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

Welcome, everyone, and welcome to join us to this fireside chat with Leidos' CFO, Jim Reagan. Thank you, Jim, for joining us. And good afternoon to everyone. And we'll start with this fireside chat. [Operator Instructions]

So Jim, I'll start with the first big picture question. And [ even sub debts ] expected to flatten out after several years of strong growth, how's Leidos' position to continue growing in a more pressured budget environment?

For -- obviously, for '21, the budget is set, and the mechanics are already well in place for setting the budget for 2022. I think that as we look out, there's probably more uncertainty around the budget for 2023 and beyond. But the national priorities that we're connected to, especially around great power competition, health care and infrastructure, these really align well with where we think that we're positioned in the market going forward. So we don't believe that there will be significant budget pressure in these end markets in the '23 time frame. But we're certainly keeping our ear close to the ground on that. But even in a flat total budget environment, we think that there are ways in those markets that we can continue to outperform our peers and maybe even take some market share away from them. Particularly when you think about IT modernization, which is really going to be critical for the DoD as well as the civilian agencies, digital modernization, cybersecurity, maintaining -- or gaining and maintaining parity with the Chinese and Russians in areas of hypersonics, those are going to be really important in places that we think we're well placed. The recent new program wins that are really the bedrock of our planned organic growth for the coming year would not be impacted by any budget pressure because they're already -- one, they're already obligated. And those are things like NGEN, that's the big IT modernization program for the Navy; MFLC, which is M-F-L-C, Military, Family Life Counseling, that is a program that we've been awarded that's already ramping up; and then RHRP, which is the Reserve Health Readiness Program where we help force readiness for the U.S. Army, we don't expect that's going to be impacted either. The -- and RHRP should be coming out of [ quarter -- the ] federal claim sometime in the second quarter and give us yet another layer of organic growth for 2021 and beyond. So when you think about a 30% increase in backlog that we had last year, that gives us great revenue visibility. And the takeaway win rate that we have of over 50% now for close to 6 quarters -- the past 6 quarters also gives us a lot of confidence in having stronger-than-market organic growth in the coming couple of years. Now in -- just in terms of how we contrast our outlook with the last budget downturn, which you remember in the mid-2000s, what's different? Well, going back to when we were SAIC, both we and the broader market had a lot more exposure to things that were funded through what was called OCO, Overseas Contingent Operations (sic) [ Overseas Contingency Operations ] line item funding. The amount of funding that we have in the -- that OCONUS side of the DoD budget is roughly 1% today. And if there's pressure on that, you won't see a material change in our expected growth rate. The threats that we're seeing from China, Russia, North Korea both on the cybersecurity side, but as I mentioned earlier, maintaining parity in other weapons, especially in hypersonics, again, it's where we see ourselves really well positioned. The President's National Security Strategic Guidance has talked about the need to move away from legacy platforms. The -- while they're old, tried and true, we really need to move to cutting-edge technologies. And those are the words straight out of the President's Security Strategy. So again, for all those reasons, we think that we're well positioned is in a world where there might be more constraints on DoD budget growth.

And do you have any way to measure how much is your exposure to those lower-priority arena?

Yes. Well, it -- we don't build ships. We don't build airplanes. We think that if there is going to be a continued drawdown in places like Afghanistan and Iraq, we think that our exposure there might be about roughly 1% of our revenue. And that is assuming it shuts down completely. We don't think that there's going to be a complete shutdown, but certainly, there's going to be some downward pressure on spend there. So if we're thinking about the areas where they're going to try to redirect some of the money that's spent in, say, Army troop strength, to the extent that the President is going to put some downward pressure on end troop strength, I think that their view is that they want to redeploy that in areas of modernization that I talked about earlier.

Okay. And then you mentioned hypersonics, nuclear, cyberspace, what other opportunities is Leidos pursuing related to national defense? And how should we think about your strategy in the long term on the products versus services kind of solutions?

Well, starting with products versus solutions, we are not a company that has big plans. We don't make airplanes. As I said, we don't make ships or boats. But we do make products that have a natural affinity to the kind of services that we offer. So when we think of designing solutions for prototyping high-energy laser systems for National Defense, whether it's counter-hypersonics or whether it's even space defense, we're really more heavily involved on the design side. And we have advanced prototyping capability that we could, if we needed to, grow into being larger-scale production. But that isn't really necessarily where we want to consider a core strength of the company to be. We are gearing up for some production capability around the hypersonic glide body, which right now, it is low-scale production but it could ramp up to, and we'll have the capability for a larger-scale production of the common glide body going forward. But that isn't going to be the big part of our business. So think about missile launch systems, we will be doing those in each-es, not in dozens or large-scale numbers. And we have partners that can help us with higher-volume production on a lot of these things. Also, for example, on the Human Lander system, we don't have a plant to build that. We actually -- if we're awarded that, we do have our eyes on a couple of production facilities we can put under temporary lease, so that we don't have to make big investments in plant facilities for doing things that will be done on each-by-each basis as opposed to large scale. So when we think that -- when we think about how we're well positioned to think about the modernization of the nuclear triad, we're thinking about having products as an adjunct to design services and development, R&D, those kinds of things that we've been doing for decades.

Okay. Organic growth was disappointing in 2020. Could you please give us some color on the main drivers and discuss the main trends behind the expected inflation on -- like inflection this year?

Sure. Well, right now, we think that moving from kind of the environment where we had stalled in our growth because primarily of reduced indirect cost means reduced pass through revenue but also because of COVID, that was a big driver of the change in our growth for the past year. Those headwinds from last year create some tailwind opportunity for us in the coming year. So in our health business, we have a backlog of medical exams that we're going to -- that we've been executing from late last year through the first quarter and we expect to continue executing on in the coming quarter. You mentioned inflation. Right now, we're not seeing inflation as being a big driver, headwind or tailwind, of our expected growth. We're always mindful of the potential for cost growth in the labor markets, and what we need to do to stay on top of our game to make sure that we don't allow labor cost growth to get in the way of us finding and hiring the right people to enable us to execute on our growth strategy. So the opportunity for us in the coming year on growth really is going to be around the contract wins that we've already talked about, plus the normal cadence of -- I call them singles and doubles, the smaller to midsize contracts where we've had -- like we have in the big ones, some strong win rates, the ability to grow within existing customer budgets on contract growth. It will be 3% to 4% of growth out of the 10% plus that we've guided to for '21. Does that help?

Yes, that's helpful. And you mentioned some disruptions from COVID. There has been also a disruption in the award environment due to the change in the administration. Can you please comment on those impacts? How should we think about them normalizing? And how does the award pipeline look in 2021?

We've heard others talk about disruption in the award cadence for their customers. We haven't really seen that, that disruption that occurred -- that -- or that some have said has occurred because of the change in administration. In our experience, the change of power, the change of administration down at the working level, the people that are contracting officers, the people that are making award decisions, that tends to run uninterrupted from administration to administration. So we really didn't see anything that gotten delayed because someone was waiting for an appointment to be made or a confirmation to get through the Senate. The thing that we had seen in the third and fourth quarter as we had said on prior -- on our earnings calls last year, and particularly in parts of the intelligence community, some slowdown in decision-making, it seems to be more COVID-driven than people waiting for there to be a decision on the election and nominations of people to cabinet posts. So the biggest headwinds that we saw, really, to getting awards done and backlog built at the end of last year, really had more to do with things like having to win NGEN a second and a third time, which we finally got that through a year after we had gotten the initial award and some slowdown in awards, like I said, related to COVID. But right now, we're seeing a nice, continuing build in our pipeline. Our pipeline of things awaiting award as well as things that are qualified in our pipeline for the next couple of years has never been bigger. And we feel really positive about the next couple of years.

All right. And you just mentioned NGEN. Have you seen -- what's the growth you have seen so far? How should we think about the timing to get to full run rate? And what would be at run rate -- at full run rate, the contribution to top line and margins?

Sure. We're operating under the transition task orders now that were awarded late last year and with a couple of small plus-ups here in the first quarter. We're going to be transitioning from that task order to the ramp-up of the big task orders that are about to be put in place that will allow us to get some major hiring done in May, June and July to ramp up to the full run rate by the end of the year. At worst, it would be very early in the first quarter of 2022, and we'll be operating at a full run rate of over $600 million a year. So that ramp allows us to think about a contribution to organic growth this year of a little over 2%, somewhere between 2% and 3%. And then even into 2022, NGEN, just by itself, should contribute another 2% to 3% of revenue growth on top of what it's doing for us here in 2021. Our customer is really eager to get the transition done on an accelerated basis. I think that they're feeling like they got a slow start because of the contractual issues and the protest issues that got them slower to start with the conversion and the transition than they would have wanted. And so we're working in tandem with them to get going on this as fast as possible.

And then next one is on cybersecurity. Have you seen any benefit so far from the emphasized focus on cybersecurity after the SolarWinds breach?

Well, the need for heightened awareness and more focus on protecting critical infrastructure, it existed under the prior administration, and it's just as acute in the Biden administration. And the American Rescue Act contains $1 billion of incremental federal IT funding for modernization, including cybersecurity -- some funding for the Cybersecurity and Infrastructure Agency (sic) [ Cybersecurity and Infrastructure Security Agency ], the CISA, to do better security of federal networks. That's not the only money that is obviously available. And there's many billions more on top of that that's already embedded in budgets. But the point there is that it's not lost on the current administration, particularly in light of SolarWinds that we need to continue to invest in protecting ourselves against bad actors, including Iran, China, Russia and elsewhere. But that emphasis should increase our opportunity across all of our existing programs, especially GSM-O, NGEN and work that we're already doing for the Department of Homeland Security in managing its security operations center.

Perfect. Next one is related to the competitive environment. We have seen [ B&P ] companies get into federal solutions. We have seen nontraditional players getting interested in U.S. Government, cybersecurity and data analytics. And we have seen a lot of M&A of companies also getting like the benefit of scale. And we have just heard about like the new Peraton or GDIT is getting traction, [ rumors already on ] divesting the services business. How does it change the competitive environment for Leidos? What are the challenges and opportunities there?

Well, it really -- well, first of all, we have a lot of respect for Microsoft, AWS, Peraton and all the companies that you've mentioned. And today, Microsoft and AWS continue to be partners that are really focused on building their federal cloud business and using companies like us to be partnered with them. And our customers are asking us to be their partners to implement those cloud solutions and staying ahead of the emerging trends there is why we bought the 1901 Group because they had some innovative processes that were marketed on an as-a-service basis to help agencies do IT services and service modernization on a more automated and structured basis. And so that's why we bought them. And right now, the demand for the people there is outstripping the supply. And we're hiring faster there than anywhere else in the business. But the -- in terms of kind of where you'll look at in the future, we're always looking over our shoulder at the -- those big guys and seeing how they might, at some point, want to enter into our market. Today, we're competing with them more for talent than we are contracts. And we want to continue to compete with them and anyone else on our ability to maintain deep domain expertise with those customers -- of those customers so that, that is our basis of competition. It's understanding their needs, having the technology, making the R&D investments so that we can always develop and deliver one step ahead of them. When you think about new Peraton, which is an interesting combination of a number of businesses, they're clearly looking at building the same kind of benefits of scale that we've enjoyed now since we combined with the IS&GS business back in 2016. And if you remember back that 2016 to 2018 period where we were working on getting our businesses integrated, figuring out what our processes were going to be, how we develop a culture and how we get on a gross footing, I think that they and anyone else that's going through such a significant business combination will be spending a lot of time dealing with the integration process. And that presents an opportunity for us as much as we presented our competitors with an opportunity back in 2016, '17 and '18. So -- and you didn't just see it with us. You saw it with GD buying CSRA and in similar big kinds of transactions like that. So it's always going to be important for us to always look over our shoulder, have a healthy dose of paranoia and making sure that we stay ahead of them by taking the advantages of scale that we have, investing in R&D and the kind of solutions that keep us with takeaway and new business win rates that are really strong.

And then a quick follow-up to that one. As the largest player, probably, when do you think that we could see that there's going to be just too many fish in the tank as everyone wants to get into this trend?

I'm sorry, in which area are you thinking, Mariana?

So how do you think that all these players getting in and everyone getting larger on scale, how -- when do we see too many fish in the tank and how that like moderates or regulates?

I don't think of it as much as too many fish in the tank. I think of it as more of at what point does scale not matter anymore? And at what point does it become a disadvantage? In other words, could you be so big that customers don't want -- customers are worried that too much of the business is going to you and that represents a risk. I don't think we're at that point yet. But if we were to think about another large-scale acquisition, that is one of the things that we would think about before we were going to get there. And right now, that has us thinking more from a capital deployment standpoint that we would rather stay where we are, integrate the acquisitions that are currently being worked on and getting the benefits of those, while at the same time, think about capital deployment in areas like stock buybacks, which we did some of it in Q4, and we certainly have plenty of headroom under our current authorization from the Board to do more. I think that you're -- getting back to your original question, though, I think that you're probably going to see more aggregation of smaller services providers that are going to need to get the benefits of scale to be competitive rather than there being too many large fish. I think it's going to be the small fish are going to continue to be targets of acquisitions.

Interesting. And then you just mentioned acquisitions and capital deployment strategy. How should we think about Leidos' M&A strategy? What technologies, capabilities, customers or contracts are you interested in pursuing?

Well, there are always things that are interesting that identify holes where we would like to have greater penetration with specific customer, particularly in the intelligence part of our portfolio, or companies that have niche capabilities that we could put to work in either a targeted area of the DoD or the Intel Community. But there, I'm talking about businesses that might have revenue of, say, $50 million or so or somewhere in the $50 million to $100 million range. And again, highly specialized things where you really have to go after almost patentable or copyrightable processes and pieces of software code, along with the people that have the domain expertise and the capability to continue developing and maintaining them. But again, I'm not talking about something that's really big there. The recent acquisition of Gibbs & Cox that we expect will close in the second quarter, we didn't have any real marine or naval architecture capability. We had the capability around autonomy that we've put to use in the 2 Sea Hunter vessels that we have. But we really wanted to be able to bring naval engineering into the NICS. And with a 91-year history, Gibbs & Cox has quite a storied past with the U.S. Navy as well as with navies around the world, and their design capability is second to none. And with them being independent of a large ship builder, we think that, that will continue as it has in the past to position them well for modernization of the existing fleet that could be a good alternative to building new hulls.

Yes. And you just mentioned 1901 Group and Gibbs & Cox. If we look at the future, which emerging technologies is Leidos most excited about or interested in investing in?

Well, the investments that we've made across the business, whether it's in Dynetics or what we think is the next generation of security products or the ability to do modernization of IT infrastructure on a much more efficient basis, all -- we're excited about all those. But if you think about where our defense establishment is going to need to go in great power competition with Russia, China and the other bad actors that are out there, we're going to need to invest in the kind of technologies that you see us continuing to double down on, primarily in the LInC, the Leidos Innovation Center, and Dynetics, which the LInC, is tucked up underneath. And so we think that, that's where we have an opportunity to get a lot more revenue traction opportunities for margin expansion and the ability to help our customers in that part of the U.S. Government solve some of the most important problems. But still, President Biden has talked about infrastructure, and undoubtedly, there's going to be an infrastructure bill there. Our balanced portfolio, balanced between defense and intel business but also health and civil. The health business is our fastest-growing part of the business. It also carries our highest margins. We think that the health care spend in our country is going to continue to well outstrip inflation. And we have a lot to bring to bear there through our Digital Health Solutions group and health but also in the -- on the infrastructure side through the civilian group, where we're going to continue to be one of the key providers of service to the FAA and making the use of airspace in the U.S. always safer and always more efficient and helping airlines burn less fuel while they're in the air. Those are the kinds of solutions we're going to continue to deliver there as well.

That's good. So I'll just continue with the commercial aerospace question. How large is your commercial aerospace exposure? And when do you think it's going to be back to 2019 or like prepandemic levels?

Yes. Well, the place where we've been impacted by the reduction in air travel, obviously, is that a lot of the security initiatives that our customers have planned in airports and even more so outside of the U.S. and inside the U.S., it's funded by passenger fees and ticket fees. And with reduced travel, that's reduced funding for that. And so that has definitely impacted us top and bottom line in that part of our business. Conversely, though, the ports and borders business that is also part of our security products business has been running pretty strong. And so border protection, border security is going to continue to be an initiative, both for our customers here in the U.S., the CBP, but also, we have customers in Mexico and customers in the Middle East, customers in Asia that are going to continue to need security products for nonairport installations. And again, it's the ability to scan railcars, the ability to scan containers when they get brought off of ships and port and those kinds of things. So from that standpoint, we see that business relatively unphased. It's going to be at least a year, probably up to 2 years, before we're going to see a meaningful recovery back to 2019 levels in the airport business.

And then how large is going to be SD&A contribution to this year?

So you broke up there, Mariana, which solutions?

So sorry. The contribution of SD&A to 2021 results?

Well, the -- that business is probably already just about 3% of the company anyway. So when we think about what that -- the contribution of that business will come down as a result of the ongoing impact of reduced air travel, think of that impact being about 1% to 1.5% of the company's total revenue. So while we're very focused in making sure that the margin profile of that business is where we want it to be, while the revenues are lower than we want them to be, again, for the factors I just mentioned, I want to make sure that we have it in context that, that business is down maybe by 1% of our total revenue. So...

And then I have a related question from the audience. And it says, on airport security, what are the opportunities you have related to TSA? And how these pipeline of opportunities and outlook for bookings is for you?

Yes. I think in TSA, that's probably one of the better stories that we have in the airport security business because there is the need to recapitalize a lot of the existing equipment there. And they're looking to move increasingly towards CT at the checkpoint. And our solution, I believe, has recently been recertified or certified by the TSA. We're looking to that being a little bit more independent of passenger user fees, obviously, because that's funded more out of tax revenue than it is user fees. And for that reason, we think that the TSA revenue stream in that business will be a little bit less impacted by the decline in global air travel than it has been outside of the U.S.

And I'll switch gears a little bit to health care. How should we think about near- and long-term growth for that business?

I think that in the near term, we're going to see some nice growth in the current year because of the recovery to normal in the health care business that was impacted by COVID-19 when we had to close clinics. And so top line recovery there will be nice in the second quarter and the third quarter. As we continue to put more investment into the development of Digital Health Solutions, and these are things that both payers and providers can use to make the delivery of health care more efficient and more streamlined, and this is marrying the systems payers use to the systems that providers use in the EHR and clinical treatment systems, that is where we see opportunity. More and more care needs to move from being in the hospital setting to home health care. And for home health care to be a meaningful substitute for in-clinic or in-hospital care, you need to have devices that the patient or the caregiver can use to make sure that the vital signs are being monitored, that medication's being administered. And all of those are the kinds of solutions that we think still have a lot of opportunity to be developed, and we continue to invest money in that arena to make those solutions work. So we think that -- and then on the government side, the Centers for Medicare & Medicaid Services is already an important customer of ours. We think that the use of artificial intelligence, machine learning are areas where we can improve their use of what is really the largest patient database in the world because they have more patients, they cover more lives than any insurance company in the world. And for that reason, we think that there's a lot that can be used to take the identify data out of the CMS databases, use those in conjunction with [ MEs ] like CDC and NIH for helping to develop and analyze trends in health care, the development of better solutions. And that is -- that, I think, is a wide-open area for us to have above-market, meaningful growth in the coming 5 to 10 years.

Great. And then last one, COVID-19. How should we think about COVID-19's impact to your operations? And what are the main headwinds that still remain?

Yes. COVID-19 has had the impact that we talked about last year, but to a much lesser extent in the coming year. We're still going to have some lingering delays in procurements in some parts of our business, most notably in the security products business, but to a lesser extent, in parts of the Defense Solutions segment, we're going to have some continuing delays. But those are going to be partially offset with backlog of medical exams that are coming into the revenue stream in Q1 and Q2. Those are going to be nice offsets. There are undoubtedly -- as the government emerges from the pandemic and thinks about ways that we can position our health care infrastructure, both on the government side and the private side, to better prepare for the next pandemic, whether it's 100 years from now or 10 years from now, there's certainly a role for companies like Leidos to play. But in terms of the impact of COVID on our top line, I think that there is plenty of tailwind that we're seeing on the health side this year. The headwinds that I talked about are already embedded in our forecast and guide for 2021. In terms of how we're operating, I'm in our office here in Reston. We're operating at a capacity of about 25%. But as the trends continue to improve and infection rates here in the United States, we're getting ready to prepare our operations and our facilities for up to 50% capacity. That will allow us to collaborate better. And that will give the employees that we have who would really like to come back into the office that opportunity. But at the same time, we have found more efficient ways to work. And things that we were spending money on 2 years ago that we don't need to spend money on ever again, so we'll -- we're going to be moving toward implementation of the strategy with a smaller real estate footprint, less money spent traveling, for sure, and that will be a permanent change with reduced budgets for that and probably more efficient ways to write proposals, interface with our customers and help develop business. And that will -- again, can help us all to remain as competitive as we possibly could be and maybe offer us also some opportunity for some margin expansion going forward.

And you mentioned margins. How should we think about the challenges to margins on new hiring, the clearing, talent development practices for people working from home or this new working environment? And how much of those incremental costs do you think you could be able to just pass to the customer?

We had already developed a pretty strong infrastructure for -- even before COVID-19, for doing interviews with candidates for jobs virtually. This enabled us to get hiring done faster and at a lower cost because you're not bringing people in for interviews. So when we had to transition to doing that 100%, it was pretty easy. We were already onboarding employees virtually. And we went to 100% virtual onboarding in a process where the day the person starts, you've got a laptop in their hands, their security credentials are there, they have access to the network and they can be revenue-producing during the first week. Probably the bigger challenge is making sure that in a world where people can't come into the office the way they normally would to be able to build and maintain the culture of the business. And we believe that the ability to come into the facility is a competitive differentiator for us. And it allows us to interact face-to-face with employees even during a pandemic in a way that is safer. And Mariana, I would tell you that there are plenty of our competitors that shut completely down. And we never did. Even March of last year, we told people to work from home when you can. If you have to come into the office, we'll provide you with a safe place to work. And for a lot of people, they welcomed that opportunity because they're going to be more effective and efficient if they're here compared to working from home. And so you've heard those kinds of stories, but for us, we made a conscious decision to work really hard to develop and maintain a safe work environment for people, we think it's paying off.

That's good. And if I may, we are a little bit late, but you just mentioned people. And talent acquisition and talent retention is probably one of the most important and key things for Leidos. How should we think about that strategy, the differentiation? And you just mentioned something now about how the pandemic changed -- or like what are the opportunities and challenges this pandemic puts on these like really competitive hiring environment?

Yes. We are -- one of the benefits of scale is that we can offer an employee that is a hot commodity, someone who's got great skills, we can offer them the ability to join this company with being part of a 40,000-person organization where they can move from 1 geography to another, from 1 organization to another and even move from 1 skill set requirement to another to help grow their resume, grow their capability, give them the opportunity for personal and professional growth like they can't find anywhere else. We have managers who grew up in this company on the defense side of the business. And today, our group president in the health group, came from the intelligence part of the business. And on the way, she worked in the civil part of our business. And so we give people those opportunities to use their skill set, grow them in different parts of the business and learn a lot more about a different discipline. And I interviewed someone today for a job in internal audit, who is a 20-year veteran of the Air Force and has been working in our aviation business. And so -- and he wanted to learn more about how program auditing and program improvement's done. And so he's interested in that kind of job. So I think for us, a differentiator is the fact that we don't put someone in a job and put them in a career path that goes in one direction. It has an opportunity to go one of many different directions. And we think that, that's part of -- a really important part of our employee acquisition and retention strategy. And we need to have those kind of differentiators if we're going to hire 9,000 people this year, and if we're going to try to keep our turnover rates lower than the benchmark for our industry. And that's going to be important from a cultural perspective. It's going to be important from a cost structure perspective. And it's going to be important for us to demonstrate to our customers that we can give them people who are Leidos lifers. People who are constantly challenging themselves and growing professionally. Mariana, we can't hear you. You might...

Oh, there. Sorry.

There we go.

Thank you very much. I was saying that I could stay here like for hours asking you questions, but we are 5 minutes over our time. And -- but thank you very, very much for joining us. It was a pleasure to interview you.

Good to be here. Thank you for having me, Mariana.

And everyone else, good night for the ones on the other side of the sea, and good afternoon for the rest.