Description

Investment Thesis

I am recommending buying SAIC stock (SAI).  SAIC is a high quality business. It has high barriers to entry. It generates high returns on capital. And, it is run by a capable, owner oriented (20% insider ownership), management team with a proven track record. The company's stock has de-rated due to fear of defense spending cuts.  These concerns have created an overhang for the entire sector (See coda516's January 6, 2011, LMT write up).  SAIC has de-rated not only relative to the SP500 but also relative to other companies in the sector. I believe SAIC will be minimally impacted, if at all, by the cuts. Once this becomes clear, over the next twelve months, the stock should re-rate closer to its historical earnings multiples in the mid teens versus eleven today.

Business Description

The following business description is an excerpt from the company's latest 10K:

"We are a provider of scientific, engineering, systems integration and technical services and solutions to all branches of the U.S. military, agencies of the U.S. Department of Defense (DoD), the intelligence community, the U.S. Department of Homeland Security (DHS) and other U.S. Government civil agencies, state and local government agencies, foreign governments and customers in select commercial markets. Our business is focused on solving issues of national and global importance in the areas of defense, intelligence, homeland security, logistics and product support, energy, environment and health. We plan to focus our investments to expand our business on areas such as: intelligence, surveillance and reconnaissance; cyber security; logistics; energy; and health technology."

VIC write up by jordan23 posted October 26, 2006 does a good job of explaining SAIC.  Most of the points are still relevant, except the stock is significantly cheaper today on an absolute and a relative basis.

SAIC's government segment accounted for 96% of revenues in FY2010.  Revenue and profitability is relatively predictable given the company's contract profile.  SAI has a high re-compete rate on historical contracts (90%+). It has a strong win rate (60%+). And, no contract accounts for greater than 4% of total revenues.

Variant perception- The budget cuts won't affect SAIC

The proposed defense budget cuts are targeting USD 100 billion of annual savings by 2015 from the current USD 711 billion proposed budget. It is impossible to analyze SAIC on a contract by contract basis with publicly available information. Revenues are derived from thousands of contracts the majority of which are less than $10 million. However, a top down analysis of the proposed cuts suggests that SAIC is unlikely to be affected by these cuts. The Proposal targets USD 28 billion in Overhead Savings and USD 20 billion in Procurement Reductions. These will involve internal cuts and consolidation. Reduced spending in RDT&E of USD 7 billion will affect weapons systems contracts in which SAIC does not participate. None of the cuts are directed at business categories of SAIC.  About 45% of SAIC's revenues are derived from core IT services to government agencies and C4 (command control, communications, and computers) services. Almost 55% of SAIC's revenues are derived from what appear to be strategic growth areas, such as cyber security and ISR (intelligence, surveillance, and reconnaissance). These areas are projected to grow at 10% annually over the next five years. 

Valuation

SAI is trading at 11x 2011 EPS and 6x 2011 EBITDA, in line with the defense sector and at a discount to the market. Since its IPO in 2006, the stock has traded at an average P/E of 17x.   Once the concerns over the defense cuts subside and investors begin to focus on business fundamentals, the company should re-rate. A 14 to 16x P/E is conservatively attainable given the company's growth prospects, competitive position, profitability, and ability to convert earnings into free cash flow.

SAIC has grown revenues and EBIT at CAGR's of 8% and 12% over the past five years. Return on equity has been expanding consistently during this period, reaching 24% in the LTM from 13% in 2006. Return on tangible capital has remained in excess of 80% every year. FCF grew at a CAGR of 25% during the same period. Free cash flow generation for the 12 months ended October 31, 2010 is $1.60 per share pre-acquisitions (operating cash flow - capex). The company consistently generates free cash flow in excess of earnings.

Please note that for the table at the header of this idea, 2010 and 2011 numbers are my estimates of fiscal 2011 and fiscal 2012 numbers. The company has a January fiscal year. The price to free cash flow is based on free cash flow pre-acquisitions (opearting cash flow- capex).

Summary Income Statement:

Profitability:

 Risks

Contract Risk

While no contracts are greater than 4% of revenues and over 60% of contracts are less than $10 mm in size, one cannot analyze individual contract economics and durations with publicly available information.  Offsetting this risk is the company's solid backlog.

DOD Budget Cuts

As discussed in the body of this recommendation, a top down analysis of the proposed budget cuts and SAIC's revenue composition suggests that the company is not vulnerable to the cuts. However, the available information does not allow one to gain much certainty. 

Acquisition Risk

Management has a successful record of acquisitions and it is likely that SAIC will continue to pursue acquisitions as it has in the past. Were management to pursue a larger than usual acquisition such as SRA International (SRX) the market might react negatively to company paying a high multiple. However, based on management's history of capital allocation, it is highly unlikely that SAIC will pursue a deal that does not add value.

Catalyst

Fears of Defense cuts' impact on SAIC's business subsiding.

Earnings beat. The estimate for 2011 (fiscal year January 2012) of $1.42 is too low and could be revised upwardly. The company has been consistently repurchasing its own shares and could also benefit from tuck in acquisitions. This is not being adequately factored in by analysts.