L3Harris Technologies, Inc. (LHX) Earnings Call Transcript & Summary

Next up, we have LHX; and Bill Brown, Chairman and CEO. So thanks very much for making the trip. I know you were somewhere else this morning and maybe wanted to touch on whatever you can share in terms of what happened there and how you all did in the fiscal '21 request. I mean, a little bit more difficult to pull out individual programs for you guys, but in terms of some of the stuff that we saw on the space side, the radio side, it looked like you did fairly well.

So yes, so we are from Florida, but I was up in D.C. this morning. The Secretary Esper meets periodically with industry leadership, and we met with him this morning for a breakfast meeting. So I was very appreciative of David moving this meeting to the afternoon from this morning. So it was very helpful and I flew down here just a couple of hours ago.

I called DoD to try and arrange that. That didn't go very, very well.

Yes, thanks for that. Thank you. Fantastic. So basically, what we were talking about this morning is really around the budget, the shape of the budget. What the Secretary's message was around the alignment between budget to strategy. What you'd expect to see in companies, luckily we're seeing it in the Pentagon as well. We're tying budget to whatever the national defense strategy was that was developed a few years ago. So to those that follow the space and defense industry, none of it should have been a major surprise. There's a tilt towards RDT&E, a little away from procurement, but a lot towards near-peer competition. And that's the -- that was the message. And that was certainly well received. Top line is basically as everyone expected. It's flat in -- roughly flat in '21 from '20. You mentioned the tactical radio line items, they've done very, very well. So we continue to see them increase over time, which is good. So if you look at '21 versus '20, the total radio line items are about 20% when you add in Army, Marine Corps, Navy, SOCOM, et cetera. The HMS line item, which gets a lot of attention, that's really Army alone, is about 16%. But it grows over time. It grows to almost a couple of billion dollars in 5 years, which is better than it was last year. So the [ FIDEB ] last year had about $7 billion of collective radio spending. Now it's moving to about $8 billion -- a little over $8 billion over the next 5 years. So that's a very good trend. So we see -- we have a $2.5 million, $2.6 million per every F-35. So you see the 79 aircraft, that's likely to get plussed up, which is quite good. Night vision is well supported. We're a big player on the Big Safari Air Force programs. They continue to be well supported. So overall, it was quite good. Space is up, which was a good sign. I think there's been a lot of discussion around space command, space force, space development agency, a lot of space and all that. Between 20% and 30% growth in the budgets in space. And we talked about a little of that this morning. And that's a good trend because we have an important position in space domain as well. So overall, I think we ended up being pretty well-funded in the budget. The thing that doesn't get a lot of people's attention, 20% of our business is in a classified domain. So we follow the MIP National Intelligence Plan budgets as well. They were up about $85 billion, $86 billion last year. This year, it's about 15%, up from 3 or 4 years ago, 20% from 5 years ago. So we're seeing a lot more growth in a classified budget, and that's been an important trajectory for a company as well. So overall, I think pretty well supported in the budget.

So at a high level, we're looking at modernization relatively flat over the last 2 years. We still have outlays growing 15-plus percent. That's obviously going to start to slow. And I think at some point, we're all going to pivot to how every company looks like. What everyone looks like in a decelerating outlays growth environment. How do you think your positioned? I think there's still some concern out there that your portfolio is shorter cycle? And how do you think you'll stack up? If we go into a decelerating outlay growth, revenue growth environment over the course of the next couple of years, how do you think you'll -- your portfolio stacks up relative to your peers?

So I think there's been a discussion around being short cycle. And I think years ago, when we were getting a lot of sort of orders off of DoD to support wars in Iraq and Afghanistan, that was more short cycle. Now there's a multiyear budget trend. And we're seeing over the last 5 years that every year, we're spending along that trend and that we see that continue over the next several years. So I think it looks pretty good. In fact, as we come into this year, we guided to mid-single digits, so 5% to 7% growth. Last year, up 10%, which is pretty special in the space, well above the S-4 we put together between Harris and L3 before we merged. As we get out and into '21, I don't know if outlays are going to slow. It's possible. We'll see what happens in the election later on this year. We've got a lot of opportunity to continue to grow within the defense space. So we have about $10 billion worth of defense revenue. We're not a gigantic player in a $700 billion market. We're investing in technology. We're investing in innovation. We're going after a broader piece of the end-to-end mission solutions. So we have an opportunity to grow there. I think we've talked a lot on the last couple of earnings calls about the momentum we're seeing on revenue synergies, which is actually a very good thing that's happening sooner than we expected in this merger. So we're seeing revenue growth opportunities. And the third piece, I think, that's going to dampen us a little bit, is international. We're underpenetrated in international. And we've got an opportunity to grow there, and we're focused pretty aggressively on that. So even if the budget, the outlays start to slow a little bit, we've got a lot of things we can do with some self-help to continue to grow at that mid-single-digit-plus level that we've been growing the last couple of years.

Wanted to touch on the legacy L3 portfolio. I think some of the challenge there for them was just the decentralized nature of the business, not having in place the systems to be able to measure performance across the individual businesses. How have you changed things there? Do you have the measurement systems in place now that you can really identify what the opportunity is? Number one. And then number two, is there anything that you think that's fundamentally different about kind of the legacy L3 portfolios compared to the Harris portfolio as to why you can't have similar kind of productivity levels, working capital levels at L3 as what you have been able to do at Harris?

So a lot in that question. I think, look, there's -- it's about focus. I mean, L3 was run -- I think everybody knows, run more as a holding company. So they had a lot of acquisition over the last 20 years, not a lot was integrated. And fundamentally, where Chris Kubasik and I are really tightly aligned is on this notion of moving from a holding company to an operating company. We've been down that path before at Harris. When I joined Harris 8 years ago -- and time's flying, it was 8 years ago. We were operating like a $6 billion, $7 billion holding company. And there was a lot of value to be had in running this -- the organization more on an integrated fashion, driving R&D across the enterprise by individual segment. So we had a better look at the portfolio, self-driving shared services. So we're completely aligned on how to do that. And I think together, we can drive a lot of productivity through that. We're down the path on this as well. So we've already started. We've centralized the IT function as well. We're going to go from 73 or 74 different ERP systems down 2/3 below that, so down low 20s over the next several years. We've centralized payroll. We offshored that as well. We're going to centralize a lot of the financial back office systems. We're making great progress on that. And the reason I think this is going to work is because the top management of the company is aligned in what we want to do. And there's just a lot of value to be had in this. So when you're running a holding company, you don't have common metrics that go across the enterprise. And today, we're building it. It's not hard to put the metrics in place. It's something that we've worked pretty hard on over the last 5, 6 years at Harris, even getting through the integration with Exelis. And I think we did a very good job with that. So we're using some of the same metrics. But the challenge is going to be what's going to take some time is, you need to get good quality data behind it and then start to trend it. So we now see good information on what defines quality. But driving that down into every site that we have, making sure it's consistent across site, that takes time. And as we're doing that, you'll see more and more opportunities. This is the operational excellence muscle that we're building within the company.

Yes. So E3, touching on that, what have you seen in terms of productivity gains or however you want to frame in, from E3 so far? What do you have baked into 2020? And how much of a -- as we think about the organic margin opportunity above and beyond synergies, what does that look like?

So E3 is our operational excellence program. And this is the muscle we're building within the company to drive productivity, working capital performance every year, year in, year out. And In fact, I think we developed a pretty good OpEx muscle at Harris, and we deployed that in the integration with Exelis, and you're seeing a lot of those same skills and talents now being deployed in integration with L3. So to me, this is fundamental. It goes beyond supply chain and factories. It's really enterprise-wide. It's in all the staff functions but it's importantly in R&D, in the R&D function. So we spend a lot of money on IRAD. We have well more than that, when you think about customer-funded R&D. It's sort of our factory in lots of ways. So we're driving a lot of productivity through the engineering function by again, instrumenting, what are the metrics, how do you use software tools to drive things faster and more lean. So to me, this is fundamental to what we're trying to do with the company. So we've seen, I think, a good start here. Typically, in a very good OpEx program, you'd see 2% to 3% net of your cost every year coming out of productivity. So we started off last year. We had a good start. It was a little less than the bottom end of that range. This year, it'll probably be a little less than the bottom end of that range as well, while we're focusing on synergies, which is going to be pretty important. And we're really just getting started. But over time, this is a 3-year integration period. We need to build that muscle so that post the third year, you start to see more organic margin expansion. We are starting to see it. It's getting offset a little bit by mix, some investment but I think we're off to a really good start.

Yes. I mean, the -- I think the -- in your bridge, the $0.43 that you're talking about this year, it looks relatively low. I guess that is a composition of mix working against you with E3 and then maybe some operating leverage.

Yes. I mean, there's some investment in there, and there's mix, without a doubt. So on a drop-through basis, it's a little bit low, but we've given our guidance range of margins in calendar '20 between 17% to 17.5%. In the middle of the range, the incremental drop-through is not so great. We're striving to the top end of the range. We get to see a much better drop-through on increments.

So following on that synergies, interesting that your run rate question -- I thought I was doing the math wrong, but your synergy run rate in '20 is below your exit rate in '19. So I guess, maybe address that. And then you've talked about hitting $300 million net in '21 to '22. You obviously had upside with Exelis. How are you thinking about the opportunity there?

So good question. So we started off -- we guided, I think, to $40 million net and then went to $50 million. We delivered $65 million in the stub year. So it got incrementally better. It happened not because we were sandbagging, it happened because we were doing a lot of integration planning before we hit the closing date, which is around July 1. We prepared for it. We were running an integration. We weren't starting. So we had a really good start in the stub year on driving integration. So in the $65 million, that was $50 million in Q4 and what you're referencing is, as you annualize that, that should be $200 million. We're not quite there next year. We do see some negative synergies popping in next year. So some of the benefits programs that we're implementing do come with some negative -- some headwind as we equalize 401(k), some different benefits plans. We're seeing a little bit of that. I think we should do a little bit better than the $185 million. But more importantly, as we get into '21 and beyond, we're moving fast enough that we have moved forward what we thought was in '22 to '21 in terms of synergies. So $300 million net, $500 million growth. We were thinking 3 years out in '22. We're now thinking that's more like in '21, but we're not going to be done in '21. So hopefully, there's some more opportunity beyond that. So I think through the year, hopefully, we can continue to drive and do better than $185 million cumulative net that we're talking about.

And you still think kind of that 60% capture rate is appropriate?

Yes. It's going to be more or less. I mean, we typically run 70-30 fixed price cost plus. But even some of the fixed price programs get renegotiated periodically every year -- every couple of years. So some savings will go back to the customer on fixed price contracts. So we try to be -- I would be conservative, but this is what we experienced with Exelis. It will be a little less than that 70%. It was more closer to 60%, 65%. And we're modeling basically the same thing as we think about L3.

Okay. And then the last one, I guess, on the margin side of things, the opportunity to put more of the L3 business on a commercial base model. I guess, what does that look like? What actually has to happen to get product -- to allow products to be sold on commercial-based terms?

It's a good question. Some of the L3 business is on a commercial model today. So the night vision business, the EO turret business at WESCAM is a commercial model. I mean you anticipate need, you invest your own R&D dollars, you develop your product, then you go and market it, and you tend to have higher margins in those businesses. So we see that in night vision, we see that in EO, we see that in our tactical business. When we bought Exelis several years ago, we moved the Exelis radio business out of Fort Wayne into Rochester. It was a noncommercial model business to a commercial model. It took us some time to do it. It's not simply moving into factories. It's about how do you translate the contracting process. And it took us some time, but we've migrated that. As we think about opportunities at L3, they have a SatCom business. That SatCom business is going to be consolidated into JROC into our Rochester facility. Maybe we can drive that more to a commercial model over time. But you're talking about a couple of hundred million dollars, not billions. So there's some opportunity to drive more of the business to the commercial model, but it's not wholesale. It's not going to be multiple billions in my view today.

So I'm sure -- transitioning to your favorite topic, which you never get asked about, cash. So starting with -- so with working capital. Numbers are moving around here a bit. But I think baseline, the combined company started low to mid-70s?

75.

75. And originally, you talked about 70 days of working capital improvement would give you $200 million to $300 million in terms of the free cash flow contribution. You already hit the 78. You're talking about a couple of days this year, a couple of days next year. So I do all this and you're now targeting, it sounds like, mid-50s. Number one, is that right? And number two, that's a couple of hundred million additive to kind of the free cash flow profile.