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

Okay. Good afternoon, everybody. I'm Matt Akers from the aerospace and defense team here at Barclays. Excited for our next guest, Leidos. Thanks for being here, guys. We've got Chris Cage, Senior VP and Controller; and then Kelly Hernandez, who heads up IR. So Chris, I think you have some opening remarks you want to run through.

Great. I'm just going to run through a couple of slides real quick to set the stage, and then we'll take some questions for Matt here. So typical cautionary forward-looking statements. You can read all our disclosures in the 10-K about that. Let me move ahead to Leidos. Just for those of you that aren't as familiar with us, we just closed down and reported our 2019 fiscal year on Tuesday, very pleased to show over 10% organic growth this past year to $11.1 billion. You can see that fairly diversified portfolio across 3 major market areas: health, civil and defense solutions, which also is a combination of our intelligence customer business and our defense customer business with the DoD. So a lot of government services predominantly through our customer base, and we have about 10% of the revenue coming from international customers as well. Our investment thesis really hasn't changed. I would say that Roger Krone, our Chairman and CEO, and the management team has been very disciplined around this thesis over the last 4 years. First of all, we're growing the top line, and we've been able to do that over the last several quarters, a great year last year, but doing that while maintaining an EBITDA margin of at or above 10%, so really making sure we're growing the bottom line in conjunction. Having a diversified portfolio, won some very large franchise programs, most recently 8 to 10 years in duration, so like the ability to have a diverse and resilient base. Generate cash, very light capital intensity, low CapEx investments, and so we are able to take that capital and then deploy it. And I'll show you on the next chart, we've been positioning for 2 transformative acquisitions here recently, but we're all about a disciplined process for capital deployment. Talking about those deals, so -- and we'll get into this more in the Q&A, 2 transactions, one of which, Dynetics, we've actually closed on January 31. This was a transaction, $1.650 billion on purchase price. When you take into consideration tax attributes of the deal, a little over 12.5x multiple, so very affordable. Funded that with some cash on hand and debt that we issued. And so off and running with that program, and we'll talk more about that with that team, very exciting capabilities based in Huntsville. And then the L3Harris security detection and automation business, this is a complement to a business profile that we've had for a number of years, again a transaction, $1 billion, 13x EBITDA multiple. We believe that both of these transactions are going to be accretive to our revenue growth, our margin profile, non-GAAP EPS. Doing both of these in short order, although we haven't closed the L3 transaction yet. That will close hopefully by the end of our second quarter. We will increase our leverage ratio for a period of time, and we're committing to work that back down aggressively over the course of the next year. Just on Dynetics, really exciting stuff that they do there, heavy research and development. So they've got capability for rapid prototyping. They're well penetrated in the Huntsville market, which has got some key customers, the Army, NASA, Defense Intelligence Agency, et cetera. And so they're well distributed as far as the number of programs and business areas that they focus on, and we just love the complement to our capabilities there. And then on -- unfortunately, that one didn't show up very well. But on our -- let me go back here real quick. No, I can't show you that. But the L3 transaction, I mentioned that we've been in a security products business for decades. And so this helps complement our aviation security products, our ports and borders. What it really does is give us an international footprint of an installed base, a sales force, a lot of synergy capabilities. We've committed to find $20 million of cost synergies associated with that transaction over the first couple of years. And then from there, we see a lot of opportunities to, again, continue to grow the installed base and transform the services delivery side of their portfolio. So with that, apologize for that slide, I'm going to go back and leave it on this, and we'll sit down and take some questions with Matt.

Great. Yes. Thanks for that introduction, Chris. I guess maybe to kick it off, maybe we could talk about the budget briefly. So we've got the request last week. Not a ton of growth or kind of flattish for defense. That was sort of as expected. But can you maybe talk about just sort of areas where you guys did well on the budget, where maybe less well, where sort of we should think about kind of the mix of the defense and the nondefense businesses kind of growth based on that?

Sure. Thank you, Matt. So in total, obviously that there was -- the headline shows that defense is roughly flat. Nondefense looks like it's down maybe as much as 10%. But I think in the aggregate, we feel like the total top line number is well positioned, and we're very confident in a budget environment like that. There'll be some jockeying, and some moneys will move around between the defense and nondefense portfolio before the dust is settled. But the areas in the nondefense agencies that will be under pressure are really not areas that we're serving client missions today, right? So we feel good about the customers that we're supporting, sustaining their key programs. And quite honestly, defense at a top line number of 7 40 or thereabouts a billion, still a lot of comfortable ability to take programs away, grow existing programs within that. And the areas that they're focusing that budget allocation to are just in our sweet spot, especially with the new Dynetics acquisition. The hypersonics space, new capabilities that the government is looking at, electronic warfare, autonomy, all things that we feel like will benefit from the budget dollar allocation before the process is settled out.

Got it. Do you have any thoughts on sort of where we are in the budget cycle? I mean I think if I look back over many budget cycles, sort of the services part of the budget, kind of O&M, how I think of it, has kind of typically been a little bit more stable and kind of peaked a little bit later, whereas kind of the modernization stuff has maybe been a little more cyclical. I mean I guess, do you have any thoughts on sort of where we are there and how much further out this cycle still has to grow?

Yes. No. All good things come to an end at some point, and we've seen the peaks and troughs. We still think that we've got a few years to run, right, in favorable budget dynamics. And quite honestly, with outlays lagging the actual budget in the first appropriations, there's still going to be some increases in the outlay process. A lot of that depends on what happens with the next election and how things play out. But I do think there's going to be a point in time where budgets will be under pressure, and we spend time thinking about that. We spend time scenario planning for what life looks like. And that was a conversation even at some of our most recent Board and management meetings, right? So anticipating that but being ready. But that's why we do the acquisitions that we did because we think those areas are going to be strategically important, even in a budget scenario where there's pressure on some other spending areas.

Got it. So I guess speaking of kind of the pressure. So a lot of headlines about Secretary Esper focusing on fourth estate areas where could maybe get some cost savings in the budget. Could you talk about maybe how much exposure you might have to those areas and if you're seeing any pressure?

Sure. So the fourth estate, essentially the nonservices aspect of the DoD. I mean, thankfully, we don't have a huge penetration with the exception of -- in DISA, the Defense Information Systems Agency. We just won our largest recompete program, the GSM-O program, to sustain the DoD network environment. That's one of the fourth estate agencies. So the good news is we've got a proven track record of delivering highly capable network, IT solutions, modernization. And what we believe would happen if over time the fourth estate agencies are under pressure to drive efficiencies, a lot of that's going to come through modernization initiatives and IT initiatives. And again, an area that we've got strength and capability and the fact that we're under-penetrated in places like Defense Logistics Agency, et cetera, we see that more as an opportunity than a threat.

Got it. I guess one area in particular, sort of the unmanned Navy ship, something you guys have talked about in the past, it looks like it was pretty well supported in the budget. Is that some -- an idea that's sort of catching on with the Navy now? And how big could that opportunity going to be?

We certainly believe so. And it's one of the things that gets us excited. Predominance of what we do is more services-oriented. So when we actually get a tangible product, we're able to make something that's really cool. And there's little replicas all around the building of our Sea Hunter prototype that we built for -- first for DARPA, and then the Navy ordered a couple whole. So we've built the small autonomous surface vessel. And the team has strategically been positioning for when the Navy comes out with the next procurements, and we believe there'll be one in the medium-size unmanned surface vessel area, and we put in a bid on that. So how it plays out with the Navy and priorities around large unmanned surface vessels versus medium, that's a little bit still TBD. There are certain aspects that we won't play in. We're not going to be a huge shipbuilder, but I mean clearly in the medium size, leveraging the capabilities we've already proven with our Sea Hunter concept, we think that can be a very substantial opportunity over a long-term time horizon and one that which we would think we could be competitive with a proven capability that we've already got out there.

Got it. Maybe switching gears a little bit to kind of the M&A side, you mentioned the 2 recent deals. Could you talk about just sort of the --sort of pipeline of deals, what you're seeing? Some of your competitors are talking kind of complaining about where multiples have gotten. Is that something you're seeing? And what do you use for sort of screening criteria for looking at these deals?

Well, that's a good question. So we've had a very thoughtful process and one that we had to build the capability and the muscle memory around M&A. We did the IS&GS transaction in 2016. On the heels of that, we weren't really going to be in the market for a period of time as we integrated that. But we were building the building blocks, putting in place our M&A team. And we've got a great team led by Randy Phillips, and rounding his team out, starting the regular rhythms and processes with the line organization. It all starts with your strategy, and Roger has been very disciplined around we're going to have a strategy. The strategy is going to have areas that you need to supplement, right, to fully execute the white space areas. And so you better not bring an opportunity forward for M&A if it hasn't been talked about previously in your strategy is an imperative, right? So once it goes through those filters and the leadership team's talked about it, and the Board's heard about it, then when these opportunities do present themselves because you never know when that's going to be the case, you already know that it's a strategic fit, then it comes down to can we get a property that makes sense financially. You look at the economics. And in this particular case, both of these properties that we're fortunate enough to -- one we close and one we expect to, fit all those criteria. And it wasn't that we're -- the only ones we looked at. We looked at a lot of things leading up to this, right? But these ones happen to culminate, fits strategic imperatives, were able to be executed at prices that we felt made sense. And so we're very excited about both of them.

So the timing of these 2 deals kind of relatively close together, how should we interpret that? I mean is it just sort of the timing of when these assets became available? Or are you just confident in the business enough to move forward with IS&GS sort of completely done? What were sort of the big drivers?

Right. I think a lot of it is the timing of when properties became available. We've been looking. We knew that there were opportunities in the marketplace from other consolidations, one of which again, the L3 transactions coming out of a merger that they orchestrated, and so waiting and seeing what parts of the portfolio might become available through a process like that. But for us, again it was we know we like our security products business. We know we think that not only is it a good business to be in with, we believe, above-average growth rates for the near term, there's also optionality if there's ever a refresh, right, of deployed and installed base. And so positioning for something like that is really important for us, but we know it's a business, again, that we made a lot of money on. We've run well for a long time and adding that portfolio just made a lot of sense. In Dynetics, it was more -- again, we know that hypersonics, directed energy, small glide munitions, space strategic imperatives for the long-haul for our government and the DoD. And so a property that gave us an opportunity to penetrate many of those at the same time, we're very fortunate, right? And so that one was one that we couldn't pass up when the opportunity presented itself.

Got it. You've done a couple of divestitures recently. So the commercial cyber business, the health staff augmentation. Are you still looking at the portfolio? And after all these deals, are there more smaller assets you could potentially divest?

Well, let's say, we always evaluate the full scope of offerings within our portfolio, and we're constantly reevaluating that. At the moment, there's nothing significant that we are contemplating. We wouldn't preview that. But I think it's fair to say that as the business continues to evolve and develop, that there could be opportunities. And we always make sure that the businesses that are underneath the portfolio are all contributing to the investment objectives that we've laid out as for commitments for the long term.

Got it. So post these 2 deals, you've indicated you're shifting more towards deleveraging for the next year. I guess should we think of that deal pipeline as sort of closed at this point? Or are you still evaluating things? And if the right deal came along, would you still be willing to go for it?

Well, I would say that we're not letting our M&A team off the hook that easy, right? So they're still keeping a track of what's out there in the landscape. Clearly, actually having a period of time where we've got to digest these 2 transactions while delevering works to our advantage, right, because we do want to get back to our leverage target. And we do know that thoughtful integration makes a difference in the long haul. But you can't control timing if a strategic property becomes available, certainly more on the tuck-in side. We're going to continue to look and see what becomes available, and Randy puts out his weekly report. And so we're definitely tracking the market, but I think it's fair to say that the likelihood is we're going to do the integration of these transactions focused on deleveraging and see where we are late in the year, Q1 of next year.

Got it. So both of these 2 recent deals, they're a little bit more of a product kind of tilt to them. And you've sort of talked about this for a while, potentially moving into more kind of product versus services. How kind of far along are we in that transition? Is there a lot further to go? Do you plan to move more into kind of product-related businesses?

Well, I would say that there's not a target, right, that says we need to get to x percentage of products versus services. We've been in the product space to a lesser degree, right? I mentioned security products. We've done some small-scale manufacturing. We've done Sea Hunter. So we've done some things, but we've always liked having an increased presence of products in the portfolio. What we really liked is products that came with a services tail to them, getting that predictability and consistency of we've got an installed base, the customer needs to come back to you for maintenance and service. How do you do that well? How do you use that as a strategic advantage? And how you manage the supply chain and proprietary parts and service aspects? So that's been in the playbook, and that will continue to be in the playbook. And so that part makes a lot of sense. Then Dynetics, of course, adds to that, and we're very hopeful that some of the things they're doing, on smaller scale from a products perspective, can continue to grow and become more prominent program of record type of things. And that's what we're hoping to position the business for over time.

Got it. I guess on Dynetics, for example, so I guess early days. But now that you've closed, anything that sort of surprised you now that you've got a closer look at the business? And I think you had described this deal as generating more synergies on the revenue side. Any more kind of concrete examples of what those could be?

Well, I'll start and maybe ask Kelly to weigh in here. What I would say that's surprised me, and I guess it shouldn't have surprised me, is just getting an opportunity to work with the team. Very impressed. I think the capability of Dave King and his leaders is just remarkable. They're very thoughtful. They're very tied in with the customers, thankfully, right out of the gates, they're working on a large proposal. And we'll continue to do more of those things. But that has given us an opportunity to kind of see them in action and just been very impressed about how they go about the process and the technical depth they've got within the team to respond. Kelly, you've seen some things, too. Anything you'd add as far as your observations?

Yes. I guess I'd add to your point, it's early days, but if there's any surprise, it's positive in the depth to which we see how aligned they are with their customers, how well they understand that Huntsville customer set that as Chris mentioned earlier where we've been a bit under-penetrated there as well as the breadth of the technical capabilities that they have that not only serve that customer set, but also the rest of the customer base where Leidos has a really strong offering. So when we talked about that deal initially, we talked about that being more of a revenue synergy-type deal than a cost synergy deal. And everything we've seen since close would further our confidence in that. I think what is nice about the combination of the 2 bringing their talent and their capabilities and their customer intimacy and bolstering that with the scale of the Leidos organization allows what we've seen already in the weeks post-close, allows the customers to have a bit more confidence in their ability to execute perhaps programs of even greater scale than they may have been able to stand-alone. And that's really where the promise and potential of this deal is.

Got it. I guess I'd like to ask about some of the big project wins you've had recently. So kind of the big things we were talking about last year, NGEN, GSM-O, Hanford, you guys won. What were sort of the biggest factors in those wins? And if you think of kind of historically, I think of DoD as being more -- a little bit more price-sensitive back in like the LPTA days, where are we on that continuum versus like highly sensitive versus more kind of value?

Right. I mean obviously we've been talking about all 3 of these programs, Hanford, GSM-O II and maybe NextGen for, you're right, more than a year. And it's been the dominant question, we've been in front of investors for a long time. So quite appreciative to win all 3. We recognize that 2 of the 3 are in protest. That's part of the process. We understand that. It's more likely than not that maybe NextGen becomes in protest as well, but we're prepared for that. That's part of our plans. I'd say it starts with, first of all, great execution with your existing programs. And the teams have done that and performed well for their customers. But really, we started the capture process on all of these well over a year ago and have put our best capture managers in front of these efforts with dedicated teams and have been thoughtful. And I would tell you from Roger Krone on down, right, leadership participation in walking the walls to look at what offerings we're going to provide to the customers in our proposal efforts. And so a lot of thought goes into a lot of effort, gets back to -- for some of these opportunities like maybe NextGen, you have to have a certain size and scale and capability to even be a qualified bidder, the past performance becomes critical. And so not that many people were even able to bid on something like this of this magnitude we were. So having those past performance qualifications is critical, and scale brings that to us, coupled with technical differentiation and the effort that we put into our CTO organization around our technical core -- competencies in the past couple of years and really riding to that and having standard go to repeatable use descriptions of how we will do software-defined networks and cloud migrations and things like that become instrumental in winning opportunities like this. So we wrote great proposals. We performed great for our customers. We -- obviously, price is a factor. We don't think it's the predominant factor in any case, but we're making sure that we're competitive from a price perspective, and that went into it. But we don't think that's how the customer is really buying things predominantly these days, back to your LPTA question. In other words, some hard lessons learned by going solely to minimum qualifications and low price on a determination criteria. And I think that they recognize that they don't like what they get oftentimes in that -- in outcomes like that and you want to go back to a best value. And we clearly think that plays to our strength because while we can be competitive, we know it's the technical areas that we can offer and that are differentiated become some of the key attributes in winning work like this.

Got it.

And we've also been -- in addition to the customer set moving away from LPTA, for the most part, the successes that we've had have enabled us to be more selective on what we bid as well and making sure that programs where we're going to spend our precious bid and proposal dollars on are those that in fact benefit and the customer would benefit and value the technical capabilities that we would bring, the innovation that we could infuse into those missions, and not bid on things that don't make sense, that don't meet our margin targets, that don't benefit from that value recognition and are perhaps only awarded based purely on price.

Right. Okay. Could you comment maybe on kind of the protest environment? So NGEN is one I think that will probably be protested. Is it -- has that gotten worse over time, especially kind of given some of the larger contracts?