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

Okay. Well, that -- yes, I know this has been a popular topic, and I think I've heard you say and read that you might be a little skeptical as this concept has been out there for decades. So I will say this concept has been out there for decades, so it's not a new idea. But I think there's something different this time, and there were 3 things that came to mind. First, the technology is significantly more advanced than it has been over the last several decades. And I think strategically, our nation needs this capability. We're not dominating our adversaries as we have in the past and we now have peer competitors. So the threat environment has clearly, clearly changed. And probably most importantly, the leadership of the DoD is completely aligned and committed to the JADC2 concept. And it is a concept, as you know, of connecting platforms to sensors, to shooters, weapons. And with today's maturity of technology, we can actually do this. And it's not an easy solution because in many cases, we're talking about thousands of miles across the battlefield. So just to reiterate, it's not a single program. Nobody is going to get a JADC2 RFP. I don't think we're going to recapitalize platforms. We're going to focus on connectivity and what we have in inventory. So when we look at the existing sensors, the data links, the systems, I think we're in a good position. I mean the -- you've heard before that Navy has Overmatch and Air Force has ABMS and the Army has Convergence. So what's actually been happening is companies like ours -- or we've been submitting concept papers. Those concept papers lead to demos. Based on the results of those demos, we're awarded programs. So to date, we have about $250 million of opportunities. We've won $50 million. We're waiting on decisions for another $60 million. And it's kind of -- it's going to be a slow and deliberate process. I guess relative to what differentiates us is we have a very strong presence in sensors in all domains. And you couple that with our focus on resilient comms, data fusion and processing, open architecture, which again, we've been embracing and the customer confirms that. The fact that we're platform-agnostic relative to JADC2, we look at all those pieces, the data links, the waveforms to allow us to pass the data in a contested environment, I think we're in really, really good shape. We have capabilities across all the frequency spectrums, acoustics, VHF, X-Band, EO/IR, the list goes on. So it's maybe not a lot of money to begin with, but early on, I think we've had some good wins. We're focused on this. We have a good footprint. Again, I think we're agile. I think we're responsive. And time will tell, but I really like what the team has done so far. And then I think the next step will be to integrate AI into this whole concept. And we're going to work and continue to work with commercial companies that have invested hundreds of millions or billions in AI and take that capability with our mission knowledge and continue to give our customers solutions and alternatives. So I think it's for real this time and I think we're off to a good start and there'll be more to come in the years ahead.

No. I think it's fascinating when you think about this if you go back to the history of Harris and essentially jitters was one of these kinds of things. And Harris essentially, by being agile, came in the back door and now has -- took the rightful helm and then with the wave forms, they were able to develop -- took strong positions there. So yes, it is interesting.

I agree with you. And I think it's going to be -- there's a couple of schools of thought on this one as we've looked into it. And are we going to spend a couple of years with trying to develop standards and protocols or are we going to be more like the commercial world and the Internet and you got what you got and let's find a way to connect it? And I think that's where the DoD is headed and that's what we're trying to do alongside with them. So I'm not sure wasting a couple of years and waiting for all sorts of protocols and standards is the right answer. We didn't do it when the Internet was developed and there's no need to do it now. So that's been our approach, again, listen to the customer and follow their lead, but that's how I see them going. I don't know if you've heard differently, but that's our plan.

Well, I think we switched -- it's actually related, but the Space and Airborne Systems. So space, again, very good budget support. But one of the things that looks challenging here is here's another business where you have, I would say, unusually high margins for that type of a business. You've got a lot of development work coming in, which is a good thing. Can you keep margins there or even expand them potentially?

Yes. And it's a great question and the answer is going to be yes because -- I'll let Jay give you a little more detail. But it's really a combination of the space and the airborne, and they're a little different but actually converging. And we talked about the airborne, the mission avionics and EW, and it's more of a high-volume factory type environment. And I mentioned that only because that's how I see space moving, especially our responsive sats and some of the LEO constellations that we've won. There'll be more than a couple of exquisite sats, right? There's going to be 10s or the potential for 30 or 40 a year. So we've actually been able to convert some of our facilities here without a lot of CapEx expenditure to a space factory. I can actually see it out my window as we speak. And our customers have been here, they've been impressed. So we'll have that ability to do more of a factory production as these constellations continue to be awarded and expanded. But before I hand it to Jay, it's what I've always said, Doug, is you got to look at the lifetime value of these major programs. And we all know they tend to start out. Usually, it's cost-plus or developmental and they're lower margins, and then we move into LRIP and full rate production, sometimes we export them. And it's really a portfolio approach. So today, at these margins, we have development programs and we have mature programs and everything in between. And we plan for that to continue. And with all the efforts on E3 and in cost synergies, I believe we can continue to grow these margins. So I don't know, Jay, if you wanted to...

Yes, that's right. I mean these are just -- these space programs are just -- these are just great opportunities for us, Doug. If you think about it where maybe in prototype cycle, these will lead to constellations. Those constellations will be recapitalized. And so we're talking long-term franchises, not unlike in commercial aerospace, we have very long platforms, and so that's what we're seeing here. And so yes, in the short term, that will put some pressure on margins. But just to give you an example here in the first quarter of what we saw, we have a guide this year for SAS at 18.25% to 18.75%. They delivered north of 19% in the first quarter, and so they surprised themselves and as well as us to the upside. I think one of the things that they're doing is really designing for cost. They're looking for opportunities for use of commonality, also use of commonality as far as engineering designs on these similar-type programs and these missile defense programs are great examples, where it's a brand-new franchise for us and they're taking 2 and trying to use as much commonality as they possibly can. And they're extending that throughout the entire portfolio. As Chris mentioned, they do have a lot of history on their airborne side in terms of taking a productionized type of environment and driving cost out. And we're very confident they'll be able to do that on the space side as well. And so we've got good results. They will put some pressure. It's not going to -- I think, probably a flattish type of outlook for them is probably the right way to think about them going forward. But we'll continue to drive our E3 cost operational excellence program and continue to deliver these strong margins as they have been.

Well, when you look at margins overall, I've got a couple of questions that have come in and I have the same question which is we look at defense as oftentimes a very good hedge if you see yourselves going into an inflationary environment because you can pass a lot of the cost, certainly in cost-plus contracts, and with repricing on fixed-price contracts, you can pass a lot of that on to the customer, so it's a great business from that standpoint. However, at -- Chris, as you said early on, on some of these commercial fixed-price contracts, do you see -- or are you concerned about possible inflation pressures, raw materials and so forth eating into your margins over the next few years? Should we see rising inflation?

Yes. It's a fair question, and note, it's not new to us. I mean we -- the way we talk about and manage E3 internally is net of headwinds. So the numbers we give and the 2 headwinds we have are inflation and then occasionally loss programs or debooking profits. So we're looking at a net basis, and it's the focus on the E3 that is going to allow us to offset those headwinds. Again, in our case, we have the benefit of the merger, so I mentioned the supply chain, the focus on resiliency, the consolidation, better buying power, so maybe it was just a good timing. But that gives us the abilities to absorb this or to even get better prices. But absolutely, nobody is going to deny the fact that there is potential inflation, it's something we focus on and are aware of and especially in the microelectronics world that's out there. But again, with these high margins and the focus on E3, we feel like we have a path here to maintain those. I don't know, Jay, if you...

Yes, agreed. And our approach is somewhat similar, Doug, whether it's government or commercial type, we look to really lock in our suppliers over time for the duration of our customer contracts. We do have in some of these contracts or many of them in terms of cost escalators as you mentioned, you do have an opportunity to reprice. And as Chris mentioned, we take into account material headwinds when we develop our plans for our E3 program. And so we have that -- much of that baked in. As you mentioned, we are seeing some inflation that is a little bit higher than probably coming into the year. I think our exposure there is fairly contained and actually fairly limited. And so I will acknowledge, though, it is dynamic. I mean it's something that we will have to continue to monitor. But for the time being, our E3 program has been able to really overcome these headwinds, and we'll continue to monitor that. But we're really on a good track for the year in the program, and we don't see this really interrupting it or disrupting it in any way.

At -- on your last earnings call, you commented that you're getting clearly a lot of benefit through the merger synergies, you're ahead of plan. That's great for margins. But I know you said on the last earnings call that you believe that beyond that, you can do successive year-over-year margin improvement going forward. Can you talk about how you come to that point of view and where the opportunities come from there?

Sure. Sure, Doug. It's a great question. It's one that we get often. And when you look at -- maybe I'll put it in '21 and going into '22 and then what that really means from a medium term and longer term. As Chris mentioned, there's still a tail on some of the integration benefits. We are completing some facility consolidations. We're around 10 this year. That will continue to provide us benefits into next year. Chris also mentioned that our ERP systems, we're just really in the early innings of consolidating those down from the 75 number down to this 20-ish number on the 3 platforms. That will continue to drive benefits for a number of years for us as far as efficiencies. We're looking at other areas of functional efficiencies, particularly in SG&A, whether it's finance, HR, legal contracts, really to do more zero-based bottoms-up type of budgeting to really drive and, at least at a minimum, hold those costs flat while the portfolio grows so we can have better drop-through. And these are all wonderful opportunities for us. Supply chain, we -- again, we have a pretty good system of value engineering as well as equipping our supply chain team, which should cause types of analysis so that we could continue to drive better negotiating positions as those supplier contracts come open each year. And finally, in direct labor, just a lot of opportunity. Chris and I were going to review this earlier this week, and we're just introducing and adopting things like collaborative robots where in particular areas we're in final assembly, we're taking assembly of a particular LRU, being able to use a robot for that, putting us at the specified technical requirements for torque requirements, but also driving the time to actually assemble this components LRU out. And we had a particular example where we went and started at 51 minutes and we took it down to 8 minutes. So not only did we took direct labor out of it but we're also going to get better quality because the torque is consistent across that assembly. Other areas where we're seeing things like projection visualization where you're able to see right on your work bench work instructions. You don't have to go to an actual screen. It's right on your work bench. You also have on the workbench is something like a shadow box where it calls out specifically what the parts are that need to go into that assembly as well as the required tooling. And so this -- and this is just early adoption of these types of initiatives and benefits, Doug, that we're really in the early innings. Well, what I would say is these are just all examples of how opportunity-rich we'll remain. We -- as you mentioned and as a lot of investors have noticed, we performed quite well in the past 2 years. We've driven up margins. But in 2 years, we have not really completely been able to avail ourselves and realize the potential and the opportunities that exist in front of us. And so there's plenty of runway there. I just gave you a couple of examples to bring them to life, but those are just isolated. I mean there's just so much opportunity across all of our sites to be able to do that. We've also embarked on just really taking a look at bottoms-up overhead costs in each of our facilities, driving that. As you know, the better you manage your input costs, your output cost is going to get better. And so these are all activities that we'll continue to drive. And we have not even -- we're just not even in the middle innings to be honest on those. We're really still in the early innings.

And I'll just chime in briefly that a lot of what Jay focused on is more of a production factory and maybe even the commercial piece, but a fair amount of our portfolio are these programs, including development programs. And the key there is -- and it's all publicly available, is cutting down on the negative EAC adjustments, right, so the -- whether it's a loss program on a fixed price or debooking prior profit. So we've been spending a lot of time on our program management excellence academy. We have 1,600 program managers. They've been trained. We've invested and earned value management. Get monthly reports, we look at the CPAR scores, the award fee scores. And we've been hiring experienced people either out of the government or primes that have run larger and big programs as we've won. So if we can execute these programs and cut the negative EACs down, that's a real differentiator. And we have goals. We're compensated and incentivized to do that and we have done it. So that's helpful. And then even on the cost-plus jobs, as you know, Doug, if you overrun cost-plus jobs, you never lose money, you just dilute your margins. So we treat the cost-plus jobs as seriously as we do the fixed-price jobs and maintain those margins by just not incurring cost and diluting. So you put those concepts in addition to what Jay said. Year-over-year growth, you get a larger base, you spread your fixed cost over a larger base. All those things are ahead of us and that's why we're so excited about the future.

Well, one other aspect of this, which there's a couple of questions that came in on, is working capital. So can you update us on where you are? You've been exceeding -- substantially exceeding your targets in the merger. Where are you now? And how much more opportunity is there?

Yes. Great question, Doug. If you look at -- in the first quarter, we were at 55 days. And we started at the date of the merger around 68 days. We've made some great progress. But if you look at some of where our peers are and where we've been able to be before the date of the merger, we believe a reasonable target is around 40 days. And so there's plenty of runway between now and then. The most significant opportunity for us really is sitting in inventory. And it's -- some of it is blocking and tackling. It's better forecasting and so that we can time our material better with our assembly processes. It's also working with our suppliers so that we book more on a pull system and all those types of concepts that are not unique to us, but it's really remaining disciplined in executing on those initiatives. In certain areas, from a contracting standpoint, we have opportunity to really get a little bit more advanced than we currently are today with performance-based type of milestone billings. And we have opportunity to do that. I think we lag our peers in that area, and that's something that we've been trying to drive more in our contracting. And so if you think about us, it's probably -- what our goal is probably 3 to 4 years per year. If we think about the context of $3 billion in 2022, that's been our target around 3 to 4 additional days in 2022 to get to $3 billion, and that will pretty much hold our working capital flat and it will enable us to drop through the benefits of the net income in our cash flow. And so we're not a $3 billion in '22 and it stops there. Our working capital opportunities are pretty significant. And again, some of these E3 foundational operational, which are largely cost reduction, but they also support lead time reduction as well, which, as you know, will also reduce our requirements for inventory carry. And so that's where we see our opportunity. Similar to E3, we see -- we're pretty confident in that. And again, we continue to have disciplined reviews. Both Chris and I as well as Bill have had since the merger every Monday, we go through different sectors and businesses and go through what the working capital progress is, what their initiatives are and ensure that they're on track. And if there's anything -- any help they need from the corporate office or the segment, we make sure that's deployed pretty quickly to get them back on track. But for the most part, they've been able to execute quite well. And I think the key focus for us will be on inventory, that's where the opportunity for us, coming back to that, is.

And I'll just say that what I think is unique and differentiates us is we've really linked the E3 and the working capital together. So there's -- there are things we can do to make us more effective and efficient, but we also look as to whether that's an added working capital benefit or maybe a headwind. So I think that integration and alignment is critical. And Jay mentioned the $3 billion. I always like to remind Doug, you and others, that on a free cash flow per share, we're looking just shy of $14 this year and probably close to $15 next year. So from a valuation perspective, I think those are pretty good numbers to keep in mind.

Well, we're going to have to wrap up here, about out of time. So -- but I'll just ask, Chris, maybe you could leave us with the thought on if you had to look at your #1 opportunity and #1 challenge as you come into the CEO role, what would you say?

What I'd say, well, the opportunity is year-over-year growth not only on the top line but the bottom line and the free cash flow. And the foundation that we built this first 2 years is really positioning us very, very well. And the strategic rationale for the merger, I think every day goes by, it's just more and more solid. So I think it's keeping that momentum and going forward. I think the biggest challenge we had was navigating this pandemic, and I'd be remiss if I didn't thank the workforce. I mean we had half the workforce coming in every single day, meeting commitments in the factory, plexiglass, masks, everything we could to keep them safe. And I think that's -- that was a challenge we overcame. Thinking ahead, I think it's just keeping the momentum. And I'm a big believer if you have momentum, positive momentum, it kind of feeds on itself. So just no unforced errors, no mistakes. But we're hiring 7,000 people a year, even during the pandemic, we've adapted to working in a hybrid model. I mean everything seems to be clicking. So just keep executing on what we're doing and keep the momentum is what I'd say. So look, I can't tell you how much we appreciate the opportunity to participate today, Doug. And as we said in the beginning, maybe next year, we can all come up to New York or wherever you are and do this face-to-face like the old days. But on behalf of Jay and I and the L3Harris team, we appreciate the conversation today.

No. Thanks, Chris and Jay. It has been great. And totally agree, next year, hopefully, we're in person. So thank you.

Thank you.

Have a good day. Thank you all for joining.