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

Okay. Why don't we get started? I'm Doug Harned, Bernstein's Aerospace and Defense analyst. And I'm really pleased to have with us today Chris Kubasik, Chairman and CEO of L3Harris; and also with us is Michelle Turner, CFO. And I know Chris wants to say a few words to start out. So I'll turn it over to you for a few minutes.

Okay. I'll just -- I'll start with a couple of opening comments. So good morning, all. Thank you for joining us. Looking forward to all your smiles and engaging nods through the audience. I'm already seeing it. Good, thank you for that. Just as a reminder, this is being recorded and webcast. So Chris and I, we'll discuss certain matters that may constitute forward-looking statements. For more information on the risk and uncertainty in these statements, please reference our safe harbor provision on our investor materials and our SEC filings on our L3Harris website. Thank you, and look forward to the discussion.

All right. Well, thank you, Michelle, and good morning, everyone. It's always great to be back in New York. It's hard to believe it's been almost 4 years since the merger of equals between L3 and Harris. And I think when we look back over the 4 years, by all accounts, it's been quite a success. I know there was a lot of questions and uncertainty when it was first announced, but everything has been tracking as planned. And one of the main reasons for that merger was to create more competition, especially with the Department of Defense. And I think when you look back on time, back in the '90s, there was a lot of consolidation, as you well know, and we were left with 5 major primes. We've been talking about creating this sixth prime, if you will. And I think we'll talk about some of the success we've had, not only as a prime contractor, we continue to subcontract major platforms, and of course, we continue to be a merchant supplier. I think what differentiates us from a lot of the other companies, we've adopted this phrase of being the trusted disruptor. Trusted in that we understand the mission of our customer, our 46,000 employees. And we've taken approach of teaming and embracing a lot of the new entrants that have tried to get into this defense industry. I view us and a lot of the primes as being more hardware-defined and software enabled. And we're working with a lot of these companies that are software-defined and hardware-enabled and having some success. In fact, yesterday, we just announced a strategic partnership with Amazon Web Services as we're going to be pursuing some markets together. And I think that's just a great combination and an example of how we try to work with partners and companies that are somewhat software-centric. One of the key things we're trying to do is differentiate ourselves through the way we deploy capital. I think over the mid- to long-term, it looks like a balanced capital approach because it is between dividends and share repurchases and acquisitions. But in the last couple months, fourth quarter of '22, 2 properties we've been looking at for a while came on the market. So you have to be opportunistic, and we went after and succeeded in acquiring both. The Viasat Tactical Data Link business, which actually closed in January. The whole focus on JADC2 and resiliency, and data Links was right in the sweet spot. And then Aerojet Rocketdyne, which I'm sure we'll talk about a little more, Doug, also came on the market. And we're in the process of getting that through the regulatory market process -- the regulatory approval process. And that's a unique opportunity to have a bolt-on into a new market area. I think since we've announced, you can see that the missiles market, the DoD calls it munitions and missiles, is up 24%. And additionally, they've been given over $200 million of DPA, Defense Production Act money, to expand the facilities, move production and digitize engineering. So strategically, I think we've been pretty clear in our strategy, and we're executing upon it. Maybe a quick word on governance. Per the merger agreement, we had 4 Board members retire in the last year or so, and we've replaced them with a couple of recently retired flag officers and a sitting Chief Operating Officer and Chief Financial Officer from large public companies. So I think we have a very diverse and experienced Board. On the ESG front, something we've spent a lot of time talking about and focused on, and I think by all accounts, we've been rated independently as the leader in A&D when it comes to ES&G and the progress that we've made there. Shifting quickly to operations. A big believer in leadership and getting the right talent. I think L3Harris is viewed as one of the hot stories in defense. And since the merger, more than half of the leadership team is new. Most of those individuals have come from larger, more complex organizations, and I think it positions us well for future growth. And as we look at the new hires, 2 of our 3 segment presidents are new, the real focus is on operational excellence, operational experience and leadership. Obviously, interacting with customers, motivating the employees, strategic thinking are important, but we're really focused on the operations. And we've had challenges in the last year or so, driven by supply chain, inflation and attrition, but we're starting to overcome that. And then finally, just a quick word on financials. We started -- a big believer in momentum. We had a good fourth quarter of '22. I thought we had a really good first quarter of '23. We have about a month to go in Q2 of '22 (sic) [ '23 ], but it looks like we're going to have not only revenue but earnings growth and positive cash as well. So I feel the momentum is building. And Doug, we look forward to your questions and those of you in the audience. So thank you.

Great. Thanks, Chris. And as you have questions, I think you'll probably know you can enter them in the pigeonhole link there.

But just to get started. If we went back a couple of years ago, at that time, we would be talking still about the completion of all the synergies -- capturing synergies in the L3-Harris merger. When you look at where you were a couple of years ago and where the company is now, are you through everything you wanted to capture out of that merger? And what are your priorities? You talked about some right there.

Yes. No, great question. We've been consistent for the last several years in communicating to the workforce, we have 3 strategic pillars, and we used to talk about growth, innovation and performance. And I think when I look back on the last couple of years, we were doing very well on the first 2, and performance was the one that was more challenging due to the headwinds that I mentioned. So for 2023, we've adopted the phrase: Performance first. Everything every executive does is focused on performance, meeting their commitments to their customers, the financial commitments to Wall Street and the commitments to our workforce. And then we give specific examples. And a good example, based on all the e-mails I've been getting, would be like the Paris Air Show. We're not going to the Paris Air Show. Nobody's sold a darn thing in the Paris Air Show for 40 years, north -- or at least I haven't. So we're not going there. We're going to do program reviews. We're going to visit our sites. We're going to meet with our employees. So it's change in the behavior. And in performance, I think we've made a lot of good progress, the biggest headwind being supply chain. We've talked about not just sitting there waiting for more and more suppliers, but we've actually engineered and developed alternative parts. And we've talked about it. I think it gets to be an old story that a lot of our products are reliant on these parts, and we book revenue upon delivery. So we've had a little bit more of a headwind. So we're doing that. And to your question specifically, we're rolling out what we call [ LHX Next ], which is really the continuation in the transformation of the business. So I'd like to say, the first couple of years, it was easier to save the $660 million. We shut down our headquarters, just a few blocks from here. We went from 6 segments to 4. We put out new $1 billion of bids for supply chain. Standardized benefits. It was relatively easy compared to what we're going to do now, which is really just challenge everything we do, look at spans, look at layers, eliminate waste, with the goal of being even more and more efficient. So that's the focus on performance. The innovation, we talk a lot about. We spend more on IRAD as a percent of revenue than most. I think we're starting to see some payoff. We're very aggressive with our CRAD, which is our customer R&D, over $1 billion. We've invested in venture capital, Shield, to help bring commercial entities into defense, focused on autonomy and space. And then on the growth front, we just continue to have record backlog, record book-to-bill. So I believe the customers are embracing us when we go for these prime bids. And our focus has really been more on speed. The #1 issue when I talk to our customers: Schedule, schedule, schedule. Which is different than 10 or 20 years ago. So we're being innovative there. We're partnering with companies, such as Amazon, and others that I mentioned. And I think we're kind of shaking things up.

When you say performance, how do you measure that? In other words, what are the metrics? Is it cost? I mean, certainly, Paris Air Shows cost. But how do you push performance...

Yes. I mean -- yes, it's a great question. And in our business, and I think the whole industry, a lot of it is on the programmatics and the estimates at complete, right? So I will tell the team, it's not that simple. But right, we sign a contract with a commitment to deliver a certain capability at a certain price at a certain time. And the key inputs there are your direct labor, your supply chain, your overhead and your profit. So we have a process that looks at that on a regular basis. The first quarter was not great. We had more negative EACs than positive EACs. And that would be, at the highest level, what we review with the board, what I look at on a monthly basis. But well below that, I think what's unique about L3Harris is that I have an executive focused on operations who reports directly to me. In addition to the programmatics, we're looking at supply chain, we're looking at continuous improvement, EHS, quality. So we have all the standard metrics there on cost of poor quality, on-time deliveries and such. And it's been a maturation. And the goal here is to identify challenges early and deploy the resources to fix them. And I think, as I said, the momentum is starting to build, but the goal would be, obviously, not to have these negative write-offs as a result of having fixed price contracts and cost growth.

Well, I want to get to the supply chain in a minute. But first, maybe you could set us up a little bit by just if you look at the Biden defense budget, how do you see L3Harris faring in that? And then we still got to get a real budget, right? We've got to get through the rest of this year, even if we get the debt ceiling taken care of this week. How do you see that Congressional process playing out for you?

Yes. I think last night, there was an overwhelming favorable vote by the House. Seems like the Senate will look at it this weekend. And hopefully, we will get the 2024 defense budget, which is coming in at $842 billion. And these numbers get so large, you just throw them out. And I looked back 2 years ago, it was $742 billion. And 3 years ago, it was barely $700 billion. And I think, well, it's important to have year-over-year growth rate. To go from $700 billion to $842 billion -- and again, this is top line, DoD as a proxy for growth, it's pretty darn impressive. So $842 billion is -- I know you've written about, is 3%, 3.5% growth. But our addressable market is really the investment accounts, and they're actually growing faster. I like the fact that it appears to be a 2-year deal so we don't have to go through this drama again. When they resolve this, I think it cuts down the probability of a year-long CR. In fact, you would think that this should be ideally approved by October 1, but my guess will be December because it always takes a few months into the year. So I think that's a huge positive. When we look at the details, and I mentioned the L3 and Harris merger of equals, we're in all domains. So on the space front, that's our fastest-growing business. A lot of money for the space force. We're priming contracts for the Missile Defense Agency, for the SDA, classified. Actually a lot of work for NASA and NOAA for the weather satellites. So I think we're well positioned there. On the airborne, we've had a long legacy of doing work for Rivet Joint ISR capability. Last year, we won the Armed Overwatch, which was kind of a pretty cool, innovative idea, taking a crop duster and putting all sorts of avionics and cameras and such on it for special ops. We support the F-35 program with Lockheed on the tech refresh. Maritime, we're on Columbia, we're on Virginia class. Those programs are going to continue. We're working unmanned autonomous naval platforms. They seem to be lagging more than I would like, but they're still part of their strategy. And then, of course, on the ground, tactical radios is kind of what we used to be known for before the merger and is a key part of our business. I'll actually be up there next week for a few days. And we just won a majority for the HMS Manpack, about just under $200 million. And yesterday, we got a couple of hundred million dollar order for Ukraine. So that is all growing. And then our cyber business, we don't talk a whole lot about. But probably like everyone you talked to yesterday and everyone that you're going to talk to today will say, "We're well positioned," based on the...

They would.

But what else are you going to say? But no, I really think when you look at all those domains, and more and more money is go into space. And then I mentioned the Aerojet acquisition. When you look at what the DoD calls munitions and missiles, but most of that is missiles, it's grown 24% year-over-year. I look at Standard Missile-6 as an example. It was $800 million in the budget, it's $1.06 billion now. And Aerojet obviously has a piece of that with the propulsion. So I like the growth, I like the trend. And -- yes.

Well, you're right. Everyone will say they're well positioned, I am sure. However, that budget increase you're talking about, which is a little more for the investment accounting, 4% and 4.5%. The problem here is, and I'm sure you even heard Lindsey Graham's commentary, inflation is pretty high. Last year, we saw in the 2023 budget, $50 billion added by the Senate for inflation. So this year, yes, the budget is up. But I look at this in a sense of trying to fit 15 pounds of potatoes in a 12-pound bag here, so not everything is going to fit in that. Do you think you're going to get more money from Congress as this goes forward for -- overall?

No, I think -- no, it's a great point. I think what -- where it suffers is the DoD is on the buying power, right? If they're historically buying 10,000 whatever, as the price increases due to inflation and everything we've talked about, they're probably going to have to get 9,500 or find more money. So it always comes down to the defense industry and how we all handle these things. We're seeing more and more fixed price development contracts coming out. We decided not to bid on 2 so far this year under the theory that I'm not going to bid fixed price on a development/production program where we have not agreed on the specs and such. So I appreciate the DoD's occasional attempt to get industry to bid and use the wrong contracting vehicle, and we will continue to pass on those opportunities. Because when you look down the road 3 to 5 years, everybody's taking these write-offs, and the reason they're taking the write-offs is they bid fixed price development and they can't get the contract mods or contract changes as the scope and technology changes. So I think that's their attempt, on occasion, to try to handle this issue, and I think the industry as a whole is going to continue to no-bid these contracts until they use the right vehicle.

Well, for L3Harris, among the major primes, you have the highest percentage of fixed-price work. Now a lot of ways, that's really good.

True.

But in an inflationary period, it's been interesting because when we've looked at inflation in defense, we found, over 20, 30 years, no correlation with defense margins because you get repricing, you have cost-plus work. But this time around, inflation has gone higher faster. And when you look at your businesses that are under fixed price contracts, how should we think about them evolving through this period? How repricing might occur? And how you can support margin expansion?

Yes, it's a great question. And I looked at it the same way. Now in our case, our backlog as a percentage of our annual revenue is the smallest in the industry because it's been perceived, rightfully so, as being more short cycle, whether it's the radio, the night vision goggles, the Wescam turret. So we have some long-term, some short-term. We're a little over 70% fixed price. What I think I see is most of this is flushing through the system. And it was more than people just tend to correlate inflation to supply chain, which I think for the whole industry and major primes is 50%, 60% cost of a program; but it's also impacting the labor, direct labor, indirect labor. You factor all those items in. And I think we believe we flushed most of this through. And then as we go through and review and bid new work, it's on Michelle and I and the executive team to say, "This is the cost of the new product. This is what we're going to bid. If it's fixed price and it's development, we're not going to bid it because we don't want to take a loss." And the impact is on the buying power that our DoD has. So we try to come up with creative systems or approaches that are may be more cost efficient, easier to get into the field. But no, that is clearly the challenge and the headwind. And I think the whole industry has kind of flushed through that in '22 and early '23, and our backlog turns rather quickly.

As so looked back a couple of years. Before we really got into this heavy inflation, I know you all had been talking about these incremental margin expansion path year-over-year. And clearly, a lot of the things that happened in the interim made that much more difficult, with inflation, with supply chain. Do you see yourselves going back to that kind of a path with this annual margin expansion?

Yes, let me give a high-level answer and I'll ask Michelle give more details. But the answer is yes, we're going to see margin improvement. As I look at it sequentially quarter-over-quarter throughout 2023, I made the conscious decision with the team in late '22 with our attrition, which I think we were all dealing with double-digit attrition, we're down below 9% in March, so I'm feeling better about that. But we spent a couple of hundred million dollars that we would not have planned for a year earlier on the workforce. We held all the employee benefits flat year-over-year. So when you get your envelope and -- or e-mail that says, what is my health care and dental? It's the same number. Which was viewed very, very favorably. We increased the defense early -- the annual wage budget and we did a few other things with spot awards, really to get the workforce engaged and stop leaving and stay with us. And it seemed to pay off. But I think it was like $200 million that we absorbed, which I thought and the team thought, was in the best interest of the company. The other option is they leave and then you spend all sorts of money recruiting new people. But you want to give a little more color on the margin?

Yes. So I think to your point, Doug, really we've been impacted by 2 headwinds. The supply chain challenges that have permeated over the last 18 months. And where we sit today, the takeaway is the worst of that is behind us, right? So when you think about 2021, electronic components really became an acute issue across the industry. We entered 2022, we saw a lot of hiccups in the first half of the year. As we got into the second half of 2022, we started to see improvement, albeit it wasn't linear, but we started to see the continuity of supply start to increase. And so where we sit here in Q2 of 2023 is we have a lot more insights in terms of the electronic components, mostly driven by the proactive actions that Chris talked about, right? So the macro environment is improving, but the overall supply chain is not back to where it was in, say, 2019. What is better, however, is the actions that we've taken to allow us to be agile and really pivot as we start to see these disruptions within the supply chain. So to Chris' points around part redesign. When we started at the beginning of this, we had a couple of hundred parts that allowed us to use alternate sources in our products. That number is over 1,300 at this point. So we've built in a level of resiliency within our supply chain that's allowing us to meet the demands of our customers, even while the macroeconomics around supply chains and ecosystems continue to be a challenge. And then to the point around inflation, right? The heightened inflation environment has permeated from about the middle of last year to where we sit today, we're starting to see that dissipate. And Chris knows I like fun facts. And so a fun fact around inflation is, if you look at the earnings results over the last 3 quarters, the number of times the word inflation has been used has sequentially decreased every quarter. And so now in Q1, it's at the point that it was in 2021. So I think across industries, inflation is starting to be at a place where it's manageable, it's controllable. Companies are taking action, we are taking action to offset that. And then the final point I would make is around our short-cycle portfolio. And this is unique to L3Harris. And we have been criticized for having a more short-cycle portfolio when comparative to our peers. However, in a heightened inflationary environment, that actually works to our favor. So if you assume that the middle of last year was the height of the inflationary environment, our average program performance period is about 12 to 18 months, so we will have worked through most of those programs by the end of 2023. So as we head into 2024, that should be a bit of a tailwind for us as we've worked off all of those programs that were priced in advance of the heightened cost environment.

And I'll just chime in. Those are all the operational things. We're also looking strategically and portfolio-shaping as well. So I've talked about the need to divest in some form or fashion, sell, spin, whatever, our noncore assets. And I think that's an important part of the margin story as well, to get a more focused portfolio. And these acquisitions, Viasat, Aerojet, get us right in high-growth, high-margin opportunities. And we will get rid of the noncore, which tends to either be overly capital-intense or lower-margins. So as we go through that process, I think we come out the other end with a higher-growth, higher-margin business. And a lot of people, sometimes, were questioning these acquisitions relative to scale. And just to clarify, we're not trying to be the largest defense contractor, we're trying to be the most valuable and that's the strategy. So we'll add a couple of billion of revenue through acquisitions. We'll probably divest a couple of billion. And then at the end of the day, we'll have a really nice, crisp, focused organization that I think we'll all be proud of.

So on the 2 most recent acquisitions, TDL, and then in process, Aerojet Rocketdyne. Can you -- first, on TDL, you've got Link 16. What -- can you talk about how you're using that capability within communication systems to ultimately, I assume, produce some real revenue synergies?

Absolutely. I think that was the acquisition that had more revenue synergies than cost. We will -- there's questions about the integration. This fits nicely into 1 of our 14 sectors, which reports up to 1 of our 3 segments. So it's a very discrete operation with dedicated resources. And we're actually, on the cost side, we are migrating a lot of the production from Southern California into our Salt Lake City facility. That will be done by the end of this calendar year. It's actually progressing quite well. Even the attrition that you would expect is below our target. So I think that move is going to save money and allow us to continue to produce and meet our on-time deliveries with higher-quality products. We've had an unusual amount of -- in our business, you spend a lot of time in D.C. and the Pentagon meeting with the customers. We were getting calls back in November, December, after we announced the acquisition, from customers. And we had to say, "Well, wait. We can't do anything yet until we actually close," which we did on January 3. So Link 16 is on over 20,000 different platforms. There will be a refresh with a more resilient, if you will, Link 16. Part of this is just having the footprint and the real estate on these different platforms. So we think that there are huge opportunities. And I think one of the lessons learned out of Ukraine is the importance of communications and resilient communications. Ukrainians have it, mainly as a result of the 15,000 radios that we've delivered. The other guys don't, and you see what's happening. So I think this just reinforces the importance, a little bit, of our portfolio with the ISR for situational awareness from space and aircraft and the ability to communicate. Everything in between is the missiles and munitions, which of course, there's a huge shortfall, and why this acquisition of Aerojet strategically makes a lot of sense to me.

Well, and on that. Before, you really -- you weren't a player really in that market. So how did you think about this? Clearly, there's growth here right now, no question about it. And there's even more growth than when you originally announced it. However, it seems different. It doesn't seem to fit into a lot of the other things you do. How do you think about this in terms of synergy?

Yes. We don't see a lot of revenue synergy. To your point, it's probably not a lot of difference in the last 5 months. Michelle mentioned the short-cycle business, right? This comes with $7 billion of backlog with annual revenue of about $2 billion. So it will give us more visibility and a longer-term view of our backlog and forecast kind of offsetting that short-cycle business. When you did the merger, it really was to get into all the domains. We look at the budget, we look at the strategy. And I'm well aware of the people that question these things, but we have a process. And the likelihood of 2 of the things that we wanted to buy come to market in the same quarter, we view it as -- having been in this industry for almost 40 years, you have to take advantage of these opportunities. There aren't that many opportunities to make acquisitions. I will go on record again and say, I don't foresee any acquisitions for the next several years, like I said. I can always say it so many times. Yes, ideally, would I have liked 1 to come into market in '22 and 1 in '23 or 1 in '23 and 1? Absolutely. But they were both for sale in the fourth quarter. And we're fixing our operational challenges through supply chain. I think that story is almost done. Viasat will be basically integrated and ready to roll by the end of the year, and then we'll take on Aerojet Rocketdyne. So I'm well aware of the feedback, how can you do 3 things at once? But one thing is being done, the other is being done and the third will be done. So they're really spread out. And again, you listen to customer, you look at the strategy, you're trying to get in high-growth markets. This is a high-growth market. It's well documented. And it's one of the biggest risks of -- anyone you talk to in the DoD, is there are not enough munitions and missiles. And this is going to take years, if not decades, to replenish the supply and to prepare for the threats that are out there. And I think there's margin opportunity. And it's further backed up by the DoD giving Aerojet Rocketdyne, $215 million for Defense Production Act. I think that's a huge focus on the importance of manufacturing. And there's only -- since -- I'm sure I'll answer the question before you ask it. We're going through the regulatory process. And the fact there's no revenue synergy confirms that we don't compete with them, and they're not a customer of mine, and I'm not a customer of theirs. So terms like vertical and horizontal competition do not exist, which is why we're confident this deal will close in the second half of '23.

So one thing about this. I mean, as I'm sure you've heard, you've had some vocal customers who have not been happy with the performance of Aerojet Rocketdyne, which appears to be an opportunity for you. There's definitely -- there should be some upside here. How do you think about that in terms of how you plan to manage this, integrate it post close, to improve performance?

Absolutely. Great question. There's only so much we can do before the deal closes under the gun-jumping rules, but we've been to -- I've been to a facility or 2. The team has been out there. We can only observe and get ready for the integration. With 46,000 employees going to 50,000, we have the tools, we have the skill sets. I mentioned our focus on operations. We view these as factories, not programs, right? So when you look at the flow of production, you look at the lead times, you look at the quality, roll throughput yield, we just see lots of opportunities where our experience, our tools and our systems can help step up the quality and the on-time delivery. So we're well aware of some of the feedback. I generally don't use other companies' names other than Amazon in my presentations. But yes, I'm well aware. And I think that's why it's in the best interest of national security and the national defense to get this thing closed quickly. And I'm hoping those same companies that are concerned about Aerojet's performance are supporting this deal because it's in their interest for us to own it sooner rather than later so that we can move forward with the execution.

And as i'm sure you know, when you do deals like this, the process before close, you can often see the loss of key people. You can see performance issues in the company that's being acquired. I mean, how do you manage that? Obviously, you're not directly involved in what they're doing. But how do you reduce the risk?

Yes. I mean, that's always the challenge. We've met, as you would imagine, the key leaders. A majority of the people want -- will be staying and want to perform well and be part of L3Harris. I did a video back, I think, in December, which was reviewed by 100 attorneys and went to the workforce. The feedback has been very positive from the Aerojet Rocketdyne employees. They want to be part of a bigger company. There's more opportunities, right? There -- it's tough to be a $2 billion company going up against companies 20x larger than on a level playing field. So I think a lot of the key leaders who we've met, they want to be part of the new company. So their performance during this period is important to them as well. So it's a clear acquisition. So the Board won't come Eileen Drake won't be part of the company. A few other corporate execs won't be. But where the rubber meets the road at the facilities in Huntsville, Camden, out in California, they're all working hard. We get regular updates. But again, as you said, during this period, like any acquisition, you can only observe and get the data. And I think they had a pretty good first quarter, right?

No, they did. If I could just add, in terms of Q1, they did report really strong results. 11% growth within Q1. This was actually a record Q1 from a revenue perspective for them. And then EPS and cash, when adjusted for onetimers, because they had some integration merger work that they had to adjust for, was in line with expectations. So they're performing well and consistent with what they've been sharing. The only other thing I would add to Chris' point around the integration work is, we are spending a lot of time understanding the portfolio, the processes, but particularly the people. So to your point, Doug, we haven't seen a lot of attrition. We did a 3-day road show. We went to 3 of their sites. Spent a lot of time what I call doing a listening tour and really trying to understand the care-abouts, the concerns. And really, how do we tap into creating value expeditiously post close? And the team is excited about being part of this journey. So we're excited about getting this behind us.

Yes. I mean, they've had a rough 2 years for well documented items I'm' not going to repeat. So I think there's excitement. And as Michelle said, their attrition is less than ours. I guess when there's a duopoly, there's only so many places you can actually go. So it's a very engaged workforce. And again, that $215 million of DPA money, the sooner we can get in there and work collaboratively with the existing team to optimize that. I think that's a game-changer, a real game-changer.

So if we switch over to some of the individual businesses. Communication Systems, fantastic high-margin business. You've got great radio contracts. However, going back to the supply chain issue, this has been an area where semiconductors have been an issue. And it looked like you were, finally in Q4, reducing inventory and getting some of that backed up -- back up in radios out there. We didn't -- it was hard to see that much in Q1 on that line. But can you help us understand how the -- what I would call almost finished inventory, the work in process there. How that is -- how you see that flowing out to the customer over the next couple of years, given the supply chain challenges you faced?

Yes. So I'll start. And then, Chris, feel free to jump in. So just for the audience's benefit, our Communications Systems part of our portfolio is about a $5 billion business. To your point, Doug, we do enjoy really nice margins within this business, north of 20%. This has been the area that's been the most acutely impacted in terms of supply chain and electronic components. We are starting to see that abate, however, based on those proactive actions that I talked about earlier. I will also note that this is the business that has also seen really strong demand as a result of the current conflict in Ukraine. And so to your point around inventories, Doug, as we purposely grew our inventories, that was aligned with demand increasing as well. And so within our product-based portfolio, which is about 25% of our overall portfolio, we saw our demand grow, our backlog grew by over 20% in 2022. So those inventories, we were purposely growing, recognizing that we were going to be growing our product revenues in 2023. And that is what you are seeing. And so to your point around Q4 versus Q1, we benefited from a lot of our suppliers trying to meet their year-end objectives in Q4. We typically have our largest deliveries within fourth quarter. Within Q1, however, we did see double-digit growth within our product deliveries and comparative to last year. And where we sit here, to Chris' point, we expect sequential improvement within Q2. And we expect that's going to continue into the second half, depleting some of those inventories.

Yes. And during that whole COVID, seemed like forever, 1 more quarter, 1 more quarter. When you're actually running the businesses during that, you're making your best estimate. And at that point, we took the approach, every part at any cost, right? Because we were out there buying everything we could to meet the demand and to meet our commitments and making alternative parts and such. And I alluded to it when we said it, and I know it gets hold, but you can't deliver a radio, think of your iPhone, unless you have every single part. You could -- I know guys in the Navy, they deliver ships, and 40 years later, you're retiring ships. And it still has a punch list because, airplanes, ships, you can deliver those. And kind of like building a house. My house in Florida still has a punch list, I've lived there 4 years. So radios, it's all parts. And we went back early on 3 years ago, list the critical parts. And we'd get the critical parts, the battery, the antenna, whatever. Then it turns out every part was critical. Because if you don't -- I mean, we were holding up for a $1.32 part, and we couldn't deliver the damn radios without this. And it's like, all right, I'll pay $2. But they didn't have them, right, because the production was actually in India, of all places. So all these things you learn about, and I think the whole industry -- or I'll speak for ourselves, we learned a lot about supply chain. And we've really increased the talent and the focus. And I've said this before. 3 years ago, I'd say we had 9,500 suppliers. And today, I'd say we have 525,000 because we have the visibility into the second, third, fourth tier. And any one of those can basically hold us hostage and put us behind the 8-ball. So we're taking a whole different approach. And this concept of people saying, "I can't wait until things get back to normal." We're like, "There is no normal. We're not going back to the way we used to do things. It's the new norm." And right now, we want to burn down this inventory. We're being much more selective. We've actually changed our supply chain approach. We have some strategic alliances with some microelectronic parts. And it's just a different way instead of reverse auctions and trying to get the lowest price. You find your key suppliers. You share the technology road map. They co-invest in developing new products. Especially on the chips, we use a lot of 28-nanometer chips. All the growth is in 3s, 5s, 10s. So how do we develop our products using some of the new modern chips versus the older ones that are not getting the resources from the big companies, like TI, Intel and others? So we feel optimistic about the future. We've learned a lot about it. And we'll -- like I said, we're going to have a decent or a really good second quarter, and we'll continue building the momentum.

And I think of this as a -- it is particularly -- the radio program is particularly interesting because, I mean, Harris essentially a long time ago came in the back door of the JTRS program to provide the waveforms that you could have commonality across the army, across the marines. So that is always implied, as we've looked at this, that there's a long runway here in terms of rolling out these radios, because if you don't get commonality, you've sort of not accomplished the whole point of this. So when you look at rolling the radios out, how far along are you in modernizing the Army and the Marine Corps?

I think we're maybe about 1/3 of the way through. We have these rather large IDIQs. I think the indefinite delivery, indefinite quantity. So yes, you look at our backlog, it looks light. But to your point, you have high confidence in the fact that you get these annual purchases and competitions. I mentioned the Manpack, HMS, just the other day like $186 million. And there's a leader follower. We got the majority, another company got the minority. I think it was a 60-40 split. So you have confidence and visibility into that. We're talking about the new norm. In the old days, we'd be proud of the fact we had common parts through all of our radios, which sounds like a good thing until that common part isn't available, right? So those are the types of things we will invest in a new radio. Do you want it to have the same exact parts of the others? You may actually come up with no, let's have some common parts or at least have dual supply. So it's just rethinking everything in the way we do it. But we have a lot of confidence in that business. And internationally, it continues to grow as well. So you don't see it in the backlog, but you do see the opportunities year after year.

One of the things that's part of this, what I consider kind of an interesting story about how you get this high-margin radio business that kind of came in through the back door, is that you did your own R&D. And that's -- as you referred to at the beginning, you spend more money on R&D, on IRAD, than really any of the other major primes as a percent of revenues. So that really delivered here. It really delivered on the night vision goggles. You get these commercial contracts. That's great. But when you think about those investments today, at higher levels of IRAD, do you have the confidence that you can do more of this kind of work, that you can get high-margin commercial work in the future?

Yes. And that's the key question going forward. We have confidence in those businesses. We also have it in Wescam, where we have the turrets or the cameras that we put on various rotary and fixed wing aircraft, that have the higher margins. But even in your more traditional businesses where you start with that cost-plus development program. As you move into production, you look at the weighted guidelines, you have the opportunity to get 15%. And then ideally, you move in international. We're up to 21% of our business international. It was a focus at the date of the merger, it's increased significantly. And I think our international customers and allies look at our portfolio of products. So all those work in unison to grow the margins year-over-year, and I think that's unique. I will not shy away from cost-plus development programs that might be 10% or 12% because you need those to set yourself up for the low rate production, the full rate production and ultimately the exports. So it's really a portfolio, but we think we have pretty good visibility to improve those margins. And I mentioned our LHX Next initiative. I mean, that's going to start paying off maybe in late '23, but early '24 as well.

One of the places where you do have a lot of cost-plus is in the space and airborne world, with space. And can you talk about -- that's your highest -- I think that's your highest-growth kind of subsegment. And as you look at it today, I mean, you're heavily participating in sort of what I refer to as new space, large LEO constellations, things like that. You're now doing your own bus manufacturing. You've got a new factory, I thought, in Florida. Can you talk about how that business is likely to change over time from initially a lot of development work on these new programs, to one with a lot of satellite production later on?

Right, right. I probably wish I had more cost-plus in space than you would think. There have been a lot of fixed price space programs, especially in low earth orbit with SDA and MDA. But again, we have existing programs where we can use -- the reuse. Yes. The -- what's interesting about the space business is really consistent with our strategy and change in the mindset for years. I think I mentioned, at the time of the merger, we had no satellites in orbit where we were prime. And my simple way of looking at it, you have the bus, which is an important part of a satellite, and then you have the payload. And we were basically the payload provider, which I would argue is more valuable. So the industry flipped, where the company with the payload became the prime and then the bus becomes the commodity, which was different than 20 or 30 years ago, where the bus provider was always the prime and the integrator. So we flipped that model. A lot of what we do are these smaller sats, low earth orbit. And in the old days, you could take 5 years to build a $1 billion satellite and launch it the last 15 years. Now it's more of this factory mindset. On SDA, we've been successful the tracking for tranche 0, tranche 1. The bid -- RFP will come out for tranche 2. So we're taking that type of approach. And the buses have become the commodity and the payload is where the value resides. We have launches coming up later this year, and we'll see -- we'll see how that plays out. I made comment at the beginning about the importance of speed. That's the #1 goal. Let's get these demos up there, let's get these satellites. They're going to have a 3- to 5-year life, and they're going to be a replenishment. So I think it's pretty darn exciting. And a fair amount of these are classified, and that's an area where we have a lot of talent, 20,000 cleared employees. And things are progressing very well.

Well, staying in space and airborne. One area that has been a challenge has been Tech Refresh 3 on the F-35. Can you -- 2 things on that. One is, maybe you can update us on how that's going. I know you're getting there, it sounds like. And then can we see actual top line growth there? As you're -- even if we're delivering, say, a flat number of F-35s, there are upgrades, you have more content. What's the growth path?

Yes. I know we're running out of time. TR3 has been a continual improvement. There will be others up here in the next few hours, you're going to ask them their opinion. And we think we're doing well. The most important thing is I think there's good collaboration and teamwork, not only within the industry, but there are meetings now in the Pentagon that has the Air Force and the Marines and the Navy and the prime and the subs and us all in the room agreeing on a path forward. First flight was a key milestone. We had that back in January. We're producing the ship sets. And Lockheed's the prime, as you well know. They're in the process of integrating. And I think it's very collaborative and working quite well. Relative to growth, it's going to come back to what the DoD decides to do relative to the already delivered aircraft. So will there be an opportunity to refresh those with TR3 capabilities? If there are, which I think they will need for strategic purposes, then that's where the growth for a company like ours and maybe others will exceed the primes. But we kind of go quarter-by-quarter on that one, and it comes back to the budget and what our customer ultimately wants.

Well, good. Well, I think we've got to wrap it up here. But Chris and Michelle, I want to thank you for joining us today. This has been great.

No, thank you. Good to be here, Doug. Appreciate it.