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

Well, we're aspirational to do that. And even in our -- some of our large contracts that are mostly cost-plus, we are having conversations with customers about moving some of IT support or application migration into fixed price as a service, where they're paying us more -- you're paying by the drink but you pay a fixed cost or a fixed price per service, and we're getting a little bit of acceptance of that. The customers, I think, like the idea of derisking some of their digital transformation. But to say at the Leidos top line level that we're going to move the mix 10 percentage points, that's a lot. I mean we're trying to win on the margin. We are trying to bid more fixed-price and just chasing the new work. But our trend is higher fixed price. But at this point, I would not say it's significant.

No, there are some newer competitors out there, a little more on the -- from a commercial background, Palantir probably most prominent, who talk about being able to go into government contracts, do a Software as a Service model and get extremely high margins. They talk about 80% type of incremental margins. I mean how do you think about that? Are there opportunities out there to get these very high margins, Software as a Service model plays?

Yes. Well, probably not that high. So when we talk about the Palantirs and the Splunks and some of the new entrants, we even put in AWS and Azure, there is a role for those companies in the government infrastructure, sometimes as a partner to us. There are times where maybe a customer will buy a Palantir and try to use it as a platform, an interoperability platform. Palantir has been selling in government space long before they went public, and they've had some success, and they've had some success being on our team. What we need to do at Leidos is we need to be the new entrant, we need to act more and more like an AWS or an Azure or Palantir, I mean, with the FireEye, Mandiant, Red Hat, all of those. We want to be viewed as sort of a new business-model-type company, we want to go to as a service, that's why we bought 1901. But given the type of contracts that we have, I don't ever see us getting to the margin of someone who is a pure software developer and is selling software kind of in a shrink-wrap environment. I mean they just have a -- their operations costs are printing another disk, although nobody uses disks anymore. And ours really come back to people and the way we do our service and delivery and operating model. But we think there are some opportunities for increased margin as we go to as a service. But we don't really view Palantir as a direct competitor at this time.

Okay. Now last year, you bought the security detection and automation business from L3Harris. How's that gone? You bought it at the time heading into the pandemic, where the -- that world looked pretty bad. But right now, we're seeing the recovery. I mean how do you reflect on that business and where you're headed?

Well, I -- we had a long-term strategy to consolidate that part of the market. And we either needed to be a consolidator or we need to be consolidated out because our part of that business is more ports and borders and airports, was subscale, and we go to an airport, we could offer check baggage, but we couldn't offer checkpoint. We had been looking at properties in the space really for a decade, Doug, long before I joined the company, and had some relatively informal discussions with some of the other players in the industry. And it was the merger of L3Harris that allowed the L3 business to become available. And for us, it was a very strategic move because, over the long term, we like the global security detection and automation business. So that was the setup. That's why we did the deal. When we signed our definitive agreement, none of us knew that COVID was going to be a global pandemic. And if we had fully understood the impact, I think we still would have done the deal. We might have been able to negotiate a slightly different price, but it is what it is, and you can't go backwards. So we've had -- in the airport side of that business, it's been a complicated year. We've seen internationally, airports deferring, a slowdown in air traffic, which generates revenue for some of the acquisition communities in these countries. But in the U.S., where we're funded through the budgeting process, we continue to see upgrades. We're now doing proof of demos for CT at the checkpoint. And we expect TSA will spend money on upgrades that goes back to the Biden budget and the infrastructure bill. But it is a -- will be a longer return on investment for us than it was when we contemplated the deal and we signed our agreement prior to the pandemic. But long term, it's a global business, it's a complicated world. You probably -- you even see this now domestically with some of the mass shootings and things, we're going to -- there's going to be a stronger need for security in the future than there is today. And we're now really well positioned strategically to take advantage of that. We're just not going to see this recovery really until the end of next year and into '23.

Because I would think, I guess, a couple of thoughts on that. One is you're seeing some businesses not the same business, but like CAE Link, training and simulation, I mean, beaten up pretty badly. But the share price is now valued all the way back up to where it was before because I think people see the recovery there. I would imagine they're sort of, when you look at this, you could say, "Yes, maybe we shouldn't have paid that much. But when we look at it now, if we're independent, it's probably worth a lot." But one question I would have around it is you talked about the U.S., and we're seeing a very uneven recovery around the world where U.S. domestic travel is -- leisure is waived -- all the way back. We're going to see Europe, hopefully, over the next several months. And then Asia Pacific, Latin America, pretty slow. When you look at that geographic mix for what you're doing, how does it play into that?

Look, I think you described it well. And there was a large acquisition in Heathrow that just has gotten postponed and that was a multi-equipment upgrade. And with the second wave in the U.K., they have essentially canceled their procurement. So we expect outside the U.S., as I said, to take another 12 to 18 months to see the recovery. We've got to get the vaccine out on a global basis. But in North America, and if you include Canada and Mexico, we've seen some strength. We've had probably more conversations in this continent in the last 6 weeks than we've had in the last 2 years. And some of that is border as the U.S. tries to come to grips with our immigration policy. So ports and borders is actually maybe a little bit ahead of where we thought it would be. And of course, U.S. travel, it's not back to pre-COVID levels, but it's better now than 2 million a day and up from 88,000 a day at the low. So I think we're going to see domestic travel and that's TSA -- we've got a large presence there. So that can help us in the short term. And then towards the end of next year and beyond, we'll finally see the international market start to pick up. What's always, I think, important and maybe important for investors is, what is the need to sell new equipment to airports? Why not just keep the equipment that I've got? And the advent of new technologies, computer tomography allows us to find new chemicals, fentanyl, black tar heroin, some of the things that the older equipment are struggling with and even our ProVision and that's the system where you have to raise your hands. You may have gone through a secondary airport. We have a concept to increase the false alarm rate there. And frankly, and someday, get to the point where it's a walk-through instead of a stand-in. And when those technologies become available, they will drive a refresh in the market globally. And so there will be a real requirement for upgrades and all the countries who want to operate in the commercial airline infrastructure are going to need to upgrade their passenger and luggage scanning.

If I switch gears here to another acquisition, which was Dynetics, hypersonics, clearly, a priority in this budget. Can you talk about how Dynetics is doing? How large could we see that business become over the next few years?

Yes. Let's say, I've gotten some other questions about that. Given that it's now going to be in our defense segment, and you won't see it in the breakout chart that we provide at earnings, it's going to be difficult to track. But I like to think of it as double in 5 years. And we're on a path -- we had seen significant mid-double-digit growth year-over-year in Dynetics in the first year. So it's really been doing well. And now we've added -- we put Gibbs & Cox into that business, and then we've taken our maritime business, which was in defense, but we put it under Dynetics. So between Dave King, who runs Dynetics and Chris Deegan, who is the Gibbs & Cox President, they see a lot of opportunity in the budget to grow their top line and their bottom line. And it's -- hypersonics in the President's budget got significantly plussed up. I'm sure you saw that, but missile defense, indirect virus protection, autonomous vehicles, both air, surface and subsurface, these are great plus-ups, and then cyber work that we do there, more as a service. We're still very, very pleased with the Dynetics acquisition, and the organization has been performing well. Doug, I can't talk about Dynetics without talking about Human Lander. And I know that's of interest to some of the people on the call. I'll just repeat again, we had no revenue for a Auction A win in our guidance because it was such a big number, and it was binary. The initial award by NASA went to SpaceX, of course, we were disappointed in that. Both Blue Origin and Dynetics filed a protest. And although it's nothing I would want to put in our guidance, but there's -- our hopeful outcome is that there will be some revenue going forward for us on Lander. And that will become clear in the next 45 to 60 days, whether the NASA administration under Biden wants to preserve more industrial base and competition in the Human Lander Program. And as we learn where they're headed, we will pass that on to our investors.

Okay. Well, JADC2, so everybody is talking about that. Conceptually, maybe the most prominent thing kind of out there right now in DoD. There are, as I've seen it, more than 54 companies that have gotten some awards there. I really -- I mean, I think of you as in the very unique position, having led the Future Combat Systems work when you were at Boeing, to think about how this is likely to proceed and what -- are we going to see a more successful effort here than we saw with some of these network-centric warfare systems in the past? What are your thoughts on that?

Well, I -- like everyone, and certainly, the other companies that you talk to today and your participants have, it's on our radar. The JADC2 program as it exists today is a collection of programs and the IBCS, AFATDS, the advanced field artillery program, some communications programs, some digital transformation programs, we have some of those. We're prime on the new field artillery program. And I'd like to say, JADC2 ought to be an architecture that provides an extensible platform for interoperability through the 4 services. And I believe we had the right idea in Future Combat Systems, but the technology maybe wasn't completely ready in processing and how we do data storage and in software-programmable radios. And here we are now, 20, 25 years later and the technology has really moved forward. And with the advent of cloud, how we deal with data in the JADC2 architecture is a lot more straightforward. But if you think of JADC2 as an architecture, you do need an architect. And often, you want your architect to have less equities in the hardware and the programs. And so that is a role that someone like a Leidos could be interested in but that raises words like something called the lead systems integrator, which you're right, Doug, I dealt with in my prior life. And there are a lot of people, both on the customer side and in the industrial base side, that don't want to be led by a lead systems integrator. So the challenge here is going to be to manage the architecture, herd the cats, keep industry involved but really to drive the commonality and the interoperability that you need. There is no reason today, from a technology standpoint, why one platform should not be communicating voice and data with all of the other platforms, if you will, in the battlefield. Sensor, shooter, combinations, with a command-and-control layer. It's not completely clear how the program will be managed from the department standpoint. Of course, they're not fully staffed, they still need some service secretaries and some acquisition officials. But I am a lot more optimistic that coming out of JADC2 will be more interoperable and extensible platforms and yes, like everybody else, we're chasing what we believe to be the components of JADC2 so that as the acquisition matures, we'll be in a position to get our fair share of that activity.

Do you see Leidos as potentially having a role certainly in the components in which you're currently involved but also in the architecture of this system?

Well, let's see, we certainly have the capability to do that, and we're having conversations. And if it was Will Roper, if Will was still the Air Force executive, I would be comfortable saying I think we could have a significant role. We don't today even have an Air Force acquisition exec, much less an Air Force secretary or an under, so I think it's really too premature. We clearly have the capabilities to help the Air Force do this. And I'm sure you recall, Doug, that our company under our former name, SAIC, was the largest partner with Boeing on Future Combat Systems. And so we still have people here at Leidos, who went through the systems, subsystems trade studies and worked on, if you remember, the System of Systems Common Operating Environment, SoSCOE, which was the software that pulled it all together. So we have that capability. We still have people with that knowledge and capability. The act strategy isn't completely set yet. So I think it's premature for us to make a statement like we could be or we would be the integrator for JADC2. We're certainly having those conversations though.

Okay. Cyber and AI, are these areas -- every year in the budget, you get more funding for things like this, tend to be mid -- sometimes mid-single digit, maybe a little more growth. One of the concerns we've had is that often when these budgets grow, the customer community has tons of open positions they've struggled to fill and it's hard often to know is the money going to go internally or will it go to outside contractors like Leidos? How do you see the growth opportunity there for you?

The -- we've all seen these cycles before, and the customer is going to want to add capability and whether they want to do integration or systems engineering, they'll attempt to do that. History has told us they are unable to attract and hire at the rate of the spend. And there will always be a need for companies like Leidos and frankly, companies that are not like Leidos who do what we call seeder work, that systems engineering and technical assistance, which is work that we're really not set up to do. That was why we separated the company back in '13. But let's say, having informed customers is a good thing for us. Having the government hire some experts in cyber AI/ML that makes them a more important buyer. So that can, in the long run, be a very positive thing for us. On the staffing side, we're not having a challenge attracting and retaining the workforce that we need. We've got some great wins that we've talked about. And that means we're adding literally thousands of people to the company this year, and we're doing a really great job of attracting the people that we need to support the programs that we've won.

Well, and then if we jump over to health care for a moment, I always -- when I look at your health care businesses, they seem very different. And I'm just -- I'm interested in understanding within health care, where do you see the growth opportunities? And it's almost all government as well. Do you see opportunities to move more out into the commercial world?

Well, we have some commercial work, where we have done digital transformation. We actually used our extensible platform to do some telehealth for some commercial providers. We've always felt there's going to be a little bit of blurring between the government, health care and the commercial health care, and we like to have a foot on the commercial side. We think it makes us better. Sometimes the commercial companies can move a little faster, how they run their RFPs and procurements are certainly more streamlined than some that we see in government. But on the other side, the government helps us build strength and big muscles. Like our DHMSM program has allowed us to do really health care IT transformation at hundreds of military treatment facilities. And by learning that, we can bring that capability over to commercial. But really, from an investor standpoint, thinking of us as a government technology company is probably the right way to think about us. I don't ever see us like being an Epic or doing a whole lot of Epic installations for Mayo Clinic or Cleveland Clinic. That's a business that we had during the time of Meaningful Use -- the HITECH Act and Meaningful Use 1 and 2. And we let that business run its course, and we're really not in that business anymore.

Well, then we're going to have to wrap up here. But one last question. Just when you pull this together and think about cash, how do you think about your cash profile going forward in terms of the free cash flow? And how do you see the deployment of that going over time?

Yes. Well, because we had such a great cash year last year, when we put our initial guide out at $0.0850 which we've raised to $0.0870, we got sort of a reaction from The Street that said, okay, you were at like $1.3 last year, now you're guiding at $0.0850. What happened to the cash? Well, what we have said is, yes, the right way to think about us is like have a 3-year moving window and put us at cash conversion certainly north of 100%. And there's nothing in our business model and the programs that we've won that should cause anyone to think about us any differently. We're very asset-light. We want high cash conversion. So -- and that presents the -- really the other half of your question was "Okay. If you're going to generate $1 billion of cash every year, what are you going to do with it?" Well, okay, we're going to pay our taxes and those things. But we're going to continue to use that cash to invest in growth. Whether that be in IRAD technology, certain capital expenditures that give us laboratories and test equipment to grow. We will continue to be involved in M&A in a strategic way, looking for modest properties like 1901, Gibbs & Cox, Dynetics that fill out our strategic portfolio. Then after that, we're a dividend payer. And we have kind of a thought where we should be relative to the market on dividend. We're going to keep the dividend where -- which is appropriate for us and our company. And then we want to keep our leverage at 3. And so we're up a little bit because of Gibbs & Cox, and we intend to get that paid down by the end of the year. And then at the end, when there's cash left over, we want to continue to find a tax-efficient way to get that back to our owners. And we have done special dividends in the past, but I'm sure you know we did a $67 million buyback, I think, in the fourth quarter. We did $100 million in the first quarter. And so we've also done things like accelerated share repurchase. But we'll keep an eye on what changes in the tax laws and marginal rates and capital gains but we'll continue to try to find a tax-efficient way to return that free cash to our owners.

Well, great. Well, let's, I guess, wrap it up here. But Roger, thank you very much for joining us today. Hopefully, next year, we can do this in person.

Yes. Doug, I'm really, really looking forward to it. I've done a little bit of travel. And it's okay. I was in airports, I wore my mask. I've actually traveled internationally. And I got through customs and I'm here to tell you that it's -- the airports are probably cleaner than the restaurant that you go to. And so it's a great place to be. And I think the airlines are doing a great job, and we're looking forward to see everybody back out on the road and to be at the conference next year.

Okay. Well, great. Same here. All right. Thanks a lot.

Thanks a lot.

Bye.