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

Good morning, everyone. Welcome to day 2 of the Barclays Industrials Conference. I'm David Strauss, I cover U.S. Aerospace and defense and to kick it off this morning, pleased to have L3Harris here. Chris Kubasik, Chairman and Chief Executive Officer; Michelle Turner, CFO. So I'm going to turn it over to Michelle to give the necessary disclaimers, forward-looking statements.

Hi. Good morning, everyone. That's energy back. We're not getting any energy back, so thank you. As a reminder, our discussion is being webcast this morning. So we may be making some forward-looking statements, if you have interest, we encourage you to go check out our SEC filings specific to the risks and uncertainties, which may permeate in terms of our go-forward projections. So thanks for joining us today.

Yes. And David, thanks for inviting us back. And it looks like we have a full house here. So thank you all for joining in person and online. I thought I'd just make a couple of quick comments on Aerojet Rocket because I know that's on everybody's mind. In late December, we announced we signed a deal to acquire Aerojet Rocketdyne. I think it fits very nicely into our strategy and gets us into some high-growth markets, specifically weapons through rocket motors, specifically in space propulsion. We filed with the HSR, filing in mid-January. It's a 30-day process, on the 30th day we executed was known as a pool and refile, which we did, which started the second 30-day clock, that runs out on March 15. So on or about 14, 15 will move the next step, whether it's a second request or whether we move forward with the transaction at that time. Aerojet Rocketdyne shareholders vote on March 16, and that's kind of a high level where the process, where the timing is. We think it's an exciting deal. We think it's a game changer for L3Harris, and it really fills in the portfolio nicely. And I believe there's going to be a lot of demand, as you've probably read and seen for munitions, missiles, weapons, whatever you want to call them, for the next several years, not only in the U.S. but internationally. And I think you'll see that reflected in the budgets going forward.

Perfect. So I wanted to ask about the '24 budget process since that seemed to get kicked off even earlier than expected this year with the speaker both. What you're hearing in terms of where the initial '24 request might shake out? Obviously, last year, we ended up way above what the initial White House request was, we're up 25 or so percent off of the last 2 years. So what you're hearing in terms of where the initial request could come out and how -- your best guess is how the process could play out from there?

Okay, absolutely. It's good for -- let me go back to '23. We actually have a 2023 defense budget. It was enacted on December 29. So in prior years, David, everybody would come up here and talk about continued resolution -- continuing resolution. I can assure you it's hard enough to run a business let alone a defense contractor, but it was good to start January with an active defense budget. So that's a big deal for not only L3Harris, but the whole industry. So now it's time to talk about the 2024 defense budget, '23 was up 10%, as you know, top line, which is a big deal. And the timing, as we understand it, is on March 9, the top line number will be disclosed without a lot of detail. So there will be a number given. We believe it's probably going to be in the 4% to 6% growth range. So coming off $818 billion is the jumping off point, maybe $850, $860 billion, and then I'll go through the normal process. I think what's unique this year will be the debt ceiling. So sometime in the summer, Congress will have to deal with the debt ceiling. I think we've all read the Democrats, the Republicans they've all drawn line to the sand for different reasons. So either cooler heads will prevail and we'll find a resolution. It just seems notwithstanding all the good things and the crazy things that Congress does that we would default on our obligations to the nation. So I think the general thought process is there will be a resolution in some form or fashion, and the budget will get approved at the right time, and we'll move forward. So maybe a continuing resolution in '24, but hopefully, we'll have a signed budget by the beginning of January '24.

So the one thing that I think we all struggle with is the budget you talked about above the $800 billion modernization above $300 billion. the industry as a whole last year, I think, was flat, maybe even down a little bit. You guys were in that range as well. Outlays there seems to be this big larger-than-normal lag between outlays in the budget. So maybe speak to that, are you seeing things loosen up at all? Would you expect to see a bit of a catch-up here? Should that lead to accelerating growth for you all and the industry?

Yes. It is interesting to see that bow wave or backlog build up. I think you see it in our financials, you're right. For those in the audience, you're looking there saying the defense budget went up 10%. And how did all you guys manage to remain flat. But what you'll see is our backlog in our case, is at an all-time high. Our tactical radio business, maybe Michelle can comment on that in a moment, is over $2 billion, which is the most it's ever been, so we're not losing orders. What's happened is we're building them up, and we need to deliver them. Supply chain has caused some of this. We've all talked about the slow contracting environment coming out of the DOD, I think that process is improving. The fact we have a budget, like I said in December is allowed January and February to pick up a little more pace. So we're seeing RFPs. We're responding to them. I think we're getting the contracts signed quicker than we have in the past, and that's going to allow for some tailwind as I see it. And I would think in '23 and '24, all the backlog we've all accumulated, we get the right people, we get the supplies, we're going to be able to see the increased revenue growth, any thoughts?

Yes. No, I agree with that. I think clearly, in '22 across the industry, we were constrained from a supply chain perspective, along with the labor attrition. And so to the extent that we start to see those bottlenecks ease that's when you're going to see the backlog flow.

Okay. So with the recent announced deals, TDL and the Aerojet announcement, this pivot towards M&A, talk about how you see the balance sheet evolving over the next couple of years, how you're going to allocate your cash flow between deleveraging and buyback and then the potential for divestitures to help in that deleveraging process?

Yes. So I'll take that, and Chris, [all] free to jump in. So to Chris' comments at the beginning, we do remain optimistic that we're going to close on Aerojet by the end of the year. And so as a result, we will be taking on increased debt, and we expect our gross leverage ratio to be close to 3.8 post that acquisition, with about $14 billion of debt. And so our focus will really be threefold: One, around repaying the debt over the next few years. That's going to be primary in terms of maintaining our credit ratings. We're also going to moderate our share repurchases to cover dilution. So that's about $500 million a year. And then we also expect that we're going to maintain a competitive dividend consistent with our peers within the industry. The other only thing I would add is from a longer-term capital deployment perspective, if you haven't had a chance here [indiscernible], check out our Investor Relations letter from our last earnings call. We included a really nice pie chart in there that illustrates our capital deployment strategies, both from a history perspective since the merger, but also through the next couple of years. And what you'll see is across the capital deployment levers, we're relatively balanced from an equivalency perspective across those levers.

And I'll just add in on the acquisitions. If we have chatted in, say, August 1, and you asked me how many acquisitions do you think you'll announce let alone close in 2022, I'd say probably nothing. Because we look at things all the time, and obviously, the sellers control the timeline, and shortly after that, the ViaSat opportunity, tactical data links, which ties in nicely to one of the acronyms I'm sure you're tired hearing about called JADC2, which is basically connecting not only the satellites to the ships, to the airplanes and allowing the data to be transmitted across these various platforms is critical to the National Defense Strategy and then Aerojet Rocketdyne came to market. So I've been in this industry a long time, as many have. There aren't that many properties that are interesting for sale and both kind of came up and we signed two deals in the fourth quarter, the right thing to do. We had numerous meetings with our Board, and we're confident that we can make piece of success. And as Michelle said, the next couple of years, go ahead and focus on debt reduction. And to your divestiture question, we have a couple of noncore assets that we've had kind of on the back burner, waiting for the markets to recover, so that we can get a full and fair value, and that will accelerate the debt reduction. So we'll be executing on that hopefully later this year.

And the size of the potential divestitures.

About $1 billion or so.

So you just mentioned there that I would ask you, in August, you wouldn't have done any deals, you ended up doing two deals. This coincided with numbers coming in below, I think, your own expectations for the year. So there's -- I think there's this narrative that you've pivoted to M&A because maybe there's something broken in the underlying business. It's not performing to expectations, and you had to bulk up to be able to compete with the big guys. I guess how would you -- I'll leave that to you, but that seems to be the narrative out there that with regards to why you've done this pivot towards M&A?

Yes. Well, if something was broken, I wouldn't do M&A. I would focus full time on fixing what is broken. What we've talked about is, yes, we were disappointed in our financial results driven mainly by supply chain, driven mainly by our tactical radio business. And I think it was in the third quarter, we talked about the fact there's a lot of products in this industry you can deliver without all the parts, you can deliver an airplane with machine parts and a punch list and a ship, probably a submarine. But certain things like radios, night vision goggles and missiles, you need every single part, and while we've been able to reduce our parts that are lagging from hundreds down to single digits, you actually need every single part to deliver a radio. And in our case, we recognize our revenue upon delivery of the product 25% of our revenues. So that is different than a lot of other companies who have longer-term contracts, percent completion. So that's why we knew it would hit us harder externally and more visibly than others. So we looked at the ease or the difficulty of these acquisitions and how they're going to affect the underlying business. So ViaSat is just one single entity carve-out, lift clean in place, he goes into one of our sectors, very simple integration. We closed January 3, as of today all their employees are on our payroll. They're on our benefits. It's not done yet, but we're probably 50%, just very simple. Aerojet Rocketdyne, we have three segments today. We'll set up a fourth segment. So this will not impact or distract the core team focused on comms, integrated mission systems and space and airborne. So that's how I looked at it. If it was another merger of equals like an L3Harris, I would have concluded that just too much of a [distraction], too much effort. So it's an opportunity -- they come upon us rarely, and it seems if we missed these opportunities, we wouldn't have -- wouldn't been able to grow inorganically for the foreseeable future. So we seize the opportunity and we're successful.

Aerojet obviously gets a lot of the attention, but TDL was a pretty sizable acquisition. Can you dumb it down for us what that capability is. I mean I think we all care Link 16 and like what is that? I mean what -- it seems like it -- combine that capability with your sensors, it gives you an advantage when it comes to space and JADC2 and all this stuff, but if you could just like layman's terms, what it means, what capability it gives you?

Usually pretty good filling up with this analogy. This one is hard to explain. I have to be honest, it is complicated. But I think in the simplest terms, Link 16 is -- think of this as being effectively modules and cards in a box to go on various platforms. So they're in 20,000 platforms. They're on ships. They're on airplanes, later this year for the first time, Link 16 will go in space and be on satellites, and it allows basically the passage of data amongst all these different platforms and different domains and different services. So we have the footprint, and then the next step would be to modernize Link 16, maybe more resiliency, more waveforms, if you already have the footprint in effect, the boxes, you can easily swap out and update the cards and the modules and get better, more secure capability. I struggle with the best I come up with, which the real smart technical people cringe, it's kind of like WiFi for the Department of Defense, right? It's like gentleman's laughing, his iPhone is connected, his TV is connected at home. It connects everything.

He just offended all the engineers.

I have offended everybody in the defense industry, but that's how I look at it, and that's the future of war fighting, obviously, is to be able to sense and shoot and we have the sensors, we now have the connectivity. We have the resiliency and I think going forward, it's going to put us in a really good spot.

Yes, I've been hearing about Link 16 air-to ground forever. So it kind of makes sense that faces in the next frontier, we kind of have it. So before all the supply chain issues, you talked about the portfolio growing mid-single digit organically. Since that time, the budgets, I think, exceeded expectations, when the supply chain normalizes, whenever that may be, is mid-single-digit growth out of the existing portfolio, still a realistic target?

Yes, I believe it absolutely is, for all the reasons we've talked about, including the backlog and the increased budget. We get the '24 budget in that 4% to 6% range. I think it's a great tailwind. And 23% of our business comes internationally, and we've been pretty successful. We've actually grown internationally each and every year since the merger. So we would expect that trend to continue as well.

And which areas specifically within the portfolio would be the leaders when it comes to the mid-single-digit growth?

It would be space. It would be cyber and it would be our yet to acquired munitions business. And then I think of Maritime is low single-digit, I think of the land and the air kind of flat to low single digits. A lot of the missions in air are moving up to space. So capabilities that were on tactical fighter aircraft are now being executed from satellites. When I look at the five domains, we have a couple that are growing upper single digits, a couple lower single-digit, maybe one that's flattish. So mid-single digit on average makes sense. And then when it's our job to deploy the R&D and the capital to where the growth is, and that's what we're doing.

I think probably for you, Michelle, supply chain, following up on that. What exactly are you assuming in the guidance that you gave this year for, I think, 1% to 4% growth for the business. What are you assuming for supply chain? Are things going to -- we hear mixed things. Some people say it's getting better, some people say it's not getting better. Where does your standpoint? And then also maybe touch on inflation, how much inflation you actually have baked into your guidance for this year?

Let me just say I'm excited that supply chain is out of the top 5. So that in itself is an indicator as to where we're at from a supply chain perspective and frankly, across the industry. So from a macro level, just to characterize our assumptions within the '23 guidance on the supply chain. We've assumed conditions that are consistent with what we experienced in the second half of 2022. So for those that have been on this journey with us, you may recall that we were first impacted by supply chain in Q3 of 2021, most acutely impacted in Q4 of 2021. And then as we transitioned into 2022, we have seen sequential improvement quarter-on-quarter from a supply chain perspective, with some quarters being a marked improvement from others. For example, in Q4, we had a really great product delivery quarter as a result of all of our suppliers wanting to ship and make their financial year-end. But as we think about transitioning into '23 and where we sit today, the way I would characterize it is between comparing 2022 to 2023 in terms of what's the same and what's different. And I think this is important in terms of how do you characterize the risk? And how do you think about the profile that we're throwing out from a '23 perspective? So what's the same? What's the same is we do continue to experience hiccups, road blocks, persistent supply chain challenges, whatever word you want to use across the entirety of our supply chain ecosystem. That continues today. It's not as acute as it was last year, but it's not as seamless as it was 2 years ago. What else is the same as what Chris alluded to, 25% of our portfolio, we recognize revenue based on delivery. So this is our product-based business, which is different than our industry peers, which take revenue over time or based on costs incurred. So to the extent that we are short in electronic component, or a washer, we're not going to be able to recognize the revenue on that particular product. And then finally, what's really important within our business is we have been most acutely impacted by electronic components, we do continue to be on a 90-day allocation with those suppliers. So historically, we would have put our demand out for the next 12 months. We would get that demand. It was very seamless. It was all behind the scenes. We continue to be on an allocation process where we sit here in Q1 this year. So that's important in terms of how do you think about supply chain within L3Harris throughout the entirety of 2023. Now what's different and what are we more optimistic about in terms of where we sit today versus last year, a couple of things. We've been talking a while in terms of engineering redesigns that we've been doing. We're going to get the full year benefit of those engineering redesigns in 2023, so what does that mean? That means that we went from a place of about 100 alternate parts is what we call them, to an alternate part bank of over a 1,000 within our Tactical Communications Systems business. So to the extent that we see supply chain scarcity on those parts, we now have alternates to go through, which are not going to stop the entire line. We also have seen an increase in terms of our BPaaS ratings. This is the prioritization that we can get within the defense industry to ensure that our product supply is being prioritized over commercial entities, for example. We've seen that number go up by double digits in 2023. Thank you to our DoD customers for supporting us in that regard. And then finally, and probably most importantly, is the number of critical parts. So when the whole supply chain prices started back in 2021, we had hundreds of critical parts, red suppliers. We are now down into the tens, so you think about that population, that population has dramatically decreased. So the takeaway on all that is that we're more optimistic about supply chain in 2023, but we're not back to the point that we were, say, 18 months ago or 2 years ago.

Yes, we've all learned a lot over the last couple of years. And I think -- the other thing I would add in '23, we're going to see some working capital improvements. Because in '22, the strategy was, buy every damn part you can as soon as you can find it, which obviously you can see on our balance sheet, the increase in inventory, now we know who the key suppliers are what the key parts are and where the risk is. So we'll be a little more discerning as to where we buy smart inventory, and I expect that the inventory balances will come down in '23 as we're more selective.

So following up on that, with the L3Harris merger, I think the combined company was 60-some working capital days, you had this target of 40, you were making great progress towards that target, pandemic, talked about inventory. I mean what -- I don't know, 40 still before we think about the business that you'll be bringing in, but is 40 still realistic or is there a new target? Or are you just going to keep trying to net working capital days down.

Yes, I think it's more focused on working the days down, right? And so to your point, we ended '23 at 53 days -- or I'm sorry, 2021 at 53 days. We saw that grow to Chris's plan. We made purposeful investments in our working capital, particularly on the product side of our portfolio, to ensure that we have the right supply as we're going into this year, which we're anticipating mid-single-digit growth on the product side of our business. And so we saw the days grow to about 55 at the end of 2022. We expect that, that's going to come down by roughly about a day. So we're going to free up about $100 million to $125 million from a working capital perspective within the current year.

We see no reason why we can't improve 1 or 2 days per year when we get into the mid-40s. We can see if 40% is in fact, a reasonable target. But I think again, we've done the easy stuff, which I think is really focused more on the payables and the billing cycle. It's all about the inventory. And that's where we see some of the growth. And some of these are one-off things where you buy a couple of airplanes that you need to mod and that adds a couple of hundred million to your balance sheet at a point in time. But we're making good progress, and it's a key focus. In fact, we're enhancing, we have a board meeting later today and tomorrow. One of the things we're going to firm up is our 2023 bonus plan, and we're going to allocate a lot more of the bonus to free cash flow. So further backing up what we're saying with how we're getting compensated. So there's tweaks like that to align the management team and motivate them to achieve our goals.

Michelle, anything you want to talk to with regard to first half versus second half of the year because you have easy -- so-called easy comps first half, harder comp second, I mean you had down first out, and I think it's most acute in CS. So how should we think about first half versus second half and making sure we're not ahead of ourselves.

Yes. So we anticipate in the first half, we are going to see a low single-digit growth and roughly flattish in the second half of the year. To your point, we did start 2022 with a guide that was much more back half end loaded. So we anticipate a much more linear spread when we look at this year. A couple of other things I note on this. We do anticipate that the product deliveries will be more skewed to the back half, which is consistent with what we would typically see from a linearity perspective and the margins will subsequently follow that as well. And then just to break it down a little bit from a segment perspective. We do anticipate our Integrated Mission Systems business will actually be down in the first half and up in the second as a result of what Chris talked about from a aircraft missionization perspective, that business tends to be a little bit more lumpy. We anticipate our space and airborne systems to be relatively flat and consistent quarter first half to second half. It's our most predominant program-based business. So there's a lot of consistency in terms of how that business performs. And then from a communication systems perspective, we do expect that, that will be more back half unloaded aligned with the product deliveries within our Tactical Communications business.

I wanted to ask about comms. You mentioned the backlog growth. That business was a $4.5 billion business before supply chain issues. Your guidance this year, I think, without TDL as it gets back close to those levels. But given the backlog growth, I mean, how should we think about that business potentially growing above and beyond where it was when they're -- before we had supply chain issues, I guess?

Yes. So it's one of our favorite businesses, as you know, everybody likes to talk about it as well. But we do anticipate organically, it's going to grow 2% to 4% this year. And so some of that backlog will be alleviated, I mean Chris alluded to this, we ended last year at over $2 billion, our highest ever from a tactical communication systems perspective. And we anticipate with the orders this year that we're going to land right around that same level. As we start to see easiness supply chain, that's when the opportunity is going to exist in terms of how to return that. Chris alluded to this earlier, we have made investments within our Rochester facility. And so we have the capacity, we actually have lower attrition rates within that region in terms of the overall people. So it really does come down to supply chain, getting the electronic components in terms of our ability to deliver on the backlog.

I think one of the lessons learned coming out of Ukraine was the importance of these resilient comms, everything you read about, right? You decide to communicate on an iPhone or something that's not going to end well for you. So having these L3Harris radios with the resiliency has been a game changer over there, and what we're hearing and what we're seeing. And we have a big demand internationally as well, not only the modernization in the U.S. but abroad. So it's a great business, and it was a great business. It hit a bump and the backlog is building. We've been able to maintain all of our contractual obligations through this process. We probably have a team who every day tries to figure out which radio to build, deliver to meet the obligations and keep everything on track based on the supplies that are coming in. So the team is up there doing a great job.

Yes. And they were -- it was amazing in terms of how they pivoted last year in terms of meeting the surgence of the Ukraine demand as well, within days of being able to turn products.

So you're seeing some of that already come through?

Yes, we're having to reprioritize other things as a result of the supply chain constraints, but yes.

And Chris, F-35, if you could just update us there. Obviously, a big program for you all. I think last year, the -- it was down for you. You've got the tech refresh, you're working on, where we are now, when it's going to cut in, and what does F-35 look like for you in the next couple of years?

Yes, we're working on with known as tech refresh 3 TR3, a couple of key products, the integrated core process are the brains of the airplane being the key part. We made our first delivery of this key component after years of work and testing to Lockheed who is the prime, back in June, they've been integrating this, and we're seeing some good progress. We're -- it's an interesting program because you do development and production simultaneously called concurrency, it's really not a best practice. That's how it's been going on. So we see a vision where this is going to cut in consistent with what the Department of Defense wants. We're in constant communication with Lockheed, and I think it should be flattish this year compared to '22 and then it just comes down to we follow the prime. So I think it's going to be about close to $1 billion of revenue for us for the foreseeable future, couple of years, it grows 1% or 2% a couple of years flat, just depends on the volume of the airplane. Great airplane and these capabilities really position it well for the new threats that the U.S. is facing.

Can we pull up the audience response questions please? all right. If everyone could user their clicker?

This is before the panel started.

No, it's real time.

Okay.

We've been up for a while.

Yes, we have been going since 7.

We're going to see the answers here.

Yes.

What do you think?

You start the timer, please?

I'll go with #2, great opportunities. Thank you all for coming. This is exciting. Are we still being webcast?

I think so. Next question, please.

[indiscernible] Yes. That's pretty good. As to kind of -- there's some symmetry there.

Yes. Next question. 59 more minutes.

This would be a good one. Yes. think #2 is 0, 5% interesting.

Next one. [indiscernible] We need faster comps. The last one please. Our new one for this year.

You didn't ask us a question on this.

We'll see what this shows. That will inform me whether I should have.

Yes, exactly. #5 globally, out of 95 aerospace and defense companies.

Yes, exactly. We can tell that David, I guess -- thanks very much.

Thank you all for joining us, have a great week.