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

Okay. Good afternoon. This is Doug Harned, Bernstein's aerospace and defense analyst. Very happy to have with us here, Roger Krone, the Chairman and CEO of Leidos. [Operator Instructions] And also, there's a Procensus survey at the end, and you should try and complete that at the end of this, and you'll get some immediate feedback on it. So with that, I'm going to hand this over to Roger, and he's going to give a short presentation, and then we'll go into the fireside chat. Roger?

Great. Thanks, Doug. And Doug, as we were saying before, it's great to see you again. Great to be with you. We appreciate the opportunity. I just have a couple of slides. I'll try to make a few quick points and then really open it up, Doug, for your questions and anyone out there on the net. We have our forward-looking statement, safe harbor language, so -- okay, we have to put those up. All right. Great. There's a lot of people who have known SAIC or known Leidos and now with the IS&GS acquisition. And now we've added the Dynetics and L3Harris, a question that occurs is, "Okay. Tell me the story, and tell me the story in a simple way." And we use this chart. The mission is really about why we think we're hearing we exist as a company, and it's about national security and health and driving efficiency into our customer set. The vision is really about where we want to go, where are we headed. And it's really about using technology to solve customer challenges and the customer problems, and I want to come back to that in just a moment. And then that second phrase is really defining our business model as being very people oriented, which means we're very, very asset light. And then that last sentence is really representative of what you all refer to as ESG, but the role that we have in the community and how we feel about our carbon footprint and the things that are becoming more and more important in the investor community. We do have values. We spend a lot of time thinking through what defines a person from our company. We added the word inclusion to the 5 values that we had and have had for the past 5 years. Inclusion really is part of the people orientation and just to make sure that everyone in the company feels like they have a voice in what we're doing. I often get a question on this slide about, "Okay. You were a services company. You just did some product acquisitions. Could you explain that?" And the way I like to talk about Leidos is we are a customer-centric organization. We are organized by customer, and I'll speak to that on the next slide. And what our go-to-market model is to be very, very close with our customers, sometime forward-deployed, sometime working in their facility, and try to understand what their emerging unmet need is. And as a result, we then try to organize the resources and capabilities of our company to meet those needs. And examples I'd like to use is if you're the Head of TSA and you have a problem at the checkpoint at the airport, you will come to Leidos and say, "I need you to make the transition from the curb to the gate an enjoyable experience for everyone that travels, but to meet the security requirements and now biometric requirements as we think about thermal scanning, facial recognition, who knows, maybe even virus testing." And so at Leidos, what we think about is what do we need to be successful in meeting that need, not are we a service company or a product company. And as we all know, because we all use to travel, we'll travel again someday, you solve that checkpoint of the future problem with hardware, software, services capability, right? And so it's a mix to solve a problem. So don't think of us as a services, IT services, government services and don't think that, overnight, we're going to become an L3Harris kind of a product company. We are really customer-oriented at trying to solve their problems. And as you see us add a little bit more content, it really is because that's what we're hearing our customer tell us that we need to do to continue to address their emerging needs. Okay. Next chart. All right. We go to market, as I mentioned, in 4 areas: Defense, Intel, Health and Civil. And they're just shown on this chart. For segment reporting, we tend -- we report Defense and Intel together, but we have 2 leaders and 2 separate groups in Defense and Intel because the Intel tends to be a definable market for us. We like our balance in portfolio. And we're -- and we'll probably talk about this, Doug, later on, what the prospects for defense may be. But on the other side of that, we see lots of opportunity for growth in the Health business and the Civil business and a nice diversity of portfolio. And 11.4% is trailing 12 as of the close of the first quarter. Okay. Next chart, please. Okay. We articulated our investment thesis really going all the way back to the closing of the large transaction we had with the Lockheed services business in August of '16. Many of you might have been at our Investor Day May of last year. We used a slide very similar to this. What -- why are we a good investment? What is sort of our story from an equity standpoint? Top line growth but, more importantly, followed by EBITDA growth and a laser focus to make sure not only are we adding new contracts and new businesses with new customers, but we're doing it profitably and returning, if you will, a margin back to the company. I showed the diverse portfolio. We think that is unique to us in the space. You'll find many of our competitors who are quite heavy in the defense world and have almost nothing in civil. You'll find very few of our competitors that have a health care business like we do, which is also our highest-growth group and our highest margin. And as we see shifts, which inevitably we will see, in the government spending portfolio, we think we are well positioned to shift along with those changing and evolving priorities. We've always talked about being people-oriented and therefore asset-light. I'm actually sitting in our New World headquarters, which, of course, we don't own. We lease, like we do most of our physical plant, which frees up our cash flow to pay our dividend, right, to invest in growth and to return to shareholders. And that's really the last bullet. It says now for many, many years, we have held to that philosophy that we want to return capital to our broad array of owners and stakeholders. And it's always started with dividend. We've been a dividend payer since the split, frankly, since we've existed as a company in September of '13. And of course, we raised the dividend last summer. And then we invest in growth, and you have seen some more M&A activity over the last couple of years, which we think fits in nicely with our long-term business strategy. And then we have always talked about excess cash we will return to you, to our shareholders and stakeholders, in a tax-efficient way. Because of the deals that we've done, we are a little above our target leverage. And we made a commitment on the first quarter earnings call, and certainly we'll make it again today, to get back to a 3.0 leverage. Very quickly on the last 2 acquisitions, both of which are now closed. Dynetics is mostly a defense. They do a little bit of NASA work, a technology company and -- primarily in Huntsville, Alabama. We got early termination on Hart-Scott and closed that early in the first quarter. Very, very excited about the business, hypersonics, unmanned aircraft, electronic warfare. And then maybe the most exciting thing that's happened in Dynetics in the last couple of months is we were named 1 of the 3 awardees from NASA on what they call the Artemis program on the human lander system. And I will quietly share with you. We had discounted that award when we were considering Dynetics. And one of reasons that Dynetics was chosen was because they were acquired by a larger company with more resources and a stronger balance sheet. So it's one of those deal synergies that paid off almost immediately for us and the team at Dynetics. The second acquisition, which just recently closed, is the acquisition of what we call the Security Detection & Automation business from L3Harris. This is primarily airport checkpoint equipment. It complements the business that we have had for years you may know of as Reveal, if you go through airports. But we also have a significant presence with our Bacchus systems in ports and borders. And this really gives us a critical mass and a leadership position in what we think is an evolving and changing and growing market, which is ports, borders and security at checkpoints. And of course, we all think about that as airports, but it is likely to be large public venues, concerts, stadiums and others. And we see the customers going through a technology refresh, adding what we call CT at the checkpoint. And then the most recent developments or the conversations we've had with customers, like Heathrow and Dubai, about adding temperature screening and other biometrics to the checkpoint, and also potentially adding a sanitization process in the tray return system. And part of the acquired business makes the tray conveyors and actually procures trays from third parties. And we expect, as a result of COVID-19, that we will put ultraviolet sanitation systems in the tray return path, and that we will also probably replace all of the low-end, cheap plastic trays with trays that are much more bacterial-resistant. So both of these acquisitions are exciting to us, and they both fall into the strategy of trying to understand the customer problem and combining some hardware, software and services to solve that customer problem. Next slide. I talked a little bit about our leverage. Of course, we had the 2 acquisitions that we had put in bridge financing for both of those. And as we had looked at our balance sheet, we clearly wanted to extend the tenor or the duration of our debt. And we are pleased that, coming out of the backside of the perturbations in the capital markets, we were able to get a $1.75 billion deal done of 3 tranches of a 3 and a 5 and a 10. And we were, I think, as many people in the capital markets are a little bit nervous about how that would be received, it's the first time we had been in the bond market in recent memory, maybe the first time we had been in the bond market as Leidos. And we're investment-grade, but we're just barely investment-grade, so we're keeping an eye on investment-grade debt. And then as we did our road show and went to market, we just could feel tremendous enthusiasm for the transaction. We were originally thinking we'd go out at $1.25 billion. And because it was so significantly oversubscribed, we went out for the $1.75 billion and are thrilled with the spread that we got over the underlying treasury. So this puts our balance sheet where we want it to be. And what you'll see us, as I mentioned before, do now over the near term is use our great cash flow generation to reduce our leverage and get back to 3.0 leverage. With that, Doug, that was all my prepared remarks. I'm going to leave the investment thesis chart up and turn it back to you for questions that you might have.

Okay. Great. Well, thanks, Roger. As a start, because it's the big thing out there right now, I just like to make sure that we all understand how the current coronavirus crisis is affecting Leidos. You talked about it some on the Q1 earnings call. But since that time, can you give us a sense of what you're seeing? And I mean that in terms of your own operations, getting access to customer facilities or even delays in processing contracts. What's happening with respect to COVID-19 for you?

Yes. Okay. Great. Thanks. Of course, our first quarter was just barely affected. And we had -- we printed a really nice first quarter with 8% organic growth and 12%, including M&A. And we were just starting to see the effects in parts of our business. Second quarter, as we have signaled -- and we did adjust our guidance downward in revenue and just down a little bit in margin. And April is probably going to be our -- the month that it will be most effective, and that's really around just a couple of our businesses. In the Intel market, what the customer is just trying to do is to go to shifts, so that they can keep 2 workforces and keep those workforces separate from each other. So they have one workforce that operates in this classified environment were to come down with COVID, they would replace it with the second. But because of the shift work, we're not able to work a 40-hour week. And under the CARES Act Section 3610, the government will reimburse us for holding our workforce in reserve. But they made a decision that they will only reimburse our cost, not our profit. And we saw pretty much the month of April and most of the month of May, where we had a significant amount of our Intel workforce in this partial go-to-work phase. And so that's going to be an impact for us in the second quarter. The other is we do medical exams for veterans, and that's how they qualify for medical benefit. Most of those have been done face-to-face. We have clinics all over the U.S. We do between 2,000 and 3,000 exams in a day, so it's a very extensive business for us. And the VA, out of an abundance of caution, stopped face-to-face exams. Now that backlog builds, so it's not as if that work goes away, but it will shift to the right. And because we have some fixed costs and other things, that will impact us in the second quarter. And then we've had secondary businesses. We're in the energy sector. That hasn't been we're doing very well. There's a program in the U.K. around air traffic management that gets revenues from ticket surcharges. That business is not going to do all that well. But beyond that, and I would say 95%, 96% of the company, we are up and operating. We are going to work. We are earning profit. We are billing. And we are getting paid. And most customer facilities, we have some access to. It's really only in the intelligence community where it's not access to the facility, it's preservation of the workforce because they work so closely in these classified environments that they can't, like, appropriately social distance. Now in the contracts world, we really have not seen a slowdown in the request for proposals and in contract awards. As I think most people know, our GSM-O and our Hanford protests were adjudicated on time. We won a program called RHRP, Reserve Health Program that actually was awarded maybe a couple of days a week earlier than we expected it. So the government acquisition organizations are working really, really hard to keep pace and to keep things moving according to the current schedule. That being said, over the -- rest of the year, we would not be surprised if some procurements slow down or the ability to do, like, oral presentations as part of the procurement process become more complicated. But in general, the government never shut down. This wasn't like a year ago when we literally had our Civil business in a government shutdown mode. We have all learned to do telework and telecommuting. We have meetings with customers now using Zoom and web chat, and it's working okay. I'm not sure it's the permanent model. I think the permanent model is somewhere in between all the business travel and all the hotel stays that we used to have and a complete virtual model. But I think that we will all find a way to operate more efficiently in the future. That will create benefits for our customers and hopefully create benefits for the company and for our shareholders.

And that brings up a topic I -- that I did want to ask you about, which is when you get to the other side of this crisis of the pandemic, are there things that you've seen or have learned that may make you operate differently in terms of managing costs, in terms of where you invest when you come out the other side?

Yes, absolutely. What we have done, we have actually created a working group, actually 4 -- with 4 work streams to try to understand how things will change on a permanent basis. Everyone talks about the new normal. So we have one on workforce and workplace, which clearly is going to be more virtual than it was. But why I don't think we're going to go to 90%, I don't think we're going to have huge buildings that we empty. But I could see our facility footprint shrinking. I could see our need for business travel, hotel, meals, that probably will be reduced. I see our employees being able to avoid a commute, especially here in the National Capital Region. I think that's going to be significant, and that will be a cost reduction, which will benefit us and also benefit our customers. And I think it will create efficiencies. But I think that is part of an acceleration of move to digital, which we were all in the middle of anyway. And we just see that accelerating, which really speaks to our second work stream, which is around what's changing with the customer, what's changing in budgets and budget priorities. Someday, there's a bill to be paid. Who's going to pay the bill? What will happen to spending and taxation? Will there be a move more from product, like aircraft carriers to more artificial intelligence, machine learning, blockchain? What are those important capabilities that we should be investing in going forward, looking at customer behavior and customer priorities? Our third area is around our own technology. We are a heavy user of IT and a heavy provider of IT. And we're even thinking about, do we have the right IT platforms, what do our firewalls look like. It probably has happened in your organizations, but with this move to virtual, the cyber risk has gone up. And we've seen an increase in attacks on our network. I think everybody has. I read about those in the press. And so we're rethinking through our technology platform. What is the -- what do you need to work at home? What do you need to be agile? And are we on the right technologies? And then our fourth area is around our processes, our command media, right, and our governance. Right now, we have a pretty rigid telework agreement that you have to sign if you're a teleworker at Leidos. We have relaxed some of those requirements because we have -- here in Fairfax County, we have employees who have kids who are at home, and there is no such thing as daycare in Fairfax County. Our normal telework agreement would require you to have childcare in the home, and we relaxed that. And we're learning about how some of our employees are balancing a workday, the needs of childcare, COVID-19, maybe an ailing relative and how we might want to redefine some of our command media and how we get things done. So that's mostly what we're doing.

Well, if I look back, you and I talked a few years ago right at the time of the IS&GS acquisition from Lockheed Martin about scale and how the role at scale plays in government IT. I mean some of the things were related to overhead rates and load balancing, across programs and leveraging technology, across customers, a lot of those topics. So if you look back now, I mean, I have to say, your -- Leidos stock has been the top performer in defense over the last year, so it looks like a lot has gone right. But can you talk about what scale means? I mean general dynamics, in a sense, followed suit with the CSRA acquisition. So you've got 2 very large players now. What does scale mean for you? What's it benefited you in? And what are the challenges in managing that scale?

Yes. Okay. Great. Well, obviously, you touched on a couple. Let me reiterate, cost is always a factor in every bid that we go after. And part of the reason that Lockheed divested the services business is because their cost structure, which is really built around things like F-35, didn't support a business that was primarily people related. And when we acquired the business, we were able to reduce what we call the wrap rate or the dollars that you charge per hour of engineering labor significantly. And because of our size, we have been able to maintain that cost competitiveness or keep our rates low and competitive. We don't want to be the lowest rate in the industry because we want to invest in R&D and business development and continuing education for our team, but we didn't want to lose programs because we were too expensive. And our size and scale has allowed us to continue to do that as we have grown, as we have done M&A. But the size and scale really has accrued benefits in 4 areas. We always like to talk about the breadth and the depth of the customer and how being in this $11 billion, $12 billion size gives us the coverage that we need to have people at customer sites in field offices, building the customer intimacy across the broad government portfolio of customers that allow us, right, to grow in multiple areas at the same time. I talked before, we're a people company. In our world, when you win a program, you have to ramp up. You have to hire people. You have to be able to attract the best. And because of our size and scope and scale, we can recruit at all of the major colleges and universities. We have a brand name. We are a place known for innovation that attracts people, both early career and mid-career. And so we have been able to hire and meet our staffing needs. By the way, even through COVID-19, we had gone pretty much through a virtual hiring model using the web and things like Zoom chat to do interviews. And all the way through March and April, we were adding 150, 200 people a week to the company. And because of our scale and our brand, we're able to get the best of the best. And if you think about that, Doug, if you hire the best every month and you do it year in and year out, you will have the best team because you have the best talent and the best tea. By the way, it's not just the best team in engineering. It's the best team in our law organization that helps us defend against protest of acquisitions. The third area is really around investment. And we always talk about R&D and investing in our technical core competencies aligned with the emerging needs of our customers. But it also means investing in maybe a special test equipment where we need it on a program, using our balance sheet a little bit to supplement some of the work that customers need to have done. But the ability for us to move quickly, to put money, to put our balance sheet in play where we need to -- and there is actually some business that we've won because we made an investment ahead of a program, and you can do that when you have a broader portfolio. And none of those programs require an undue percentage of your capability. And then the last thing that we've always talked about, somewhat unique in our sector, to bid on certain jobs, you need to have qualified credentials. And we call that past performance, and that means you need to have done similar work with that customer in recent times. And so like the Navy NextGen program, our largest award, although it's under protest, there were only 3 companies even qualified to bid. And I might argue that Perspecta was maybe marginal to bid on that. And so there are now opportunities for which there will only be 2 or 3 bidders, and we have the past performance quals to bid on literally any program that we want to bid across the government spectrum.

Now that raises a question for me. When I think of the range of your businesses, I will say, I mean, having a government customer is a common theme across most of them. But I think of health care as being quite different than defense as being different from energy. You did decide that commercial cyber was not an appropriate business for Leidos when you divested it a little while back. How do you think about what does make sense to be in the Leidos portfolio?

Yes. The commercial cyber business was one we really agonized over because we have a significant part of our business that we would refer to as cyber, and most of that is government. A lot of it is in the intelligence community. And so we, as others in the industry, always talk, "Well, the technical knowledge we have in the cyber space should apply to the commercial space." And in fact, if you get way down in the value stream, firewalls and proxy servers and virtualization probably does apply. But the front end of that business was so different than the front end of what we are used to doing that we just couldn't break through the commercial market. We didn't have the sales force. We didn't know how to posture the value proposition. And although we had no trouble executing the work, our ability to go up against Mandiant, it -- we just didn't have that capability. And we said, "What would it take for us to develop a nationwide commercial cybersecurity sales force? And would we be any good at it?" And we just said, no, we were not the logical owner for that business. And we thought that Capgemini clearly would be a better owner. And in fact, I think that business has actually thrived under Capgemini. So for us, it's really about, does it fit our portfolio, does it fit our value stream, does it align with our mission and our vision of the company. And we are in some commercial businesses, but in places where that acquisition process more mimics what we see in the government space.

Well, if you move to the government space here then, if I look at your Defense Solutions business, you've described this as really an 8% type margin business. Not that high. I mean presumably, that's because you've got a lot of cost-plus work, whether it's service or development work. How do you see that mix moving forward? Is this a business that could have higher margins?

Let's see. We definitely think that our Defense business, and if you -- we have a -- the Defense business and the Intel business, but whether you think about that combined business or just the Defense businesses we define as a group, we were at 8% because of mix, right? And that is a mix both of fixed price and cost plus. It's a little more difficult to get the higher margins on cost plus. But it is also inherently the nature of the work. So lowest price technically acceptable, low-end services work, like you might see more characterized by a company like DynCorp or the old AECOM, now Amentum. And for us, yes, we have to continue to perform, deliver on our commitments, high -- earn high award fees, but it's really about shifting that portfolio over time. And one of the challenges that we have, which is probably a good thing, is with nominally 2 years of backlog. It takes a long time to shift the portfolio. But we are committed to get the margin up in our Defense segment. And winning programs, like NextGen, give us the opportunity and to do that over the longer period.

You touched on this at the beginning. When you add Dynetics, and Dynetics is a very different type of business, can you talk about how -- I mean at least, I think of it as very different from the bulk of what you do there. Can you talk about how that fits in? How do you think about operating a business like Dynetics here? And maybe also give a little bit of a sense for what the scale of opportunity is with that.

Yes. Well, our enthusiasm for Dynetics started with discussions with a Defense customer. So when we talked to their service executives, we talked to Mike Griffin, who's essentially the Chief Technology Officer of the Pentagon, if we review the national defense strategy, they highlighted areas of about 10 technologies that they saw to be very, very important in their portfolio going forward. And we looked internally and said, "We are undercovered on many of those." I thought -- we felt pretty good about 3 or 4, but there clearly were 5 or 6 that we felt were appropriate for us to be in, but for which we had very little penetration. And in one transaction, this company in Huntsville, we were able to add breadth and depth against those emerging needs for our Defense customer, hypersonics, electronic warfare, unmanned aerial vehicles, the Intel business, all of which came with the deal. I would also remind everyone that Dynetics started as a services company. And they are, today, probably about 40% services. And although they're may be characterized by the common hypersonic glide body or the Gremlins program, they actually do a significant amount of services work, and that exist today. So they fit our business model maybe better than people realize. We're also using Dynetics to unlock some value that we sort of feel like we've had trapped in Leidos. We have the Leidos Innovation Center, which is sort of our skunkworks organization. And it does a great job of capturing work from DARPA and Air Force Research lab, what we call early stage R&D. It's always struggled to take those great research projects and transition them to prototype and then to programs of record. So what we have done now with the acquisition, we're combining the Leidos Innovation Center with Dynetics to free up trapped technical content in the Leidos Innovation Center and to bring that to market through Dynetics with the hope that it will further accelerate growth. Now -- and we talked about this on the earnings call, on a quarter over -- or year-over-year quarter, first quarter-over-first quarter, we had about a 25% increase in revenue in Dynetics, and that is just a huge number. We don't expect it to continue at that pace, but we do expect Dynetics to grow faster than Leidos with large because of the swim lanes in which they play and the commitment of customers to prioritize those swim lanes and their funding.

Now a question that's come across here relates to talent, and you touched on this a little bit earlier. But the question is, how do you compete for talent because this is a talent-driven business against the likes of Booz Allen Hamilton or others, but I would add in there, against the likes of commercial players like Google or Fortinet, others in the commercial industries? How does that work for Leidos?

Yes. So we survey our organization frequently, and we're coming off an all employee survey. And so we've asked our employees, "Why do you come to work here? What are those things that differentiate us? What gets you excited about coming to work every day?" And we find that there are 4 predominant factors. The first is the nature of the work and what people get to do. We're very autonomous. A lot of our people all are forward deployed. They work at a customer site. They get to do real meaningful, nationally important work every day. And we're very, very thin at the top and very empowering down in the organization. And Doug, that goes all the way back to our culture of employee ownership, which relates back to the really 43 years of our 51 years when the company was owned by our employees. The second thing people love, they love the professionalism and the people that they get to work with. So you're working with leading experts, the top team. You're working with the people who feel passionate about national security, about health care. And they love the environment and the culture of the company. And really, our best recruiters of talent are our current employees. The third area is around professional development. The great thing about growing is when you grow, you promote, you give people new opportunities. They get to expand their portfolio. And then we have a huge and very strong continuing education, which is now much more virtual than it's ever been to allow people to add certifications, to get master's degrees, to get PhDs. And we have a great job rotation program. So their ability to develop themselves has been a differentiator. And the last one, which is really a new one, should had been interesting, I'm a baby boomer, but we will soon be -- to the point where the majority of our employees are millennials, and they care a lot about workplace and flexibility. And that is time banks, working from home, office sharing. It's -- it turns out to be one of the biggest benefits that we have for people. We have a process where if you get your 80 hours done by Thursday afternoon, and you and your supervisor agreed, you can comp out Friday. But if, like your child has a recital on Tuesday, and you want to take Tuesday, you can comp it and you can make it up within one pay period. Our view is we have a very mature workforce. We have the confidence in them to manage their own week and how they charge their hours and that they'll fill, if you will, their time card out appropriately. And in today's world, that flexibility and how you get your work done is a huge differentiator for us.

Well, I know we have to wrap it up here, but I just -- I think as a last question, given all that you've laid out, how do you see your growth trajectory over the next 3 to 5 years at this stage?

Yes. We're still very, very enthusiastic about the 3- to 5-year horizon. On our earnings call, we talked about high single digits as we manage our way through COVID-19, being fully back on a run rate by the end of the year, and that's essentially what supported the guidance that we have laid out. We like to think there's always potential to grow more, and we try not to get ahead of our skis on our forecast. But we believe we have the right capabilities in the right markets with the right customer relationship at the right time and think that the growth prospects for top line and bottom line have never been better for the company.

Well, with that, Roger, I want to thank you. I want to encourage everyone listening to fill out the poll at the end. But Roger, it's been great talking with you. I hope everything is going well down there and look forward to catching up again soon.

Great, Doug. Thanks for hosting this. Appreciate it, and it's great to see you. And I can't wait for the day sometime when we can be together again face to face.

Same here. Great. Thanks. All right.