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

All right. Good afternoon, everyone. Glad to have you back here at the Barclays Industrial Select Conference. Our next company is Leidos, and we have Jim Reagan, the CFO, with us. Peter, I don't know if you guys want to say anything from a forward-looking statement standpoint. And I know you guys are in a quiet period here, and you're going to report next Tuesday, so we're going to try and keep the questions at a high level.

Yes. That's fine. Peter stepped out briefly, but I would just emphasize what you just said, David, and that is that we're in the quiet period. And I know that your questions will be aimed more at a high level as opposed to asking us anything about the fourth quarter, and we appreciate that.

Exactly. Well, we appreciate you being here in the midst of quiet period. So we'll do our best to stay away from anything sensitive.

So I guess to start with, at a high level, you guys are among the companies kind of in the traditional services space. You guys are a little bit unique in that you have a higher level of non-DoD exposure. You're more diverse in terms of your exposure. You obviously have a pretty large Civil business and Health business. How do you view your mix and what that might mean for your growth rate going forward? Given where we are in the federal budget cycle with DoD budgets at least likely peaking, Civil budgets are pretty high levels as well. But what we've seen typically in the past is that the civil side of the house tends to hold up a bit better in a broader federal budget downturn. So just your thoughts around how your portfolio you think could do during a federal budget slowdown.

Well, your point is a good one, David, and that is that if you go back the last 20, 30, 40 years, that there's some countercyclicality between civil agency budgets and DoD budgets. And when we have put our portfolio together, especially with the acquisition of the IS&GS business a few years ago, it helped us to balance the Civil and the DoD and the Intel and the Health out to have a portfolio that is more resilient during periods of budget pressure in any 1 sector of the federal economy. Today, the President has articulated some emphasis on infrastructure spend and infrastructure improvement. We have a lot of work in those areas, whether they're in civilian agencies or places like the FAA, where, for years, we've been supporting the nation's aviation infrastructure and air traffic management work that has long been the mainstay of our work with that customer.

Got it. Okay. Focusing for a second on the DoD side, with the Dynetics acquisition, moving a little bit more into the product side of things, how do you view your exposure at this point to the DoD modernization budget as opposed to, I think, traditionally, where you've seen gotten most of your business from the O&M side?

Well, the Dynetics acquisition is a good proof point in, again, putting some more emphasis in our portfolio around modernization. And the vast majority of the revenue that Dynetics earns comes out of the modernization line items in the budget as opposed to O&M. So if we think about the priorities of the DoD and the Intelligence community around things like advancing our position in hypersonics, precision-guided munitions and things like that, the Dynetics acquisition is turning out to be one of the highest growing parts of our business, and we're really pleased with that outcome.

So I wanted to ask you about 2021 since you put some high-level guidance out there, the 10% to 12% organic growth that you've forecast. Can you just kind of give us the algorithm on how you get there between your existing business you already have in place, what that grows, the COVID, any sort of recovery on the COVID -- from the COVID impact and then obviously, new wins. And then, you know, is 10% to 12% still the right way to think about NGEN. I think there's been another extension for Perspecta. Just all -- however you want to take that question on.

Yes. Sure. Well, yes, to start with the latter part of your question first. I believe that the extension on the NGEN contract for Perspecta is really aimed at making sure that they have the right kind of funding in place to handle the transition over to our NGEN contract. Getting to your point about growth, we expect, as we've said, that growth rate in the 10% to 12% range organically to really be predicated on the following high-level assumptions. One of them is the core of our business as well as the smaller contract wins will give us 3% to 4% growth. And some of that is on existing contracts and some of it is on the large number of contracts that makes up that strong book-to-bill rate that we've had year-to-date. Then you have kind of the big movers. One of them is NGEN, and that should be a -- say, roughly 2 percentage points. And then there's COVID recovery. Remember, a lot of the work that had been deferred from 2020 is going to be moved into 2021. That will give us a couple of points of growth. And then some of the other larger wins, for example, in the Health Group, where we were recently awarded the MFLC contract. That and other large contract wins that we've recently announced will give us another couple of points. So when you add all that up, you do get to kind of a high-level view of about 10%, and we remain confident in that number.

So not all -- all these big program wins, NGEN included, I don't think are going to be fully ramped by the end of '21. How much more is there kind of on the other side or as we get to '22? Or, I guess, another way of saying it is, if those programs -- your big program wins had been fully ramped in -- if we kind of annualized in 2021, how much would that add to the kind of 10% that were -- that you're talking about?

Yes. We haven't yet said what we think the growth rate for '22 is going to be. But what we have made sure that you and others understand is that, because NGEN will not be fully at run rate by the middle or even latter part of 2021, there will be year-over-year growth on NGEN, it will likely be year-over-year growth on MFLC and a couple of the other larger contract wins that we have had as either new contract awards or takeaways. And that ramp is going to give us some nice year-over-year growth in '22 over '21. We'll get -- probably get more granular about how that's looking as 2021 shakes out, say, middle to latter part of the year.

Okay. And is NGEN still supposed to be, when you get to full run rate, kind of a $600 million annual revenue program?

That's a good ballpark. A lot of the steady-state run rate of NGEN is going to depend upon how many additional services that they need to add into that or build into that contract. And we think that there is probably a meaningful amount of upside on that number. But the number that you articulated just now is consistent with how we're thinking about how NGEN will factor into the kind of growth that we laid out in our last earnings conference call.

Okay. What about on the other side of things, meaningful recompetes that could be a headwind as we think about moving forward? Or any programs today that are going to run off that will be a headwind to your growth? Anything significant there that we should be aware of?

The runoff of contracts that are kind of going to their natural end state already have been factored into the numbers that we've talked about, the 10% to 12%. What I would point out is that we've really been through the most significant of our recompetes recently. The biggest one or one of the biggest ones, of course, was the Hanford recompete which we won and are transitioning to the new contract from the old contract right now. The GSM-O II award this year was the recompete of GSM-O I, and that contract transition is also underway this year. So the -- I would call the headline risk around recompete that was looming a year ago, that cycle is behind us. And we're looking forward to a 2021 where the sheer volume of recompete is much lower than the volume of recompete work that's in front -- was in front of us this time a year ago. So what that means is instead of kind of looking at more recompetes to be ramping from the legacy work in 2021, what is really in front of us is transitioning work from other contractors and onboarding some new employees and some employees that are being rebadged from the legacy contracts, and that will be a nice problem to have in 2021 as we look at that strong growth.

Okay. I wanted to touch on the margin profile. And before we consider what the new program wins will do to margins, just wanted to -- just want to kind of think about your EBITDA margins relative to your peers as we stand here today. So you're in the high 10% level on an EBITDA margin basis, but you have a mix of Civil -- higher mix of Civil and Health, which, certainly, Health comes in at a higher margin. How do you think -- again, before we think about the new programs coming in, how do you view the margin opportunity for kind of the baseline business today?

Well, we did have strong margins in the most recently reported quarter and year-to-date. We did have a nice pickup from the settlement of an issue that we had known as the VirnetX settlement, and that gave us $81 million of operating income tailwind in the -- and I believe that was the second quarter. And if you strip out from our results year-to-date, reported through Q3, if you strip out VirnetX and if you strip out our estimated impact of COVID-19, we're kind of hanging in at around 10.4%. And there has been some nice strength showing up in the core business where programs are performing really well and the estimated completion numbers for contracts are improving, meaning some margins on T&M and fixed-price contracts are showing some strength. And part of that is because just strong program execution, strong program performance, but also reduced allocation of indirect costs because we're enjoying better fringe benefit costs and reduced cost of bidding new programs and travel and conference attendance and those kinds of things. So long and short of it is, we have a pretty optimistic outlook for our margins in 2021. And we'll have a little bit more to talk about at our earnings conference call next week when we provide guidance for the full year. But certainly, the program performance and indirect cost management through the third quarter tells us that we should have reason to feel pretty good about it.

Okay. And these new program wins, the big one, should we think about them coming in at much lower than kind of corporate average margins today? I mean I can see what Perspecta has talked about in terms of -- they're showing their numbers with NGEN and without it. And it looks like NGEN is a low-teen EBITDA margin business for them. So I mean are these wins really going to be dilutive to your margin?

Well, we don't comment on the margin on specific contracts. But what we could -- what I -- we have shared in the past, and it's worth reiterating is that large programs like that or like GSM-O, typically do have lower margins in the start-up years when you're making some investments in business processes as you're onboarding people and incurring those kinds of start-up costs that don't make their way into the EACs that you straight-line earnings margins on. So I think that the answer to your question is, yes, we certainly -- on large program start-ups, those will be things that press margin down a bit. But at the same time, programs that are near the end of their life or coming up to a recompete cycle typically will have margins that are higher. And we always have to think of the company as a portfolio of programs, some large, some big. And as programs are nearing the end of their life cycle, margins are typically much higher than average and those we typically think of as offsetting the start-up margins that are early in a program's life cycle. So you always have some of those.

Okay. I wanted to focus for a second on Dynetics. So what exactly is Dynetics' role on the HGB, or Hypersonic Glide Body, program? Where does that development stand today? What is the hypersonics opportunity for Dynetics beyond just this Army program?