Investment Summary
There are currently several broad macro signals telling us there could be a potential US economic slowdown. Despite this, broad equity markets have held up well, trading flat in the last two months near their previous all-time highs. With the European Central Bank, the first economic powerhouse to cut rates this week, delivering a 25 basis points relief to its policy rate, the question is what this means for companies with high revenue exposure to the US (and other major nations that are well away from their cutting cycle).
The US industrial sector has performed well this year to date, underpinned by strong correlations with commodity prices and inflation inputs. As evidence of this, the iShares U.S. Industrials ETF (IYJ) has climbed 6% since January, delivering dividends of $1.17 per share in the last 12 months to shareholders. Whilst it has lagged the S&P 500 Index, within the sector, there are many attractive industries and corporations with attractive idiosyncratic risk premia.
After a sharp pullback in its stock price following its Q1 2025 earnings, we are drawn to the economic prospects of Science Applications International Corporation (NASDAQ:SAIC). The company has potential value trading at 14x earnings and comes on with a 7% forward earnings yield and 9% trailing free cash flow yield at the time of publication.
Figure 1.
Here, I will discuss why I believe that SAIC is a buy on factors of fundamentals and valuation.
Background fundamentals
SAIC provides full life cycle services to the information technology (“IT”) market. This includes the engineering and enterprise IT markets as well. It was incorporated in 1969 and now has 24,000 employees, averaging $19,000 in profit per employee. This places it in the top 1/3 of companies in the research and consulting services industry for profit per employee. I use this metric as one measure of a corporation’s “return on talent.”
The research and consulting services industry is a relatively low-margin, low-turnover, asset-heavy domain. As seen in Figure 2, gross margins average around 44% for the industry, on operating margins of 4.4% on average. SAIC has a competitive advantage here in my opinion. It appears the company has a pricing advantage over its competitors and can price its offerings below comparable industry averages.
We see this in the lower gross margin versus the industry (indicating the sales price) but the 260 basis points difference in operating margin. This culminates in a higher return on capital of 13%, versus the industry’s 6.5%. The nearly double business returns justify having a lower free cash flow margin; I am not displeased with management reinvesting cash back into the business to maintain such healthy returns. Moreover, as we will see later, the magnitude of free cash flow and economic value that management is producing offsets this compressed margin.
Industry outlook
Opinions on the outlook of the market are notably strong in my opinion. The broad consulting services market is expected to grow at a compounding rate of 4.8% into 2029, reaching a value of $447 billion by that time. Additional estimates project the research, promotional and consulting services market to grow at a compounding rate of 5.3% over the same period. This is an attractive proposition, in my opinion, growing roughly 300 basis points more than the long-term average GDP.
Factors expected to drive the growth include higher demand for data analytics and integration of artificial intelligence into new business systems. In my opinion, this fits the bill because we are going to need a large upheaval in the current level of data processing that will be required to fulfill the demand of 1) the electrification of things, and 2) advancements in the way we do computing.
For SAIC, these developments are industry tail wins that factor into the broader thesis.
Figure 2.
Q1 2025 earnings insights
It was another period of flat business for the company in its Q1 FY 2025; however, I’m not surprised by this given its maturity cycle. We are not after growth in this name, as I will explain later. It put up $1.85 billion of revenues, 9% year-over-year decline, and put this down to adjusted EBITDA of $166 million, a 9% pre-tax margin. Earnings of $1.48 per year were down from $1.79 year over year.
The CEO made some interesting arguments on the call, and listed the company’s “strategic priorities” moving forward:
“SAIC’s expertise in integrating emerging technology positions the company to deliver profitable growth by serving our customers across five national imperatives: All-Domain Warfighting, Next-Generation Space, Citizen Experience, Border of the Future, and Undersea Dominance. These imperatives represent drivers of long-term and enduring customer demand. In order to increase value to our customers’ missions and grow more profitably across the five imperatives, we will work to progressively shift our portfolio and bid into four key growth vectors: Integrated Solutions, Enterprise and Mission IT, Civilian, and Mission Advisory.”
Critically, management noted that its total contract value (“TCV”) wins of less than $500 million have remained in good stead, and this is a sweet spot for its pipeline moving forward. Management said that its pipeline is more skewed towards these TCV levels.
Additionally, submission volumes – which measure the company’s ability to convert its pipeline into submitted proposals – were $8 billion for Q1. This put it on track to hit a target of $22 billion in submission volume by the end of its fiscal 2025 [A $7 billion increase over FY 2024].
Furthermore, net bookings settled were at $2.6 billion for the quarter. An additional tailwind, around 66% of the submission volume is categorized as new business wins. Consequently, it left the quarter with a book-to-bill ratio of 1.4, consisting of roughly 2/3 new business (as a reminder, a book-to-bill ratio >1 is preferred, as it signals the company has more orders in its pipeline than it is currently fulfilling).
Management retained its FY 2025 guidance calling for $7.35 billion up to $7.5 billion of revenues, looking to pull this to pre-tax earnings of $700 million at the upper end of the range. Management projects $500 million of free cash flow on this.
My view of the company’s first quarter in fiscal 2025 was that (i) it was in line with expectations, and (ii) the momentum of SAIC’s pipeline signals it has plenty of inventory work through to realize in cash over the coming 2 to 3 years.
Fundamental economics underpinning buy thesis
In industries with large capacity and excessive competitiveness, illustrated by razor-thin operating margins, productivity is paramount. As shown earlier, returns on capital in the industry average around 6.5%, which is around the return of the average US large corporation. SAIC nearly doubles this figure on every rolling 12-month period and has done so over the last three years at a minimum.
This is a competitive advantage. In my view, it is brought about by management’s ability to run the business by pricing its offering lower than industry peers. This is not only evidenced by the rate of contract wins in the quarter, for example, but further exhibited by 1) the ability to run on nearly 4 times less gross margin, 2) running operating costs as a percentage of sales lower than peers, 3) thereby producing higher operating margins, 4) coupled with higher capital turnover than the industry average.
For instance, the company had $76 per share of invested in the business at the end of Q1 FY 2025. In the 12 months to this date, it produced net operating profit after tax of $9.26 per share on this, a 12.2% trailing return on investment.
The drivers of the returns are clear. It has a higher post-tax margin than the industry (even though it is quite thin at <7%) but turns over sales on capital 1.8 to 1.9x rolling 12-month period. This means one dollar invested into the business is returning around $1.90 in revenues.
Figure 3.
These are attractive economics, in my opinion, which enable the business to operate on exceptionally higher trailing free cash flow yields. Figure 4 illustrates the trailing free cash flow yield SAIC has done business on over the past two years on a rolling 12-month basis. As seen, investors have had multiple occasions to purchase this stock at an above 10% free cash flow yield, with six opportunities presented. My opinion is this relationship will maintain itself moving forward.
Figure 4.
Because of this, I have reorganized the interpretation of free cash flow to separate capital expenditure into growth and maintenance investment.
Maintenance investment is approximated at the level of depreciation each period, whereas growth investment is any capital deployed above this amount. Acquisitions are included, and dividends buybacks are included in the definition of cash flow to shareholders (Figure 5).
As you can see, the company has maintained tremendously strong levels of free cash flow over this period. It has thrown off anywhere from $700 million to $1.1 billion of cash after considering all growth and maintenance investments. It is hard to argue with a company with this kind of earning power, even though there is not an extensive reinvestment runway to redeploy the funds. They will, however, continue to finance dividends and buyback into the future. Buybacks are attractive to me because 1) they increase my ownership in the company without any additional investment, plus 2) they increase the payout ratio of the company from dividends and earning perspective. This adds to my bullish thesis.
Figure 5.
As a result of the economics discussed above, management has created tremendous value for shareholders in my opinion. I measure this as the “economic earnings” versus the accounting earnings of the business. Earnings are economically valuable if they are produced on invested capital at a rate above what we could generally expect to achieve elsewhere. I estimate this to be 10% in this instance, calculated as the 12% long-term average of the broad indices, with a minus 200 basis points inflation charge.
Anything above this 10% level is economically valuable. Since 2021, on a rolling 12-month basis, the company has produced 807 million dollars in economic value, otherwise $15.10 per share. The share price has increased by $23.50, since Q3 2021 earnings, meaning investors have applied a 1.5x multiple to this economic profit.
Figure 6.
Projections of corporate value
Consensus forecasts around $7.4 billion in revenues this year, flat on the prior 12 months, stretching up 3% in FY 2026 to $7.6 billion. It expects 4% growth in pre-tax earnings and expects 6% bottom-line growth on this. My numbers are remarkably similar, and I discussed this a little later. Firstly, I want to get an understanding of what these projections imply.
Revenue growth is flat, but with the ~4% projected pre-tax earnings growth, this looks to add around 40 basis points of pre-tax margin. Assuming a similar tax rate, we get to $507 million in net operating profit after tax implied for CY 2024. This is quite an optimistic projection, but not out of the realms of reality in my opinion. Should it do this, it would imply a 5% growth in intrinsic value and a 12% return on capital for the company.
Figure 8.
One of the factors that attracts me to this company is the relatively steady free cash flow, making the predictability of future cash flows more certain.
The capital allocation decisions of management are seen in the figure below, alongside the financial performance of the company on a rolling 12-month basis. As seen, sales Grove has been flat in line with the maturity cycle of the company. The pretax margin has averaged 8.5%.
To produce an extra dollar revenue, management has had to invest around $0.10 to working capital and has wound down fixed asset intensity by $0.16 on the dollar.
Figure 9.
I am going to carry these assumptions going forward, as I believe they fit the fundamentals well. Projecting these out over the coming three years, I get to $7.4 billion in sales by FY 2025, with free cash flow of $302 million after around $180-$190 million of capital expenditures.
As noted earlier, it is working through a higher amount of inventory (inventory was $104 million vs. $3 million over the last quarter), so my estimation it can reduce net working capital as a function of this revenue growth.
Figure 10.
Valuation
SAIC trades at a discount to the sector act 14.8x trailing earnings, and 16x trailing EBIT. These are 24% and 7% discounts to the sector respectively. Interestingly, whilst it is priced relatively low to the earnings of the business, it is priced higher relative to the net assets of the company, trading at 3.4x book value. This is on a return on equity of 26%, so the investor return on equity starts at 7.6% if paying that multiple.
Being that I have a very long-term horizon in mind with this company, it’s important to see what type of economic earnings it could produce over the next 5 years. I am going to apply a 6% charge on the projected post-tax earnings to reflect the starting yields of most investment-grade corporates right now. It better produce a return on capital above this; otherwise, I don’t think I would be interested. Here, I discount the projected economic earnings at the 10% total rate from earlier.
Projecting my cash flows over the next five years, and performing the process, I get to a valuation of $156 per share, 35% upside potential from the time of writing. This further supports a buy.
Figure 11.
Conclusion
SAIC presents with exceptional economics that sees it throw off stable, high free cash flows each rolling 12-month period. It methodically rotates earnings into free cash flow given the high returns on management produce period as well. These are the kinds of economics I like to position against for the long term.
My opinion is that SAIC can continue adding economic value above what investors could reasonably achieve elsewhere with a similar level of risk, and this warrants a fair valuation of $156 per share given all the provable facts we have at the moment. Rate buy.
Read the full article here