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

Good afternoon, and welcome back to Day 3 of Morgan Stanley's Virtual Laguna Conference. My name is Matt Sharpe. I'm the firm's government services analyst. And it's my pleasure to host CFO of Leidos, Chris Cage. And before we get started, I do need to read some disclaimers. For important disclosures, please see Morgan Stanley research disclosures website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. And with that, Chris, welcome, and thanks so much for joining us this afternoon.

Matt, thanks for having me. I appreciate it. Looking forward to the chatting with you.

Our pleasure. Our pleasure. Chris, I want to start by talking about top line revenue growth. You guys have done a nice job of executing over the first half of the year. How should we think about growth potential into the back half of 2021 and the exit rate? Maybe talk about in the context of risk and opportunities, what should we think about in terms of building blocks here?

Sure. So well, thank you. I think we are very pleased with the first half of the year and the momentum we've shown on growth. And so as we think about the back half of the year, obviously, we're anticipating some additional ramp-up of certain programs, specifically the Navy NextGen program, which the team has really been doing a great job on the performance side. We've had a lot of activity over the summer transitioning all their networks to Leidos responsibility, bringing on a lot of staff. And so that is a program that will continue to expand in the third quarter and should hit its full run rate potential in our fourth quarter, which will help us carry that momentum into 2022. Another program of size and consequence is the Military and Family Life Counseling Program, that's in our Health segment. That is a large program that we started ramping in the first quarter. It will continue to build. We're adding more and more staffing and counselors on the program. And so again, that should pick up momentum in the third and fourth quarter and again, also kind of be at a full run rate by the end of the year. So those are some of the larger program specifics. We're also continuing to execute in our Health segment. We had, last year with COVID, a lot of our medical exam business that was not able to be fulfilled. We have been working aggressively to bring that backlog down to prosecute the examinations to help support our veterans and our customer. And so that workload is continuing to run strong, and our expectation was that would continue through the third quarter. We might see that continue through the fourth quarter. And at some point, we'll have that come back to more modest levels. But that's a variable that continue -- could continue to see a little bit elevated activity level through the balance of the year. So those are some things that are nice drivers. We were hoping for some other catalysts like the -- we won the AEGIS program with NASA. But unfortunately, that got protested, so we're not expecting that to be something that's a catalyst for second half growth for us. But still bullish on the prospects of that one working its way through the protest process and hopefully something that can contribute to growth next year and beyond. Other than that, Matt, I mean, there's a variety of things. We've got a lot of things in the pipeline, a lot of bid activity. We're hopeful that we'll get some more nice win notifications that come our way. But nothing probably of the size and consequence that we've talked about.

Got it. Got it. So sticking with revenue here for a moment. The guide right now is $13.7 billion to $14.1 billion. You mentioned a couple of ramping programs there. You mentioned COVID-19. Is it just a matter of executing on those programs and COVID-19 sort of shaking out the way you baked it into guidance? Or are there additional things that might need to occur in order for you to get to, say, the top end of guidance?

Well, certainly, to move towards the top end, we would need to continue to see more win momentum, more new start programs, which, certainly possible. We're getting a little bit later in the year for those to have a meaningful impact. So there's always expansion opportunities. Even on a program like NGEN, I told you we're getting to what we see as a full run rate. But there's still a lot of contract ceiling over and above that, right? And so what needs does the customer have? Is there anything in the shorter-term material cycle that could emerge, that could fulfill mission needs for the customer in the near term? Those are the kinds of things that could move us up in our range. But I think that as the year progresses, getting to the top end, it will be a little bit more difficult. And so we like the way we're positioned. We are monitoring the downside risk over COVID, like you talked about. Right now, we've not seen any adverse impacts as far as facilities getting shut down at keys customers locations or inability to fulfill customer requirements for the VA. So right now, we continue to watch that, but things are trending as we hoped.

Got it. Now as I mentioned, obviously, you guys have seen some very nice growth across the first half. Naturally, some of that will abate. That said, if I look at backlog, you're up, I think, 9% year-over-year. If I look at the trailing 12-month book-to-bill, you're at 1.2x. These figures should support some healthy growth ahead. But at times, across the entire government services group, these indicators don't necessarily either tell the full story or can see some disconnect. So what else should we consider when we think about 2022 and beyond in terms of growth? Because like I said, it's not as simple as backlog is up 9% year-over-year, you're going to grow at 9%. There's other things to consider at play here.

Sure. Yes. No, I wish it was that simple. Unfortunately, it's not always that simple. You have to take things into consideration like contract duration. And then are you winning IDIQ vehicles in addition to standard contracts? And how much backlog does the customer ultimately decide midway through to do something differently. So the federal budget process will be important, how that plays out. Some of that will take a little bit longer to turn into adjudication. So we're paying attention to that. The demand signal, though, is really what's most important. And right now, we're still seeing plenty of opportunities where customers have needs, especially on the modernization side. That's where the bigger IT projects are still coming from. There's been a number of those that have come out. We've won more than our fair share, some we haven't won. We still think there's plenty of those ahead of us with the Air Force and the Army IT as a Service opportunities. Defense Enclave Services, this is a big one that could be a growth -- major growth catalyst, right, for somebody that is able to prevail there, and we like to think we're a viable competitor for that. So I see a lot on the modernization side to continue to help our customers move their IT environments forward to help their mission. And then in the other areas, we're seeing in our civilian agency and our health business, those are areas that, with under the Biden administration, have more and more focus and more and more potential opportunities. So we're excited about the prospects across many of our customer sets and where their budgets are growing and how that might manifest itself into near-term outlook. So I think it's -- what's the big budget picture, what's the demand signal? Are we demonstrating an ability to continue to win, right? Do we have that recipe dialed in just right? And I think all of those things are pointing to, yes, we feel good about the growth prospects. The backlog, as you say, is just one piece of the equation. It does help us have a confidence level of a certain amount of revenue that we can then build off of, right, for a growth picture to be more fulfilling.

Let's sort of drill down a little bit into the demand signals you mentioned. A lot of changes in this environment in recent months, recent years. We've got COVID. We've got Afghanistan. We've got the administration change, et cetera, et cetera. They're all sort of creating ebbs and flows when it comes to priorities of the USG. Now how are you thinking about your end market strength right now? And then how are you thinking about reprioritization or prioritization relative to where it might have been? Are there certain areas that are becoming more important or that you see as more important for Leidos and its growth picture ahead?

Well, again, I think we're seeing certainly the benefits of having a diversified portfolio. And we put this together 5 years ago, right? So we've continued to build out our civil and health capabilities, and those are very large and meaningful businesses for us. Not that we ever took our eye off the ball in growing our defense and intelligence business, that's still a huge part of the portfolio. But it wasn't always -- it didn't dominate everything else. And so the demand signal in those particular agencies, it's great when we're seeing the DHS or CISA with major IT modernization, Coast Guard cyber needs, right? So there's no shortage of opportunities coming out of some of the civilian agency customer set, which is exciting for us. And then on the health side, we've obviously had the franchise program and the Defense Health Agency to modernize the electronic health record system. But there's more than that going on. We sustained the legacy environment. Health and human services customers, we're seeing increased demand on the IT side. So security agency, that's been kind of underinvested in for decades. IRS, you're starting to see those guys potentially have more resources thrown their way to help their environments, right? So those are important customer opportunities for us. So those things are exciting from our end market perspective. And then on the DoD side, obviously, there's the IT aspect, which we've had great success winning the Navy NextGen or the GSM-O contracts. But what's kind of most exciting is what's going on with Dynetics, right? So they've -- they're positioned more on the engineering and manufacturing, the weapon system side, really going from proof of concept and prototypes to demonstrating they've got the capability to take things all the way through to a program of record. And that's just something we didn't have before. We had an R&D engine in the heritage Leidos side that did a ton of work for DARPA and Air Force Research Laboratory and other R&D-focused clients, but we didn't have the capability to take those ideas to prototype to production. And Dynetics has demonstrated the ability to do that, most recently winning the indirect fire protection contract in a competitive process, and they'll be able to build some prototypes there. And if that goes successfully, there's a lot of things to happen ahead of us. But that could really turn into a very large opportunity set into the future. They're already well positioned in hypersonics. They're in directed energy. These things are going to be pervasive priorities, we believe, over the next a certain number of years, right, in any administration.

Sure. Yes, it clearly seems like there's an environment out there that still has plenty of demand, plenty of opportunity from an end customer standpoint. However, the other side of the coin is those priorities, those opportunities need to be resourced. And we're getting towards the end of our fiscal year here, and it looks like we're headed towards a CR. Maybe you can just share with us your expectations for budget. Do you see any risk out there when it comes to near-term performance as a result of a looming CR? And just give us your sort of overall view of the budget environment we're currently in.

Well, I mean there's certainly a lot of things to get done in Congress, a lot of legislation to be passed, a lot of bills to push through. That adds an extra level of challenge to the whole dynamic. So that part will be interesting. I mean I think the CR in and of itself is something we've come to expect, right? It's standard operating procedure, unfortunately, for the government. Again, the real question this time is, does anything else get attached to that, that makes it more problematic to get resolved? But we're used to operating in the CR. We expect a CR. Certainly, probably it might take multiple CRs to get to the finish line at this time around. And so we're prepared for that to go on for an extended period. Most of the things we're pursuing, I don't think there'll be a big impact. Critical missions will get funded. Base level activity in most clients is still pretty good. Any of the new start stuff is really what you're worried about. And so how much of that we'll have to rack and stack and see of the programs, and we haven't done all that work yet. That might be tied to new start funding. But I think big picture-wise, CR is standard operating procedure. I expect things to continue on at a relatively good clip. And hopefully, we just don't get into some of the political maneuvering that really gets this thing bugged down for too long trying to push through some of the infrastructure bill activity and the debt ceiling discussions and things like that.

Absolutely. Okay. Why don't we take this opportunity to pivot here and sort of move down the P&L, if you will, and talk margins for a moment. Obviously, levels have been pretty impressive in recent quarters. You're currently trending above your long-term guidance, but that's complicated by COVID, amongst other things. And so when we sit here and we think about normalized margin levels, what can you share with us to sort of get comfortable with where normalized is? And then are there structural reasons why the performance for '21 couldn't, say, carry into '22?

Right. Now that's a good question, Matt. We recognize we've probably made it more complicated than we'd like it to be, but mostly to the positive, right? And there's been some goodness that has rolled through over the last 2 years, let's say, that they've complicated the margin story. I think the COVID impact, we're on the somewhat of the tail end of what that's doing to margins. But it's probably been more upside for most than downside of it, right?

Yes.

So stepping back, when we guided into the year, we expected the margin profile of 10.4% was kind of our midpoint. And we had a favorable Q1, a one-timer in there, some other good news. But 10.4% was kind of the level to think about. And 10.4% is exactly what we delivered in Q2 on the EBITDA margins, right? And that's kind of where the midpoint of our guidance would point you for the back half of the year. So a lot of signs are saying, hey, 10.4% feels pretty good as a normalized jumping off point. Now the only challenge there is, as part of delivering 10.4% margins as we've got this health business that's working off a backlog of medical examinations, that's helped us with some good margin performance out of health. There's some other things going on there. So how sustainable is that? So that's one of the things that, as we move into '22, if that puts any downward pressure on margins, what do we have to offset that? And that's what we're highly focused on, right? And there's a number of things that we're talking about internally and looking hard at the business of what we can do. And without making any compromises, we still want to heavily focus on the research and development side and allocate all the resources we need towards new business activity. So no compromises there. But I think there are levers that we'll continue to turn, and not just for '22, but moving ahead beyond that. Facilities optimization is one big one, right? So there's other things like that. But I think 10.4% is the number that's reasonable to think about. A little bit of downward pressure from when the exams roll off, and then it's our job to figure out a way to fill that bucket back up and keep it at that level going forward.

Got it. Got it. That's good insight there and very helpful. I want to jump over to M&A here for a moment. You mentioned Dynetics earlier and some great opportunities and some great wins for them of late. But that's obviously not the only deal that you've done in recent quarters or recent years, 901 -- or 1901 Group, Gibbs & Cox, et cetera. What can you tell us about these deals in terms of maybe, one, why you did them? And two, how they've performed thus far and what they bring to the table for you as Leidos?

Sure. So we start with Dynetics because we've been talking about that a little bit. Obviously, it was -- it brought us a number of things, some of which we talked about: the engineering capability; the manufacturing capability to take ideas, prototypes, the programs of record; depth and technical talent on cyber and other areas; kind of presence in Huntsville, quite honestly, that we didn't have. It's an important market, important customer down there. Multiple customers down there with the Army customer and the NASA customer. So again, all those things made Dynetics really a great opportunity for us. And we've been very pleased with their performance. The only negative with Dynetics is we had a [ blue bird ] with the human lander system where we got a big program. We worked on the option period of the human lander. That was a nice piece of revenue that will be nonrecurring because, unfortunately, a couple of billionaires came to the party. And it looks like they're going on different direction on the option A phase. But nonetheless, all other aspects to the Dynetics, we couldn't be happier with how they're doing and see good prospects still ahead of us there. 1901 Group, you mentioned that one, too. So that was a smaller deal and more strategic to enhance our IT delivery capabilities. How do we get from a people focused set of activities to a process and tool focused and as a service model. They had figured a lot of those things out. They've developed great customer relationships. So that's a deal that sponsored by our defense group, but really, we're finding a lot of synergies across the enterprise, a lot of opportunities to pull them in to more and more of our IT modernization bids in the civilian agency side, potentially also in the health side. So I think that's -- how that one continues to evolve, hopefully, it will be a modest contributor to our revenue but more of a contributor to an enhanced delivery capability that should enhance margins over time, right, getting more efficient in how we're delivering those things. I really like the team there. Excited about that particular prospect. Gibbs & Cox, that one was strategic because, from a Navy customer perspective, we didn't have as much penetration and access as we would like. And now we won the Navy NextGen program, which gets us a lot more access on the IT side, which is great. The Gibbs & Cox team, they're viewed as a strategic asset for the Navy and have a lot of different capabilities there, long-term relationships, well-run business. And we just thought with where we want to go, we have a maritime business to especially focus on long-term prospects like autonomy, undersea. And so how do we leverage the Gibbs & Cox capabilities on the engineering side, the customer access side with some of the things we were doing more strategically with where we thought the maritime world was going. And it was -- it made a lot of financial sense to pursue that strategy. And the last one would be, not to finish this one with a downer, but the Security Detection and Automation business. I mean that one, we've always been in the security products business for a number of years. And we've got a well-run piece of business that focuses on ports and borders in our portfolio. And we have been looking for a long time of how do we gain some scale in that particular line of business. And properties like that aren't always available. This one came up. We still like the long-term prospects. But obviously, COVID has had a bigger impact on the aviation market, especially international. So the SD&A acquisition at this point in time is not where we would like it to be. But again, that recovery horizon, it's probably pushed out a little bit. We see by 2023 that, that should bounce back. And again, there's just a lot of synergies with what we were already doing and what that brings to the table and some prospects to continue to build off of that going forward. So that's why that one made a lot of sense. It wasn't like entering a new market. It was something that we were already doing and how do we put together more critical mass to leverage the global service and delivery network, sales network, those type of things.

Sure. Sure. I mean, it really looks like you guys have added some interesting capabilities with these 4 most recent deals and continuing to evolve the Leidos portfolio. As you sit here today and you look at that portfolio and then you look at the M&A pipeline that's out there and I'm sure also evolving, are there any particular areas, any gaps, any channels to market? Or what can you tell us about the pipeline as well as your needs to help us think about where you might take your M&A program from here?

Well, I would -- so we definitely have a team focused on what's out there in the market, what's going on, what's the deal flow look like? So we kind of keep a constant watch on that. And so we pay attention to any properties that we think might fit a strategic need. Because for us, that's really where it all starts. It's what's our strategy? Out of that strategy process, did we identify any gaps on the customer access side or on the technology side? And okay, how does an M&A opportunity help address those things? Right now, our priority is 4 deals, various stages of integration. Let's get that right. Let's nail that down. We're getting closer on some of those. There's still work ahead of us on others. And we're also not where we desire to be from a leverage perspective, we're very close. But we kind of committed to getting back to 3x debt-to-EBITDA leverage ratio, and we expect to be able to do that certainly early part of next year as we repay the financing we took out of the Gibbs & Cox. So in a perfect world, those things would line up nicely. We check a few things off the to-do list and then we would look and see what's next on the M&A frontier. It doesn't always line up from a timing perspective that perfectly, so we pay attention. And I would just say, I'm not going to tip our hand on what's most strategic to us. But what I've seen is more companies out there have made moves to gain presence in markets that we already had a nice presence in. So certainly, competition is stepping up in certain areas, we recognize that. So there's something we think we need to do from a customer access perspective per se, but something that complements what we already have going on, whether it's add more cyber capabilities, analytics capabilities, production capabilities. If it's something strategic on the Dynetics front, those kinds of things would potentially be in the conversation.

Got it. Got it. That's helpful. Maybe we can just, for a moment here, jump back to COVID-19. We talked about it earlier, more in the context of the impact this has had on your end markets and sort of some underlying dynamics with respect to revenue. But I want to talk about it a little bit more in the context of the economics of the business on a go-forward basis. We've been operating in this environment for 1.5 years now. There's obviously some learning that has gone on. There have been some adjustments that have been made to businesses. And as you go through your annual planning process as well as your longer-range planning process, I'm sure that you look at the current setup and say, well, some of this is going to stick around and some of this is going to go away. So my question to you is, as you sit here today and you think about the changes you've made to the business and the sort of underlying economics of the business, do any of the changes that have been made or that you're considering making change either the profitability or the cash flow or any other aspect of the underlying business on a go-forward basis? Or is it simply just, hey, even if we change our business structurally, we do a lot of cost-plus contracting and all sort of return to normal over time?

Yes. I don't think there's anything that just is going to look well that's totally different that comes out of this. I mean there's definitely some efficiency opportunities that are out there, no doubt about it. And we'll look to capitalize on those. I've mentioned briefly, facility is being one. And I'm sure anybody in our space, in multiple spaces are looking hard at their facility footprint and what their needs are over a multiyear horizon. We're no different. So that should be something we can gain efficiencies from. How we go interface with customers at trade shows, I think some of those things will structurally change and realize that, hey, you don't always need to go set up the super ginormous booth and spend a bunch of money and send 100 people to all these trade shows and key events. We'll do that more modestly potentially. So some things like that will change in about in half the employee side, right? I mean what's important to them? Not only just the freedom to work remotely or virtually, but they're going to have different thoughts coming out of COVID. And some of those might put different pressures on company to take some of the resources they were investing in facilities, for example, and make investments in other things that are more important, right? So that's why I'm reluctant to say, hey, there's a real opportunity to drive improved profitability out of all this because I recognize that we're still a people-based company. And the most important thing is to have the talent we need to be successful. So I'm willing to make those investments. I don't expect to let this erode our profitability. But I'm certainly not going to commit that there's uplift at this point in time until we make sure that we're doing all the right things to drive high retention of our talent and we continue to attract the right people we need to grow the company.

Got it. So actually, to that point, nice segue into human capital here. We're in a very tight labor market. You're a people business at the heart of it. It's the talent that allows you to execute on programs, allows you to ramp the top line, et cetera. It's fundamental to the business model. So what are your observations with respect to, one, the labor market in recent quarters? And then two, as you think about your ability to grow, does this become a gating factor at some point? Or does it weigh on your ability to grow, just given the tightness of the market right now?

Well, certainly. So I think it's something we pay a lot of attention to. We spend time each week in our leadership meetings focused on how we're doing on the hiring front, and as importantly, how we're doing on the retention front, right? You want to keep the people that you've got. Are we doing all the right things to make sure that, that metric is where it needs to be. And that -- in all levels of the company, we're paying attention to it. So I mean, in pockets, we're certainly seeing some labor aspects that are finding great opportunities. It's a little bit more challenging. I wouldn't say that's pervasive, but I would say specialized skills, high technical capabilities, maybe it's clearances. If you find a few people that have that, they're in high demand and they're getting offers out there that are tough to compete with at times. But big picture, we're still successful in bringing a lot of people into our more than 4,500 new hires in the first half of the year. We'll continue that trend in the second half, we believe. It does help when you win large takeaway programs like an NGEN. You're able to go after a workforce that's kind of already in place and many of those you want to bring over. So that has helped our success. And it also helps having -- we talked about Dynetics earlier being in a market like Huntsville, which is still a tough labor market. But when you're working on the cool things that the engineers really want to go be part of, that attraction is really important. And Dave King and the team down there have been able to find really good talent because they want to be a part of that. And so that's what we strive to have going on across the company. People are passionate about the work we're doing, our mission, and they really identify with that. And that becomes one more factor to attract and recruit paying people. And so demonstrating those values, living the mission, highlighting that, featuring that is all part of the equation. But at the end of the day, we will continue to tighten in the labor markets. And we have to have strategies like finding alternative locations. We've employed that before. Stood up software development teams in different geographies outside of the national capital region, that's been very effective. And maybe one more positive out of COVID is more of our customers have shown a willingness to have delivery of IT services especially done differently. So it gives us more degrees of freedom on how we could perform that work and where we can hire the people. Not in all cases, but in some, which is great.

Got it. That's good context there. I appreciate it. It looks like we're up against our stops here, but I do have one more question for you, Chris. You've given $1 incremental dollar of IRAD or $1 incremental dollar to your M&A program. What tech are you going to place it on? Where is your bet going to be?

Oh man, you're giving me way too much credit for my technical chops here.

Oh, come on.

Listen, I mean, I love to spend time with our CTO team. Unfortunately, they don't just ask for that $1 incremental dollar. It's usually a bigger price tag than that. And so what I've seen most recently, again, on the cyber side, from an offense and defensive perspective, I think there's a ton of demand there, right? So it's going to be some skills that are really focused on continuing to augment that capability that we can deliver to our customer, if I had to place $1 of bet because I think we have the best opportunity for a near-term return. But like I said, I don't think I can get anything done for $1, Matt, but I'll...

Fair enough. Fair enough, Chris. I appreciate the answer. And I appreciate you spending some time here with us this afternoon. Look forward to doing it again. Looking forward to your Investor Day and seeing you guys soon.

Great. Thanks for having us today. Thanks so much.

Sure. Thanks. Take care.