Image source: The Motley Fool.
PAE Incorporated (PAE)
Q3Â 2020 Earnings Call
Nov 5, 2020, 8:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good morning, ladies and gentlemen, and welcome to PAE's Third Quarter 2020 Earnings Conference Call. My name is Chris, and I will be your conference operator today. [Operator Instructions]
I would like to turn the presentation over now to your host for today's call, Mark Zindler, Vice President of Investor Relations for PAE. Please go ahead, Mr. Zindler.
Mark Zindler -- Investor Relations
Good morning, and thank you for participating in PAE's Third Quarter 2020 Earnings Announcement. We hope you've had an opportunity to read the press release that we issued earlier this morning. We have also provided presentation slides on the Investor Relations section of our website. Joining me today to discuss our business and financial results are John Heller, PAE's President and Chief Executive Officer; and Charles Peiffer, our Chief Financial Officer. Following our prepared remarks, we'll close with a question-and-answer session.
Management may make forward-looking statements during the call regarding future events, anticipated future trends and the anticipated future performance of the company. We caution you that such statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Actual results may differ materially from those projected in the forward-looking statements due to a variety of factors. These factors are described in our SEC filings.
Please refer to our earnings press release for PAE's complete forward-looking statement disclosure. We do not undertake any obligation to update forward-looking statements. Management will also discuss non-GAAP financial measures during this call and we remind you that these non-GAAP financial measures are not a substitute for their comparable GAAP measures. Reconciliations of these non-GAAP financial measures to the comparable GAAP measures are contained in the press release and investor presentation issued earlier today.
And now I will turn the call over to John Heller.
John Heller -- President and Chief Executive Officer
Thank you all for joining us this morning for our third quarter earnings conference call. I hope that you and your loved ones are safe and healthy in these challenging times, and thank you to our employees, who through their dedication and perseverance throughout the pandemic have delivered strong performance while dealing with various challenges the year is presented. For the agenda for today's call, I'll start with the key highlights related to the third quarter and move on to a discussion of our perspectives on the long-term federal budget outlook, followed by an overview of our strategic growth initiatives.
Starting with our third quarter results. I am pleased to report we achieved $1.4 billion in net bookings or 2.1 times revenue. We generated revenue in line with our expectations and adjusted EBITDA and margins exceeded expectations. Furthermore, we delivered another strong quarter of strong free cash flow. I continue to be very excited about how the business is performing despite the challenging backdrop. We are delivering strong financial results and achieving our growth, profitability and capital structure initiatives in accordance with our strategy.
Based on our results through the first nine months of the year, we are maintaining and narrowing our revenue guidance, reiterating our adjusted EBITDA guidance, and we are increasing our free cash flow guidance. In our first earnings call as a public company in March of this year, I provided our top three priorities: driving top line growth, expanding profit margins and lowering our cost of debt. I am proud to report that we are delivering on all three of these priorities. The business is generating strong margins that are exceeding our original guidance.
And following the end of the quarter, we completed a well-received and attractively priced debt refinancing. And following the successful debt refinancing, we announced the signed purchase agreement with CENTRA Technology, a leading provider of intelligence and national security mission support. We will continue our relentless focus on driving growth and profitability and generating value for our shareholders. Now I'll turn to an overview of backlog and bookings. As I mentioned, we generated $1.4 billion in net bookings for the quarter and $2.8 billion on a trailing 12-month basis. Backlog improved to $7 billion and normalized with the U.S. Customs and Border Protection, or CBP, award previously protested, backlog would be $8.3 billion. In addition, trailing 12-month book-to-bill improved to 1.1 times and normalized for CVP, it would be 1.6 times.
Notable awards included the U.S. Navy Integrated Training Environment initiative in which PAE is a subcontractor to Alion Science and Technology to provide an integrated training platform. This win is a great example of our focus to take the business up the value chain. Our winning proposal focused on the Navy's vision of transforming to a live virtual constructive training environment, representing an innovative approach and operating test training range activity. Additionally, our joint venture with Parsons was awarded the $545 million naval Guam base operations support contract. Following the withdrawal of a protest by a competitor. This program has been in our contract portfolio since 2005 and is indicative of the stable recurring work our GMS segment is built on.
This program is firmly aligned with our strategy of continued U.S. Navy expansion as well as the U.S. Navy's PACOM AOR mission. Moving to COVID-19 response awards. Our GMS segment was awarded an approximate $50 million contract with the Navajo Nation to serve as the joint logistics and medical integrator for the Navajo Department of Health COVID-19 response efforts. This was on top of our COVID response award with the Southeastern Conference, providing COVID-19 testing services for all in season fall sports. These COVID-19 response contracts are a testament to our team's agility and the diversified capabilities we deliver in times of need. We have generated about $125 million in year-to-date COVID response awards, helping to offset a portion of the COVID-19 revenue impacts this year.
Lastly, our NSS segment was awarded a $17 million contract to deliver global capacity building initiatives to strengthen partner weapons of mass destruction, interdiction capabilities through training and exercise events. Next, I'll provide a summary of the bid pipeline. At the end of the quarter, we had about $7.4 billion in awards under evaluation, split nearly evenly between new business and recompete awards. We also have an incremental $1.5 billion in the proposal writing process, 100% of which is new business. In GMS, we are awaiting about $6.8 billion in awards, which includes PAE's previously awarded $1.3 billion CBP contract, which was protested. Approximately $3.8 billion are recompete awards and about $3 billion are new business opportunities.
In our NSS segment, we are awaiting about $600 million in awards, a little over half is new business in business processes solutions and training related programs. Next, I'll provide a brief update on the $1.3 billion CBP award. As we previously discussed, our 10-year $1.3 billion contract award with the U.S. Customs and Border Protection was protest. The customer is conducting further evaluation of the award, and we anticipate the award will be decided during the fourth quarter. While we won the award in May of this year, our policy is to not take this award into backlog or bookings until the matter is resolved in our favor. Now I'll spend a few minutes discussing the federal budget outlook and our strategic growth initiatives. Starting with the federal budget outlook.
In the short term, we anticipate total discretionary spending may increase from COVID-related stimulus but flatten or slightly decline longer term. However, our focus as a service provider is not on total discretionary spending. But rather, on the outlook for contracted services. We believe the federal government will continue to rely on contractors to perform mission essential services, even in a flat or slightly declining total budget environment. In terms of our core addressable market, although the market is large, we anticipate low to mid single-digit percentage growth and higher growth rates across several adjacent end markets. The focus of our strategic growth initiatives is delivering differentiated mission-focused services to a diversified set of government customers in defense, intelligence and federal civilian end markets.
And we'll execute against this strategy by utilizing a diverse, global and agile workforce, coupled with strategic alliances with best-in-class technology and industry partners. Our strategic imperatives can be summarized across two top priorities: growing market share in our core business and expanding our addressable market. Starting with growing market share in our core markets, the rationale is, one, our core end markets are large addressable markets with stable funding profiles. Two, contracts in PAE's core markets are typically longer in duration compared to many market areas. And three, the U.S. government will have a continual need in demand for maintenance and modernization of infrastructure regardless of political outcomes and top lying budget levels.
The continued primary focus areas will include training services, mission-oriented services and infrastructure operations, all well funded business areas with bipartisan support. Moving to expanding our addressable market. The rationale is straightforward. One, there are several current adjacent market areas that are expected to outpace PAE's current addressable market in terms of long term growth; and two, the government's strong focus on innovation is creating significant opportunities for federal contractors; and three, these targeted adjacent market areas are typically higher margins compared to PAE's core. Notable focus areas for expanding total addressable market include intelligence analysis, which was strengthened through our recently announced signed acquisition agreement with CENTRA Technology, health support services and engineering services.
All examples of PAE moving up the value chain and continuing to diversify our business. Next, I'd like to unpack these adjacent market areas that provide additional growth options for PAE. Intelligence analysis, a key core competency of CENTRA represents an approximate $12 billion addressable market, poised for mid-single-digit growth over the next five years. This type of work requires extensive past performance and experience and represents attractive margin expansion potential for PAE. The second area health support services is a $25 billion market overall, with mid-single-digit growth potential. The growth opportunity for PAE is focused on leveraging our core capabilities with adjacent federal health missions. Our expectation is that the federal health market is poised to see continued growth over the foreseeable future, and PAE is attractive past performance to leverage through its USAID work, Ebola support and current COVID response programs.
The third area of our market expansion strategy is centered around growth in the engineering services market. Engineering services include the designed installation and integration of systems and platforms for the federal government. This work is a natural extension of our GMS and NSS existing work and allows PAE to leverage existing customer relationships while moving the company up the value chain. The key variables in executing this strategy will be attracting and retaining top talent as well as continuing to build our strategic IDIQ portfolio.
I've been successful expanding our IDIQ portfolio organically, and this is also an important attribute of the CENTRA acquisition. We cannot control the federal budget outcome. What we can do is build a resilient and diversified business model that can thrive and grow under any scenario. We are accomplishing this organically and through our recently announced signed acquisition agreement with CENTRA.
With that, I'll hand the call over to Charlie for an overview of our third quarter 2020 financial results and 2020 financial guidance.
Charles Peiffer -- Chief Financial Officer
Thanks, John, and good morning, everyone. I'll start with a high-level overview of our third quarter results and then move on to our 2020 financial outlook. Despite the revenue impact caused by COVID, we continued to deliver on our commitment to expand margins and generate strong free cash flow. We've been successful increasing margins and maintaining our adjusted EBITDA outlook as well as increasing our free cash flow forecast through driving growth in higher-margin business areas as well as managing costs and working capital.
As we've mentioned on our prior calls, the COVID impact has been felt most notably across three areas of our business. First, nonlabor revenue or the logistics operation of delivering materials, items such as food, fuel, maintenance parts, etc., has slowed considerably due to reduction in air traffic and airport closures overseas. And second, we've been -- we have seen moderate reductions in billable labor, primarily due to certain training programs being rescheduled and, to a lesser extent, closures of government facilities. Lastly, and the third area of COVID impact is our business plan, which included certain assumptions for new business awards, while win rates have increased to mid-40% range for new business, adjudicated awards have been slowed.
These award delays have resulted in a portion of our anticipated new business revenue shifting into fiscal year 2021. The year-to-date COVID gross revenue impact was $125 million, of which 74% is lower margin nonlabor related. Partially offsetting this, we have recognized $49 million in year-to-date COVID response revenue, which generates higher margins than our consolidated results. In the third quarter, the gross impact of COVID impact -- of COVID-19 totaled $53 million, of which about $43 million was nonlabor and approximately $10 million was labor related. Moving on to third quarter results. Revenue of $666 million decreased about $32 million below the same period last year due to the previously discussed $53 million COVID-19 impact and partially offset by $22 million in on-contract growth and new business programs.
We delivered over $46 million of adjusted EBITDA at a 6.9% margin, a healthy improvement over expectations for the quarter. We continue to generate increased profitability on many programs in both operating segments. Second, the majority of the revenue decline is attributable to nonlabor revenue, which drives a lower profit margin. Third, we are managing costs efficiently through reduction in SG&A expenses. And lastly, we are generating incremental margins relative to the consolidated results on our COVID response revenue. Our adjusted EBITDA for the third quarter backs out roughly $7.8 million of operating expenses. Approximately $4 million is related to equity-based compensation expense, and the remaining $3.8 million relates to M&A expenses associated with the announced acquisition and nonrecurring public company readiness setup costs. Turning to the cash flow statement.
Net cash provided by operating activities was nearly $37 million for the quarter. A reduction in cash flow from operations compared to the prior year period, is solely due to timing of cash collections in 2019 following the end of the government shutdown. DSO, which was 62 days for the quarter continues to outperform our historical averages. This is a direct result of the emphasis we place on managing DSO throughout the company. We remain highly focused on DSO, and we'll continue to implement process improvements to drive DSO even lower moving forward. capex was approximately $1 million, resulting in free cash flow of about $36 million for the quarter. Next, I will turn to our segment results. GMS revenues for the quarter of $521 million decreased $14 million or 2.7% compared to the prior year quarter.
The decrease was due to $39 million in COVID-19 impacts, the majority of which was nonlabor. This decrease was partially offset by a $25 million increase in on-contract growth and new business programs. GMS adjusted operating income and margins increased year-over-year due to increased volume on higher-margin programs and revenue mix. And partially offset by lower revenue volume and higher SG&A expenses. In our NSS segment, revenues for the quarter of approximately $145 million, decreased about $17 million compared to the prior year quarter. The decrease was attributable to a $15 million impact from COVID-19, the majority of which was nonlabor. Revenue was also impacted by a $2 million decrease from 2019 small business set aside recompete losses, net of new business wins.
Operating income was $11 million or 7.3% of revenue in the quarter. The variance compared to the prior year period was driven by the timing of net profit adjustments incurred last year and lower revenue volume. Turning to the balance sheet. We ended the quarter in a strong liquidity position with about $145 million in cash and had not drawn on our credit revolver. Furthermore, we lowered net debt to estimated adjusted EBITDA to 2.7 times based on 2020 guidance. In addition, on October 20, we announced the closing of a debt refinancing, whereby we paid off our existing credit facility and raised a $740 million term loan B priced at LIBOR floor of 75 basis points plus a spread of 4.5%. We also secured a $150 million delayed draw term loan at the same terms as the term loan B.
In addition to $175 million credit revolver. Pro forma for the recently announced CENTRA acquisition, which is expected to close in the fourth quarter, net leverage will be almost 3.6 times, with ample liquidity provided by cash on hand, free cash flow generation and our credit revolver. We plan to fund the transaction and associated fees with cash on hand and borrowings from the delayed draw term loan.
Moving on to 2020 financial guidance. Based on our financial results for the first nine months of the year and our updated outlook for the remainder of the year, we are revising our fiscal year 2020 guidance as follows. For fiscal year 2020, we are maintaining and narrowing revenue to the range of $2.625 billion to $2.675 billion, despite continued impacts from COVID-19. Based on the revised guidance and year-to-date contract awards, nearly 100% of our revised guidance is at the midpoint is in backlog. We are reiterating our adjusted EBITDA guidance in the range of $172 million to $178 million. And we are increasing our free cash flow guidance from $100 million to $110 million or greater. Please note the 2020 financial guidance excludes the announced acquisition of CENTRA.
Excluding COVID-19 impacts, we would be generating revenue within our original guidance range, and adjusted EBITDA would have exceeded the high end of the original range. Our adjusted EBITDA guidance is based on the recognition that we have experienced a negligible impact to adjusted EBITDA from COVID-19, we are seeing growth in higher-margin areas of our business, just as we had expected, in accordance with our strategy.
In addition, we have experienced a trade-off to COVID, in which we've seen a reduction in lower margin, nonlabor revenue and an increase in shorter duration labor-focused COVID response revenue. We expect margins to decline in the fourth quarter due to seasonality. We've seen historically and due to a moderate increase in nonlabor revenue. Full year adjusted EBITDA is expected to deliver a 60 basis point margin increase for the full year compared to last year, 40 basis points greater than our original guidance. With regards to cash generation, we are increasing free cash flow guidance to at least $110 million, reflecting strong margin performance and working capital management. Other key assumptions for our 2020 guidance are available in our third quarter earnings presentation on the Investors section of our website.
With that, operator, let's open the call for questions.
Questions and Answers:
Operator
[Operator Instructions] And our first question comes from the line of Ashish Sabadra with Deutsche Bank. Your line is now open.
Alexis Phili -- Deutsche Bank -- Analyst
Hi, good morning. This is Alexis on for Ashish. Thanks for taking my question. Maybe if we could start, can you please discuss the IDIQ opportunities and your line of sight for those? Maybe if you can comment on the GTACS, IDIQ task order opportunities or the status of any of them? Thanks.
John Heller -- President and Chief Executive Officer
Well, with respect to GTACS, specifically, we have seen a few task orders come out. We actually won one of the first awarded task orders with a partner on GTACS. But we do have a very strong line of sight from what the government has laid out in terms of volume over the next 12 months, which adds up to about $1 billion in IDIQ task order volume that we're expecting. And the government has laid out kind of what the specific scope is for these task orders. And we are actively kind of working to capture on these and expect to see some good volume in the next six months. With respect to our other -- yeah...
Alexis Phili -- Deutsche Bank -- Analyst
Oh, sorry, please continue.
John Heller -- President and Chief Executive Officer
Yeah, yeah. Just in general, IDIQ volume has been very solid, kind of what we'd expect typically in a fiscal year. CFT, AFCAP, AFRICAP have all been very good IDIQs for us this year. We've had a good number of wins, including some recent wins that show kind of keeping up with our plan in terms of the expectation of volume, even though we've got this COVID going on.
Alexis Phili -- Deutsche Bank -- Analyst
Great. Thank you. And then maybe one more. Having announced the CENTRA acquisition, do you expect any more M&A opportunities? Is there any color you can provide on the pipeline or area -- or strategic areas of focus for you for acquisitions? Thanks.
John Heller -- President and Chief Executive Officer
Yeah, sure. I think, we're very excited about the CENTRA acquisition. We're hoping to close that shortly with our refinancing. We think it put us in a great position to execute our strategy and to make this acquisition happen. I think as we look forward, we see a market that has many properties that are either out or coming out in the near future. And with respect to our strategic focus, we're gonna continue to look at opportunities that could continue to drive solid organic growth by expanding addressable market significantly in the national security space, intelligence space, similar to what we've done with CENTRA.
Obviously, we're going to, as we have talked to -- Charlie has talked as well, we're gonna be very cognizant of where our leverage is and kind of stay within a corridor, we think, works for PAE. And we've proven our ability to pay down debt quickly over time and really focus on opportunities that have high free cash flow characteristics similar to ours. But I think there's continued opportunity for us to look at acquisitions, and we're gonna stay active in the market.
Alexis Phili -- Deutsche Bank -- Analyst
Great. Thank you.
Operator
Thank you. Our next question comes from the line of Chris Moore of CJS Securities. Your line is now open.
Chris Moore -- CJS Securities -- Analyst
Hey. Good morning, guys. I was hoping maybe you could talk a little bit more about the updated guidance. It looks like the revenue range is tightening a little bit. EBITDA is unchanged, free cash flow is up. Maybe just a little bit more about the puts and takes there?
Charles Peiffer -- Chief Financial Officer
Sure. First of all, I would like to comment that as you look at our Q4 overall guidance in the Q4 perspective, we're taking a conservative approach on the forecast first of all. We do expect a change in revenue mix in the fourth quarter. There'll be higher ODCs, which will generally have lower margins, and that will be coming predominantly from our GMS business. We did experience a surge in on-contract growth in the third quarter, which also helped to drive the margin in quarter on several of our higher-margin programs. And then we're going to see certain lower-margin programs start to ramp up in Q4 versus Q3, which is really driving the mix when you look at where you're gonna see the top line versus Q3, and where you would see EBITDA versus Q3 as well. And from a free cash flow perspective, the major drivers there are really the same factors impacting adjusted EBITDA as well.
Chris Moore -- CJS Securities -- Analyst
Helpful. I'll jump back in line, let someone else try. Thank you.
John Heller -- President and Chief Executive Officer
Thank you.
Operator
[Operator Instructions] Our next question comes from the line of Josh Sullivan with The Benchmark Company. Your line is now open.
Josh Sullivan -- The Benchmark Company -- Analyst
Hey. Good morning.
John Heller -- President and Chief Executive Officer
Hey, Josh. Good morning.
Josh Sullivan -- The Benchmark Company -- Analyst
If we look to 2021, what are your thoughts on if we do end up with more of a split kind of government here. How do you see that playing out for PAE?
John Heller -- President and Chief Executive Officer
Well, as we addressed, Josh, and good morning. But as we addressed in our earnings release, we expect that we've got a CR right now. We think that, that'll probably get renewed or kicked to the right as things start to work out. And you know as well as I do how that's gonna work out. But we just believe that for 2021 budget, this is not a year where either party is going to want to make the budget the central issue when we're still dealing with the coronavirus, and we do see this coronavirus problem extending into 2021 calendar year. So our expectation is, from a budget standpoint, we're gonna see a rather similar spending level in 2021.
And we think that bodes well for PAE as we're focused on that kind of mission support, enduring mission elements of the government that have been very strong in prior CR years and even where we've seen government shutdowns in the past. We've typically remained mostly at work during these difficult times because the things that we do just have to get done. And we think CENTRA as well fits that profile in terms of what they do, so that just adds to kind of that enduring base of mission support work. And we're not looking at 2021 as a big difference in terms of spending compared to 2020.
Josh Sullivan -- The Benchmark Company -- Analyst
And if we do see some support flow back to the state department from the DoD or other areas, do you have exposure there? Do you think that would be beneficial to some of your legacy programs?
John Heller -- President and Chief Executive Officer
Well, we certainly believe that the state department has been a constant kind of steady customer for PAE over many years, over decades, really. And that different administrations, obviously, foreign policy and engagement externally is a less priority or a greater priority. We're -- I think over the last few years, we've seen it kind of go to be less aggressive externally in terms of engagement. And we think that as that ebbs and flows, this could -- we could be looking at a period of time where we see an increase in focus with the state department engagement externally, which could be positive for PAE.
Josh Sullivan -- The Benchmark Company -- Analyst
And then just following up on the CENTRA questions. Those -- can you give us some color on -- you mentioned some properties that you're looking at, what technologies or capabilities are those? And maybe what is the timing you're looking at some of those opportunities?
John Heller -- President and Chief Executive Officer
Sure, sure. I think with the CENTRA acquisition, it expands our footprint within the intelligence community. It expands what PAE does from a capability standpoint and areas of intelligence analytics, in particular, secure communication systems, implementation, integration, maintenance. And we see the kind of the domain of intelligence analytics as a significant focus area strategically for us. We also see medical services as a very strong growth area, depending -- as we've seen going through the coronavirus that medical services, medical support has become a bigger priority, and we've seen this under both administrations that we've just gone through, the Obama administration, Trump administration. So we do think those are two areas strategically that we feel fit PAE very well. They will have a strong spending profile and support behind it. And that as we look at what we'd like to continue to add to shore up our ability to grow in those areas, we'd be looking at companies that have those characteristics, those capabilities, the customer past performance in those areas.
Josh Sullivan -- The Benchmark Company -- Analyst
Thank you for the time.
John Heller -- President and Chief Executive Officer
Thanks, Josh.
Operator
Thank you. And I'm not showing any further questions on the phone line at this time. I would now like to turn the call back to Mark Zindler for any closing remarks.
Mark Zindler -- Investor Relations
Thank you very much for your continued interest in PAE, and thanks for joining us this morning. If you have any questions, please don't hesitate to give me a call. Thank you.https://tranceirs.digital-nirvana.com/process/dn/edit-xml
Operator
[Operator Closing Remarks]
Duration: 37 minutes
Call participants:
Mark Zindler -- Investor Relations
John Heller -- President and Chief Executive Officer
Charles Peiffer -- Chief Financial Officer
Alexis Phili -- Deutsche Bank -- Analyst
Chris Moore -- CJS Securities -- Analyst
Josh Sullivan -- The Benchmark Company -- Analyst
