BAH - Booz Allen Hamilton: Consultancy Is A Great Investment Opportunity

2023-06-04 23:40:23 ET

Summary

• Booz Allen Hamilton is a leading provider of management and technology consulting services with potential growth opportunities in data analytics, digital transformation, and cybersecurity.
• Revenue has grown at a CAGR of 5%, but we think the company can exceed this in the coming years.
• AI, Cybersecurity, and Cloud services represent key growth in which BAH has developed deep expertise.
• Key risks to the investment thesis include economic downturns, increased competition, and potential regulatory changes.

Investment thesis

Our current investment thesis is:

• The consultancy industry is highly attractive due to the increased complexity of business operations, as well as the current technological revolution.
• AI, Cybersecurity, and Cloud services represent key growth areas that could support medium-term outperformance.
• We are forecasting improve growth vs. historically achieved, which will likely be supplemented by M&A.

Company description

Booz Allen Hamilton Holding Corporation ( BAH ) is a leading provider of management and technology consulting services, analytics, engineering, digital solutions, mission operations, and cyber services.

It serves a wide range of clients including governments, corporations, and non-profit organizations in the United States and around the world.

Share price

BAH's share price has made impressive gains in the last decade, with over 400% returns. This reflects a period of impressive growth, partnered with accretive returns.

Financial analysis

Presented above is BAH's financial performance for the last decade.

Revenue

BAH has grown revenue at a CAGR of 5%, although much of this has occurred in the last 7 years, offsetting 3 years of negative growth. This has been driven by internal development at BAH, as well as improving consulting conditions contributing to greater demand for its services.

One of the primary drivers of increased consulting demand is the increasing availability of data and the need to derive actionable insights. We are in the information generation and businesses are quickly discovering that data is invaluable if analyzed correctly. The reason for this is that data can be used to maximize the value proposition to customers (internal) and allow for efficient targeting of customers (external). Many companies are underutilizing the information they possess, creating scope for consulting services to leverage advanced analytics techniques and tools.

Furthermore, we are seeing companies increasingly seeking consultants with deep industry knowledge and expertise. It is less clear as to why this is a growing opportunity, as complex industries have always existed. We attribute this to increased utilization of technology and the expectation for businesses to innovate where possible, resulting in the need for specific expertise. Rapid technological advancements are required to stay competitive in most industries, no longer are there specific "tech-enabled" industries and "traditional" ones. Similar to other firms, BAH has been investing heavily in developing industry capabilities. In the consulting world, this usually materializes through M&A (acquiring specialized firms) or the recruitment of specialized teams from Rival firms.

This leads us to another key trend in the consulting industry, that being consolidation, as larger firms acquire smaller specialized firms to broaden their service offerings. Accenture ( ACN ) has gained notoriety for its M&A strategy and we are now seeing many others follow suit. BAH has increased its M&A activity in recent years, spending more in the last 2 years than it did in the last 10. The most recent two acquisitions were Liberty IT Solutions (c.$725m) and EverWatch (c.$440m). These acquisitions sought to develop BAH's capabilities in critical modernization capabilities and software development work in the national security community.

The increased collection and analysis of data has contributed to the increasing frequency and sophistication of cyber threats. The average cost of a cyber security attack has reached $4.25m . For this reason, we have seen companies seek to modernize and develop their IT infrastructure and controls in order to reduce the risk of an intrusion. BAH refers to itself as " One of the world’s largest cybersecurity solution providers " and has done well to exploit this growing trend. We expect growth to be strong in this area going forward.

With increased data collection and processing, we are also seeing greater adoption of cloud-based solutions and modernizing IT infrastructure. This is required in a modern environment, given the quantum of data collected and the global nature of workforces. BAH provides a wide range of cloud-based solutions, assisting businesses across a wide range of complexities.

The rise of artificial intelligence ((AI)) is transforming business operations and decision-making processes. This has been an area of investment for many years and we are finally seeing a rapid uptake in the capabilities. Many businesses are now looking for expertise to guide them, both to defend their current operations and to utilize the capabilities to enhance their operations. BAH has already launched an AI service and is continuing to invest in the area to grow its expertise. We believe this could be a critical growth opportunity in the coming years. BAH states the following on its website " Booz Allen’s one-of-a-kind, lean manufacturing approach to AI engineering, aiSSEMBLE™, is a holistic method for designing, developing, and fielding AI specifically for the U.S. federal government and commercial sectors ."

Overall, we are very bullish on the consulting industry. There are many factors that are supporting consistent growth, such as the development of AI and the need for Cyber security support, as well as a genuine increase in support required by Management, such as with Data management and navigating technological complexity.

Economic considerations

Current economic conditions represent the potential for short-term headwinds in our view, primarily because we could see corporates reduce their spending as a means of cost controls. This is especially the case as many are struggling with both demand-side issues and inflationary pressures. Although this could slow growth, we believe the bullish factors discussed above will offset any impact.

Margin

BAH's margins were historically flat, with an EBITDA-M of c.10% and a NIM of c.5%. This is reasonable as it is an employee-heavy business and so remuneration is likely to move in line with revenue growth, otherwise the firm faces the risk of churn.

In the most recent period, BAH's margins have noticeably declined, driven by a 44% increase in Opex. This is partially due to a one-off cost relating to the U.S. Department of Justice's investigation of the Company recorded in Q4'23, as well as higher unallowable spending and inflationary pressures. The investigation related to " highly technical elements of the company's cost accounting and indirect cost charging practices with the U.S. government ". Given the one-off nature of this, we expect margins to bounce back in the coming year.

Balance sheet

Despite the elevated ND/EBITDA ratio, BAH is reasonably financed. If we adjust EBITDA for the one-off charge, the company's ratio would fall below 3x, bringing it to a manageable level.

Distributions come in the form of both dividends and buybacks. With the company generating c.$600-700m in cash, we believe the current levels to be both attractive and sustainable.

Outlook

Presented above is Wall Street's consensus view on the coming 5 years.

Revenue is forecast to grow at a 5-10% rate over the coming years, which is above the company's historical average. We concur with this view as quality development is observed to tailor the company's service toward growing areas.

Further, margin improvement is unlikely, which again we consider to be reasonable due to the human capital-heavy nature.

Valuation

BAH stock is currently trading at 14x NTM EBITDA and 20x NTM P/E. This represents a 24% EBITDA premium on its historical average and 15% at an earnings level.

Our view is that this is pushing toward the top range of value, although still represents upside in our view. The primary reasons are that BAH is on an upward trajectory, with expectations for growth to improve in the coming years. Further, the company is engaging in greater M&A, which should drive further outperformance. Finally, the industry is highly attractive and of greater importance.

Key risks with our thesis

The risks to our current thesis are:

• Acquisitions come with numerous risks such as dilution of margins and integration. This is a noticeable risk going forward given the strategic shift.
• Economic conditions causing a greater impact than forecast, contributing to a change in sentiment.

Final thoughts

BAH looks to be a winner in the coming years. The industry is highly attractive and continues to develop positively through technological development and the increasing complexity of business operations. BAH is positioned well, with a quality brand name, expertise, and resources to conduct M&A.

Although BAH's valuation is pricey, we believe some upside still exists, especially given the company will likely post resilient results in the coming quarters while other industries underperform.

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