October 26, 2006 - 2:29pm EST by
2006 2007
Price: 18.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 7,800 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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SAIC, Inc. (“SAI”), previously known as Science Applications International Corporation, is a  high technology research and engineering company. The company was formed by a group of scientists in 1969.


Generic description: SAI’s engineers and scientists work to solve complex technical problems in national and homeland security, energy, the environment, space, telecommunications, health care and logistics through systems engineering, systems integration and advanced technical services. The U.S. government accounts for over 80% of revenue, with the U.S. military being a very significant contributor. They don’t build hardware but mostly work as contract labor to advise, install, and integrate high-tech solutions.


Until its IPO a couple of weeks ago, it was 100% owned by employees (43,000 total employees), of which 23,00 have security clearances (almost a license to print money). 1/3 of the employees sit side by side with the customer. With $8 billion in trailing Revenue, this is one of the largest companies that no one on Wall Street had ever heard of.


At current price of $18 per share, SAI is valued at 90% of revenues, while its peers trade a least 1/3rd higher.


The business itself is very stable. They have 9,000 contracts and the top 10 contracts account for less than 14% of sales. They also win 70% of the contracts that they bid on. SAI has strong positions in its end markets and should grow at over 5% per year organically.


There is a lot of opportunity for the SAI business to improve. SAI is on the verge of acceleration in its revenue growth. SAI’s current total backlog of $16 bn is twice its annual revenue. In the last two and a half years, SAI experienced very significant growth of 59% in its unfunded backlog ($12 bn currently) but only modest growth of 19% in its funded backlog ($4 bn), which was constrained by diversion of government funds to military deployment in Iraq and Afghanistan. Recent legislation has authorized substantially better funding of SAI’s backlog. This should allow for a large portion of the unfunded backlog to convert to the funded status and revenue in the near term. Moreover, since SAI’s latest published financials and metrics dated July 2006, the company has experienced a surge in bidding activity and awards that should add to it its total backlog further.


The bigger story is margins. EBIT is 7% of revenues. Peers have margins 9% or better. It is understandable why. SAI brought in a new CEO three years ago and a new CFO last year. They see a lot of opportunity:


1) On the vast majority of Materials & Sub-contract revenue (37% of total revenue), SAI gets no margin. Standard industry practice is to charge 4%. If they do that, SAI would add 150 bp to its margins.

2) Another opportunity is from the mix shift towards higher margin time & materials and fixed price contracts and away from sub-contracting. Surely, it’s a shift to higher-risk, higher-margin offering vs. lower-risk, cost-plus, but management contends that they’ve been in business for so long and are so ingrained into government organizations (often co-located, and co-develop the project) that the added risk is small compared to added margin. They maintain that margins on Fixed Price are in double digits while cost-reimbursement contracts are bad. If they manage to substitute 10% of Revenue that relates to Cost Plus with Fixed Price, it should lift the overall EBIT margin by up to 100 bp.

3) Another lever to increase margins is improvement in operational efficiency. When the new CEO came in, there were 70 operating units. He described the culture as Byzantine. 300 managers have been cut over the last two years. He promises to cut more than that in the next 2 years. At $100K per person (very conservative), that’s $40 mm per year in cost saves, which should add 50 bps (on $8 bn in revenues) to its margins.



The three points above should give their EBIT margin a boost of 300 bp and get them to above average industry margin. I could have also mentioned… that they are optimizing bidding & business development functions at SAI… that they should earn some return on internal infrastructure expenditures (expensed as incurred) made in the two years leading up to the IPO… that given so much forward looking project opportunity for them, profitability of new projects added to the backlog now should be better than recent past, etc…. but why get greedy?


For what’s it worth, the CEO thinks he can achieve a “best in class” margin.



Finally, there is a significant opportunity on the balance sheet. SAI went public significantly overcapitalized with no net financial debt, while having almost no capital requirements to sustain and grow the business, 70%+ win rates on its contracts, multi-year backlog and the majority of expenses being reimbursable by the government  They also have valuable real estate holdings (in La Jolla, CA and Tyson’s Corner, VA). They carry those at about $250 mm on the balance sheet, which are likely worth at least twice as much. There is also a possibility to obtain a favorable tax ruling (in the hundreds of millions) that should shield part of its future income. 


Putting this all together, the upside case is over $11 bn in revenues at a 9% EBIT margin is fiscal 2009, which is basically calendar 2008, and it earns about $1.50 per share.


If SAI returns $350 mm of free cash flow, monetizes $500 mm of real estate and takes 3 turns of EBIT leverage, it can buy back half the company. At that point earnings would be around $2.50 per share and the stock dramatically higher.


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