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

Good morning, everyone. This is Sheila Kahyaoglu with the Jefferies aerospace and defense equity research team. Today, we're lucky enough to have LHX with us. We have Jay Malave, who's SVP and CFO of L3Harris. Prior to becoming CFO of LHX in 2019, Jay served in various financial roles within United Technologies. We also have Rajeev Lalwani here, Vice President of Investor Relations. Jay is going to start off with a few brief prepared remarks, and then we're going to kick it off with Q&A. Jay, go ahead. The floor is yours.

Thanks, Sheila, and good morning, everyone. On behalf of the 50,000 L3Harris employees, thank you for having us participate in your conference. And just a few takeaways from our earnings call last week. First, we continue to execute in a challenging environment, and the benefits of the merger, in just the first 12 months, are quite clear. We've had strong margin expansion. We continue to drive down working capital and deliver strong free cash flow. Secondly, in our guidance, we did hold the line. Based on everything that we're seeing, as we look at the back half and the opportunity, there's certainly upside there, and we talked about that last week. And lastly, on capital returns. We're resuming -- or have resumed our share repurchase activity consistent with our commitment to return the divestiture proceeds to our owners here in the third quarter. And we see that as a good starting point as we look at the rest of the balance of the year. So all in all, we're feeling good about our ability to continue delivering on our commitments, both on the top line and bottom line over the coming quarters as well as years. So Sheila, why don't we just get into your questions?

Perfect. Jay, you started off with that. It's been a little over a year since the merger closed. A lot of big milestones have already been accomplished. As you stand here today, what's left out in front of you? And maybe where do you see trends ahead of plan and whether on synergies or free cash flow side of business?

It's a great question, and this allows us to put the progress made of this merger in perspective. And I'll start off a little bit, just a little color on the accomplishments and then go into the larger milestones. But in the first year, we brought together 50,000 employees on the 2 different companies and put them under a single operating system. We've consolidated 6 segments, 3 in each business, to 4 assigned segment and functional leadership with clear accountability and ownership and laid out 5 organizational priorities and focused the entire organization integration in creating a sustainable continuous improvement system with our E3 operational excellence program. And we've made really good progress so far. If you look at value capture, we've expected about $185 million of cost synergies this year. On a cumulative basis, by the end of the year, we'll be at $250 million, so well on our way to achieving $300 million. We're approaching 18% target as far as margins, and we actually touched above that here in the second quarter. We've achieved 13 working capital days reduction since the merger date, and that's on an operational basis, and that's enabled us to really drive strong cash flow. And even in a COVID-impacted environment, we've hired over 3,000. We're approaching now 4,000 employees so far this year, and we're keeping our investment profile on track with over $1 billion in R&D and CapEx to be invested this year. Looking forward on the milestones ahead, it comes down to the synergies. As I mentioned, we'll be $250 million on a cumulative basis by the end of this year and on a clear track to deliver $300 million in 2021. Same with free cash flow. Again, at the merger date, we had set a target of $3 billion in 2022. And we're on track towards achieving that. We have to get to a little bit over -- around 50, maybe below 50 working capital days. We've got a clear line of sight to be able to do that and deliver on that $3 billion cash flow target. We expect, once the synergies subside and something maybe we can talk about a little later on, is we continue to see margin expansion through our E3 productivity initiatives. And so where are we ahead? We're certainly well ahead of where we thought we'd be in synergies. We thought we would achieve the $300 million in 2022. We'll get there in 2021 with $250 million, as I mentioned, in 2020. And same thing with working capital. We thought we'd be able to do 2, 3 days a year, and we've already been able to do 13 days in the first 12 months. So excellent progress but certainly more to come.

That's helpful. And you mentioned 18% margins in Q2, that's almost 1,000 basis points above your peers. Clearly, had a nice beat in the quarter due to profitability but you didn't raise the 2020 outlook. So some contingency in there, maybe what are some of your risk assumptions that you're planning for in the back half?

Sure. We had a really strong quarter, as you mentioned. It was ahead of expectations. We're -- as I mentioned, we're trending towards the upper half of our guidance based on those results. And our operating performance was and continues to be strong. With that said, we do expect R&D to pick up in the back half. It's just a matter of timing. It's a little bit lower, about 3.5% of sales in the first half. And we expect that to approach around 3.8% in the back half of the year. And then we also left a placeholder for incremental COVID cost in the back half, which is about 20 basis points of headwind. But that could be a source of upside if the risk doesn't materialize, just a mix sitting at IMX -- I'm sorry, to IMS. But in the big picture, we didn't raise our guidance because of the COVID unknowns. And if those risks ease, then I would expect us to deliver upside this year.

That's helpful. And then on the earnings call, you highlighted the free cash flow target of $3 billion is intact. I don't think anybody ever doubted that. Then you also gave us a little bit of a care insight that you said growth thereafter.

Right.

As we get into 2023 plus, what are the potential drivers of growth, especially considering the defense budget declines potentially? And how do you kind of drive all that together with your free cash flow outlook?

Right. The path to delivering free cash flow growth beyond '22 is similar to how we get there in 2022, but it looks slightly different. And let me just say, we do have a solid road map to deliver the $3 billion in '22. And if you think about it, it's a little bit more of the same, where we continue to expect net income growth through top line growth and continued margin expansion. Our businesses are positioned well. Even in a challenging budget environment, it would support in areas like tactical ground communication, space, night vision goggles, ISR and F-35. In addition to merger-related potential opportunities that ramp post-2021, such as sales synergies and growth -- stronger growth internationally. On margins, the synergies will subside in 2021, but our operational excellence program and system will enable us to continue to drive margin expansion. So when you layer on net income growth with continued also improvement in working capital -- and we mentioned last week, that we saw a path to being around 40 best-in-class type of working capital days beyond where we're going to be around 50-ish in 2022. So we continue to see upside and cash flow beyond 2020 with net income growth and continued progress in working capital.

That's helpful. And then just somewhat layered on to that, what do you think about the structure of your business? Would you expect to outgrow your larger peers on the basis of their defense business? And perhaps touching on the revenue synergies, you mentioned that starts really converting post-2021. Can you talk about that pipeline?

Sure. We continue to target mid-single-digit growth over the medium term. And we understand and the DoD budget outlook is likely to be under some pressure, but we still have confidence in our ability to deliver a growth plan that's mid-single digits. And it's really based on 3 elements: the first is the alignment of our capabilities and portfolio with the DoD's priorities in managing near peer threats. The second is our expanded capability set as one company and the ability to drive revenue synergies. And third is really focusing on international opportunities and expanding our international business. So I'm just going to -- I won't take too much time but just a little bit more color on what I mean by all 3. When we talk about alignment with the DoD priority and you look at where our portfolio is, I'll give you some examples, such a space, we're a market leader as far as exquisite payloads as well as end-to-end responsive satellite mission solutions. And that's really driven -- where we're going to see the growth is driven by space become a war fighting domain. If you think about ISR, which we have a strong capability there amongst signals, intelligence, electro-optical as well as adding electronic warfare capability, all of those capabilities enable platform upgrades and multi-system integration through open systems and multifunction capabilities. If you think about tactical communication and our tactical radio business, we see a structural modernization cycle that's underpinned by the requirement to maintain resilient ground communication. And we see right now, we're just in the beginning of the early innings of that modernization cycle within the DoD. Another example, which we don't really talk about as much and Chris touched on it during the call, is our maritime business. We have moved from being a component supplier to a mission systems provider. And we see a lot of opportunity there, particularly in autonomy. We were selected as the prime platform systems integrator on the medium unmanned surface vehicle. And again, that just shows our progression towards a broader capability set to be a mission systems provider. And lastly, I'd say classified programs. We have 20% revenue exposure to classified, and we see that also well supported. So a strong core capability with our portfolio, and that will be augmented by revenue synergies. And we see some focus areas such as space, our capabilities expanded with a broader range related around optics as well as navigation software. And areas such as electronic warfare, we now have a stronger suite combining capabilities to identify and locate threats with processing and jamming and some other areas in classified. So nice, nice growth potential there. We mentioned last week that we've been now selected in 13 of 23 proposals, and that encompasses technology studies as well as demonstration programs that will eventually lead to full-scale development and production programs over time. We mentioned about $100 million of revenue opportunity a year. But that's where it will start, and it will grow from there. Of the pipeline that we're looking at right now is over $5 billion of lifetime revenue potential on all the proposals that we have in process. So the last thing I'll say about revenue synergies, that even for those where we may not be as successful, we will be given the opportunity to really demonstrate our capability set to our customers. And by doing so and opening that aperture with them, that will open up opportunities downstream that we can't even envision today. And finally, let me just close on the international. Again, we're lower penetration of some of our peers around 20%, and we see a lot of opportunity sitting in ISR, maritime, electro-optical, tactical ground communication and electronic warfare. And again, it's very similar to the U.S. because we see those requirements based on near peer threats. If you look at ISR, and for example, we're an Australian paragon program, we have a strong already franchise and tactical ground communication as well as ground network communication. So a lot of -- again, a lot of opportunity there. We've aligned our resources, so international business development organization is aligned around segment growth targets. So we're working towards similar objectives across the organization, whether it's functional or within each particular business unit. So just to wrap that up, a strong mid-single-digit growth outlook that's supported by our strong capability set within the core and it's augmented by our specific revenue synergies as well as international expansion, and all of this will ramp up as we see outlays starting to ease.

That's a very helpful picture that you painted for us, Jay. That turns to profit or brings us to profit. LHX is one of the few defense contractors with the margin expansion opportunity, cost synergies or otherwise. Part of that is obviously tied to deal synergies, but also we're seeing underlying operations, maybe improved productivity. Is there a ceiling? Or do you have some thoughts on where margins could eventually go and your thoughts there?

Yes. It's a really good question. At a high level, margins will continue to be a source of opportunity over the medium term. This year, we're looking at mid- to upper-17s. And with the benefit of synergies, which we fully expect will drop-through, we'll be in the 18%-plus range starting next year. Mix is a player. There's no question about it. As you win new programs, you start off typically with lower development type sales margins as well as when low rate production as you're learning out the product, they just come in at lower margins. But that's why we put in place our E3 operational excellence program. It's really to offset those mix headwinds and continue to enable us to drive margin expansion. It's hard to say exactly where it will go. I mean a lot of people want to know whether it's something like 20%, and it's going to vary. The mix headwinds will vary from year-to-year. But I can tell you that there's still margin expansion opportunity from where we are and where we see things going even next year. And so if you think about E3, there's a lot of opportunity beyond our synergies. We continue to look at value engineering in the supply chain, should-cost analysis, labor productivity in our shops, functional and overhead cost structure savings. And when you think about it, you kind of take our sales and profit and back into our cost. There's over $15 billion of cost. There remains an opportunity to us to further go and make ourselves more effective as well as more efficient.

That's helpful. And then this all ties into free cash flow, both revenue and margin mix. You talked about $3 billion free cash flow target that you laid out for 2022. The guidance here is closer to $2.65 billion for 2020. What are some of the biggest drivers as you think about that 2-year ramp and maybe areas of upside?

Sure. For 2022, our -- this year, we're, like you said, $2.65 billion. There's some upside there with a little bit lower CapEx, a little bit higher-margin expansion. And so we're trending towards the higher end there. As we do that and get beyond 2020, it's more of what I said before, we see continued opportunity from a sales growth and net income growth perspective, both in sales and margin expansion and continuing to drive working capital down. And the formula will be is as long as we can continue to keep working capital in check, so as our business grows, our working capital does not and the net income can drop through all the way down to free cash flow. That will be a consistent formula for us to continue to drive cash flow growth beyond 2022.

No, that's helpful. And then you scaled back share repurchases for 2020, but how do you think about capital deployment going forward? What are some of the highest return areas in your view, whether dividend, share repurchases or additional acquisitions?

Yes. So as I mentioned, to open, we did our -- resuming share repurchase this quarter. And we're not really focused pretty much on the $1 billion of share proceeds. We'll continue to monitor the environment and for deployment opportunities beyond $1 billion and find the right balance between our cash buffer, stock and other things such as pension contributions. Overall, I'd expect us to continue with our balanced approach to capital deployment. As I mentioned, we invest over $1 billion in R&D and CapEx to drive growth, and that will continue to grow. And we've been able to take excess cash and return it to shareholders, and I expect that approach to continue. So as far as M&A, it's still early for us as an organization. We're a year in -- a little bit over a year now in terms of a pretty large-scale integration. And that's what remains our focus on both integration and execution. If something compelling were to come along, of course, we would look at it. But right now, the M&A bar for us is quite high. As far as dividends, we had increased our dividend 10% at the beginning -- right at the beginning of the merger last year. We came back in the beginning of this year with a 13% dividend increase. And we'll continue to monitor that as the years progress. I wouldn't see -- I would probably continue to expect that type of dividend payout going forward.

That's helpful. We've covered a lot of big picture, but I wanted to delve into a little bit of the details because you are a very diversified organization. So one area that's been growing is the U.S. radio modernization business, with 35% growth in U.S. tactical. How much runway is there for that business to grow? I know you can't grow double digits forever when we think about the various programs. And how much visibility do you have over the next few years when we think about Rifleman, Manpack and other programs for SOCOM? And how long can -- how do you think about the overall growth rate for that business over the next few years?

Right. As you mentioned, the radio modernization growth has been -- it's been pretty strong, 35%-plus is pretty special. And naturally, that rate is going to come down. But we're still in the early innings. And if you're able to look at the fight up, you could see a clear line of sight to continued growth in tactical radio modernization over the next 5 years. And the key programs for us are the HMS Manpack and Leader, where there's a $15 billion IDIQs between 2 players for the handheld, 2 players for the Manpack that goes out 10 years. There's only been $1 billion utilized to date under that $15 billion IDIQ. So we're in the early stages. For some of the other forces at SOCOM, Navy and the Marines, there's over $1 billion remaining on those IDIQs, and those are sole sourced. And so there's plenty of runway here for growth. And as I mentioned earlier, we really see this as a structural requirement over the next 5 years because of the need to maintain resilient communications. So again, 30% growth is pretty special. That's going to naturally come down. But we still see continued growth there, and that will be a nice contributor to our mid-single-digit growth objective.

Perfect. And then just on the flip side of that, the international business, it's about 800 million business unit. How much of that business is driven by what you're doing on the domestic side? And how do you think about the trajectory of the international business when we think about modernization across different regions? How do you think about growth when looking at different regions, whether Middle East, Asia and Europe?

Right. We see some of the similar trends from our allies, whether it's the requirement for resilient communications, but that's also augmented by a desire or a preference to have interoperability with the U.S. So as the U.S. modernizes, we see the allies -- there is a lag, but we see the allies requiring modernization as well. And so that will fit nicely in our growth profile. It probably -- over the next 5 years, the growth will lag the DoD somewhat, but we still expect there to be growth. Similarly in developing countries, where they're both either building an installed base or refreshing radios, in some areas, they have or do not have satellite communication systems. We have -- we can support both, whether it's satellite communications or HF radios. And that's where we're seeing nice demand. We have a great portfolio of products in both of those areas. And it's something, again, I think it will be a nice source of growth for us, maybe not as strong as the DoD but still a nice source of growth for us.

And then you mentioned space is an area of potential outgrowth relative to the budget. What are some of the biggest opportunities? Obviously, tough compares this particular quarter, and that segment's book-to-bill has been below 1. So what are your growth expectations there as we think about the opportunities converting into revenues over the next 1 to 2 years?

Sure. Let me just go back to the quarter a little bit and just dissect it because, yes, the segment itself was below 1, but the space business itself was actually above 1. What we saw was below 1 was more of our platform-related businesses, which are just more lumpy. And they're platform based, and they're lot based. And so those just vary in terms of the timing of the order. And space, as I mentioned, we were a little bit above 1 in the quarter. And there's been a lot of activity there, a lot of proposal activity. And as I mentioned earlier in our discussion, we see a lot of activity because space is becoming a war fighting domain. And we think that plays well in our capability set as a leading provider of exquisite payloads, whether it's optics or RF. And we're supplementing that with our responsive satellite systems. And so there, we're a mission provider. And we see a lot of opportunity there, whether it's in tracking in the area of hypersonics or in other areas. That's going to be a source of growth for years to come, and we believe that we're well positioned to participate in that growth.

And then one area of synergies from the deal with international. I've heard Ed and Dana talk a lot about the domestic opportunities. But when we think about the portfolio, many of these products have exportability capability as well. So what are you seeing in terms of international pursuits? And how has that opportunity set grown since the deal closed?

Yes. We see a lot of activity there as well internationally. And particularly in areas like ISR, as I mentioned before, we have the Australian paragon program. And a lot of what we're seeing from foreign countries is a requirement to develop the same level of ISR capability. And again, you put that in the context of near peer threats, the ability to observe and track. We also see similar, under ISR, electro-optical business, which they may or may not be a platform that we modernize or missionize. Tactical ground communications, we just talked about the international opportunities there as well as maritime. Autonomy is not something that's just specific to the U.S. We're seeing other countries looking for autonomous capability, and we're right in the middle of those types of opportunities. And this also includes areas such as electronic warfare, whether with the platforms, airborne-type platforms as well, and the ability to really detect and jam where necessary. And so similar to what I said before when we talked about revenue synergies and the ability to create incremental opportunities, we're seeing very similar types of demand internationally in these areas as well. And as I mentioned, we're around 20% of our sales. We know there's room to grow. We know that's lower than some of our peer companies, and that's a focus area for us.

That's super helpful. And then one of my -- on IMS, we touched upon it a little bit, your full year guidance of 13.5%. That compares to first half performance of 15.7% margins. What are some of the risks embedded into the second half? And how do we think about upside drivers? And also what drove some of those great margins in the first half where the electro-optical business and Wescam in particular? So how do we think about margins as we head into 2021 as Wescam slows down?

Yes. It's not so much risk, it's more of just timing of items. Like I talked about R&D at the consolidated level, R&D is an area where we're going to see an uptick in spending in IMS. And so that will just -- is going to have a natural reduction in the margins there. We also see just some mix headwinds in the second half that weren't there in the first half. This is a function of the timing of certain types of sales in the second half. Having said that, going back to your question on the performance in the first half, we've seen excellent synergy drop-through. And on top of that, just excellent core organic margin expansion through their E3 productivity initiatives. And so we would continue to expect that. Yes, there's going to be some headwinds in the back half. I think we're generally -- we're conservative in what we said here, around 14.5% for the year. There's probably some upside there. But again, just kind of see how things go, and we'll take a look at it again as Q3 ends, and we report again and see what the year looks like.

That's perfect, Jay. And then just 2 more questions, maybe to wrap it up, focused on free cash flow in your portfolio. We talked about this a little bit on Friday. But you mentioned 6 businesses with high working capital and a potential of $500 million cash opportunity. How do you think about these opportunities? You mentioned it's mostly on inventory and the design process. So it starts early on. We also calculated that these businesses will be fairly sizable in the $700 million range. So what does that say about them? And maybe you could talk about any impediments to driving that improvement.

Well, yes. I mean in that revenue range, I think, is right on average. When you think about it, there's nothing magical. There's nothing really glorious about what we have to do. It's good old-fashioned attention to detail, blocking and tackling. It's synchronizing our internal operations with our supply chain. It's being able to better forecast material requirements with our production schedules. It's having our suppliers manage more of the inventory, so we're more on a pull system. It's helping our suppliers make sure that they deliver on time with better quality, and so we don't have to go backwards in any of our areas. It's also leaning out our shops so that they're most efficient. And so you get also cost savings on top of working capital benefits there. And so none of these things are unique, say, to us, it's just more management attention and a disciplined program management approach to delivering these benefits. And that's what we've seen in the first 12 months, and that's what we'll continue to see going forward.

And then my last question for you, Jay, is you've talked about divesting 8% to 10% of revenues, which implies you're less than halfway done. What makes the business that doesn't fit within the overall LHX portfolio? And how do you think about the use of proceeds? And I guess it is a difficult time to enter into the M&A market, given projections are difficult, so how does all factor into the divestment outlook?

Yes. We've looked at a number of factors when we're evaluating a portfolio. It includes top line revenue growth potential. It includes margin expansion potential. It includes technological fit. It includes what type of management attention and investment it would require to achieve these potentials. And we really went through all of that and took it through a type of filter and helped us identify exactly. Really, we pretty much know amongst that 8% to 10% which businesses we've targeted. Of the proceeds, the way we're looking at it is just offsetting the dilution created by the lost earnings of those businesses. And we've mentioned this, I think, a few times in the past where what we're looking to do is replace one asset with another asset, and that asset being L3Harris. And so we just expect that we would return that to buy back shares really to again just trading assets from one to the other.

That's perfect, and that wraps up our 30 minutes, Jay. And thank you for being with us, everyone. That concludes our webcast.

Well, thank you again, Sheila. I appreciate being on.

Thanks.