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

Okay. We're going to get rolling here. Welcome, everybody. My name is Matt Sharpe. I'm Morgan Stanley's government services and technology analyst. And just before we get going here, I do have to read one disclosure. For important disclosures, please see the Morgan Stanley research disclosures website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. With that, it's my pleasure to host Chris Cage, Executive Vice President and CFO of Leidos. Chris, welcome.

Matt, thanks for having me. Glad to be here. My pleasure. My pleasure.

Chris, I want to start sort of high level on the company. Would you maybe briefly just touch on Leidos' customer mix, its core capabilities and how it goes about differentiating itself relative to some of the other government services peers.

Sure. No. Thank you, Matt. So Leidos is over $14 billion of top line revenue on a trailing 12-month basis. We've got guidance out there this year. We've been in a growth mode and expect to continue to grow through the balance of the year. We're diversified. Our 3 main customer-facing segments are the Defense Solutions, civilian agency customers and then our health markets. So -- and each one of those is very robust, north of $2.5 billion in each segment. Defense Solutions is further broken down. We've got intelligence customers. We've got core DoD customers. And we've got some of the emerging customer areas within DoD and the rapid capability offices, DARPA, et cetera. So a lot of advanced capabilities. IT modernization is probably 1/3 of the portfolio. We've got another kind of 1/3 is more of the legacy operations and maintenance support services. But then really kind of the other 1/3 is around integration, mission systems integration where you're talking about products, networks, capabilities, where we're leveraging technology to kind of provide differentiation in areas like autonomy, force protection, hypersonics, et cetera; security product -- aviation security products, a number of submarkets that we're in.

Got it. Great. So you delivered some real strong performance in the first half of the year. You reiterated guidance at the latest earnings call. Talk to us a little bit about the balance of this year and what that holds and what the exit rate might look like heading into 2023.

Sure. So as I mentioned, we put out guidance for the year of $13.9 billion to $14.3 billion of revenue. At our last earnings call, we communicated it was more likely that we'd be in the upper end of the range on revenue guidance. So have grown over 4% organically in the first half of the year. That would suggest a slight deceleration in the growth rate in the back half of the year, but we're still seeing a lot of significant opportunities ahead of us and actually some significant program wins, which aren't yet contributing any revenue. So those will be catalysts for growth in 2023 and beyond, programs like our largest ever win Defense Enclave Services, right? So that was an $11 billion single-award IDIQ. We're going to modernize the fourth state DoD agency network environment, and that will have a multiyear runway where we're migrating customers to that new environment. So this year, we'll be on a nice growth trajectory. We see opportunities to accelerate that growth rate kind of going into 2023, a lot of programs that we're really excited about in the Dynetics portfolio. Our health business has been a strong growth catalyst, so across many fronts. We're in a good budget environment. That helps as a positive backdrop.

You mentioned you're going to be in that upper half of your guidance range. Maybe you could just talk a little bit about what the risks and opportunities are around the range, what might push you up, what might push you down? What can we sort of observe as outsiders?

Sure. So it's getting later in the year, and so when we're at this time of the year, there's not a lot of new contract award decisions that are going to make a meaningful impact on 2022, some, but it's -- they're more positioning for the future. So I'd say, at this point in time, as we navigate the government fiscal year-end, are we seeing customers with budget capacity that want to generate increased demand on existing programs? So we call it on-contract growth. And so we have several large programs that we're well positioned to provide additional capabilities to customers, for example, like our Navy NextGen program as they look at turning on different project work to modernize the environment, that could provide a growth catalyst. Same thing as we're ramping up our brand-new NASA AEGIS win, right, as we work with the customer on potential additional capabilities there. So mostly, we will be driven by expansion on existing programs. The hiring environment will continue to be a factor as it relates to the revenue volume and just making sure we maintain positive staffing environments on our particular programs. And beyond that, one other factor would be what's happening in the health market. On a positive development for Leidos, the legislation that recently passed, the PACT Act, provides for increased disability examination and benefits for our veterans, which we prosecute a large number of examinations and claims for veterans today. So that will actually increase the demand signal for veterans as they have more presumptive cases that would qualify for disability benefits. So that's the catalyst that could push us towards that upper end of the range as well. So I mean all things considered, we're kind of coming to the end of the year where it's a little tighter range. I would say more things are encouraging than things that have not gone our way. So we're feeling really good about the guidance range.

Great. Great. With that as context and your view going into 2023 still being very constructive, I wanted to touch on sort of an industry-wide observation that we made, right? Looking at 2Q, in particular, bookings across the group were rather light no matter how you measure it. Whether it's on an absolute basis, seasonally adjusted basis, there's been a bottleneck in government in terms of getting contracts out. What else should we be, as analysts or investors, looking at to help frame the growth to date in '23 and beyond, simply just say, here's my book to bill or here's my backlog?

Well, that's a very fair question. And I would say it's difficult to point to the tangible factors. I mean one of the things that, in our industry, most of the contractors have a large percentage of cost reimbursable type contracts in their portfolio as do we. It's about 50% of the mix. So what you're seeing on just the normal inflationary salary adjustment side is going to pass through and provide contract growth in that part of the portfolio, ordinary course, right? And so some other contracts you might have inflationary adjustment opportunities as well on your fixed price and T&M. But the bookings environment, I think you have to look longer term. So quarter-to-quarter, it can be difficult. But I think if you go back and you look at -- we pointed people to more of a trailing 12 months. What's happened over the course of the past year, from a bookings perspective, and is that positive? Is that above 1? How much above 1 is that as an indicator of where the growth trajectory should be going? And so while we would have liked the second quarter to be more robust, it wasn't. I do think there's a fundamental issue as a government customer of getting the money that's been appropriated, if you will, on to contracts. There's maybe some indication that's modestly improving. It's not where it needs to be. I think we'll continue to see progress on that over the next handful of quarters. But generally speaking, the big picture, the budget environment is positive. There's a lot of needs out there. Demand signal's high. I think that will be the case as we go into the government fiscal year 2023 budget. So those things lend themselves to a positive backdrop for growth for contractors.

Do you see some of the bottlenecks alleviating in a material way as we're at the high watermark or the end of the government fiscal year where, traditionally, we see August, September has a big surge, couple that seasonality with the fact that we did have this pent-up, whether it's adjudication or RFP environment. Is there a flush here? Is this quarter higher than seasonally?

No, I think we're not all the way through it yet, right? So a lot can still happen in the end of the last few weeks here. Like I said, we never expected it to be a budget-flush season. We expect it to be a good quarter for us and for the industry at large. I think that's the way it will play out. I don't perceive it to be a blowout quarter necessarily. And that's okay, right? I mean I think, again, the longer-term signals are still good. We'll get some things resolved. We'll get contracts moving. But I don't think the government solves all those problems in that short order as far as having the qualified contracting staff to move procurements along and they're being very deliberate in the process too because they understand that the protest windows -- we've seen a lot of protest activity, generally speaking, in the market, and they're trying to do all they can to prevent that. So -- but the deliberateness and maybe the staffing challenges, I don't think the problem is solved just yet, but we're seeing some improvement.

Some of the other sort of changes in the environment, whether it's the withdrawal of Afghanistan a little over a year ago, variants of COVID, transition of the administration, et cetera, et cetera. Have you seen any shift or reprioritization maybe of where dollars are flowing? And how does Leidos align to maybe some of those shifts?

Well, I mean that's the one thing we really like about our portfolio is it's balanced across multiple customer segments. And actually, what tend to be happening is, as we've seen some challenges politically and some deadlock, trying to get legislation passed, what's happened more often than not is compromised and where the Ukraine war actually stimulated more interest in maintaining and growing our defense budget, what we're seeing to kind of get that through the Democratic side is an equal amount of growth on the civilian agency customer budget. So right now, I think all customer sets have seen substantial budget growth. Priorities will continue to be modernizing their IT environment. I think that there's still plenty of runway left in customers to help them bring those environments forward, protect them better from a cyber perspective. But clearly, when you get into the DoD and the research and development budget environment, we're definitely focused on the great power competition, kind of long-term capabilities as it relates to the China fight. You see DoD [ breadth ], talking more and more about that. And that's where you want to be positioned, is how do you play in that particular scenario, which is why, again, we've got some capabilities we're excited about coming out of the Dynetics arena that position us well there. So I think it's that next-generation fight. It's IT modernization. It's optimization of some parts of the portfolio. But generally speaking, a lot of the customers are in a quality budget environment. I think that's going to be the case for the next few years certainly.

Got you. Got you. Maybe we could just think about -- shift gears here a little bit and talk about profitability. When you think about the portfolio of capabilities as it's constructed today in the context of adjusted EBITDA margins, your target for 2024, I think you said 10.5% plus. There's a lot of moving pieces, whether it's the abating sort of support from COVID-19, right, indirect versus suppressed, et cetera. Do you see a world where you go lower before higher, one? And then two, what levers do you have to pull on here to drive north of that 10.5% mark?

Yes. No. Thanks, Matt. So -- and we set a target out there. Obviously, we feel like there were a number of paths to potentially get there. We didn't want to overcommit, but I mean there's some work ahead of us. Even though we're close to that number today, we guided to -- we're probably headed towards the low end of our guidance, call it, 10.3% margin today. But what needs to happen for us is we have seen and we still expect margins in our health business to moderate down a bit. We're not all the way through that, right? So we've been signaling that for some time. The good news is we've been still generating higher margins. But again, as the dynamics of several contracts play out, that's going to come down a little bit. Meanwhile, we've been working hard to drive margin increases in our Defense Solutions and Civil portfolios. And we see the line of sight on what it's going to take to get there in our civilian line of business. It's a multiple of things, but one of the big drivers will be what happens in our security products business. Our aviation screening market, our ports and border screening market, and again, that market has been depressed through COVID. We have seen some positive signs that there's some market demand that's returning, but we've continued to communicate 2024 as when we expect that to be back in a more meaningful way, right? So that's a tailwind on margins where the product, coupled with the service and software upgrades, are tend to be higher margin than some of our other services business. On the defense side, we see a number of opportunities to drive margins higher with our Dynetics portfolio. We have some force protection programs. We have hypersonics programs. We have small sat payload programs. Each of those, as they progress from kind of lower rate production to increase production, hopefully, as we get through various phases and hopefully receive additional contract awards and expansion, have opportunities to grow that margin profile. We just were with our team this week in San Diego kind of getting a briefing on where those programs are and they're working really hard, making the progress that we need to see, and this will go through 2023 but again, setting us up to hopefully be in a position to capture the follow-on low rate production, full rate production. So very bullish on those business areas. And then on some of the digital modernization programs that we've won, we typically seen in a 8- or 10-year program, year 1, year 2 are not going to be your best margin years, right? You're coming in. You're doing transition. You're bringing over incumbent workforce. You're evaluating the environment. You're looking for opportunities where customers need expanded capabilities. And so all those things tend to play out. As you get more familiar with them, they get more familiar with you. And so that's why I feel bullish on programs like Navy NextGen, GSM-O, ultimately, DES, we'll have opportunities to drive our margin performance better over time.

What about inflation play as we think through the profitability dynamic? And what mechanisms do you have to maybe deal with some of the impacts of inflation?

Sure. So I mean inflation is real. I think everybody is dealing with that in the industry. Again, this goes back to the good news is we have a large portion of the portfolio that is in a cost-plus environment. That's helpful. So you're looking at strategies to mitigate the impact on the rest of the portfolio. And that's through a number of things, right? I mean it starts with how we're pricing new work, and we update those pricing rates every so often. And so we're trying to be thoughtful around where we see that going as we price new work. You're working with customers on making sure you have the right clauses in the contracts to potentially have opportunities to reopen discussions if circumstances change significantly. And then you get into how you execute on the particular contracts. So sometimes taking on fixed price or time and materials work, you got a little bit more flexibility on how you deliver outcomes for customers. And so you're trying to be thoughtful there too. But I mean I do think this is such a situation, it's challenging right now. It takes away some of the typical levers you might see that can drive margins higher. So that's why, to your earlier question, will margins go lower before they go higher, I hope not, but that's possible as you navigate an environment like this. But at the same time, you look at it and you go, okay, we're on the -- we've been in the middle of this for some time now, and we're still within our margin target range, right? So it's having an impact, but it's not a significant impact. I think to keep that in perspective is that it makes things more challenging. But hopefully, we're seeing a scenario in 2023 where that begins to moderate down to something we want.

Got it. Leidos, over the last several years, made some interesting acquisitions. So I want to touch on those. You mentioned Dynetics as one of them earlier. Maybe you could just talk a little bit about Dynetics; most recently, Cobham Aviation Services as well as Gibbs & Cox and 1901, how have they performed? What did you gain from each of them? And why were you pursuing them?

Yes, I think -- I mean, first of all, when you have to -- when you look at acquisitions, you do have to take a long-term perspective. I think you're buying some of these companies and you're not looking at did I get my return in year 1 or year 2, right? You're there for the long haul. And I think Dynetics is a perfect example of that. We acquired a company that gave us significant presence in Huntsville, which we did not have. It gave us closer access to critical customers in NASA, and so not only has that proximity to NASA helped us with what the Dynetics team is doing directly, but it also helped position us to win a digital modernization program on the AEGIS program, right, where I would tell you some relationships that were really important. But Dynetics, again, they're looking at bringing what Leidos had done historically in looking at development stage program or idea generation, doing work for DARPA or Air Force Research Laboratory and having really smart people come up with some concepts. Dynetics brought the capability to extend that into a prototype and then ultimately low rate and full rate production. And we're seeing that now, like I mentioned, space payloads, very excited about what the team is doing to advance technology and increase our production rates. And so that's what they brought, is the agility, the engineering talent, the agility, the affordability to solve some hard challenges on emerging needs for customers and Dynetics has been able to rapidly deliver in that regard. So we've got a number of things we're excited about. Not all of them will probably, what they call, bridge the valley of death, they go from technology readiness level 7 to 9 or 10, right? But we're very bullish that there's a number of different opportunities that they bring to bear and get us into customer areas that we weren't as well finished with, which is a similar story for the Gibbs & Cox acquisition. The Gibbs & Cox brought us maritime architecture engineering capability, and so we were excited. We've done some work with the Navy on the autonomy side, but Gibbs & Cox really brought to bear qualifications, deep engineering and talent well embedded with the customer. And as we see the Navy, continue to look and evaluate what their autonomous needs are over time, and that's one area that gives us kind of the full spectrum capability from the design and the engineering talent to bring those concepts to reality, partnered with key shipbuilders over time. So we really like Gibbs & Cox and maybe was an underpenetrated account for us. So that's another thing we look for, is what customer access does this create for us and how can that be leveraged across some of our other offerings. So we're excited about that one. And again, I think the best days are ahead of it because we're early -- it's early innings. They've had a couple of nice wins. The DDG(X) contract is not yet ramping at the pace we'd hope, but I think that will see itself grow into 2023 and beyond and be a nice driver for us. You mentioned Cobham. That's the latest deal and it hasn't closed yet, so we'll be a little bit reserved on what we can say. But what we liked about it, certainly, we're in Australia. We have an international footprint, predominantly in the U.K. and Australia. The Australia business for us today is growing. It's attractive margins. It's well run, right? So how do we leverage that asset and extend its capability? This particular one got us into a part of the customer set that, on the mission side, that we didn't previously have access to. We did a lot of IT work for them. We did some mission work, but this really extended that with the border force and other parts of the Australian Ministry of Defense. And you look at, again, back to the great power competition, the long-term demand signals, Australia is certainly going to be interested in securing their nation border protection ISR-type capabilities, which we felt this platform certainly provided. And you couple that with the fact that this is work that we do for our DoD customer on the Army side today, so we have people that understand it, can manage it and puts us in an attractive growing market area, which is great. And finally, 1901, that was a capability. It was a smaller transaction but really brought as-a-service capability on the IT side, on the cloud migration side, and we're seeing some of these mega contracts that we've been successful in winning and really more of a demand signal across both the DoD and civilian agency customer set. 1901 was a natural extension of our capabilities that will allow us to probably do a lot of that work more effectively and affordably. And so it's less of a growth catalyst, but more of a capability and margin enhancement capability over time. So we're happy to have that group as part of the team as well.

Will the company remain acquisitive? Or how are you thinking about your pipeline of potential targets given, I think, you're a touch over your 3x leverage target going into the back end of this year?

That's right. So we've done 5 or 6 deals over the past 2.5 years or so. And we are -- stated a leverage target of 3x debt to EBITDA. We're slightly above that now in 3 years so. And we expect to be -- we're on a path to get down to that leverage target early next year, first -- or late first, early second quarter. So I mean that's certainly a priority for us, is to deliver on that commitment that we've made to our rating agencies and just generally speaking to our shareholders. I think we'll continue to pay attention to what deals are out there. I would say, at our size and scale, there aren't a lot of compelling gaps to execute our strategy. But when we see something that can accelerate that or as I mentioned earlier, give us some additional customer access, we will pay attention to that. I won't get into the areas that we're most interested in. But our deal team understands that, and we look at deal flow. But we're going to be disciplined. I would tell you that we're going to be very disciplined, look for opportunities that we think we can generate a reasonable return on. And if we don't find those, we've done some investments organically to drive growth. Our CapEx has been pretty well behaved. But at times, you'll see us make a move from a capital investment perspective that we think can generate a quality return. But absent that, we're happy to do share repurchases. We think that's great value for our shareholders if we're able to do that. So that will be part of the capital deployment thought process.

Is there a framework or any sort of target levels across Veritas Capital deployment channels that you look for? Or how do you think about trading amongst them?

Well, I wouldn't say we've gone so far as to set targets, if you will, as far as how we want to allocate the capital. What we've done is that organic growth is most important. So we'll look hardest at areas where if we're going to invest in new lab space or a new prototype equipment for demo purposes or what have you, right, like new airplanes to run ISR missions, we think those give us the best opportunity for a great return. That will be part of the priority. But so far, that's a relatively modest amount of the free cash flow, the operating cash flow that we generate. And we've sized that to approximately 1% of revenue. We've got a dividend program, and that is something we look at, at least annually to make sure we feel like that is attractive and relative to kind of our peer group. So that would be another priority on capital deployment. And then beyond that, it really gets to absent a compelling M&A need or gap filler or value creation opportunity, it's going to be more of share repurchases would be part of the priority set.

While we've still got a little bit of time, I want to touch on one trend or one dynamic within this market that's been growing in importance and that's human capital. It's always been important, but given the tight labor market, all the more important. Your 2Q earnings, I think you had noted the environment or at least your hiring trends were fairly robust quarter-to-quarter. We're north of 2/3 of the way through this quarter. What have you seen thus far? What can you tell us about that environment and how it's trended?

Yes. No, I would say, look, what we try to do is make Leidos an employer of choice, right, create a good environment, have great values, tone at the top, live those every day, take care of our people, be flexible, be accommodating, give them career growth opportunities, invest in them. And so that is the message that we're trying to send to people as we bring them onboard and talk to them about opportunities with Leidos. And that's the same message we're trying to send to the employees we have today. So we've absolutely been able to create a pipeline of talent that's interested in joining the company. And what we've seen internally is, yes, attrition this year has been higher and as for the whole industry and kind of globally, right, than in years past. And we would like to see that come down, and we've been working hard to share those messages and live those messages. And we're seeing -- definitely seeing an inflection point where it's not getting worse. It got slightly better. It's holding steady, but it's still above where we'd like it to be. So that's been kind of the primary focus is doing all the right things, continuing to evaluate our compensation structure, our benefit structure. We're making the right investments in our people. But talent attractiveness has been still strong, and so the hiring engine has been running hot. And so again -- and we've seen a little bit more normal behavior on the wage side. I mean we're still elevated with inflation, but I think that is kind of moderating a bit, too. So all those things, we have 44,000 people today. We'll continue to grow headcount, but there -- we could put another approximately 1,500 people to work tomorrow if we could fill all the open billets. And some of those are specialty positions. They require a top-secret security clearance, et cetera, right? So not every position is easy to find talent for, but we're working that on a day-to-day basis.

Great. Great. I'm going to sneak one more question in here and that's this, one incremental dollar of IRAD, where would you put it?

An incremental dollar of IRAD, I feel like I get asked that question all the time from my technical team who wants more dollars. Look, there's a lot of things going on that are really exciting. We're doing some really cool things in the cyber protection arena, quite honestly. And I know that has a compelling value proposition across a number of customer sets and I just -- we just met with our team this week that's focused on electronic warfare and finding talent in those areas. They're super compelling opportunities in that particular arena and then AI/ML. So I'd have a hard time choosing between what we're doing on advanced analytics and the AI/ML capabilities. Advanced cyber offensive and defensive capabilities are super compelling. So I trust my CTO. I'd give it to him and see where that takes us.

Target-rich environment.

There you go.

There we go. Well, we're up against our stops. Really appreciate your time. It's been a great conversation.

Thanks again, Matt.

Thanks for joining us.

Appreciate it.