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

Okay. I think we're live. So it's Rob Spingarn from Crédit Suisse, and I'm thrilled to welcome Jim Reagan from Leidos once again, who is an annual participant in this event. Normally not virtual, but that's where we are today. So welcome and happy Thanksgiving, Jim.

Thanks, Rob. And same to you. Thanks for having us. And it's not quite sunny Florida, but I think we'll get through it.

Right, exactly. And I would just want to remind anybody who's on this -- who's viewing today that if you have a question for Jim, I'm glad to ask it. Just e-mail me, and I will ask it anonymously. And that's [email protected]. That's a mouthful.

So with that, I thought maybe we'd start high level, Jim, and perhaps turn it over to you for sort of just a broad comment on the latest trends and how you and Roger are looking at the business, especially with the climate in Washington and the fact that we don't necessarily know how this is going to play out.

Sure. Well, I'll start with how the business has been performing through the COVID crisis. As you remember, we were hit kind of hard in the second quarter. But in the third quarter, we recovered in that part of the business that was affected by COVID-19, pretty nicely generating strong margins and good recovery in the Health business that was impacted in the second quarter. We had record -- or a near-record cash conversion ratio, 265% operating cash over net income. And we were really pleased with where we ended up with a balance sheet with a leverage at 3.0x. We weren't expecting to get there until the second quarter of next year, but strong results on the cash flow side enabled us to get back to that leverage target a little faster than we thought. We had another quarter of strong awards. And today, even the awards number we had didn't include about $9 billion worth of awards that are currently under protest. And we're optimistic about both the timing and outcome of how those will get resolved between Q4 and Q1 of next year. So with that, I think that we feel pretty good about the trajectory of the business. And during our third quarter call, we also set that up, an expectation that we have for organic revenue growth at or above 10% -- somewhere in the 10% to 12% range with a more sustainable, strong margins. And I suspect you want to talk a little bit more about that later. Just in terms of the environment here in Washington, as we've said before, we were kind of agnostic on how the outcome of the presidential election would go from the standpoint of how it impacts our business. With the addition of the Lockheed Martin portfolio back in 2016, we were really aiming to develop a portfolio of programs and customers that was well balanced between DoD and civilian agencies, including agencies like CMS and NIH and FAA, et cetera, that provide a nice balance in insulation from any DoD budget pressures that might come about. That said, if you look back at Joe Biden's history in the Senate, he's been typically, historically a strong supporter of the DoD. And what you're hearing out of the transition team is that they're going to continue to support modernization initiatives at the DoD, a lot of emphasis on space, a lot of emphasis on things like hypersonics, that would help us realize the promise of our investment dynamics, [ for example ]. So with that, to your next question, Rob.

Well, with that, just -- and we will get into that. Just on the budget, what's the latest on the '21 budget? We've seen some movement here. And how are you guys thinking about the CR and the length of the CR?

Yes. We expect that there will be an extension of the CR. It could go as short as a couple of weeks. It could go into the early part of the first quarter. There's a bit of a kerfuffle right now about the NDAA. And hopefully, that's going to get resolved fairly soon. And just in terms of where the budget priorities in the period that they'll be fleshing out, again, no surprises, and we expect to have continuing support of some of the modernization initiatives that we're under contract for today.

Yes, I was going to say, do you see any new starts that could be affected here even -- if this were to linger?

The big new starts that we have are already funded for their first year. And we don't think that -- we don't see any threat to some of the contract awards having the right amount of funding for 2021. As we look out a little further to the time period beyond '21 and where the budget priorities might fall, I think that they might -- there might be a little bit of pressure on the Department of the Army budget. We do have some support for the Army, but -- particularly in intelligence collection and overseas venues. But probably more important, there seems to be maybe stronger support than we would have seen under a Trump administration for the kind of modernization initiatives, enterprise transformation, digital transformation, AI/ML kinds of things and particularly in the area where we're looking to achieve parity with our adversaries in the area of hypersonics. And we continue to be a supporter and vendor for the common hypersonic glide body that probably we'll see more volume through the Department of the Army than the other service agencies. But certainly, we think that, that has a lot of upside potential for us.

Okay. And you talked about your guidance. You alluded to the 10% a few minutes ago that you talked about on a prior call. That's -- look, it's a very strong number. We think it's going to be at or near the top of the pack within the industry. I was hoping you might dig in a little bit and talk about that across the businesses, at least to the extent that you can.

Sure. Well, with really strong book-to-bill that we've had over the last 18 months and strong win rates particularly in new programs and in takeaway work, it gives us great visibility into strong organic growth in kind of the core of our business, even outside of the big contracts. So for example, if you think about on contract growth and the growth of kind of the smaller contracts that range from $10 million to $500 million, that will give us a core growth rate of 4% to 5% organic. Layer on top of that things like the ramp-up of the NGEN program that can yield us between 2 and 3 points, there's going to be a couple of points undoubtedly from the carryover of backlog work from COVID-19. That can be as much as $250 million, $270 million. And then other new business wins like the STAMP program that is still under protest and RHRP and others, that should yield us -- the larger programs that you yield is another 2%. So that racks up to easily a 10% to 12% organic growth for next year. And we're really excited that all of these larger wins are really demonstrating the payoff of the investments that we've been making for the last 3 years to build enterprise core capabilities in the areas that we're prosecuting as well as a really efficient business development engine that leverages this thing we call the BD Vault, a lot of reusable content that enables us to bid more with the same level of new business dollars.

One of the things that I think is just astonishing, and we touched on it here with NGENs and these things that are rising. But if I look at your backlog and I compare it today or, call it, October -- end of the quarter, September 30 to 2017, for example, total backlog's up 82%. And if I look at consensus sales or rough sales number for this year versus 2017, that's up 22%. Now you talked about some decent growth next year, so maybe next year is the better number to use. But even there, sales growth between '17 and '21 is still less than half of the growth of backlog. Now granted, that's total backlog, it's not funded, you've had this massive growth in Defense Solutions over the past 1.5 years. And one might get the impression that you should be able to string together a few years of really -- of better-than-market growth.

Yes. Well, we're already talking about the kind of visibility that we have into 2022. Right now, all eyes are in -- are on kind of 2021 and making sure that we prove out the thesis that we can grow organically between 10% and 12%, and we're very comfortable with what we said before. We will provide more formal guidance across all the metrics that we normally guide to in our fourth quarter conference call. But as I was starting to say, our visibility on 2022 is already pretty good. For example, the ramp of -- the continuing ramp of the NGEN program through next year, what is fully operating and running full tilt by the end of next year, it's going to give us year-over-year, '21 to '22, another couple of points of organic growth on top of the core businesses. Similarly, with a large program like RHRP, that's not going to be operating at full capacity until the latter part of next year. And having a full year of that revenue in '20 -- in '22 compared to '21 will also give us another year of healthy revenue uplift. The bid pipeline, that is the things that we have some visibility to and will be submitting bids on in 2021, also gives us comfort that there will be plenty of opportunity for us to grow at a level faster than the market beyond '21 and certainly in '22.

Is there anything about this funded backlog to unfunded backlog or total backlog ratio that's different than normal in terms of conversion? In other words, has the nature of the total backlog gotten a little looser so the fact that it's bigger doesn't mean as much? Or can investors start to really look at that and say, "Wait a minute. There's an uptick coming here."?

Yes. There's been some element of lumpiness on what contract capacity has been funded from time to time. And to the extent that there is risk that something has contractual value but might not get funded, we always put a reserve against that. So a hypothetical example, we win a $1 billion contract. We don't put the full $1 billion in backlog. We will discount it based on what had been the historical trends for how much of it gets funded and run off. And that way, we really reduce the risk that, in the future, we're going to have what in the business is known as a debooking. Typically, we would only want to have ourselves exposed to a debooking not because of a lack of funding but because, for whatever reason, the contract might get canceled. And that would be the only thing we ever want to see a debooking for. So what we show in total backlog is what our best estimate is based on historical trends, is actually going to get burned off as revenue.

Okay. And then you did mention Dynetics earlier. I don't want to give you a leading question on this. But once we started to learn about that company, we started to think about what the potential was there. So perhaps you can refresh those who are listening to this conversation on what they do, why it matters, why it's resilient whatever happens going forward and if it's still looking to both grow top line and margins faster than the overall business.

Sure. Well, why it's important and what they do? This is the -- probably the area of higher technology along with the LInC, which is the legacy part of the business that was called the Leidos Innovation Center. We've combined those 2 under a unit that we now call the Dynetics group. And they do work around very highly technical, classified work in ISR for the 3-letter agencies. And that's one example. They do a lot of R&D under government contracts to develop precision glided munition systems, and in fact, they're actually in the business of producing them for the DoD. The thing that is probably the highest growth area of work that we're doing today for the Army out of the Dynetics group is work for the common hypersonic glide body that is under an Army contract but also is capable and expected to be bought and used by other services under DoD. So that's the DoD part and a couple of examples of why they're very important there. But they also get us into space. And one of the things that we heavily discounted because we looked at this business and valued it on a conservative basis when we bought it a year ago was space. And the notion that they were going to be a top contender for the human lander system to take the first woman and the next man to the moon was not something that we factored into our calculus. And when they won option, that is the first option for that work, a $250 million contract that we're about 70% finished with today, it was certainly beyond our expectation and represented a lot of upside for us. Today, we believe that we stand as being the top evaluated solution to be put on top of a launch vehicle to go up there. And right now, it's targeted for 2024. That could stretch. We don't know yet, but we're ready to submit our proposal on that in the next couple of weeks when we feel like we could be 1 of the 2 finalists for that. But again, we should find out in the first quarter of next year whether we've been downselected as part of that program. But that will obviously be -- have a lot of revenue potential to it over the next 4 to 6 years.

Just on the Health segment -- I'm working down my list in the various areas. Health's come up next. You talked about some of the volatility in the business and then, of course, the second quarter pressure, which reversed in Q3. But we now have this surge in Q4. Should people be worried about that just relative to what we saw last time? Or is it different?

Well, I mean there's 2 surges: One, I think you're talking about the surge in the virus and infection rates, and that has us concerned, and we're vigilant about that. There's also a surge in requisitions and orders for exams in our clinics and our affiliates' clinics. And that business is continuing to run strong. We haven't had to close a center yet. And we're believing that the operating protocols that we and our customers have in that area and the fact that we do not have a known spread of the virus or an infection that's come out of our clinics yet even with the numbers as they are, we think that we're improving our ability to serve our customers and their patients well. And as long as we can continue to have the kind of discipline that you see in our clinics, a lot of the same disciplines we have here in our office, and I mean our headquarters in Reston, and our numbers are really, really low, we think that we're in pretty good shape. More broadly, going beyond just the Health group, though, we think that this wave, while the numbers are pretty high, it's going to be a little bit different in how our customers are reacting. Some of them are going to go to shift work but not -- we're not seeing very many do that yet. And we think that most of them have figured it out, and they've figured out how we can continue to support them remotely with a lot of our employees doing billable work from home or other locations. But we're also helping our customers figure that out and figure out how to do work securely, even doing some kind -- some semi-classified work, if there is such a thing, how to take classified work and carve out a piece of it that could be done in an unclassified setting and leaving the shift workers who are in the SCIFs to do the classified work. And we think that that's continuing to work really well for a couple of our intelligence agency customers and will continue to keep the revenue stream resilient through this current wave.

So okay. So -- but the -- I guess the bottom line on all that is that Q4 doesn't have the sensitivity perhaps that Q2 did.

Absolutely. We haven't heard any incidents that give our customers concern to do the kinds of things that they did in the medical exam business in the second quarter.

Okay. I wanted to ask you a margin question and just touch on the fact that one of the conversations we frequently have with investors is whether or not there's a fundamental limit to EBITDA margin for any business working with the federal government and if that constraint where that ceiling is fairly low, just given the monopsony nature of the marketplace, everyone is the same customer. How do you think about that with regard to Leidos? And where do you aspire to get the business long term in terms of margins?

Well, we haven't set a limit on how we're going to define success and how we expand our margin because we think that more is always better and more is always attainable. We had our third quarter margin at 10.6% on an adjusted EBITDA basis. And normally, we wouldn't expect to see that unless there were some clear onetime items. But what we've started to see in the business is that our indirect cost structure is more efficient than it's ever been. And program performance, because of the kinds of reviews and management practices that we have, program performance has also been very, very strong. And the combination of those 2 things makes a short-term sustainable EBITDA margin of 10.5% or 10.6% within reach. We'll have more to say about that in our Q4 conference call. What we did say in our last earnings call was that kind of our early view of next year is that margin can be 10.3% or better. And we're doing the planning work right now to nail down what our expectation for next year ought to be and how we're defining success. The things that kind of move you up and down off of the number that we saw in Q3, though, are -- would include the ramp-up of some of these large new programs that in the first year are always going to be dilutive to our margins. And those are programs like the first year of the maybe NextGen program, the first year of the recompete that we just won with DISA. That's the GSM-O II contract. Those are always going to be -- the first year is always when you're investing in the kind of innovation that it takes to deliver a lower-cost program more efficiently to our customers. And so those kinds of things are going to dilute you a little bit, but at the same time, those are going to be offset by the tailing years of programs where we have contract reserves to release. But net-net, we're very comfortable that, what we used to say is a long-term margin that's north of 10%, we can now think of it as north of 10.3%. And we'll have a lot more to say about that in February.

Is there any reason -- or is it maybe a bad comparison to think about the hardware primes and that their EBITDA margins can sometimes get into the mid-teens? Is it just a different business?

Yes. And look, we have parts of our business where we make things where our margins are easily into the mid-teens. We believe that -- well, I can tell you that parts of the Dynetics business where you're actually manufacturing things, once you're at scale, you're manufacturing things in margins that are well north of the margins that you see in our services business. And the security products business also, our target margins there are into the teens. So when we've been asked in the past, how you think about a products business and why are you interested in bringing a products mix into what has traditionally been a services business? And the answer is we -- there are a lot of natural areas where you can combine a very profitable products business onto a platform that is traditionally in services. And the example is the work that we do for TSA, where you have a services business where you're going out and you're maintaining machines combined with the ability to sell product. And there are plenty of even better examples of that in the Dynetics business as well.

Just quickly, the -- almost a flipped question, on why health care has such high margins.

Yes. The health care margins are where they are because those businesses are more of a commercial model, where we're making the higher margins and you're really paying -- the customer's paying a fixed unit rate for something that we have been able to optimize of the cost per unit. So think about the way to convert a physical exam of a patient into a finished report. When you're doing those using processes that make sure you're delivering quality, delivering the product on a timely basis and doing it in a way that shows the right kind of care for the patient, you can do that in a way that's more than 8% margin. And certainly, that business is like that, especially when you're able to do it in volume. And yet you're still able to keep your prices competitive with the rest of the market.

Okay. We've got a couple of minutes left. So I thought I'd finish on capital allocation. And just our numbers have the company generating nearly $2 billion of free cash flow over the next 2 years. That's about 14% of market cap, which speaks to what we think is a value positioning, if you will, of the stock. And so the question is, what do you do with all of that cash given that you've met your leverage targets?

Yes. Well, we've done a good job of stretching out the maturities on the debt side of the balance sheet with some of the bond transactions that we've done opportunistically with a great weighted average cost of the debt capital we've raised. So we're happy with that. We don't see a need to reduce our leverage that materially other than through the normal mandatory retirements of our term loan. And beyond kind of those requirements, we are always looking for opportunities to add to the portfolio through M&A. Most of what we look at is tuck-in. I haven't seen anything that is transformative like the IS&GS transaction that we did in 2016, but we're always open to those kinds of ideas. And aside from some modest amount of debt paydown and the possibility of M&A and keeping some dry powder for that, the next thing obviously is stock buyback and -- buying back stock. The one thing I also forgot to mention is we are increasing our R&D budget for next year. We want to drive research and development as close to 1% of revenue as we can in those areas where we believe the priorities of our DoD and civilian agency customers will gain some traction. So that really is the core thesis or the core of our capital deployment strategy.

Okay. That makes a lot of sense. Just on M&A, one thing we've been hearing, just talking to lots of companies, and some of them are even more on the aerospace side, but just that there are more properties available in the defense arena now because they're not impaired, and maybe there's some fear around the budget in the administration and also because of the potential tax changes for capital gains tax may be motivating some sellers. Has this shown up in the pipeline of what you guys see?

Yes. We've seen a couple of ideas out there where there are unitary owners. These are smaller ideas where some of the things that are coming to market motivated by people that are worried that there will be a change in the tax rate. We don't think that there's going to be a change in the tax structure in 2021 and probably not even in 2022, particularly if the Republican party retains control of the Senate. But there's also -- I do think that there are some that are motivated by concern that there could be flattening out of budget growth on the DoD side. We think, though -- we have a somewhat contrarian view that the Biden administration, in the areas that we serve around innovation in the intel community, innovation in how digital modernization is accomplished, we think that we're still in a place where there will be opportunities for budget growth that are a little bit higher than the overall DoD budget. So I think that there's still some great properties out there. And we're always on the hunt for something that fits well into our strategy for how to keep growing the business faster than the market.

Okay. I think that's a good place for us to leave it. We're a minute or 2 over with these shorter sessions. I want to thank you for being gracious with your time and for spending the day with us. And I look forward to seeing you soon. So thanks so much, Jim.

Thank you, Rob. Good to see you.

Take care.

Take care. Bye-bye.