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

Thanks, everybody, for participating in our session with L3Harris. We've got CFO, Ken Bedingfield; and Ross Niebergall, President of Aerojet Rocketdyne. Thanks, guys.

Thank you.

Thanks, Gavin, for having us. And just real quick, a couple of comments regarding forward-looking statements. They do involve risks and uncertainties, and we may be making comments that involve forward-looking statements today, and I'd just refer you to our SEC filings for more information.

Got that one memorized. So I guess starting high level on the budget and obviously, national security is a high priority, but we have a new administration. We have a "Department of Government Efficiency" Can you just kind of talk about where you see the spending priorities of the new administration, what the potential risk is and if you still think there is broad bipartisan support for national security going forward?

Sure. Yes. Look, I think that, first of all, just to address the geopolitical aspect of it, clearly, a lot going on in the world between Ukraine and Israel. And I think in terms of the broader focus, clearly, China remains the ultimate threat and potential adversary. Our assessment is that the focus on that will continue. In terms of the new administration, Department of Government Efficiency and that focus. Our perspective is that we're gathering as much information as possible and certainly trying to understand what the focus will be. And as much as anything, I think as a company, we're very focused on our culture as the trusted disruptor, being agile, being nimble, being able to respond to changes, whether that's a change in focus, whether that's a change in budget or a change in mission needs. We are here to support our customer. Our customers need to move fast to address rapidly evolving threats as well as enduring threats that are out there, and we're ready to support them. We are largely platform agnostic. We like to think of ourselves as kind of the honest broker, listen to our customer and their challenges and needs, help them solve problems from across a relatively diverse portfolio at L3Harris. And especially if you think about our partnerships with others in the industry or even those in new technology, in defense, how we enable the use of those partnerships to help our customers solve, again, some of those complex problems. So we're gathering as much information as possible, try to stay nimble and then be ready to support as the administration determines its path forward, the budget, the levels and the mission capabilities that are needed.

And it seems like maybe the recommendations from the Department of Government Efficiency would ultimately need to go through Congress. But do you have any sense for how efficiency initiatives might play out within the government?

Again, I would say it remains to be seen. And we understand the focus and the effort. And like any administration, we are absolutely here to support the administration, the DoD as well as the authorizers and appropriators on Capitol Hill with the focus and the ultimate execution of what moves forward and when. And a lot of ideas floated out there currently, and we're certainly taking all that information in, driving strategies for, again, how we can be nimble and reactive to be supportive as changes occur.

And I want to come back on LHX NeXt, but you're already in efficiency mode. Is that something that your customer has recognized and acknowledged?

Yes. I would say, from my perspective, so we've started a program we call LHX NeXt, which is to save $1 billion of run rate cost on an annual basis no later than 2026. We've made tremendous progress on the program. We had announced about $400 million of savings for 2024. We recently updated that we will hit roughly $600 million. And making great progress on the program, whether it's -- we've made some difficult decisions around labor and driving labor savings, facilities savings. Certainly working very hard on the supply chain and engaging with our suppliers and how we drive savings there. And then as importantly on the program, it's how do we do things differently, how do we make better data-driven decisions, how do we get better data across the enterprise such that we can rapidly make the best decisions possible wherever that might be, whether that's in the supply chain or even in how we help the customer address some of their needs and capabilities? So making really good progress on that front. And yes, I think the customer absolutely appreciates it. We've talked about a reasonable amount, roughly 40% of the savings accruing to us in terms of margin opportunity. That means about 60% will accrue to the government in terms of savings on their side. That enables us to be more competitive from a price perspective. And as we drive down cost, it enables us to have that right risk/reward relationship for the types of business that we're entering into going forward. And I think there is a recognition certainly in the department as well as on the Hill that we're doing good things. It's not easy. It takes a lot of effort. And the team is really working at all levels together to accomplish it. But it is good to see that the customer knows we're trying to do good things on their behalf.

Got it. And Ross, Aerojet has maybe been in integration mode for the last 1.5 years or so, but how has that gone? And how does Aerojet play into the LHX NeXt savings?

Yes. Thanks for the question. So at the time of the acquisition, we forecast $50 million in gross annual run rate savings as part of the integration into L3Harris. So I think it's gone very well, and we've now exceeded that significantly. For us, there was really a threefold strategy for doing that integration. The first phase was related to reducing the costs associated with a publicly traded company that was done relatively quickly. The second phase was to go after the benefits of being part of a larger company with more finely-tuned infrastructure, so this includes in areas like supply chain and getting the benefits from being part of the bigger company finance forecasting. So shared services that we get from the larger company. And then the third phase is really where it starts combining with the benefits we're getting from LHX NeXt. And for Aerojet Rocketdyne, that third phase is really all about really a complete transformation of how we do business and how we operate. I mentioned that we were getting benefits from the larger scale of supply chain. But now we're learning abilities to negotiate getting the economies of scale of the overall L3Harris company, and that's adding a tremendous amount of benefit, and that's really part of LHX NeXt as well. I would also emphasize that one of the areas where I think Aerojet Rocketdyne was slightly behind was in the digital capabilities of engineering and manufacturing. So really leveraging the broad capabilities across L3Harris have really benefited our business. And even though we've been here now for 15 months since the close of the deal, we're absolutely seeing the benefits of some of that digital capability and our ability to be more predictive about how we're delivering product. Another benefit that we're taking advantage of really on an almost daily basis is the broad capabilities and engineering and operations that we truly have across the company. And there was a great example just within the last 2 weeks where we've been struggling with a particularly thorny manufacturing issue with a change in material from one of the providers. We did the standard root cause action to understand and look at the fish bones to figure out what the issue was. And we reached out to the broader L3Harris, the group, in particular, that we have doing aircraft facilitization in Texas. And they were able to narrow it down almost immediately and so get the benefit of that more broad company. So the final piece that I would touch on is that since we've closed on the acquisition, again, with the breadth of L3Harris, we have a bigger draw or ability to attract and draw talent. So the leadership team now for Aerojet Rocketdyne is new. It's about 80% have experience with one of the large defense primes and 50% come from a background of actually working on missile programs. So I think we're getting a lot of benefit from this bigger perspective on how to do the business. I expect integration -- the integration phase really is going to be completing in the first quarter of next year, but they will continue with that ongoing efficiency that comes out of LHX NeXt.

Maybe in terms of supply chain, I guess, specific to Aerojet, but also more broadly, just a topic that continues to be an issue. And it's -- you're not demand constrained or your supply chain constrained, so can you help us with some metrics around how that is progressing?

Yes, sure. So this was another area where Aerojet Rocketdyne has benefited for the larger L3Harris in that we've adopted a page out of the L3Harris playbook, and that's creating individual supplier management teams. For some of our big suppliers, these are groups of people that will actually be deployed on the site to support the extended transformation that L3Harris is going through into that -- into those individual companies as well, many of which are sole source providers of capabilities. And in the missile business, that's significant because qualification of new providers can be arduous. So we've been investing in helping them with not only going after Defense Production Act funding, so actually applying to the DoD for the aids and expanding their capacity, but then us going in and training people and helping them get those pieces of equipment up to speed quicker. So we've been investing in the supply chain, and it's paying off. But in addition to that, there are areas like in particular, raw materials, where we get that larger buying capacity. And another thing that Aerojet Rocketdyne wasn't necessarily proficient at was doing multiyear projections and then signing up for long-term deals with discounts. And so I think that reflective of what we're seeing in supply chain across the company, we're getting a tremendous lift in that.

Yes. I would just add, broadly, that supply chain is obviously a big chunk of the effort from an LHX NeXt perspective and obviously, one of the biggest line items of cost for the company. And we're spending a lot of time and effort in not only negotiating long-term agreements and working with the supply chain but really investing in the team and the tools that we have. It's one of the areas where I think aggregating data across the entity has been very helpful. And it's not just ERP systems, but it's manufacturing systems, engineering systems, labor systems and the ability to gather all that data into one usable place where we can start to make quicker and better decisions about it. So I think it's going really well. In terms of LHX NeXt, supply chain savings are about 60% or 65% of the overall run rate savings. And we do think that as we're making real progress here and investing, that it can become a differentiator for us. And I think a great example would be like working with our suppliers to give a better projection of what we see in terms of demand so that they may be able to make investments to ultimately drive costs down as we work together to deliver capability to the customer. Making great progress in that particular part of LHX NeXt. More to go in 2025. The team continues to have work to do. It's probably the hardest of the efforts in the program, but ultimately, I think will yield the most meaningful benefit down the road. And it takes time to get the supply chain benefits cut in at times. Long-term agreements are great, but we've got to get some of the inventory out of the system, finish up commitments under existing agreements and things like that. So we'll see those benefits start to flow through the EACs in '25. And ultimately, that will be a significant contributor to our 2026 financial framework that we've talked about of at least 16% margins as a business. And we see that as, again, a significant contributor to that margin improvement.

Maybe turning to that financial framework, starting on top line and moving to margins. You guys have talked about growing faster in '26 than in '25. Just what are the puts and takes to that?

So there's a couple of layers of that. And I guess we've given guidance for '24 and we've got the framework for '26. And just trying to make sure it's understood that it's not necessarily a linear path from '24 to '25 to '26. So we probably see a bit more growth in '26 than in '25, but '25 also grows from '24 on an organic basis. We've got some -- a few puts and takes there. But a couple of things. One, obviously, we're working through a change in administration, continuing resolution and potential for some other budgetary impacts. So we're keeping an eye on that and how that could impact some programs that we look to move forward to orders and revenue in '25. We have a few things that are just sort of more tactical in nature. So as an example, on the F-35 program, we'll see a reduction in development of TR-3 that won't necessarily be immediately filled in with production volumes on some of the components that we deliver for that program. We're seeing a few challenges in the space community. The space customers have been pretty clear that they've got a little bit of a budget challenge in '25. So we've seen a few space awards that we had expected maybe in the mid-'25 timeframe, start to slide into early '26. Good news, we've started to see a little bit of a pullback into maybe later '25 for some of those awards, so we're excited about that. Space continues to be a significant and meaningful growth opportunity for us. Just maybe a little bit of a pause in what has been one of the most robust areas of growth for the company. And then in Ross's business, at Aerojet and I can let him comment a little bit more, but it's a long-cycle business. I think Ross and the team are doing a great job of capacitizing or facilitizing for capacity improvement. But it does take time. I think they've identified where those log jams are through good, solid industrial engineering, what suppliers, we've got to work with, potentially make some investments where we've got choke points in the production processes. And Ross and team have put some capital to work in order to do that, including we're getting ready to break ground on some of the capacity improvements that came along with the government's award to us of $216 million of Defense Production Act funding to really increase capacity for a couple smaller solid rocket motors. So I think that's why we see '26 as a little bit more of a growth opportunity than '25. But anything else you want to add on your business, Ross?

Yes. I think you really hit on it. The capacity is the key for growth in our business. It's a surprising number, but we deliver more than 100,000 rocket motors a year. Some of these can fit into carry-on suitcase and others are the size of a school bus. So the infrastructure to grow that in a meaningful way is significant. We've taken a 4-pronged approach to this. One is investment ourselves. That's the area that we want to do the least of, but there are some pieces of equipment that really span across multiple programs, a number of project areas that are absolutely critical that, that is really an enterprise asset. And we've been buying those things like mixers and curing ovens that are necessary to build solid rocket motors. And in some cases, these have up to a year lead time to buy the equipment. So that's why it gives us better visibility into 2026. Second piece is looking at embedding the cost into specific programs. We're doing that, but in that case, the asset is generally only usable for that program without jumping through some support from customers. Next is talking to our suppliers and getting them to invest in themselves, which becomes a great business case when we can really clearly demonstrate to them that the need is there. And then the final area is in building out capacity with the government support Defense Production Act, as Ken talked about. Defense Production Act came as late notice, but we had to go through a certain type of environmental assurance process, something called NEPA, N-E-P-A, National Environmental Protection Act (sic) [ National Environmental Policy Act ] for when government invests in projects like this, they have to go through a more extensive review. We just finished that on the Camden facility about 2 months ago, and now construction is in full swing where we're going to have an official groundbreaking early in the new year on that. But that's the drive that we're getting. Since we're just starting construction, into '25 or early '26 is when we start seeing the benefits from that.

100,000 rocket motors is today? Or that's the target...

That's today.

That's today. What does the new facility unlock...

So the Defense Production Act is focused on 3 motors for 3 different systems. These are all done in the context of Ukraine and supporting that conflict in Ukraine. The 3 systems are something called GMLRS, Guided Multiple Launch Rocket System. Next is Stinger, which is a shoulder-mounted or small vehicular-mounted anti-aircraft system and then Javelin anti-tank system. So that investment is focused on those particular products. And it's looking at about a 50% increase across the board for those particular products. But what that does is it frees us up capacity for other systems. So off the top of my head, this is probably going to give us a couple of thousand more just based on that. But what it does is it gives us capacity as the needs of the Department of Defense change to put those same resources behind other programs.

And Ross mentioned Ukraine. I would just add that this capacity is not just for Ukraine and that or itself, but also to replenish U.S. stockpiles that have been reduced as we have been supporting our allies as well as our own, as an example, Navy has been using its munitions to keep shipping lanes open and help support Israel and things like that.

Absolutely. I mean all of these capabilities are absolutely critical for peer and near-peer threats that would include Iran and North Korea and the traditional peer threats in Russia and China as well.

Hypersonics is a significant contributor for Aerojet?

So hypersonics is an area that we've been investing IRAD in for several years, and there are certain capabilities. So again, hypersonics are capabilities that can go faster than Mach 5. We are a leader in hypersonics engines. These are generally liquid air breathing engines, so might look closer to a jet turbine than a rocket motor in some sense. We have actually demonstrated several years ago a dual mode ramjet, which means that it can operate as a ramjet for slower capabilities and a scramjet, supersonic ramjet for speeds above Mach 5. Ramjet, Mach 1 to 5; dual mode -- sorry, scramjet, 5 and above. When you pair that with a turbine engine, this can actually create a hypersonic capability that can start -- take off from a start -- from a stop and actually achieve these supersonic speeds. So absolutely, that is an important piece of our portfolio. The U.S. is really just now ramping up to programs of record in that. I think that there's a great future is what I'm saying, because we're really at the nascent phase of it.

I think ballpark, maybe Aerojet is 1/3 space and 2/3 missiles. How does hypersonics fit into that?

So hypersonics are in the missile portion of the business. Right now, it would be in the single-digit percent of that overall missile business. And again, that's only reflective of the fact that the U.S. currently does not have a fielded hypersonic system. So all of them are still under development.

The Sentinel program, that's shifted to the right a little bit. The schedule has changed. Has that affected you at all?

So yes, the Sentinel program, Ground Based Strategic Deterrent, is the U.S. replacement for the Minuteman missiles, ICBMs. It's obviously a key piece of our strategic deterrence as a nation. We build propulsion for that program. And that program also went through something called a Nunn–McCurdy breach, which meant that it had to be reauthorized because it was overspending. As it turns out, the missile itself is doing fantastic in that whole story. The cost growth has been fundamentally in the infrastructure, so silos, roads, networking, all of those things. The missile itself is doing very well. There have been some schedule extensions that we're working along with the prime, not really necessarily related to our performance, but this is modifications in scope and such for that program. From our perspective, I think it's going very well, and I think it has a great future. This is one of those programs where we invested in our internal development to get a good foothold in that program, and it's going to be paying off for the next 2 decades.

Is Aerojet the segment where you have by far the most visibility?

Look, I would say we've got pretty robust visibility across the segments. We've certainly been investing in making sure we've got the capability to forecast where we're going. And I think that each of the segments is -- has pretty good visibility. Probably clearly, CS would be the shortest cycle of the businesses, but very mature business, extensively robust demand from customers for their products. Record backlog in that business, so I think we've got probably as much visibility at CS as we've ever had and great tools and techniques for forecasting demand, working with the customers, investing in kind of the commercial business model to continue to improve the product, continue to bring waveforms to market that can upgrade the software-defined radios as well as just robust international demand as lessons learned come out of probably mostly the war in Ukraine, but also in Israel, what you need in order to be able to communicate on the battlefield. So I think solid ability to kind of project demand at CS. SAS and IMS are both a little bit more like Aerojet, longer cycle businesses, a bit more driven by programmatic rather than product cycles and good visibility there as well. And then we've had Aerojet Rocketdyne in the portfolio, as Ross mentioned, for about 15 months. So while Ross and the team have done a great job of integrating -- not just integrating the cost and into the LHX NeXt program, but I think also culturally, -- it's been a great integration of bringing that business in. We're very proud to have Aerojet Rocketdyne in the portfolio. I think that it shows up in the attrition rate, which is really at a low point today. And we're still learning, I guess, I would say. We're working through some dynamics. Obviously, we're working on closing out some of the legacy programs that we had acquired with Aerojet Rocketdyne. I think we've done a great job of negotiating new programs with, again, appropriate margins and appropriate kind of risk-reward equation. Certainly, there were some challenges in terms of kind of making sure that the relationships with the customers were as well as could be and working to get those into a better place as we move forward from an industrial base perspective, and I think making good progress on that. And as we give guidance for 2025, I think you'll see that Aerojet will be fully integrated into that just like any of the other segments.

You mentioned some of those low-margin legacy contracts in Aerojet. Roughly what proportion of the business is that -- does that account for? And when do those roll off?

So look, Aerojet had a pretty robust portfolio of contracts at the time of acquisition, not all of which were, I'll say, below market contracts. Some of them were in very solid shape. But we've probably worked through the required accounting rules for -- under U.S. GAAP for how you do purchase accounting of an acquisition, adjusted probably somewhere in the range of half of the contracts to market levels. And that will amortize off probably between now and the end of '25 or maybe into early '26, at which point we'll see what I call kind of the economic profit of the new contracts, the newly negotiated contracts that will be bringing a commensurate amount of cash with the margins. That will roughly fill in as the purchase accounting starts to amortize off the new contracts will be kind of filling in that gap. So we expect profitability at Aerojet to be consistent, if not have some opportunity for improvement as we look to move on to those newer production programs.

And if I could just add on to that. I mean, one of the reasons why we're confident in our performance as we transition to these new contracts is that we made a tremendous amount of progress within Aerojet Rocketdyne on changing the cycle or changing the background on our performance capabilities. At the time of the close of acquisition, it was fairly widely known that there were some many troubled development programs. Aerojet Rocketdyne was overdue to contract on really thousands of solid rocket motors. Since the close, we've reduced that by 60%. It will be 60% by the end of the year. We've been making tremendous progress on that, and that really is undoing several years of eroding performance. Just as an example of what I think of as tremendous success here is that we have achieved 18 different programs in this quarter where we have hit new records in production, and that might be a record for a month, record for a quarter or records for the entire year so far. So I'm really excited about that progress that we're making in burning down that legacy contract and positioning us very well for the renewals.

Good. On the broader margin subject, how much of the upside to 16% plus is NeXt versus other drivers in the business?

I think there's multiple contributors, and LHX NeXt certainly is one of them. And it's significant. I would say, if I thought about it in kind of 3 buckets, maybe there are similar sized opportunities in terms of margin improvement. One would be clearly LHX NeXt and those cost savings and the amount of the profitability improvement that accrues back to us as we reduce those costs, largely on fixed price programs, but get a little bit of benefit on other programs as well. The second would be just really solid program performance. We had some program challenges in '22 and '23. Some of that was just a few kind of engineering challenges, but some of it was some new businesses that we had entered into strategically. So we are now a prime in space where previously we had just been a payload provider. But we saw some payloads that we thought could -- through some tweaks and some software and some algorithms, execute other missions for the customer like missile tracking, missile warning. And we went and won some business in that area, and that resulted in some lower margin, lower profitability early on in that development and production phase. But now as we've now got kind of 3 contracts under our belt, we're starting to see that profitability improve. And I think we've put some program management tools in place, earned value management and some training for team members as well as some new industry experienced team members in the program management world that are doing a great job of really stabilizing our program execution. So call that maybe 1/3 of the margin improvement increase or opportunity. And then the other one, I think, is really our disciplined bidding approach. And don't take that as meaning we are deciding not to bid on opportunities. Largely, we're bidding on opportunities, but we're doing it with a confidence in our cost profile and a confidence in our schedule, which is enabled by NeXt and the cost that we've been trying to drive down as well as some of the tools that we've been investing in from a forecasting and management and earned value perspective. And so the disciplined bidding enables us to, again, realize an appropriate return for the type of work that we're doing. And I think that disciplined bidding and that profitable growth probably represents the other 1/3 of the margin improvement opportunity to enable us to have the confidence to get to at least 16% margins in 2026. Again, when we announced the midterm financial framework through '26, it was approximately 16% margins. And I know it's not the biggest update to say at least 16%, but we did want to highlight that we are gaining more confidence in our ability to get to that number. And so we are comfortable saying that we will be at least at that 16% bogey in '26.

This year, I think you've gone from 15% to 15.5% at the midpoint. Anything that's not repeatable or that would cause margins to go backwards next year towards the -- relative to the 16%?

No, nothing that comes to mind. I mean, obviously, we do hard stuff. We take on complex engineering challenges, complex programs, different integrations and a lot of systems engineering work that has to tie it all together. So we've got to keep all of our program execution, program performance and schedules on track. There's always challenges, but there's always opportunities as well. And I think the team does a great job of managing the portfolio in that regard. So nothing jumps out at me. In fact, from a margin opportunity perspective, I would expect that maybe to be a bit more linear than the revenue line as we talked about that having maybe a little bit more growth opportunity in 2026.

Maybe one more in the room, if we have one? Great. I guess final question then on cash flow. Raised the margin target. What's the opportunity on the cash flow targets?

So from a cash flow perspective, I think we continue to be comfortable with our cash flow guidance. And largely, we generated $2 billion of cash in '23. We'll be at $2.2 billion here in '24. We did provide '25 guidance for cash at $2.4 billion and then $2.8 billion as we look at '26. Biggest drivers of cash continue to be the profitable growth. So growing to $23 billion in sales, increasing the margins to at least 16%, turning that into cash, effective working capital management. So for now, we're sticking with the cash flow targets that we've laid out. And obviously, we'll provide '25 guidance in January. And if there's any update, we'll let you know at that point in time.

Perfect. I think we'll cut it there. Thank you very much, guys.

Great. Thanks, Gavin.

Thank you. Appreciate it.