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

Good morning, everyone, and welcome to the Aerospace and Defense track at the 2024 JPMorgan Industrials Conference. I'm Seth Seifman, the aerospace and defense equity research analyst for North America, and we are very pleased and grateful to have Leidos here with us this morning. And so we have Chris Cage, who is the CFO and we have Stuart Davis from IR as well. And we've got -- I guess, I'll ask a bunch of questions. I'll open it up to all of you to ask some questions as well. But maybe to kick it off, I'll turn it over to Chris. Thanks for being here. And Chris, maybe you want to kind of set the stage for us with a couple of minutes about how things have been going recently at Leidos.

Sure. Seth, appreciate it. As always, thanks for having us out. So as Seth mentioned, Leidos, CFO and we've been on a nice run. What's happened over the last year is a new transition to a CEO, Tom Bell. So Tom has come in and helped put Leidos on an excellent trajectory as it relates to steady performance, improving performance on a growth and margin trajectory. One of the first things that Tom undertook last year is to look at the organizational alignment, and we made some changes going into '24, so our fiscal year '24. So if you followed Leidos, you'll see that we've now reorganized into 4 new segments focused on our health and civil business, our national security and digital part of the portfolio that does a lot of mega programs in the digital modernization space and a lot of work for our defense and intel customers. And then we've organized all of our defense systems work into a common sector and segment. You'll see that in our external reporting. And that is built around the Dynetics acquisition that we did 3 years ago, coupled with some legacy heritage, maritime and airborne assets that we've got in the portfolio. And finally, a commercial and international piece of the business. We've got some exciting parts of the portfolio that focus on work for utilities and energy customers, coupled with our security detection work, and that was brought together with the international lines of business that we've got at Leidos. So excited about those new organizations hitting their stride in '24. This is a big strategy year for us. So we're going to be deep diving into those lines of business and figuring out what does the next horizon look like as it relates to areas that we want to have increased investment in area of focus. But we're excited in the meantime to continue to deliver strong margins, revenue growth and cash conversion as we were able to close out 2023 on a high note. So with that, Seth, we can dive into your questions.

Excellent. Excellent. It sounds good. Well, I'll start off, just to be very topical. We saw the DoD budget release yesterday for fiscal '25. So 1% increase. I don't think it was very surprising to anyone that was what was required under the Fiscal Responsibility Act. But if you think about what was in there for Leidos, as you think about kind of wrapping up 2024, how do you see the budget playing out for Leidos?

Sure. Well, you're right. I mean, I think we looked at that the same way generally as expected, the President's budget request. And I think we all know that there's a long way to go before that gets turned into appropriations in '25. We're focused right now more on the near-term activities. And the good news is that we've got some bills put in place to fund the government -- several of the agencies, the most important to us being energy and the Veterans Administration. So those budgets are in place now. And now we're turning our attention to what happens between now and March 22 for the DoD, Homeland Security and the other agencies. I'd say our optimism levels increased, having gotten something done. Speaker Johnson has taken some heat. But hopefully, again, we'll see that momentum carry forward. And basically, customers want to see budget certainty. It's less important whether the President's budget request is 1% growth, 2% growth. It's more of can we get something done? Is there a certainty? Can we move forward on mission areas? Leidos has shaped the portfolio to try to be in the areas that are better protected from a budget perspective. We feel that continues to be the case. And it's not just growing with the budget. We've historically had a lot of success taking share. As we look at our pipeline and opportunity set, there's plenty of areas to grow in addition to just growing with the contracts that we've got today. So we'll continue to pursue those growth strategies as the year unfolds.

Excellent. And so it was interesting to see the resegmentation of the company recently. So it's good for analysts. It gives us something new to [indiscernible] exactly in our spreadsheets. And so the biggest segment at the company now is national security and digital. So can you talk a little bit about your sense of kind of the long-term growth rate in that market, medium to long-term growth rate in that market. And then how you think about Leidos' ability to participate in that growth?

Sure. So you're right. Our largest segment, national security and digital, which actually includes a third component, we call it our Leidos Innovation Center. So some of our leading-edge innovation work that we do for agencies like DARPA and Air Force Research Laboratory is a small part of that, too. So there's a lot of compelling capabilities that exist within that segment. The national security part obviously, is going to benefit from defense budget. And given that there's bipartisan support for growing the defense budget over the intermediate time horizon, I think, that's well positioned. And there's strong capabilities in there with things like cybersecurity work that we do on the offense and defensive side, logistics support work. We won a nice contract last year in that arena, and we've got several others to kind of build around. But the more exciting part of the portfolio is still the digital modernization piece of that. And there is, again, continuing need to help our customers run their network environments, operate their IT environments, modernize, migrate certain agencies to the cloud. So there's no shortage of demand signal in the IT digital modernization space. We've won some very large programs that kind of underpins our capabilities there. And that's -- whether that's the Navy Next Gen or the work we do for NASA, where we're the biggest IT provider, Social Security Administration, and the list goes on. Bringing that all together into one organizational unit for the first time, I think, is going to unlock a lot of additional potential. So we had a number of these programs sprinkled across our portfolio. bringing those together now under common leadership, we'll get a lot of leverage on things like how we leverage our technical depth on the bench and how we create and reuse repeatable solutions for customers and how we partner. And so there's -- that's an area where there are several partnership opportunities that we've announced in the past, and we'll continue to look for innovative partners such as -- we announced something last month with [indiscernible] on generative AI-enabled software development capabilities that we can deploy for our customers there. So a lot of that work is going to take place in that national security and digital part of the portfolio. And that should continue to be not just a steady grower for us, but we see some margin uplift potential over time as we optimize those repeatable solutions in the DigMod space.

Okay. Yes, you mentioned partnerships. I think it was last week, you guys announced a collaboration with Amazon Web Services. And there's always, I guess, a lot of focus when you see one of those big tech kind of cloud providers. How does the relationship between Leidos and AWS work? And is there anything you'd highlight with regard to this announcement in particular to be aware of?

Well, I just think it just incrementally supports the long-term relationships that we've had. And let's be realistic. We're not going to be exclusive with AWS. There's a lot of providers that they'll go to market with. But 2 years running, we've been a partner of choice, a leading partner with them. This announcement signals some additional areas where we're co-investing to create some capabilities that are unique that Leidos can help bring to market. And we've had other announcements in the past with companies like Microsoft. So it's important to be in that ecosystem and our size and scale kind of gets us maybe a little different seat at the table as it relates to those conversations with partners like AWS. So it's an important part of the strategy, and we'll continue to leverage a broad network of those industry partners at scale but also emerging. But AWS will continue to be an important partner for us, and we're happy that both sides of the equation are kind of putting resources behind investing for innovation.

Excellent. You mentioned profitability in this segment. And so I think it's been kind of the past 2 years or so, about 10% segment, adjusted EBIT margin. This year, I think the commentary was that there was a bit of pressure on the margin in 2024. I guess maybe if you could talk a little bit about what's driving that pressure. And then it sounds like there's maybe a different outlook as we go further. And so how do we think about the trajectory after 2024 and what drives the margin rate?

Sure. So you're right. So we did signal -- and I wouldn't say significant, but modest margin pressure in the near term, and that's only because we had an excellent year in '23 especially as you look at how we're performing on programs and several of the programs are structured with award or incentive fee opportunities. And last year was a very strong year in that regard. So as we look at '24, kind of our initial expectations is there might be a modest pullback in that arena. But over time, again, getting back to -- there are several programs, especially in the digital modernization space where you're able to contract on a fixed cost or fixed unit rate basis. So as you innovate and as you optimize and you deliver solutions for your customers that aren't as people-driven. So again, third-party capabilities, AI-driven capabilities, repeat use solutions all lead to margin improvement opportunities because you can deliver the same outcomes with less effort, basically. So that's where we see a path towards margins above that 10% threshold that company average driving those higher over the next handful of years.

Okay. Health and civil is another one of the new segments. And this is a place where you talked about above average company growth in 2024. So what's driving that growth this year? And then how do we think about the growth rate in that segment maybe relative to the company moving on over the medium term?

Sure. Well, I mean, just as it relates to anything intermediate or longer term, I want to make a point that we're going to march towards an updated Investor Day early next year. As part of that, we'll have a more informed point of view on a longer-term set of financial growth and profitability expectations for the whole company, right? So this is an important strategy or work to be done to kind of crystallize that view. We're closing out '24 as the last year of our 3-year set of financial projections that we laid out in '21. So a little -- I would say a little bit more TBD-ish on what that longer-term horizon looks like. But you step back to health and you say this business has performed exceptionally well. And Liz Porter that runs that for us and her team have done a great job. And it's a combination of things. disability examination work has been performing exceptionally well. There's a tailwind behind that, but it's more than that, right? We've won other contracts like the Reserve Health Readiness program, worked with health and human services. more recently in digital first with the Department of Health, the Defense Health Agency, right, as to moderate some of the downdraft on our DHMSM electronic health record deployment. So we've had a lot of things that have been growth catalysts in health. And ultimately, we continue to see that momentum continuing. That's why we said this year has the potential to, first of all, be above the company average growth rate, but secondly, probably have the most additional upside if things break our way. And so again, it gets back to winning some important contracts, executing those efficiently. The customers in this space tend to reward positive outcomes, right? They'll incentivize the contractors to deliver and overdeliver on performance expectations and then share the benefits of doing so. So we've seen some tailwinds again on the disability exam side, but that's where we've invested in capacity. We've invested to improve our throughput. That's allowed us to capitalize on incentives to drive more volume and to serve more veterans and we've been able to do that, and we've deployed innovation to have been able to enable that with a more efficient back end process. So all those things we see continuing as we look through '24 into the future.

When we think about that disability exam business, which has been very strong for a few years now, is that a place where you see kind of structural growth in that business over time? Is it something that is -- can be kind of sustained at this elevated level that we're seeing now? Or is it something where the level of demand now is maybe somewhat higher than what we're likely to see over time?

Well, it's one where we don't have a perfect crystal ball. I would say the demand signal is still very strong, and the customer -- the signals that we read are the customers telling industry, continue to invest in your capacity, raising the bar on the throughput requirements with the expectation that there's still veterans that we want to insure are being met and seen timely. So there's a demand signal out there. There's a backlog of referrals that need to be taken care of. And the VA, several years ago, decided this was something that they wanted to outsource more to industry. And so Leidos is in a good position to continue to capitalize on that. And like I said, we've made investments both in on-site real clinics and mobile clinics. We've done a lot to increase the capacity of veterans that we can see and drive that throughput and service level. So yes, I think the signal continues to remain strong, and there's opportunities to continue to innovate and drive efficiencies through the process as well.

It also seems -- you mentioned out to industry, and so maybe that's more than just Leidos, but it seems based on the investments that you've made that -- I mean, would it be fair to say that you're kind of maintaining or taking share in exams?

Well, I would say this fluctuates, right? There's a number of different parts of the country. There's an international component. We're not afraid of competition as you get graded. Every veteran that gets seen is giving a feedback on how their experience was. And we strive to make those experiences extremely positive. And those things, how you're doing as it relates to service levels, customer satisfaction, throughput, all dictate who is going to get more share. And so over time, again, we've prioritized making those investments, we'll continue to do that so we can sustain a strong share of the market and potentially above a fair share if we're able to continue to perform exceptionally well.

Okay. Excellent. Maybe we'll move on to the next segment in terms of the new organization of the company. So that's commercial and international. And so I guess 1 of the things that stood out to me and kind of to sell-side analysts. So we make all these crude judgments as soon as we see a number and jump to conclusions. But I think about an 8% margin last year. And when I think about commercial work, and I think about international work, you usually think about those being end markets for whether it's products or services in the -- when your customer is the government, the commercial and international realms tend to have higher margins. And so how do we think about why that margin is where it is today? Is it mainly because of what's happening in the Security Products business? And how do we think about where the potential is for that business over time?

That's a great question, Seth, and you can jump to those conclusions. That's your job. I would say that we put that organization together for a reason, right? This is -- these businesses, we believe there should be some complementary synergies to them, but also all of them don't need the overhead and the oversight tied to our federal government lines of business, right? So bringing them together will allow us to look for opportunities where we can be more intentional about how and where we go internationally and how do we do that as efficiently as possible. There are some really strong portions of that portfolio that we're very proud of. Again, I mentioned earlier, commercial energy work, and I think that's one that the capabilities that we've delivered for our utility customers here in the states, we see opportunities to extend that capability internationally over time, right, smartly, whether it's energy efficiency projects, energy engineering, efforts, grid resiliency, et cetera. Our business down in Australia has been well run for a long period of time. It's -- and we've expanded that over the last couple of years to broaden beyond just the traditional IT support services for major Australian governmental agencies into the mission space with our airborne capability that we acquired, and we see a path to additional growth there. I'd say the areas of the portfolio that need to continue to improve their margins over time. SES would be a piece of the business, and we've made no secret about the fact that it was a little bit lumpy last year. We have taken on some efforts to improve performance there, and we saw results from that over the last 2 to 3 quarters of 2023 with improving margins in our civil portfolio, and that was one of the reasons. But also our business in the U.K., we've got a large presence in the U.K. and there are a couple of opportunities to improve performance on some programs. There's also a large program there that structurally, it's going to be a little bit lower margin, but it's an important franchise program for us to extend capabilities elsewhere with the U.K. MOD. But again, opportunities to drive that segment profitability higher. Certainly, we feel that way. And how far and over what period of time, we'll be putting a finer point on that with the strategy work that we do this year, and that would certainly be something we look forward to talking about as part of an Investor Day, but definitely, to keep it in the portfolio long term, we need to see a path to margins at or above the company average to stay in the commercial and international space.

Okay. And then within the SES business, how far along would you say in terms of -- let's take the demand aside for a second. Okay, that's a separate given. But in terms of how that business is structured, I know last year after that business stumbled in the first quarter last year, you made a decision to take some manufacturing in-house. In terms of how that business is organized right now, having the internal capacity, having the right people in the right places? How far along in that process are you?

Well, we've made a lot of progress last year. The work is never done. But stepping back, first of all, big picture for the audience. I mean this is still less than 5% of the portfolio as you look at that business. You got to put in context, we feel it's strategic and we believe in the trajectory that has got over the intermediate to longer term to be an attractive part of the portfolio, but it's not a dominant piece of portfolio. So what did we do last year? We did make some changes on the management team side. We have new leadership that took over later last year. They're really doing a good job. And we took a lot of costs out of the business, reorganized. Really, when you look at the market. And the market demand isn't what we expected it to be a few years ago, it took us longer than we probably should have to reorganize that cost structure for where we were today, not where we hope the business could get back to more quickly. Did stand up our capability in Charleston for manufacturing of some key products. So that is operational. In fact, several of the leadership will be visiting that location here soon. Many have already gone down there. So that's in place. We took efforts to improve some of our supplier base to shore up some of those challenges. And really, further integrated the business. I mean you're talking about, we had a heritage ports and borders line of business. We complemented that with an aviation product line of business, where there's synergy opportunities in shared maintenance and service. And so those lines of business have been integrated together and doing that efficiently globally is an opportunity where margins can continue to run very strong. And so that work has been completed. So again, more work to be done to drive certain consistency as it relates to other aspects of procurement, sales and marketing, we did make a strategic decision last year to step back from a few different lines -- product lines that we offered in stepping back from a few geographies that we determined didn't have the opportunity to be as profitable. And that is in the near term, putting a little bit of a headwind on growth but to the benefit of profitability, and then we believe longer term, gives us a clear, more stable platform to grow off of.

Right. Okay. Okay. So it sounds like that's -- depending on where we're talking about in the world, that can be a fairly competitive market.

It can be. Oftentimes, especially in the aviation space, there's less potential differentiation, if you will. I mean, again, this is where we try to differentiate is software and algorithms. You don't want to compete on price. But I mean if you've got compelling software, which we believe that scenario we have invested in a system called ProSight, where it gives the customer better command and control of their entire environment as an example, right? So they can integrate not just Leidos equipment, but other things to understand the whole situational ops picture of what's going on in any given time. So those are things where you've got to continue to differentiate because certain customers, certain areas are more price sensitive. And therefore, opportunities to make returns are tied to a longer tail of service and maintenance.

Okay. And so it's not something that just because the air traffic is back, we shouldn't be thinking that is like correlated.

It's not that simple. Yes. I mean it takes time to then turn that into certainty about the budget, the funding actually exists and procurement gets determined and an award gets made and equipment gets made and gets installed. So there's a longer period of time between those two. But obviously, that is a good leading indicator of ultimately the demand signal improving. But we've also looked beyond just the aviation market. We've talked in the past of critical infrastructure. There's other opportunities where we believe we've got a compelling offering, and we're looking to explore more fully those growth prospects.

Okay. Okay. Excellent. And then the fourth new segment is Defense Systems. And kind of in some ways a similar situation as commercial and international, we're looking at about 8.5% margin last year. And typically, we think about defense products unit, you look at maybe the Mission Systems businesses of the different primes and stuff like that being double-digit type margin business. So what's the path to improved profitability in this business?

Sure. So again, I thought it was important to put together not just our Dynetics piece of the portfolio, but some of the heritage complementary pieces of the portfolio into one Integrated Defense Systems unit and set that up with greater engineering depth and consistency on the program execution side that had experience in some of these more product-centric programs. And ultimately, that's the key. We've got several early-stage development stage programs, and that's not where you generate high returns. Those can be challenged at times. The good news is we're nearing the finish line on some of those. They've got to get to more steady state production, right? And there's a couple of areas where we see a demand signal from our customer that we're excited about. But that is the key is, okay, you take your [ lumps ], you have your learnings, you apply that more consistently. We've already made investments in capacity to ramp up on some of those particular lines of products. And so that's the path to higher margins. And we agree with you. I mean having those businesses in the portfolio, if they can't deliver above the company average margin now on EBITDA, we said 10.5% to mid-10s to high-10s, so I'm looking for something ultimately that's accretive to that from those parts of the portfolio. So that's the focus that we've got. And we've got leadership that's aligned around that as well. There's some new blood in that organization. So we're excited about those prospects.

Okay. Yes. There's a couple of areas there from the Dynetics portfolio that where there's growth opportunity. So maybe if we could run through some of those. I think the ones that people think about maybe most identify with Dynetics is hypersonics. So we saw in yesterday's budget for the Army, we saw a nice increase in the long-range hypersonic weapon. That obviously will take time to flow through. Do you view that increase being in the budget, do you view that as a sign of the Army's kind of confidence and determination to move forward here, making it -- it's kind of just becomes a matter of time before you start to ramp up there?

Yes. It's consistent with what we've always been hearing from the customer that the Army wanted to field this capability. It has been slower than we would have liked, and the customer would have liked for a variety of reasons. It's not because we're unable to perform. It's -- we're -- and the long-range hypersonic weapon is there's a platform capability for the mobile trailers, but there's the weapon itself, the common hypersonic glide body, we provide a critical component of that, but we don't develop the [ integrator round ], right? So there's other players in another -- there's -- to manufacture an All Up Round to get it through testing, that's the cycle that needs to really play out in '24. That being said, I mean, it's an area where we're expecting follow-on funding and consistent with what you just indicated later this year attached to that demand signal. So I'm optimistic if the Army is signaling '25 a more robust budget allocation in that direction, Leidos certainly could benefit from that.

Okay. And then two of the other areas within Dynetics, it may be space. We've talked about the FDA and the opportunities there and then force protection.

Sure. Well, space is one where we had a capability that came out of the heritage Leidos side around algorithms to -- for the Wide-field of View satellite payload. And now we've seen other applications for some of that capability beyond just the initial SDA Wide-field of View tranche 0. And so we won tranche 0. We won tranche 1. Unfortunately, our prime wasn't selected on tranche 2, but we're -- customer likes our capability. We're looking for other opportunities to continue to offer that capability to the Space Development Agency. But as I mentioned, that's extended now into other potential programs that we're bidding on, on a satellite payload. So the good news is we've got a capability that's on orbit that the customer has actually been able -- been pleased with the imagery that's coming back from that, right? And so extending that capability. We've invested in Dynetics for clean room manufacturing right, to take that -- the design work that originally came out of our San Diego team and moved that to Huntsville for manufacturing. And so we still feel that's got a nice trajectory over the next 3 to 5 years, at least, right? Force protection is probably something we're more excited about in the near term, right? This has been the development stage program for 16 Enduring Shield indirect fire protection mobile launchers. And we've delivered some of those now to the customer, passed a major test at the end of our fiscal 2023 deployed the first set of those units to the customer for Army testing during the first half of '24. So important tests ahead of us. And that's the precursor to moving to the next phase, which is a low rate production and full rate production. The demand signal is strong. This is also something that you've seen Army leadership talking about the desire to field more of these capabilities, defense of Guam and other areas where they've identified this as the solution that they prefer to go forward with. So this has the potential to be something significant for us, but it's got to work. It's got to be affordable and those are the steps we've been progressing through slowly but surely, and look forward to more to talk about later this year after we get through some of the successful testing events.

When we think about the Defense Solutions business, I mean, one of the questions, I definitely agree with you, I think after last week, it looks -- I don't know -- fingers crossed, but it looks very likely we'll get a fiscal '24 budget 3% growth. We saw the budget request for '25 yesterday. There's also this potential for a supplemental for Ukraine. And there's -- a lot in there focused on missiles and munitions, launchers, stuff like that. Is that something that's relevant at all for the Defense products business?

I wouldn't say there's a direct benefit. There's not meaningful programs that are reliant upon supplemental funding. There's some activity in the airborne space that touches that a bit. But I think it's the indirect benefit. Getting the supplemental funding through provides customers clarity on certain aspects that they can move forward with and it doesn't divert budgetary resources away from things that are priority. So I'd say second order effect, if that gets done, great, but we're not relying upon the supplemental funding for any of the major programs that we're focused on right now.

Okay. Excellent. One of the things I wanted to touch on, I think when Tom arrived as the CEO last year, he emphasized speed as one of the parameters on which Leidos could differentiate itself as a company. So I guess if you could talk a little bit about what that means more specifically and what you've been doing to kind of leverage that?

Sure. Well, speed gets back to some of the examples in Defense Systems. We're in that business and we're relevant because we can field the capability with the customer much more rapidly than some of the big primes could. And again, you heard -- again, some of the Army leadership, I think it might have been Doug Bush or somebody just last Friday talking about on the indirect fire protection in hypersonics. Some of these things are going to be a 5-year cycle versus a 10-plus year cycle, right? And so being agile like that is important in our ability to be relevant. But Tom's philosophy on being agile and being rapid. I mean things like how we are making decisions internally. We -- one of the first things he did was look at where the certain authorities lie in the organization, and we've revamped some of those things to push that down a level. So that not everything has to come to the top of the corporation to move forward. And I think that's empowered our leadership. And I think you're seeing that showing up in the results, right? Quicker decision-making, taking ownership of those things driving that accountability promises made, promises kept, but the rhythms around how we're monitoring our performance, driving decisions are all making us more nimble and agile. And that will be something that will be critical in our strategy process this year is making sure that's one of the advantages we should continue to have, right, is to be more innovative and responsive. And it gets to the tech innovation side, whether it's partnerships allow us to get to market faster with the capability or where do we think customers' needs are emerging and being tied in with them on our innovation center. Those investments to be agile and nimble will continue to be a dominant part of what we're spending our discretionary resources in the R&D space on as well. So I think it's showing up across the board and just how we operate as a company. We've prided ourselves on being nimble, but sometimes it takes new leadership to come in and go, you thought you were, but this is what that looks like to me, and we adapt accordingly and Leidos will continue to be on the leading innovation engine.

Okay. Yes. No, that's very interesting and kind of gets at the -- a lot of the things you hear from the department about what they want to see and how the industry should be different, and there's an assumption that it's going to have to come from Silicon Valley or outside or something like that, but maybe not necessarily...

Yes. Having that unparalleled customer understanding is what we say is that gives you those insights to where we need to be to be relevant to them. And if you can't be relevant to them years down the road, you've got to be relevant to them now because the need and the threat environment continues to change rapidly, and Leidos, again, we'll be well positioned to respond there.

Excellent. And with that, we are at time.

Okay. Great.

Thank you so much.

Seth, appreciate it. Thanks for having me out today.

Thanks for being here everyone.