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

Okay. Thank you, and good morning, everyone. Thank you very much for joining us today. My name is Peter Arment. I'm the senior aerospace defense analyst here at Baird. We're very pleased to have with us the management team from L3Harris Technologies. This is a fireside chat. We refer to anyone via the web portal, if they have a question to do so. And if time permits, we'll try to get that addressed. From L3Harris, we have Jay Malave, Senior Vice President and Chief Financial Officer, joining us today. I'm very pleased to have you, Jay, and thank you for coming to the conference. And I know we're going to kick it off with a couple of opening comments and some commentary on where things left off in the third quarter. So over to you, Jay.

Well, thank you, Peter, and thank you for inviting us. It's -- I'm happy to be here and represent the 47,000 dedicated employees of L3Harris. And yes, I'll make a few comments, but obviously, I won't go into too much detail on the third quarter results. We just reported those a few weeks back. And I think just when you put it all together, we continue to demonstrate and deliver the benefits of the merger. We did have a little bit of top line pressure as other companies did as well, mainly related to electronic component shortages. But in spite of that, we delivered some pretty strong underlying results, which continue to show the underlying strong operating performance that we have, our margins were at a record of 19.6% in the quarter. That enabled us to deliver 13% earnings per share growth and solid free cash flow as well. And we continue just to see outperformance in our underlying operations, whether it's program performance, our E3 productivity initiatives and just overall cost management. It has just been a good story for us, and we expect that to continue in the future. During the call, we did talk a little bit about 2022 and we laid out some interim expectations in terms of top line growth around low to mid-single digits. And we'll provide more specific and concrete guidance in January. But again, I think everything at the company is intact. We continue to expect to drive what you've seen over the past 2.5 years since the formation of the merger of the combined company. And yes, we have to navigate and continue to navigate COVID and other effects. But we've been able to do that, I think, quite well. And so we expect that we'll be able to continue to deliver growth for the foreseeable future. And with that, why don't we take your questions.

I appreciate that, Jay. It's a great overview for those who aren't familiar with L3Harris and I appreciate that. I wanted to ask about the budgets and maybe just get your perspective on kind of when you envisioned the merger, the focus was really on aligning the national -- aligning around the National Defense Strategy and sort of the future requirements, really not what administration was in the White House. So when you're thinking about that today, when you look at the primary building blocks and kind of supporting that low to mid-single-digit top line growth, if there is a shift to budgets to more technical needs versus legacy mods or modifications, how should investors think about it from an L3Harris perspective?

Yes. It's a great question, Peter. And I think we have coming -- going into the merger and continue to believe that our key and core capabilities of the company are actually positioned quite well with the defense priorities. And what I'd like to do maybe just take us back to what those defense priorities actually are in the National Defense Strategy. And we're basically 8 elements of modernizing key capabilities for the DoD. That includes modernizing the nuclear triad, investing in space and cyber as a war-fighting domain. C4ISR capabilities and continuing to drive resilient survivable networks and info -- information ecosystems, missile defense, joint lethality in contested environments, forward force maneuvering and posture resilience, advanced autonomous systems and resilient and agile logistics. And so when you look at our portfolio, and we certainly did then and we continue to do now, our key capabilities, about 70% of our portfolio is aligned and consistent with these National Defense priorities from a modernization aspect. And so we're pretty excited that as we, over the past 2.5 years, have sharpened and probably more narrowly focused our portfolio on those core capabilities as well as invest in our R&D towards continuing to modernize and mature technologies in our key capabilities that provide support to these defense priorities. I'll give you some examples. Just when you talk about space and that being a war-fighting domain, we have developed and continue to develop responsive satellites. We were successful in our SDA tracking program as well as the HP TSS programs, we've talked a lot about that. We've also seen some strong success in ground systems, and it's just a number of classified programs that we have won and we have won as a prime provider to the DoD. We've had, in the past 18 months, about 11 prime wins in our programs. We're pretty excited about being able to deliver that capability to the customer. But that's just 1 example of us really where you're seeing budget shifts towards these areas and where we not only can provide a solution to the customer, we're actually being selected as the prime provider of that solution. In sea and maritime, you talk about the nuclear triad, we obviously have significant content on the Columbia class. We also provide significant content on the new Constellation frigate. And we're also a prime on the medium unmanned service vehicles. So when you talk about autonomy and autonomous with a prime capability there, we're also participate in a large unmanned surface vehicle as well, as well as undersea vehicles and potential programs. In the air domain, we provide the multifunction processor under the Tech Refresh 3 program for the F-35. That's a key capability to enable not only just more computing power to bring all the mission systems together and let them be integrated more effectively. We're also, as you know, Peter, very strong in ISR capabilities and some of those may be legacy programs like the Rivet Joint, but we see those programs because of their core capability, their exquisite capability, those programs really surviving for a long period of time into beyond 2030. Cyber, we have a strong $1 billion business there. And we have a very excellent capability as far as dealing with offensive solutions for ultra hard targets. Obviously, it's classified. We really can't speak much about it, but it's a very strong, solid business there that we expect to continue to grow over the next -- over the medium term. And in land, everyone knows, I think about the radio capabilities that we have. We have these 2 army modernization programs that just kicked off for production. We won majority shares on both the handheld as well as in the manpack. And I think that is further evidence and endorsement by the Army and the DoD having resilient networks, resilient communication solutions for the customer, and that extends internationally as well as allies try to be -- or try to extend interoperability with the U.S. So pretty well positioned, we believe, as the budget shift towards these modernization capabilities. I mentioned a little bit on Rivet Joint in terms of our legacy programs, maybe about 1/3 of our revenue exposure is on these legacies, I talked about the ISR, which is just the continuing need -- we may see some pressure on programs like F-18 and things like that over time. We heard that the Air Force talk about -- I'm sorry, the DoD talked about A10s and things like that. We understand that, and there probably will be just about every defense contractor has some exposure to these legacy programs, so that will provide a limit about head -- a limited amount of headwind. But when you talk about 70% exposure to the growing capabilities versus the 30%, you should still be able to drive some pretty solid growth over the medium term.

So it's a great rundown of kind of those key building blocks because I know you're -- it does look like you've got a lot of key capabilities that's going to enable to continue to drive top line growth. Maybe one of the questions we get from investors, Jay, is around kind of O&M exposure. If you could size that for us or at least that there's a perception out there that some of your portfolio, the portfolio is shorter cycle than your peer group. How much of the portfolio do you view as short cycle and converting into kind of from backlog into sales that still maybe lasted 12 months?

Sure. Yes. And yes, I'll answer that maybe in 2 ways. I'll just talk about O&M for the moment. About 20% of our overall sales, so you're talking in the range of $3.5 billion is exposed to DoD O&M. And when you look at that, we have some pretty significant program of record exposure in that. And so I'll talk about that in a few minutes here. But we feel pretty good about where we are from an O&M because it's these types of things, whether it's ISR type of capabilities, where it's not just taking -- just providing new products, it's really continuing to modernize and it's really in that vein where we have a little bit a significant amount of our exposure. And so we're actually pretty comfortable with that exposure that we have from an O&M standpoint. On long cycle versus short cycle, our business, and I think you've got the right way, I mean we look at it in terms of anything that's over a 1.0 book-to-bill in terms of annual revenues. And in our case, about 60% of our revenues are long cycle. So it doesn't make us a short-cycle business, I think you had it right. We're probably a little bit shorter cycle than other defense primes, but we're certainly not short cycle business. And if I talk a little bit more about where these short cycle businesses may be, tactical radios is one. And again, this is -- we're going through a modernization cycle. I'll just refer to that a little bit, but we're in the early innings of a modernization cycle. The DoD has an installed base of 1 million units. This modernization cycle that we're going through is only going to modernize about 1/3 of that installed base. And of that, we're only about 15% of the way through. And so we saw the current -- the most recent procurements for production on the Army HMS programs, both the manpack and the handheld. And from our perspective, that was an endorsement of the modernization even in this budget environment that we're in. And so again, I think what's underpinning that is really the need to maintain a capability to communicate on a resilient basis, and that's exactly what our products in tactical radios is providing. Night vision is similar there where we're providing a pretty unique capability with our ENVG program. That program of record is about 100,000 units. We're just starting delivering of the 6,000 units of that. So very early innings there. It is dual sourced. But again, in that program, on the most recent production award, we did win the majority share on that one as well. And so we're excited about that program and continued modernization there. And then as I mentioned, ISR is just -- for us, ISR, in total, it's about a 3 -- a little bit over $3 billion business. And we have some longer scale programs in there and then we talk a lot about Rivet Joint and Rivet Joint-type programs. When you talk about singles intelligence and it provides an exclusive signals intelligence capability, to Big Safari, that's something that we, again, as I mentioned before, foresee that being sustained for a longer period of time, even beyond really the medium term. And so when you look at our exposure, whether it's O&M or exposure in the shorter-cycle business, they're underpinned by their modernization or a key requirement capability that the DoD needs going forward. So it's not like a sustainment of these legacy programs that we see being retired, it's actually modernizing a capability that the DoD is going to continue to need over the next 5 to 10 years.

Yes. No, that's -- it's a great way to put it. I mean a lot of short cycle -- some short-cycle exposure, but it's core to the DoD. So very, very helpful. Maybe, Jay, if we could just turn to space. Space is an area that's just got a lot of interest from the community. What are the opportunities maybe you're going to call out for L3Harris that you see as well that you're really well positioned on? And should we be expecting maybe increasing book of bills related to space?

Yes. This is an area -- it's exciting for us, and we continue to move up the value chain here from a component provider to a payload provider all the way to a space vehicle provider as a prime. And when you look at maybe our revenue breakdown today in a $2 billion business, we still have 40% exposure on these exquisite systems that will go into orbit over the next few years. 20% of it is on these responses smaller type of satellites, and then 40% around in ground systems. And we're really seeing a lot of growth in the responsive and into the ground areas currently. And so we've got a solid base in terms of exquisite programs with growth in responsive and ground. And a lot of these, I mean, you can't talk about those specifically because of the classified nature of the capabilities being provided. But I mentioned before, National Defense priority space being -- becoming a war-fighting domain. What that means is that the mission set, there's 2 things that are happening. The mission set is increasing in space because it is becoming a war-fighting domain. Also, what we're doing, what we're seeing is that these smaller responsive systems are providing augmentation to these larger exquisite systems to provide a level of, say, redundancy or level of protection to maintain a resilient type of capability in space. And what that is doing is it's driving some significant requirements. And so as I mentioned before, we've had 11 prime awards in the last 18 months that's both in -- on orbit as well as in ground capabilities. And we continue to see a lot of bit of proposal activity around that, and we expect that to be a solid grower for us for the time being. And we've talked about solid growth in that area being mid-single-digit plus. This year, we're delivering 10% growth. So to be honest, we probably can't see stronger growth from what we're projecting forward. But again, it's dependent on timing of budgets and timing of awards and all of that type of activity. But bottom line, when you look at our capabilities, we provide RF capabilities, radar-based imaging, communication links and other intelligence capabilities. We provide electrical optical capabilities. It enables Earth-based as well as space-based observation and then also infrared. So that labels to detect, and this is weather domain, but also in missile tracking, and that was really the basis of our wins on the SDA tracking as well as the HBTSS programs. And so you're just seeing -- we're seeing this tremendous amount of expansion of mission capability in space. And given our capabilities on these core technologies and our payloads, we're in the thick in the middle of pretty much all of the activity that's happening there. We're very excited about this franchise growing, as I mentioned, mid-single-digit plus in the foreseeable future here. So again, you'll continue to see that our book-to-bill, it's pretty solid here. Year-to-date, we're around 1.15 and pretty strong, and that will drive us for growth next year and beyond.

That's great. That's great. That's -- it is a very exciting area, and you guys are right in the heart of it, so that's a great rundown. A circle back to one of the building blocks on kind of low single-digit, mid-single-digit organic growth is revenue synergies. What product areas are you seeing kind of the most progress on and our best kind of practices emerging from this effort that can be shared throughout the L3Harris organization.

Sure. Revenue synergies, again, it's just been a bright spot for us. And we've won about $900 million of awards to date on 50-plus separate awards and they vary in dollars. The pipeline, you're talking $7 billion of pipeline that we continue to compete for in life of program opportunities. We're pretty comfortable with it being able to contribute about 1 point of growth per year on a compounded basis for the foreseeable future here in the medium term, and we're pretty excited about that. And when we talk about specific areas and products, it's space has been an area where we've been able to really bring capabilities together. As I mentioned, the legacy Harris had a lot of the capabilities from a payload perspective, and I talked about RF, I talked about EO, I talked about infrared. What the legacy L3 businesses brought together was the ability to integrate systems on the space vehicle itself and enable us to be the entire space vehicle provider, including the payload. And so this is things like Avionics, communication systems in other areas, and we've been able to integrate and make us more competitive on these awards that we've been winning on. And so that's an area that's been -- we've just been able to really -- that's really where we've seen some significant success. I'd say airborne opportunities probably in -- more in the classified areas, we're able to bring different capabilities together and new technologies on these kind of NGA-type of programs in the future. And things that just an example of things that we're working for multifunction apertures which is really bringing together different mission capability sets. And having 1 aperture that enables space electronic warfare, enables communications and enables signals intelligence all together in 1 system. We -- when you think about the value to the customer, it provides lower size, lower weight and less power consumption. And so when you think about future technologies, we're able to integrate different mission capabilities together and drive technology maturation to be able to bring that to the customer. And so those are areas that just this multifunction area that we've been able and we just continue to mature our technology and drive value propositions to our customers.

Yes. No, it's the revenue story and L3 has just been one that is a good news story and one that just keeps getting better, so it's really fun to track the progress. Another area that within the DoD that's getting a lot of attention is JADC2, it's constantly hearing about it from your peers as a major opportunity. Do you see this as L3 playing has an opportunity on a broader effort? And if do you have any kind of differentiating capabilities that are bringing to the table and opportunities that you might be targeting?

Yes. I mean I think the answer to that question is yes and yes, pretty emphatically. Certainly, the customer, the DoD customer views us as an imperative to really bring together disparate -- what has historically been disparate platforms and sensors and the like in being able to network them and so they can act with the appropriate course of action more quickly. And in our case, when you think about it, we -- I think Chris has talked about this in this context where JADC2, you boil it down, sense -- make sense of the data and the information and it act on data and information. In our case, when you break it down, those 3, our sensing capability is incredibly strong. Our EO/IR sensors, our singles intelligence capabilities, our radar capabilities as well as domain capabilities, domain awareness. We're able to bring together the things that will detect a potential adversary or whatever the issue may be and bring that to life. Making sense of the data, we have that capability today. And a lot of that is in our ISR and it's really fusing data processing and making sense of it so that you can figure out what take to -- what actions to take on it. And as I mentioned, our signals intelligence franchise and our ISR businesses really do that today. And so we continue to build out our ability to process information and to put it into a synthesized basis so that you can take action on it. And we're pretty capable there. We're pretty excited about the opportunity there and finally acting on it, we have various forms of whether it's electronic warfare to provide some level of effect. We're also a player in maturing technology and weapon systems. I mean so those are areas that we will be able to deliver as well. And so when you talk about the different areas of JADC2, we have capabilities that are just in all aspects of it. And just to give you an example, from a communications standpoint, resilient, we're upgrading the E-4B platforms for satellite communications and making it more resilient, survivable and interoperable with this JADC2 type of infrastructure. And so as we upgraded today, it's being done to be able to enable it to interoperate with the future communications capabilities in the future. And so there's a few other programs that were also participated on. There's your classified, but yes, we're really right in the middle of -- in the thick of JADC2 capabilities. I think Chris, has mentioned in the past, this will be probably a collection of various programs over a number of years. But again, we'll be a player in these various programs as they mature and as they go into a production type of context.

It's very helpful. And it certainly sounds like a lot of incremental opportunities to the portfolio. Hey, Jay, let's just switch over to the operational gains and kind of our remaining few minutes we have here. The margin performance continues to benefit from synergies, E3 program, some maturing programs, you're going to finish the year around, I think, 18.75%. All that -- with all that in context, the synergies nearing completion, what's the best way to frame the path to potentially a margin expansion story? I know potentially towards that 20% level that we kind of mentioned to you.

Yes, it's a great question. And we don't really talk about it specific target per se. I think the way we looked at it is 20 to 25 basis points per year over the medium term, over the next, say, 3 years. And we think that's very doable. And really because of the backbone of our E3 program, the benefit we'll have going into next year, and we've spoken about this in the past, is that there's still some carryover from the synergy program. We have some facilities consolidations that will complete into next year, so that will run into incremental savings into next year. We also continue to really consolidate and improve our -- not only our ERP systems. We've talked about having -- when we had the merger about 75 systems that will go into less than 20 instances when we're complete with that. But we're also just going through transformation as far as digitizing various elements of our operations, whether it's having a manufacturing execution systems, getting better electronic visibility into our supply chain so that we can act quicker and also just drive better performance out of supply chain and better cost reduction there. We also are developing tools and have deployed tools and training to our program managers so they can just manage programs better. When you think about a defense company like ours, we are very programmed driven and we rely on our program managers to drive to a particular milestone schedule, deliver on those milestones and then take a program to a full rate production so we can deliver capability to our customer. And so it's important that we can perform to schedule and to cost on these programs. And we're pretty comfortable that we've been -- just been able to do that. And so when you look at those various areas of cost reduction for us, whether it's in our operations, on our shop floors, really just automating our operations, we're really in the early innings of that. When you talk about things like collaborative robots, also visualization aids on the shop floor, we just really are scratching the service and providing that capability to our operations across the company in the portfolio. We talk about supply chain, again, our visibility continues to improve there. We continue to engage with our supply chain, and we're starting to spend more money and just effort on ship cost analysis as well as value engineering. There's just a lot of runway there as well. And then as I mentioned, the tools to equip our program managers. And then when you think about in the context of a $15 billion cost structure, we're always analyzing and reviewing just our overhead costs and figuring out how to make that better, how to make us more competitive. But that ultimately will continue to drive some improvement from a margin perspective as well. And so when you think at it at a high level, gross -- I'll call it net productivity, net of escalation, whether it's material or labor inflation in the range of 50 to maybe 75 basis points of improvement there in year in and year out. And then we know because of new programs that we're winning that come in that, particularly on the development side with lower margins you're talking anywhere between, say, 25 to 50 basis points of headwind depending on the year. So net-net, you're talking that 25 basis point range that we believe, on an ongoing basis, is doable. And we have the visibility to it, and we're pretty excited about that.

It's great. It's very run down. And obviously, there's -- the L3 is -- continues to be a margin expansion story. So Jay, we have about 2 minutes left, but I think it's important to ask, it's about I know you guys have been working hard on mitigating headwinds in your aero business and supply chain. And more broadly, can you size the COVID impact here and the biggest exposure? And then the outlook going forward, probably a good place to end going into '22? Thanks.

Sure. Well, you know I mean our commercial aerospace businesses were -- commercial aero was about an $800 -- $850 million business before COVID. This year, it will be probably in the 450-ish range for us. So still plenty of ways to go from the peak. We've been pretty -- when we saw COVID, I give a lot of credit to the management team that was running the commercial aerospace business and continues to run it is they were very aggressive as far as cost take out and making sure they can rightsize the cost structure based on the volume reductions that we were seeing. And as we've come out of it, the business has grown pretty much in line with the industry that we're seeing. The commercial era was up around 40% here in Q3. We expect that to be the case in same in Q4, if not a little bit better. That's very consistent with what we are expecting coming into the year. And so we've been very pleased with what we've seen there. We're participating in the recovery. We're winning. We've won some simulator deals,quite frankly, with some key customers or companies that important airlines, so we're getting traction there. And in our Avionics business, we continue to deliver there, and we've seen some bounce back in the aftermarket as well as obviously in the OEM side there. So we're pretty comfortable where that business is heading not only to the fourth quarter, but into next year from a recovery standpoint. PSPC, the public safety business on the radio side, a little much slower recovery. We've been excited about the ARPA, the stimulus funds that are going to stay at municipalities. It's a little bit slower, albeit that we've seen nice proposed activity, but that will probably go -- we probably won't see the benefits of that probably into maybe the back half of next year from public safety. But again, it's consistent with what our expectations. We saw nice high-teens growth in the third quarter. So again, that business has been pretty much aligned with our expectations there. So we've been pretty happy with what the COVID-impacted businesses, more specifically or more directly their recovery situations. Our supply chain, I know we're kind of up against time here, but we're doing everything that you would expect us to do, Peter. We're basically engaging at the lower levels of the electronic components providers down at the OEM level, direct conversations with them to drive and making sure that we're tracking delivery schedules. We have committed longer term as far as commitments for POs to make sure they have the visibility. It's not just talking about it, the -- we're making commitments to them, so they know exactly what to manufacture. And then we're also just in looking at alternatives, and we've been able to -- we've had some successful alternative sources of supply as well as redesigning some of our components. And so all the things that you would expect us to do, we're doing. And I think we're confident we'll come out of the supply chain disruption stronger as a company. As we mentioned on the call, we expect to see some recovery into next year and then recovery -- full recovery into 2023, particularly in the tactical radio business. But I think the key thing there is that we're not losing sales. Yes, they're being pushed to the right, but it's not really a market share issue per se, it's more of just a longer delay in the delivery of the products to the customer.

Well, I appreciate that, Jay. It was a really thorough discussion, one that adds a lot of confidence on the top line, large expansion and still continue excellent cash generation. So I know we're up against our hard break. But Jay, thanks again for joining us. Appreciate L3Harris supporting the conference. And hopefully, we can do it in person next year. Thanks again, Jay.

Thank you, Peter. Thank you for having us.