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

Good morning, everyone. I'm Kristine Liwag, Head of Aerospace and Defense Research at Morgan Stanley. So thank you for joining us today. We have -- our next panelist would be for L3Harris, and we have Michelle Turner. She's SVP and CFO of L3Harris. So welcome, Michelle.

Thank you. Thanks. I'm excited to be here. This is actually my first presentation since joining L3Harris back in Q1. So super excited to be here. Super excited to be representing our 47,000 employees across the globe and all the great work that they do in support of our customers' missions. If it's okay, before we jump into the Q&A, I'd love to give some upfront framing comments because I think it will help color in as we go through some of the more tactical questions. So where are we at in terms of the L3Harris story? We're about 3 years into the merger of L3 and Harris. A lot of great work has been done in terms of cost efficiencies post integration, along with revenue synergies as well. But a lot of work has really been done in terms of establishing a foundation related to our strategy, our strategy of being a trusted disruptor within the defense industry. And so what does that mean? It means we're trusted with the legacy that both L3 and Harris brings to the table in terms of knowing our customers' missions very intimately and understanding how the DoD works. But the disruptor part is our differentiator, and this is what we're bringing to the table in terms of driving value for all of our stakeholders. And so what does that mean? It means that at the foundation, innovation is core to who we are as a defense company. And that innovation can come from various sources, diversity in terms of innovation. It doesn't have to be invented internally within L3Harris, even though we do have industry-leading R&D, but we are very open to partnering externally, whether that be through commercial entrants, like a Palantir or an Anduril, or through incubator funds where we get access to early technologies in advance of them maturing to enable our portfolio to become a 1 plus 1 equals 3 type of solution. So our differentiator is about that openness to innovation regardless of where it comes from with the lens on quick capabilities, agility and the ability to get those innovations in the hands of our war fighters in a timely manner, especially in an environment today with such a heightened threat environment. Now our strategy is working. So I'm super excited to be here because I've got tangible examples of awards that we're winning as a result of that. And we'll talk about those as we go through the Q&A. But at the same time, I also want to recognize, I'd be remiss not to acknowledge the current environment. Similar to our peers, we too are also struggling with some short-term headwinds in terms of overall execution, whether that be supply chain, labor attrition or inflation. Those are also acute pain points for us as well. And so what are we doing within L3Harris? We're focusing on what we call controlling the controllables. We're trying to remove ourselves from being distracted by these macroeconomic ecosystem challenges, focusing on the things we can control to ensure that we're continuing to drive long-term value for our shareholders. And I think as we go through the Q&A today, you're going to see some very real tangible examples of that. But the important thing that I want you to walk away with is our value creation story continues to be a robust one, and you're going to see real examples of our strategy come into action as we go through the Q&A.

Well, great. Thank you, Michelle. So before we dive into Q&A, standard disclosures here. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. I'm pretty sure you've all been going to this website the past 2 days. If you have any questions, please contact your Morgan Stanley sales representative.

So with that, Michelle, starting off with the budget, I mean we saw plus-up to the fiscal year '22 defense budget despite a lengthy continuing resolution. And it appears that we'll see a similar situation for fiscal year '23 with a sizable congressional plus-up and also a potential continuing resolution. How are L3Harris programs faring in this environment? And as you track this legislation coming through Congress, is there anything that we should watch out for?

Yes. So you're absolutely right, I think at the start of this year, nobody would have guessed where we're landing from a DoD budget perspective. So 6% in terms of current year. The current trends was just 9% to 10% for FY '23. It's a nice place to be in, in terms of an overall budgetary environment perspective. With that being said, CR, right, a continuing resolution as we think about this year is going to happen within fourth quarter. And so it continues to be a bit fluid in terms of how those dollars actually play out. And if you look at the last 15 of the 20 years, there has been a continuing resolution. And so our hope, our optimism is in that today's heightened threat environment that the CR only last through the end of this year and that we start the year in a much more normal pattern in terms of contract awards and the funds starting to flow. So thinking about our overall portfolio, about 40% of our portfolio is in the airborne business. And when we look at those budgetary line items, whether it's Rivet Joint, F-35, 3D, continues to be well funded. So we don't see any risk from an airborne perspective. When we look at our growth engines within L3Harris, which is really space and cyber, both of those line items within the budget continue to be well funded, if not plussed up when you think over the next couple of years. And so that very much aligns with our trusted disruptor strategy and where we're placing our internal of the bets and where we're investing. Our land portfolio, which we have a long legacy with, we continue to see support around the communication modernization budget. That's about 20% of our overall portfolio. And we're also seeing near-term demand from a Ukraine perspective in that portfolio as well. And then within sea, which is about 10% of our overall portfolio, unmanned autonomous sea submarines, Columbia, Virginia, those also continue to be well supported. So budgetary-wise, we feel good about where we're positioning and where we're landing. I think the question will become, what does this look like post '23? Does that meter off or does it go down? I think that story is yet to be told at this point.

Thanks, Michelle. And putting things into perspective, you've got low single-digit growth outlook for 2023 -- sorry, 2022. And then beyond '22, the previous guidance from management was about mid-single-digit growth. But this multiyear outlook was given in an environment before Russia's invasion of Ukraine. Now with -- first, how does this geopolitical change, either Russia and Ukraine or the Asia Pacific, change the environment? And then second, how should we look at that multiyear growth in the context where you're talking about 9% to 10% potential fiscal year '23 budget request? How much upside is there to that mid-single-digit growth in the future?

Yes. So let me start with 2022. To your point, we did guide to the low end of our 1% to 3% range. Coming into the year, we are optimistic in terms of overall supply chain recovery along with contract awards. And so we talked a little bit in our first half earnings call around they're just generically being a more lethargic contracting environment. Now we are starting to see that pick up as we're getting into the second half of the year, but we certainly saw an impact within the first half of the year, both on the DoD side, but also internationally, right? And as you think about kind of the macro execution environment is what I call it, there's a lot of distractions in the system. And one of those distractions is permeating and impacting overall contract awards. I am hopeful with the recent trends over the last couple of months, especially with the DoD outlays, which continue to improve month over month, that we're starting to see that return to a normal pace. So that had an impact in terms of our 2022 outlook along with the recovery of supply chain. So we came into the year knowing that we would be down single digits in the first half, which is aligned with what we actually performed to. However, we assumed in the second half, there was going to be a steeper ramp in terms of that recovery. We are continuing to see the recovery, however, it's more muted than what we initially anticipated. And we do anticipate that, that will elongate into 2023. And so I think our challenge, both in the near term and as we think about 2023 and 2024, is there certainly is demand signals that are indicating. Predictive indicators, whether it be book-to-bill, growing backlog, the demand for our products, the fact that even with the supply chain challenges, we continue to meet the deliverables for our customers, not without a lot of work, but we have not missed a critical customer delivery. So all the demand signals are there. The challenge is, what does that elongation in terms of the execution ecosystem look like in terms of impacting the top line performance?

Thanks, Michelle. And maybe focusing specifically on space. You guys have won a few big space programs, right? You've got the FDA's Tracking Layer and MDA's Hypersonic and Ballistic Tracking Space Sensor. Sorry, I had to read that. I couldn't understand what it's called. I just call it HBTSS.

That's right. That's what we call it, too. Otherwise, it's a tongue twister.

And then you've got -- so today, you have a $2 billion space portfolio. But then previously, you have highlighted that there's a pipeline potentially of $20 billion of opportunity. How should we think about that growth trajectory for space if we don't have these supply chain issues?

Yes. So thanks for bringing this up. This is a highlight for us. We're super proud of the space franchise that we've been building. Big complements to Kelle and our space team. This is an example of our trusted disruptor strategy in action. This was an area that early on, post integration, the acknowledgment of where the budgets lie from a DoD perspective, where the DoD, our customers are investing, we recognized those early signals and invested internally to ensure that we were building a payload expertise that would allow us to show up and be competitive to win at the prime level. And that's part of our trusted disruptor strategy is how do we prime more to ensure that we're moving up the food chain. To your point, we have had some recent wins. The most recent one is SDA Tranche 1, a $700 million award that we just got awarded last month. But there's a lot of smaller awards that you don't hear a ton about because they're classified, about 13 of those over the last year, 1.5 years. And so that franchise continues to be, I would say, mid-single-digit plus in terms of growth for us. So it is a growth engine across L3Harris, and we're excited about the future.

And in Ukraine, we've seen demand for things like night vision goggles and radios, which are typically more shorter-cycle products. How quickly do you think the demand signals from international customers could convert to orders? And when can we see revenues from those orders materializing?

Yes. So let me just start with saying that we're incredibly proud of the team in terms of the urgency and agility in response to the current geopolitical environment and our ability to get our products in theater in record time is the way I would describe it. And so we are seeing an increase of demand already. You're not seeing that, however, play out in terms of our financials because these are the areas where we are supply chain constrained today. And so what's happening internally is as we're getting these orders -- and we are, first and foremost, putting our customers' missions first. So to the extent that it's the most urgent request, we are prioritizing those orders along with the supply side of the equation. So think about it. I know you're sitting through a lot of meetings this week and you hear a ton about supply chain, supply chain, supply chain. And then every organization is prioritizing supply chain at this point. But we're also prioritizing demand, right? And so it's the marrying of those 2 things together to ensure that we're meeting the most urgent need when we think about the geopolitical environment to be able to get the products in the hands of the war fighter in a timely fashion to ensure that they're able to deliver on those critical missions. So what's happening is we're reprioritizing within our product lines. We are delivering on these Ukraine orders. There's a couple of hundred million dollars for us at this point. And we're continuing to meet all of our critical customer missions delivery dates. We typically have some float, if you will, within those demand schedules, which is allowing us to reprioritize. And so as a result, we haven't missed any key deliveries. I anticipate that this upside, if you will, will play out over the next couple of years. That's how I would think about it. And it really does come down to what is the current execution environment. So the more elongated this environment is, the more challenging it is. I think that's how you should meter in terms of the expectations of the returns. But what I want to make sure people understand is the demand continues to be incredibly strong for our products, right? And so the value creation is there. It's just a matter of timing in terms of when it plays out.

Thanks for the color. And switching gears to the F-35. The F-35 historically was about $1 billion in annual revenue for LHX. We're seeing some transition in the program as the development war kind of winds down and we've got -- we get to see production fully pick up to offset that. So can you give us an update on F-35 and highlight the key moving pieces and where you are on Block 4 upgrades? And then if I could add another one, sorry, it's a long question. It's all F-35-related.

People love F-35.

We now have -- Lockheed signed the Lot 15 to 17 with a customer or a strong handshake. I don't know what it means to have a strong handshake. Maybe a weak handshake, I'm not sure. But you have this Lot 15 to 17. What does that give in terms of visibility for you and the program?

Yes. So this, to me, is a great example of we're focusing on what we can control, right? And so for L3Harris, F-35, just for context, is less than 5% of our overall portfolio, right? We have a very diverse portfolio, and we have a key role in terms of the IPP on the F-35. We got through the technical challenges that we were having earlier this year. We delivered and completed the software qualification in the middle of the year. June 30, it will ever -- forever be etched in our minds because of the criticality of this program. And we've actually delivered 3 test shipsets since then. We are making the transition now into production, to your point. And we anticipate that this product area for us will be about $800 million over the next few years. So why can't you translate when you see everything in the news in terms of F-35 and this country is buying this and this country is buying that? The reason is that for our product line and how we're setting up our capacity and production is that to the extent that there's ebbs and flows in the overall F-35 production, we are filling that with retrofits. So we've got 2 kind of parallel work streams, if you will. So to the extent that kind of new production is occurring, we're filling that with retrofits, and we're going to keep our capacity at those high levels of about $800 million.

Great. Thank you for that. You mentioned supply chain a lot, especially in your prepared remarks. It's been an issue. You guys have highlighted that you've had to redesign over 1,000 components to circumvent the bottlenecks and meet the new targets that you've given in the lower end of the 2022 guide. Can you give more color in terms of the mitigating actions you're taking and how long you think this bottleneck could extend to?

Yes. So going back to my opening comments because I think this is really important. Although the supply chain recovery is not where any of us would want it to be, it is improving. So if you go and look at our financials, particularly within our product part of our portfolio, which is about 25% of our overall portfolio, Q3 is when we were most acutely impacted last year. And so as you look quarter-on-quarter into Q4, Q1 and Q2, we are seeing incremental improvement. It's just not as deep as a ramp as what we anticipated coming in at the start of the year. And so you may remember, as part of Q3, Q4 and into Q1, we talked about a lot of our mitigating actions, which we continue to take today, which includes putting our suppliers on long-term agreements. If I think about where we're at in terms of supply indicators into our -- or I'm sorry, demand indicators into our suppliers, we are well far ahead of where we would have been at the same point last year. And what does that mean for our suppliers? One, that they can plan accordingly; and two, that they can ensure that they've got the right level of capacity to be able to meet our needs. And so that was a huge step that we took at the end of last year to start to build that demand pipeline. The second is around DPAS ratings and ensuring that to the extent that we're committing -- competing with commercial products, ensuring our products are at the front end of that prioritization, we continue to leverage that with some recent Ukraine orders. We were able to get the DPAS rating on those Ukraine orders to allow our products to be prioritized. And then the third would be around smart inventory. So you saw our balance sheet grow at the beginning of the year to ensure that we were doubling down in terms of any single-sourced products or supply risk that we saw in the near term to ensure that we're carrying the right level of inventory. So as we get through this more acute pain point, which is related to the chip shortage, we are ready to ship those products in a very agile and quick fashion. I think it's important, too, when you think about the overall supply chain and the challenges that we're seeing, you talked a lot about the redesign efforts, we kicked those off in Q3. That's one of the ramp-ups that you're seeing in the second half of this year. Those don't happen overnight by any means. And so you have to go through a qualification process in terms of having second-sourced components. And so that effort, we continue to drive through our customer community to ensure that we are not bottlenecked by single sources. And I'll give a great example of that -- of this. Coming into the quarter, we had assumed a certain amount of allocation from one of our big-name chip supplier. Unfortunately, because of their own sub-tier challenges, whether it be COVID or some raw material constraints, they weren't able to meet our demand within the quarter. The team quickly reacted to that. We started pulling old radios, if you will. A great example of this, we went to one of our customers where they knew that they -- we knew they were disposing of some old radios. We took those radios back. We broke them down. We're using the FPGs -- the FPGAs within those radios to rebuild them into the current formation to be able to meet the demand and delivery. We joke a little bit that this is a real-time example of a circular economy when you think about reuse, right? It's a great example of that in real time. But clearly, there's a lot of work happening behind the scenes to ensure that we're continuing to meet not only financial expectations, but equally as important, our customers' needs, which is very real and heightened in today's environment.

Switching gears to margins. Margin improvement had been a focus of the L3 and Harris integration, and you're guiding to 16% to 16.25% of segment margins in '22. How much more gas is there left in the tank of E3? Where can margins go from here?

Yes. So how much gas is left in the tank? Well, we like to think of ourselves as more of kind of an electric car, right? A little scrappy, we'll innovate...

So no more gas.

Yes, less gas. And really, it's a funny analogy because we truly believe and we've demonstrated the ability to recharge our E3 savings, if you will. And so we truly don't see it as you just continue to burn it down and at some point, you get to zero. One of the cultural elements that's unique from my perspective, look, and I've been at the company less than a year, in comparative to some of the more traditional primes, which I have background in, is this mentality of not accepting the status quo, being agile and the recognition that there's always an opportunity to improve. You see that show up in our innovation solutions that we bring to the table, but it also permeates throughout our culture in terms of, okay, we just took an hour out of this production process. What can we do next to continue that evolution cycle? So I do think there's still gas in the tank or charge to be had, if you will. With that being said, right, I'd be remiss not to acknowledge the current environment. It's a challenging environment. You can see cost input across the board. And what we're doing is being proactive in taking actions early to ensure that, to the extent we can, we're mitigating those things that we have control over. And I'll give a great example of this. We announced the voluntary retirement program a few weeks ago. We don't take any kind of resource actions or talent actions easily. We take them very seriously. But with the acknowledgment that this is going to be an elongated period that we are managing through, we took this voluntary action to create some level of financial flexibility, recognizing that we would also need to increase merits next year, right? And so we're effectively self-funding, if you will, through those savings to be able to afford merit increases. And we have examples like this across the board. But the important thing that I want this group to walk away with is this is an example of us proactively acknowledging the environment that we're in, taking control of our own destiny and taking action as a result of it.

Thanks. And switching gears to M&A. Sorry, I'm switching a lot. We went through growth, supply chain margins...

Love M&A. Please, switch.

Okay. I mean, for M&A, the earmarked dollar has been $1 billion for M&A this year. But when you look at the environment, it seems like a commentary from the DoD is more on restrictive -- has been more restrictive on M&A lately. So first, where in the portfolio do you want to add that you see strategic value? And then second, do you think those kind of deals could still get done in this kind of environment?

Yes. No, it's a great question. And just for everyone's benefit, the last couple of years from an L3Harris perspective have really been about portfolio shaping, right, ensuring that we've got the right mix post integration in terms of our strategic initiatives, imperatives and where we're heading in the future. And so a lot of that work, I'd say, 85% plus is done. And so we are very much in a mode of what acquisitions are out there. What can we do to create the 1 plus 1 equals 3 type of impact for our overall stakeholders? And so the things that we're considering, the things we would love and we would be super interested in are in our growth imperatives, whether that be space or cyber, networks. Weapons is another area. The $1 billion range, I know Chris Kubasik, our CEO, has thrown that out a couple of times, which I'm completely aligned with. Chris has got experience with L3, which was a lot of small acquisitions. And anybody that's done an acquisition before knows that acquisitions, regardless of their size, take a lot of work. And so to the extent that we can find an acquisition that's in that plus $1 billion range, a few billion dollars, that absolutely makes sense for us in terms of kind of complementing our scale. And it also plays into, from our perspective, help making us a better competitor within the defense market. So to your point about regulatory, where the challenges are is in the big primes getting bigger. And we truly believe that to the extent that we can add scale to who we are in kind of that mid-cap range, that adds another competitor within the industry. So we actually think it aligns with the DoD's initiatives to create more competition.

I see. And then if you're not able to find deals, when you look at buybacks -- I mean buyback was also a big priority for capital return to shareholders. I think you guys reduced your share count by 15% since 2020. You've got $1.5 billion earmarked for buybacks this year. If you don't find these opportunities or if the regulatory environment is such that it's too restrictive, would we see this $1 billion earmarked for M&A be put towards share repurchases?

Yes. So we will continue to have a friendly capital allocation strategy, if you will. Look, I'm optimistic on the M&A front. And so that, first and foremost, is kind of where we're focusing in our efforts internally.

Great. And working capital has been a focus also, especially inventory management. You've touched on the supply chain issue. So with the supply chain as it is and the shortages that we're seeing that seems to extend longer than we would have anticipated initially, are we witnessing a new normal here? Will we see L3Harris continue to help the supply chain, buy more inventory and not have that working capital reversed until later on?

Yes. No, I definitely think that this is a conversation that's happening across all industries right now. So prior to joining L3Harris, I was outside of the defense industry. And I was actually the supply chain CFO within this company. And so I have a great appreciation for what the words resilient supply chain means. And it truly does mean that's the methodologies of the past, right, just-in-time inventory, our ability to beat on our suppliers to get parts overnight. That is not the environment that we're in today, and I don't think anybody is going to tell you that that's changing overnight. The challenge for us within the industry and across all industries is what does that new normal -- they didn't like my answer. So what does that new normal look like? And we're working that through our strategic plan right now. I would tell you, I don't see it going back to where it was before, where everything was just in time. Should it be at the elevated levels that it's at today? No. Right? So what is that happy medium in between in terms of how do you have the right level of inventory, the smart inventory is what we're talking about it internally, so that we are able to continue to meet both our financial expectations along with the customers' needs while ensuring that we've got the right capital allocation strategy as well. So it's about balancing of all of those parts.

Great. And there's one thing I wanted to touch on with the time that we have left. In your prepared remarks, you mentioned something about being a trusted disruptor. So first of all, what does that mean? And then how do you thread the needle between being one of the primes versus a trusted disruptor? And is the customer valuing this approach?

Yes. Thank you. Thanks for letting me end on this because, frankly, it's the reason that I joined L3Harris. Admittedly, when I got the call, I was like, oh, I'm not sure if I want to go back to defense. But within the first meeting, I realized how different it was from my previous big prime experiences and in terms of how we show up from an agility perspective, the energy we bring, the urgency, the impact that we want to have. And breaking it down into its 2 components: trusted, again, is kind of the heritage, it's the legacy. It's the fact that both L3 and Harris grew up in the defense industry. We understand how it works. We understand the customers. And we're very intimate in terms of the missions and the critical capabilities that are needed to be successful within defense. The disruptor piece is what's different about it. Again, we're open to innovation regardless of where it comes from, whether it's internal or external, but it's all with the lens of how do we create value quickly, both for our customers and our overall stakeholders. And I think what makes us unique is we don't have these big, grandiose, 20-year plans in terms of large platforms. It's all about what do we need to do today to win both from our customers' perspective in this high-threat environment, but also for our shareholders.

And the last part with the customers valuing that, are they acknowledging your approach? And is that being validated? And can you share with us maybe some tangible examples of how they've done so?

Yes. I would say yes. And that's one of the reasons I'm excited to be here today because within the last 3 months, we've got some very tangible real examples of awards that we've received. The SDA tracking, I talked about that, Tranche 1, $700 million award within our space franchise where we are prime. Just a couple of years ago, we wouldn't even have been considered within that competition. Also within our ISR business, our surveillance and reconnaissance systems, Armed Overwatch, up to $3 billion award, 75 aircraft. Again, an example of us bringing novel solutions to the table that can improve the overall war fighter's capabilities real time. And then finally, its a small award, it's a space award. We were 1 of 3 winners, about a $2 million study contract within the weapons space. Again, this is an example of wouldn't even have heard L3Harris associated with weapons even a year ago. And so it's an example of how we're showing up differently. The customers are acknowledging it. They're recognizing it, and they're rewarding us programs as a result.

Well, great. Well, thank you very much, Michelle.

Thank you. This was great.

Thank you for joining us. And this concludes our presentation with L3Harris today.