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

Great. Thank you to everybody joining us on the webcast. Really excited to have Jim Reagan from Leidos, CFO of Leidos here, today. I think we'll hop right into Q&A and just format this as a fireside chat. If folks that are listening on the webcast have questions they would like to get answered, feel free to e-mail me at [email protected] or use the webcast interface. Either one should be fine. Now I'll do the best I can to get those answered. But Jim, thanks again for taking the time today.

My pleasure. Thank you, Joe.

Yes. Maybe we can just start with kind of the obligatory COVID-19 question. I mean is -- can you maybe just update us, to the extent you can, on how operations are performing? Is the recovery kind of meeting your expectations as economies and markets reopen?

Yes. We're seeing our customers that did need to curtail activities, they're starting to implement their plans to return to work. As you've heard us say before, the most pronounced impacts that we're feeling are in the Intelligence Community, where our customers there had needed to close the offices where they do work in skips, either close or implement some significant social distancing by having roughly half of the workforce come in, in one shift and the other half come in, in a different shift. And then for the hours that are lost there for contractors, including ourselves, the work goes into a standby leave code, and we're able to recover cost but not fees. So it's going to -- that has had some impact on margin for the intelligence part of our Defense Solutions segment. But those customers, like I said, are implementing their return-to-work plans. They're eager to minimize and to recoup some of the mission impact that they've been feeling as a result of needing to slow down the pace of the work that's being done, and we're looking forward to partnering with them to get those return-to-work plans implemented. Elsewhere, the more pronounced impact was also in our Health Solutions segment, where some work we've been doing for one of our larger customers, where we were doing independent medical exams and exam reviews that required us to have direct interface with people, those locations had been closed down. And we are now implementing reopening procedures on a phased basis, starting with those places that don't have intense pockets of virus impacting them. And so we're following the customers' lead there in how quickly we reopen them, but they're happening on roughly the pace that we had expected when we developed and announced what our full year earnings guidance was and what the COVID-19 impacts were.

Got it. That makes sense. When you think about the earnings power of the business in 2021, whatever that was before all of this, do you think that this lowers the earnings power? Does it increase it? Maybe you catch up some of what you've lost this year? Or is it the same as you had thought it would be 3 months ago?

There are 2 things that we see as being really strong for -- going into 2021. First, there will be some carryover of work that was not able -- we and the -- we were not able to get it done in 2020. It'll spill over into 2021. And some of that work is at higher margins, and so it'll definitely put a little bit of upward pressure on what we expect the EBITDA margin to be for 2021. But even perhaps more importantly, we went into COVID-19 with some really strong organic growth. And we believe that coming out of it, we'll have some strong organic growth in the business that, as we've said previously, will probably be upper single digits. And we're still feeling pretty bullish about that. We've got some really great contract wins that are contributing to that. The NGEN protest, which is one of our most important recent wins. That is -- the NGEN protest is expected to be resolved this month, and that contract should start ramping and carry with it some strong operating income potential that, on a margin basis, will be ramping up in 2021 and 2022 and beyond.

Got it. Last one kind of related to COVID and then we can move on to other. We've heard from some of your peers that kind of the pace of RFP has been pretty strong of late, but that it's taking longer for awards to be adjudicated. Is that consistent with what you're seeing? Or you're seeing something different?

We're not seeing -- for the RFPs that we are responding to, we're seeing, in all but a couple of parts of the business, the pace being pretty much consistent with how it had been before. And the time it takes to turn an award around is about the same pace as we had before as well. The one notable exception is in the Intelligence Community, where we do see a slowdown there in the pace of getting RFPs on the street and getting the process turned around on them.

Got it. Okay. If you look back over the last 12 to 24 months, a big driver of the success of the business has been the booking strength and your ability to start to grow organically at rates that's faster than some of your peers, even though you're quite a bit larger than they are, and a big piece of that has been the takeaway win success. Can you just talk about what's allowed you to have that success? Is it an anomaly where you just had kind of a bubble of opportunities that were just really favorable? Or is that something that you think is kind of a sustainable advantage that you have going forward that's going to allow you to gain share and grow despite your size?

Well, when we analyze what the real secret to our success is, Joe, it's been that we made some significant investments back in the latter part of 2016 and early 2017 in putting a lot more rigor around our business development processes. We invested in the cadre of people that -- whose sole job is to manage accounts and manage account relationships with our key customers. We put a much more rigorous process in around making decisions on where to bid, where not to bid. And when we make decisions to bid, how we manage the sale process through knowing that an RFP is going to hit the street all the way through bidding and winning. And we called it Win Plan 1.0, and we're up to Win Plan 2.0 or maybe higher. And so included in that process was the development of reusable proposal content that we didn't have before, where artifacts and key components of some -- the repeatable components of winning proposals are kept in a vault, a virtual vault. And this makes the proposal process more efficient. We're able to propose on more things that we're capable of winning, and we're able to do it for less money now. And these are all benefits of scale. And in addition to that, we were able to build a scalable cost structure in 2017, 2018 that made us more competitive so that today, when we lose, we're not losing because of -- we're not losing on price. We're losing because someone wrote a better proposal than we did. And so today, we're continuing to refine our solutions, continuing to refine the process by which we analyze our customers' need and respond to it in a proposal. And so this leads me to the answer -- the answer to your question is, is it sustainable? If you had asked me 18 months ago how sustainable were win rates like we had been experiencing, and I probably would have given you a pretty conservative answer that would have suggested that someone is going to catch up to us. Well, we're continuing to run pretty fast, and we're now continuing to see sustainment of win rates for takeaway bids and new business opportunities that are higher than we believe our peers are experiencing. And it's really supportive of the statement that we made in the Q1 earnings call, which is we believe 2021, we're set up for high single-digit growth.

I think one aspect of the industry that investors still struggle with is kind of differentiating one services company from the other. You all have -- I think it's easier for -- to differentiate you than others. You have greater scale, diversity. Those are the 2 easy ones. Can you talk about the advantages that scale provide you? I don't think it's related to cost and being able to offer lower unit cost. Maybe that's an element of it, but I think it's more related to capabilities and bidding opportunities. But can you talk about the advantage that you think that provides you?

Sure. There are really 4 areas that we believe that scale helps to drive competitive advantage for us. First is that we're able to differentiate ourselves across several technical vectors. We're able to be deep across all of our customer verticals in 7 areas that include digital modernization, which, depending upon how you count it, it's roughly 1/3 of the business that we drive in -- through Leidos, including cyber operations, which is really attached one way or another to almost everything that we do. We have strong operations and logistics capabilities and tremendous depth of experience there, and you see that in the Antarctic. You see it in how we run the logistics operations for the U.K. Ministry of Defence and the fact that we, today, pack and ship payloads of supplies for NASA up to the space station. Mission software systems, a strong capability to develop complex systems for Intelligence Agency and DoD customers. Integrated systems where we have hardware and software that is used to keep ports and borders, airports and public venues safe, sensors, collections, phenomenology, and these are where we put our best scientists to work, developing physical and virtual devices that are used in some of the most sensitive applications used by the Department of Defense and the Intelligence Community in protecting our country, both from threats abroad as well as threats domestically. And then mission support, which is kind of akin to logistics, but that's where we support a lot of missions primarily in the air around the world for our U.S. Army and other customers. So those are the ways that we're able to be deep and differentiating ourselves technically. We're able to build -- we're able to -- the second of the 4 key vectors is the ability to invest in strong customer relationships. And I mentioned earlier how we made a decision back in 2017 to invest some of the savings from cost synergies from the consolidation with the IS&GS and invest that in an organization that builds strong customer relationships and account management in a way that we had not been able to afford before. Third, the ability to attract, reward and retain key personnel. Being among the biggest, if -- I mean, unarguably, the largest stand-alone services provider for the U.S. government, we're able to be an employer of choice and provide people the kind of career opportunities that have -- would have been moving across all of those core competencies, core capabilities that I talked about earlier, but also across different kind of mission customers. And that provides people great career paths and great career opportunities. And then lastly, having been around for over 50 years now and with deep customer relationships, many of which span over 40 years, that we have deep past performance citations that are a key part of our ability to win new work and gain more share from some of our competitors. So that is how we think scale provides advantage.

That's helpful. I mean, Jim, I think a couple of years ago, you had talked about, from an M&A standpoint, not having much of an appetite to just acquire additional pure-play services businesses that you are looking for companies with hardware components to them. And since then, you've done Dynetics and the security business from L-3. Is that still kind of your mindset that there's an opportunity to a broad expand into the additional hardware from here?

It is certainly -- I mean as we think about where M&A opportunities would be, we have some ideas that are kind of smaller scale hardware ideas. As we said before, right now, our capital deployment priority beyond keeping our dividend steady where it has been, we're looking to delever from our free cash flow for the next few quarters. But that doesn't rule out tuck-ins. It doesn't rule out us having ideas for when our leverage is back to our target, looking at things that might be of more scale. There are ideas that we've got on our road map that would be pure services providers, pure services plays. But they would have something, some kind of intellectual property that would further differentiate us and fill in a couple of important holes that we see in our set of offerings. So I wouldn't exclude either a pure services or kind of a solutions and product hybrid from what we have in our road map.

What do you think some of the more relevant or kind of the hole that stand out most to you are now? What areas are those in?

We think that we're always -- and we're not alone in this, in our view, but we're always going to be looking at companies that have really deep cyber expertise and people and groups of people, cyber analysts, cyber experts, scientists who can provide us even deeper understanding and knowledge of where threats are, how to defend against them, how to provide our customers with offensive capabilities that are cutting edge. So I believe that, that could be an area where we would want to further deepen our expertise. That's, again, an example on the services side. It is also possible that we might want to expand some of the capabilities that we have in our Health group, where we're already growing faster than the other parts of the business and growing at stronger margins over the past 6 or 8 quarters, where we might want to also deepen some of the capabilities that we have in the Health group. So those are a couple of areas that are kind of front of mind for us.

Jim, when you think about kind of in the context of the last 10 or 20 years, kind of major events which have, I don't know, shaped government spending and defense spending priorities, where do you think kind of the importance of COVID ranks relative to that? Is this something that you think really should cause you to rethink certain areas of the portfolio in where you want exposure and where you don't within the government budget? Or less so?

I think that where COVID provides us opportunity to be ready when the government moves out of kind of repairing some of the damage that's been done to our economy because of COVID-19 and how we can build more resilience. I think that the relationships that we have today with NIH and CDC have an opportunity to get deeper. Today, we run the National Cancer Institute's laboratories up in Frederick, Maryland and a strong relationship we have with NIH. We do that as kind of a contract manager for them. They're all -- all the employees up, they have Leidos badges. And -- but because we manage the spending for them in a different kind of contract for more of a government-owned contractor operated format, you don't see that revenue -- all the research revenue running through our books. But nonetheless, that gives us a lot of knowledge, a lot of qualifications to deepen the kind of work that we do there as well as for other entities in the government and perhaps even abroad. That's one example of where I think we will probably be right there and ready to support the need of our government as they look for ways to improve our resilience and ability to respond more rapidly to what could be the next big pandemic. And yes, I mean, I could go on and on, but I think that without a doubt, we're pretty well positioned to be able to support that. We've done -- we supported NIH in the clinical trials of remdesivir, which is an antiviral that has been shown to help the body's response to the coronavirus more rapidly and with less deep symptoms. And we're positioned well already to support clinical trials of some of the vaccines that the government's taken a look at. So we're there. We're ready to support. Whether that is ever going to be a really big portion of our revenue stream, though, is an open question because it still is going to be dwarfed by all the other things that we do in the national security space, whether it's defense or intelligence.

Sure. And maybe one of those bigger opportunities that you guys won is NGEN. I know you've talked a little bit about it, and I know how much you like talking about revenue and profitability specifics on certain contracts. But can -- Perspecta has talked about that as kind of a $550 million to $600 million contract. Should we just assume that for you all, there's a little bit of a haircut to that on the margin side as well just as that program ramps up?

Yes. Well, you're right, we don't talk about specific contracts. But what we have said, and I'll put a little bit more clarity on that, I think that the number that you just mentioned is not too far outside of where we're looking at. These contracts, these big transformative IT services and transformation contracts, digital transformation contracts, tend to have more investment in the early years of the contracts. This one is no exception, and that means that the operating margin contribution to the business -- the operating margin of the contract tends to go up after the first 3 or 4 years of the contract. That's the way GSM-O operated. I'm sure that that's how NGEN operated in its early years when it was initially won by EDS. So that's the way it will work with us, but we've got a bunch of contracts that are continuing to mature with increasing margins that will offset what would, on a stand-alone basis, look like margin dilution. So we're still confident that, that is not going to have a materially dilutive impact on the margin of the business.

Got it. So kind of combined with the high single-digit organic growth is stable margins with opportunities for expansion kind of beyond that in the outer years?

Yes, absolutely.

I think one of the other exciting opportunities you guys have relates to Dynetics. I know you bought it for reasons other than kind of the hypersonics opportunities that they have. But can you talk a little bit about that aspect of the portfolio, the hypersonics work that they're doing? It certainly seems that that's going to be an area of increasing spending and focus within the DoD, but it's a little less clear how that shakes out which the program survive, which don't. Can you talk a little bit about which programs are most important to Dynetics and whether you need some of those to actually materialize and ramp up in order to justify the transaction?

Sure. The core of that business today, it is a lot of different things. It's counter UAS technologies, it is advanced radar technology, radar countermeasure technologies, things that they have a lot of capability in the cyber realm. And the work that they do in hypersonics, it's important. And I think it's an important part of the growth story, but it is not the thing that is the foundation of the business. The -- it really is an extension of the ability of that business to do -- have a core capability in rapid prototyping and advanced development capabilities that has them right there with the U.S. Army and helping them to develop their -- the Army's hypersonics capabilities. And we're doing this work on a direct contract to the U.S. Army, where they're actually doing all of the hardware integration at an army base. And the thing that's unique about what we're able to do is at our facilities down in Huntsville, do -- we have really strong fabrication and test capabilities down there, and we also already have all of the factory floor space when -- for when we are moving into more production at scale. The ability that we have and the -- I'm not kidding, the rocket scientists that we have on there, many of whom have worked in places like NASA and in other government agencies that are affiliated, that's really important to our space strategy. And we bought Dynetics partly because we think that, for example, the creation of the space force is just another vector that proves out the importance of Leidos and having the capability to do both the engineering and fabrication of things that will go into space. And so our win -- our recent win of the Human Lander system design job is certainly a proof point of one of the many reasons that we think that the investment in Dynetics is going to prove out to be a home run for us.

When you look at some of the kind of the unique capabilities that a business like that provides you, I mean certainly relative to some of your peers, I think, classified manufacturing and prototyping and that type of thing, I mean how applicable are those capabilities to other areas of the business that, I don't know, in terms of differentiating you to past performance to technical capabilities, like to what degree can you apply some of those capabilities to maybe the more traditional services market?

Well, the kinds of things that we do really well down there play really well in integrating with what we call the LInC, which is the Leidos Innovation Center. So by combining the LInC with Dynetics, we're actually able to take a lot of the concepts that we would be prototyping on a small scale within the LInC, and we're able to produce them at a larger scale with the kind of facilities that we've acquired down at Huntsville. But even more broadly than just the integration with the LInC, we've done prototyping and manufacturing for some of our intelligence agency customers. We have done it at some scale for the legacy security products business that sits in our Civil Group today. And you -- for years, you've heard us talk about our security products business, which we've always been frustrated as not having enough scale. So that's why we bought the L3Harris security products and automation businesses. So that brings us scale there. But the -- again, the kind of technology and the manufacturing capability that we have down in Huntsville will certainly put us in a much better place where we're able to do more R&D, more efficient R&D in all of our businesses because of what we've acquired down there.

Great. Jim, I think we'll leave it there so everybody can stay on schedule, but thank you again for taking the time to chat with us today.

It's been a pleasure, Joe. Thank you very much for having us.

Yes, my pleasure. Thanks, everybody, for listening in. Enjoy the rest of the conference.