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

Good afternoon, everyone. This is Sheila Kahyaoglu with the Jefferies aerospace and defense equity research team. This afternoon, we're very lucky to have Roger Krone with us, who's Chairman and CEO of Leidos. Prior to becoming CEO of Leidos in 2014, Roger was President of Network and Space Systems at Boeing. With that, we'll kick it off with a fireside chat, and I know Roger will make it very interesting for us.

So Roger, to just start, maybe can you talk about the evolution of Leidos? I ask you every year, but I feel like it continues to evolve and pretty quickly. You bought Lockheed's IS&GS business in 2016. How do you see the business evolving from here for the next 5 years as we think about Health and some of your Civil businesses?

Yes. Well, obviously, we're really thrilled with the progress that we've made and how we've been able to grow the company, both organically and inorganically. And a big inflection point for us was IS&GS, but we've obviously been active in the M&A market and added IMX, which is a medical exam business last year. And now we've done Dynetics. We've done the L3 business. And we look ahead kind of 5 years and say, we want to continue kind of, if you will, industry-leading growth. We think we're the segment leader, both organically and inorganically. We want to continue to maintain our double-digit margins, which we think is really, really important, certainly from an investor standpoint. And I think everyone says, "Well, how do you define the company and therefore, the business model?" And there's always a struggle. Are you services solutions? Are you the old SAIC? Are you Leidos? Are you IS&GS? And we always like to say, we really want to solve sort of complex technology-driven problems for our customers. And our customers tend to be government, government agencies or commercial agencies that have an acquisition process that is very similar to the government. Retail would scare us, but RFP processes, long, complicated acquisitions and then we win. We always try to be differentiated. We're trying to stay away from LPTA. We're trying to stay out of commodity, low ramp rate-type business. And so we've got a set of technical core competencies. I think we really used to screen out what we put in our pipeline. And then first and foremost, we're a people company. We're at probably 38,000 as we speak. Once we get through the Navy NextGen project, we could be at 41,000, 42,000 by the first quarter of next year. And then kind of 3 things that we think are important to kind of characterize us is our continued agility and speed, which we think kind of makes us different than the big primes, the size and the scale being the industry leader, what we can do with our balance sheet. And that we think about physical security, but maybe more important, cybersecurity and everything that we do and digital transformation, certainly in this time of COVID. To be able to do what we do in a secure way is part of our differentiation.

That's super helpful. And then you talked about this a little -- you've talked about this for a while. You have 2 large addressable markets, not only defense, but you're also very levered to health care, which is about 1/3 of your business. How do you think about the underlying market growth and Leidos' specific growth within these markets?

Yes, and there's a lot of discussion now with an election upcoming about what may or may not happen in the defense budget. And we're still a lot more bullish than I think some of the print that you read that the spending level in federal government's going to be maintained. When we talk to the Biden camp, that's what we hear. And that as they have to shift priorities perhaps within the Department of Defense, they'll shift from old technologies to new technologies. And we've worked really hard to be positioned against the emerging technologies, hypersonics and cyber, electronic warfare, space and next-generation space. So we feel really good about our Department of Defense business. And then health, a big, big priority for the Biden administration and a priority for us. And I think what COVID-19 has exposed some areas that we could have been more prepared whether that be the stockpile program, antivirals, population health, data analytics against the clinical data. But we continue to see Health as a terrific market. And until last quarter, Health really, for the past 3 or 4 years, has been our largest growth and our highest profitability segment. And we're very confident that it will shortly return to be that again.

That's perfect. And then 2 questions on COVID, one shorter term, so I apologize, and the second one longer term. Now how do you think about the COVID impact? You've clearly quantified $670 million revenue impact. How much of that -- majority is within Health. How much of that was clearances versus site access? And do you feel confident in the second half growth outlook? Because it seems like a lot of that will start coming through with -- is in the backlog.

Yes. And Sheila, as you recall, our overall number's about $600 million. That's about $400 million of COVID and about $100 million of what we call Navy NextGen due to a prolonged protest through the Court of Federal Claims, and then there's smaller programs underneath that. But of the COVID piece, obviously, Health is probably our largest revenue number, but by far and away, our largest EBITDA number. And that has to do with holding idle facilities in our medical exam business. But in the intel world, we've gone to this -- shift work is, as everyone has seen across the industry, where the intel community is using Section 3610 under the CARES Act to maintain some of the workforce in a ready state, but they reimbursed salary but not profit. So that's in the order of $100 million. And then there's a kind of another $100 million in the defense work scattered around. We've got some programs that are international, one in the U.K. that was particularly hit. But between the Health business and the Intel business, that really covers most of the impact. We've now had 4 or 5 months of operating under COVID-19, and I've done monthly bottoms-up forecast. So we're really, really confident we understand the mechanism now. And we've made an assumption that COVID-19 stays around through the vaccine. So again, high fidelity in our forecast, high confidence that the second half is going to be significantly better than the first half, and '21 is actually going to be better again still.

That helps. And I continue to ask you this question because I think you are very levered to this. How do you think about how quickly the government can move when it comes to defeating microbes over missiles? You mentioned some opportunities, whether it's stockpiling. I would think for you, it's digitalization of health records. So maybe can you talk about what the COVID opportunity is for you, whether it is in health care or maybe even your newly expanded security business?

Yes. Actually, the COVID opportunity, some of the secondary and tertiary effects of that like increased cyber-attacks, network vulnerabilities, things like telecommute and telehealth, a big opportunity for us in the digital transformation work that we do on the health care side, both for government agencies and for commercial health care providers. It's almost, for us, a reflection of the work that we've done to position ourselves in all 4 businesses. So civil infrastructure, which is where our security business is, touchless screening at airports, biometric screening that we certainly in the U.S. have not done a lot of. We touched on Health, the electronic health care records, the telehealth, stockpiling, antivirals, vaccine, working with health care providers. The intel community, because of what this has done from a threat standpoint, we continue to see strong work in the Intel community. And then in our Defense business, where we have a significant digital transformation business, we've facilitated work from home from the rank-and-file people that come to work all the way up to the 4 stars and being able to provide work at home in a virtual desktop environment, where they can do classified work remotely, has been a big plus. And it's allowed what we call continuity of operations for our defense customers and frankly, for our customers across the board.

That's helpful. And I just wanted to touch upon your 2 recent deals, Dynetics and LHX Security. Just starting off maybe on LHX Security. A lot of people have been skeptical about the double-digit growth, but the first quarter actually came pretty nicely. Maybe can you talk about some of the opportunities there? And Dynetics has seen 20% growth. What are some of the program drivers driving that going forward?

Yes. Well, we closed the deal at the end of January. So we've got quite a bit of the integration under our belt now. And the hypersonic program continues to be great, the weapons, what they do and the intel work and in the cyber. But the -- so the first very significant positive surprise was the win of the Human Lander Program from NASA, a $237 million contract, which we had significantly discounted in our business case. And we're off in executing that. We have to spend that money to get to essentially a CDR by the end of January '21. So we're rapidly ramping up, both our staffing on that program and the others in the supply chain. The big integration effort that we haven't perhaps talked that much about is that we had an innovation engine at Leidos called the Leidos Innovation Center. And it was always our thought that there was a lot of trapped value in intellectual property and technology in the Leidos Innovation Center. And what Dynetics is great at doing is taking technology and bridging into programs of record. So now we have merged those 2 organizations as of the 1st of July. And so Dave King, who's the group President of Dynetics, now has Dynetics and the LInC. And we've already started to see the cross-fertilization of the systems engineering that Dynetics is so good at and the technology that we had reposited in the LInC of talking to each other and talking about what we can do to accelerate growth.

Do you want to talk about LHX Security assets too for a second, if you don't mind?

Yes. No, I'd be happy to. So we have been in the airport and border security business for a long time. Those who've been following the company for a decade knows we bought Reveal over a decade ago. But we were always short of a full product offering. And when the L3Harris merger happened, a decision was made on their part that, that was not a business that they wanted to be in. And so it set up an opportunity for us to buy the security detection and automation. By the way, the automation piece is the conveyor belts that return trays in the U.K., but allowed us to bid for and to win that business, and we closed in May. And I know there's been a lot of question about, "Well, gosh, do you really want to double down in that business at a time when people are not traveling?" And that's actually turned out to be a terrific opportunity for the business is while people are not at airports, the airports are catching up on capital projects. And we've talked about Edinburgh. We talked about Munich. And even some of the installations here domestically, like we've seen Delta reach out for a pilot where we're doing anti-microbial trays and ultraviolet sanitation in the tray return pathway. But the airport business is perhaps even stronger than we thought it would be. And then the border, what we call ports and border business, which is a traditional strength of ours, continues to grow. And I was listening to the news this morning, and I know that Vice President Biden was asked a question yesterday about what was his position on the border. And his comment coming back was, "Well, I'm not going to build any more wall, but I'm still going to spend the money, and I'm going to shift more towards technology." And when he's talking about technology at the border, he's talking in many ways about our VACIS system and the work that we do on rail, truck and vehicle inspection. So again, we expect the security detection and automation business to be a significant winner for us as well.

That's helpful. And then just moving on to maybe some program specifics. NGEN, you took out $100 million in the quarter, and that GAO report was actually quite positive on Leidos' capability. It supported the win. So how do we think about what your capabilities were and what's really driving -- how do we think about the ramp in '21 and '22 in regards to revenue? And you mentioned, I think, 3,000 people will be hired for that program if your employees increased to 41,000. So do we think about any sort of margin impact associated with that as well?

Yes. Okay, great. Well, just to bring everyone up to speed is we won the normal protest, which goes through GAO, and the public record is available. It was highly complementary to our offering and showed a lot of distance between our offering and how we're evaluated and how our competitor was evaluated. We won in technical differentiation. We won [ keepers ]. We won past performance. And we were significantly lowering price. So you never know what the Court of Federal Claims will do. But we are as positive as we can be at this point that we will overturn the lawsuit that's been filed in the Court of Federal Claims. Oral arguments are set for the 28th of October. And then usually, it takes 3 or 4 weeks after that for the judge to rule. And what that has done is extended the ramp-up of the program to what we thought was going to be a June, July time frame, really to the end of the year. And then, Sheila, you're right, we will be hiring literally thousands of people. We are doing contingent hiring now in getting ready for the transition. But once we are fully able to execute the contract, we see a significant ramp up. That being said, it will take us all of '21 to get to fully operating on the NextGen program. So you can almost think of it as 0.5 year's of revenue in '21 with probably our first full year being '22, simply because of the delay. But -- and the number is about right. We call them full-time equivalents. The total staff on the program should be around 3,000. Now that will be a mix between Leidos employees and some of our partners and subcontractors. Oh, and the margin. We've always said on -- when we start a new program, we tend to be more conservative in our booking, and that will be true on the NextGen program. But there is no reason that over the life of the NextGen program, it won't be able to achieve what we call our segment average margins.

Okay. That's super helpful. And then just on DHMSM. Maybe could you provide an update there? Does it ramp at all? Where are you in sort of the deployment? If you wouldn't mind providing an overview because there's been some puts and takes there.

Right. Our Defense Health Management Systems Modernization program or electronic health care records for the Department of Defense for the active military, the program is in a ramp stage, which means we are adding more waves. We talk about our deployment occurring in waves. And a wave is a group of military health care facilities that we do that tend to be geographically located. And we were just in the beginning of hitting our stride, starting a wave about every quarter when COVID hit. And of course, there are priorities for health care facilities in the military as well as in civilian life. And so we have had to flex our work so that we continue to make progress and to be ready when we have full access to the facilities. Let's see, the good news is our fully operable end date, which is at the end of 2023, has not changed. Our staffing is still very strong. Our ramp profile may have changed a little bit, but we're almost completely back to where we were pre-COVID. And we expect to continue to ramp for the remainder of this year, and then there'll be a little bit of growth in that program in '21 as well. And the programs are doing real well. You may have read, we were able to add the Coast Guard to the program. So it's not just the Department of Defense, but we have a program to deploy in the Coast Guard as well.

And then maybe just overall on the business outlook. When we think about your 3 segments, we don't often talk about the segments, Health, Defense and Civil. Can you rank order them in terms of growth outlooks over the medium term?

Well, we had an Investor Day last year. We kind of put out some numbers where we thought at that time, Defense might be a little bit higher, 5%, 6% with Civil and Health sort of at 5%. If I were to do '21 to '20 simply because of the impact that we had in our disability exam business, you might see '21 for Health to be actually our highest growth business because we had a couple of months that we were shut down in our exam business, but we still see high single-digit, low double-digit growth, '21 to '20. And I think what people should find comfort in is our sustained high book-to-bill. So we were 1.6 last quarter, but more importantly, we've been 1.6 book-to-bill on a trailing 12. And that's led to $30 billion and some change of backlog that we carry forward. And as we often say about third quarter, because of the DoD cycle in trying to get programs under contract before the end of the government fiscal year, the third quarter is always our strongest booking quarter, and we expect that to happen this year as well despite the COVID-19. We find that the government is up and operating across all of our sectors, and we're looking forward to an increase in our book-to-bill in third quarter as we have seen in past years. So all that really speaks strongly to continued strong organic growth as we look at '21. And then for the people out there doing modeling, I would just remind them in the acquisitions, Dynetics is only 11 months in '20. And in '21, that will be 12. And the L3Harris security detection business, really, we closed in May and next year, we'll have a full 12 months of the L3Harris business as well. So that's going to drive our top line.

That's super helpful. And then you mentioned your book-to-bill, 1.6x in the last quarter. You're clearly gaining some share. So maybe can you talk about what areas you think you're gaining share?

Well, digital transformation has just been a great area of our business. And we went into -- beginning of last year, we had 3 major programs. We had Hanford, which is really on our digital transformation, but we wanted to rewin our DISA program or GSM-O, and we are able to do that. And then the win on Navy NextGen has really solidified our leadership position there. But there's an Air Force program where we provide IT in the national capital region. There's a lot that we do in the health care world. We actually have a commercial health care digital transformation business, where we go into very large commercial health care organizations and help them do virtualization, move to the cloud. And that has been a growing business for us as well. So -- and I think people look to us for leadership in that area, and we continue to attract the best talent and win the majority of what we bid on.

That's super helpful. So it seems like mid-single to high single-digit growth is solidified for 1 or 2 years. Moving forward just to profitability, we have all this growth coming in. We talked about NGEN in that ramp. How do we think about some of the other programs ramping and how that plays to your double-digit margin target?

Yes. What's great about whether it be the Dynetics business or the security detection business or the medical exam business coming back, a lot of the growth that's going to fuel '21 and '22 are businesses that have traditionally been strong EBITDA businesses for us. A point -- and we kind of made this on the earnings call, but I want to reiterate is that if you strip away the COVID effect and VirnetX and you look at the margin that we printed in the quarter, it really was stronger than traditionally we speak to. We've always guided this as we want to be at 10% or 10 plus. And because of what we've done on SG&A, we're not going to trade shows, we've cut down travel, we clearly are reducing our physical footprint as our other companies. We actually see some upside in our margin. And we don't see any reason why we can't carry that and that type of an operating model forward into '21 and '22. So we actually see more upside potential in the bottom line than we may have seen in the past. So it's interesting what we're all learning from operating in the pandemic with telework and telecommuting. I think it's really paying some dividends, really, across the industry.

And maybe just one last question on margins as it relates to workforce and hiring. Are you seeing any trouble adding folks? Are you seeing any wage inflation? Or has it actually come down and it's easier to hire folks?

Yes. As I think before we came on the air, we were remarking about our summer intern program. And I know that there are people in the industry who have curtailed some of their hiring and their intern program. And we had already moved to a virtual hiring platform. So we had used the web, and we had done Zoom chats and things like that for hiring. Our new employee orientation is all virtual. We've actually -- we hired more people in the second quarter in the middle of COVID than we did in the first quarter. And because we're hiring and because we're growing, and I think somewhat because of the reputation we have as a great place to work, we've been able to continue to attract the kind of talent that we need. And we have plans, as we were talking earlier, to add literally thousands of more people between now and the end of the year. And what virtualization, telecommuting has done for us is allowed us to go out to a broader market. It used to be -- if you were in the national capital region, and you had to hire people within 50 miles of facility, and because of the telecommuting and teleworking and what we've done with our virtual private network, we can cast a much wider net geographically, and that has paid off. And we have put in these facilities we call software factories or software development facilities outside of the traditional urban centers. So we have Charlottesville, Morgantown, St. Louis, Eagan, Minnesota, and that's allowed us to attract a different market and a different set of people. And that has allowed us to not chase what we call the unicorn, right, which is a computer science major with a master's and 10 years of experience and a security clearance that everyone in the industry is chasing. And every 2 years, that person moves, and that does create the wage inflation. We've been able to source to other markets where there is less competition. By the way -- and they are less likely to move around in St. Louis or kind of in the Midwest, they love we have an intercity location where people like to work, people love coming to work there. And our retention numbers are better in those locations. So we feel very, very good about our ability to hire. I did mention on the call, security clearances are always problematic. And although we can get the base clearance, what we call our collateral secret or top secret because a lie detector, a polygraph requires a lot of human-to-human interaction. We still see some challenges in getting people who don't have a lie detector or a polygraph through the polygraph system and get them on some of our intel contracts. And I think across the board, that's always going to be a challenge, and it's just a little bit more of a challenge, where we have to social distance. And the person administering the polygraph, we've got to make sure that we don't put them at risk. So security clearance is always something that we'll be dealing with.

That's super helpful. And I'm glad you finally defined a unicorn for all of us because I don't think that's what we had in mind. Last question for you. I think one of the things that's underappreciated about Leidos is the way you and Jim utilize the balance sheet. You're not lazy about it. You monetize assets. You backed your working capital. Do you think working capital is something we should watch going forward given your programs are ramping, so -- and you have growth, so that's a natural usage? And then if you wouldn't mind on continued usage of free cash flow going forward.

Yes. So we look at DSOs or DWC. And Jim is very focused and keeps a firm hand on working capital. But if we grow, when we grow, that requires working capital. And so as we think about what's going to happen in '21, there will be some use of cash in working capital. Now to counter that, '20 was a year of quite a bit of new facilities for us. Where I sit today is our new world headquarters building in Reston. Although we leased the building, we did have to spend some capital on furniture and leasehold improvements. We had a new facility up in Gaithersburg and a new facility in San Diego. Those won't happen next year. But we will spend some of our cash next year on working capital as we grow the top line. That being said, we have a very capital-light, asset-light business model. We strive to generate more than 100% net earnings and free cash. We've obviously been able to do that this year. There are some things next year that are legislative like tax deferrals and other things that came about as the CARES Act that will reverse. But net, overall, we will have another strong cash flow generation year in '21, which always brings up the, "Okay, what, Leidos, are you going to do with your free cash?" And we've been essentially reciting our cash deployment philosophy, unchanged for the past 4 years, which is to continue to pay the dividend, to invest in growth, which is things like working capital, but it could be some smaller kind of bolt-on technology M&A. And then with the free cash that's left over to find an efficient -- tax-efficient way to return the extra cash at the end of the day to our owners, which are our shareholders. So -- and that will happen again next year. We have always had this target of 3x leverage and some of the VirnetX and the good things that have happened to us this year had accelerated, are paying down our debt and what we've been able to do on the balance sheet. We expect to be at 3x early next year, and then we'll be in this mode where we're finding ways to give cash back to our shareholder base.

Well, thank you very much, Roger. That wraps it up. It was great seeing you, and thank you for joining us.

Great, Sheila, and thanks for the conference. And I guess we're all learning and getting more and more comfortable with doing these things virtually.

It's not as much fun. Hopefully, in '21, we'll see each other. Thank you very much.

I hope so. Thank you.

See you. Bye.