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

All right. Good morning, everyone. My name is Gavin Parsons. I'm the government IT and services analyst here at Goldman. Pleased to have Jim Reagan with Leidos with us. Jim, thanks for joining.

Glad to meet you again. Thank you, Gavin.

Yes. Everybody on the webcast, feel free to submit questions, and we can cover those at the end. But, Jim, do you mind just giving us a quick overview of Leidos for anybody that might not be familiar?

Sure. Leidos, we've been around over 50 years. We are primarily a government services provider in a lot of different disciplines. We're organized by 3 principal segments: one is the government solutions segment; one is the health segment; and the other is the civil segment. We operate globally, but about 90% of our revenues come from the United States with other principal presences in the U.K. offices and sales offices around the globe, but also not only in the U.K. but also Australia. The other thing that's distinguishing about us is that roughly 90% of our global revenue is also in what we think of as highly regulated, mostly, obviously, the United States government. But also, we do have an energy business that deals in the regulated utility sector, a very small part of the civil group. Over 40,000 employees with revenues guiding to a midpoint of about $13.9 billion this year. The company started as -- known as Science Applications International out of San Diego by Dr. Bob Beyster. We started as an ESOP and then went public in the early 2000s. And today, we sit as the largest pure-play government services provider, again, over 40,000 people.

Well, maybe starting high level then from the government and budget side of things. New administration, some different priorities, some the same. At your Investor Day a couple of years ago, you guys had a 5% end market growth outlook. Can you maybe touch on how that's evolved? What the new administration may change within that? And obviously, there are plenty of unknowns on budget details, but whether or not that still holds?

We think that while there's definitely some tempering of the DoD spend in the budget outlook under the new administration, the areas we play around cybersecurity, digital modernization and parity with our overseas adversaries in areas like hypersonics, those are going to continue to be thrusts of new administration. We're glad that we're not in the plane or the shipbuilding business, where those large platforms are probably going to be areas where there's going to be reduced emphasis going forward. When we merged with the IS&GS business of Lockheed Martin back in 2016, our strategy there was to have a balanced portfolio that includes a more significant emphasis in Health and Civil so that we would be able to easily weather the storm of budget issues in the DoD, or for that matter, the non-DoD budget line items. And so having this diversified portfolio of businesses gives us the ability to benefit from a countercyclical nature of defense versus nondefense budget.

You bring up a great point there, too. And is national security now more emphasized within kind of the civil and health care budgets, not just viewed as a DoD issue?

Yes. I think that it is. I mean border security is just as important today as it was, for example, 4 years ago. It's just a question of how are you going to deploy that money. And today, only about 5% of the cargo ship output or imports get scanned or inspected by CBP. And we have a contract today where we're going to be providing some additional infrastructure for inspection of railcars coming across the border. And we think that there's similar kind of opportunities for the inspection of things that are coming into marine ports. So from that -- that's one example of where we think there's going to be continued emphasis in national security outside of DoD. Another good example is in cyber. And of course, the attack on the Colonial Pipeline, it further emphasizes the need for protection of critical infrastructure. And I think that we can all expect there to be more government involvement and oversight for the benefit of protecting critical infrastructure like utilities and those kinds of things going forward.

And you mentioned planes and boats. Some of the last budget downturns it feels like services have been cut in preference of maintaining some of those longer-term hardware programs. Based on those examples that you just gave, does it feel like that's different today? If the budget comes under more pressure? Does IT modernization and cyber and just services in general hold up better?

Yes, we believe so. And we think that there's going to be a greater emphasis in health. We have a Health business that is the highest-margin, fastest-growing part of our portfolio over the last several years. And we think that, that's going to continue going forward. When we execute really critical programs, like the defense health modernization, which is continuing, we're about 30% deployed there. That program is going to continue to ramp over the next year or 2 and then enter into a sustainment phase. Health care is going to continue to be a growing part of our country's GDP. And the ability of our company to develop and deploy systems that accelerate the speed and quality of health information across exchanges is going to continue to be a core competency that will play out well, whether it's defense health modernization or at the VA or in the private sector. We have a business that's growing that assists private sector enterprises, whether they be payers or providers, in accelerating the quality and intelligence around that kind of data. So we think that that's where the future of our Health business, for example, is going. And as there's more demand and more expectation for improvement in civil infrastructure that, I think, plays well for the Civil business that we've gotten.

Makes a lot of sense. You mentioned civil infrastructure. Do you stand to benefit from a potential infrastructure bill? What areas of the business are exposed there?

Yes. We've got a business that is really aimed at improving the quality and maintaining the safety and even further improving the safety of the critical infrastructure around air traffic management. About 60% of the flights globally, at one point from takeoff to touch down, are touched by a Leidos system. And we're one of the biggest providers of that kind of service for the FAA, but also in many other countries as well. So air traffic control, air traffic management is one thing. We also have a consulting business, a relatively small part of the Civil business, but we think there's great opportunity for growth there around the management of infrastructure at the airport level. So this is travel -- or traffic flow of individuals and cargo around airports. And that's based out of Germany. And then there's always increasing emphasis in space, and we do a lot of work today for NASA, both on the IT side, but also through the Dynetics subsidiary. And we're looking forward to continuing to be a valued partner with NASA. So those are some examples of where, with the increased emphasis in civil and infrastructure, we think that we can play well.

You've cited the SD&A business. Have you ever touched on how much that total FAA aviation exposure is for Leidos?

We haven't talked that much about it, but other than to say that, that business has grown well over the past few years, and we continue to punch above our weight in terms of takeaways from our competitors. So for example, last year, we won a radar modernization job, and we have a partnership with Thales, where we're modernizing radar facilities in a number of airports around the United States. And these are examples of where we're able to grow faster than the budgets in a lot of these areas, particularly, like I said, around the civil side.

Okay. Maybe thinking about how that mechanically impacts Leidos' growth rate. I mean COVID, obviously, was pretty disruptive last year. But even then your growth has been fairly lumpy over the last few years and 0%, 10%, 0% then 10% plus this year. And is that just the nature of how new wins ramp up and how recompetes interact? Or is there any ability to smooth that as we go forward?

Yes. I think there's probably more ability to smooth that expectation going forward, Gavin. I think that if you look back at the things that had put some lumpiness around the growth rates, when we combined with the IS&GS business in 2016, we had been working through the runoff of a couple of contracts on the legacy Leidos side. And similarly, the IS&GS business that we were acquiring, they had made some decisions to no bid some of the work there, and they were also running off some large contracts. And so we spent the 2017, 2018 period, reinvesting in growth there. So we cut $400 million of cost run rate out of the business. We invested a significant piece of that in revamping the business development process and really targeting areas that we could win more than our fair share of new work. And so that 2017, 2018 period set us up for 2 things: one, accelerating our margin, taking the business from roughly an 8% EBITDA business to 10 plus. But also taking the business from kind of flat growth to proving the successful integration and showing some accelerating growth in 2018 and 2019, with 2020 being kind of the year of COVID, where it took a little bit of wind out of our sales, but we're back in a year in 2021 where we expect to grow well above the growth rate of the budget. So we're guiding to somewhere between 10% and 12% organic growth this year.

As you look at it today, what are the headwinds and tailwinds in 2022 that we can keep an eye on from our end?

Yes. Well, we're still going to be seeing some headwinds in the SD&A business that we acquired last year. A lot of their business -- one of the attractive things about it was they provided more geographic diversity for us with a lot of their business coming from Europe and Asia. But at the same time, what COVID did to that business is that it -- because a lot of the infrastructure that gets purchased from that business is funded with passenger ticket fees and passenger ticket surcharges, particularly in Europe, a lot of the work that airport authorities in that part of the world, they've put it on hold. We think that the business in Asia is probably going to wake up a little bit sooner. They're all -- when we -- and every day, we track passenger volume worldwide. And passenger volumes are coming up nicely in Asia faster than they have been in Europe. They're coming up nicely in the United States here, too, but we're less reliant in the states on passenger service fees. We think a recapitalization of security equipment in the U.S. could come a little bit sooner than it is. But to sum up kind of the answer to your question, Gavin, the SD&A business, we think will be poised for a nice recovery. But it's not going to be until late next year at the earliest, maybe sometime in the 2023.

Got it. Any big recompetes next year we should keep an eye on?

We got through our biggest recompetes in the past year with the Hanford recompete and a recompete of GSM-O, which is a big IT services bid for the DoD. Probably our largest recompete that we're eyeing for this year is one with an intelligence community agency. And that is probably a $4 billion to $5 billion recompete of work that we've already got, and then the next one is much smaller than that. So we're feeling pretty good that recompete risk is a lot lower this year than it has been in the past. The thing that we're really emphasizing for sustained growth kind of beyond the visibility that we have in 2023 is to continue our R&D investments that position us well for programs of record in 2023, 2024. So in the current year, we're investing more -- a higher percentage of our revenue than we ever have in the 6 years I've been here at least. And with a view that we want to continue positioning our company for winning more than our share of the budget increase that means competing on technical qualifications, competing on innovative solutions so that the win rates that we've talked about last year of recompete win rates in the 90s, takeaway win rates over 50%, if we can sustain those, those are going to position us well for above-market growth beyond 2023. But again, there's still a lot of work to go between now and then.

Got it. Can I just ask a clarifying comment on the 2023 visibility? Are you saying visibility to achieve the Investor Day growth rate targets? Or is that visibility to just grow regardless of the budget?

To grow in excess of the budget. When we think of visibility, we know where -- how well we're positioned for 2022 and to a great measure 2023. As NGEN ramps up and we've got a large IT services bid in the hopper that is going to be very competitive, but we've competed pretty well in that arena over the past 3 or 4 years, and we think that we're as well positioned as anyone for them. But again, we're already feeling pretty good about 2022. We got a few things to get in the hopper to position us well for sustained growth in -- above market in 2023. But it's really the R&D investment that I was talking about earlier that we're investing today for the programs that will become PORs in '23 and '24 that we want to make sure we're competitive for. And that's why we're spending the money today.

Got it. And I want to come back to that. But on -- maybe on headwinds. Does DHMSM become a big headwind at some point in that time frame? Or does that become offset by the VA contract?

What we are really thinking of is that we're only 30% deployed. So we're going to continue having nice results in terms of growth in margin in the DHMSM program this year and next. And then it levels off into sustainment. And from a growth rate standpoint, we have to have things that are going to offset that. And we've got over $50 billion worth of bids that are kind of awaiting a customer decision today. And there's a couple of those that have a long ramp to them that if we win them, they can be offsets to the leveling off and potential downturn once we're beyond the implementation on DHMSM.

Got it. And then maybe similar question on Dynetics on what the long-term growth rate looks like there, given -- I know you don't speak to specific portions of Leidos, but that's in pretty different end markets than traditional government IT. What does the longer-term growth rate look like there? And then is that a pretty tough comp in 2021 given how strong that growth was last year?

Yes. I think, well, first of all, it's going to contribute to organic growth this year, especially if you consider -- if you take out the impact of the lander program, which was kind of a 1-year shot in the arm in Dynetics last year. But it's going to continue to contribute nicely to our overall growth, but not at the same kind of pro forma organic growth rate that it had last year. It is a is a very important part of our strategic positioning in areas that we think are going to be areas of emphasis for the DoD budget next year, especially in areas of hypersonics, precision-guided munitions, indirect fire protection systems that are going to be used or missiles and fire control systems and those kinds of platforms. But probably one of the more visible areas where there's widespread consensus on both sides of the aisle in Congress, there are important areas of emphasis in DoD is getting parity on hypersonics with China and Russia. And we're definitely front and center for that.

Got it. A moment ago, you mentioned bids submitted or bids outstanding. You guys used to provide that number more consistently. That number sounds pretty big relative to what I think it was historically. Is that above where it was in the past? Or is that number relatively consistent with where it has been over the last few years?

Yes. There's one bid we've talked about that is probably the largest single piece of that, and that's the Defense Enclave Services bid, which there's us and 2 other known entities out there that are probably considered the strongest competitors for it. And so that does skew the number higher. But yes, if you're asking if is it a record-high number, it certainly is the highest number we've had since I've been around in the last 6 years.

And I mean, does -- is that dependent at all on budget growth? Or is that -- that's planned for programs that are budgeted and not as dependent on the total top line?

Yes. Well, there is appropriation today for all of those, and they're active bids. Is it possible that budget dollars could be reprioritized, yes. But I think that the areas that are going to be targeted are going to be things that don't involve -- I'll put it in a different way. I think the big platform programs, airplanes and ships, probably are going to be more targeted than things that are modernization. Things that are aimed at getting us parity, strategic parity, things that are aimed at protecting IT systems, things that are aimed at improving the flow of information around the defense and intel establishment. Those are areas where we think are going to be sustained areas of budget support.

I'm sure the Enclave Services contract has a meaningful impact. But do you have a sense for what percentage of that is new work to Leidos?

I -- we haven't said publicly what it is. I don't have that number in front of me. I think there's probably -- a disproportionately large piece of that number is new work for Leidos for sure. Again, because we've only -- the largest recompete bid that we have out of that is about -- well, it's in the mid-single digits of billions. So...

Got it. And then you talked a little bit about the increased R&D, bid in proposal. You've increased CapEx as a percentage of revenue as well. I assume that supports that much larger pipeline. What is the trend in investments if the budget doesn't grow as fast as it has over the last few years? Does that mean you need to invest more to remain competitive? Or does that mean you can spend a little bit less because there's not as much work to go after?

I think that we'll spend a little bit less because there's not as much work to go after. But that's not on the R&D line. I think that we're going to continue to support R&D because that is something that's really looking to sustaining our growth beyond '24. That's really a longer-term play than what we invest year-to-year in getting submits out the door. Now this year, bid submits are going to be -- what our expectation will be at a record level again this year. So our budget is designed around that. You asked -- you mentioned CapEx. I think the CapEx budget is going to be probably much easier to tamp down now that we've got the bulk of our real estate consolidation behind us. There's still going to be some as we aim to reduce the real estate footprint by about 25% over the next 3 years. That's going to mean providing spaces and facilities that allow for more hoteling, more spaces for the people that work at home or at a remote site part time to still spend some time in the office. Because we do believe that face time is important for organizational and career development for people. But these are all things that are really aimed at ensuring that the investment dollars that we spend are really aimed at growing the business and making it, at the same time, more efficient.

Got it. So in thinking about how that translates to total EBITDA margins, you have the 10%-plus target. But beyond NGEN, it increasingly looks like Health and Civil will outgrow Defense. That's mixed positive. Dynetics and SD&A are margin accretive. You've been mixing higher on fixed price. I mean should we think of Leidos as a business that can expand margins long term? Or are the current levels more representative?

Well, in the short term, the current levels, I think, are more representative and that's consistent with how we've guided, Gavin. But the -- part of our mix changed and part of where you've seen us emphasize M&A going forward is in areas where we can be more differentiated, be -- drive higher-value solutions and work with customers that are more willing to pay us for value as opposed to us chasing commodity work where price is your only differentiator. So what I'm really getting at there is that our strategy all along has been not only find ways to operate the business more efficiently to allow us to drive margins up, but also to grow in areas where customers and the opportunities are in higher-margin areas. Now -- so what does that mean? It really means that we've got an established base of business. And as we add more into it, we're looking to add more high-margin work. But this moves the needle 10 basis points at a time, not 100 basis points at a time. So I think you can look at our objective to be continuing to move it up incrementally every period.

Does pricing become more important to the government in a tighter budget environment? Or was that kind of shown last time that LPTA didn't really work for anybody?

Budget is always going to be important, and to dismiss it would be foolish. The areas where we believe we can be -- how we are able to be competitive is to make sure that we continue to take advantage of scale as a way to have lower wrap rates and lower indirect cost allocations on all of our bids. But also in terms of solution development, be able to put proposals together where innovation also drives reduced cost. Figuring out a way to provide service to end users in our IT services contracts that use less people, that use more automated solutions, that provide automated provisioning of circuits instead of manual provisioning of circuits, and even automating supply chain management are areas that we've been able to win some work and differentiate better by, again, finding solutions that can do things more effectively with less people and lower cost.

Got it. Maybe same question on margins on free cash flow. I mean you've pretty consistently exceeded your 100% of net income conversion, cash from ops to net income target. I mean, is that something that you can sustain over the longer term? Or is 100% kind of a more normalized level still?

Yes. In our earnings call, we talked about thinking about this kind of on a rolling 3-year window. We're not going to be quite at 100% this year because we had a lot of tailwinds last year coming out of the CARES Act that -- and other things, some customer advance payments that are going to be turning around this year and next. But if you look back on the rolling 3 years, we've done well over 100%, and our objective is to continue to be at or above 100% on a consistent basis. Again, not every quarter, not every year, but we certainly are setting an objective to be at or better than that next year if you kind of, again, look at these 3-year windows.

Got it. Last year, obviously, had a number of onetime tailwinds. This year has a number of headwinds but no tailwinds. Is there any opportunity to offset some of the onetime headwinds in free cash this year?

Well, we talked about, in the first quarter call, a $25 million tailwind that we made an upward adjustment to guidance for it. And that was the settlement of a legal matter that has a cash inflow coming with it. We're not ready to put anything definitive forward other than to say that we're always looking for ways to optimize and speed up our billing processes. That's one area. And we are -- the place where we've talked about recurring, nonrecurring, and we've already had one this quarter. We don't have anything that's squarely in our sights for the rest of the year, but I never say never. We're always looking for ways that we can improve on the cash flow picture through continued monetization of the balance sheet. And we've done a really good job of that over the last 5 years. But also thinking about is there ways that we can improve the monetization of our deferred tax assets. And we've got a lot of them on the balance sheet, but a lot of it coming from acquisitions. And we're always going to be looking for ways to accelerate that.

Got it. Thinking about acquisitions. You mentioned in the beginning that IS&GS was initially a disruptive to growth. But clearly now it's paying off manyfold. There's been a lot of other large consolidation in the space recently. And you guys have talked about how that IS&GS transaction kind of put you a couple of years ahead of some of those other large-scale M&A and provided multiple advantages and benefits. Is there any scenario where another large transaction makes sense? Or has kind of the strategy since IS&GS been kind of something that you've been comfortable with and that's kind of more of the go-forward plan?

Well, yes, I never say never. And I never want to put myself in a position where my successor is going to have to eat my words, right? But today, we're seeing the advantages of the scale that we got back in 2016 continuing to give us the benefits that we had set out then. There are some great companies that some people would think would make for a great business combination with us. But if it's just for scale, we don't think that it would be worth paying a 13 or 14x multiple for that others might be willing to pay for. We think that the best way and the thing that benefits our shareholders the most is to continue with the kind of investments that we've been making that are giving us the kind of outsized organic growth that we're looking at this year and probably into next year. So if we can continue growing faster than the market just by investing out of our indirect cost savings, the benefits of scale, if we can continue investing then in R&D and in better business capture processes and in people that help us win more work, that's going to be the best return on investment for our shareholders going forward.

Makes sense. How robust is the M&A pipeline? I mean you just closed Gibbs & Cox. You mentioned maybe elevated multiples in some areas of the market. How robust is the pipeline and then how palatable are multiples?

The pipeline is really healthy. But it is -- we've done the Gibbs & Cox acquisition that we closed late last week, and we're onboarding those people today. We think that the kinds of solutions that they can already -- we can already see them bringing in terms of naval architecture capability, combining with the capability that Leidos has around autonomy, that's going to be a great way for us to grow our maritime business. The 1901 acquisition, again, not really big, but it's one that allows us to immediately accelerate our strategy in cloud deployment and the automation around IT transformation for our customers. Those are the kinds of things that we think are going to make sense for us in the near term. Your question about multiples, are they palatable. We've seen some deals go that we had taken a look at, and they went for a multiple that we wouldn't be willing to pay. And we're going to pass on those kinds of things all day long. We're really looking for the kinds of things that will accelerate growth where culturally, there's a good fit. And one of the interesting things about Dynetics is the management team at Dynetics saw an immediate cultural synergy with us. And if any kind of deal got steered more in our direction than in someone else's direction, Dynetics is an example of that. But I think that we're already seeing that Gibbs & Cox, the team there was really interested in finding a way to make a deal work with Leidos. And I think that culturally, that's a great fit. And so what I'm saying, Gavin, is that sometimes it isn't just about price. Sometimes it's finding kind of a symbiotic cultural fit, where we can make a deal where price isn't an obstacle, but it's not just about price. And those, I think, are going to be the kinds of deals that make the most sense for us going forward.

Okay. It makes sense. We're up against time here, but maybe I'll squeeze one last quick one in. You guys delivered Seahawk last month. Sounds like that might align a little bit maybe with Gibbs & Cox and some of the other maritime autonomous and naval capability. Any other opportunities there going forward?

Specifically with Gibbs & Cox, they've got a lot of things on the drawing board in ways that we can accelerate our ability to support the Navy and other customers globally with their aspirations for upgrading existing assets. But if there are things that might be brand-new platforms, we can certainly support that. But in our view, where Gibbs & Cox is going to have sustainable advantage for us is in areas of autonomy, but also in areas where taking existing fleet assets and modernizing them in ways that are probably more compatible with the expected growth of the DoD budget is a great place to be.

Makes sense. Jim, thank you so much for the time. Appreciate it.

Gavin, thank you for having me. Appreciate it.