increase share buybacks.

 

The Engility/Unisys acquisitions have made it difficult to calculate the underlying organic growth. The Engility acquisition, in particular, is confusing because SAIC must return some synergies to the government and so organic revenue drops while margins improve significantly. This makes organic comparisons very difficult. However, with some conservative assumptions, SAIC has more than met the organic revenue + organic margin expansion > 4%. 

 

The acquisitions have higher organic growth and so I expect 3+% top-line growth over the next half dozen years and another 2% EBITDA growth from margin expansion . . . and this will translate to 6% FCF growth over the next half dozen years. 

 

VALUATION  

Let's understand the valuation. There are several factors in play here:

 

1) COVID effects. I believe that mgmt's method for calculating COVID effects under-states the effects, but I use their numbers. The reason their numbers under-state is because they are only counting known contracts that are delayed or slower in rolling out rather than probabilistic contracts that might have been.

 

2) Tax Shields. SAIC has about $500mm of PV in un-used tax shields from amortization and NOLs. Note that $800mm of goodwill is not tax deductible because stock merger goodwill and that tax amort has exceeded GAAP amort by about $800mm.

 

3) Interest. Current interest is over-stated due to interest rate swaps that roll off soon. The current swaps have $50mm of negative value (after tax). Normalized interest using today's 5 yr swap rate is a 3.0% rate on loans (plus 4.875% on notes). Norm'd total interest is $80mm versus the $105mm we see using GAAP accounting. This slightly over-states the interest due to financing the acquisition with higher EBITDA ratio. At near 3x EBITDA and $2.3 bn of total debt, could finance at $75mm interest. 

 

4) Capex. CapEx has been temporarily on the high side and mgmt has indicated it will drop back to previous levels.

 

This analysis does not take into account the latest acquisition, but it has no effect on the multiples.

 

Market Cap: 58.7mm * $84 = $4,931mm

Net Debt as of end of Q2 FY'22 = $2,110mm 

(I assume all FCF from Q2 used for debt reduction)

TEV = $7,041mm

Adjustments:

- $500mm PV of tax shields and tax assets.

- Negative $50mm of under-water swaps

Adjusted Mkt Cap = $4,481mm

 

Norm'd NTM (Q3FY22-Q2FY23) Revenue = $7.65bn

Norm'd EBITDA = $675mm (8.8% Adj EBITDA Margin)

Less Norm'd Capex ($40mm)

Less Norm'd Interest ($80mm)

Cash EBT = $555mm

FCF-to-Equity = $432mm (10.4x Adj Mkt Cap)

 

I used a 22% tax rate as R&D credits tend to be offset by local taxes. 

My FCF number can be reconciled closely to SAIC's FY 2022 guidance midpoint of $450mm using:

- COVID effects

- growth over 6 months

- capex difference

- interest difference

- stock comp -- I include stock comp expense; company does not in FCF

- cash taxes vs my higher Norm'd taxes

- acquisition and integration costs included in company numbers

The catalysts are admittedly soft: 

(1) A sentiment change in value vs growth would benefit this stock, but many of us have been waiting for this for a long time.

(2) The onerous interest rate swaps rolling off will immediately benefit FCF. One small one rolled off at the end of July, and a second rolls off in 2023.

(3) Similar as the acquisition and integration costs cease as the Unisys integration is largely completed.

(4) Clean post-COVID numbers 

(5) Share buybacks will continue for a year (over $200mm over next 12 months) and then accelerate beginning in a year as debt reaches 3x.

(6) Non-acquisition period showing clean organic growth and margin growth.