Description

Amid the turmoil of Trump’s trade wars, investors searching for “defensive quality” – meaning minimal international risk (tariff / FX / supply chains), stable free cash flows (FCF), and high visibility / limited cyclical risk to revenue, earnings and FCF growth – should consider shares of Science Applications International Corporation (“SAIC”).  In our base case, shares of SAIC are worth $104, or +36% upside from the current price. In our downside scenario, shares would be worth $72, or -6%. This exceptionally favorable risk-reward is a central component of our investment thesis, and provides the downside protection we believe investors should be seeking in such turbulent markets.

SAIC is a $4.5bn market cap, $6.6bn revenue government contractor specializing in IT modernization and outsourced intelligence services for the U.S. military and intelligence agencies, NASA, the FAA, and government agencies including the Departments of Defense, Justice, and State. SAIC is among the largest government contractors by revenue and workforce, with 17,000 employees including over 10,000 with national security clearances.

Some key facts relating to SAIC’s “defensive quality”:

• 95% of SAIC’s revenue comes from the U.S. government, minimizing international risks. With a revenue base primarily comprised of multi-year contracts with government customers, SAIC’s medium-term revenue outlook is exceptionally stable, with minimal downside risk over the next few years.
  • Recent awards include a 5-year, $292 million IT support contract at NASA (won April 2019), and a 5-year, $597 million contract for IT systems modernization and technical support at the Navy’s Space and Naval Warfare Systems Center.
  • SAIC currently has a $14 billion backlog (over 2x 2019 revenue), of which over $3.0 billion is already funded, and has submitted contract proposals awaiting decision of approximately $13 billion. If SAIC wins awards more than currently anticipated, revenue growth could accelerate meaningfully over the next 1-2 years.

• SAIC’s EBIT margins, while not particularly impressive at 5-7%, are exceptionally stable, and due to SAIC’s minimal capital intensity (capex 1-2% of revenue) and favorable payments terms with the U.S. government, the company consistently generates steady and growing free cash flow (FCF). 
  • Based on the company’s own long-term guidance (which it increased on the Q4 earnings call March 28th), SAIC is likely to generate $1.4 billion of FCF over the next 3 years, equal to ~31% of the company’s total market cap!

• SAIC completed a well-timed acquisition of smaller peer Engility Holdings (“EGL”) in January 2019. The acquisition increased SAIC’s revenue by 40%, EBITDA by >50%, and immediately boosted EBIT margins by +100bps, without straining SAIC’s balance sheet (leverage guided to < 3.5x by end-2019).
  • On its Q4 earnings call March 28th, SAIC said, “The integration of Engility is on schedule and on budget. As we anticipated at our January Investor Day, we successfully achieved 85% of the year one cost synergies of $38 million upon close on January 14th. The remainder of our synergy targets have been identified and are well on track.”

In short, SAIC’s medium-term revenue, earnings, and FCF profile has minimal downside risk and potential upside as the company’s acquisition of Engility appears to be running ahead of schedule (with 85% of synergy actions complete just months after the acquisition closed).  Over the next few years, SAIC is poised to generate sector-leading EPS growth and Free Cash Flow generation. As shown in the tables below (compiled from Bloomberg consensus as of 5/31), SAIC is set to grow EPS at an 11% CAGR over the next three years, second-highest among peers after Booz Allen Hamilton (BAH), and well ahead of Leidos (LDOS) and CACI, and to generate, by far, the best free cash flow in the sector.

And yet, despite its compelling fundamentals, SAIC trades at a meaningful discount to government contractor peers:

It’s worth noting that simply applying its peer-average FY+2 P/E of 15.2x to SAIC results in a share price of $105, or +37% upside to the current price. Applying the peer-average FY+2 FCF yield of 6.8% to SAIC results in a share price of $124, or +61% upside to the current price.

So why is SAIC so under-valued? Investors primarily appear skeptical of SAIC’s ability to improve organic growth, with notes highlighting (a) that EGL’s organic revenue was declining YoY for multiple quarters before the acquisition, (b) that “legacy” SAIC’s organic growth guidance is only ~3% (well below the 6-9% long-term growth guidance BAH has provided), and (c) a tough revenue comp in the upcoming Q1-2019 report (SAIC reports June 6th).

Our quick response to each issue:

1. Investors should read the transcript from EGL’s Q3-2018 earnings, which EGL reported one month after the SAIC acquisition was announced. EGL reported very strong Q3-2018 results, including the highest book-to-bill ratio in company history (with awards in the Q being 2.38x higher than EGL’s revenue, implying a meaningful acceleration in future growth). More importantly, EGL outlined “confidence that we will achieve organic revenue growth approaching mid-single digits in 2019” based on its strong bookings. On SAIC’s Q4 call in March, management confirmed their expectation that EGL will produce positive organic growth in 2019.
2. Analyst skepticism is predicated on SAIC reporting a book-to-bill (BTB) ratio < 1.0x in its last quarter, which implies a slowing of organic growth. However, SAIC’s BTB calculation significantly under-stated future organic growth. Without getting too technical, SAIC only books the first year of revenue from multi-year contracts into backlog, and does not book any amount from large “IDIQ” (indefinite duration, indefinite quantity) contracts that have multiple awardees – as a result, reported BTB does not capture all of the future revenue that SAIC will receive from recent wins. BAH reports BTB on a similar methodology, and its prior two quarterly BTBs have been 0.45x and 0.36x – and yet BAH is likely to grow >6% organically for the next several years. In short, SAIC’s future revenue growth is significantly under-stated, and upside vs. guidance seems very likely.
3. While our positive view is not predicated on Q1 results being better than expected, we do believe SAIC will post at least an in-line quarter. More critically, we are looking for signs that EGL integration is ahead of schedule, for commentary indicating an acceleration in organic growth, and for a BTB that reinforces that outlook (BAH’s 0.36x BTB is a reasonable threshold, but we’d hope total awards, including those not reported in backlog, to be at least 0.60x the company’s revenue).

In summary, our view is that shares of SAIC represent an attractively valued entry point into a defensive, stable, and growing business with an exceptionally robust FCF outlook.  SAIC’s operating stability and growing revenue, earnings, and FCF base should support shares, limiting downside and creating significant shareholder value over the next few years. Our base case assumes SAIC deploys its FCF to repurchase shares, driving FCF / share of $9.20 by the company’s FY22 (CY 2021). We apply an 8% FCF yield, a slight discount to SAIC’s peers’ current valuations, and discount one year at 10% to arrive at a price target of $104.

Catalyst

In summary, our view is that shares of SAIC represent an attractively valued entry point into a defensive, stable, and growing business with an exceptionally robust FCF outlook.  SAIC’s operating stability and growing revenue, earnings, and FCF base should support shares, limiting downside and creating significant shareholder value over the next few years. Our base case assumes SAIC deploys its FCF to repurchase shares, driving FCF / share of $9.20 by the company’s FY22 (CY 2021). We apply an 8% FCF yield, a slight discount to SAIC’s peers’ current valuations, and discount one year at 10% to arrive at a price target of $104.