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

Okay, if we're all here, let's move on. We're delighted to have with us Roger Krone, Chairman and CEO of Leidos. He's coming off a very busy week. He's had a couple of no-dose so he's ready to get moving along. So Roger, he's got a couple of slides. So why don't you start with your slides?

Great. I'll do that. I anticipated a couple of questions, so I thought I would just use a slide or 2, and then I'll sit down. I'm going to read this in total. Sorry about that. We had our Investor Day last May. Some of this is a repeat from there. But our goal has always been to diversify the company and not be overly concentrated. And although we show defense in this bar at 49%, most of you know that defense for us is composed of defense and intel. So we still look at the company sort of in the 4 markets: health, civil, defense and intel. And of course, this is -- we're in our quiet period. So this isn't fourth quarter. This is as of trailing 12 in third quarter. So what we're so excited about this and some of the moves we made in the last week or 2 is to continue to diversify our portfolio, and we'll talk about that. america Our theme hasn't changed. We've been sort of at this for a long time, and we continue all 4 parts of this. And we look for both top line and bottom line growth. We have been -- in the 6 years I've been there, we've more than doubled, almost tripled the company. So that's been exciting, and we want EBITDA to grow with that. And if we can get a little bit of margin expansion, then that's good as well. As I said, we like the diversity of our portfolio. We like the longer duration of our contracts. Something like NextGen is a huge win for us. I'm sure we'll talk about that. I've always said, the great thing about this company compared to other companies that I worked for is our ability to convert to cash. And the cash flow, which is just, like, a most amazing thing for companies that are in our space, and they're coming from big OEMs. This is still an amazing thing. And the acquisitions we view is generating cash in the same way. And we can talk about that in the Q&A. And then of course, that gives us the challenge of, "What do you do with the cash? How do you deploy that in a disciplined way to grow shareholder value?" And we've said all along, the first thing we're going to do is invest for growth, right? We don't overleverage and then what we have left, we're going to return to you, our owners, our shareholders. I think the last couple of weeks are a good reflection of what is literally years and years of discipline in our cash deployment. We said we had a really underlevered balance sheet. We had a fair amount of cash on hand, and we were able to move quickly to take advantage of a couple of opportunities. The Dynetics deal, which is now closed, so we own Dynetics, which is really a systems engineering technology company based in Huntsville, Alabama. And I'll talk a little bit more about that on the next slide. And then the L3Harris, which is their security detection and automation business. Most of us know that as the provision at the airport that you go through and get scanned. They're moving to what we call CT at the checkpoint, and I'll talk about that a little bit. Many of you know we've always been in the security business. We make products under the Reveal name, something under the VACIS name, and we also do a lot of services. And we've always thought that we needed to complement that business so we could be a full product and service provider. And when we close the L3Harris deal, it'll let us do that. Very, very quickly on Dynetics. Great growth company, great set of people. Huntsville is a terrific place to do business. One, it is capturing some very, very significant programs for a multitude of customers that we'll touch on. Has this ability to do rapid design and prototyping and moves us a little further into the prototyping than we had been in the past. And they expand our customer base and the key programs, and Cai and I will probably talk about them as the hypersonic glide body, what they do in the intel world, the -- what they're doing in the uninhabited space and then some weapons work that they do. The L3Harris is, as I said -- it's expanding into what we call checkpoint of the future, a really exciting opportunity for us. Not strategic for Bill Brown and his team at L3Harris, but very strategic for us. So I think it -- one of those deals had created value on both sides. It's in our civil portfolio, so it helps to further expand our diversity, and also has a really nice global presence. And so it expands our business, which is primarily in the U.S. and in North America, to where we're truly, truly global. And again, we'll talk about some of what they do. And with that, Cai, I'll leave that up and grab the seat and answer your questions.

Thank you. So now that Dynetics is closed, maybe tell us, what are the top couple of programs that you feel they've got.

Yes. Great. And the -- one of the exciting things about Dynetics is if we look at the budget, which came out Monday, it's like they wrote the budget around Dynetics. So we're really, really excited about the areas that they're in. I think the one that everybody is talking about is the hypersonic glide body, which is really a premier program. We have -- we -- Dynetics has the army hypersonic glide vehicle, and they're going to produce that down in Huntsville. They have a high-energy laser that's on a vehicle, which is a counter rocket and mortar program that is going to put a 300-kilowatt laser on a mobile vehicle and use it for point defense. And again, another terrific program. They've had a long-standing contract with -- there's an army group called the Missiles and Space Intelligence Center (sic) [ Missile and Space Intelligence Center ], and they do a lot of the analysis, which is actually not just paper studies, they actually get into the hardware and decomposition. That's a great intel program and, of course, we have an intel unit. And then they have a significant piece of the space launch system over at United Launch Alliance, which is in Decatur, very close to Huntsville. And then they have a couple of weapons programs, something called the Small Glide Munition, which is a nonpowered but GPS-guided small bomb. So -- and then there's a lot in their pipeline. We were as excited, by the way, about -- as excited about what was in their pipeline as what was in their backlog.

Got it. It looked like -- just like if you ticked all the boxes, they had everything you'd kind of -- all the areas you'd want to be in. But it doesn't really look like there are a lot of synergies with what you already do. Are there synergies? Or are you just buying a great separate business? If so, how do you run it?

Yes. There are synergies. There are clearly revenue synergies. Unlike our IS&GS transaction, where we saw significant cost synergies, I think our view going in is there's not a lot of cost synergies. There may be some corporate office functions, some back-office and accounting. This was -- and there are synergies both ways. One is they needed a balance sheet processes, a place to go to get talent. They were growing so fast they couldn't hire people. And so they viewed us -- and they needed, by the way, a culture that matched theirs. And many of you know, we were an ESOP. We were privately owned for 42 of our 51 years. And they were an ESOP, so they were employee owned. And that actually -- we could tell that from the beginning. We were kind of sharing cultures and say we're looking for a company to join up with that kind of match their culture. But what we were looking for is rapid design, systems engineering, rapid prototyping, light manufacturing, but that could go from a prototype design to a hardware, to deployment in months. And we have an organization in Leidos called the Leidos Innovations Center. We abbreviate that as the LInC. And they're really good at what we call 6263 research. They're good at like single-use prototyping. And the challenge for us in the LInC is to move into program of records. And what Dynetics does extremely well is to take technology and drive it into a program of record and scale. So in a way, we unlock some value in Dynetics because of what we bring from our balance sheet and our processes, we call it the Leidos business framework. And they have actually unlocked value in our Leidos Innovations Center by allowing us and teaching us how to scale, how to go capture programs of records and rapidly deploy technology.

So are there any important programs coming up that you feel a whole lot better bidding together than you would have bidding alone?

Yes, there are, and maybe some that we'll announce in the next month or so. And by the way, there is both programs that we will now bid together that neither of us would bid. There is some overlap in the pipeline, too, which actually speaks to synergy that says, "Hey, we were going after the same programs. That must mean that we have a lot of the same aspirations." But we're not ready to talk about what's in the pipeline. So -- but stay tuned. We hope to make some announcements in the next month or 2.

So you mentioned you did well in the fiscal '21 budget. Maybe what are 1 or 2 of the highlights for you?

Well, yes, Mike Griffin -- and I said this on our call on Dynetics, Mike has identified a series of technology areas in the Pentagon and -- that did very, very well. Hypersonics did well. By the way, space went large, and we have now much -- a much larger space footprint. Our MHS GENESIS program essentially came through untouched. We saw at NASA -- the NASA budget get plussed up by almost $3 billion on the Artemis program, and that's something we now have a significant presence in. And of course, the overall cap: we're at 7 40 on the defense side; about, I think, 5 20, 5 50 on the nondefense side. But those are great numbers to work with and getting a budget this early. And what we are hearing from the committees is that they want to get to the R-Forms and get to budgets and bills and get this thing passed kind of mid-summer. So we may see the fastest budget process we've ever seen. The good news is the White House and the Senate and the House have kind of agreed on the top layer. And I don't think there's going to be much abate over the level of spending, and then there'll be some discussion about what gets -- where it gets allocated. And here, there are always some pluses and minuses, and those usually get sorted out and committed. So we're very, very happy with the budget.

So your second products acquisition, L3 security, I mean, obviously, that looks like you do have cost and cross-sell potential with VACIS and Reveal. Are there any technology synergies out of that tie-up that are worth noting?

Yes. No, we're very excited. I mean -- and maybe the good news for all of us as travelers is there will be a worldwide refresh, certainly at the checkpoint, where we use CT imagery on top of what we have today, just normal X-ray. And it means we'll be able to get through the checkpoint faster, and we can apply automation. And L3 has mature CT at the checkpoint technology, and we have aspirational CT at the checkpoint in our, we call it, VistA or our security products division. So that's the first one. That's something coming our way from L3. What's interesting going the other way is we do a chem/bio detection, facial recognition, biometrics. And so that goes the other way. We can add to the checkpoint biometrics. And as we think about the checkpoint of the future, which is really what this play is all about, is to be able to make the experience for all of us, like JFK Terminal 4, where it's much more seamless, much less intrusive. The airport authority gets a lot more information, and they can detect, by the way, certain organic chemicals so we'll be able to detect like Sentinel or opioids and pull those right out of baggage and luggage. And so it's a -- it was a product play. It was a global play. It is a technology play. And then kind of going the other way, L3 has typically been a hardware producer. And of course, our business has a significant service component to it. And we believe we can take our service, our field techs and cover the L3 products with small incremental additions in staff and increase the services revenue on the L3 side.

Great. So you forecasted low-teens revenue growth. These guys have never grown low teen. I mean I followed them when they were part of L3, like a 5%, 6%, 7%, that's a great year. And you talk of like almost 400 bps of margin upside. Those seem extremely aggressive. How do we get to them?

Yes. There's a couple of things going on in their business. And of course, we're not closed. So this is all aspirational, and I'll be able to give you more detail after we close the business. And we can't operate the business until we get through Hart-Scott. But they went through a process transformation. They went from in-source manufacturing to contract manufacturing, and they're almost through that transition. And I think that was a complicated process for them, and I think it suppressed margins. There's also -- and we announced at our call, about $20 million in cost synergies. And we think there actually is cost synergies in that deal as opposed to Dynetics. And I think we said we'll get $10 million the first year and $20 million in the second year. And so between -- what we can rationalize in the back office, the contract manufacturing, some of the process work that we have, what I think was going to be a natural lift in margin anyway on their business, and then we add the synergies that we can provide by combining the 2 businesses. And again, the 380 or 400 bps is our estimate based upon due diligence and the knowledge that we have and kind of what we put in our forecast, and we'll be able to update that after we close and we get in and we start operating with their team.

Got it. So coronavirus, is that an issue, particularly for L3 or any...

And whether I'm -- we're all in kind of the transportation business at large and the coronavirus if it suppresses air travel, and we went back and looked at what happened during SARS outbreak. The SARS, there was about 3 or 4 months of depressed travel, especially into the Pacific Rim. And one would expect we'll have a similar reaction. There are clearly some countries where there's people not traveling to. We don't know where this coronavirus thing ends yet. I don't know whether we've seen the worst. I think it was over 1,000 as of this morning. It's a lot of people. Many of our customers for this security inspection and baggage inspection equipment, they generate their revenue on surcharges on travelers, whether it be on tickets or taxes on retail and airports. And so if there is less travel, there could be some delays of purchasing some equipment and what have you. It's a little early for us to make any calls. Again, we got -- we're not in operating the L3 business yet. I suspect that the coronavirus, we will have solved that issue and it will be behind us by the time we close. It will take us probably maybe another 60, 70 days to get through the antitrust filing. And I certainly hope that the coronavirus is history by the time we close.

Got it. Okay. And then -- so you had some big wins in the fourth quarter, GSM-O and Hanford. Both of them protested. Where are we with these protests? And when are they likely to be behind us?

Yes. Protest is sort of something we plan on, on any big multibillion-dollar award now. And I guess I was actually surprised on one of those that got protested, but it did. And there's a 99-day clock. Most of the people are familiar with that. And those should end -- I think both of those end in April: one in early April; and one in late April. But there's always opportunity. I had one program that was protested multiple times, which was really frustrating for us and the customer because we thought we solved the issue, and the protest was withdrawn. They reawarded it and the competitors just filed another protest on top of that. We don't anticipate that. We anticipate both of those programs ramping up in the second quarter in the April time frame.

Got it. And then -- so you recently won the big one, the NGEN takeaway bid. Is this going to be -- has it been protested? Do you expect it to be protested?

Well, yes, I guess, we expect it will be protested because that's how we put our plans together. And it's just -- it's the artifact of the business that we're in today. I will tell you, we're under contract today. And so we have opened up charge numbers, if you will. We have staff. We are putting plans together. We're meeting with the customer, and this will help us to get started. And we can -- we won't have the IPR yet, but we will put in place all of the transition plans. We will get as much work done as we can. And then the way this works, you get a outbriefing on the win or the loss, depending upon where you are. Those are scheduled, actually, I think, next week. And then there's a window after you were briefing, which you can file a protest. And then you start a clock, and it's 99 days from there. And so our expectation is end of this month, early next month, we will know whether we're in protest or not. And then usually, if you file a protest with the GAO, you ask for a stop work. You often get that. That means that we will get a stop work from the Navy. We'll have to stop what we're doing, destaff. We will keep a team together on our own money to build a bridge, and then we'll support the customer. We put people inside the protective order for the 99 days and, hopefully, come out the other side of a protest. The award letter is in the public domain. It's been redacted. And as I read the award letter, we won by a significant amount. So it was not a $7.8 billion award that we won by millions. It would appear, from the way I read the letter, that we were significantly better value than the next competitor. We don't know who the next competitor was. They redact that. But that doesn't mean you won't file a protest, but it gives us a little bit more confidence that the protest will move quickly through the GAO process. And we are, we believe, likely to have the protest overturned and confirm our award.

But -- so if you're significantly better, does this mean below average margins?

Well -- and Cai, we've talked about this every time. The good news is we won. Always in the beginning, we always are at a lower accrual rate. As we understand, we have a huge staffing challenge ahead of us on the program, and we always start accruing very conservatively. It is a program that, over its life, will be at the average margin of the defense group. So there's nothing inherent in the program that will make it any less profitable than other programs we have of its size and scale. But as we are ramping up and we're adding staff, as those who watched us know that we're always thoughtful about -- rev rec is not the problem, but recognizing earnings. And there's some award fees and other things associated with that, which you have to have demonstrated performance.

How -- what is the -- how long does it take to ramp up to rate? And is rate then about $700 million plus?

Well, we haven't said that, and we're probably not ready to say much until we get through the protest period. I think it's -- I wouldn't take the total amount and the 8-year duration and do the math and say the run rate is going to be at that level. It clearly has the potential to be. It will start out slower. It will take us probably 1.5 years, maybe even 2 years to fully staff. It is literally thousands of people at hundreds of locations around the world that support the Navy. We have a core group. There are people working on the program now who we think will want to stay on the program, might be coming to work for Leidos. We call that incumbent capture. About half of the people that we need on the program will come to us through partners and subcontractors, but it will start slow. And it will ramp slowly in '21, realizing it probably won't even start until midyear. So you won't see -- it will be greater than 100, but nowhere near the number, Cai, that you put forward. It'll probably take us all of next year to get to full rate.