You Cannot Quantify The Risks Facing Booz Allen
Jun 27 2013, 11:04 | about: BAH
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Unless you have been living in a cave for the last few weeks, you are most likely acutely aware that potentially one of the largest national security breaches in US history recently took place. Immediately after the news broke, I highlighted in an article the connection the rogue employee who stole the sensitive data had to Booz Allen Hamilton (BAH). Without diving into much detail about the company itself, I presented the case that Booz Allen should be considered untouchable as a potential investment. The article intimated that regardless of what Booz Allen could have done to prevent the security breach of an employee hell bent on committing what should be considered treason, the company henceforth would see damage to its reputation and could potentially lose significant amounts of business. In the preceding few weeks since the initial revelation, more damning evidence has come out that casts Booz Allen in an even worse light than the original revelation did. A US Senate committee investigation has brought to light that Booz Allen identified apparent discrepancies in the employee’s resume which possibly should have raised a red flag. Another government screening agency also identified discrepancies and still the employee was hired. The rest is history. In the words of the Director of the National Security Advisor, when referring to Edward Snowden who committed the crime:
What Snowden has revealed has caused irreversible and significant damage to our country and to our allies.
The stock of Booz Allen is down just about 7% from where it was prior to the revelation. I continue to believe that the fallout from this incident will hit home on multiple fronts. First, the company is at risk for a loss of its government contracts, specifically those dealing with national security type interests. It is impossible to quantify how large this risk may be, but just giving investors an idea of how important this business is to Booz Allen will paint the picture of the potential impact. Second, it is an unequivocal fact that the company will incur material expenses both in determining how this breach occurred and implementing processes to ensure that it does not occur again. Consultants, attorneys and any other number of outside firms will have to be paid so that the company can prove that it is minding the store so to speak. The recent capital actions taken by the company, in terms of the special dividend in 2012 and raising significant debt to fund this dividend, leaves the company with a heavy debt load at an inopportune time.
How Does Booz Allen Make Money?
Booz Allen makes money in a very simple manner. Through government contracts. The following language comes straight from the FY2013 10-K report:
Substantially all of the company’s revenue is derived from services and solutions provided to the U.S. government and its agencies, primarily by the company’s consulting staff and, to a lesser extent, subcontractors.
Substantially can be defined as over 99% of the company’s revenue as of FY 2013.
Where the story begins to get complicated is what portion of the total revenue Booz Allen derives from governmental clients that would not be so pleased to find out that the company has lax controls that might contribute to a rogue employee stealing US intelligence. Here, we see how big of a piece of the revenue pie the work for intelligence agencies is, again from the 2013 10-K:
Our business in support of major U.S. intelligence agencies represented 23% of our business based on revenue for fiscal 2013, or approximately $1.3 billion. Additional revenue from our intelligence support of military commands and military intelligence agencies is included in revenue attributable to Defense clients.
23% of the total revenue is directly tied to intelligence agency contracts. The benign last sentence from the paragraph above is what catches my eye. The company notes that additional revenue tied to supporting intelligence type activities is included in its revenue attributed to Defense clients. This is where the biggest piece of the revenue pie comes from:
Our reputation and track record in serving the U.S. military and defense agencies spans more than 70 years. Our defense business represented 55% of our business based on revenue for fiscal 2013. Our revenue in this area for fiscal 2013 was approximately $3.2 billion.
This leads to a whopping 78% of the total revenue in FY2013 tied in some way to either US intelligence agencies or defense departments (Army, Navy, etc…).
Booz Allen is constantly ranked as one of the top employers to work for in the US and has ties with the US government that go back over 70 years. I’m not speculating that one seemingly isolated incident is enough to destroy what this company has become today and the valuable services it provides to the US Government. I am, however, willing to say that the company will be under the spotlight, which is never a good thing. The bigger issue will end up being the US Congress openly debating the role of private companies augmenting the US government for items sensitive enough to be required the highest levels of security clearance.
Part of the reason for my skepticism surrounding Booz Allen is that the company is not necessarily a bastion of growth to begin with. Management is very shareholder friendly with multiple special dividends over the last few years. At the same time, core operating results have been under pressure, specifically on the top line as seen below from the Q4 2013 earnings presentation:
(click to enlarge)
The one item the company threw on this slide that it is obviously trying to highlight is its backlog of future revenue, representing contracts signed as of 3/31/13 that could ultimately turn into revenue. The company conveniently leaves out of this slide that the majority of the increase in backlog is related to contracts that are not yet funded via any type of governmental appropriation. In fact, the portion of the backlog that has received funding and is more of a guaranteed future revenue stream fell 13% from the prior year as seen below from the 2013 10-K:
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Keep in mind that all of these figures preceded the theft of US intelligence information discussed in the introduction.
The outlook for FY2014 shows a decline in revenue and earnings compared to the prior year:
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An item of note is that the company made an acquisition during 2013 that is helping to support its revenue number for FY 2014. An analyst questioned company management on the Q4 2013 earnings call, and management indicated that the organic revenue excluding the impact of the acquisition would show a decline of 5 to 6% from the prior year.
Another item that pains me to see as a shareholder is the absolutely ridiculous growth in the number of shares outstanding which is shown in the chart below:
BAH Shares Outstanding data by YCharts
Over a 4 year time period, the total number of shares outstanding grew over 20%. The company had over 144M diluted shares as of the end of FY 2013, compared to 116M at the end of FY2010.
From a balance sheet standpoint, the company has not been afraid to lever up with debt to fund special dividends and acquisitions over the past few years as seen below:
BAH LT Debt data by YCharts
The track record for Booz Allen is to pay out special dividends, use its substantial cash flow to reduce debt, and then pay out more special dividends and issue debt again. It is a wash, rinse, repeat cycle. In 2012, the company paid a roughly $750M special dividend which was the equivalent of ~$6.50 a share. No small potato for a stock with a market cap of ~$2.7B prior to the special dividend being paid out. The company is clearly shareholder friendly in this regard, but potentially friendly only to those who hold the majority of its shares, which in the case of Booz Allen is a the well known private equity Carlyle Group. Individual investors should not kid themselves about the intent of Booz Allen with its shareholder actions. When the Carlyle Group owns almost 70% of the outstanding shares, any shareholder friendly action is directed at the private equity fund and not Average Joe shareholder.
What Happens Next / Investment Outlook
If there is no fallout related to this incident than I will frankly be more concerned about our country than I am today. Booz Allen has a section in its 10-K that discusses the security clearance levels given to its employees, and what percentage of employees receive those security levels:
As of March 31, 2013, 76% of our people held government security clearances: 27% at Top Secret/Sensitive Compartmented Information, 21% at Top Secret (excluding Sensitive Compartmented Information) and 28% at Secret. High-level security clearances generally afford a person access to data that affect national security, counterterrorism or counterintelligence, or other highly sensitive data. Persons with the highest security clearance, Top Secret, have access to information that would cause “exceptionally grave damage” to national security if disclosed to the public. Persons with access to the most sensitive and carefully controlled intelligence information hold a Top-Secret/Sensitive Compartmented Information clearance. Persons with the second-highest clearance classification, Secret, have access to information that would cause “serious damage” to national security if disclosed to the public.
Booz Allen employed 24,500 people at the end of FY2013. Of those, 21% had access to Top Secret information that would cause “exceptionally grave damage” to national security if disclosed to the public. The company had over 5,000 employees with access to this type of information, and all it took was 1 employee to bring about one of the greatest intelligence failures in the history of the US. This is not an indictment of Booz Allen. The US government cannot fire itself if one of its employees disclosed top secret information. It can fire a private company. When you are Booz Allen and the entirety of your revenue stream is dependent on the US government, the last thing you need is to be thrust in the spotlight as the sequestration goes into full effect and every liberal in the US Congress is already itching to cut spending on national security and defense budgets. This just gives those looking to cut these types of costs more ammo. I am of the belief that the final shoe has not dropped and that Booz Allen will incur material costs both of a one time and recurring nature, to provide the appearance that it is completely revamping how it ensures that the employees it hires have been properly vetted. I also believe it is inevitable that the company will lose some portion of its intelligence contracts if for nothing else so that an example can be made. I would expect to see a downward revision to earnings estimates with the reasoning being the sequestration and non-recurring costs related to the national security incident. There are also very real questions about liability in this matter. The US government will incur significant costs to change protocols, potentially revamp entire programs of a sensitive nature that may have been compromised, and ultimately spend hundreds of millions of dollars trying to undo the damage caused by this security leak. Is it safe to assume that Booz Allen will not be asked to share in these costs? I would hope not, as a taxpayer funding both the US government and Booz Allen and its private equity majority shareholder.