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

Good afternoon, everyone. This is Jon Raviv, Citi's U.S. aerospace and defense analyst. This is day 2 of our Global Industrials Conference, brought to you over virtual world as opposed to Miami. We'll get back there soon enough, I promise. Not really in my control, but we should be. This afternoon, we're joined by Jim Reagan, CFO of Leidos. We're very pleased to have him with us today and very grateful to have this opportunity to speak with him. We'll do about a 40-minute conversation, cover some key questions that have been on everyone's mind recently. And then also, if you want to ask any questions through the online portal, feel free, they'll come to me, and I can ask it on your behalf. But I also want to hand this over right now to Peter Berl, Head of Investor Relations, to go over a couple of disclosures and other items. Peter?

Great. Thanks, John. Just real quickly, I'll give you our abbreviated safe harbor disclosure. Today's discussion may contain forward-looking statements based on the environment as we currently see it and as such, does include risks and uncertainties. I'll also add that we will have our fourth quarter earnings call and '21 guidance discussion next Tuesday at 8:00 a.m. Hopefully, you all can make it. And I'll pass it back over to you all.

All right. Yes. We look forward to next Tuesday, absolutely. But in the meantime, we have Jim here now to talk about some of the larger big-picture items going on with the company and not obviously, about earnings specifically.

So with that in mind, this industry and the peer group, a lot of the focus here is on, obviously, I hate to say, it's on growth. So we don't have to talk about 2021 guidance specifically, obviously. But overall, Leidos' position in the market positions it for what kind of growth versus an overall market, if you will? And how do you see that market dynamic going forward in this deficit environment?

Everyone does talk a lot about what we're going to need to do to kind of fund or what are the bill payers going to be around the current deficit that's generated by COVID aid? For us, we still think that there are going to be a lot of priorities from the Biden administration around the continuity of the current level of defense spending. I don't think that any president would want to be making cuts to the defense budget in either the current fiscal year, which is already baked, but even the '22 request, given the ongoing threat environment that we have, particularly from the adversaries that we all know and love, and the need to gain parity in a number of really key things, including missile defense systems. Space is going to continue to be a place where there's increasing emphasis, in our view, increasing spending and the need for modernization as a way to get more out of existing assets. Whether they are assets in the air or assets on the water, we think that one of the key growth areas is going to continue to be modernization of those existing assets. And that's where, particularly around the research and development spend line items into budget, the acquisition of Dynetics was a really good move for us.

Understood. And I think it's interesting, Jim, the conversation usually goes to, what are you going to do when the defense budget flattens out. And I think what that question forgets is that you don't just do defense. You have a pretty diverse asset on your hands there. I think that was one of the big reasons behind the IS&GS combination, if you will. So how do you think about your end market diversity as an asset in this kind of market, whether it just means you can be more resilient or it means you can take some capability over here and bring it over there? So yes, how does Leidos approach that diversity, which, again, is, I'd say, you're more so than others in the industry?

Well, of course, underpinning all of our end markets is the key capabilities on the technical side that we have, whether it's enterprise IT, complex logistics, enterprise software, integrated systems. The diversity of our end market makeup, as you said, Jon, is a real strength for us. The highest margin-generating and the fastest-growing part of our business is in Health. We have a significant base of commercial customers there as well as our government agency customers. And our ability to be cost -- or price competitive, cost competitive in an area where we're generating strong margins and higher growth rates, I think, is something where we're really finding ourselves well placed in an environment where the current administration is putting more emphasis on things like health care, infrastructure where a lot of the work that we do in the Civil side is really at -- is aimed at things like making air traffic management more effective, greener because we're implementing programs with our customers there that reduce the level of greenhouse gas emissions in the commercial air fleet. And then other things that we're doing in the Civil side, such as making the internal revenue service more efficient through the deployment of better systems, better AI and better software infrastructure. So those are a few of the ideas and a few of the areas where we're playing currently that give us a sense that we're going to be resilient in the event that the '22 or the '23 budget has more downward pressure on it out of the DoD side.

Yes. And I mean, how would you characterize at this point in these various end markets? I mean defense is a place where -- and defense for you, for Leidos, includes intelligence as well. So I'd say defense and intel, and that's a place where geopolitical threats and near-peer competition, all those things you mentioned earlier are still alive and well. But it seems like this administration might bring a little more focus on the Civil and Health side as well. So I mean, are you sensing that yet in terms of conversations? Or I mean, quite frankly, it's only mid-February, so let some people get some jobs first, right?

Yes. And it is just -- like you said, just mid-February, but the things that we're putting a lot of focus on that represents spend out of the DoD are continued strengthening of the readiness of our force. So one of the programs that is in protest and we're confident that like the other protests that we've dealt with, we're going to dispense with it, but the RHRP program, which is really aimed at enhancing the readiness of our army force and making sure that they're ready and able when the call comes. Overall, on the side of modernization of weapon systems, we're really aimed at helping the DoD gain parity on hypersonics with our hypersonic capability. But even in missile launch systems, precision fires capability, precision-guided munitions, the kinds of things where a lot of R&D money is spent to gain and exceed the capabilities of adversaries, is where I think you're still going to see some budget priorities and budget growth over the next 2, 3, 4, 5 years, and we're going to continue to play well. I think that we're glad that we're not in some of the riskier areas, which is heavy hardware. We don't make tanks, we don't make ships, and we don't make airplanes. And while a lot of great work is being done there by some of our peers in the A&D community, it isn't where we would want to be right now.

Have -- in terms of customer conversations, have you noticed or has the pace or I should say, really, characterization of those conversations changed over the last year, probably due to COVID, and a lot of the pressures being put on the customer to keep on doing stuff in a disaggregated fashion. But then also, when I think about things like the Sunburst attack. I mean clearly, every company has some sort of cyber capability, you all working in the information technology sphere, are on the front end of that kind of work. So have any of those, I'd say, more sharper shocks that the world has felt over the last year, including the Sunburst attacks, impacted or starting to shift or starting to come up in conversation with your customers?

I think that, fortunately, the recent attack that many of our peers and some of our customers had absorbed through the SolarWinds issue. We were fortunate that we weren't a victim of that attack. And while we don't want to gloat about that and while sometimes you feel like, well, maybe we were lucky, we were also good. And we're helping many of our customers not just to further their own cyber strategies around embedding cyber within complex and key systems, but also in those parts of the DoD, where the view is the best defense is strong offensive capabilities. On the cyber side, we certainly are flexing our muscle there. So Jon, I -- without getting into specifics that could get me into trouble, I think that I can say confidently that we're -- we are supporting our government in those kind of capabilities against those adversaries.

Fair to say that if nothing else, the recent year's reminded us all of the types of risks that are out there, and you can't just take it for granted...

Sure.

That what's working doesn't work forever.

To just amplify one other point you raised a second ago. I think that when we reflect back now that we've been dealing with the pandemic for a year, we've been pleased and maybe a little bit surprised that the government customers have been able to react as nimbly as they have and repurpose their workforce and their way of doing business. And we've all talked about, not just us but some of our peers have talked about how some contract actions have been slowed down because of COVID, and that's undoubtedly true. But we were able -- I should say, our customer was able to get the NGEN award out, 2 different protests were handled. And while we were delayed a few months from getting started up, we're currently in the process of getting that program stood up and transitioned. And how much of that delay was because of COVID? How much of it was kind of the normal process that our customer has to operate under, it's hard to say. But I think overall, we've seen remarkable progress made in keeping the machinery going in spite of a pandemic that 13 months ago, we couldn't have imagined being this significant.

Yes. And it seems like one of the ways that, I mean, all -- I shouldn't say all industries, but a lot of industries have been able to persist in a way that was, again, 13 months ago, not really contemplated in the fact that we're having this conversation right here, obviously, is a little different than how it was a year ago for better or worse. But it's all enabled by technology. And it strikes me that Leidos is a technology company in many respects. So the question really is, in what way is this technology enabling both yourselves and also your customers to create new capabilities or create new business models or expand your addressable market in a way that you wouldn't have been able to do I'll say, 10 years ago? I know, Jim, you've been around this industry for some time. I'm not going to age you, but for a little bit.

A long time, Jon.

A long time. Right. You've been -- you're really old, Jim, you've been around for a long time. But -- I'm sorry. But you sort of -- and you've worked in various sort of companies in this world. So how do you feel like this industry as a whole and Leidos specifically, is where they are positioned now than they weren't positioned in 10, 15 years ago?

I think that there's some progress to be made by our customers and even by many of us in the industry and how to work better with commercial partners that have a lot of really great advanced technologies. And I think that the leadership over the years at DoD has recognized that and they're continuing to work on that, particularly with things that we've benefited from like OTAs and kind of more novel ways for the government to be more nimble in how it pursues business. But I think that what's more interesting is what the future holds because of the learnings of the last 12 months or so. And that is that the pandemic has not just shown us resilience, but it's shown us that certain things that we didn't think we would be able to do securely or be able to do efficiently, we're actually able to do. And it was back in, I guess, it was November, I was playing a round of golf with one of the chiefs of the service branches, who plays golf a lot better than I do. And I was -- it was a privilege to be with him, but I had the chance to ask him what he has learned in how his branch of the military is operating because of COVID. He said, "Well, first of all, one of the greatest epiphanies that I had is I've got a SCIF in my house" because he lives on a base. "I got a SCIF in my house, and I don't have to go to the 5-sided building anymore." And they had been on lockdown and quarantined because one of the service branch chiefs had come down with COVID. And he said, the other thing that he had learned is that how many people that traditionally had gone into the building could work remotely. And how many people who work for them could work remotely. And I do think that the government and the DoD, in particular, are going to continue to find ways to make permanent new ways and innovative and revolutionary ways of doing business internally and with partners like us, much the way we have found that a huge portion of our workforce doesn't have to come to the office every day.

Yes. It certainly keeps the conversation interesting going forward where we've had a year of change. No one's really sure of what the future is going to be. But as you said, it's probably going to be a little bit different. And you can maybe derive some opportunities for you all.

Yes. Absolutely. And speaking of more opportunity, we've talked a little bit about this, and we talked a little bit about it in the third quarter conference call, but it bears repeating. And that is that one of the more intangible benefits from the way we're operating today is that things that weren't essential, meetings that you didn't have to go to that you went to before, it's more inconvenient now because you're attending via Skype or something, and you don't really have to go to that meeting. And instead, you can go do your regular day job and you're running your program. And I talked to a couple of people that run programs, and they think that they're actually more efficient, they're able to focus on program performance more. And that is part of the calculus in what we think has given rise to some margin uptick that we've seen over the past couple of quarters.

Yes. That's all sorts of changes. I include me having to wear glasses for the first time is one of the structural changes too, Jim, over the last year, but it might just be my age catching up to me.

Well, you don't see me wearing mine today.

No. Will love that.

Yes.

I'm at the point of pandemic where if I take these glasses off, I can't see it anymore. Let's go to -- let's think a little bit about margin performance. You brought it up where you've had some recent margin opportunity around that higher productivity in terms of people being able to focus on their stuff as opposed to all these distractions and maybe communities distraction. But when you -- you bought IS, you combined IS and GS, you had a really nice margin start coming out of that. You've pitched the portfolio in a certain way where you're doing things into more -- you're sort of -- you're mixing up in terms of margin. What's your perspective on what's enabled the 2020 outperformance thus far in the quarters that you've reported? And again, you've talked a little bit about how there might be some compression in 2021. Remind us what those items are, essentially? What happened in 2020 that does not necessarily repeat in '21? Is that mostly that productivity dynamic around COVID? Or if there's anything else?

Well, I think that some of the productivity dynamic we're going to be able to sustain, but just focusing first on 2020 and what has happened. You might recall that the margin uptick that we had in the second quarter was largely driven by a one-timer called VirnetX, which is kind of, I guess, the second time we've had a VirnetX windfall and they come kind of episodically, and they're not predictable. We were able to deploy that cash to doing other things. That -- but when you kind of strip that out and then normalize for the impact of COVID, you can think about us operating at roughly a 10.4% EBITDA margin year-to-date through the third quarter. The third quarter though was something where we're starting to see not just kind of the impact of programs running well, but we're also continuing to see, through the third quarter, some reduction in indirect costs because fringe benefit costs were lower, people weren't going to the doctor, they weren't going to the dentist. We hope that, that's not sustainable because we want people to stay healthy. We want people to get their tests done. We think that, that's going to kind of normalize back to pre-pandemic levels in no later than the second half of the year. The other things that we're seeing is a reduction in travel, both on the direct program side and the indirect side. That helps with margin, but it also helps with the cost structure. And then we're certainly seeing a higher level of employee productivity, meaning billability. Because we seem to continue to eke out more efficiencies in our bid and proposal operations. What that means, Jon, is for a given level of proposal generation, it's taking incrementally less labor hours to get a proposal built and published into the customer. And we think that, that could be partly pandemic-driven but just partly because we're continuing to invest in artifacts that make proposal preparation more scalable, repeatable, more repeatable content or stuff that's in this vault of legacy materials. So it's a lot done back in what I just told you, but clearly, there is some level of sustainability to the efficiencies that we've gotten that are helping us to fully offset what we're forecasting is the early-stage margin impact from large program start-ups for things like NGEN.

Got it. The mix dynamic on the new programs like NGEN. So holding here in the low 10s is a good thing, considering that you're getting a bunch of growth from that -- from a brand-new program, which is lower margin, as you've said?

Sure. And it's clearly our view that those programs after year 1 or year 2 are kind of at the norm for the company average.

Yes. Thinking longer-term trend, this -- again, you've been around this industry for a little bit. This industry used to be considered, I'd say, something in the high single digit kind of margin range as just the reality of what you deal with in this industry. Clearly, a lot of folks, including yourselves, have moved into the double-digit range in terms of what is the fair margin in this industry, so to speak. How should we think about long-term margin opportunity for, call it, the services industry, I call it, the government technology industry, if you will? And how is that impacted by things like new contract structures, some of the M&A activity you've all been pursuing, investments and also some of your recent competitive wins, which I know start -- as you said, start low and come up high. But should we start thinking about this industry of being -- doing something more in terms of long-term margin opportunity versus where we are today?

I think if you move forward more than a year and 5 years out, I think there's a clear opportunity for the industry to pursue the potential for higher margins. And by that, I mean, you're still in low teens, but it could be 11% or 12% on the services side, and here's how it happens. And yes, I think you briefly mentioned it, and that is new contracting structures. It's not just good for industry, but it's also good for the customer if a strong industry partner can go to the customer and help them think differently about how to procure something where they allow the industry partner to bring more innovation to building a solution instead of having it prescribed by the number of brains and seats that a customer wants. So if we or any of our peers, for that matter, could go and come up with some kind of out-based contract structure, where the incentives are aligned to reduce cost to get the good outcome there, the customer shouldn't really care about how much margin the contractor makes as long as they're getting the best possible outcome at the lowest possible price. So I think that's what you might see the battleship moving over time.

Do you feel like COVID has been able to accelerate that conversation around contract structure specifically because everyone's minds have been open to new ways of doing things? Or the way that ship was sailing pre-COVID, its sail through COVID and it's continued to move?