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

Welcome back to Morgan Stanley's Virtual Laguna Industrials Conference. My name is Matt Sharpe. I'm the firm's government services analyst today. And with me is the team from Leidos, in particular, Jim Reagan, Executive Vice President and CFO. Now before I get started, there are some disclosures I have to read. Please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see Morgan Stanley's research disclosures website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. And with that, let's dive right in. So Jim, welcome, and thank you so much for joining us this afternoon.

Glad to be with you, Matt. I just wish that we were all at Laguna Beach. But if not there, it's fine to be on webcast.

I'm there mentally. It's -- you and I both. We wish. Hopefully, hopefully next year, but I hope everybody's safe and healthy on your end.

For sure.

So let's dive in here. I sort of wanted to start big picture with Leidos. You guys have been, from the get-go, quite an acquisitive company since the separation from SAIC, followed by the RMT with IS&GS, and most recently, 2 very interesting deals. And I think over the course of that period, Leidos has sort of blurred the lines between what we used to know as a government services company and what we see here today. So I was hoping maybe you could start us off with sort of characterizing how you see Leidos in terms of product, services, end markets. There's a lot of nuances there that I don't think investors always appreciate.

Sure. Well, the one thing that's going to be common to our history and the recent M&A activity is that we really do focus, not just on government customers, but really any kind of customer that's in a regulated kind of environment. So we do have all pieces of our business that, for example, is in commercial energy. But over 90% of our business is really government-focused, whether it's here in the United States or other countries like the U.K. and Australia. And one of the things that has been more prevalent in our focus and how we're growing the business, particularly on the inorganic front, is that we've been looking more at services and solutions platforms that include some element of a product, something developed through our intellectual property or something that we've acquired. And that is really our focus on the Dynetics acquisition, where we do a lot of work for the DoD on the product side as well as NASA being one of our key customers there. And then in the security detection and automation businesses that we acquired from the 3 areas, obviously, there is a security products business there that's focused on airports, ports, borders, secure venues that has a heavy element of product and intellectual property, AI now mixed in there but also an element of services to that. So both of which are driving higher margins that is typical for the legacy business and helping us to continue to make that progress up the margin curve.

Sure, sure. So why don't we just stick with that for a moment here, Dynetics in the LHX security and detection assets? Maybe you can provide us with an update as to how they've been performing since you closed the deals, what you've learned as you've sort of gotten under the hood, so to speak, and poked around further now that the transactions are done with, right? We've seen some really high-profile wins at Dynetics that I think were impressive and surprised some investors. And then on the other hand, the security and detection businesses are probably seeing some interesting opportunities bubble up here as the commercial air traffic market evolves fairly rapidly. So maybe just starting there with some updates.

Sure. Well, in Dynetics, when we acquired that business, we were really excited about what it did for the part of our business that we consider really more high-end, R&D focused, use of higher-end science and technologies to drive growth, particularly in, again, areas where we can expect higher returns. The business has been performing really, really well, and one of the things that I think that we underestimated at the outset with that is some of the revenue synergy opportunities. And while there's a piece of that business that's more commercially focused that has been seeing some COVID headwinds, that's been more than offset with a revenue synergy opportunity that came to fruition shortly after the deal closed, and that was the NASA lunar-lander, the human lander system project. And that's a $253 million first-phase contract that we acquired in April. It's a pretty fast-running program that should run through the first quarter of next year. And if we continue to prosecute that work successfully, it will come to fruition at a date what we're calling a second phase that is the actual construction of the human lander system. The initial contract has been awarded to 3 companies, ourselves and 2 competitors, and they're going to announce elects to 2. Right now, we're really optimistic about where we stand on it, but it's kind of one of those binary things. It's on or off, and we're not including it in any of our forecast for next year's growth. But it certainly would be a game changer should we -- as we hope, get chosen to be 1 of the 2 down-selected companies for what could be a $4 billion to $5 billion opportunity to build a system that puts the first woman and the next man on the moon.

Fantastic. And then maybe just your thoughts here on the security and detection assets. I mean, on one hand, you're dealing with a challenging backdrop and that air travel has dropped off somewhat. But on the other hand, there seems to be some white space there where you have an opportunity here to sort of evolve the product set and make something interesting that can solve some of the challenges around air traffic right now.

Sure. And the obvious one is that there's a desire at most airports to get increasingly touchless in the experience from when you have your passport or your ID checks, going into the security area to when your baggage comes out on the other end, and you're putting your shoes and belts back on. And so we do have some modifications to the tray-return system that exposes those trays to ultraviolet light to provide a higher level of sanitation, and we've designed and we're selling trays as part of the automated tray-return system that have a Microban treatment on them. And those are things that customers want to expect. Those aren't really big drivers of revenue and margin. Perhaps most importantly, it's that there's an increasing desire in a lot of places for increased fidelity in imaging, whether you're at a venue that needs security like a stadium or you're in an airport, government facilities. And of course, there's a pretty big market in ports and borders for the things that have the SD&A products we offer and the legacy Leidos family of products that include the backup system. So then getting to the business that we acquired from LHX, that's performing well. There certainly will be some puts and takes in terms of some businesses or some opportunities and moving a bit to the right because of COVID. But in some areas, customers are trying to seize on an opportunity to close parts of an airport and do an overhaul and modernization of their equipment. So the kind of scanning equipment that offers enhanced imagery, particularly for hydrite chemicals and devices, those opportunities are certainly there. And we've recently submitted a $100 million bid, for example, on one of Europe's 5 largest airports, and we expect to hear back on that in the first quarter. That's an airport authority where -- to the point I just made, they're looking to use the slowdown in air traffic as an opportunity to make the upgrades in a way that's not very intrusive to the traveling public. So we're really excited about those kinds of opportunities, whether they're in Europe or in Asia.

Sure. Now you've got, on one hand, some great opportunities inorganically. But on the organic side, there's some fairly robust growth as well. Obviously, when we look back over the last 12 months, we saw you guys win your recompetes on GSM-O and Hanford, and then you had some takeaways and an engine that's being adjudicated right now. Help us think through the organic growth building blocks over the sort of near term, medium term, right? Because there's going to be some puts and takes. You have some protests. You have some work pushing out due to COVID. Just what can you tell us about, say, the next 12 months or so in terms of the growth profile and how we should think about it cadencing going forward.

Sure. Well, one of the things that we've been really successful at over the last 18 months or so is achieving sustainable book-to-bill rates that are over 1. And in fact, the drilling 12-month book-to-bill is 1.6. And then average contract length has not been getting stretched out by that. Even though some of these contracts are 10-year contracts, we're only booking the piece of that contract that is fixed and determinable and achievable within a reasonable amount of time. And so you've seen the average contract length staying about 2.5, 2.6 years. So you run the math on that, and it tells you that just what we've already got booked should easily sustain a growth rate of 5% or better. And then when you add on top of that the carryover work from the COVID programs and COVID delays from 2020 to 2021, that's another couple of percentage points of growth for next year. We expect to have a successful resolution of the engine protest late this year, probably late November, and we're already getting started on that program. But after the resolution of that program, we're going to be at liberty to work to more aggressively transition legacy personnel from the incumbent contractor over to our new contract. And that will be ramping us from kind of a current run rate of about $50 million a year for the work we're doing today on the transition part of the contract up to a run rate by the end of next year we're estimating about $700 million. So that will give us nice organic growth, both in 2021 and into 2022 of over -- somewhere between 2% and 3%, layered on top of what I've already talked about. So when you add those things up, you're at about 10%, and that's before we get into a new $1 billion-plus program win, and that's for the Reserve Health Readiness Program for the DoD, where that's, again, another $1 billion program over 5 years. And that will also be a nice effort added to our organic growth. So all of these things are going to be able to both help move us into an increasingly competitive cost structure, one where we're able to spread our fixed overhead costs over a larger base, improve profit margins on all of our fixed price work and to continue the velocity that we have and winning more, both on a technical capability basis as well as on a cost structure basis.

Got it. You mentioned your book-to-bill, so 1.6 trailing 12 months. Traditionally, August, September are the high watermarks for the DoD. Maybe you could provide a little color on what you're seeing out of your end customers in terms of pace. Are they experiencing any delays as a result of COVID? And so September, August, to some extent, is not nearly what it is or in the past? Or what can you share with us in terms of that dynamic to help us get comfortable with what the bookings profile looks like from here?

We think that the third quarter is going to be it's typical seasonal strong bookings quarter end. Especially given that there is a potential change of administrations coming out, there are a lot of program types that are going to want to get things on contract, get budgets obligated before the end of the government fiscal year. And you see that in varying degrees every year. We think that this is going to be another year where we have a really strong bookings quarter in calendar Q3. Q4 also looks like it's going to be pretty strong, although, generally, that's seasonally the weakest quarter from the standpoint of bookings. But we think that even Q4 has an opportunity. Depending on where certain things fall, that could also be a quarter with a book to bill of north of 1. So I think, overall, this is going to be a really strong year for backlog growth, particularly where it is. It's in takeaway wins. Our win rate on takeaways has been over 50%. And the things that we're bidding that are brand-new greenfield programs, we've also got very strong win rates there. And of course, with the Hanford recompete and GSM-O, the recompete win rates have been exceptionally strong, too.

Does the fiscal '21 DoD or broader federal budget play into how you're looking at things right now? Obviously, we don't have final legislation. We'll probably be seeing a CR in the not-too-distant future. And of course, we have an election here on the horizon. So how does that picture play into how does the DC political landscape and legislation picture play into how you think about growth here? Do you need a rising budget? Can you grow through it? Just what dynamics are at play there that you watch?

In the past couple of weeks, the Biden campaign has been pretty clear on where it stands on the federal defense budget, for example. They've talked a lot in the past about infrastructure and health care. They've been more clear recently about the defense priorities being really important also to the candidate. And if you look back at his legislative record, he has been a friend of the defense industry. And any concern someone has about Biden looking at cutting the defense budget, I think that his recent comments have been really clear that he's not looking to cut the defense budget. One thing that they have said is that they might realign priorities within the line items of the defense budget. And where we see them thinking about in terms of modernization of the force continuing to do more to support military families in terms of supporting what it is to be, not just on the front lines, but to be a family member of someone who is deployed. There are a lot of programs that we're looking at and certainly have in our pipeline to support that. But on the weapon side, our Dynetics acquisition has a lot of work that is looking to remain funded under either the Trump or the potential Biden administration. Achieving parity in hypersonics, we're in serious competition with China and Russia in that area, and we have a significant contract to provide both the Army and the Navy with a hypersonic glide body that will have other contractors, these parts integrated into it by the services. And we believe that that's a contract that we're -- that's going to continue to accelerate in volume. So -- and on the nondefense side, the Biden administration will continue to support the return to the moon currently targeted by NASA for 2024. He recently said that he is -- like President Trump, he's supportive of that initiative, and we're really excited about the possibilities there. And then lastly, candidate Biden is, for a long time, talked about the need to improve infrastructure. And we're there with our partners at the FAA and other civilian agencies, where we do a lot to manage, support the FAA managing air traffic and the efficiency of air traffic in this people return to the skies. Air traffic is undoubtedly going to be picking up, and we're there to support the efficiency of that.

Great. Maybe shifting gears here for a moment. You mentioned margins a few minutes ago. The portfolio has changed. You've added businesses that are certainly accretive to your margin profile. You've got some really healthy organic growth ahead of you, so the business is going to continue to scale. How do we think about the margin potential now given the changes in the portfolio and the scale and growth beyond your previous level. Is there additional upside here? What are the building blocks? Help us sort of think about what the potential is going forward.