When SAIC Spins, No One Wins

• Email
• Share
• Print

By now you've probably heard: SAIC (NYSE: SAI) reported fiscal Q3 2009 earnings Tuesday. As usual, the mainstream press dutifully regurgitated the news, with MarketWatch reciting how:

• Revenues grew 11% to $2.63 billion.
• While per-share profits rose 20% to $0.30 per share.

The Associated Press did SAIC one better, reciting not just the numbers, but characterizing them as an earnings beat, and then proceeding to parrot the party line: "Looking ahead, SAIC says it's on track to meet its long-term financial goals in fiscal 2009."

And then there's me. I call shenanigans.

The party line
According to CFO Mark Sopp: "We are on track to meet all of our key financial metrics for the year, including revenue, operating margin, earnings per share, and cash flows from operations." All of which sounds good, but for one small detail: It's bunk.

In our pre-earnings Foolish Forecast, we discussed the "key financial metrics" that SAIC was targeting this year. Specifically: "Management targets booking revenues between $9.7 billion and $10 billion this year on as much as 9% organic growth, and to earn an operating margin of 7.7% or 7.8% on its revenues."

Now, score one for SAIC, because sales rose 11%, and organic growth constituted 10 of these percentage points -- so, revenue did better than expected. Unfortunately, the point of this game isn't just to generate revenues -- it's to generate revenue profitably. Specifically, to earn 7.7% to 7.8% operating margins on revenues. Which poses three problems:

• First, SAIC failed to earn these margins in the first half of FY 09.
• Second, SAIC failed to make up the difference in Q3.
• And third ... in fact, SAIC went the wrong way. Its margins got worse relative to last year.

Operating margin in the third quarter was 7.8%, whereas in Q3 of last year, SAIC had earned 8.0%. The company offered the following explanation for decline: “The year-over-year decline in operating margin was primarily attributable to fewer shipments of higher margin border and port security products, lower recovery of prior year indirect cost over-runs, and a higher percentage of revenues from lower margin materials and subcontractor revenues compared to the third quarter of fiscal year 2008.”

All of which may be true. But it doesn't change the fact that SAIC failed to deliver what it promised in October: improved margins. So far this year, SAIC's operating margin is running at 7.5%. Don't get me wrong -- that's better than Computer Sciences (NYSE: CSC) can manage, and on par with SRA International (NYSE: SRX). But it's far worse than firms like L-3 Communications (NYSE: LLL) and Lockheed Martin (NYSE: LMT) earn.

Most important to SAIC investors, though, margins haven't improved from the 7.5% operating margin that SAIC was earning by this time last year. Instead of getting better, they're stagnant. If SAIC is to generate its hoped-for 7.7% to 7.8% operating margin for the year, therefore, it must do literally all of the heavy lifting in this current fourth fiscal quarter -- because so far this year, it's dropped the ball every time it got the chance.

Foolish takeaway
Unless a miracle happens between now and the end of its fiscal fourth quarter next month, SAIC likely won't hit its margin goals, which could cause it to miss its earnings target as well.

Sure, in the grand scheme of things, how much does one quarter's performance matter? Like Warren Buffett, we all want to invest in companies for the long term, not obsess over the quarter-by-quarter earnings game.

However, in a defense sector that's been hit pretty hard across the board, SAIC is already trading at a premium to several of its rivals. Boeing (NYSE: BA), for example, sells for just 0.5 times its sales, despite earning an 8.2% operating margin thereon. Northrop Grumman (NYSE: NOC) gets an 8.3% margin, yet just a 0.4 times sales multiple.

Meanwhile, here SAIC sits, earning worse profit margins but commanding a sales multiple twice as high as Northrop. Now, if SAIC pulls a rabbit out of the hat and delivers on its promises this quarter -- fine and dandy. Maybe it deserves the premium. But if SAIC fails to deliver?

Then look out below.

You've read what Rich thinks. Now find out whether the analysts at Motley Fool Inside Value agree. Sign up for a free trial subscription to Inside Value now, and learn whether they see a fluffy white tail poking out from under SAIC's hat.