Booz Allen Hamilton: Declining Margins And ROIC (NYSE:BAH)

Introduction

Today, as a part of my series evaluating consistent compounders, I will be taking a look at Booz Allen Hamilton (NYSE:BAH), an interesting consulting company that has grown by 372% since 2011, besting the S&P by more than 140%.

Any company that is able to generate that much alpha, especially in the face of market volatility, earns a place on my watchlist. They may not always be a good buy, but there is usually something that can be learned by examining their business.

Founded in 1914, Booz Allen Hamilton has been in business for over 100 years, providing professional services that to governments, corporations, and non-profits. They specialize in management and technology consulting, engineering, digital solutions, and mission operations, making them a major partner for some of the world’s most important agencies such as the US Department of Homeland Security as well as the SEC.

Within this article, I’ll:

• Provide an overview of Booz Allen Hamilton’s business
• Compare its long-term financial performance versus industry peers
• Opine on its valuation against those peers

Overview

One of the things that sets Booz Allen Hamilton apart from other companies in the consulting industry has been its ability to secure long-term contracts with government agencies (huge TAM).

In the world of government consulting, contracts tend to be sticky, with agencies often renewing contracts with known suppliers (like Booz Allen) to avoid taking on unnecessary risk. Booz Allen Hamilton’s long history of working with the government and in-depth understanding of its needs and processes make it an attractive choice for government agencies.

In addition to its strong relationships with so many government agencies, they have also built close ties with both major political parties in the US through large donations to a number of causes and candidates. While perhaps controversial, this is especially valuable in a highly politicized industry, where contracts can be affected by changes in government.

With its connections on both sides of the aisle, Booz Allen can weather changes in political leadership and ensure a steady flow of government contracts so that no matter who wins, Booz Allen can likely win too.

Helping to further stabilize its revenue growth is its practice of hiring foreign government officials. This approach has allowed Booz Allen to tap into a deep pool of trusted expertise and build strong relationships with governments by leveraging the networks of its connected employees.

Q3 2023 Update

In January of this year, Booz Allen Hamilton’s third quarter of its fiscal year 2023. According to management, organic revenue growth exceeded their expectations, with double-digit growth across all of its federal markets. Total revenue for the quarter was $2.3 billion, a year-over-year increase of 12.1%, and revenue excluding billable expenses grew by 11.2% to $1.6 billion. The company’s adjusted EBITDA margin was 11.5%, and it deployed $714 million of capital through three quarters, a combination of dividends, share repurchases, and the completed acquisition of EverWatch.

Booz Allen expects EverWatch to contribute to its growth targets due to an increased capability in classified software development gained from the takeover. I’m a bit perplexed by this move as it seems to be a departure from their previous strategy that seemed to be working well. My question to management, if I could ask, would be why should the focus be on M&A as opposed to organic growth.

Well then, again, perhaps the answer is simple, consultants do love M&A after all.

Financials

Now that we’ve discussed what Booz Allen Hamilton does, let’s take a look to see how they’ve performed financially over the past decade. In this article, I’ll be focusing on cash flow from operations per share, operating margin, and returns on invested capital.

Cash Flow

Starting first with their cash flow from operations per share, we can see that Booz Allen Hamilton has increased that value by roughly 2x since 2010. In this analysis, the most comparable peers are probably CRA International (CRAI) and FTI Consulting (FCN) because of their focus on consulting, over a company focused more on software like Verisk (VRSK).

Among the consulting peers, Booz Allen has increased their CFO at a faster clip than either CRA or FTI but they lag behind the growth at Verisk perhaps due to the scalability of software versus consulting, something I discussed at length within my prior articles on Palantir (PLTR).

Margins

Looking at the operating margins of the group we can immediately identify one outlier, Verisk, due to their extraordinarily high operating margin (42%) compared to the rest of the group which is closer to the high single-digit range (~10% historically). Unfortunately for Booz Allen, they have the weakest operating margin of the group, just 7%, after a rapid decrease in margins over recent quarters.

Due to the large labor expense, consulting is usually a low-margin business, but Booz Allen’s margins are especially worrying and not something I would expect given their strong cash flow growth and share price performance.

Return on Invested Capital

Shifting our attention to return on invested capital, we can see a similarly concerning trend, returns on invested capital are declining, potentially driven by weaker operating margins. Over the last 12 months, their returns on invested capital were 11%, 5% below their longer-term average of ~16.5%.

This is happening at the same time peers like CRA and Verisk are improving their returns on invested capital. Over the past decade, Booz Allen has declined from best in class to returns on invested capital to worst in class (among these peers).

Risks

Before I get to the valuation and conclusion, I’d like to highlight the main risk I see facing the company, which I believe is its diversification into other lines of businesses where they are less knowledgeable. For example, the company recently acquired EverWatch expanding its software development ability, while this sounds like a smart move on the face of it, and I am generally a fan of software firms due to the scalability of their business, I would just question if Booz Allen is the best company to operate in this space. Given their strong track record in consulting, yes with some IT experience, why diverge from that strategy? If they continue to grow by expanding to different verticals where they lack expertise, we may see a further deterioration of returns on invested capital.

Valuation

Taking a look at Booz Allen’s valuation versus its peers just creates further confusion… despite its declining profitability and returns on the capital, they are still priced relatively in line with the software-focused Verisk, and consulting peer FTI.

Even more confusing is the fact that CRA trades for 18x earnings compared to Booz Allen which trades at 28x despite CRA having both better profitability metrics and returns on capital.

This is absolutely puzzling to me.

Conclusion

In conclusion, Booz Allen Hamilton has been an outperformer in the market, generating impressive returns for investors. Their long-term contracts with government agencies, strong relationships with both major political parties, and hiring of foreign government officials help to stabilize revenues. However, recent decreases in operating margins and returns on invested capital are concerning, particularly given the company’s weak operating margin compared to peers.

As such, I rate Booz Allen a Sell.

For investors still interested in the consulting industry, CRA International may be an attractive alternative to consider.