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

All right, everyone. We're going to get started. Well, thanks for joining us. This is the kickoff of the 39th Annual Barclays Industrials Conference. We're super excited to be back in person this year. It was quite the struggle to make this happen, but we're here, and we want to thank our events team for putting in all of this together and a lot of work that went on behind the scenes to get down here. So I'm David Strauss, U.S. Aerospace and Defense Analyst for Barclays, and we're pleased to kick off the aerospace and defense track today with L3Harris, Chris and Michelle, and thanks for taking the time to support our conference. So let me get started with the big picture. So we kind of have 2 budget processes going on, I guess, at this point. We've got fiscal '22 that still hasn't been concluded. It looks like we're going to have an extension to the continuing resolution. We had an authorization bill that was passed and looked very good. Maybe you could touch on how the authorization bill looks for you all, the path may be for an appropriations bill. And obviously, there's starting to be some things that are coming out with regard to '23 and when we might see '23.

All right. Well, good morning, and thank you all for being here. It's good to see you. I have [indiscernible] thoughts. It's good to be in person and good to see everybody without masks. And thanks for coming to our home state of Florida. We appreciate it. Now it's been an unusual year. It's been an unusual 2 years due to the pandemic. And I think -- as I look back, I think the industry did a pretty good job navigating all the uncertainty with the workforce, the vaccine mandates and such. So very proud of the people. We had half of our employees come in each and every day. But you layer on top of that the budget, which is kind of a key driver for our company and the others will be talking to. There is a difference between authorization and appropriations, and ultimately, it's about the appropriation bill where the money is. As you said, the CR has been extended. Everything we're hearing is that we should have something in March relative to an appropriation bill, not only for defense, but all 12 appropriation bills, so some of the other -- all the other government agencies in which we also have a part of our portfolio. And so I think that's going to look good. Everything we talk about with the merger being in all time domains, there's a lot of money going to space, which plays well for us, Maritime, Cyber. So we're pretty comfortable with how it's playing out. So we'll have a '22 budget halfway through the fiscal year, but Michelle will comment in a moment how that ties into our guidance. But shortly after that, we expect to [ buy that ] for '23 to '27. And again, there's been lots of rumors or press articles that are suggesting something in the $770 million top line for '23, which I think would be good for us, good for industry, while the inflation headwinds that we'll have to absorb, so they [indiscernible], it's flattish, but that's the starting point to '23. We'll be interested to see if it's a couple of percent growth thereafter. We could be in the $800 million range top line. So anything you want to add?

Yes, only to the comment around the continuing resolution. So our guidance does assume that, that gets rightsized, if you will, by the end of March. And so if that continues, we would have a headwind related to that. And I think the key word here is fluidity. You're going to hear this a lot, I think today, in terms of whether it's supply chain inflation budgets, it continues to be a very fluid environment.

Yes. So I wanted to touch on that next.

So he is asking [ good ] question.

Yes, exactly. You're turning it around.

Whoever wants to take it. So you've guided 1% to 3% top line growth this year. You talked about supply chain challenges. You have a couple of headwinds, specific headwinds like on F-35. Maybe touch on the guidance as well as the longer-term growth algorithm that you've talked about between domestic, international gross revenue synergies. And you've targeted this mid-single-digit range and whether once we get past some of these video [ syncretic ] issues, I guess, in '22, if that's still the right way to think about the top line growth potential of the company?

All right. Maybe I'll start with '23 and then Michelle could do '22. So I think longer term, based on what we're seeing, there's a potential budget, we're in that low to mid-single-digit top line growth. Some of the accelerators that we have that are unique to us, I mentioned revenue synergies. So when we put the 2 companies together almost 2.5 years ago, I think this was one of those pleasant surprises. We knew we could get the cost synergies out. We knew we could do best in noncore businesses. This was a little faster and larger than we expected. So we have over $1 billion of orders as a result of both the 2 companies together. I think a lot of the space, prime positions that we won recently, like SDA tracking, HBTSS for the Missile Defense Agency would not have occurred. We have a pretty strict internal definition, which is neither company would have bid this have we not merged together. So $1 billion of orders, that's given us about a 1% tailwind. I think at some point, maybe this year, we're probably going to stop trying to calculate. We're just going to win more, bid more, not trying to figure out if it was a synergy or not. We were -- we thought we were lagging where we shouldn't be on the international front, but we've had close to double-digit growth internationally over the last few years. So that gives us [indiscernible] percent, if you will. And we have a unique model internationally because we're one of the companies that have both products and programs. On the product side, we use what we call CDRs, consultants, distributors and reps for like radios, turrets, night vision goggles and programs. We have [ 10 focus ] companies where we have in-country executive, local country nationals or expats on the country to develop those relationships, and that model seems to work quite well. So now we take the base budget and we have those to accelerate time and again. So aspirationally, I'd love to be mid-single digits for '23 and beyond. We just need a little more visibility.

Yes. So to your point, we did guide to 1% to 3%. And if you look at that across our 3 segments, all 3 of our segments are growing within 2022. It is a bit offset, however, from a headwind, from a supply chain perspective. So I'll start with our Communication Systems business. You may recall that at the end of last year, this was a business of experienced impacts as a result of the electronic component shortages from a supply chain perspective. So we saw that headwind at the end of last year. We'll continue to see the headwind in the first half of this year, with that recovery projected to be in the second half of the year, very much consistent with what you're hearing from an overall industry perspective and the totality of the electronic component supply chain recovery, if you will. So that business, we're anticipating a 2% to 4% growth within 2022. Our Integrated Mission Systems business, we're also anticipating 2% to 4% growth, really driven by the demands that Chris mentioned, our Maritime business, and also a recovery of our commercial aviation business as well in the second half of the year. And then from a space perspective, we're targeting -- we have a guide out of 0% to 2%, really a tale of 2 cities here. F-35 development starting to go down a bit of a valley, if you will, in 2022 before that projection starts to ramp in the post-2022 time period, offset by growth, continued strong mid- to high single-digit growth within space, Intel and Cyber.

I'd like to just chime in on -- so we talked about, I just want to highlight, through the whole income statement set of financials. We're growing the free cash flow per share close to double digits, which is more than our EPS growth per share, which is more than our top line. So I think it's the perfect -- you got the top line, EPS is growing more free cash flow, we had a good conversion rate, implies margin expansion dollar efficiency. So just to bring down the whole story, I think it's a pretty good setup.

So I want to dig in a little deeper on one of the segments. So SAS, I guess of all the guidance, the biggest spread, at least to me, was the lag to 2%, kind of flattish, maybe down margins for SAS. So maybe just a little bit more detail in terms of the moving pieces there between the avionics business response in space. What's going on with missile defense? Just how the different pieces are laying out?

All right. I'll take revenue, you want to do more?

Yes.

All right. So the -- yes, when you look at the sectors or the domain, space is growing mid-single digit plus. It's really been on a roll in space. Historically, if we were a supplier of payloads to exclude satellites, what's happened here, the customers have seen -- I think the industry has realized that value is impacting payloads. So we have these unique payloads, which we've resulted in priming and the buses in effect have become the commodities. We've been very successful in response with SAS. I mentioned for the SDA, the missile tracking program, of course, for missile defense. And I never -- I know it's never satisfying, but there's always those classified programs that we can't talk about. So space, both the LEO, the GEO and actually on the ground, we've been very successful [indiscernible] in the ground space program. So that's growing quite well. We have about $1 billion of cyber business that again is highly classified, but both all sensitive defense and cyber. We made a few acquisitions premerger, and those are doing quite well. So I look at that as mid-single digits. When we consolidated from 4 segments to 3, we have work that we do for the FAA, it's called Mission Networks. There's a big multibillion dollar recompete later this year for the FAA. But that's historically just been flattish business. So some of our $50 million of revenue, that's kind of flat and always has been and probably always will be. But the headwind is really on the air domain. And you call it the valley, I'll call it a bathtub. We're going to have 3 simultaneous bathtubs occurring with the F-35 for the transition for on Tech Refresh 2. We're working on Tech Refresh 3. 2 is winding down. We do development on 3. That's winding down. And the production then later this year in '23. So I call that the F-35 bathtub. F-18, we have a lot of the capabilities, maybe some process of going to the next-generation advanced EW. That's going to be a mod or existing contract or competition you're trying to figure out. You kind of have the EW bathtub, the F-16, or what we call Viper Shield, it's a big opportunity internationally. That's been slowed down just because of the pandemic, in my opinion, some of the pressures for these international budgets. So between the F-16, the F-18 and the F-35 going through these simultaneous bathtubs. We're experiencing the stiffer headwinds. So 1 market shrinking, once flat to growth, from 0 to 2 for the year. But longer term, very optimistic, and we do work on the B-52 and all those other aircraft and next-gen aircraft. And those are kind of '23, '24 initiatives, so good technology.

And before we get to the margins, say, on F-35, you said it's around $1 billion a year, that's dropping $150 million or so this year?

That's what I said. That's what I look at. Yes.

And Michelle, you touched on the margin...

Yes. Just from a margin perspective, I'll just take the bathtub analogy times 3 of those bathtubs, if you will, play into the margin story as well. So we do have a bit of a tailwind in terms of F-35, and that development is starting to wind down. But that's essentially being offset by a lot of new program wins. And as this group probably knows, there's upfront investment that goes with those new program lines, but we expect that, that rebounds as we start to move out of development into production in the later years. So very attractive business, as Chris talked about.

So I wanted to move on and touch about -- touch on margins broadly for the company and the opportunity still from here from E3. Obviously, you've had the upside from synergies on the back of the merger. So just maybe touch on the opportunities still with E3, the different buckets that you've identified, which is the biggest bucket? I guess you talked about factor out the optimization supply chain overhead, just how you size each of those projects.

Yes. Let me take an overall comment. Michelle can get into the E3 detail. So first, I can point out for those that don't follow us too closely. Back in January, we stripped out all the pension income with that below the line. Just so you and Michelle and I get better visibility to the no kidding operating results. So we're kind of in the 16%, you thought of us as having 19% margin with 16% operationally. So you can see that. And I'll just -- relative to margins, that's clearly an area where we want to drive. But I look over the life cycle of this industry being a defense contractor, you want to win new business, first and foremost. And most of those, if not all those businesses start out with lower margins, especially the cost-plus program. So on the cycle, I want to win new business and I want to bring in, unfortunately, but the way it works, lower margin business. 2 or 3 years later, it transitions to production, that's where you get the big step up. And then ultimately, you want to export it to get even bigger spend and step up. So I look at it as a portfolio of new business production, international and you want to have business in all parts of that, right? So clearly, the margin improvement is an initiative. But at some point, if we get to 20% margin, you should be concerned if that would be just from not winning anything, so I'll just leave that as a philosophical statement. Do you want to tell how we're going to get margins up...

Yes. Before we fall off the cliff, apparently. Yes -- so clearly, E3 is an important part of what we drive in terms of margin improvement. To Chris' point though, to reinvest back in the business to grow, so it's not just about driving bottom line, but it's about having the financial flexibility to be able to grow the business from a top line perspective as well. So we really think about it in 3 pillars. One is kind of the traditional factory optimization. Think about that as your traditional productivity cycle time improvements, which, by the way, is our single biggest lever in terms of driving bottom line performance. The other is around engineering excellence. Think about this as IA -- is that right? No, AI. I'm saying this backwards now. Think about that as like machine learning, building into your processes in an automated fashion in terms of as you see errors, if you will, or quality defects, that fixes itself within the system. So you're not having a person have to touch it from a cycle time perspective. And then the third would be really around our facility rationalization and supply chain. And so I'll give you a great example of this. This has actually just hit my desk yesterday, at least renewal. You would think, "Oh, as the CFO, I'm not going to be happy about this. We're continuing to have the footprint that we have." When I dug into it a little bit more, however, it was actually taking 2 facilities, combining them into one. So factory rationalization, couple that with employee engagement because we were actually doing some upgrades within this facility whilst creating a layout that aligned with our E3 philosophies, right? So we were driving a more efficient design in this new facility that we were bringing together, own and couple that with, it's actually going to be a more sustainable facility on top of it. So you got a win-win, win-win in terms of all the initiatives that we're trying to drive across the organization. So I think where we have the opportunity is really in combining a lot of these initiatives and ensuring that we're meeting the long-term objectives in terms of driving bottom line, but also being able to reinvest back in the business as well from a growth perspective.

And on the reinvestment, as you've heard us say, we spent a larger percent of revenue on IRAD in terms of research and development, close to 4% for the very reason we have the ability to still have, I think, the best margins in the industry that's more in R&D positioning us for longer-term artificial intelligence...

Yes, that's the word I was going for. That's right.

Yes. I'll just throw in a point on sustainment. We spend more time than you might imagine focus on ESG. We'll be coming out with our second annual report on March 14, I'm very excited about. And there's so many different rating agencies but Sustainalytics seems to be one. We're very proud to have best score last year in the industry, our first year out. And it's kind of like golf, the lower the score better because when I got a 29, I was a little nervous. But apparently, that's better than a 39. So it's something we spend a lot of time on. And I think it makes a difference from employee engagement. Of course, you heard the Pentagon is focused on climate and these initiatives as well. So I'm sure many of you were focused on ESG and...

So in terms of, I guess, going back to E3, I mean, is it the right way to still think about that 20 to 30 bps a year in terms of what you think you can generate from E3?

Yes, I would say so. And this is net of all headwinds, inflation being the biggest. So this is the year where when you look at our guidance, you might say a 10 of 12 bps improvement. But we try to be realistic given the tight characteristics this year, and I think it was different from this program. It's really more -- when we focus on the cost, it's really more of an operating model and philosophy. So we have quality. We have environmental health and safety. Everything comes under this philosophy. Continuous improvement is one, and so it's been with other companies I have as well. I think this is a holistic game changer. It's not just putting out RFPs, trying to drive the supply chain. We're looking at the first batch you rolled throughput yield, that's really taken how we will make this business more efficient versus right shops and just trying to get a lower bid from a supplier.

Yes. And I'll just complement that to Chris' point. My most recent experience within the commercial environment, I think our secret sauce is really in that holistic approach and not having the siloed work streams, whether it be productivity, cycle time or sustainability, but how do you integrate them all together to really drive the 1 plus 1 equals 3 impact.

So Chris, you brought up growing cash flow at free cash flow per share at a double digit or close to double-digit rate. So a big driver of your cash flow growth has been focused on working capital. So when you brought -- the 2 companies came together, I think they're working a couple of days, we're in the 60s, close to 70, driven that down. But I guess, last year, you did have some growth in the inventory contract assets payables kind of offset. Just talk about the moving pieces of working capital through here, where the big opportunity is and whether getting down to that work at 40-day level is realistic? And if so, by when?

Yes. I'll tell you that this has been a key focus. I mean cash, like all the metrics, but cash is a good one. And our balance sheet has some inefficiencies. We've really streamlined and focused on CapEx as an example, brought that rate down over a couple -- last couple of years. And my focus and the team's focus for the most part has been on the inventory, how do we do our business differently? And some of the growth we saw, if you have these great initiatives, looking that long ago, everybody would be proud of the just-in-time inventory system or vendor-managed inventory. But with the pandemic, with the headwinds, with the supply chain basis, we adopted our smart inventory approach, which is what key components, especially on like products, should we start buying sooner and earlier so we can deliver. And I think we were hit a little more than most peers. I think everybody was hit, but we were [indiscernible] more from us was because of our products, such as radio, night vision goggle, where we recognize revenue on delivering. So it's just part. You can't make delivery. You can't book the revenue. So that's why we're back-end loaded this year. I'm a little nervous about the radio business. But when I look at it, we have 3 major competitions. We won the majority for all 3. We have our largest backlog in history. We have the highest book-to-bill. So this is just a slip. Nobody is not by our product, we're just slipping. And amazingly, we haven't missed a customer commitment contractually even with the headwinds. So the growth was in the -- as a result of the supply chain. We're now ordering, lead times are nowhere close to what we've seen in the past. It used to be a couple of weeks, now they're 40, 50. We placed the orders for probably 85% of what we need is right to 2023. We placed all of our orders for '22 because of the lead time. So all those dynamics, but a little bit ahead for the underlying initiatives on inventory is really recently remodel, would we do differently, take the time, fundamentally change the way we do business. We have too many SKUs on certain products, what are we selling, what for? We don't need parts for something we delivered back in the '80s. Our customers, here it is. And you know what adds up? We have thousands of schemes in some of these businesses for 1 or 2 off sales, like we're not going to do it, shut it down, focus on the new technology but the new growth. And like everybody in the industry, the government increased the prog pay, progress payments from 80 to 90. And to keep the supply chain going each and every company, the only way to get it to a small business was to give it to us to give to them that sale. So we did that as well. I don't know if there's more you want to...

No. I think the only other thing I would share, just based on my 4 weeks in at this finance, there certainly is much more of a rigor around cash management and working capital and a focus in terms of kind of what I call basic hygiene in how you manage inventory, accounts payable and AR in comparison to my previous defense space is what I would say. And so what I'm excited about coming in is being able to deploy a lot of those commercial tactics that I've learned over the years in an environment where we've driven a culture through the E3 program, where people get it, the value of a good cash management, not just good bottom line P&L management as well.

So our last couple of minutes here before we get to audience questions. I want to touch on the balance sheet. So overall, you're less than 2x lever. You have a headwind potentially still, I guess, from the R&D amortization issue. We'll see what happens there. So how are you thinking about the balance sheet, using it to potentially augment cash returns and then cash return to shareholders? And then you started discussing the potential maybe for a small bolt-on M&A, and now you've come through the divestiture process thoughts on the M&A landscape.

Yes, we are underlevered, so that's a fact. Everybody assures me the R&D capitalization get repealed or deferred. So until that happens, I thought it was appropriate to give guidance based on the current law. We're focused on returning cash to shareholders. We had a record since the merger of both companies, premerger, the annual dividend increases. So that's something we review with our Board generally in the first quarter of each year. So I would expect that you'll continue to see dividend increases. We talked about the share repurchase. Now most people -- and we led you to believe it would be $2 billion. I took it down to $1.5 billion this year because of R&D. Obviously, what that does will increase the cash -- free cash flow guidance will increase the share repurchase guidance. It's just -- I think we're just a few months away from what I've been told. But we'll see what happens there. Then on the M&A front, I think I said medium on -- we were -- it's called small to medium. But these are just adjectives. We don't even know what this means. So I kind of throw out numbers like something in the $1 billion range, I would say. The reality is there aren't that many properties out there, but we're not the first to make an acquisition. So that's part of our growth strategy. When you look at the different blocks, it's going to be defense technology. There's some great defense service companies out there. Harris divested a bunch of theirs premerger. L3 divested a bunch. We're not a service company. We're a technology company. We're not going to diversify outside of the government in the tech. So we're not going to build into the commercial market. We're not going to do anything transformational. We're looking for $500 million, $1 billion, $1.5 billion-type acquisitions that augments our portfolio. And what I like about the portfolio, when everybody likes what they have, what I really like is we have a pretty good presence in each of the 5 domains in space and here and there, prime, land, cyber. And then we hear all about the connectivity JADC2, ABMS, it's all about resiliency, it's about comms. We're in the sweet spot of the volumes. So as we try to communicate, I think 3 of these domains, from cyber, maritime, space, are growing really well. Air is going through this transition. A lot of those capabilities have moved into the space from a customer's perspective. And land is about 10% of our portfolio, mainly the radio, night vision goggles. That's solid growth with a bright future and we keep winning, so that's the...

All right. Can we choose the most insane part of the presentation for fireside chat? Can we queue the audience questions?

We just learned about this 28 minutes ago, so this is an immediate feedback, right?

Yes. Hopefully, it works.

Hopefully, it works.

Okay. The questions don't appear up on the screen. Okay. We'll get you the feedback.

We do show [ a hand ].

Yes. Questions?

You guys [indiscernible] to ramp up to 2023. [indiscernible] in year 1. So any macro insights that [indiscernible]. We aren't hearing much. As investors, we're not hearing really anything. So can you give us sort of like your view on 2023?

Okay. I mean the question -- yes, that question is basically macro insights for '23 budget and beyond. I understand investors don't have a lot of visibility and insight. And actually, industry doesn't look like they have a lot of visibility and insight and spend time with the Pentagon on like others, you talk to your customers. They're still working it. It's always -- I think what the DoD has done well for the last decade or so, similar to the business, they start on strategy and they've developed their strategy and the budget line on the strategy, which sounds obvious, but there's probably times in history where there was no correlation. So I think we have a national defense strategy, the classified one, which have seen the unclassified one, which you can't see. That talks about the talked about the near-peer threats, right, when you hear the secretary, everybody say China, China, China is the focus. So you look at space as the next warfighting domain, right? So it's all about space. We stood up as a country, the space for us. So I would be surprised that there is not more money in space and then maybe a maritime with a focus on Indo-Pacific region I would think would do reasonably well. And then from what you read in here, I think the Army is the one that's kind of the bill payer for the other 2. And Army is 10% of our portfolio, maybe in Air Force and space force, our larger customers in addition to 20% international. So I think that's where you're going to see and it's a combination of how you've taken legacy platforms, like a B-52, where we won a $1 billion IDIQ to upgrade and modernize it mainly on an electronic attack or EW capabilities with new and next-gen systems. And clearly, you need stealth, you need lethality, you need speed, those types of things. And I'm just not that familiar with ground vehicles. We don't have a lot or any. But you would see where does a ground vehicle or a tank help you with China. A lot of people would say no. So I wouldn't expect to see any failure. That's a good space to develop the next-gen aircraft. So hopefully, that helps. But we'll all know it will take time, I think.

All right. We're out of time. Chris, that's all. Thank you very much.

Thank you.

Thank you.

All righty.