Description

We recommend purchase of Science Applications International (SAIC), a $6.5 billion revenue government IT Services Company:  Note that SAIC is on a 1/31 year end.

• Trading at 10x FCF with a PF Debt/EBITDA of 3.2x.  Recently completed $2.25 billion Engility acquisition

This is a stable low growth business with a very compelling setup from today's share price:

• Engility acquisition synergies alone should provide two years’ worth of EBITDA/FCF growth
• Company targeting LSD organic revenue growth/10-20bps EBITDA margin improvement annually
• Company expects fiscal 2020 FCF of $400m ($6.60 p/s) to grow to $500m ($9+ p/s) by fiscal 2022
  • EBITDA growth, low cash taxes (NOL’s), flattish cap-ex, declining restructuring costs
• Should see big buybacks.  Fiscal 2020-2022 will generate $1 billion in post dividend/debt pay-down FCF
  • SAIC could easily repurchase $650-$750m worth of stock over 3 years.  15%+ of the company
  • From its late 2013 spin through the end of 2018 SAIC repurchased $650m of its stock
• FY 2022 FCF (basically calendar 2021) of $500m with a large buyback brings $9+ FCF per share
  • With zero organic growth you’d still get to $8.35 per share FCF on synergies alone
  • EBITDA growth + required debt pay-down ($165m) brings leverage to 2.2x by end of fiscal 2022

Business Description.  SAIC was spun-out of Leidos Holdings in September 2013.  The company provides IT integration services to United States government agencies through its 24,000 employees (16,000 employees with clearance).  The company refers to itself as a “technology integrator”, i.e. the company does not develop any technology, there is no R&D, gross margins are only about 11% and EBITDA margins are about 8%-9%.  What SAIC does do is provide trained technology workers/consultants that utilize existing technologies (i.e. AWS) to perform projects for the government. Providing services to the government is its own core competency – heavy “bid and proposal” spend, workers with government clearance etc.  

The company breaks out its pro forma revenue as follows: Defense Systems Group (Department of Defense) 46% of revenues, National Security Group (i.e. CIA, FBI, other intelligence agencies) 27% of revenues, Civilian Markets Group (non-defense agencies i.e. NASA, USDA) 27% of revenues.  The Department of Defense represents a bit over 50% of revenue with some of that work included in the National Security Group. No one contract represents more than 10% of revenue and SAIC claims to have a 90%+ renewal rate on renewable contracts. Bid and Proposal activity for new/renewal contracts is a significant expense (fewer contracts coming up for renewal in 2019 will enable more B&P spend on new opportunities).  In terms of pro forma contract mix, 52% of revenue comes from cost plus contracts, 23% time and materials, 15% fixed price and 10% fixed price supply chain.

Engility Acquisition.  SAIC completed its acquisition of Engility on January 14, 2019.  Engility’s business is very similar to SAIC, both are “leading government service providers with highly complementary capabilities, customers and cultures”.  The combined company is now the second largest amongst the pure play public companies, after Leidos with $10.4 billion in revenue and just ahead of Booz Allen with $6.3 billion in revenue.  The deal brings increased scale, more relationships, an additional 6,000 employees with clearance and added focus on higher value intelligence and aerospace work.

The highly accretive transaction was done with SAIC stock which was then trading at 13x EBITDA:

• Transaction value of $2.5 billion – issued 17m SAIC shares @ $89.86 + $900m EGL debt
  • Transaction value is $2.25 billion adjusted for $250m NOL’s received from Engility 
  • SAIC share price at closing date was $64.14 – values transaction at $1.7 billion (with NOL’s)
• For the $2.25 billion purchase price, SAIC gets EGL EBITDA of $170m.  Adding $75m in synergies (40%+ were achieved day one) brings total additional EBITDA to $245m.  Implies about a 9x EBITDA multiple
• In terms of FCF per share accretion….(these are company estimates prior to government shutdown)
  • 1/31/19.  Pre-Engility.  Guiding to $250m on 43m shares – $5.80 per share
  • 1/31/20.  With Engility.  Guiding to $400m on 60m shares – $6.66 per share
  • Engility synergies of $75m brings FCF of $450m on 60m shares – $7.50 per share

The company’s one other material acquisition was Scitor, which was acquired in May 2015 for $790m in an all cash transaction.  Factoring in $132m of tax assets, the net purchase price of $660m was a bit over 10.5x Scitor’s $60m in EBITDA. With minimal cap-ex and cash taxes, the transaction was accretive to per share FCF though it doesn’t seem to have driven much growth.  

Financials.  Pre and post the Engility transaction financials are below:  The $250m 1/31/19 FCF excludes $50m Engility acquisition costs and was guidance given by the company pre shutdown. Shutdown costs of $10m revenue per week are not included in these estimates.

Adjusted EBITDA includes stock compensation as an addback. (1) Scitor acquisition completed May 4, 2015.  

While SAIC has historically been a flattish business organically (some of which related to the lagging impact of sequestration) the last five quarters have shown organic revenue and EBITDA growth.  SAIC management has been investing money in and bidding on some large truck assembly contracts (doesn’t make a ton of sense to us but it was higher margin work) none of which has come through and which has been a cause of the share price weakness.  Going forward, the company is guiding to 3% organic annual revenue growth post fiscal 2020 (which will see some work eliminated because of the merger – organizational conflicts of interest). The target could be considered aggressive, particularly since defense budgets are likely to come down a bit after significant increases in 2018 and 2019 – management says that based on their view of bidding and contract activity that they are highly confident in the 3% number.  Re-compete volume in 2019 is low at 13%, which will enable greater investment in new business (i.e. more money for bid and proposal work).

If you don’t believe management and are willing to assume a base case of flat, you still get to $450-$460m FCF (from $400m this year) on synergies alone.  The 3% growth target would be nice but does not have to happen for the stock to work out.

For what it’s worth, the book to bill tends to be all over the map (0.8 in Q1, 1.4 in Q2 and 1.0 in Q3) and the pro forma backlog at $14.5 billion hasn’t changed much over the past few quarters.  

Valuation.  On a current market cap of $4.1b / EV of $5.8b, management is targeting the following:

• Fiscal 2020 (this year) Revenue/EBITDA/FCF of $6.6 billion, $590 million and $400 million
• By fiscal 2022 Revenue/EBITDA/FCF grows to $7.0 billion, $685 million and $500 million
• $400m FCF this year grows to $500m by fiscal 2021 – mostly from synergies, some growth

Current EV/EBITDA is close to 10x while the FCF multiple is 10x as well.  Bear in mind that with low cap-ex and NOL’s that SAIC has an EBITDA/FCF conversion of about 70%.  Debt/EBITDA is about 3x when combining both companies 2018 calendar Adjusted EBITDA plus $38m of expected first year synergies.  

SAIC should generate 2020-2022 FCF of $1.35 billion of which $160m will be used to pay-down debt while $200m will be used to pay cash dividends.  This leaves about $1 billion of discretionary free cash flow, which given that material M&A is unlikely (just acquired EGL) very likely means large buybacks, which the company has a history of doing.  Total buybacks of $700m would likely bring the share count down from 60.5m currently to about 54m by the end of fiscal 2022 and still leave $300m for tuck in M&A or additional debt reduction.

Fiscal 2022 FCF of $485m (we are being a bit conservative) on 54m shares outstanding would bring $9 per share of FCF.  If the company achieved no organic growth, then synergies alone bring $460m of FCF, which on 55m shares outstanding brings $8.35 per share.  Either way, the current $67 share price seems quite low relative to the possibilities. If per share FCF were valued at 10x-11x (arguably too low) you’d end up with a range of $83.50 to $99.00 share price by the end of 2021, about a 10%-16% IRR from here.

Summary.  While SAIC is not the best business in the space (comps EBITDA margins are a few hundred bps higher) and results in recent years have been flattish, there are a number of positives; providing services to the government is very stable, the FCF multiple is quite low, the company will grow its earnings even if just from synergies, a large buyback is very likely, and the company has an ability to grow nicely via accretive M&A.  Shutdown costs are estimated at $10m a week of revenue, the cash flow impact would be felt in the 1/31/19 year (i.e the $250m could be less).   

Catalyst

Aggressive buybacks