Leidos Holdings, Inc.
Q4 2013 Earnings Call Transcript

Published: 26 Mar 2013

[Operator:]

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to the SAIC Fourth Quarter Fiscal Year 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, Tuesday, March 26, 2013. And at this time, I'd like to turn the conference over to Paul Levi, SAIC's Senior VP of Investor Relations. Please go ahead, sir.

[Paul E. Levi:]

Thank you, Vince, and good afternoon. I would like to welcome you to our fourth quarter fiscal year 2013 earnings conference call. Joining me today are John Jumper, our Chairman and CEO; Stu Shea, our COO; Mark Sopp, our CFO; and other members of our leadership team. During this call, we'll make forward-looking statements to assist you in understanding the company and our expectations about its future financial and operating performance. These statements are subject to a number of risks that could cause actual events to differ materially, and I refer you to our SEC filings for a discussion of these risks. In addition, the statements represent our views as of today. We anticipate that subsequent events and developments will cause our views to change. We may elect to update the forward-looking statements at some point in the future, but we specifically disclaim any obligation to do so. I would like for our audience to please note that our management will speak of our Q4 and year-to-date results as compared to adjusted prior year periods. The adjustments center on the CityTime charges incurred last fiscal year. A GAAP reconciliation of these adjustments is provided in our earnings release issued today. I would now like to turn the call over to John Jumper, our Chairman and CEO.

[John P. Jumper:]

Thank you, Paul, and good afternoon, everyone. During the call today, I'll be discussing 4 key items. I'll start with our quarterly performance, followed by a discussion of our journey to achieve greater cost efficiencies, then third, I'll talk about market conditions and finally, our capital allocation decisions and plans. After my comments, Stu Shea will update you on the progress of our planned separation, our actions to expand our pipeline of opportunities and review new business development results. Mark Sopp will then follow with details on the financial results, guidance for FY '14 and then we'll answer your questions. First, our Q4 performance. During the quarter, our revenue growth trended down, and our full year ended with just modest growth but within our expectations. Our margins were lower than our normal run rates and were largely impacted by nonrecurring costs, including those required to achieve the planned separation and a few legal and program adjustments. Stu will provide the details in a few moments and discuss our continuing actions to improve margins. Many of the actions needed to provide sustainable margin improvement have been or are being implemented, and further actions being taken early this fiscal year will deliver benefits to both companies after separation. The second item is cost efficiency. Today, through Project Gemini, we're focused on ensuring the cost structures of 2 companies being created are appropriate for the markets they will serve. Since our IPO in 2006, various efforts to control costs allowed us to improve margins and invest more in technology and business development. However, the markets have become more competitive and stressed, requiring us to raise the bar on cost efficiency considerably more. As we prepare for our planned separation, our goal is much higher, with plans to reduce our indirect costs by at least $350 million annually in order to maintain competitiveness and profitability. For example, we've undertaken a careful review of our facility footprint and have identified ways to reduce our facilities by over 30%, saving about $70 million per year. We'll implement these reductions in the coming months. Our intent is to achieve top quartile competitiveness in our industry to address the market uncertainty we now face. Let me move to my third key point and update you on the current conditions we are facing on our government market and brief -- and a brief look at our commercial business market. Of course, we have now transitioned from the threat of sequestration to the realities of sequestration in our government markets. Sequestration, combined with the drawdown in overseas operations, provides significant headwinds for FY '14. Mark will provide additional color in his remarks on our guidance, but we believe we have realistically addressed the range of impacts embedded in sequestration. We have and will continue to work closely with our customers in these difficult financial circumstances to ensure critical operations are supported as effectively as possible, with decisions that respect our obligation to shareholder value. Whatever the impact of sequestration, the restructuring and cost efficiencies embedded in Project Gemini are essential to the long-term competitiveness and financial success of the 2 companies. Turning to our Commercial business, which is growing nicely. We continue to be the largest third-party electronic health care record implementation provider in the U.S. and this market continues to grow. Although sequestration and the fiscal cliff created some short-term uncertainty in our federal health clients, we expect this overall segment of our business to grow significantly over the next few years and beyond. In addition, large clinical system implementation opportunities in Canada provided -- will provide additional growth opportunities for the company. Let me conclude with my fourth and final key message, capital allocation. In addition to continuing substantial regular dividend -- the substantial regular dividend we started one year ago, I'm pleased to announce that our Board of Directors has approved a special dividend payment of $1 per share to our shareholders this June. The action demonstrates our commitment to return capital when appropriate to our shareholders and help lock in their returns on investment. This action, combined with the capital structures planned for the 2 separated companies, still allows both companies to have the flexibility needed to achieve future value creation and shareholder returns. Since my joining SAIC as a CEO a year ago, we have accomplished a number of critical actions to position ourselves to execute well in these dynamic markets into the future. We have a strong and dedicated leadership team of 40,000 highly talented employees who will make the next stage of our journey a success. For that, I'm very thankful. I'll turn it over now to Stu.

[K. Stuart Shea:]

Thanks, John. Good afternoon, everyone. I want to cover 3 topical areas during my comments

[Mark W. Sopp:]

Great. Thanks, Stu. I'll cover the financial highlights for Q4 and also for full fiscal '13 and then address forward guidance for fiscal '14, which started back on February 1. On the top line, total revenues were down 4% for Q4 but grew 2% for the full fiscal year. Corresponding internal revenue was down 6% in the fourth quarter but was also up, in this case, 1% for the full year. The midyear acquisition of maxIT accounted for 1% of full year growth. As expected, the most significant drivers for contraction in the fourth quarter were the declines in 2 large programs

[John P. Jumper:]

Thank you, Stu and Mark. For the past month and for the next few weeks, we are all visiting more than 30 SAIC sites to meet with our employees and to talk with them about the future of SAIC and Leidos. Our employees are bearing a significant burden during the separation, but they are demonstrating the courage to commit to these changes and the excitement of forming 2 companies, configured to compete on day one of the separation and with real opportunities for growth. Many of them are listening today and I thank them. Now I'll turn it back over to Paul for our question-and-answer session.

[Paul E. Levi:]

Thank you. Vince, we're going to take the first question.

[Operator:]

[Operator Instructions] And our first question is from the line of Joe Nadol with JPMorgan.

[Christopher Sands:]

It's actually Chris Sands on for Joe. Mark, I was wondering if you could help us out with revenue and guidance by segment, particularly in Health, Energy and Civil. John mentioned it's expected to be a growth engine over the next several years, but obviously, it lagged particularly last year. When did that start to pick up? And what are the big moving pieces there?

[Mark W. Sopp:]

Chris, we decided not to issue guidance for our segments at this time. That's something we may do later so I'm going to refrain from doing that. But I will say and as you probably expect, our commercial health business is expected to continue to be a growth engine for the company. I think the fed civ area, I think you mentioned that in your question, will continue to be stressed. And I think our Intelligence and Cyber business will continue to be a relative strength across the business, particularly in the government space. That's about all the color I think we should provide in terms of segments at this time. When we are preparing for the separation and get into separate roadshows for the 2 parties closer to the transaction itself, I think you'll expect to see more color there.

[Christopher Sands:]

Okay. And can you provide any color on the M&A pipeline and the environment there, just given all the uncertainty? Obviously, you're very focused on the spin, so has that changed your behavior in that aspect at all?

[John P. Jumper:]

Well, this is John. And I think as we've said before, each quarter, the board considers all the opportunities. And as you -- as M&A opportunities are, in fact, opportunistic, you've got to take them when they come. And so we are still sticking with our strategy that M&A is what we're looking for in our growth areas and we'll stick with that. But those opportunities just have to be at the right place and the right time.

[Christopher Sands:]

But in terms of volume of opportunities, are you seeing more or less now than you were say 12 to 18 months ago?

[John P. Jumper:]

Probably less just because of the environment.

[Christopher Sands:]

Okay. And then, Mark, one last one. Is there any share repurchase factored into the guidance?

[Mark W. Sopp:]

There was not, Chris. We have a pretty small amount of creep, it's about 5 million shares so it's not really moving the needle, but we have not factored in and assumed buyback for fiscal '14.

[Operator:]

Our next question comes from the line of Cai Von Rumohr with Cowen and Company.

[Cai Von Rumohr:]

Am I correct, this $140 million of expenses costs are included in your guidance?

[Mark W. Sopp:]

Yes, sir Cai, that's correct.

[Cai Von Rumohr:]

Okay. And which basically is saying you expect to have 8.5% to 9% margins sort of is the rough math on a go-forward basis in fiscal '15, is that correct?

[Mark W. Sopp:]

Well, we might have some issues in the tax rates and other matters, Cai, because it's not that high. I mentioned in my remarks that absent those items, we expect to be in the mid-7% range.

[Cai Von Rumohr:]

Okay. I mean, absent those items, I mean, because basically if those items are in there and you hit your number, you are in the 7% range with those items. So that's the confusion I think I've got.

[Mark W. Sopp:]

We can perhaps work with you on the side. But we're quite convinced the $140 million, assuming it's incurred, of course, and net of those will -- well, pro forma for those, if you add them back, if you will, will produce mid-7% range, now there are some dynamics in the allowability of the $140 million, so some of that piece is allowable, others parts are not. And so there's some recovery in part of the $140 million that could be part of the dynamics there.

[Cai Von Rumohr:]

Got it. What -- so what sort of a tax rate? You said $0.06, but just what sort of a tax rate are we looking at for the year?

[Mark W. Sopp:]

Our normative tax rate is 36%. We have a slightly lower rate projected for '14 due to the planned discrete item we have from settling some prior year items. But that's just about 2 percentage points. So if you're really looking at longer term, think 36%. Short term, we got about a 2% pickup in fiscal '14.

[Cai Von Rumohr:]

Terrific. And the last one, if you could tell us the commercial health care, the maxIT, the Vitalize, what sort of growth did that commercial business have in the fourth quarter? And what are you assuming for fiscal '14?

[Mark W. Sopp:]

Cai, we were well into the double digits for all quarters of fiscal '13. It was a little stronger in the third quarter. There was a little bit of slowdown from some of the, I think, confusion around some of the meaningful use regulations, but we are actually seeing restoration of momentum there already, so we view that as temporary.

[Operator:]

Our next question is from the line of Jason Kupferberg with Jefferies & Company.

[Amit Singh:]

This is actually Amit Singh for Jason Kupferberg. Just coming back to the margins again. What kind of margins are you expecting to generate in the 2 different companies, in the solutions and services company, how much different do you expect the margins in that to be between the 2 companies?

[Mark W. Sopp:]

We'll provide more color on that as time progresses. As we've previously discussed, there is a spread. It's greater than 1%, it's in the 1% to 2% range and we'll line up more precision to that as we complete the designs of the 2 companies and the forward expectations and revenue volumes of the 2 closer to the separation. But that's a ballpark range of the spread in the current business construct.

[Amit Singh:]

Perfect. And can you provide any sort of free cash flow projections? I mean, do you still expect long term sort of it to be above 90% of net income?

[Mark W. Sopp:]

Yes. We expect to have no change in the cash flow conversion, if you will, of our profitability, no material change in our capital expenditure profile and capital intensity. So the historical experience you've seen for SAIC, you can expect to apply to Leidos, the new SAIC.

[Operator:]

Our next question comes from the line of Robert Spingarn with Credit Suisse.

[Robert Spingarn:]

Mark, if I could just clarify a couple of things. First on the margin, going back the last couple of questions. The guidance that you provided for '14 assumes the cost structure -- it's given as a single company guidance, but it assumes the cost structure including the 2 corporate cost structures of the post-transaction companies, is that correct?

[Mark W. Sopp:]

I was distracted with some side work here. Could you mind repeating that, Rob? I apologize.

[Robert Spingarn:]

So when you talk about your guidance and you talk about your margins, you're talking about having 2 distinctly separate corporate overheads for the period of time that you will have them in '14, et cetera. In other words, this guidance doesn't decline once you transact and we see 2 separate companies?

[Mark W. Sopp:]

I think this answers your question. We are actually incurring some of the dis-synergies today to prepare for the separation, and we have fully incorporated those into our fiscal '14 guidance. During the course of the year, we'll conduct, as Stu mentioned, more cost reductions, and we expect the aggregate of those dis-synergies to be $50 million, not to exceed $50 million for the 2 companies. Far and far exceeding that are the cost reductions that we mentioned. [indiscernible] that includes -- sorry, go ahead.

[Robert Spingarn:]

I was just going to say so you've accounted for the increased costs. So you're going to have some increase in certain costs when you have 2 separate entities, and that's reflected here?

[Mark W. Sopp:]

Yes, sir, absolutely.

[Robert Spingarn:]

Okay. So sticking with that, I think you've said that ex costs, you'd be in the mid-7s '14. What are the margins as expected in '14 with those costs if the mid...

[Mark W. Sopp:]

They are in the midst of -- the GAAP margins expect to be in the mid-6% range, inclusive of the costs.

[Robert Spingarn:]

Okay. About 100 basis points of costs if we...

[Mark W. Sopp:]

Yes, you got it. Yes.

[Robert Spingarn:]

Okay. Now briefly, switching to what I think you already talked about but I want to clarify. You have embedded full sequestration here in your revenue decline from the mid-11s down to somewhere in the low 10s?

[Mark W. Sopp:]

That's right. For what we know of full sequestration, we have made every attempt to cover the best scenario and worse scenario, as I described in my remarks.

[Robert Spingarn:]

Okay. So that's already reflected here. And what are the swing factors between $10 billion and $10.7 billion?

[Mark W. Sopp:]

I think I mentioned them. First and foremost, the number of wins we have during the course of the year, starting now. Second, I think, as I mentioned, the bow wave of outlays from prior government fiscal appropriations should factor in and should dampen the effect of the $42.5 billion defense reductions by some degree. Hard to tell which programs precisely and so forth. A big factor is what the assumption is for government fiscal '14, so the last 4 months of our fiscal year will be governed by government fiscal '14. We've assumed a flat rate from '13 to '14 on the government side, which is the line we see in the Budget Control Act. Where that shakes out, we will see, but we thought that was a reasonable assumption. And then in addition to that, as you know, $10 billion was added to the O&M accounts pretty late in the game, and we're a pretty big O&M player and so we hope to have our fair share of benefits from those. So how those things stack up, I think will dictate where we fall in the range.

[Robert Spingarn:]

Okay. And then just lastly, you had some write-downs in the quarter. You talked about, and I think it was about $25 million in the quarter, some asset impairments, et cetera. When you think about the normal course of this type of activity, what is reflected in the '14 guidance, let's say, relative to '13 in terms of asset write-downs, et cetera?

[Mark W. Sopp:]

We are expecting no more impairments. We're expecting no more major litigation-related provisions. And we expect a balance, a historical balance of program write-ups and write-downs. We happen to have an imbalance of write-downs in our fourth quarter fiscal '13. We do not plan or expect to repeat that.

[Operator:]

Our next question comes from the line of Ed Caso with Wells Fargo.

[Edward S. Caso:]

I guess my question -- first question is on pricing, if you could talk a little bit about what you're seeing in the market, particularly around your need to have takeaways. So how much of your forward guidance is a function of takeaways? And what are you seeing as incumbents protect those positions?

[K. Stuart Shea:]

This is Stu. I think we're seeing some silliness in the market in terms of people getting desperate on the pricing. And a lot of that results around low-priced technically acceptable, as we've said many times, I'd love for somebody to come out and describe what technically acceptable means. We're actually not seeing what I would consider to be an across-the-board impact on pricing. We're seeing obviously a tightening of it. We're seeing people being much more aggressive because it's about defending their existing business. But often when we go after a takeaway, we take away something that we believe that we could win because we have a better answer, a better solution, a better product. We're not lowballing the prices and trying to just sweep it underneath the folks, it's not our style. We're looking at winning it because we are going to be the best answer and solution for what the customer needs.

[Edward S. Caso:]

Can you address at all the expectation for a financial leverage for the new SAIC at this time?

[Mark W. Sopp:]

Joe, I'll cover that one, Ed. So we're still sticking to the framework that we discussed all the way back to August. We still expect to have the range that we provided in August, which was $500 million to $700 million. That is our direction right now for leveraging of new SAIC prior to the separation. And because that will happen just prior to the separation and only when that is deemed eminent, we did not put the costs related to that in our guidance at this time. But that is the path we are on, and that allows us to achieve balance between the 2 companies in terms of their capital structure and their leverage as we laid out back in August.

[Edward S. Caso:]

So you obviously provided a special dividend here sort of getting you down to that $500 million, $600 million comfort range that you've historically had. Does this dividend provide an opportunity for another special dividend or are you working to sort of reduce the net debt level of Leidos?

[Mark W. Sopp:]

We're just seeking to deploy excess capital for the benefit of our shareholders in light of our view that, that was the best use of the funds at this time, given what's in front of us. And so we would like to keep and will remain to keep all other options available to us as opportunities present themselves, as John Jumper said, in the case of M&A or under the right conditions, buybacks and so forth. But as you've seen over our history, we have tried to achieve a balance deployment as conditions change, and that was expressed here with our special dividend right now.

[Edward S. Caso:]

Great. Last question, timing of the 10-K and the updated F10?

[Mark W. Sopp:]

Tomorrow morning for the 10-K. In terms of the modification, the next round of modifications to the Form 10, we expect that to be in mid-April.

[Operator:]

Ladies and gentlemen, that does conclude our question-and-answer session. At this time, I'd like to turn the conference back over to management for any closing remarks.

[Paul E. Levi:]

Thank you, Vince. On behalf of SAIC team, I want to thank everyone on the call today for their participation and interest in the company. Have a good evening.

[Operator:]

Thank you, sir. Ladies and gentlemen, that does conclude our conference for today. Thank you very much for your participation and for using ACT Teleconference. You may now disconnect.