Description

SUMMARY

We think SAIC is worth approximately $122/sh today, or 43% above current prices. SAIC was written up on January 28, 2019 at $67/sh. The stock has worked well and we think it’s going much higher.

Contested awards (which have now been officially awarded to SAIC and are now ramping) and Engility revenue dis-synergies (known at the time of acquisition in early 2019) drove weak headline organic revenue growth in 2019 versus the comparable group and pressured SAIC’s multiple. Furthermore, SAIC announced and closed a sizable acquisition that required debt capital markets during the escalation of the COVID pandemic which both created complexity and drove up leverage at a time when investors wanted neither. Growth, deal complexity and leverage are all fleeting concerns and is a major reason why we think the discount SAIC trades versus the comp group is also fleeting.

In addition to these temporary dynamics, street estimates look light and adds fuel to the rerating story.

So let’s dig into the above:

·         On growth, when SAIC bought Engility in January 2019, there were some revenue “dis-synergies” that came with acquisition ($120m or 2%). Engility is back to growing LSD % - MSD % as planned. Additionally, SAIC had 3 sizeable contracts that itwon last year that were delayed due to protest by competitors. All 3 have been resolved in SAIC’s favor and SAIC is ramping on those contracts.

On SAIC’s 4Q20 earnings call on March 26, management “soft guided” (due to potential COVID impacts) to 3%-6% organic growth or roughly in-line with closest comp CACI. COVID could certainly have an impact, but as recently as the May 13 Goldman Sachs conference, management stated that “we’ve seen minimal impact on the business from the COVID-19 pandemic.”

Space and intelligence, mission engineering, and digital transformation are combined HSD% growth businesses and represent about half of the portfolio. The other half is LSD % growth. Over time, the portfolio should grow MSD %.

·         On deal complexity, the debt financing and deal close for Unisys Federal ($1.2b) were completed in early / mid-March (post quarter-end which was also their fiscal year-end of 1/31). Unisys Federal got SAIC into IT modernization and the acquired business is expected to grow double-digits organically for the foreseeable future.

·         On leverage, LTM leverage looks high at 5.1x, but add in the Unisys Federal EBITDA and this year’s FCF after dividend and you’re at 3.3x at the end of the year and down to 2.5x by the end of CY21. So at calendar-end 2020, SAIC’s forward leverage will look like closest comp CACI’s forward leverage today. SAIC will likely be an aggressive buyer of stock in 2021 if prices stay anywhere close to these levels as it seems that they have interest when leverage gets into the lower 3x range. SAIC generates a copious amount of cash and guided to $550m in CY21 FCF before the interest expense upside discussed below. An additional note is that SAIC is a clear winner of the CARES Act as it will save about $75m on payroll tax this year, accelerating deleveraging from an already rapid pace.

·         Street estimates look light, likely due to the post-quarter close of the Unisys Federal acquisition and interest expense modeling. CY21 EPS (FY22) and EBITDA look 12% and 4% too low and are driven half by mis-modeling of the Unisys Federal acquisition post-quarter and half due to interest expense miscalculation. With 86% of the debt stack based on LIBOR (down 160bps YTD), we estimate Street interest expense estimates are nearly 50% too high:

VALUATION

We believe SAIC is worth $122/sh or 43% above today’s trading price. We value SAIC in-line with CACI given similar leverage, capital intensity, pro-forma organic growth profiles, and similar leverage in 12 months. BAH, LDOS and MANT all trade higher due to better expected growth. To put the valuation spread in context:

·         You get almost 40% more unleveraged FCF in SAIC today vs CACI for the same enterprise value.

·         And if SAIC remains at this price in a year, it will be trading at 10x fully GAAP-taxed year-forward EPS vs comps today at 19x and EV/EBITDA of 9.8x vs comps today of 13.5x.

SAIC and CACI used to trade on top of each other until early 2019. One-time hits to revenue from the Engility acquisition and contested awards drove a temporary revenue deceleration in 2019. Added leverage in 2019 from the EGL acquisition and more recently with Unisys Federal was an added kicker.

Forward P/E and EV/EBITDA (SAIC blue line, CACI white line):

SAIC HISTORY AND OVERVIEW

SAIC is a five-decade old company and was spun-off from Leidos in 2013 to accelerate growth. The combined company was disqualified from bidding on work that they could bid on as independent entities. For background, if a company has provided systems engineering and technical assistance for the government it may be disqualified from selling the solution to the government due to an organizational conflict of interest (OCI). Separating the companies resolved this issue. SAIC acquired Engility ($2.4b) in January 2019 for its space business (National Reconnaissance, CIA) and Unisys Federal in March 2020 ($1.2b) for its high growth IT modernization business.

SAIC is a large, pure-play service provider to the U.S. government. SAIC provides engineering, systems integration and information technology offerings for large, complex government projects and offer a broad range of services with a targeted emphasis on higher-end, differentiated technology services. With Engility and Unisys Federal now fully integrated in the portfolio, SAIC takes a dominant position in two of the fastest growing segments in government—space and digital transformation.

Customer mix is 50% defense (Army, Navy, etc), 30% civilian, and 20% national security. SAIC was recently re-awarded a couple of its largest existing books of business – systems engineering and software development from AMCOM or the US Army Aviation and Missile Command (defense) and the contract for air traffic controller training by the FAA (civilian). Another large contract for SAIC is running network infrastructure for Department of State around world (embassies, consulates, etc). 70% of SAIC’s 24,000 employees hold a security clearance.

SAIC collaborates with competitors to bid on large contracts, while competes with them in other situations. Competitors include the engineering and technical services divisions of large defense contractors like (General Dynamics, Northrop Grumman and Raytheon), contractors focused on technical and IT services (Booz Allen Hamilton, CACI International, Leidos Holdings, ManTech International, Serco Group, and Perspecta Inc), diversified companies that also provide U.S. government IT services (Accenture and IBM) and contractors that offer supply chain management and other logistics services (Agility Logistics Corporation and SupplyCore).  

Awards are won based on technical expertise and qualified and/or security-cleared personnel, ability to deliver cost-effective solutions in a timely manner, successful program execution on previous programs, reputation and standing with customers, pricing, and the size and geographic presence of the company.

Contracts are, on average, 5 years in length (ranging from 3 to 10 years) with the bulk in the 5 year category. Renewal rates are 90%+ and contracts rarely cancel. It’s a very sticky business and has been the case for many years. Large recompetes are largely settled for 2020.

SAIC has tax assets that provide for a low-teens cash tax rate through 2026 (22% GAAP) and then the cash tax rate slowly increases from there. Furthermore, the CARES Act provides for the deferral of payroll tax into CY21 which will accelerate SAIC’s deleveraging. Margins for the group are all in the 9%-10% range (BAH, CACI, LDOS, MANT) and we expect SAIC to be in the middle of this range after full synergy realization from Engility and after incorporating in Unisys Federal’s low double-digit margin business.

Historically, SAIC has been very consistent in buying back its stock. They were well on that path again before the Unisys Federal deal was brought to them. While the company itself is focusing on debt paydown for now with a longer-term target leverage of 2.5x to 3.0x, SAIC’s CEO bought $1m of stock on April 3, as soon as the window opened, at $71/sh.

Most comparable transactions over the last few years have been in the low-to-mid teens EBITDA range. SAIC paid 14x for 1-year forward Engility EBITDA and paid 12x for 1-year forward Unisys Federal EBITDA.

RISKS

·         COVID-19

o   Like many companies, SAIC caveated guidance, but said that ex-COVID they expected 2020 organic revenue growth of 3%-6%. COVID impacts seem relatively minor and they should still come close to or exceed the bottom end of the range. Additionally, the CARES act payroll tax provides for deferral of taxes into next year which should equate to a large FCF generation year in 2020, accelerating debt paydown.

·         Government spending

o   There is concern that rising deficits will pressure government spending.

o   Within defense, pressure would likely be on big ticket items (boats, tanks, etc) and SAIC is a net beneficiary of the government’s push to “modernize”.

o   For the foreseeable future, there’s going to be pressure on employment due to COVID. It seems unlikely that the federal government would want to contribute to even higher unemployment and SAIC should be very insulated from macro pressures that might exist from high unemployment.

o   For the moment at the very least, agitation between major economic powers seems to be elevated and globalism is under pressure, further underpinning the importance of government and defense spending.

·         Political

o   The best case is that there’s balance between house and the senate (ie one republican and the other democratic). It provides stability because one party can’t overly influence the budget. If white house is republican, it’s probably additive as well. Right now, the house is likely to remain Democratic and the Senate will likely remain Republican but bears watching.

·         Loss of major contracts

o   We don’t see this on the horizon given the recent AMCOM win and given the vast number of smaller contracts within SAIC’s book of business, but it is always a risk to be aware of in the future.

·         Leverage

o   Leverage won’t come down immediately and if there is another COVID panic, investors could sell higher leveraged companies first and ask questions later.

Catalyst

• Near term (next 3-6 months)
  • Reporting growth in-line with much higher valued peers (June 4 report date)
  • Positive Street estimate revisions (June 4 report date)
  • Demonstrating business model resiliency in a volatile COVID world
• Medium term (next 12-18 months)
  • Aggressively buying back stock