Booz Allen Hamilton Holding Corp (BAH) 2015 Q3 法說會逐字稿

Good morning. Thank you for standing by, and welcome to Booz Allen Hamilton's earnings call covering third-quarter results for fiscal 2015. At this time, all lines are in a listen-only mode.

(Operator Instructions)

I'd now like to turn the call over to Mr. Curt Riggle.

Good morning, and thank you all for joining us today for Booz Allen's third-quarter fiscal 2015 earnings announcement. We hope you've had an opportunity to read the press release for our third-quarter earnings that we issued earlier this morning. We've also provided presentation slides on the website, and we're now on slide 1.

I'm Curt Riggle, Vice President Investor Relations. And with me to talk about our business and financial results are Horacio Rozanski, our President and Chief Executive Officer, and Kevin Cook, Senior Vice President and Chief Financial Officer.

As shown on the disclaimer on slide 2, please keep in mind that some of the items that we will discuss this morning will include statements that may be considered forward-looking and, therefore, are subject to known and unknown risks and uncertainties, which may cause our actual results in future periods to differ materially from forecasted results. Those risks and uncertainties include, among other things, general economic conditions, the availability of government funding for our Company's services, and other factors discussed in today's earnings release and set forth under the forward-looking statements disclaimer included in our third-quarter fiscal 2015 earnings release and in our SEC filings.

We caution you not to place undue reliance on any forward-looking statement that we may make today and remind you that we will assume no obligation to update or revise the information discussed on this call.

During today's call, we will also discuss some non-GAAP financial measures and other metrics, which we believe provide useful information for investors. We include an explanation of adjustments and other reconciliations of our non-GAAP measures to the most comparable GAAP measures in our third-quarter fiscal 2015 slides.

It's now my pleasure to turn the call over to Horacio Rozanski, our CEO, and he will start on slide 3.

Thank you, Curt, and thank you, all of you, for joining us. Let me begin by saying how proud and humbled I am to lead this remarkable institution as we begin our second century in business. I am fortunate to be surrounded by a highly skilled and experienced leadership team that is both managing the business exceptionally well and executing our ambitious strategy for the future.

Today, Kevin and I will take you through our third-quarter results and how we view them in the bigger picture. Then, as in recent calls, I will talk a bit about our progress under Vision 2020, the growth strategy we launched over two years ago.

As you saw in the press release this morning, we have good news to report for the third quarter. This reflects what we believe is the beginning of a recovery in the government contracting market, which is improving our revenue and backlog. The market is not yet growing, but the decline is easing.

Clients are feeling less budget uncertainty, which allows them to focus more on mission. And at the same time, prices are beginning to stabilize. Having said that, we're still operating in a highly competitive environment on both pricing and demand. And of course, there remains significant political uncertainty as we look ahead to Congressional debates on the Federal debt ceiling and the government's fiscal 2016 budget.

In this environment, our focus is twofold -- gain market share by being an essential partner to clients, which already is stabilizing our revenue base, and invest in capabilities in markets that best position us for the long-term vis-a-vis our competition. This combination, gaining market share and investing for the future, will create sustainable quality growth.

We're not simply taking an easy road, looking for short-term revenue gains. We're playing the long game, pursuing a multi-year strategy and making necessary investments. It may take some time to reach sustainable quality growth, but this approach ensures that Booz Allen remains what it has always been -- the differentiated leader in our industry.

With that as a backdrop, let me give you the financial headlines. Third-quarter revenue was $1.3 billion, compared to $1.27 billion in the prior-year period, a 2.5% increase. This gain must be viewed in context. When we factor in the estimated $30 million revenue impact of last October's 16-day government shutdown, our revenue is roughly flat. Still, that represents continuing improvement in our top line, as it follows diminishing revenue declines in the first and second quarters of this year.

Adjusted diluted earnings per share was $0.36 for the third quarter, compared with $0.33 per share in the prior-year quarter. We saw positive trends in adjusted EBITDA margin, days sales outstanding, and funded and unfunded backlog. We also had a seasonally strong book-to-bill ratio.

We are revising our guidance for the fiscal year, raising our top-line revenue and narrowing our bottom-line ADEPS range, with an increase to the midpoint. We're announcing an increase to our share repurchase authorization, which now totals $180 million.

We're also announcing an 18% increase in a regular recurring quarterly dividend. Beginning this quarter, it is $0.13 per share, which reflects both our confidence in the business and our commitment to return value to our shareholders.

Before turning the call over to Kevin for more detail on our results, I want to take a moment to highlight an extraordinary accomplishment of the men and women of Booz Allen. December 31 marked the end of our Centennial Community Challenge, a year-long campaign in which we challenged our staff to give at least 100,000 hours of volunteer service to their communities.

As it is usually the case at Booz Allen, our people charged way past our goal. They volunteer more than 155,000 hours, benefiting nearly 1,500 nonprofit organizations across the country.

Josh Guenther, our associate in northern Virginia, was our top volunteer, with nearly 3,700 hours as a firefighter and animal rescue volunteer. Together, our top three volunteers gave more than 9,000 hours.

We are incredibly proud of the lasting impact our staff made in celebration of our first 100 years, and I know that we'll carry this spirit of service forward. It is fundamental to our culture and success at Booz Allen -- one of the truly special things about working here.

Let me, at this point, turn the discussion over to Kevin, who will walk you through our third-quarter in greater detail.

Thank you, Horacio.

As Horacio noted, we've delivered a strong third quarter in fiscal year 2015, with growth at both the top and bottom lines. We are experiencing a more stabilized government spending environment as a result of a return to budget certainty, even if only for the remainder of government fiscal year 2015.

Our 2.5% revenue growth in the quarter is the result of a number of factors, including the improving environment. However, I want to repeat Horacio's comment that when you adjust for the estimated $30 million impact of last year's government shutdown, the quarter was relatively flat. That said, we are pleased to see that the third quarter continues the sequential trend of lower rates of revenue decline.

Additionally, margins were up as expected, and we saw growth in funded and unfunded backlog and a seasonally strong book-to-bill ratio. I echo Horacio's point that all of these positive outcomes give us confirmation that we are on the right track, and that our long-term strategy of investing smartly today to drive sustainable quality growth for the long-term is the right approach.

Operationally, we saw continuing strengths in the third quarter. Staff productivity remains high, we are maintaining effective management of our cost structure, and we continue to experience solid profitability on contracts and task orders. In fact, the third quarter saw the first quarterly organic net gain in consulting staff headcount in more than three years. We continue to lean forward on hiring to take advantage of our backlog of work and to build a bench for opportunities that lie ahead.

Now, I'd like to go through the specifics of our performance in the third quarter, so please turn to slide 4. The 2.5% revenue growth was the result of an improved government spending environment compared to the year-ago period, which was impacted by the 16-day government shutdown. Specifically, the increase over the prior year was the result of an increase in staff billability, which drove an increase in billable hours and an increase in billable expenses.

Before I leave revenue, I'd like to point out that we saw an increase in the percentage of fixed-price revenue in the quarter. The factors that contribute to this increase primarily include the delivery of equipment on a government contract that was converted from cost reimbursable to fixed-price during the first half of fiscal 2014 and revenue increases from two fixed-price commercial contracts.

The situation also contributed to the increase in operating income and operating margin in the third quarter. We do expect the percentage of fixed-price revenue to return to a more normalized level in the fourth quarter.

Operating income increased by 8.5%, and adjusted operating income increased by 7.2% over the prior-year period. These increases are attributable to revenue improvements, including the increase in fixed-price revenue mentioned a moment ago; lower aggregate compensation and related benefits based on lower headcount when compared to the prior-year period; and to a lesser extent, a decrease in depreciation and amortization expense.

The operating income improvements were partially offset by an increased level of bid and proposal activity in the quarter as well as investments in growth platforms. This increase in investment activity was expected and is consistent with the ramp-up that we previously indicated would occur in the second half of our fiscal year.

Adjusted EBITDA margin of 9.2% for the quarter benefited from effective management of staff productivity and the qualification for certain Federal and state tax credits, a portion of which benefits our indirect rates and, therefore, benefits EBITDA. Year-to-date, the adjusted EBITDA margin of 10.6% is in-line with our forecast and as occurred last year, reflects an expected decline in the second half as a result of higher indirect spending and higher costs for fringe benefits, including holidays and paid time off.

The factors that drove the increases in net income and adjusted net income, compared to the prior-year period, were largely the result of the factors affecting operating income and adjusted operating income.

In the third quarter, diluted earnings per share increased to $0.35 per share from $0.31 in the prior-year period. Adjusted diluted earnings per share increased to $0.36 per share, compared to $0.33 in the prior-year period. The per share earnings were driven by the same factors as net income and adjusted net income.

Turning to backlog. While the December quarter is a seasonally light award quarter for our business, you should note that our 0.36 times book-to-bill ratio was a significant improvement over the December quarter of our prior two fiscal years. Total backlog declined by 3% over the prior-year period. However, within the overall backlog, funded backlog increased 7% to $2.7 billion and unfunded backlog increased by 1.4% to $2.7 billion.

The decline in overall backlog was, therefore, driven by a decline in priced options. A primary driver of this priced options decline is the timing of contract transitions and extensions.

Next, let's talk about cash. Cash balance at December 31 reflects payments for two acquisitions, the repurchase of 1 million shares of our stock, and the one-time payout of a deferred executive compensation plan, all of which occurred during the quarter. Free cash flow in the first three quarters of fiscal 2015 declined 24.8% over the prior-year period to $210.6 million. Although collections were strong in the quarter, as reflected in the decrease in days sales outstanding, the overall accounts receivable balance is down year-over-year as a result of revenue declines.

With that, I'll turn it back over to Horacio. And please turn to slide number 5.

Thanks, Kevin.

Now, as we've done in recent quarters, I would like to highlight a few developments under our long-term strategy. You may recall that Vision 2020 is a comprehensive second-century growth strategy that we describe in three building blocks.

First, expanding our capacity to serve as our client's essential partner through a combination of deep domain understanding, market leading consulting expertise, and broader technical capabilities. Second, investing in differentiated growth platforms including engineering, system delivery, cyber, advanced analytics, our innovation agenda, and the commercial and international markets. Third, building distinctive business and people models to support those growth platforms.

Today, I'll focus my remarks in two areas in particular -- international and engineering. We announced last summer a significant expansion of our business in the Middle East and North Africa, where we see market growth and margin opportunities. That business is already showing great potential.

Today, I'm pleased to share news that we have opened a regional Southeast Asia office in Singapore. Initially, we will focus on building business in Singapore, then broaden to Indonesia, Malaysia, Thailand, Vietnam, and possibly other countries in the future. Applying lessons learned from our entry into the Middle East, we will start with a small core team and focus on offering clients our unique blend of general management consulting combined with technology, cyber, and analytics expertise.

Let's turn now to engineering. [A people to great] technical content in the work we do is central to our growth strategy. Clients are demanding it, and we need to deliver.

This was the reason for our acquisition a little over two years ago of a significant engineering capability now called Booz Allen Engineering Services, or BES. Under Joe Logue, the leader our defense and intelligence group, we have seen excellent performance from BES among its core client base, and we're extending its services to markets across our business.

To give you the big picture, our opportunity pipeline for engineering has grown by 30%. Government spending has declined in two years since we made the acquisition, yet BES has maintained gross revenue year-over-year and improved profit margins. Also, BES is winning new areas of work for us, including a $413 million Air Force contract and a place on the $22 billion Department of Homeland Security Eagle IDIQ contract.

Let me give you a few tangible examples of the engineering solutions we're delivering across our client base. Working with the Defense Department, we reverse engineered the damage that improvised explosive devices inflict on mine-resistant ambush protection vehicles, or MRAPs. We then modified the vehicle design, adding more safety exits. This improvement will not only make our MRAPs safer, but can also be incorporated into future vehicle designs.

In the area of systems engineering and integration, we applied a new approach to the Air Force's operational launch range systems, an innovation that transformed how the enterprise operates. Through this multi-year effort, the Air Force Space Command now has extensive documentation for aging systems, a better decision-making process driven by data, and millions of dollars in annual cost savings. That success has led to additional business for us related to the nation's space launch infrastructure.

A final example is VAMPIRE, a device that conducts realtime forensics analysis in the field. It performs on-site fingerprint identification and matching analysis in just seconds. Evaluations of the product are underway by Federal law enforcement, defense, and intelligence agencies.

VAMPIRE is opening doors to new clients and changing our brands with current ones. Put simply, these innovations deepen and expand our ability to solve our clients' toughest problems, and we are proud that this early in the game, VAMPIRE was awarded Law Enforcement Magazine's Hot Products of 2014.

As we create and demonstrate these and other engineering solutions, we see more and more opportunities to provide them to clients in the US and international. It is early days, but I am excited by the progress we are making.

Importantly, all of our Vision 2020 investments are enhanced by our innovation agenda, led by Karen Dahut, who oversees our strategic innovation group. As we approach the third year of the SIG, we're beginning to move innovations that are developed or scaled within the SIG into new markets. You can expect to hear more about the impact of our market-driven innovation in future calls.

Returning now to the financials, Kevin will give our new guidance for 2015.

Thanks, Horacio.

Before I talk about guidance, I want to note how pleased I am with our announcements today that we're increasing our regular quarterly cash dividend and increasing our share repurchase authorization from $30 million to $180 million. The increase of the quarterly recurring dividend represents our confidence in our business and the success of our business model. Relative to the share repurchases, our intent is to keep the diluted share count relatively stable over time, and the approval level we're announcing today provides the authorization necessary to execute on this intent.

Please now turn to slide 6. For the full year of fiscal 2015, we are increasing our top-line revenue guidance from a mid-single percentage decline in revenue to now reflect our expectation for a low-single-digit percentage decline. At the bottom line, we are narrowing the range by increasing the bottom end of our guidance. We are now forecasting our full-year diluted earnings per share to be in the range of $1.52 to $1.56 per share and adjusted earnings per share to be in the range of $1.58 to $1.62 per share.

Let me also point out that in the fourth quarter of fiscal 2014, we realized $0.025 associated with qualification for certain state and Federal tax credits. This year, we again qualified for these credits. However, the benefits associated with these tax credits were realized in the second and third quarters.

Now, I will turn the call back to Curt so we can move to the Q&A portion of our call.

All right. Thank you, Kevin and Horacio. Shannon, at this point, can you provide instructions for the question and answer portion of the call?

(Operator Instructions)

Carter Copeland, Barclays.

Hey. Good morning, guys, and good quarter. Just a couple of questions regarding your comments, Horacio, on the growth agenda.

First off, on the expansion into Southeast Asia, can you give us some color around what the thrust of that effort is, at least from a capability basis, relative to what you were doing in the Middle East and North Africa? Secondly, you mentioned that we'll hear more about capabilities to come out of the SIG in the coming quarters. Are there, from a high level, particular end markets or customer sets that we're most likely to see those first capabilities going to?

Two great questions.

On the international expansion, our view regarding Southeast Asia, based on the work we've done there, as we prepare to launch, is that the capability requirements and -- call it -- the cocktail that is creating the success in the Middle East will apply there just as well. The notion that we bring in the traditional management consulting expertise, blended with the ability to bring in true technologists, cyber experts, and analytics -- especially on the big data side -- is where we think the sweet spot is going to be.

In addition, as you probably know, a number of companies have set up their innovation centers in Singapore. And the fact that we have a strong innovation agenda and a lot to say about that, we believe, will be of value. So that's our starting point, and then we will go from there based, really, on what the clients demand, much like we've done elsewhere.

With regards to the SIG, I think the way to think about the SIG is not about specific end markets, but really, about building capabilities and building innovations that apply to the vast majority of our clients. There is -- really, the MO is, in part, coming up with new things in the SIG. But in large part, looking for things that we're doing already for a client that are truly breakthroughs and breakouts and figuring out how we can make that service or that offering available to the breadth of our client base. And that's where the success has been, and that's probably where the success will continue to be. So it's really a horizontal play, if you will, across the entirety of our markets that we're focused on.

Should we think about it as taking a capability, primarily, from one end market to another, as opposed to developing new breakthrough technologies? What's the more likely thing we'll see?

I think you're going to see all of the above. And in addition to that, you're going to see us leveraging the alliances and partnerships that we're forming with our innovators to be able to be a channel of those innovations into the Federal marketplace.

So, it's really, where do we find the best ideas -- whether internally because we're doing them, whether we create them, or externally -- to focus on solving our clients' toughest problems. That's really the core of what we do, and that's what the SIG is really helping us leap forward on.

Okay. Great. Thanks. I will stick to two.

That was three by my count, but who's counting? (laughter)

No. The follow-up -- the follow-up counts differently. Thanks, guys.

Bill Loomis, Stifel.

Hi. Thank you, good morning, and congratulations on some good results.

Horacio, you mentioned a couple of times, prices are stabilizing -- and Kevin did. What you mean by that? Is that the competitive pressures have cooled off a little bit, or are clients pushing less to lowest price [technically] acceptable? What are you seeing to cause you to say that?

Bill, my sense is that, first of all, the competitive pressures are still extremely strong because the market is declining. And so there's more capacity than demand, if you will. But, having said that, we are beginning to see, in some parts of the market that went very strongly into everything LPTA early on, have some of the missions be affected by the over-reliance of that mechanism. And so we are seeing some things come back as best value or qualified in a different way so that quality really enters into the equation much more strongly.

It's not true everywhere. We tend to talk about this market as if it's one thing, and it really isn't. There's lots of different sub-markets and accounts, each one of them with its own dynamics.

But on the whole and on the main, the movement towards LPTA, while the number of contracts that are like that is still very high, it doesn't seem to be accelerating anymore.

Okay.

On the bid pipeline, you certainly talked about how customers are more comfortable in funding. How do you see -- can you give us any sense of the bids you have outstanding, and what that pipeline looks for you? Do expect a pick-up in awards, here, in your final quarter? How do you see that playing out over the next couple of quarters?

Hey, Bill, it's Kevin.

The pipeline is fairly full. I think what we're seeing -- and I mentioned earlier that we've seen some increase in bid and proposal costs in our third quarter, ending December 31. That's a bit unusual.

As you know, there's a big ramp in marketing and bid and proposal leading up to the September 30 quarter-end at the end of the government fiscal year. But we look at it as almost a smaller but a second bidding season that we're going through right now, specifically in the civil market, with also some ramp-up in the defense intelligence market, as well.

So, you know how it goes -- even if awards are made, there's protest. So, I think we're very much more optimistic than we were this time last year. I'll say that and would look for continuing awards.

Bill, the macro point I would make is, we've said all along that it's not the size of the market that affects our ability to compete, it's our clients' uncertainty about their budgets. And as the budgets have become a little more certain, clients can begin to set priorities and spend money on things that matter because they know they are going to have it -- can turn back to delivering on mission and looking for quality in the places where they really need because it's central to their mission. That's the dynamic that we're hoping will continue if stability remains.

As I also said in the remarks, we're all painfully aware that the political processes are not stable yet and that we're going to go through a debt ceiling debate. We're going to go through a new budget for next year. And that could change the dynamic.

Right now, it is comforting to see clients really be able to plan and execute their mission with a little more certainty than in the past. That's where we play best.

Okay. Good. Thank you.

Cai von Rumohr, Cowen and Company.

This is Lucy, dialing in for Cai.

You talked about some of the initiatives on the international front. Can you maybe provide an update on the other end markets -- defense, intel, civil, and commercial?

Sure. This is Kevin Cook.

We are seeing demand coming out of our civil market in a variety of accounts, from health to other civilian agencies. Strong demand in commercial space, which you may or may not know. We house that within our civil market. So, in the civil space, specifically -- and that's a variety of capabilities, whether it's software development or others.

In the defense space, I think it goes back to what Horacio was just saying. The clients are more comfortable with the budget levels. They've been operating in this mode for a while. There's less uncertainty.

So we are seeing a pickup across the board, actually, in many sub-accounts, as we call them -- Air Force, Army, et cetera. So it's pretty broad-based, I would say. And especially, I would highlight demand in the commercial space in a variety of vertical markets in commercial.

And then secondly, maybe just on an adjusted basis, you saw flat revenues, year-over-year, in the quarter. You hinted with the increase in headcount that you are expecting revenues to pick up gradually here.

Can you maybe speak to the cadence of how you're expecting that to happen over the coming quarters? Would that be ahead of your peers, et cetera?

Well, there's a lot of variability that goes into that -- different contracts won at different points of the year. It is going to be choppy.

We can't say that, with a 2.5% organic revenue growth this quarter -- albeit flat when you factor in the $30 million from the government shutdown the year before -- that doesn't mean that we're going to see growth every quarter from here on out. We'll give our FY16 guidance on our earnings call at the end of May.

As Horacio mentioned, there are potential road bumps along the way with the debt ceiling debate as well as the government budget for their fiscal year 2016. So we're going to take the next 3 1/2, 4 months, evaluate all that, and give you an FY16 revenue forecast when we get together again.

Steven Cahall, Royal Bank of Canada.

Yes. Thank you.

Maybe a first question on cash deployment. You raised the dividend, you spent more on share buyback in the quarter than we've seen for probably ever, and you increased the authorization. And your largest shareholder -- who may or may not have been a big fan of the special dividend -- is now below 50%. Is it fair for us to think about this as a turning point in cash deployment with, possibly, incrementally more M&A ahead as well as a much bigger focus on the recurring dividend and the offsetting share creep from here?

Hey, Steve, it's Kevin.

No, I would not view it as a turning point or an inflection point. Our commitments are the same, the same priorities -- operating cash followed by recurring dividend, then the preference for M&A.

We've talked about it before, where we're somewhat choosy. We're looking for capabilities, not just revenue. It has to be a good culture fit, and it has to be priced reasonably.

So we continue to look. Activity is picking up.

After acquisitions, I would say we're still looking at special dividends, share repurchases. As I said in the commentary leading up to the Q&A, this doesn't mean that we're going to shift from special dividends to share repurchases. What we're really trying to do, here, is try to keep the share count relatively flat so that it doesn't put any downward pressure on the earnings per share going forward.

It doesn't mean we're moving away from special dividends at all. It's just another mechanism we have to deploy capital.

Okay.

I don't see us paying down debt anytime soon, as low as the interest rates are.

That's very helpful.

And then, maybe just as a follow-up. As we think about what the guidance implies for the fourth quarter, just looking at some mid-point numbers, I'm guessing, like historically, with the nice revenue pick-up, you're going to have a lot of headroom on the general and administrative expenses line to pick up your costs, there.

When we think about how you allocate that, you've got a lot of bid and proposal out there. Horacio, you spoke a lot about the opportunities in terms of organic capability growth. So, how do we think about the allocation of some of those general expenses over the next quarter?

Steve, normally we don't talk about the quarter. But since you've already got three quarters of actuals and you've got our full-year guidance, I'll give you a little color.

We managed -- the last two years, we've managed the first half very tightly. Two years ago, it was because we didn't think there would be a government shutdown, but we managed tightly just in case. And it turned out to be a very good decision on our part.

This year, we managed almost as tightly to make sure that we were going to be able to deliver on our commitments to you all and our investors. But what that means is then we really invest heavily in the second half of the year into our growth strategy, which Horacio discussed earlier.

So, you'll see investment activities in the SIG ramp up. Clearly, commercial and international -- we continue to invest in. And in addition to the bid and proposal that we see on the government side, those are the types of costs that we'll really spend on. And we did spend in on the third quarter, and we'll continue in the fourth quarter.

Thank you.

Tim McHugh, William Blair & Company.

Yes. Just wanted to ask a little bit. So your comment about -- first, just the headcount and the consultant headcount and even the administrative headcount or not consultant headcount picking up, sequentially.

Along the lines of an earlier question, is that an inflection point, as we think about the overall business here? I know you highlight areas you've been investing, but you've been doing that all along the way. Are you just at a point, generally speaking, where, given the market or given how far you've cut back, that you just start to see the overall headcount growing from here?

It's Kevin, again. Well, clearly, we need two things to grow. We need backlog, and we need headcount.

We drove a very high book-to-bill in our second-quarter ending September 30. And we had a seasonally strong book-to-bill in Q3, compared to the prior two years.

So, we are driving backlog. We are hiring to meet that demand. I would say that the headcount growth we saw was fairly modest, quarter over quarter, so we're still at work.

One of the things we haven't been able to do in the last couple of years, frankly, is build a bench, if you will. We were at a point where it was just-in-time recruiting. We'd win the contract, then we'd recruit, as opposed to the model we used to follow, which was recruiting ahead of the demand that we saw coming and having people on the bench, ready to go.

I don't think we're going to be back to where we were, maybe, three years ago. But we are trying to build somewhat of a bench, which will also use up some of the indirect costs that the previous caller was asking about in our fourth quarter. Positions us well to go into the next year, albeit with some potential bumps along the road there with the Federal Government debt ceiling and budget discussions.

Okay.

And then, just at a high level -- your comment about, earlier in the call, that the market is still declining. I guess, in the context that you've also described the market as stable. Can you elaborate a little?

I mean, as we think at a very high level, the budget environment being stable, but you're still seeing -- your perception that the market is still in decline. And I think you made the comment it could take some time to transition that. Could you elaborate a little bit more on what you meant?

It's Horacio. I'm not sure that there is much more we can say.

Our sense is there's still significant pressure on the industry, overall, in terms of revenue. We look at ourselves as doing better than our peers in gaining market share. But, the reality is, it's a very tough market out there. It continues to be a tough market.

The only good news in it is, like I said, there's a sense of stability from our clients' perspective, in terms of knowing what money they have in front of them and being able to plan accordingly to prioritize their missions. So that's where, we believe, is the opportunity for us. That's why, as Kevin highlighted, we're getting a little more aggressive on capacity. That's why, we believe, our backlog is growing.

But at the end of the day, it will take a while for the market to completely shake out and organize itself around the new dynamic. It's beginning to do it, but somebody talked about it as an inflection point. I don't think we're there. I think we were talking about, maybe, a nascent recovery, and a fragile one, at best.

But certainly, the market is better, and our clients feel better than they did two years ago. And hopefully, that trend will continue.

Okay. Thank you.

Jon Raviv, Citi.

Hey. Good morning, guys, and nice quarter.

Horacio, I was wondering if you could talk to whether your clients are maybe better equipped to deal with uncertainty, versus previous years. So even if we hit a budget [buzz saw] or sequester, do you think they can weather it more effectively and not subject you guys to the same volatility we've seen over recent years?

You know, I'm peering deep into my crystal ball, and I'm not sure. I will say that, on both sides of industry and the client base, certainly, this is a much more battle tested and savvy group that we're dealing with than we were all a few years ago when, frankly, this market had not seen a significant downturn.

So, from that perspective, clients have begun to adjust, and their practices and their ability to deal with this is greater. However, a big shock to the system is a big shock to the system, and it does paralyze activity. So, it is very hard to tell whether a more experienced, more savvy crew would handle a return to the sequester more effectively or not, if that were to pass.

Quite candidly, our focus is on the things we can control. And so we're driving our business smartly. We're focusing on the areas where we think the government will have to invest in growth regardless of the overall budget process.

And we're playing for the long game, recognizing, as Kevin said, that things are still going to be choppy. And we're not trying to focus on what exactly will happen in one quarter versus another -- more focused on one year versus another, and then, over time.

Thanks.

And as a quick follow-up, perhaps, for Kevin, how is margin growth impacted by turnaround in end markets, given your higher B&P and investments you want to make? I mean, margin growth is still pacing ahead of that 10 basis points you guys always talk about. But does this margin growth, perhaps, slow to that 10 basis point as things pick up?

That's a good question. Clearly, for FY15, we feel like we're in pretty good shape on delivering on that goal of a 10 basis point improvement at the adjusted EBITDA margin line.

Going forward, we think that, with some of the new innovations coming out of the SIG, which will drive higher margin revenues both on the government and commercial space, and the overall accelerating growth of our commercial and international markets, which are at a much higher margin than the government space, we think the combination of that will continue to allow us to deliver on that 10 basis point growth, year-over-year. Clearly, we've knocked the ball out of the park since the IPO, in that regard. I can't say that we're going to maintain that pace, but we are comfortable with the goal of growing the 10 basis points per year.

Thanks.

Edward Caso, Wells Fargo.

Good morning. Congratulations on the results, here.

I wanted to ask, again, about the shift -- what appears to be away from cost-plus towards fixed-price. You mentioned a few specific items in the quarter, but there has been a definite uptick in the amount of fixed-price work.

Is that change in government client behavior, or is that a mix of the commercial business? And then what influence has that had on the margins you've been able to produce?

Hey, Ed. It's Kevin.

I think that the fixed-price percent of revenue will drop back in Q4. I think we had a heavy deliverable on that one fixed-price contract I mentioned earlier.

We used to be in the 15% range. I think we'll probably stay in the 18%, 19% range. But that's developed over the last couple of years.

And to be honest, I think it is the government is looking to do more fixed-price work. I don't know that it really matches with the types of services we deliver, but that doesn't necessarily stop our clients from trying to fixed-price things.

So I would think, yes, that 19% range is probably more steady-state. The commercial does impact it a little bit, but it's such a small part of the portfolio today that it's not that significant.

Could you talk a little -- it's a competition question -- can you talk about, are you focused at all on trying to pick up some of the services business traditionally done by the aerospace and defense primes as a market focus, particularly with your engineering group? Thank you.

Yes. Ed, we don't necessary look at it as to whether it's work that used to be done by the aerospace prime services division or one of the government services pure plays. We look for where we can sell our capabilities to our clients, whether that's -- it's generally in a prime position; sometimes it's in a subcontractor position.

But, we don't shy away from competing with anybody, whether it's aerospace firms or pure plays. It's really about what clients need our capabilities.

Now, to your point with the growth in engineering and some of our other technical areas, we may be, in the future, competing more with some of those. But make no mistake, we're very focused at OCI. We will stay on that -- let's call it -- friend of government side. We're not going to compete, certainly, with the product side of those aerospace firms. I guess I'd sum it up that way.

Thank you.

Denny Galindo, Morgan Stanley.

Good morning.

I would add a question on what we'll see first, in terms of when things pick up -- when we reach an inflection point -- whether we would see a book-to-bill increase first to going over one, or whether we would see persistent growth in your employees on a year-over-year basis? Which one of those is the first thing that you would see?

Well, it's got to be backlog, right? Because we're not going to hire a lot of people and run the risk of having over-capacity and having to downsize. So backlog has to come first.

We feel good about the backlog we're building. Then you have to go out and make sure that you've got the people to deliver against that backlog. So it's really the combination, but the backlog has to come first.

Okay.

And then, on a different topic, with all the talk of cyber security and North Korea hacking, is that translating into more commercial wins for you guys? Or maybe at least more opportunities to bid for new work?

I think, across the board, whether it's North Korea, other government-sponsored initiatives, organized crime -- it almost spans the waterfront -- I think what's happened is, over the last couple years, that boards, in particular, are becoming much more attuned to the threat. And therefore, in many boardrooms, I think the cyber risk is becoming a much higher priority.

And that's my way of saying, yes. It's driving increased demand, not only in the financial services, healthcare, and energy markets that we've been focused on, but we're also seeing demand coming out of manufacturing and especially retail, given some of the headlines. So, I think that demand will continue. I don't see any falloff in demand, in that regard.

And then, lastly, just delving into the backlog a little bit, you talked about priced options were down. And that was due to the timing of extensions and additions.

Could you give a little bit more color on that, in terms of what we can read into that number? Does it mean that customers are more likely to take advantage of these options that they are signing up for in advance, and that's why some of it's rolling off early? Or is there any other read-through we can make on that number?

No. There's really two factors. The first that was mentioned earlier, was the timing of extensions. So, a lot of what's happened is that in lieu of awarding new contracts on the timetable originally targeted by our clients, in many cases, that has slipped.

Let's just use an example that it slipped a year. So when we get that bridge or extension to that original contract, the funding goes into funded and unfunded. Whereas if they had originally -- if they had awarded the re-compete and we won, we would have seen funded, unfunded, and priced options go into our backlog. So, you don't see the priced options when you see the contract extensions. That's the first item.

And then, the second factor is that -- we have talked on this call before -- that we've seen the average period of performance drop across the contracts that we've been bidding and winning in the last couple years. And so if the government has gone from five-year contracts to three-year contracts, that's, by definition, going to show up as a bigger reduction in priced options than it would in funded or unfunded.

Those are the two primary drivers. At some point, if the government reverts back to longer contracts, then I would expect to see that trend reverse and priced options begin to increase.

Thanks for taking my questions.

Certainly.

Robert Spingarn, Credit Suisse.

Good morning. Apologies for not being there earlier. I just have been moving between calls this morning.

But, Horacio, at a high level, I wanted to ask you about the upcoming defense budget. And the numbers look pretty good, from a request perspective. And I wanted to, perhaps, think about those from your perspective at Booz.

It looks like we may get about a 7% increase in the base budget request. But there is going to be some crowding out from procurement, which is actually looking to go up in the mid-teens, based on early reports.

How do you think about your positioning and your exposure to O&M versus procurement and whether Booz can perform at the growth rate that the budget shows? Or is there some kind of adjustment we should be thinking or context we should be using?

You know, to be honest, we look at the budget process more in terms of the overall certainty or uncertainty that it will create for clients than in the specific numbers. Our business is really driven by great people building these client relationships and us making ourselves valuable in the core mission in solving their problems. And then, hoping that the budget process does not create such big dislocations that our clients, essentially, become paralyzed until things get sorted out.

So the movement of money between accounts and those things are a secondary order for us. Our order of business, here, is to build a sustainable, quality growth platform by bringing new capabilities and by helping our clients across the breadth of their needs. But increasingly, the closer we get to the core mission, the more sustainable our position becomes because, at the end of the day, as budgets move around and especially as budgets get challenged, the things that are closer to the mission will get prioritized and protected over everything else.

I think it will be interesting to see how the budget process unfolds and what ultimately gets done, vis-a-vis the request. But I don't think that is going to be -- assuming sort of a steady course of events, that's not going to be the primary driver of our performance.

Okay. That's a very fair answer.

Maybe just thinking about it a slightly different way -- if we get away from the movement before the interplay between the accounts and we just think about the fact that, with this kind of growth in the request and, likely, some kind of meeting of the minds on the actual budget that shows growth for the first time in -- let's call it -- five years, should we assume that the better behavior you're seeing out of the -- or the greater ability that the customer has now to make decisions that you're experiencing here in the last few quarters, that should improve even further as we get into this growth budget?

I think the budget remains to be seen, Rob. I'm not sure that I want to or am in a position to comment intelligently as to what, exactly, is going to happen through the legislative process and how it's going to affect us at this point.

Okay. Fair enough. Thank you, Horacio.

Thank you. I'd now like to turn the call back over to Horacio Rozanski.

Thank you very much for the questions and the conversation. I hope we have conveyed our pride in Booz Allen's strong financial performance and our focus on investing to create a sustainable, quality growth platform for the future.

Clients always tell us, and I believe deeply, that we have the best talent in the business. And we also have an experienced leadership team executing on a solid strategy.

By building this foundation for our second century, we will not only maintain, but rather, strengthen our position as the industry leader. That's what we're focused on at Booz Allen, and I hope we conveyed that to you on the call.

Thank you for joining us.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day.