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

Hi. Good morning, everyone. My name is Jon Raviv. I'm Citigroup's aerospace and defense analyst. Why am I here on day 1 of Citi's Global Technology Conference? Again, welcome to you all. I'm here because I cover a group of companies that do a lot in the technology world, going to look at companies not in technology, but a company like Leidos, who we're joined by today, is a real innovator in the space, delivering technology-driven solutions to the government across a variety of end markets. We're very pleased to have Roger Krone, the CEO; and also Peter Berl, who's the Head of Investor Relations with us from Leidos headquarters. I know that Roger will provide us with a brief update on kind of what he's seeing, what's going on. They've had some developments over the weekend, and then we'll jump into Q&A. But with that, Roger, please take it away. And again, thank you for being here.

Yes. Hey, Jon, thanks, and thanks for hosting us and for everybody who's on the fireside chat. We'll have the chat part, I don't think we're going to be anywhere near a fireside, but we're all learning to work kind of in this new normal. It's been an exciting time for us in the industry. We're really pleased with sort of how things have gone at Leidos, and we'll expand on that over the next 45 minutes. I often get questions about what's going on in the election, what do you think about funding or about a CR, and I just thought I'd touch on those. Boy, we are now in the election season. After we get through Labor Day, both candidates are out campaigning. And we are pleased with how we are positioned as a company. Regardless of how the election goes, we see growth in our core businesses. And our diverse portfolio, we think, provides us some resiliency against how priorities are set by both governments. I always get the question about this time of year about what's going to happen at the end of the government fiscal year. And we know in the past, we've seen the budget process be used as negotiation between the 2 parties. And therefore, we have seen government shutdowns in the past. And kind of the good news, we're here in D.C. and so we're always listening to what's going on up on The Hill. And we think they have actually come to a tentative agreement on a fairly clean continuing resolution. Mnuchin and Pelosi have met and I think they have decided to keep the government funded and pass the CR and try to keep politics on the campaign trail and out of our funding process. So -- and that's good news for us. We are open. We have been open through COVID-19 and operating, and we just see things getting better, and continued top and bottom line growth for the company. And with that, I'll turn it back, Jon, to you for your questions.

Yes, sure. Again, thank you. And thank you, Roger, for that. And yes, it is generally good to keep politics and elections out of whether we fund the government or not. So I would agree that it's encouraging to see some progress on that point. In an area where they don't see much progress sometimes, it's certainly good to see a good development for Leidos and the space as well. So let's bring it back to the technology side of things. I think one interesting thing that Leidos presents, you're the largest stand-alone in the "services" space, but the line between services and products and hardware is being burned all the time. And you yourselves have made a lot of interesting moves over the last, gosh, it's probably been just under a year at this point, adding a couple of new companies in your portfolio and capabilities and technologies. But this is a technology conference. For the purposes of folks listening at home, and they're definitely at home, what is a -- what's a technology you consider to be core to the company? How do you develop it? I want to know what's a tangible example so I can put our hands on as to what Leidos might deliver.

Yes. Great, Jon. I -- and at Leidos, we always get the question, okay, we don't know whether you're a government IT business, you're government services or you're doing products. And we have made some moves in 2020 to add to our portfolio through M&A, and people have viewed those as sort of product moves. And by the way, both businesses, the Dynetics business and Security Detection & Automation have a significant part of their portfolio, 50% or more, in what someone might define services. But I really want people to think about Leidos as supporting a customer mission company, right? And that's really how it all begins with us. It's a conversation that we have with one of our customers across our broad portfolio, and they talk about an unmet need to conduct their mission. And you say, "Well, mission, I understand that's military." No, no, no. That can be health care. It can be the FAA and providing secure airways to the airlines. And so we're always in those discussions with the customers about what are their unmet needs. And our view is always to create a differentiated offering to meet their unmet needs. And so that is not a services staff kind of an offering for us, it is a differentiated offering based upon deep content. And that content, we say, is based in technology, which we have defined, and it's on our website, our 7 core technologies: digital modernization; cyber operations, both virtual and physical; operations and logistics; software; integrated systems, which is a combination of hardware and software; our sensors and phenomenology business, which goes all the way back to the founding of the company; and then the mission operations, mission support business, where we actually operate platforms on behalf of companies. But those technical core competencies are really to support mission based upon the promulgated technological needs of our customers. And we've talked a lot in the defense side, Jon, about hypersonics and directed energy, and electronic warfare and a bigger presence in space and unmanned or uninhabited vehicles in all domains, underwater, on the surface, in the air and in space. And our process has always been one of starting with the customer, bringing our team together, our business development folks, with our Chief Technology Officer, to find where we need to invest to create differentiated offerings in the future. And then that prioritizes our internal research and development, the contract research and development that we go chase. And then over time, that leads into whole offerings. And we tend to be an integrator, doing systems engineering. We tend to have about Leidos content for approximately half of the work. And then we partner with industry for the other half. And that, we think, allows us to win more than our fair share because we differentiate as opposed to going low cost.

Yes. And it's interesting when we think about framing the company as a -- it's not products, it's not services, it's supporting the mission. But to what extent is the ability or the -- or to what extent is how you support a mission perhaps changed or not? I mean not to date you, Roger, but you've been around this business in various roles, in very senior roles for some years. How is the way that industry supports missions, again not just defense, across the solutions space changing? And how is it impacted by the advent of the acceleration of technological adoption among not just the government, but it's also among consumers in the private sector?

Yes. I think it begins, Jon, that the mission has evolved. The mission used to be clear. And if you go -- if you're going to go way back, if we talk about Europe, fill the gap, we were going to have tanks and that was how we expected to operate. And it was a much, much more physical world. And today -- and by the way, this is true across our 4 markets, is it's a much more virtual, right, IT as a service world. And we are, in the Department of Defense, as worried about a cyber-attack as we are about a physical attack. Frankly, if you go all the way to our health care business, yes, we are still involved in our customers who provide actual health care. But some of the secrets to getting costs down in health care are based in artificial intelligence, machine learning, big data, right? So the skill sets that you -- it's interesting, the skill sets that you need to have to differentiate yourself today, and therefore the technology that you need, are very, very different. When I grew up -- when I started in the industry, it was about the strength of your factory, could you drill holes in metal, could you put fasteners in, could you operate. Today, I would say that part of our industry is a commodity. There are factories, there are shipyards, there are vehicle manufacturing plants, and you can borrow those or rent those. And that's what we do in our ship business, we actually use somebody else's shipyard. The value add and the differentiator is what you put in the ship. It's how you build the system, how you do integration, how you integrate information from sensors into processors, how you communicate off of that platform back to virtual operation and how you conduct those operations. We have one contract where we support the unmanned vehicle op center for the Special Forces at Cannon Air Force Base in [ Woodbourne ]. And we actually facilitate the operation of unmanned air vehicles for Special Forces. And it's interesting, I grew up in the F-16 program, people would go out to the flight line, get it in an airplane and go fly a mission. While out at Cannon Air Force Base, somebody goes to an op center on base and sits in a virtual cockpit and conducts a mission and then at 5:00, they're done with the mission, they leave their virtual op center. They pick their daughter up from soccer, they go buy at Pizza Hut and buy dinner, and they go home. And so the world has changed really across all of our industries. And therefore, what used to be differentiated technology, like manufacturing technology, is now a commodity. And I think the new differentiators are some of those core competencies that I talked about earlier.

Yes. No, it's an interesting world as that dynamic shifts. So I feel like it gets repetitive, and you mentioned in your prepared remarks on this whole budget talk. And I know -- let's also establish that Leidos is not just defense but in fact, I believe, defense is a lower-than-50% share of the business that you do. But nevertheless, a lot of what is the future of your company gets tied up in the what is the future of the budget. But in the context of the mission evolving and the ways that mission is evolving based on the mission type and the attack surface being different, is budget the right proxy to be looking at here or is it something deeper? And I guess at the end of the -- the short version of this question is, how do you outperform? How do you address the concerns that, well, the budget has never been higher, we have a massive deficit on our books right now, what do you do when the government really pulls back potentially -- again, we don't know, potentially pulls back on discretionary spending?

Yes, I -- let's say, you can't ignore the top line budget, right? And so we all look at that, and it's a place where the conversation starts. But if my team stop their market analysis by looking at the top line federal budget, we wouldn't be doing our job. And so we have to segment and segment and segment until we get into the relative markets. And in any market, parts of that market are going to grow faster than others. And I think our job is to continually reposition the company, again, across all of our markets to move to the faster-growing, more enduring needs where there are gaps in missions and capabilities, and to deemphasize those areas that we view as growing slower or disappearing altogether. And we've all seen companies who have held on to a market too long that was being obsoleted by technology. And we don't want to be the company that we were 10 years ago, because we were in the right markets 10 years ago. We want to be 3 to 5 years ahead of where we see customers moving. And that's why when we make a move like buying Dynetics, yes, there are some people who go, "Well, I don't know whether that's the right move now." It's our assessment that the technologies that were brought to Leidos and Dynetics and some of the DARPA contracts that we go after, and again some of the small technology plays, we like those because they make sense to us 5 years from now. And that's the way the world is going to play differently. And if you don't constantly redefine your markets and therefore your differentiated technology, you run the risk of waking up 1 day and finding you're in the wrong part of the budget. And we -- by the way, the budget is huge. Our market share in any given market is very, very small. So our ability to take share and to grow in all of our target markets is clearly there. And yes, there are probably macroeconomic people who worry about the top line and how that money rolls into growth into M1 and what does that do to GNP, but we're not a GNP company. We are a health care digital transformation company, which is a much, much more narrow part of the federal spend.

Yes. And when we think about the environment that we're in right now, obviously, we're hosting this, the way we're hosting and the fact that I think I've seen you in that room in that chair so much this summer, I'm not sure you've moved, Roger. So pan to the left, I see a little cot on the side perhaps. But that's the world we operate in right now. What's your sense of what the customer demand dynamic has been in this environment? Some people say everything will change forever. Some people say things will change a little bit forever. What is the customer conversation? Because technology modernization, cloud migration, you guys are already like putting health care records into electronic format already. So is this just a continuation or an acceleration? Or have new opportunities popped up that were not previously considered given the extent of the pandemic risk going forward? We can't shut off the economy once every decade because we can't get control over a public health crisis.

Yes, I -- let's say, I -- we have seen an acceleration in digital transformation, right? I mean, it's real. Every program that we have, our GSM-O will be our Navy NextGen, our Air Force National Capital Region IT support program, the Army Corps program, our End-User Services contract with NASA, they have all come to us and said, "Oh, my gosh, we were not set up to operate virtually. We want you to expand our virtual private network. We need to get laptops. We need to understand security at the end point. We need virtual desktop, VDI. We need to understand how to do classified remotely." And that won't come back. More people will telecommute post-COVID than did before COVID. We found a lot of benefits, less indirect costs, less travel. And even if they're not 100% telecommuting, a lot of us, including myself, are going to telecommute a day a week, 2 days a week, something like that. It's good. It's good mental health. It's good for traffic. It's good for wear and tear on -- here in D.C., the commute. So we think that's a permanent change which highlights how important IT infrastructure, digital transformation, virtualization is to the efficient operation of our customer. Now some of the fundamental missions of our customers are not going to change, like CMS providing health care and social security providing benefit checks. And the IRS isn't going to change. The FAA is not really going to fundamentally change. But all of those agencies are thinking through how can I provide mission at a lower price point. We're bidding on a digital transformation opportunity with a large health care company, an integrated, multi-hospital commercial health care company. And the RFP process has sort of transitioned through COVID. It's interesting. In the beginning, it was all about enhanced user experience, right, and digital devices and iPads and edge nodes and more insight into health care and health care data. And over this period, the RFP has changed to they want 20% cost reduction at essentially the same service. And what we have gone back to them and said, "You get to 20% cost reduction the same way you got to enhance user experience by moving off of legacy on to modern platforms and this concept of as a service. So you pay by the drink, software as a service, IT as a service." We think that's going to accelerate as a service across all markets, and it's an area that we're investing in.

Speaking of such, let's pivot to growth now. I was thinking when we think about what's gone on in your space, I mean the coronavirus, as we just talked about, creates an acceleration in realizing, wow, we have to do X, Y and Z that we didn't think about before. We have to achieve outcomes that we weren't previously considering at the outset of an RFP process. But there's also been some disruptions certainly in terms of your growth and your business this year. I know the health care business, especially, has been disrupted by the sheer reason that people are not able to physically go into offices to get exams. So talk about what the -- without getting too detailed in terms of the impact this year, what is sustainable growth going forward in this kind of market? I know this year is down. And then next year you've talked about you're committed to or targeted above 10%. What should things look like going forward even in a constrained budget environment?

Yes. Well, we talk about our physical exam business. And when the customers won't let us conduct physical exams, it certainly is a headwind for the business. And we initially talked about a COVID impact of $270 million top line, and we adjusted that at last earnings call to about $400 million on a total basis. But what we emphasized was a significant portion of that will come back. And that means customers need to conduct these disability exams, whether it's Department of Labor or workman's comp or the military or veterans. And in fact, in September, they have allowed us to do face-to-face exams again, and we would tell you that we are at -- on a run rate in September, at or better than pre-COVID. That doesn't mean the third quarter we're back to pre-COVID, but we're very optimistic fourth quarter will be at or better than pre-COVID. And now that inventory, that backlog of exams, has moved into '21. So we will see now some accelerated growth in '21 as we work through the inventory, right, of the medical exam business, so we're going to see a little bit of a turboing in the health care, and then we'll come back to more normative levels. But overall -- and I know it's really hard for all of us to fathom this, but our customers and their acquisition processes have not slowed down. The RFPs have come out, if anything, more on time. The acquisition process has moved at its normal pace. By the way, the protests have occurred at their normal pace. And we don't see a big blip in the base core business that we have. We have seen maybe NextGen get delayed because one of our competitors filed in the Court of Federal Claims and we had not built that into our planning numbers, but we hope to get that resolved before the end of the year. And so if you look at our trailing 12, 1.6, the 1.6 we painted in the second quarter, the preview we gave that our third quarter is always our strongest, which means it could be north of 1.6. And then we said, if you run the numbers on that, we've got sort of a place to begin next year at about 10%. If you include organic and inorganic because of the full year run rate on Dynetics and the Security Detection & Automation business. But we -- with our $30.7 billion in backlog, a record backlog, and our customers continuing to put out request for proposals and make awards on a timely basis, we are very, very bullish about what '21 is going to look like.

And '22 and '23 and '24. I won't keep it at those just yet, Roger.