Science Applications International Corp 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations and quantitative and qualitative disclosures about market risk should be read in conjunction with our unaudited condensed and consolidated financial statements and the related notes. It contains forward-looking statements (which may be identified by words such as those described in “Risk Factors—Forward-Looking Statement Risks” in Part I of the most recently filed Annual Report on Form 10-K), including statements regarding our intent, belief, or current expectations with respect to, among other things, trends affecting our financial condition or results of operations (including our financial targets discussed below under “Management of Operating Performance and Reporting” and “Liquidity and Capital Resources”); backlog; our industry; government budgets and spending; market opportunities; the impact of competition; and the impact of acquisitions. Such statements are not guarantees of future performance and involve risks and uncertainties, and actual results may differ materially from those in the forward-looking statements as a result of various factors. Risks, uncertainties and assumptions that could cause or contribute to these differences include those discussed below, in “Risk Factors” in Part II of this report and in Part I of the most recently filed Annual Report on Form 10-K. Due to such risks, uncertainties and assumptions, you are cautioned not to place undue reliance on such forward-looking statements, which speak only as of the date hereof. We do not undertake any obligation to update these factors or to publicly announce the results of any changes to our forward-looking statements due to future results or developments. We use the terms "SAIC," the “Company,” “we,” “us” and “our” to refer to Science Applications International Corporation and its consolidated subsidiaries. The Company utilizes a 52/53 week fiscal year, ending on the Friday closest to January 31, with fiscal quarters typically consisting of 13 weeks. Fiscal 2023 began on January 29, 2022 and ends on February 3, 2023, while fiscal 2022 began on January 30, 2021 and ended on January 28, 2022. Business Overview We are a leading technology integrator providing full life cycle services and solutions in the technical, engineering and enterprise information technology (IT) markets. We developed our brand by addressing our customers’ mission critical needs and solving their most complex problems for over 50 years. As one of the largest pure-play technology service providers to the U.S. government, we serve markets of significant scale and opportunity. Our primary customers are the departments and agencies of the U.S. government. We serve our customers through approximately 1,900 active contracts and task orders and employ approximately 26,000 individuals who are led by an experienced executive team of proven industry leaders. Our long history of serving the U.S. government has afforded us the ability to develop strong and longstanding relationships with some of the largest customers in the markets we serve. Substantially all of our revenues and tangible long-lived assets are generated by or owned by entities located in the United States. Economic Opportunities, Challenges, and Risks During the three and nine months ended October 28, 2022, we generated approximately 98% of our revenues from contracts with the U.S. government, including subcontracts on which we perform. Our business performance is affected by the overall level of U.S. government spending and the alignment of our offerings and capabilities with the budget priorities of the U.S. government. Appropriations measures passed in March 2022 provided full funding for the federal government through the end of government fiscal year (GFY) 2022. The U.S. government is currently operating under a Continuing Resolution for GFY 2023. In October 2021, the Federal debt ceiling was increased by $480 billion and in December 2021 was further increased by $2.5 trillion which is expected to allow the U.S. government to operate into 2023. It is unlikely but possible these measures could expire without extension and lead to a partial or full government shutdown. Adverse changes in fiscal and economic conditions could materially impact our business. Some changes that could have an adverse impact on our business include adverse regulations, the implementation of future spending reductions (including sequestration), delayed passage of appropriations bills resulting in temporary or full-year continuing resolutions, extreme inflationary increases adversely impacting fixed price contracts, inability to increase or suspend the Federal debt ceiling, and potential government shutdowns. -20- Table of Contents SCIENCE APPLICATIONS INTERNATIONAL CORPORATION Spending packages, including the infrastructure bill, Inflation Reduction Act, and CHIPS and Science Act, as well as future potential spending packages, may provide additional opportunity in areas of SAIC focus such as digital modernization, cyber, microelectronics support, and climate resiliency. The U.S. government has increasingly relied on contracts that are subject to a competitive bidding process (including indefinite delivery, indefinite quantity (IDIQ), U.S. General Services Administration (GSA) schedules, and other multi-award contracts), which has resulted in greater competition and increased pricing pressure. Additionally, the U.S. government has put renewed emphasis on increasing the number of small business prime set-aside contracts that further reduce the addressable market in some areas. Despite the budget and competitive pressures affecting the industry, we believe we are well-positioned to protect and expand existing customer relationships and benefit from opportunities that we have not previously pursued. Our scale, size, and prime contractor leadership position are expected to help differentiate us from our competitors, especially on large contract opportunities. We believe our long-term, trusted customer relationships and deep technical expertise provide us with the sophistication to handle highly complex, mission-critical contracts. Our value proposition is found in the proven ability to serve as a trusted adviser to our customers. In doing so, we leverage our expertise and scale to help them execute their mission. We succeed as a business based on the solutions we deliver, our past performance, and our ability to compete on price. Our solutions are inspired through innovation based on adoption of best practices and technology integration of the best capabilities available. Our past performance was achieved by employees dedicated to supporting our customers' most challenging missions. Our current cost structure and ongoing efforts to reduce costs by strategic sourcing and developing repeatable offerings sold "as a service" and as managed services in a more commercial business model are expected to allow us to compete effectively on price in an evolving environment. Our ability to be competitive in the future will continue to be driven by our reputation for successful program execution, competitive cost structure, development of new pricing and business models, and efficiencies in assigning the right people, at the right time, in support of our contracts. On July 2, 2021, we completed the acquisition of Halfaker and Associates, LLC (Halfaker). The acquisition of Halfaker, in alignment with our long-term strategy, grows the Company's digital transformation portfolio while expanding its ability to support the government's healthcare mission. Impacts of the COVID-19 Pandemic We are continuing to monitor the ongoing outbreak of the coronavirus disease 2019 (COVID-19) and we continue to work with our stakeholders to assess further possible implications to our business, supply chain and customers, and to take actions in an effort to mitigate adverse consequences. The CARES Act allowed for the deferral of certain payroll tax payments through December 31, 2020 and we deferred total payments of approximately $103 million. The first installment of these deferred payroll taxes was paid during the third quarter of fiscal 2022 (approximately $51 million) with the remaining amounts due in the fourth quarter of fiscal 2023. We have not experienced a significant impact to our liquidity or access to capital as a result of the COVID-19 pandemic. While we continue to navigate the impacts of the COVID-19 pandemic, COVID-19 did not have a material impact to revenues and operating income for the three and nine months ended October 28, 2022. The full extent of the impact of COVID-19 on our business and our operational and financial performance will depend on future developments, including the duration and spread of the pandemic, all of which are uncertain and cannot be predicted. Management of Operating Performance and Reporting Our business and program management process is directed by professional managers focused on serving our customers by providing high quality services in achieving program requirements. These managers carefully monitor contract margin performance by constantly evaluating contract risks and opportunities. Throughout each contract's life cycle, program managers review performance and update contract performance estimates to reflect their understanding of the best information available. For performance obligations satisfied over time, updates to estimates are generally recognized on inception-to-date activity, during the period of adjustment, resulting in either a favorable or unfavorable impact to operating income. -21- Table of Contents SCIENCE APPLICATIONS INTERNATIONAL CORPORATION We evaluate our results of operations by considering the drivers causing changes in revenues, operating income and operating cash flows. Given that revenues fluctuate on our contract portfolio over time due to contract awards and completions, changes in customer requirements, and increases or decreases in ordering volume of materials, we evaluate significant trends and fluctuations in these terms. Whether performed by our employees or by our subcontractors, we primarily provide services and, as a result, our cost of revenues are predominantly variable. We also analyze our cost mix (labor, subcontractor or materials) in order to understand operating margin because programs with a higher proportion of SAIC labor are generally more profitable. Changes in cost of revenues as a percentage of revenues other than from revenue volume or cost mix are normally driven by fluctuations in shared or corporate costs, or cumulative revenue adjustments due to changes in estimates. Changes in operating cash flows are described with regard to changes in cash generated through the delivery of services, significant drivers of fluctuations in assets or liabilities and the impacts of changes in timing of cash receipts or disbursements. Results of Operations The primary financial performance measures we use to manage our business and monitor results of operations are revenues, operating income, and cash flows from operating activities. The following table summarizes our results of operations: Three Months Ended Nine Months Ended October 28, 2022 Percent change October 29, 2021 October 28, 2022 Percent change October 29, 2021 (dollars in millions) Revenues $ 1,909 1 % $ 1,898 $ 5,736 2 % $ 5,612 Cost of revenues 1,688 — % 1,685 5,070 2 % 4,950 As a percentage of revenues 88.4 % 88.8 % 88.4 % 88.2 % Selling, general and administrative expenses 87 — % 87 272 8 % 252 Acquisition and integration costs 1 (92 %) 12 11 (69 %) 36 Other operating income — — % — — (100 %) (3) Operating income 133 17 % 114 383 2 % 377 As a percentage of revenues 7.0 % 6.0 % 6.7 % 6.7 % Net income attributable to common stockholders $ 80 13 % $ 71 $ 226 (3 %) $ 234 Net cash provided by operating activities $ 128 (4 %) $ 134 $ 387 (7 %) $ 415 Revenues. Revenues increased $11 million for the three months ended October 28, 2022 as compared to the same period in the prior year primarily due to ramp up on new and existing contracts, partially offset by contract completions and lower accelerated amortization on certain off-market liability contracts. Revenues increased $124 million for the nine months ended October 28, 2022 as compared to the same period in the prior year due to ramp up on new and existing contracts and the acquisition of Halfaker (approximately $72 million), partially offset by contract completions, one fewer working day compared to the prior year period, lower net favorable changes in contract estimates, and lower accelerated amortization on certain off-market liability contracts. Adjusting for the impact of acquired and divested revenues, revenues grew approximately 1%. Cost of Revenues. Cost of revenues increased $3 million for the three months ended October 28, 2022 as compared to the same period in the prior year primarily due to ramp up on new and existing contracts. Cost of revenues increased $120 million for the nine months ended October 28, 2022 as compared to the same period in the prior year primarily due to ramp up on new and existing contracts and the acquisition of Halfaker. Selling, General and Administrative Expenses. SG&A remained consistent for the three months ended October 28, 2022 as compared with the same period in the prior year. SG&A increased $20 million for the nine months ended October 28, 2022 as compared to the same period in the prior year primarily due to higher indirect expenses and the acquisition of Halfaker. -22- Table of Contents SCIENCE APPLICATIONS INTERNATIONAL CORPORATION Operating Income. Operating income as a percentage of revenues for the three months ended October 28, 2022 increased from the comparable prior year period primarily due to lower acquisition and integration costs and indirect costs, partially offset by lower accelerated amortization on certain off-market liability contracts. Operating income as a percentage of revenues remained consistent for the nine months ended October 28, 2022 as compared with the same period in the prior year. Lower net favorable changes in contract estimates and accelerated amortization on certain off-market liability contracts were offset by lower acquisition and integration costs. Net Cash Provided by Operating Activities. Net cash provided by operating activities was $387 million for the nine months ended October 28, 2022, a decrease of $28 million compared to the prior year, primarily due to the timing of customer collections and other changes in working capital, cash payments during the year associated with certain change in control provisions related to the acquisition of Halfaker, and lower net earnings, partially offset by the first installment of the deferred payroll taxes allowed under the CARES Act paid in the prior year and higher cash provided by the MARPA Facility. Non-GAAP Measures Earnings before interest, taxes, depreciation and amortization (EBITDA), and adjusted EBITDA are non-GAAP financial measures. While we believe that these non-GAAP financial measures may be useful in evaluating our financial information, they should be considered as supplemental in nature and not as a substitute for financial information prepared in accordance with GAAP. Reconciliations, definitions, and how we believe these measures are useful to management and investors are provided below. Other companies may define similar measures differently. EBITDA and Adjusted EBITDA. The performance measure EBITDA is calculated by taking net income and excluding interest and loss on sale of receivables, provision for income taxes, and depreciation and amortization. Adjusted EBITDA is a performance measure that excludes costs that we do not consider to be indicative of our ongoing performance. Adjusted EBITDA is calculated by taking EBITDA and excluding acquisition and integration costs, impairments, restructuring costs, and any other material non-recurring costs. Integration costs are costs to integrate acquired companies including costs of strategic consulting services, facility consolidations and employee-related costs such as retention and severance costs. The acquisition and integration costs relate to the Company's acquisitions of Halfaker and Koverse in fiscal 2022 and Unisys Federal in fiscal 2021. We believe that EBITDA and adjusted EBITDA provide management and investors with useful information in assessing trends in our ongoing operating performance and may provide greater visibility in understanding the long-term financial performance of the Company. -23- Table of Contents SCIENCE APPLICATIONS INTERNATIONAL CORPORATION EBITDA and adjusted EBITDA for the periods presented were calculated as follows: Three Months Ended Nine Months Ended October 28, 2022 October 29, 2021 October 28, 2022 October 29, 2021 (in millions) Net income $ 80 $ 71 $ 228 $ 235 Interest expense and loss on sale of receivables 32 27 91 81 Interest income (1) — (1) — Provision for income taxes 20 17 62 66 Depreciation and amortization 37 44 118 123 EBITDA 168 159 498 505 EBITDA as a percentage of revenues 8.8 % 8.4 % 8.7 % 9.0 % Acquisition and integration costs 1 12 11 36 Restructuring and impairment costs 5 1 7 1 Depreciation included in acquisition and integration costs and restructuring and impairment costs (1) — (1) (1) Recovery of acquisition and integration costs and restructuring and impairment costs (1) (3) (1) (6) (1) Adjusted EBITDA $ 170 $ 171 $ 509 $ 540 Adjusted EBITDA as a percentage of revenues 8.9 % 9.0 % 8.9 % 9.6 % (1) Adjustment reflects the portion of acquisition and integration costs and restructuring and impairment costs recovered through the Company's indirect rates in accordance with U.S. government Cost Accounting Standards. Adjusted EBITDA as a percentage of revenues for the three months ended October 28, 2022 decreased to 8.9% from 9.0% for the same period in the prior year primarily due to lower revenue resulting from accelerated amortization on certain off-market liability contracts and net unfavorable changes in contract estimates, partially offset by lower indirect costs. Adjusted EBITDA as a percentage of revenues for the nine months ended October 28, 2022 decreased to 8.9% from 9.6% for the same period in the prior year primarily due to lower net favorable changes in contract estimates and lower revenue resulting from accelerated amortization on certain off-market liability contracts. Other Key Performance Measures In addition to the financial measures described above, we believe that bookings and backlog are useful measures for management and investors to evaluate our potential future revenues. We also consider measures such as contract types and cost of revenues mix to be useful for management and investors to evaluate our operating income and performance. Net Bookings and Backlog. Net bookings represent the estimated amount of revenues to be earned in the future from funded and negotiated unfunded contract awards that were received during the period, net of adjustments to estimates on previously awarded contracts. We calculate net bookings as the period’s ending backlog plus the period’s revenues less the prior period’s ending backlog and initial backlog obtained through acquisitions. Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts as work is performed. We do not include in backlog estimates of revenues to be derived from IDIQ contracts, but rather record backlog and bookings when task orders are awarded on these contracts. Given that much of our revenue is derived from IDIQ contract task orders that renew annually, bookings on these contracts tend to refresh annually as the task orders are renewed. Additionally, we do not include in backlog contract awards that are under protest until the protest is resolved in our favor. -24- Table of Contents SCIENCE APPLICATIONS INTERNATIONAL CORPORATION We segregate our backlog into two categories as follows: • Funded Backlog. Funded backlog for contracts with government agencies primarily represents estimated amounts of revenue to be earned in the future from contracts for which funding is appropriated less revenues previously recognized on these contracts. It does not include the unfunded portion of contracts in which funding is incrementally appropriated or authorized on a quarterly or annual basis by the U.S. government and other customers even though the contract may call for performance over a number of years. Funded backlog for contracts with non-government customers represents the estimated value on contracts, which may cover multiple future years, under which we are obligated to perform, less revenues previously recognized on these contracts. • Negotiated Unfunded Backlog. Negotiated unfunded backlog represents estimated amounts of revenue to be earned in the future from negotiated contracts for which funding has not been appropriated or otherwise authorized and from unexercised priced contract options. Negotiated unfunded backlog does not include any estimate of future potential task orders expected to be awarded under IDIQ, GSA Schedules or other master agreement contract vehicles. We expect to recognize revenue from a substantial portion of our funded backlog within the next twelve months. However, the U.S. government can adjust the scope of services of or cancel contracts at any time. Similarly, certain contracts with commercial customers include provisions that allow the customer to cancel prior to contract completion. Most of our contracts have cancellation terms that would permit us to recover all or a portion of our incurred costs and fees (contract profit) for work performed. The estimated value of our total backlog as of the dates presented was: October 28, 2022 January 28, 2022 (in millions) Funded backlog $ 4,019 $ 3,491 Negotiated unfunded backlog 20,413 20,601 Total backlog $ 24,432 $ 24,092 We had net bookings worth an estimated $2.0 billion and $6.1 billion during the three and nine months ended October 28, 2022. Total backlog at the end of the third quarter is consistent with our total backlog at prior year end. -25- Table of Contents SCIENCE APPLICATIONS INTERNATIONAL CORPORATION Contract Types. Our earnings and profitability may vary materially depending on changes in the proportionate amount of revenues derived from each type of contract. For a discussion of the types of contracts under which we generate revenues, see “Contract Types” in Part I of the most recently filed Annual Report on Form 10-K. The following table summarizes revenues by contract type as a percentage of revenues for the periods presented: Nine Months Ended October 28, 2022 October 29, 2021 Cost reimbursement 56 % 54 % Time and materials (T&M) 19 % 20 % Firm-fixed price (FFP) 25 % 26 % Total 100 % 100 % Cost of Revenues Mix. We generate revenues by providing a customized mix of services to our customers. The profit generated from our service contracts is affected by the proportion of cost of revenues incurred from the efforts of our employees (which we refer to below as labor-related cost of revenues), the efforts of our subcontractors and the cost of materials used in the performance of our service obligations under our contracts. Contracts performed with a higher proportion of SAIC labor are generally more profitable. The following table presents cost mix for the periods presented: Three Months Ended Nine Months Ended October 28, 2022 October 29, 2021 October 28, 2022 October 29, 2021 (as a % of total cost of revenues) Labor-related cost of revenues 53 % 53 % 54 % 54 % Subcontractor-related cost of revenues 29 % 30 % 29 % 29 % Supply chain materials-related cost of revenues 8 % 7 % 7 % 8 % Other materials-related cost of revenues 10 % 10 % 10 % 9 % Total 100 % 100 % 100 % 100 % Cost of revenues mix for the three and nine months ended October 28, 2022 were consistent with the same periods in the prior year. Liquidity and Capital Resources As a services provider, our business generally requires minimal infrastructure investment. We expect to fund our ongoing working capital, commitments and any other discretionary investments with cash on hand, future operating cash flows and, if needed, borrowings under our $1.0 billion Revolving Credit Facility and $300 million MARPA Facility. We anticipate that our future cash needs will be for working capital, capital expenditures, and contractual and other commitments. We consider various financial measures when we develop and update our capital deployment strategy, which include evaluating cash provided by operating activities, free cash flow and financial leverage. When our cash generation enables us to exceed our target average minimum cash balance, we intend to deploy excess cash through dividends, share repurchases, debt prepayments or strategic acquisitions. Our ability to fund these needs will depend, in part, on our ability to generate cash in the future, which depends on our future financial results. Our future results are subject to general economic, financial, competitive, legislative and regulatory factors that may be outside of our direct control. Although we believe that the financing arrangements in place will permit us to finance our operations on acceptable terms and conditions for at least the next year, our future access to, and the availability of financing on acceptable terms and conditions will be impacted by many factors (including our credit rating, capital market liquidity and overall economic conditions). Therefore, we cannot ensure that such financing will be available to us on acceptable terms or that such financing will be available at all. Nevertheless, we believe that our existing cash on hand, generation of future operating cash flows, and access to bank financing and capital markets will provide adequate resources to meet our short-term liquidity and long-term capital needs. -26- Table of Contents SCIENCE APPLICATIONS INTERNATIONAL CORPORATION During the second quarter of fiscal 2023, we amended our Credit Facility. See Note 7 to the condensed and consolidated financial statements contained within this report for additional information. Beginning in fiscal 2023, the Tax Cuts and Jobs Act of 2017 requires the capitalization of research and development costs for tax purposes and requires taxpayers to amortize such expenditures over five years. Congress may defer, modify, or repeal this provision, however, if the current effective date and current legislation remain in place, the Company's initial assessment is that cash flows from operations in fiscal 2023 will decrease by a minimum of $90 million, but net deferred tax assets will increase by a similar amount. The cash flow impact would continue over the five-year amortization period, but would decrease over the period and be immaterial in year six. Historical Cash Flow Trends The following table summarizes our cash flows: Nine Months Ended October 28, 2022 October 29, 2021 (in millions) Net cash provided by operating activities $ 387 $ 415 Net cash used in investing activities (23) (272) Net cash used in financing activities (417) (176) Net decrease in cash, cash equivalents and restricted cash $ (53) $ (33) Net Cash Provided by Operating Activities. Refer to “Results of Operations” above for a discussion of the changes in cash provided by operating activities between the nine months ended October 28, 2022 and the comparable prior year period. Net Cash Used in Investing Activities. Cash used in investing activities for the nine months ended October 28, 2022 decreased compared to the prior year period primarily due to cash paid for the acquisitions of Halfaker and Koverse in the prior year period. Net Cash Used in Financing Activities. Cash used in financing activities for the nine months ended October 28, 2022 increased compared to the prior year period as a result of borrowings obtained to finance the Halfaker acquisition in the prior year period, a $90 million voluntary principal prepayment during the third quarter of fiscal 2023, and higher share repurchases of $53 million. Critical Accounting Policies There have been no changes to our critical accounting policies during the nine months ended October 28, 2022 from those disclosed in our most recently filed Annual Report on Form 10-K. Recently Issued But Not Yet Adopted Accounting Pronouncements For information on recently issued but not yet adopted accounting pronouncements, see Note 1 to the condensed and consolidated financial statements contained within this report. Item 3. Quantitative and Qualitative Disclosures About Market Risk There have been no material changes to our market risks from those discussed in our most recently filed Annual Report on Form 10-K.