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

My name is Jon Raviv. I'm Citigroup's Aerospace Defense Analyst. We're very happy to have Leidos here. Leidos is a -- well, the largest, not a -- the largest stand-alone government technology provider, providing solutions to both U.S. and foreign customers. The microphones are live.

Okay.

So we're good to go. Again, so Jon Raviv here, we're joined by Chris Cage, the Vice President and Controller of the company; and Kelly Hernandez, who's the Vice President of Investor Relations at Leidos. As you can see, this is a large square table format, and we'll be just running a little bit of a conversation here crossed with a congressional hearing. So with that said -- well, I should also, for everyone's context, Leidos did report what I think could be considered a robust 4Q '19 result on Tuesday?

Yes.

And guided to a continued robust 2020 ahead. So pretty much all good news for you guys.

It's been a good run.

Yes. Well, it continues to be a good run, Chris.

So let's start with growth then. I mean in May 2019, you guys talked about a 5% CAGR. That was issued at a time where you're just sort of approaching that number, and now you've pretty much exceeded that number pretty handily, growing double digit in 2019 and talking the about 7% organic growth, I think, in 2020. So what has created in your mind, the opportunity to generate that kind of growth and also sustain it for a couple of years at least, if not more?

That's great. And I can almost see you over there, Jon, so -- across the table. I would say, we've been fortunate, right? When we did lay out that 5% growth target in May, we had a couple of quarters under our belt that had started to show growth. We've been able to build on that over the back half of 2019. And a couple of factors contributed to that. I mean number one, we've done very well on the hiring environment. As you know, people-driven business, services business. Bringing in the right people in the right locations oftentimes with security clearances is critical to our ability to continue to expand and grow, and our teams have done a fantastic job in that regard. We've got a great recruiting team, onboarding. And we've done a number of initiatives to continue to make ourselves an attractive employer of choice. And it doesn't hurt when you're able to win work, especially when you're taking away work from other competitors. And oftentimes, you're able to bring incumbent workforce over with you. So that's played a role there, too. The second thing that we really laid out a game plan over the course of the past couple of years to look for opportunities, to expand our relationships with the clients, where we're already doing work for them. We call it, on-contract growth, right? We're in our customers' environments on a daily basis. We've got program managers and technical teams that are there, and they're seeing what additional opportunities there are to expand that relationship and putting new ideas in front of customers and finding opportunities to make sure that we use the available budget dollars that the customer has to drive increased work share. So those initiatives have been paying -- bearing fruits. We put a lot of emphasis into training and goal setting around initiatives such as that, and we've seen a lot of success in 2019.

And growth is never hurt and only helped by a supportive spending environment. So would you be able -- I mean between -- you've succeeded very nicely on your hiring plans, which are sort of key when it comes to growing. If you have all the demand you need, you sort of hire against it and then also expanding on contract. But the spending environment, and you have -- you operate in 3 broad markets. Would you able to characterize how each of those markets is going in terms of that spending environment? I know all were up, so still positive.

Right. No, that's great. We've got -- we report externally 3 key segments in our civilian agency, our Health and our Defense Solutions. Within Defense Solutions, it's actually a combination of our defense customer business and our intelligence customer business. And over the past couple of years, the budget environment has been favorable across the board there. We've been successful in winning new work across each of those areas. So when you think about it, I mean, in the Health space, not only are we in front of the largest program in the -- for the Defense Health Agency in implementing their modernized electronic health record system. And that program we've had for several years now and it continues to ramp up and grow, and we're almost to a point where it will reach a steady state, but that's a major contributor to us. And couple that with -- we do research, scientific research. We do medical services, and we've seen opportunities for growth across a number of those dimensions. So that's been a diversified area for us that we continue to see increasing opportunities. In the Civil space, civilian agencies, and we'll talk further about that, I'm sure, if we talk about the upcoming budget. But our teams have been very successful on winning major work share away from competitors. And so we've seen nice growth on large programs like one we won for NASA that we're running the IT environment across all of their centers. We've got an Army Corps of Engineer program to run the IT for that organization, that's ramped up nicely. So we typically see very large programs in our Civil segment, and we've also got a large program in the U.K. around logistics support that continues to perform well. And then finally, on the Defense segment, again, I mentioned it's Defense & Intelligence. Variety of things that we do there from digital transformation in the IT side, we certainly do that, and that's evident with some of the most recent wins that we've announced on the Navy NextGen program. And our incumbent work for GSM-O for the DSA -- D-I-S-A, DISA organization. But on top of that, we also run a lot of scientific work, and we run intelligence and reconnaissance work across a number of customer sets and data collection, data analysis, those types of things. So it's a very diverse portfolio, one of which that is going to be complemented by the capabilities we're bringing in from the new acquisitions that we recently announced.

We'll certainly get to those acquisitions because you've been very busy there. You also brought up the overall spending environment, the budget, you have defense, you have intelligence, you have civil. It's probably too easy to say, well, the budget is this, and therefore, you're that, clearly, there's a lot of opportunities beneath the line, both in defense budgets, intelligence budgets and all the civilian agencies out there.

Right.

So how would you characterize how you're lining up against various priorities and various requests coming in from the executive branch for the insurance broad buckets?

Well, I mean, first of all, we think that we're pleased with the starting point. Now the President put a budget request out there. It will go through a process through Congress, things will move, we know that, we expect that. But starting with the defense appropriation recommendation, we're comfortable with that number, it's essentially flat. The budget environment has been robust the last few years. I think there's no shortage of opportunities at that type of number. And when you look at the nondefense spending, although, on the one hand, it looks like it will be under pressure in certain organizations. As we peel that back and look at where we really have important mission support for key customers in the FAA, the Department of Energy, except NASA, we believe those areas actually will come out just fine. And in fact, in certain areas, such as NASA, you're seeing plus ups, right, that we haven't seen in the past that would create some additional opportunities for us. So we know, again, not done. There's work to be done over the next several months. But we believe that there is going to be a lot of desire on both sides to work through that in advance of the election season, hopefully, and it'll provide some certainty one way or the other. But we think it's a comfortable budget to continue to sustain and grow from. And quite honestly, you talk about budget and appropriations, we still have a delay in the outlay cycle. So from prior budgets, you're still seeing moneys come out to drive budget expansion, and that's been a nice a couple of year run that we've enjoyed and expect to have that continue for the next couple of years as well.

I appreciate that. And I mean, one thing that always occurs to me on the Civil side or when the administration, whatever administration, wants to look for ways to do things more cheaply. It also occurs to me that government -- excuse me, that technology can actually help accelerate that opportunity to do things more efficiently, get more for less and whatnot, placing old systems with new systems. Is that a -- I mean clearly, with -- you've got also wins here that are aligned to that, but is that also a fair way to characterize the opportunity set even in a pressured budget environment?

Oh, absolutely. We think so. We call that our digital transformation initiatives, right? And first of all, we've been very thoughtful around what are the tech core quant that we see as sustaining into the future that we want to concentrate our investment and our capabilities around. And so digital transformation has certainly been one of those, there is others. But oftentimes, to drive efficiencies, it means you need to make some upfront investments in new capabilities, IT led. And then using that to enable modernization, right? How are you going to leverage the data out of your systems more efficiently? How are you going to drive analytics, visualization, et cetera? So we've seen that with key civilian agency customers. We think that's clearly an opportunity that we'll see more of on the DoD side as we go forward as well. And that's certainly one of the key areas that we've got a lot of capabilities and is foundational across really all of our end customer segments.

So you have the right capabilities aligned in a broadly supportive spending environment, you're not growing as much as it was, but nevertheless, supportive. And as you said, still plenty of room for you to grow within a flat top line, let's say, for Defense. So to put that in the context of your growth targets, going back to that 5% CAGR right out of the May 2019 Investor Day, clearly you've outperformed. Now thinking longer term, do things like your recent M&A activity, we'll get to those in specifics, but do things like that and also, with winning NextGen can give you a brief pop up but then over time, maybe it normalizes. But getting into those sorts of markets, so does that give us an opportunity to reset expectations around the multiyear growth trajectory here?

It does. And I mean we're not in a position today, right, where we're coming out with new long-term growth targets, but it's something we've been talking about internally. And one of the things that -- we set out the 5% goal, and that was important in May because we didn't have a long track record of demonstrating growth up to that point in time. And then we've been very fortunate, right? We took our 2 biggest recompete contracts off the table with victories here in December. Those are both in protest. This is the GSM-O contract and the Hanford mission support contract in Washington. But derisking the top line with those wins is critically important, number one, so you can grow off of that. And then really getting back to the technical confidence that we've seen, the incremental investments, not only have we invested in those and can demonstrate those capabilities in past performance, we've done a much better job with strong leadership from our CTO organization and Jim Carlini, and Jim Cantor before him, to make sure that we have those well written and documented and repeatable use in our playbooks. And more of those are getting incorporated into our proposals going forward. So we think, again, that will only help sustain and enhance our win rates on the work that we're going after. We've got no shortage of work in the pipeline. Our BD teams are busy. We spend a lot of money on business development efforts every year, and again, been bearing fruit. So you couple that with, okay, we closed out last year at about 10% organic growth -- 14% organic growth in the fourth quarter. We've -- we're going to talk about 2 acquisitions that we believe and we've communicated are accretive to the 5% growth rate that we talked about. So all signs say it will -- it should be going higher. And in fact, in our 2020 guidance that we just put out on Tuesday, implied in that was a 7% organic growth rate for 2020. And there is some modest contribution from the Navy NextGen program assumed in there. But again, we expect there'll be a protest period, and we expect that, that will have some delayed start transitions. And so again, that will hopefully be one that ramps up more significantly over time.

If you go back to what we said at Investor Day, Jon, the 5% growth target that we put out there was predicated on approximately 5% growth in our Defense Solutions business in the defense end market as well as roughly 4% in Civil and Health. So to your point earlier, as you look at the budget request, and you think about the outlays that would follow that over the subsequent years, the subsegments within those agencies that we are looking to focus on and that we're targeting through our solutions are designed to, in our view, grow in that 4% to 5% range by segment, 5% overall. The acquisitions, the great wins we've had, particularly the takeaway wins, are all proof points of our ability to continue to drive growth further beyond that.

So I sense a desire to talk about M&A. So we'll go there now. The -- so the 2 -- so I mean, again, so going back to May, you laid out some multiyear targets, including capital allocation. And I think for -- I mean for -- ever since you completed the IS&GS, which came up from Lockheed Martin. Ever since you essentially completed that integration, I think the message from you guys has been generating a lot of cash, and there's an opportunity to do more M&A at some point, we'll see when. Maybe it took a little bit longer, but we got 2 big ones in pretty quick succession with Dynetics and the L3Harris divestiture of their security detection business, long set up. The question -- so the initial question here actually is, when I look at those 2 acquisitions, Dynetics and L3Harris asset, on the face of it, they don't look the same. So can you talk about the connective tissue between those 2 approaches and then what's the M&A strategy -- or within the context of what are the M&A strategy here at Leidos?

No. Thanks, Jon. I'd say that the intent wasn't that there is necessarily a connective tissue between these deals, but there clearly is connective tissue with the broader corporation and our strategy, right? So Roger and the management team are very disciplined about the strategy process, and we go through that annually as a refresh to make sure we're on the right trajectory. And the thought process is, we know we're going, right, strategically, M&A needs to fill a gap in that strategy and be complementary. And so when you think about the Dynetics acquisition, some of our strategy early on was to focus on, where is the DoD priorities going to shift, right? And we've had forever, a group of very talented individuals within the company we call our Leidos Innovation Center link that have always focused on the tough R&D programs. We've done some work in some of the same areas that Dynetics brings capability to us. But we knew electronic warfare, space, hypersonics, directed energy, those were things that we saw budget dollars shifting to as we looked over the intermediate to long term. And while we did some work in those areas, Dynetics really allowed us to accelerate our capabilities significantly in that space. And so it just made perfect sense, right, to say we can round that out, we can bring more technical depth. And oh, by the way, they bring to us, not only the front-end research and development, but they've also extended that to the ability to drive rapid prototyping to not only design but start to build and then drive that towards a higher end production of things that come through that cycle, right? And that's the whole goal is we'll see some of those programs evolve over time into programs of record, and how do we position ourselves early on, on the front end with that, and Dynetics with that exceptional team in Huntsville, Alabama brings that opportunity to us. The other deal that you mentioned, the L3Harris Security Detection and Automation business also fit our strategy. It just so happens that there was a business line within our Civil portfolio that we've always had, we called our security products business. And that, by the way, has got product offerings that provide secure detection of contraband and explosives for ports and borders, but also a product line that fits the aviation market, and we felt we were underpenetrated there. But we've been in that business for some time, right? So we knew strategically that we like that business. We thought that the security detection business over a longer-term time horizon have the opportunity to grow at above average rates. And so we looked at various properties over time. This is one that happened to come available, thankfully, out of the L3Harris merger, right, that it no longer was a strategic to them. But to us, it was very strategic and made a lot of sense. So that expanded our footprint. We're in the security product business. We're going to be able to grow that substantially because they've got a significant installed base of products. They've got a significantly more international presence than we've had historically, and they're in 70 additional countries that we weren't in, right? So we like the fact that that helps us grow and expand, cross-sell our offerings to customers that each side was previously in and then look to implement some of our best practices that have made our business so successful over time. So again, I think that the connective tissue between the 2, I wouldn't look there, but I would look to the fact that we like having a diverse and resilient portfolio, security products has been in it, these other DoD priority areas have been in it, and both of these deals really complement work that we were previously doing.

So I mean, you talked about both being accretive to growth. So not only do they add sales dollars to 2020 versus your guidance, I believe, it also should add growth. So the 7% organic is still what we can think of as Leidos. And these deals that will close this year will be additive to that growth rate. Is that the right way to think about it?

That's right.

Yes. The 2020 guidance that we just put out a couple of days ago includes 7% organic growth as well as approximately $900 million of revenue contribution from Dynetics. That transaction closed already on the 31st of January, so we're able to roll in 47 weeks of that into the guidance. There is no impact included yet for anything to do with the L3Harris transaction since that hasn't closed. Once that does close, we'll update guidance reflecting that transaction.

But to your -- where you're going with your question, too, Jon. And we've communicated this, the properties that we bought, we believe not only add absolute dollars, but they're also growing at a higher organic rate than we have been. So they'll be accretive to the organic growth rate as we move forward.

Understood. So similar -- so accreting to growth rate, I believe, also accreting to margin. So just as we're on the M&A topic, what -- how do these deals then also change the way you guys think about your margin outlook? I mean I think, historically, the -- Jim, the CFO's message has been -- or your message has been, it's an above 10% EBITDA business, if we're too high above, it means we're not investing enough to plant those seeds of growth; if you're too low, then, well, we're just not doing a good job. How does that message start to shift in the context of Dynetics, L3 and also just doing your business better on an underlying basis as well?

No. I think that it does to start to shift the dialogue, no doubt about it, we recognize that the products business, in general, certainly on the security detection business, should have higher margins. It does have higher margins than the core business overall. It doesn't have as higher margin business as what our security products business has been. So there's opportunities there to see that as it becomes a more significant portion of the portfolio, right, then we'll start to think about how does that blend up our average margin profile. And Dynetics is in the same boat. Right now, I mean they do -- they've got a better complement of fixed price work than we do, which gives them opportunities to drive margin increases. And as that grows, which has been on a rapid growth trajectory. We would believe that that will also help blend up our overall margin opportunity. So we recognize that we've said 10% floor. We think the bias going forward will be higher, right? But we're not at the point where we're giving guidance beyond 2020. And for 2020, we said 10% to 10.2% on EBITDA margins. And that reflects Dynetics' contribution. It does not reflect L3Harris, as Kelly pointed out, but it also reflects the fact that we've had these large recent wins, GSM-O II, Navy NextGen, they'll go through a start-up phase, a period of time. And usually, in programs of that size and scale, the front end is less profitable than once you get them in and get them at sustained performance level and then you can find opportunities to drive margin improvement over time. So those things are also factoring into why we're at 10% to 10.2% for the coming year.

For '20?

For '20.

Right, with those new things picking up. And beyond the M&A, beyond GSM-O where you compete, win; NextGen, win. The NextGen isn't really -- I mean NextGen, fair to say, ramps up later that -- well, depending on the success.