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

So next up, we have L3Harris, and we have Chris Kubasik, Chairman and CEO; and Ken Bedingfield, CFO. Do you have any forward-looking statements or we good to go?

I think we're good to go.

Okay. Great.

So I want to -- we'll start high level, I wanted to ask you about the budget situation. The clock is ticking. I recall in 2013, I think it was -- no one thought we would have a sequester. Then we had a sequester. This year, I think the House is on recess for 2 weeks now. We've got the continuing resolution that's going to expire. And then obviously, Congress has to pass -- somehow pass all 13 appropriation bills. So I guess what are you hearing with regard to getting this all done? And what happens -- what's it mean for you guys if we actually have a sequester?

Yes. Well, first of all, good morning. Thanks for the invite as always, David. That is a unique situation. As you said, we have to get all the appropriation bills passed by 2013. I don't think they're going to all be passed on the same day. I think they'll be in a couple of different tranches. But it is a unique situation. Speaker Johnson and all the leaders continue to say their top priority is to get these bills passed. So we're kind of going on that assumption. Now if we go into a sequester, we'll talk about a 1% cut relative to the '23 budget. So just using the top line. The President's budget is $842 billion this year. Last year was $816 billion. So with a sequester the budget for the DoD would be $808 billion. And I think the question is what and how does the department handle that money? And I think they'll take care of the troops first. They'll take care of O&M. So I believe the investment accounts will clearly be hit much more than the 1%. So that's the part that we need to figure out and see. Our guidance that we gave in January contemplates a budget in the end of Q1. So it'll be interesting to see how that plays out. Clearly, they'll have to truncate programs or stop new starts and all that. So we kind of have to wait and see. DoD's keeping close to the best what they'd do, but I'm sure they're running scenarios.

Right. Yes, we've seen some stuff around. It looks like F-35 and canceled for, and it seems like they're moving in that -- or at least preparing for that potential. So absent that, you talked about that your guidance wasn't incorporated. You guide to 3% -- 3% organic growth.

Yes, I like to think I'm guiding to 8%. Go ahead.

Right. Right. 3% organic growth. I think last year was much higher than that. We still have this big bucket of outlays to come through that still haven't kind of caught up to where the budget actually even is. So however, you want to take it, why does growth decelerate that much this year?

The three things we're focused on is growing the top line organically, which we're doing; improving the margins, which we've committed to not only for this year, but through 2026; and increasing the free cash flow 10% this year. So when I look at the top line growth, I look at the margins and I look at the free cash flow growth, I think we've got a pretty good plan and strategy to execute upon. The big areas we're growing above the 3%, we've talked about this for years, is in the space domain. So we've been very successful with new opportunities as we've executed our space strategy. Our tactical radio business, we had a big catch-up last year as we were impacted by supply chain in 2022. So we're still growing above the 3% in TCOM, but less than we did in '23. And then the Aerojet Rocketdyne organically is above the 3%, obviously, inorganically since we bought them in July. And then the last one is our broadband communications, which is where we bought the resilient comm business, ViaSat's tactical data link. So those four are outgrowing. Airborne is pretty flat. The FAA business is flat, very diverse portfolio comes out to three. It'd be good to have a budget and get out of the CR before 7 of the 12 months of the year are done. So we got to factor that in as well.

Right. And maybe, Ken, you talked a little bit on the call about kind of the first half versus second half dynamic in terms of the growth. Do you want to expand on that a little bit?

Yes. Just as we look at the growth relative to 2023, we do see that similar to the '23 profile, it will kind of build as we progress through the year. You asked about the growth. And I think Chris appropriately answered. The only thing I would add to that would be as we look at our LHX NeXt cost savings program, as we are reducing our cost, that obviously in this long-term contracting business has an impact on compressing sales a little bit as well. So that's a little bit of a headwind to growth as well. But we had a solid growth early in '23, and we saw that build in '24. We see that kind of similar progression through the year. And just as we think about the business, again, we do have a complex and diverse portfolio, which I think at a high level means it's probably harder for us to consistently outgrow the market. We've always got programs that are growing. Chris mentioned some, in particular space and some of the communications businesses that are growing faster than the market, and we've got some that are a little bit flatter. And I think from a growth perspective that says, yes, we may look more like what the market is. But if we can execute on the strategy to increase the margins, really execute on the LHX NeXt cost reduction program and then create that ultimate 10% free cash flow growth for '24, but accelerating towards our $2.8 billion forecast or target for 2026, that's really where we see the value. And I think as we think about the business, we're prioritizing profitable growth. We're prioritizing the ability to realize the right risk-return equations and the bids we're putting forward over just growing the business. And I think that's the discipline that Chris is driving down through the team. And that's what we see in terms of our growth profile. But I think if you look at us relative to our peers, where we really differentiate is our ability to accelerate margins and ultimately, that margin dollar growth.

Yes. So you touched on this a little bit, I mean what everyone is concerned about with regard to the entire industry as some of these fixed-price development contracts that were seem to have been taken on over the last 5-plus years or so that are now coming through. I guess, what have you done to kind of change your process in terms of bidding, reviewing programs that should make us feel comfortable, I guess, that the worst is kind of behind at this point, at least from your portfolio?

Yes, let me start. Maybe Ken will chime in. So we've changed our process over the last couple of years. We have multiple reviews. So when the RFPs hit, we immediately meet to try to figure out, can we do this work? Should we do this work? And then do we want a prime? Do we want a sub? Do we want to be a merchant supplier? What is the best business model for L3Harris and for the customer? So I think we're unique in that position. We do about 62% prime, 38% sub/merchant suppliers. So we're kind of well, we are agnostic, what makes the best business sense. And in the space world, we've talked about moving up the food chain and being a prime versus just selling antennas as an example. We've lowered the delegations of authority. So we have -- I mean, we literally put in thousands, like 9,000 bids a year given the size and complexity and diversity of the company. So my team and I, a small group of four, review, probably about 100 a year. And then the segment Presidents and Sector Presidents as well. So we learn from the past, especially with the pandemic. I think we're all now much more aggressive in getting escalation clauses in the contracts for inflation. The customer realizes and acknowledges it. And on the fixed price contracts that I've talked about, to clarify is when you get the RFP, where they -- at the same time, you're bidding development, they also want you to bid low rate production and fixed price production. Makes no sense, in my opinion, to bid production when you haven't yet developed. And I think there's a long history of people looking at the root cause corrective action as to why they have losses that kind of pops up more and more. And locking in your subs fixed price makes you feel good in the near term, but it really doesn't solve the problem because if they can't deliver on a timely basis, it affects you as the prime as well. So we're pushing back. I think generally, the DoD gets it. They understand. And I think the whole industry just wants a fair contracting vehicle based on the risks. So we balance the risk-reward potential. And I'm not sure that's one of the headwinds, as you might suggest on the revenue growth, but we're going to bid profitable growth. We say internally, profitable growth is one word. And just the way we're managing the business. I don't know, Ken, if there's anything you want to add?

Yes. No, I would agree with that. I think the only thing I might add to that would be aligning the incentives for the team. I know Chris has been working hard with making sure that we've got the right short-term and long-term incentives. And then I think consistently messaging to the company, whether that's on leadership calls about what the strategy is, what the importance is, what we're focused on in terms of bidding and winning new business. And then as we meet individually with the teams, having those individual discussions about where those businesses are going and how we're trying to get there with a consistent focus on profitable growth. Chris and I have been traveling around the company, having a chance to visit some of the sites, meeting with not only the leaders, but some of the folks kind of at that next level down, whether -- depending on the business, whether that's a product line or a program leader and having those honest discussions about where we want to go, what our expectations are, how we get there. And it's not that there's a line in the sand to say, this is what we'll do, and this is what we don't. We need to strategically think about each opportunity, figure out, again, as Chris said, can we do this, do we have the right capabilities? Do we have the right experience? Do we have the right team, whether that's our team or suppliers that we work with? Should we do it? Does it have the right risk return for us? And then how do we go execute and how does it align with the incentives that we're setting for the team and the messaging that we're talking to our shareholders about, about our ability to drive that profitable growth, the margin expansion as we grow with the market. So I think it's just kind of that constant messaging, so the team understands. And when the folks come in with opportunities, it is, in my view, 9 weeks in to the company, a very open and honest discussion. And I think that's what having kind of a smaller team review enables us to do, kind of have that strategic discussion, make some decisions and then proceed forward. So for me, it's been very refreshing as I've joined L3Harris to see how we can be nimble and reactive as we make some of these decisions.

And I guess I didn't answer the program review question. It's similar, but a lot of this is just the culture. You got to have a culture of transparency and you have to encourage people to bring forward problems. We have our early warning metrics, earned value, right? We have program managers that we train. But ultimately, the messaging we say internally, if you have a challenge, you have an issue, raise your hand as a PM because I believe there's not an issue we can't solve, if we find out about it early enough in the program and then we have our oversight and review. So I think it may not fully be appreciated, but the culture of transparency and openness, as Ken mentioned, I think, makes a big difference. And been in this industry a long time, and there's war stories of 20 or 30 years ago. People bring bad news and you fire them, probably not going to get an honest assessment of where these programs are. So we're a kind of friendlier approach to solving problems. And I think it's making a difference.

IMS, I think, is where most of this is the least hourly to us manifested itself, some of the issues there around the ISR business. How -- I think you talked about a profile there that, that some -- most of this fixed-price development work should be behind or kind of reined in through the first half of this year. Is that still the trajectory that we're -- that, that business is on? You still feel comfortable with that, that the kind of biggest issues are behind from a fixed price development standpoint?

Yes, I do. In fact, Ken and I were there the last couple of days doing classified-unclassified program reviews. That was a longer cycle business. So the hit on the inflation and the attrition is lagging a little more than the quick turn business. So yes, I think we feel pretty confident that we have those bound. And then as we're bidding and winning new business, especially in the international, we're looking at double-digit plus margins, which is going to help us with the growth in ISR. So anything you want to add?

Yes. I would just say we were just in Greenville and Waco this week visiting with that ISR business. And as I have a chance to get more familiar with the specific sectors that we operate in, it really is a great business down there. We have seen a little bit of margin compression as we've seen the mix move from more international to more domestic. And then ISR, a bit got hit not really as much during the pandemic, but a little bit of post-pandemic as we saw some competitors in the area and maybe not business competitors, but labor market competitors as the airlines were expanding post-pandemic. We saw some labor moving and we had to train up some new folks, and that took a little bit of time. And these are longer-term programs, but we've got now, I think, a great employee base that's been trained up. The work is complex and requires a fair amount of precision as I've learned more and more over the last couple of days. But I do think we've got a good mix now of ability to perform as well as we're starting to see some international opportunities in front of us that should help us expand the margin. LHX NeXt will obviously have an impact. And I think that impact will be enduring in that business, but it takes a little more time to see that cut in, in some of these longer-term programs. So I do think there's opportunity at ISR first of all, I think getting some of the program challenges that we've seen, as you mentioned, kind of behind us and then an ability to expand margins both on kind of the business mix as well as the benefits of LHX NeXt as we look forward in that business.

Yes. And I'll just say lots of new leaders down there over the last 12 months.

So you touched on LHX NeXt, $400 million in kind of net cost savings you're targeting. You've given us a high-level view of kind of what you're doing. But how does that break out? And you've also talked about each business having the ability to expand margins by over 100 basis points and we've all tried to dig in a little bit. Where -- I guess, by business, how would you rank the LHX NeXt opportunity?

I think I answered this question in January, so now I got to remember what I said, but a...

You kind of answered. That's why I'm asking it again.

I didn't do a very good job. All right. I'll try to do a little better job. So this is starting at the -- it's really in addition to our E3 program, which is a continuous improvement. And that's why we've set a corporate target, all the compensation for all of our executives in 2024, assuming the compensation committee approves it tomorrow, will be focused to achieve this $400 million run rate because a lot of what we're talking about is doing what is best for the entire enterprise. So trying to divvy that up at this point is not always that obvious. So we're looking -- supply chain is a big driver of both direct and indirect costs, getting long-term agreements, changing the way we approach our supply chain from being way too tactical and transactional to in case -- in certain cases, be a more strategic share in the technology road map and negotiating LTAs, long-term agreements, and we've had some early success in that regard. We're taking a fresh look at our whole IT organization and how to skip a generation and accelerate some of the technologies in that regard. And then we're looking at each and every function to figure out how to optimize it. And in this industry or in my business experience, people will tactically look and say, well, I think there's too many -- we'll pick on HR -- too many HR people at corporate or too many -- you got to look at it in total. How many total human resource people do we have at L3Harris? And what is the right to -- they'll probably listen in and get nervous, what is the right number? And whether they all are charging corporate or dispersed, really doesn't matter. We want to get the total number right where they sit on an even day is interesting, but irrelevant to me and that's what we're going through. So when you -- I think IMS has the greatest opportunity given the fact that there's currently 100 entities, 26, I think, different ERP systems. We just combined 10:1 on January 1. Most of that was legacy L3 businesses that had not been integrated like we've talked about. So I think that has the greatest opportunity. I also think communication systems, which has the commercial business models probably in second place and everybody immediately jumps to -- well, they already have 24% margins. How much higher you can go? And nobody has a pass. I mean, you can actually go higher. And I said it's a heck of a lot easier to add 100 basis points from '24 to '25 and going from 8 to 9 or 11 to 12. And with the commercial business model, we keep a lot more of the savings rather than giving it back to the customer. So nobody gets a free pass. We've looked at that. We're focused on the cost of poor quality, reducing that, improving the roll throughput yield. We made some investments for the SIOP systems instead of having manual spreadsheets is now automated for demand management, all these things that make them a better company. And I think that's been the mindset. Our margin target is 15%. We have 16 sectors. There's not one of them that's making 15%. You either make up more than 15% or less than 15% and everybody has to go up, and that's the plan we've put in place. And then probably put Aerojet third and SAS fourth just because SAS is already cost-plus, and we've been able to consolidate the disclosure statements and such. So yes, we'll be reporting, and you'll start to see some of the benefits. But I'm excited about it. It's one of Ken's main responsibilities. We meet monthly review on the progress, and I think it's going to be a game changer for us. And it's not only the cost takeout. It's just the agility and the speed, eliminating layers and spams and building a world-class organization that moves quicker and faster and lower cost than our competitors.

I wanted to ask you about working capital improvement was a big focus here. And we got to the pandemic. You had to take on additional inventory, all that. Now that you're -- you've been in the seat for a little bit, how do you -- you came from an organization -- did a very good job from a working capital perspective. How do you kind of -- now that you're into a little bit more, how do you view the working capital opportunity and what potentially you could do here and how that could contribute to the cash flow growth that you're projecting?

Yes. Look, I think at the end of the day, what we're focused on is really disciplined balance sheet management at the end of the day. And Chris and I are probably both kind of, at the end of the day, balance sheet guys that really -- everything kind of flows through there. And different ways to kind of maximize the benefit, whether in a more traditional product-based business might be more kind of inventory management. Although I think we learned through the pandemic, you don't want to push it too hard in case there are supply chain issues, how do you make sure that you can still deliver product and grow the business. Radios aren't something that you can deliver if you're missing a part. So thinking strategically about making sure that we've got the right kind of risk relationship of a good and disciplined supply chain inventory management strategy, along with in some of the other businesses, how do we negotiate with the customers for the right cash flow profile in our businesses, performance-based payments, if we have to take progress payments, what impact does that have? Timing of where we can try to get opportunities to monetize some of our receivables and things like that. So very much a focus. I do see opportunity, in particular, as we integrate Aerojet, I think there's some opportunity there. But as I slice and dice across the segments within the company, there's slightly different strategies as to how we get there. But certainly, disciplined balance sheet management will be a big part of how we generate our free cash flow growth. But at the end of the day, it's a mix. I think more than anything, it will come from our growing margin dollars. But as we turn those growing margin dollars into disciplined not only working capital, but also, I think we talked about CapEx staying around 2% of revenue, I think that yields this growing free cash flow that we've talked about. And I have a lot of confidence that between those couple of dynamics, again, growing dollars, managing the working capital and managing the CapEx that we've got a really solid path towards that nice free cash flow trajectory.

Yes. In terms of the balance sheet and the leverage and delevering, what is -- you have still have the CAS divestiture to close. What is the opportunity? You've talked about the potential for additional divestitures. What is the potential there?

Yes. I've thrown out the number of about $2 billion of revenue that...

Incremental to...

Incremental to CAS that would be on the list of potential divestitures that don't meet our focus, which is really to be a national security company focused on technology. So that -- divestitures have been tough the last few years with the rising interest rates and the regulatory environment to be candid. So the businesses are profitable and performing, and we just have to figure out the right time as to when we want to monetize them. We got lots of inbound calls usually when I say what I just said, but we'll run the right process at the right time. And as we said, we want to get to 3-0 leverage and then, of course, start returning cash to shareholders through modest dividend increases and mainly share repurchases and that's tracking. So if we can close CAS here in the second half of '24, pay the debt down, keep the free cash flow coming, we could be in a position late '24, early '25 to accelerate the share repos.

Any key upcoming big competitions from your standpoint that we should watch out for, you're keenly focused on?

Yes. I focus on all of them, but we're off to a good start this year, actually already here in February. The SDA tracking tranche 2 for 18 satellites. So we're proud of the team and the only company to win Tranche 0, Tranche 1, Tranche 2, 4, 8, 18 satellites. So that was a big win early in the year. In fact, we just launched on Valentine's Day, 5 satellites, 4 of them were the Tranche 0 satellites. So that strategy is working well. We talk about ISR and business jets. We have an undisclosed European country where we secured two aircraft in January to missionize their business jets. So that continues the trend of business jet ISR aircraft. So that's a pretty good opportunity. We have a bunch in the radios, HMS, a lot of international. You still have Ukraine, didn't talk about the supplemental. But once the appropriation bills are passed, I've been told, they'll focus on the supplemental, but Ukraine supplemental would be helpful to our tactical communication radio business. We've already delivered 15,000 radios. So another $100 million or so probably tied up in the supplemental that we could use there. And Aerojet, we have a lot of proposals outstanding, some PAC-3, solid rocket motors, GMLRS and such. So those are progressing through the system. And then there's always the classified stuff that we can't talk about, but we're doing quite well in that regard. And probably not a day goes by, we're not hanging out in the skiff for a meeting or a Zoom or something. So a lot of good stuff going in that world as well.

Any update you want to give on Aerojet, how things are progressing there in terms of -- you talked about attrition. Attrition has improved since you've taken over. But how things are progressing in terms of getting production ramping up?

Yes, the issues we look at is really one of capacity. We have more than enough work to do and there's just certain chokepoints relative to the equipment in the facilities, which is what we're investing in, mainly using the Defense Production Act money that you've heard us talk about in the past. At the date of closure, there was a certain number of, they call it backlog, but that's confusing. I'll just call it delinquencies. These are rocket motors that we have not delivered to our contractual obligation, basically late. So we've been able to -- in the 5 months that we owned the business, we brought that number down by 10%. And we have a plan to reduce that throughout '24 and '25. Some of that's a result of capacity. So we're doing quite well. This will probably have the four segments, the second highest margins of the four. And we're glad we made the acquisition. We have a good team. Lot of talent that are familiar with rocket motors and missiles, both internal and external that we've put in there. We've already hit our synergy goals of $50 million. So we know how to do that. We do it quickly, but the focus is clearly on the production. And we've made good progress, but heck of a lot more to do, but we've got the right team and the right strategy, and we're working on it. And the customer relations are all positive.

Can we start the audience response system? It's coming, I think.

This is the fun part of the...

I know you look forward to this, if we can get it to work. It's not coming up here.

We can go old school and raise hands. What was your first question?

Do you own the stock, I believe.

That's fair enough. I do.

Is it working? May restart it?

How are you thinking...

Hooked up.

Great opportunity. Thank you for joining.

Next question, please. Next question, please. I know you kind of talked about that some things growing faster, some things not. So kind of in line. Next question?

The first two will be zero, but we'll see.

There you go. I think that's it. Is that it. All right. Chris, Ken thanks for coming this year. I appreciate it.

All right. Thank you all for joining us today.

I'm going to come up to your meeting.

Okay.

Good to see you.