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

All right. Good morning, everybody. Our -- this is Gavin Parsons with Goldman Sachs. And our next presentation is Leidos, and I'm pleased to introduce Jim Reagan, CFO. I'll turn it over to him for some prepared remarks, and then we'll do Q&A. Jim?

Good morning, everyone. Thank you, Gavin, and certainly, appreciate being invited to the conference in this virtual format. I'm going to just spend a couple of minutes briefly going through a number of slide charts that have been made available to you all. And just flipping past the forward-looking statements, which I encourage you all to take a look at. Just to introduce those of you who aren't familiar with the company, on Slide 3, Leidos is a diversified company that is primarily engaged in developing services and solutions for the government and other regulated markets worldwide, but primarily here in the United States. We are involved in defense solutions. That's roughly half of our business by way of 1 reportable segment that includes customers like the DoD and the Intel Community. But we also have a substantial health business that's about almost 20% of our revenues. And then at Civil business that's primarily civilian agencies, such as the FAA and the DHS as well as in the civil business, we have some customers, such as the National Science Foundation, et cetera. The -- and we'll go into a little bit more detail on that in just a minute. Flipping to Slide 4, the investment thesis chart. The company is -- has been showing a nice path of organic growth recently. That is particularly supported by very, very strong new contract awards and new bookings. We have win rates on newly acquired work as well as work that we compete to take away from our competitors when contract renewal cycles come up. Win rates that are at or above [ 50% ] over the last 18 months or so. And that -- the long-term nature of our contracts makes our top line a very resilient revenue stream. The business has great cash generation, strong cash conversion. We target 100% or more of non-GAAP net income as the amount of operating cash flow that we generate. And we have a disciplined capital deployment philosophy that certainly for the coming several quarters, we'll be really focused on delevering after we have raised some debt to finance recent acquisitions. Speaking of 2 recent acquisitions, flipping to Page 5, we recently announced the acquisitions and have closed the acquisitions of a company called Dynetics and also the L3Harris Security Detection and Automation businesses. I'm not going to drain this slide and go through all of these details, but both of these acquisitions were really geared to move us increasingly into more of a solutions-based revenue stream that has nice accretion to our EBITDA margins, moves us up into businesses that have a higher barrier to entry and have a great integration of not just the services that has been really core to Leidos historically, but also products that gear into the services that we offer. Dynetics, Page 6. It's an industry-leading Applied Research and National Solutions company. The high-growth areas that we're engaged in, you see over on the right-hand side of this chart, the development and manufacture of components for hypersonics and space solutions. And then also, we do a lot of services work around Intelligence and Electronic Warfare, avionics, and also weapons technology, including things like unmanned and counter unmanned systems, Small Glide Munitions. Most recently, Dynetics was awarded a contract with NASA to do the initial development and conceptual design of the next lunar lander. That is targeted to reach the moon in 2024 after 3 companies, of which we are one, after those 3 companies that are doing the design finish that design, NASA is going to neck it down to 2 companies that will actually do the construction and operation of the lander, and we're looking forward to the ability to compete meaningfully there. The L3Harris Security Detection and Automation businesses, that's outlined on Slide 7. This is a business that complements well the existing Leidos business that we have in making things like baggage screening equipment as well as mobile detection equipment that is used to help protect our borders by scanning railcars, trucks, automobiles. And these are solutions, not so much for airports, although there's a big airports business there but also to protect rail ports as well as marine ports and border crossings around the world. The compelling benefits of the L3Harris Security Detection and Automation businesses acquisition is really that it expands us globally. Until we acquired this business, most of the revenue in the legacy Leidos business would channel through the United States. There's a big U.S. component to the L3Harris business, but also they have a very significant presence in Europe and Asia. The product portfolio, again, products and solutions that are growing faster than the rest of our company. And we believe that we're very excited about this business because as airports and other venues that require high levels of security are going to be looking increasingly toward an integrated end-to-end solution that includes screening solutions for biometrics as well as health screening for people, we believe that this business is really well positioned for that. Turning to our recent update on Page 8. The 2 acquisitions that we had were financed initially with bridge financing. We recently placed $1.75 billion of bonds to refinance the bridge loan for Dynetics as well as about half of the loan that was used to purchase the L3Harris business. That bond offering last week had a lot of strong demand, and it was oversubscribed to by about 12x. And you can see at the bottom that we've got a blended coupon of 3.75% worth of tranches that you see outlined there. Again, I think that the strength of that bond offering really came on the heels of a strong Q1 as well as, quite honestly, really good timing that we had coming into the market. With that, I think I'm going to turn it over to Gavin. Gavin, you have some questions and fire away.

That's great. Okay. Thanks, Jim. Maybe just starting with the most topical, COVID-19. You guys covered it in length in earnings last week and really pretty minimal disruption there. Can you talk a little bit about just how that evolves from kind of the first shutdown to today, and whether there was initially a lot of confusion about what work could be done remotely? And if that's largely cleared up at this point and you have your arm's pretty much around kind of the full extent of the disruption?

Sure. Yes, as it became apparent that COVID-19 was going to be disruptive to our customers' operations worldwide, we mobilized teams, focused customer-by-customer and how we would be able to continue delivering on our services to those customers. The vast majority of our U.S. government customers find our work to be mission-critical. And therefore, we've, so far, seen a minimal impact with roughly 5 -- think about roughly 5% of our employees being impacted because they are not able to do the work that they need to do for customers remotely. Intelligence agency customers need to have the work done in a skiff. And because of that and because they want to protect their workforce, roughly half of the workforce is on standby leave and about half of that workforce, for impacted programs, are still coming into a skiff, either our skiff or the customer skiff. And right now, those customers are already looking to further minimize mission impact by starting to schedule employees coming back full time. And that's consistent with really how we did our forecast that was the foundation for our guidance that we did at the end of the Q1 call. But more broadly, in the rest of our customer sets, they're allowing the Leidos teams to work either in Leidos locations or work remotely at home. And we're really pleased with how our workforce has risen to the occasion and shown the same levels of productivity and, in some cases, more productivity by working remotely in getting customer mission done. So we haven't seen a meaningful impact on cash flow or a meaningful impact in revenue other than what we've outlined already in our Q1 call. And again, I think that it really underscores a mission-critical nature of the work that we do.

On the work completion side of things. I mean is this more of a slip to the ride on work that maybe can't get done on time? Or is 2021, kind of a catch-up year, where you think the customer will try to get back on track with some of these contracts and maybe make up product slippage that they can take delivery of this year?

Yes. I think that what we are not able to do this year is really going to get pushed into the right. And that is why we are confident that our growth rate -- our organic growth rate in 2021 is going to be in the high single digits. Think about for the intelligence work that we do, a lot of that is system development work. That isn't going to go away, that gets pushed out to the right. In some cases, we're going to be able to get some of that work done by adding more people to contracts to make up for the work that didn't get done during the COVID hiatus. We also have work done in our health care group for certain customers affiliated with both the Defense Health Agency and the Veterans Administration. And that work, that just stays in backlog. And that gets pushed out either into Q3 or Q4 to the extent that the work that we do there can't get done. And these are medical exams, that gets pushed out to the right as well, and to some extent, into 2021.

Got it. I'm going to circle up on that high single-digit '21 growth rate. But some of those opportunities in the health business, and correct me if I'm wrong, but I think with QTC, you do medical examination support, you monitor clinical trials. If you also operate drug and vaccine manufacturing facilities like digital health transformation business? I mean can you talk about -- a little bit more about some of those things that you're doing there and what exactly the market opportunity size is? And whether or not that's just kind of a 1-year boost this year or next year, if you think that's a longer-term opportunity?

Well, yes, I think that we're already looking at how we can capitalize on which should be an increasing opportunity for a number of things in the health business. And in particular, readiness for the next pandemic. I think that there's going to be a real push from Congress and the administration to make sure that we do have increased capability to do clinical trials to build greater resiliency into the government's ability to respond. You mentioned QTC, the work that we do there, again, it's critical to how we handle veterans' claims, veterans' health. And that is going to continue to be a business that, in our view, that is a business that's going to continue to grow. Right now, we're working with that customer to find ways to, where it's possible, to deliver a lot of that work through telehealth, telemedicine, which is growing everywhere, not just within our business. And then I think lastly, while we are very proud of the work that we've done in working with our customers on clinical trials for things like remdesivir. I don't want anyone to think that, that's a huge part of our business today or that it's going to be something like high single digits of share in the future. But again, it's very important as far as, in our view, to show those as important qualifications, important work and certainly something that we're ready to grow as fast as our customer will allow us.

That makes sense. And from the National Security side of things rather than health care, you mentioned preparing for the next pandemic. Do you think this changes the way the government thinks about national security, and whether that be in terms of IT infrastructure or digital security?

Well, I think that -- and not just really health or intel, but I think more broadly, I think your question is spot on. Just last week, Secretary Esper publicly stated that they're going to be looking to continue investment in digital modernization and other things to modernize capabilities within the DoD. And the kind of contracts that we have around digital modernization, the recent NGEN win, which is under protest, but we're feeling confident about our ability to get started on that later this year as well as our recent win of the GSM-O II competition, which was a recompete that we were able to hold on to. Both of those are great proof points around the work that we do to continue the modernization efforts of really critical infrastructure inside of our government. And so with a lot of our growth coming from that part of our business, those capabilities were -- we think that we're well positioned to continue growing that into 2021 and 2022.

So then if we take a look at the budget and then the support that's in the budget for that growth rate, Roger talked about the possibility of a downturn part of '23. Obviously, there's an obligated balance that could help extend that. But is that what you're hearing from your conversations in DC? Or is that just prudence given the large increase in the deficit?

I'd say it's more of the latter, Gavin. We have not heard from our customers that they're starting to look rarely at any of the kinds of work that we do, and how much they're going to need to spend well into the future. But I think what you heard Roger really reflecting on in those remarks was you can't ignore the fact that the recent spending on stimulus as well as likely future spend on stimulus, it's going to increase the national debt. And there's certainly going to be pressure on a lot of budgets. With that said, we believe that we're in those parts of the budget, in those parts of supporting our customers that are much more mission critical. When you're thinking about veterans' health and when you're thinking about digital modernization and making the operation of government more efficient, making the delivery of air traffic management more efficient. People will be traveling again, and we're going to continue to need to support the mission of the FAA. We're going to need to support those businesses and those operations well into the future.

Great. And then coming back to your 2021 high single-digit organic growth comment, I think that was. If I look back in 2018, a 1.3 book-to-bill and then you grew 10% in '19. '19 had a 1.3 book-to-bill on your guide for '20 pre COVID was plus 7% at the midpoint. Now coming out of first quarter '20, you have a 1.5 trailing 12-month book-to-bill. You've got things like NGEN that aren't even in backlog. You got Dynetics sets. Because you said this year growing 30% organically. You've got L3 Security. I mean how much visibility do you have into sustained high single-digit growth rate? And how much of that '21 high single digit is catch-up from this year?

Great question, Gavin. I think that the way to characterize our view and our visibility into it is, our view is, I think, prudent, and it reflects. There's still a little bit of unknown in terms of -- and I think some conservatism embedded in this. We talked about a $100 million element of our new guide that is simply seeing a little bit of -- or being ready for the possibility that some existing programs are going to slow down a little bit. But again, with that said, when you do the math and you look at the bottoms-up roll-up of where the existing backlog is and forecast for new additions, including things like NGEN. It gives us a lot of confidence that next year's high single-digit forecast is going to be achievable with maybe 1 point of that or a little bit more than 1 point of that being some catch-up from the current year. I'll remind you that when we came in -- when we came out of Q4 last year, we had double-digit organic growth. And I think I mentioned on the earnings call that until we had -- until we saw COVID, through February, we also were seeing double-digit organic growth. So when we think about and we say high single digits for 2021, it's -- with a backdrop of -- we really came into this year really strong, and we're just being very cautious about guiding higher than what we did simply because there is some element of unknown in terms of how quickly customers are going to be ramping back up.

That makes sense. And then on NGEN specifically, you mentioned the protest. What's your expectation on the time line of that resolution, when it might be fully ramped? And how much of that could contribute at full run rate?

We expect that the resolution of the protest will happen sometime in the current quarter. And that the contract will start ramping in the -- assuming that it's resolved in our favor. It should start ramping in Q3. And the ramp on that contract, simply because of its size and the nature of the transition plan, it's not going to be fully ramped until 2022. But it will provide meaningful contribution to revenue growth in 2021 as well as into 2022.

Got it. Helpful. And then on higher levels, you're one of the biggest government IT contractors. And then as you just get this math, does that make it more difficult to outgrow the underlying budget? Or is that actually the opposite where your scale actually allows you to win more and consolidate share?

What we've been finding recently is that scale -- the scale of the business gives us a number of benefits. One of them is that we have a cost structure that allows us to compete. And although, what we're finding is that we're not really winning on price as much as we are winning on technical solution that really -- the technical solutions reflect the depth of our people and their capabilities and the depth of the company's experience that comes from weaving together legacy Leidos, IS&GS, now Dynetics as well as the L3Harris Security Detection and Automation businesses. Weaving those together give us deep capabilities, deep past performances. And we embed these -- you've heard us talk about these TCCs, Technical Core Capabilities, we weave those across the verticals across the organization to be able to deploy these capabilities everywhere. So whether it's deep cyber expertise, the ability to take on large, complex, scalable IT modernization programs, a really deep ability to do complex logistics, where over in the U.K., we run the MoD's logistics operation through the LCST contract. We managed the logistics down in the South Pole and the Arctic. I mean, so there are a lot of complex logistics that we do. And again, the size of our business, the scale enables us to bring those experiences to bear and deliver great services and solutions for the customer set. So I think a long-winded answer to your question, Gavin, but scale does help, scale matters. And as the largest pure-play in our space, we think that, that is why we've had a strong book-to-bill, strong organic growth, and that's why we feel like even in times when budgets are going to have some pressure, which is not something new to us, we're going to be able to outgrow the market.

Are there any bad actors on price or is the industry relatively disciplined?

I think that occasionally, you'll see competitors take a dive to the bottom, okay? And the way we -- actually, the way our customer now responds to that is by -- the customer's response is looking carefully at what they call price a realism, and they do an assessment of whether a price is realistic and sometimes they will actually score a technical solution lower because there's an obvious inability to perform at the price that a contractor might be bidding. Sometimes that happens because a competitor completely misses what the right solution is. So they did the wrong solution and the wrong price. And I think that the -- our customers are really getting much more sophisticated in how they look at a bid, and how they sniff out a solution that's been under bid that puts them at performance risk.

So as LPTA largely gone altogether?

I think LPTA is something that is never going to go away completely. And I'm not going to say it's gone. You tend to see LPTA still more in areas where something is a bit more of a commodity, and that is a space that we try to avoid playing in now. What we really try to do is to really gear our business development efforts in the space where we can differentiate ourselves well, where barriers to entry are getting higher, and where we have domain expertise, domain knowledge that is not easily replicated elsewhere.

Got it. And then on the growth versus margin trade-off, maybe less a trade-off, sounds like you're doing both pretty well at this point. The 10%-plus commitments that you've made or at least at the Investor Day over the medium term, now that was prior to Dynetics and Security Detection, which are both accretive to the average. So did that kind of create a step function higher? Or does that just give you more capability to hold the 10%-plus or also investing even more in the business? How do you think about that trade-off?

It gives us more confidence that we're going to be able to deliver at or above 10%. As you've heard us say that new programs tends to have lower margins in the early years. And some of the big wins that we recently had are no exception. But when we do our forecast, we're fortunate that, again, scale of the business gives us a lot of mature programs, where the margins have been increasing over time and are continuing to increase so that we can maintain that 10%-plus margin profile even when you have new programs like GSM-O II or NGEN that are on a ramp where there is investment in the early phases of the programs. And still, again, scale of the business while we're ramping those up, gives us that confidence at being at 10% or above.

Given that dynamic, and I mean this is altogether hypothetical. But is there a dynamic where if revenue growth slows, EBITDA and free cash flow growth actually are unchanged because you're maturing contracts and you're not adding lower margin new work?

I think that I would change that a little bit. I think what I would say is that if there is some pressure on growth rates, and we're growing slower than high single digits, what you're probably going to see is that the businesses that have higher margins will continue growing maybe a bit faster. So what we would like to think of is that the programs we've been pursuing, the things that we've been investing in are higher-growth, higher-margin businesses like Dynetics, like the L3Harris Security Detection business. And so if those businesses continue to grow faster than the rest of the company is growing, yes, I think that you'll see that certainly help the margin profile. But I'm careful to use the word step function in talking about that. It depends on how you define step function, right?

Yes, absolutely. And then of course, you have the possibility of something like COVID-19 come and knock a couple of tens of basis points off the margin, so always unknowns out there. In terms of recap, yes, in terms of free cash flow, you mentioned the 100% target conversion. I mean you guys have been doing a decent amount better than that, but I think there may have been some kind of net onetime positives. Obviously, there been a couple of negatives in there as well. But I mean, are there other kind of, let's call them onetime contributors that you can keep recognizing, and I think there's a VirnetX patent infringement award that you guys have a claim on? And are there things you can do to keep your conversion kind of well above that 100% base business?

Well, if VirnetX is an example of something that has given us a kind of, I call it, the recurring, nonrecurring. Last year, we had a settlement on a dispute with the Greek government on a very old program and a receivable that we'd written off. And the VirnetX claim is one that we've been pursuing for years. And while we continue to get good news on the legal front that way, it's really unclear to us when that's going to get resolved. But I think that what you're pointing out, Gavin, is we always do have something that's hard to forecast and is a bit of a blue bird and VirnetX would certainly be one of those things. And we're looking forward to seeing that get resolved whenever it does.

Got it. And are there any potential drags? I mean I know you'd mentioned that Dynetics would be a user of working cap to support their growth. But can you help size that or any other potential headwinds to free cash flow in the near term?

Well, we have really been working hard to keep our business, what we call, capital light. And this year as well as last year, 2019, we did have some drag on free cash that was in the form of the consolidation of our real estate footprint in the D.C. area, both up in Suburban Maryland and our new headquarters in Reston. And now that we're built out in Reston and we're working to continue to migrate some of our workforce into the new headquarters, that bump in CapEx is going to largely subside. With the acquisition of Dynetics and the lunar lander win, there is likely to be some amount of CapEx required to build out some of the capabilities and some of the space that we need to do that work. But yes, nothing that's going to get us to a point where CapEx runs higher than 1.5% of revenue. So I'm really pleased with our ability to manage overall cash flow. DSO continues to be well within what we expect our norms to be. And again, CapEx overall for the business is -- we're not building big factories, we do have some light manufacturing work that we do. But certainly nothing that is going to threaten what our overall cash return targets are.

Good. And then coming up on time here, maybe 1 final question on the Security Detection and Automation business, where Roger and you on call, obviously, discussed kind of the balancing of weaker airport traffic with the need to modernize checkpoints. What's your kind of sense of what the current run rate is for revenue relative to the $500 million annualized? And your best guess on when you think you can get back to that $500 million you'd originally guided?

Yes. We think that there's some amount of short-term impact. It's not that large. We think that we've guided -- well captured in our current forecast and guide. And I think the reason why we don't feel like it's that significant of an impact is that we -- before we closed the transaction, we went out and talked to customers. We talked to customers in Asia, we talked to customers in Europe, talked to customers in the U.S. And their spending plans are not changed materially, and there might be -- there are a couple of cases where timing might be delayed. But in some cases, we have customers that are viewing this as an opportunity to accelerate modernization plans. And so that gets us actually into some of these venues, which include airports or other things, gets us in there earlier, and gets us also in a position where we can bring some additional innovation in technology to help with screening out people that might be healthy well before they get to the checkpoint. And so we have some customers that are asking us to work with them to develop some solutions that protect the traveling public by using biometrics, using temperature sensors and temperature screeners to pull people away from the line before they get in it and allow us to do some -- or allow our customers to do some screening in advance of people getting in the queue to go through the more conventional screening solutions.

Great. Well, I think with that, we're out of time. So Jim, really appreciate your time, and appreciate you participating today.

Yes. Well, thanks for having us, and enjoy the rest of your day. Thanks.