Leidos Holdings, Inc. (LDOS) Earnings Call Transcript & Summary

Greetings and welcome to the Leidos Transaction Announcement Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Kelly Hernandez, Investor Relations for Leidos. Please go ahead.

Thank you, Kevin. Good morning, everyone, and thank you for joining us on such short notice. On the call with me today are Roger Krone, Chairman and CEO of Leidos; and Jim Reagan, CFO of Leidos. Today's discussion contains forward-looking statements based on the environment as we currently see it, and as such, does include risks and uncertainties. Please refer to our presentation posted on our website for more information on the specific risk factors that could cause actual results to differ materially. In conjunction with our announcement, we have also provided a set of slides detailing the transaction, which we will reference throughout the call. These slides are available on the Investor Relations section of our website at ir.leidos.com. Finally, during the call, we will discuss GAAP and non-GAAP financial measures. Definitions of non-GAAP financial measures are included in the presentation slides we just mentioned. With that said, I will turn the call over to Roger Krone.

Thanks, Kelly, and good morning, everyone. I'm excited to announce that Leidos has entered into an agreement to acquire L3Harris' Security Detection and Automation businesses in a transaction that will advance our mission of making the world safer and enhance our platform to deliver sustainable, profitable growth. These businesses from L3Harris add complementary security and automation products that expand our portfolio to create a more comprehensive security platform. The acquisition of these businesses also deliver on our stated objectives to diversify our revenues through numerous customer relationships, which expand our international presence into 75 additional countries. I'll start with a brief overview of the details of the transaction, which you can see on Slide 3. The all-cash transaction is valued at $1 billion, which represents a go-forward EBITDA multiple in our first full year of operations, 2021, of 9.4x, when we expect to realize significant operational opportunities as we combine the 2 businesses. We will fund the transaction through a combination of cash on hand and incremental debt. Once completed, these 2 businesses will be combined with our existing security products business and reported externally as part of our civil segment. The transaction is also expected to be immediately accretive to revenue growth, EBITDA margins and non-GAAP earnings per share. We've also identified cost and revenue synergy opportunities, which we'll discuss in more detail in a few minutes. The transaction has been approved unanimously by the Board of Directors of both companies. It's subject to certain closing conditions, including receipt of regulatory approvals, and we look forward to closing by the end of the second quarter of 2020. Now I'd like to give a brief overview of these 2 acquired businesses and why we believe this acquisition is a great fit. First, I'll start with L3Harris' Security Detection business. Headquartered in Tewksbury, Massachusetts, this business is a leading provider of airport and critical infrastructure screening products and services such as checkpoint security scanners and checked baggage screeners. L3Harris' MacDonald Humfrey's Automation business headquartered in United Kingdom produces automated tray return systems and other industrial automation products. These 2 complementary businesses have a total of 1,200 employees worldwide, who are a key reason for our interest in the business, and they will join our Leidos team. We look forward to working closely with them to realize the benefits of this transaction. These businesses have a global presence with more than 20,000 systems and are active in 16 of the world's top 20 airports. Turning to Slide 5. I'll spend some time discussing why these businesses are such a strong fit within our existing security products business and discuss some of the compelling strategic benefits of the acquisition. First, this is an exciting market. The global security product market is expected to grow in excess of the domestic federal budget, and we expect the business we are acquiring to grow at a low to mid-teens revenue CAGR over the next 3 years. With the addition of these businesses, we expect Leidos' product portfolio in this market with complementary products that broaden our offerings to create a more comprehensive security and detection platform. Second, our goal has been to diversify our revenue outside of the United States, and this acquisition increases our international revenue for this business by a factor of 6 and expands customer penetration into 75 additional countries. At the consolidated level, the acquisition adds an additional 3 points of international revenue, bringing our total for the company to approximately 13% international revenues. Third, the enhanced scale enabled by this transaction will further accelerate Leidos' growth and innovation efforts. Our combined security portfolio will become significantly larger, which provides a number of benefits. For example, applying Leidos' services model to these new businesses will yield more efficient service delivery for our global customers. We'll also be able to better leverage technology investments across the combined security platform portfolio to accelerate innovation and benefit our customers. Let me continue by going into detail on the specific products we are acquiring from L3Harris on Slide 6 and how we believe this creates a more comprehensive product portfolio. To date, we have focused on specific products within this business: stand-alone reduced speed checked baggage scanners and vehicle and cargo inspection systems used at ports and borders. With the addition of L3Harris' complementary security detection and automation businesses, Leidos will have broader capabilities without overlapping products. L3's people scanners, which I'm sure you've all come across in airports around the world, are the largest installed base of advanced personnel screening systems. They also bring products such as the checkpoint CT, which leverages advanced algorithms to screen cabin baggage and deliver the highest level of explosive threat detection. Within the automation business, we are acquiring a product that is a leader in checkpoint management systems, security efficiency software and process and automation control solutions on a global scale. At this time, there are nearly 750 smart lanes leveraging this technology deployed around the world. Our combined customers will benefit as these products will now all be under the same roof and supported by the same service staff and model that Jim will talk about in a few minutes. In short, these businesses will be a complementary fit within the Leidos Civil segment, enabling us to compete more broadly and capitalize on new opportunities for growth. As I mentioned, L3Harris' businesses have been successful in driving revenue outside of the United States, which is a key reason why we were attracted to them and what we view as a significant opportunity to unlock value for Leidos. As chart 7 shows, we will have access to more customers and the ability to cross-sell current Leidos products more broadly internationally with our expansion into 75 additional countries. Our combined footprint of deployed products will span about 120 countries or more than 60% of the world. The sales team and channel partners that has enabled success in this broad global footprint will be a valuable asset, which we can leverage throughout the rest of the company. Now I will turn it over to Jim to discuss the benefits of the enhanced scale from the acquisition and the financial overview of the transaction. Jim?

Thank you, Roger. Slide 8 provides more detail on the combined business and the value that we can create with enhanced scale. The combined portfolio that you see in the middle of the slide includes a balanced revenue mix of checkpoint, checked baggage and automation products as well as border security products from Leidos' legacy business. The combined portfolio also reflects our revenue mix that is roughly 60% product, 40% service. As you can see, however, there are differences in the proportion of services and product revenues between our distinct businesses. Leidos has a highly efficient proprietary service model that drives an inverse in the revenue -- the product revenue mix that is 40% product, 60% service. We intend to apply our model to these 2 new businesses in order to grow a longer tail of service revenue streams for the product lines that we're acquiring. We believe that this approach will create a more seamless and efficient experience for our customers and also drive revenue growth over time. Instrumental in their global penetration, the security detection and automation businesses have detected -- have developed a successful global sales channel, in particular, serving airports. Leidos has developed a successful global sales channel, though more focused on serving ports and borders. The combination of the 2 will allow for potential revenue synergies as we leverage the 2 channels to cross-sell our combined product portfolio. We expect that this cross-channel opportunity, combined with the improved service delivery model, will create value now and in the future beyond the incremental $500 million of revenue that the transaction brings. You'll also note that Leidos and the L3Harris businesses have different approaches when it comes to manufacturing, with Leidos owning and operating our own manufacturing facilities for our security products, while L3Harris leverages outsourced manufacturing. We believe some combination of the 2 may be appropriate, but we'll evaluate this over time. The outsourced model of the acquired businesses allows them to have a capital-light model with annual CapEx below the 2% threshold that we target for our own businesses. A significant benefit that the scale of the combined business enables is the innovation that this will provide for our customers. You can see on Slide 8 the relevant security technologies that each of us has invested in over the years. Supported by our strong R&D engine at Leidos, we will integrate the technical expertise of the security detection and automation team and then leverage our collective technology investments across a broader portfolio to accelerate innovation. When combined, our respective technical competencies allow for a complementary portfolio of end-to-end security products that are applicable not just in airports but also ports, borders and other high-density venues. The combination will also allow for some improved R&D efficiencies, which we expect to realize over time as part of the transaction's overall cost synergies. Fundamentally, this is a business that is and has always been very strategic for us. As we did with our IS&GS transaction, acquiring an asset that wasn't strategic under its prior owner and incorporating it under Leidos, where the business is highly strategic, will create value in the short and long term for all of our stakeholders. In the immediate term, upon close, we will be focused on integrating the businesses in order to realize the synergies that we've discussed, accelerate our growth, expand our margins and continue to bring innovation to our customers. Let me now turn to the financial benefits of the transaction on Slide 9. When we looked at this transaction, one of the first things that stood out to our team were the clear synergy opportunities. We expect to generate approximately $20 million of annualized cost synergies by 2022, which we expect to achieve through elimination of redundant costs as well as manufacturing synergies. Post closing, additional synergies may be identified, leveraging our nearly 30-year legacy in the security products business. We also anticipate additional opportunities for revenue synergies through areas Roger discussed earlier, such as growing maintenance and services revenues and leveraging cross-channel sales opportunities. We expect that this acquisition will also give us access to a higher margin portfolio and drive our EBITDA margin higher. This transaction is expected to be immediately accretive to Leidos' non-GAAP earnings with expected annualized adjusted EBITDA of approximately $75 million in 2020 and $105 million in 2021. These estimates exclude approximately $30 million of onetime pretax acquisition-related expenses or approximately $23 million after taxes. In short, this transaction makes financial as well as strategic sense, and we're committed to executing to achieve the benefits that we've laid out today. And with that, I'll turn the call back over to Roger.

Thanks, Jim. Slide 10. As we communicated today, this transaction will drive value for all of our stakeholders. With more diversified revenues, both by products and geography, this transaction is very exciting for us. Shareholders will benefit from the accelerating revenue growth, margin expansion and the accretion that Jim just spoke about. Our collective customers will benefit from a more innovative and comprehensive security product platform and improved service. And for our collective employees, this transaction not only expands our business consistent with our mission of making the world safer but also offers more opportunities for professional development, career mobility and innovative work in an exciting market. I'm confident that together we will capitalize on the many opportunities this combination provides. With that, I'd like to open the line for questions. Kevin?

[Operator Instructions] Our first question today is coming from Sheila Kahyaoglu from Jefferies.

Roger, 2 deals in 2 months and 2 product deals. I mean you continue to evolve as a company. How do you think about your business over the next 3 years? Are you done? Are you comfortable with the health care portfolio? Are you comfortable with the service portfolio? Can you maybe elaborate a bit more?

Yes, thanks, Sheila, and thanks for joining us early on such short notice. Sometimes you have to take the deals as they come. And this was an opportunity really came out of the combination of L3 and Harris. And we had been thinking strategically about our security products business for a long time. And I'm just so thrilled we had the flexibility in the balance sheet to be able to move quickly to be able to capture this transaction. We've been talking on our calls that we were looking for more diversity between services and products, and this was an opportunity to add to a product portfolio that we already had. We've also been very clear, Sheila, that we like a balance across our 4 businesses and the diversity of markets that we have and this furthers that diversity, and so it fit really, really well with our promulgated strategy.

Okay. That makes sense. And then just a question on the revenue growth CAGR of low to mid-teens. How do you square that with maybe IATA RPK growth of 4% to 6%?

I'm sorry, I didn't -- say that again?

So the revenue growth profile of the business, I think, is low to mid-teens. How do you kind of square that away with IATA revenue -- IATA passenger mile growth of 4% to 5%? So how is it growing double the market?

Yes, I'm with you. First of all, as you know, as this is a bottoms-up forecast that we've worked market by market, literally customer by customer. It is our view that there is a technology refresh coming through both the baggage screening and the passenger screening. And the onset of CT at the Checkpoint CT in baggage and the algorithms that allow us to better exploit the information gained through the scan is going to drive essentially a worldwide technology refresh of a lot of the existing equipment and the installed base. So if we were just going to grow with passenger miles, the CAGR would be lower, but we actually see an opportunity to replace aging equipment throughout the airports and ports and borders in the world.

Our next question is coming from Robert Spingarn from Crédit Suisse.

Just on the back of that, with the higher growth, how do you think about the total addressable market here in terms of size and what the share of this business is and who your major competitors are?

Rob, we have a view of that. I think it's a little bit early for us to start to talk at that level of detail. Clearly, there are many competitors in this market worldwide. And we all see them when we go to airports. And we also think, although there is a size of the addressable market today, unfortunately, the world continues to be a complex place, and we think the market for expanding screening and detection is going to grow outside the traditional markets. So we see top line of the market expanding as I was talking with Sheila. But there are a large number of traditional suppliers in this market, and we have seen a lot of new entrants over the past couple of years. So it's a pretty robust competitive market, but it's one that we're excited about.

And how cyclical would you say the business is? Obviously, upgrade cycles are important here, and you've touched on this already, but is some of this teens growth reflecting an upgrade cycle that at some point would -- the growth could fade until the next upgrade cycle?

I think that's a fair assumption as it is in any upgrade cycle whether it be in personal computing or in cell phone like a 5G technology. But it is a long upgrade path. Given the capacity in the industry and the demand, we expect this growth to continue for a significant number of years.

Our next question is coming from Seth Seifman from JPMorgan.

Can you tell us what kind of backlog that the business comes with? And then maybe if the -- in the upgrade cycle that's coming, if all the products that you intend to sell through that cycle has been -- are those products already developed and ready to go? Or is there still some kind of development work to go?

Yes, Seth, I don't want to disappoint you, but as you probably know, we don't give those level of details in any of our current business as we report backlog at an aggregate level. And we're just not going to do that on this business either. It's just the way we have done this. But relative to the state of maturity of the products, in our due diligence, we were very pleased with how much R&D the L3Harris team has spent and the maturity and ready for market of these new CT products are. And so we're really, really excited about being able to take that into cross-sell with our sales force and our channel partners and to be able to go out and see immediate growth in sales.

Great. And then just as a follow-up, if you look at kind of the implied EBITDA for 2021, the growth [ of ] 2020, and I don't know, maybe half the synergies come through in 2021. It's a pretty nice incremental margin. Is that just kind of the nature of the business? Or does that come from some of the business model transitions that you were talking about and kind of the relationship between products and services?

Most of it -- this is Jim. Most of it is just the nature of the business and then our experience with our own security products business where we believe we're taking a pretty conservative view of what the potential is for how margins will expand as the businesses are combined and as we kind of migrate the business model as I discussed on the call.

Our next question is coming from Tobey Sommer from SunTrust.

Your top line CAGR, does that assume a market rate of growth? Or are you believing that the business can gain share?

Tobey, thanks for joining us. First of all, we think that there is top line growth as one question referred to. I mean there's top line growth in revenue passenger miles, and therefore, there is top line growth in airport traffic. So there's a base in our model, and then there's a refresh replacement cycle on top of that. And that's how we get to double digits.

Okay. With respect to your -- what you commented about shifting the business model and emphasizing services, as you've done with your legacy business, what are the implications for that strategy as far as EBITDA margin?

Tobey, this is Jim. The implication is that as we expand -- because the services revenues that we have, have EBITDA margins that are higher than the average for the company, we're expecting that to be accretive to margins. We have a great services business where -- within the legacy Leidos footprint where we service not just the products that we sell but we service the products of our competitors for the TSA and for other customers. And we think that applying that model to the broader product set as well as the broader geographical footprint that we're going to have allows us to realize some significant upside over the model that we've baked into this acquisition price.