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

Okay. Why don't we get started here? I'm Doug Harned, Bernstein's global aerospace and defense analyst, and I'm really happy to have with us again, Chris Kubasik, Chairman and CEO of L3Harris. I don't know if you have a few -- anything you want to...

Probably say it's great to be here. I probably ought to start by saying that I will be making forward-looking statements, so refer to our SEC filings there. And it's always good to be here, and I'm sure you've got a lot of questions. So it's been an exciting 5 years since L3 and Harris merged and love to talk about what we've done and where we're going.

Actually, why don't we start right there. If you look back 4 to 5 years, you put these two companies together, when you look at how all that's worked out, what do you think have been the big successes? What do you think perhaps could be better?

Yes. I think that's a great question. I mean what we -- when I look back on this 5 years ago, I think the strategic rationale for the merger of equals makes more and more sense each and every day. Both L3 and Harris, when we looked at it independently, felt were too small to compete with the primes and arguably too large to compete with the small. So they were two companies stuck in the middle. They came together, wanted to give different alternatives to our customer, different capabilities. We've had lots of successes in space and other domains where we're disrupting the market. We've kind of branded ourselves as the trusted disruptor. But I'd say a majority of what happened went on plan, at one schedule were better from the integration cost of over $600 million. Everything per the merger agreement with the terms and conditions, the Board, succession planning, moving headquarters, everything went exactly how we laid it out. There was a disruption relative to our integration as a result of COVID and the pandemic. So that would probably be the one area where we lost some momentum, which is why we're rolling out what we're calling LHX NeXt, which is really the continuation or the second wave of the integration or transformation of the company. Did some portfolio shaping, sold some noncore assets, made a couple of acquisitions as you're well aware of. So we're pleased with where we are, and we think we've had good success. We've laid out, back in December, our 2026 framework of $23 billion of revenue. We already have industry-leading margins, but we committed to at least 16% margins and $2.8 billion of free cash flow, up from $2 billion last year. So pretty aggressive targets. We had a good first quarter. Everything is tracking.

So if you pull back and look at the budget, the macro level, so the 2025 budget has been constrained by congressional caps. So it's actually even down a little bit in real dollars. How do you look at that budget environment from an L3Harris lens?

No, that's -- we spend a lot of time looking at the budget. Just to recalibrate everyone, for 2024, and we just use the top line budget as a proxy, is $844 billion. And the constraint is a 1% growth. So 2025 would be $852 billion. Now fortunately, we had a $67 billion supplemental. So I look at 2024 as $911 billion, I guess, arguably going to $852 billion. It is an election year. And I think history has shown when you look at the threats in the world, which everybody acknowledges is getting more and more dangerous, the budget ultimately follows. Senator Wicker just put out a letter yesterday, I think, who's the leading Republican on the Senate Armed Services Committee, requesting another $55 billion for 2025. And I think there's a lot of discussion about the need to increase the 2025 defense budget. There'll be a continuing resolution as always. And I think post election, there'll be markups and we think there'll be growth in the defense budget. But maybe more importantly, when I look at our portfolio, which we have purposely focused on national security and for the future fight or future warfare, I like where our positioning is. We have capabilities in space, capabilities in air, maritime, a lot of autonomy, ground with resilient communications and cyber and of course, with Aerojet Rocketdyne, munitions and solid rocket motors. So I think when you look at the budget and where the money is going, it aligns pretty well with our portfolio.

In your discussions on The Hill, how do you see the dynamics playing out? I would argue this has been a pretty dysfunctional Congress in terms of trying to pass any kind of budget. Do you see any potential for breakthroughs here? Clearly, we've got an election coming up, which complicates things. But what do you hear?

Yes. I hear it's the usual battle, right? I think there's a general belief that you need more money in defense. And then you have those say, well, for every dollar you put in defense, you ought to add dollar to nondefense. Some people were for that, some people were against it, right? So it's going to be that balancing act. And then of course, we have the national debt that's really, I think, the bigger concern, how much more debt can we incur, the cost of the debt is getting more expensive. So we go through all those dynamics. We also diversify a little bit of that with going to international markets, about 20% of our revenues from our allies. So those markets tend to be growing. But back here in the U.S., I think it's going to be a deliberation process. And I think, ultimately, they're going to look at what's going on around the world, and there'll be additional funding. Everybody in the DoD wants it. And I think it's ultimately just getting the mindset of the ecosystem being on a wartime footing. And I've said this before, I think the defense industry is on this wartime footing mindset. We have several factories running 2 shifts, 3 shifts. We need Congress on a wartime footing, which means you approve the budget timely, you need the DoD to award contracts on schedule or early make decisions. Until the whole ecosystem is there, it's going to continue like it has in the past decade, and we're going to have these inefficiencies.

The supplemental was passed. How did L3Harris fare in the supplemental?

Yes. I mean from what we look at, we're in pretty good shape. There was money in there for tactical radios, which, again, I think is one of the lessons learned in Ukraine, is the importance of having resilient communications, being able to pass data, video, voice without having it jammed, interrupted or intercepted. So that's one of our sweet spots with a lot of our technology in waveforms, Data link as an example, some money in there for night vision goggles. And then as a supplier to a couple of missile primes, with our solid rocket motors, we have a fair amount of work in there as well.

Yes. Now supply chain has been a chance over the last few years. Semiconductors were a big part of that. Can you talk about where you stand today kind of across that supply chain? What's difficult? How it's getting better?

It's definitely getting better. I wouldn't want to ever declare success, but I think it's for the most part behind us. We're continuing under our LHX NeXt initiative to really focus on supply chain here, not only the resiliency, but the ability to be more strategic, enter long-term agreements, maybe not just have single source or sole source suppliers, diversify a little bit. And then more importantly, as we develop new technologies, new capabilities, our engineers are really focused more on the design for supply chain, design for manufacturability, how do we design products where we know there's a supply chain and able to make them efficiently with higher quality and on-time delivery. So that's kind of what's changing. But I think for the most part, it's behind us. There'll be a couple of things pop up here and there, but that's kind of business as usual.

I mean you had a buildup in the inventories a little bit, particularly in communication systems related to semiconductors. I mean is that kind of washing through now?

That is washing through. I can assure you, our CFO and myself and our P&L leaders spend a lot of time managing the balance sheet and bringing down those inventory balances. I am proud to say, even through all that churn, we did not miss any contractual deliveries out of our communications business because we were clearly focused on getting every part, unfortunately, at any cost, expediting fees and such. But we did meet our commitments, and I think that's allowed us to continue to win new business and build record backlog, not only in communications, but for the company in total.

Now related to supply chain, it's been inflation. And at one point, I would have thought was completely a virtue was the high percentage of fixed price contracts you have. But when you get into these high inflation environment, that gets tough, and I know that's impacted your margins. How do you see things now in terms of the effective inflation, both on the contracts you have in place and the ability when you're doing follow-ons or new contracts to get that pricing in there?

Yes. No, that's a great question. Yes. So inflation has been around forever, right? And we've been pricing -- you go back 20, 30 years, I think the industry had inflationary assumptions. And then when the inflation didn't occur, I think we all use that to our benefit and increase our margins and then it turned around on us, right? We had certain assumptions, but not enough for the inflationary impacts. And it's been well communicated. The defense industry pretty much did absorb the inflationary impacts for the Department of Defense for several years, given all of our backlog. We have long-term contracts. We could not renegotiate those. The DoD never funded -- had the money to reimburse us. So I think we've all given up on going back and trying to get made whole.

So that's on like doing equitable prices...

Equitable price. They talk a good game, but they -- something's going on here in this room. But the -- yes, they talked a good game, but nobody got any money to the best of my knowledge. So I think we've all kind of given up and moved forward. So what we have to do on our bidding discipline, there's a lot of focus on fees and types of contracts. It's really getting the cost basis right. So you have actual data as to how long it takes to build a satellite or whatever the product is. You know the cost of the labor because you're currently paying them and you have inflationary assumptions and the same with the supply chain. So our goal is to adequately bid our products, what's the labor, what's material, what's the overhead and what's the reasonable fee for that work. So we've been doing that each and every year, and I think we're getting better and better. And we're building that into our new products. So the DoD in effect is now paying market value based on the cost of labor and materials. And I think they recognize that.

So we jump over to communication systems. I mean this is a very high-margin business. You've got a lot of your own intellectual property in there. It's allowed you to do commercial contracts. When you look at the tactical radio business, how do you see that progressing in terms of demand, both in terms of outfitting the U.S. Army, Navy and international?

Yes. So that is clearly our highest margin business. Tactical radios, we'll start with the U.S., domestically, there's a modernization in process to give you some calibration. There's a discussion about the need for 425,000 radios. I think year to -- inception to date, we're probably about 130,000. So you can look at that and see a 7- to 10-year runway, at least for the Army. I think for the Marines, maybe it's kind of 3 to 5, but there's literally hundreds of thousands of radios that need to continue to be modernized. So we have pretty good visibility.

Now on those radios, so is that a steady run? Or is it something that grows over time? How should we think about the trajectory for that need?

Yes. We tend to be about 50% domestic, 50% international. So we look at continuous growth in that market. We have record backlog, over $2 billion in tactical radios, which I don't think anyone ever thought was possible. There's been huge demand internationally with the NATO countries, the need for, as I mentioned, resilient comms, the supplemental, if you look at what we're doing with Ukraine, Europe, really on a global basis. First half of this year was a little more heavily weighted towards domestic deliveries, which is why the margins were a little lower than our guide, and then we'll have much more international deliveries in the second half. So that will get the margins up. But there's pretty good visibility and transparency. These are all software-defined radios, so they're easy to modernize and update. And it's kind of year-to-year quick turn business orders. There are scenarios where we can actually get an order and deliver a radio within the same week. So that's -- that kind of gives you the magnitude of the speed that this works, which is kind of unusual for a defense contractor.

When you were in the throes of the supply chain difficulties, at that point in time, I think you were prioritizing a little more on the international deliveries, which are higher margin. You built up some inventory. I mean where do you stand now in terms of getting back to that inventory question, burning off that old inventory that's stacked up? Are we still going to see a little bit of a wave here of inventory release in radios?

You should see a reduction in inventory, absolutely, and you should see the ramp in the revenue and the deliveries. So we prioritize based on our contractual commitments that was -- which happened in that case, to be more international. As I mentioned, we made all those commitments. But clearly, there's a lot of common parts in these radios, which is one of the reasons we're able to turn them so quickly and deliver the high margins.

And so when -- going back to what you talked about back at your investor conference, where you're looking at 100 basis point improvements in margins in each of your four businesses, I mean this was the one -- and I think I asked you about this on an earnings call, this was the one you pointed to is the -- perhaps the easiest opportunity.

Yes, I might have. I don't think any of it's easy. I think I said it was the nearer term.

Easy might be the wrong word, but highest potential in a sense.

I think it's the first to get there. They'll all get there. I think this one will get there quicker because of the commerciality. The fact that we get to keep a majority of the savings, right, the ability to improve our on-time deliveries, our rolled throughput yield, improve on quality, all those steps, cut the cycle time and increase the profitability. We're doing longer-term agreements with our supply chain, kind of a change in mindset instead of going quarter-to-quarter purchase order to purchase order. We're laying out and giving them insight to our road map. A lot of our suppliers are willing to invest in new machinery, new equipment to enhance their own productivity and we're entering those long-term agreements where it makes sense. So all those things are going to contribute to the 100 basis points. And I think that's just in comp, and that's TACOM, which is part of a larger segment. So I think they have the likelihood to get there first and maybe easiest. I'm sure the team's listening.

I know no one wants to hear that word. But...

It's more based on the business model and the short-cycle business.

And if you're -- and is this -- I mean, should we think about this as a 25% margin business? So given the commercial nature of a lot of your contracts, I mean what's the potential here?

Well, you're talking about the segment level, which we have some more traditional programmatic places, right, that tend to run 10%, 12%, 13% margin. So when you blend it together, 25% is not a bad aspiration and then we go year-over-year improvement. So I don't want to put a cap on it or limit it, but we should continue to grow margins year-over-year.

And then if you take another attractive structure, which is on the night vision goggles there, what's the outlook for that now? It seems to go up and down in the budget quite a bit.

It does seem to go up and down. It is in the budget finally. So I think there's great technology in these night vision goggles. There's a lot of focus on virtual reality and all that type of stuff. And I think those programs are struggling. I think it's well known that there's technical difficulties. And I think when the Army looks at the importance of the mission, you need both the more traditional night vision goggles that we produce when you're actually in battle and maybe the virtual reality and such is better used for training. So I think there's enough room for both. And again, when you look at the capabilities, not only domestically but internationally, we seem to have a tailwind here in the night vision. And I think that's one of the lessons from a lot of these conflicts, nobody likes these conflicts, right? But there's all this view about future warfare, JADC2 and communications. But at the end of the day, you ultimately end up with boots on the ground. You need the radios. You need to be able to communicate, not be jammed, you need the night vision goggles to see obviously the adversaries and such. So I don't see a future where you don't have those.

Having tried them, they're pretty amazing.

They are pretty amazing. I think you can get them on the Internet.

Really?

Yes, if anyone's interested.

Okay. Not including that in your growth...

That's not in my growth profile. That's all upside...

Okay.

Ken will be passing out coupons at the end.

So you did the TDL acquisition, so you have Link 16 in there. Can you talk about now that you have it, what opportunities is that giving you?

Yes. TDL, this was the tactical data link part of ViaSat that we bought in January of '93. We were just out of Salt Lake City, the last couple of days, Ken and I are going through the business, looking at the opportunities. Again, we're seeing more and more focus on the importance of having the ability to communicate without being jammed, without being interrupted, intercepted without being geo-located. Link 16 has been a great addition to the portfolio. It gives us a footprint on 20,000 different platforms of all types of aircraft, ships and such. So now we're able to insert and sell different waveforms, different data links into these existing platforms. So it's probably working out a little better than we thought. We were able to get Link 16 in space. Just the other day, one of the Generals talked about the importance of Link 16 in space and how that's been a game changer. And that was why when we were going through the acquisition, we really wanted to make sure not only that we got the more traditional business, they did have a space business, and that was kind of -- took a while to negotiate. But we get Link 16 in space, which we started. It's a game changer, and that's the customer speaking, not me. So I think there's tons of opportunity. Again, commercial business model on a fair amount of their products, which gives us the opportunity for higher margins, 20% range or so. So I think that's going to -- we're going to look back and see that, that was a really good deal.

And how does -- how do you tie in TDL? I'm trying to picture with your other products what the leverage is. So I understand the attractiveness of TDL itself, but how does it fit with what other things you're doing?

Yes. This goes back to the acronym that we talk about, this Joint All Domain Command and Control. This has been a major focus of the DoD, although it's hard to find contracts and budget line items for this. So it's just the ability to get these satellites to communicate amongst themselves, satellites to air vehicles, air vehicles to ships. So it just kind of becomes built into some of our solutions. I think by all accounts, it's somewhat lagging from a DoD perspective. They've been talking about this it seems like for a decade. But ultimately, that's where it needs to go. And I think that's where we feel we're well positioned.

Well, it's interesting to describe it that way because you hear some conversations about it as kind of grand unified field theory of everything. But on the other hand, philosophically, it can be down at a more segmented level where you're connecting some things together. Is that how you view it more...

I view you just kind of have to start connecting piece by piece and then you look back years from now, and then there's more pieces connected than less. But you're going to sit around for this grand vision that someday everything's going to be connected to each other. You can only go there product by product, program by program. And that's kind of the approach we've been taking.

So we switch over to space, so Space & Airborne. I mean this is one where I was in your facility down in Melbourne and very impressive sort of doing small sets in what I would call next-gen space. What do you see as the opportunity for growth in space?

Yes. I mean we're kind of saying mid-single digit for growth in space. But clearly, this is probably the best example going back to your first question, where we believe we've disrupted a market and are now a new entrant. Like to talk about at the time of merger, we had no satellites in orbit. Today, between what's in orbit, what's in backlog, it's over 60. So we are a prime provider of satellites. We've run the table with the FDA having won Tranche 0, 1 and 2, each more profitable than the latter. No other company has done that. And it's our speed to market and reliability. We have some great technologies, in this case, that you've heard us talk about, that was more focused on weather that we've been able to repurpose for missile tracking and missile warning. There's a lot of classified satellites. These are constellations with 3- to 5-year lives. So this is a replenishment factor. It's taking capability that was historically airborne and moving into space. So from our side, having the ability to have literally dozens or hundreds of satellites in orbit with 3- to 5-year lives, it really becomes an annuity. And I think it differentiates us from our competitors. And these are $40 million, $50 million satellites, not $1 billion satellites, mainly in low earth orbit, some other orbits, but we're proud of what we've accomplished. The team has done a great job. We're investing in a new factory. And it's becoming about reliability and speed. We're delivering on time, satellites are working.

So how all of this works, I have to say it's not obvious to most people. And can you -- when you look at these constellations, which can have hundreds of satellites in them, and when you think about bids, they're traditional suppliers, there's L3Harris -- so it's probably Lockheed Martin, there are new entrants that have been -- people tried to bring them in. So you're bidding on individual tranches, how does all of this fit together? I mean, are we going to see a long-term satellite production system here where we continue to see tranches that are always competed?

Yes, I think the government always likes competition. I think we've -- I think Tranche 0, there might have been 9 bidders and 3 winners, and then Tranche 1, probably a couple of guys went out of business or lost money or didn't work. I'm guessing there were like 6 bidders and 3 winners. And I think this last one, there were 5 bidders and 3 winners and some companies have withdrawn from the market for a variety of reasons. So I think you probably get down to just a handful. I could see given the quantity down the road, maybe always -- I'd like a two-person split by based on performance, capability and price. But I don't know if they're ever going to put all their eggs in one basket because I don't know, from a capacity, if anyone can crank out 75, 100 satellites a year.

But you do think this will narrow down a little bit?

I think it's just...

It's too complex to have too many -- I mean constantly bidding on each tranche. I mean I don't know how you switch out providers.

Well, yes, we're 3 for 3, so I kind of like what we're doing. I would think if I was 0 for 3, and the team came forward and say, let's bid Tranche 3. At some point, you got to prioritize your R&D and your bidding proposal and your marketing cost and say, it appears that our probability of winning is pretty low. And each time you win, it increases your probability of the next one because you have the know-how, the learning curve, right? You have the presence, you have the past performance and if the past performance is good. So I think it's just natural that people are just going to focus on different capabilities. But we're in this market. We plan to stay on it. I think from a customer perspective, they put out RFPs and 3, 5, 7 bid. The more the merrier from their mind and they pick it based on the selection criteria, which is usually scheduled, technical and cost. We've been performing quite well. And...

If you look at these with 3- to 5-year lifetimes. So you've got kind of a constant flywheel of replacements that will go for as long as one can imagine here, I think. So what does that look like in terms of your plans to potentially increase capacity, and because these will be fixed price in nature, expand margins?