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

Thanks so much, and thank you, everyone, for joining us. I'm Bert Subin senior research analyst here at Stifel, covering Aerospace and Defense. Today, we have the pleasure of hearing from Leidos. We have Chris Cage, CFO. Leidos has been on a little bit of, I would guess, a recovery or a rebound. I mean there are currently some events in '23 that brought in the question sort of where the company is going, but now you've been on a tear and earnings have exceeded even sort of the most bullish expectations.

So maybe to set the stage, Chris, if you could just sort of give us an overview of Leidos, maybe what's happened over the last year, 1.5 years and where the company is going?

Sure. Well, Bert, first of all, thanks for having us out. You guys do a great job at a great conference. Happy to be here. And you're right. Over the last year, we've seen excellent performance from the company, but there's a few different things going on. We've always had the building blocks for exceptional performance. And I think one of the main things that happened, obviously, is the CEO transition. Tom Bill came on board in May of last year and really helped the organization focus, get back to some discipline on the execution side and really optimize the pieces of the portfolio that we had already in place. And Leidos is headed towards a $16 billion government technology and services company, addressing some of the most critical missions for our customers. And that's U.S. and internationally. And so one of the things that we've done over the last 5 months is the reorganization. So put the piece parts together a little bit differently to unlock the next year in performance. We had acquired some capabilities in the 2020-and 2021-time horizon. And it was an opportunity to really reconfigure how those pieces fit together in the portfolio. We had also won some significant programs in our -- in the digital modernization space to a lot of government IT support work and transformation work for our customers, putting that together in a more critical way. So organizationally, unlocking the next gear. We've always had the talent, the people kind of doubled down on our innovation agenda. And you're right, you look at the last year, 8% top line growth, 20% -- 25% EPS growth, more than 100% free cash flow conversion. So really the organization has been hitting on all cylinders.

I guess as we think about that growth trajectory, I think there's certainly been a good portion of that has come from the health business. Can you just talk about maybe what changed in the health business. We go back to '22 and the PACT Act was passed and there was sort of this idea that, that would drive some growth. And I think what we've seen has certainly better than we expected. But I mean, there's obviously been other components to that growth worry. So maybe how would you segment sort of what's driven that uptick [ when you did ]?

Right. Well, our health business, which is now part of our Health and Civil segment that you can see reported externally has been a standout performer and excellent leadership at the top, first and foremost, a great strategy. We were well penetrated within our VA customers. So that's one of our primary customers, but we obviously do a lot of work for the DHA for health and human services, et cetera. But within the VA space, we had a disability examination business that had been performing well. And it's a business that rewards investment in optimizing throughput, optimizing customer satisfaction and quality, and those are characteristics that Leidos always prioritize. PACT Act created an additional demand signal, right? So the volume of veterans that were eligible for disability benefits increased substantially, and we see that continuing into -- certainly through 2025. And it also created more complexity with each veteran that was being seen, multiple conditions needed to be evaluated. So the dynamic was changing. Volume was elevated. You were leveraging your fixed cost base more effectively, investments applying capabilities that Leidos brings to bear in areas like IA and robotic process automation, things like that could be leveraged to increase the number of veterans that were being seen most importantly, but then yield excellent results because the way we're contracted to provide those services is on a fixed unit rate basis. So that business is an area that we're looking to how do we expand that platform of our managed health services beyond just the VA. We do some of that today, and we think we can expand more significantly into some areas of the commercial market insurance providers, et cetera. We do work a similar vein with the reserve, health readiness program, leveraging a platform to make sure they get the examinations for states of readiness. So there's a lot of opportunities to continue to take that business forward as we execute our strategy here over the next year.

I mean -- when I spoke with Tom soon after he joined, he said he was asking all the business has sort of prepare a plan sort of what they thought would be like the most bullish outcome and wanted to think about like the best way to maybe allocate capital. If we fast forward today, you guys have gone through that re-segmenting exercise and sort of have the leaders in place for the businesses that sort of as the business is going to go forward. What has that exercise yielded? And where does Health and Civil fall into in terms of the category for where you think the company is going? Is that going to be the growth arm for the company, not just in '24, but maybe through the 2020s or is that more of a temporary thing?

Well, I mean, I'd certainly say health is an important part of the longer-term view. So big picture, you're right. Tom has come on board, and we're in a year of deep strategic thinking, as you would characterize it. And we're, I'd say, middle of the movie working through a robust set of strategy dialogues with all of our units and really evaluating which of those have the best potential to accelerate growth and profitability from where they are today, really getting deep into areas of our capability into the customer demand space, and more work to be done there to finalize that. And our plan is to have a robust dialogue with investors early part of next year at an Investor Day to kind of reveal some of that strategic thinking. But I think the important part is that, yes, we wanted to be more intentional with resource allocation into the parts of the business that showed the most promise easier said than done, right? You've got $16 billion. We got a lot of contracts. We get a lot of work that we're executing on today but redistributing some of those resources for maximum benefit. And we're doing some of that right now. We've actually, with our good performance, have been able to increase the investment in innovation this year. But as we transition into 2025, you'll even see more of that. Back to your health question, absolutely, they'll be an important part of that strategic horizon. Again, like I mentioned, there's areas of the managed health services space that are suboptimized within our customers, whether it's DHA, whether it's VA, whether it's even in the commercial arena, where we can apply some of the capabilities we've developed more broadly because the health care trends in this nation will continue to drive increased spending demand. So more to come on the specifics around how we execute that, but we do believe that's a business that has a lot of legs, and we like the way, again, it's set up and structured where it rewards investments in optimization and innovation.

Maybe just like, I guess, a high-level question. If we go back in the history books on Leidos, you have the split with SAIC in 2013, sort of the acquisition merger of the Lockheed services business. You bought QTC, which got you into the -- the [ VA ] exam world. And I think the business was starting to become known for winning these major enterprise IT programs you had maybe NGEN, AEGIS in the DHMSM defense health program. And then sort of went down the path of maybe acquiring more into the product side bought Dynetics, bought the SD&A business from L3Harris. And now maybe I wouldn't say backtracking on that, but maybe a little more emphasis back on services and not necessarily just enterprise IT. I mean, I guess, as I think forward and the strategy, I mean, is the mindset changed to where you want to be more sort of all in on services, enterprise IT large programs still big focus or there's fewer of those to go after. And so thinking about sort of how you can grow the medium-sized programs, like just from a strategic standpoint, thinking over the next last decade to maybe the next decade.

Right. Well, there definitely was an opportunity in the business has gone through a lot of transformation over the last decade. Starting with the mega enterprise IT jobs, right? So that's not something that we were moving away from, but there aren't as many of those to go after. I do think that Leidos has proven capability, the scale, the size, the past performance to be a credible bidder for some of those as they get consolidated into mega jobs across key clients. So as those come up, you would expect us to continue to be a strong competitor for some of those opportunities. But I do think there is a sweet spot in a level down on size to that perhaps we weren't as focused on. And those can be areas that as we've built out this digital modernization organization and today, they're looking at bringing those contracts together has allowed us to evaluate how do we deliver cloud migration, desktop support services, cyber, et cetera, across multiple customer sets into an optimal delivery, a repeatable offering. And that will help us get even more efficient in that delivery mechanism, and that can be applied to contracts that are potentially smaller in scale as well to make us a viable, strong competitor in that domain. And I think the other area that we haven't unlocked full value is really getting into some of those mega client environments and expanding, right, beyond the base set of activities we are contracting for. So as customers need more cyber protection, more software development, app development, et cetera, there is opportunities to expand that. So digital modernization, I think, has a lot of room to grow, and I think both the mega and midsized programs. You mentioned some of the non-services parts of the portfolio. We're still excited about the prospects there as we think about the application of even in the hardware arena, it's come down to software. It comes down to cyber, it comes down to trusted mission, artificial intelligence application. Those are things that Leidos brings that can be differentiators for us. And so those parts of the portfolio aren't yet where they can be from a growth and margin perspective, but we still think there is a lot of exciting demand and growth prospects in that part of the portfolio, too.

Maybe if we bring this, I know this has sort of started like high-level theoretical more than anything. But if we bring this into the context of 2024, you've given pretty decent, I would say, segment by segment sort of guidance on a revenue and a margin basis. And we drilled down into the National Security and Digital business, which is historically the core of the business. You're looking for, call it, a 3-ish percent growth year. The market or to your peers are certainly growing a little faster than that, on a margin basis, sort of high 9%, low 10% range, maybe help us understand like how to calibrate that, why there's not opportunity maybe for more growth in this market?

Yes. And I think that there -- I think there certainly can be, no doubt. Every year's situation dependent, whether you had some contracts ending or rolling off or maybe a recompete that didn't go our way in the case of 1 Intel job. But there are definitely some growth tailwinds in that particular sector, programs like Defense Enclave Services, has been slower to get to where we are today than we expected but still see a significant ramp-up as we migrate other parts of the DoD for the state agency onto the DoD network. And sustain and modernize that for them over time as an example of a growth catalyst. So yes, there is absolutely parts of the DoD and Intel services market, where we see a robust set of opportunities in the pipeline. Actually, that's 1 of the more exciting parts of the portfolio as it relates to bidding activity and what we can see in the intermediate horizon. It doesn't mean we'll win everything we're going after. We know that, but there's a lot of activity, which sets us up for growth momentum in '25 and beyond. From a margin perspective, this gets back to what I was saying earlier, Bert, on the repeatable offering. I think in digital, specifically, there's -- most of the contracts that we perform on a fixed unit rate it's outcome-based, right? So as you optimize your delivery, you can capture more margin opportunity. And so there's a lot of those programs that are still relatively in the early innings, NGEN year 3, DES year 2, AEGIS year 2 plus, right, on sometimes 8- to 10-year horizons. And you find opportunities as you get into the middle innings to drive even superior performance. We're very focused on that. So I'm bullish on the opportunities in that particular segment to drive margins higher over time and hopefully, couple that with a good win rate against the robust opportunity set, and we can set ourselves up for more growth as we pivot into '25 and beyond.

But you mentioned DES Defense Enclave Services. That was the marquee win, the $11.5 billion contract that won back in '22. You also won CHS-6, which is a phenomenal takeaway win last year, and that's transition now. Those 2 programs by themselves, I know CHS-6 was an $8 billion ceiling, but it wasn't running. I think it was running around half of that. But DES, sort of anyone's guess where it could go, I know you sort of previously Roger used to set expectations little lower for where it was going to go. There's a lot of opportunity there. What's the best way to think about that? Because I think people would have anticipated CHS-6 to ramp more this year feel like the expectation has been maybe that's a little slower. And then DES has taken a little longer. Is there still an opportunity for those to get to a substantially higher level the way they are today?

Well, yes, in both cases, I take them each in turn. I talked a little bit about Defense Enclave Services. So it's a unique [ animal ]. This was a new start program, right? And -- but the scope of work was being conducted in a variety of defense agencies that bought their IT and network support and cyber protection individually. Bringing them along a journey to migrate to a new modernized secure network is it's a long process. DISA as the contact agency is excited about that as are we. There's been great dialogue around planning for the next wave of migrations, and ultimately, yes, we'll pull more of these agencies onto the network. You'll have a robust set of users, and that will drive the volume substantially higher. So we would have like to have been further along. I think we were prepared to be further along. But working through this customer dynamic, we're not in control of that all the time and the budgetary aspects associated with that. But there is still a robust business case around that and you can look forward to multiple years in front of us of additional growth there. CHS-6, similar, it was never going to -- even though the volume like you said, of army buying activity was maybe half the ceiling. We won't recognize even that level into revenue necessarily given some of the way the contract is handled. But what we've seen is more users want to use that vehicle. So it's an attractive vehicle for the customer. There's some long-lead procurements already being put on order under that contract. So it sets up the future to see a higher demand signal. And ultimately, it should be a nice profit driver for us because even some of the things that don't translate into revenue, we make a nice fee and management fee associated with the procurement activity. So early innings, a little slower ramp up, but a long opportunity ahead of us to grow and scale that contract up. And really, they've broadened it to a full [indiscernible] ISR procurement vehicle. And so I think there's a robust demand signal that will come into that.

That was an example, I think where Tom talked about, there's an opportunity for cyber for AI. And how does that fit into a contract like that where there's a degree of sort of acquiring technology and ruggedized equipment? Like how does that play into it.

Well, yes. I mean there's the logistics aspect, I mean, planning and prepositioning and the ruggedization. But I think the it's opening the aperture of what they can buy. They're not going to be buying services under it, but they can buy improved products, right, configured products, ruggedized products. And so as they branch out beyond the traditional buying command, I think the jury is still out on what types of things could be put on to the catalog of offerings per se. That continues to be built out. And so we're only, what, 6-or-so months into kind of happen, maybe 9 months into having that in place. But ultimately, I expect that will continue to grow.

Maybe just to wrap up conversation in this segment. I guess, should we think about the margin opportunity being the maturity of some of the sort of the larger, longer-dated contracts since that provides you a little bit of a modest life path to higher margins over time from a 10% level.

I'd say that's fair. I mean, again, this isn't one that I'd point to substantial margin expansion. But clearly, we're challenging the teams to look for areas to drive tens of basis points improvement, 0.5-point improvement, maturing of long-dated contracts. Some of -- again, as we get certain customers to pivot some of the buying behavior to more outcome-based maximizing your award and incentive fee. A lot of the Intel and DoD agencies still like to buy under a cost-plus award fee or a fixed fee arrangement. But negotiating a little bit more on the fee side and some of those. So modest uptick is where the team is focused, and we'll hopefully be able to put together a robust plan to execute that.

So maybe moving back into the Health and Civil side, that was a segment that did 19% margin in the first quarter. I think operating income grew something like over $100 million year-over-year. This is a big step-up, and we talked about the PACT Act. Maybe just, I guess the last comment there. You mentioned that that's going under a recompete just as a function of hitting its ceiling value early. Is there any -- how should we think about that recompete process? Is it more procedural in nature. And so probably things stay more or less the same? Or is there -- you think the VA is focused on taking back that economics?

Well, listen, we approach every recompete as if we had to win it for the first time. And so the teams are -- even though there's no RFP on the street, the team has already needy, and how do we plan for a very competitive procurement cycle. But that being said, what you focus on is the VA needs to serve the veterans. And we're a proven commodity. We think we've delivered exceptional service. We tend to score very high as a provider on of the key metrics that they're focused on. And so keeping that performance up is the best way to rewin a recompete, right, and continuing to invest to help the VA be effective and efficient, putting things like a lot of capital into mobile clinics, so we can go reach the rural veterans. So Leidos is I think, prioritize that better in service over anything else, and that ultimately has been rewarding for us as well. So recompete, I would never call it procedural, but yes, you'd like to believe that things have been working well. The providers they've got in place today are doing a good job stepping up to the increased volume. We're a key part of that ecosystem, and our job is to make sure we preserve that.

This is a type of contract because you don't get a sign like a share in the contract. It's just there's a ceiling and you can go -- you can help process claims. Is that right? So there's not an element where under a recompete gets resegmented in terms of how many claims you can have under the domestic side?

Yes. You don't get a committed share. I mean, in theory if everybody has optimized their performance, they'll split it equally. But really as a day-to-day, week-to-week, month-to-month thing. I mean who is driving throughput, who's providing exceptional service, who's ready to take on more of the demand because there is more demand than throughput capacity today, right? So our job is to stay a step ahead of that and to be able to continue to capture more of that activity on an ongoing basis.

So maybe besides the VA business, can you give us just sort of an idea of how the rest of Health and Civil is performing? I know DHMSM was expected to step down a little bit. It's probably your biggest headwind this year. Where is that program going? And what else in the portfolio you may be excited about?

Sure. So well DHMSM, just to touch on that, we're very proud of the performance there on the deployment. I mean this has been a year 9 of a 10-year vehicle, right? So there is a horizon in '25 and what's next. But to be able to deliver the capability on schedule, under budget, deployed to all of the key locations. We're proud of that performance. We've got a great partnership and a great execution team there. And the customer is interested and now that they've got the capability deployed, how do they continue to modernize and optimize the experience for the medical providers and the Defense Health Agency. And so we're working with them on things like Digital First and other expansion opportunities. Our job is to win the follow-on, right? So there will be a follow-on that continues to sustain the program and provide more capacity for modernization, right, because there's an ongoing cycle of modernization there. So that's a franchise program for us that we'll continue to perform excellently on and target the future. But beyond that, there's some significant opportunities to expand. VA has got to be a supply chain, which is a mega job as it relates to their digital ecosystem to manage how they do the logistics, if you will, across all the VA centers. There's opportunities within CMS and within HHS. And we've had some success on the digital and data analytics side and cloud side. And so there's no shortage of pipeline opportunity that's competitive, no doubt. But in the health arena and the customer set, those economics have been good and attractive, and we see areas that we can expand. On the civil side, we've had a long-standing FAA software business, right, where we've built and operate a lot of the key FAA systems, international expansions around those capabilities. This is actually an exciting area for us as it relates to -- we announced earlier this year, setting up a hub in Singapore as it relates to innovation, looking at some of the global markets where we can extend that capability. And then there's other software development. That's a secret sauce for us in the large mission software and development space civilian customers are continuing to look for some of those key capabilities and there's a lot of exciting things in the pipeline there. So Health and Civil has excellent growth prospects. I mean, the VA will continue to be the dominant piece of the story in the near and the intermediate term, which is great, but really leveraging that capability beyond that.

Maybe -- moving on to the commercial and international side of things. This is the business that, I mean, I guess, houses SES, which is the airport security business. What have you seen in terms of the last several quarters in terms of improvement? I guess if I went back a couple of years, I would have thought this business was going to grow a ton just based on air travel demand resuming and the needs for security, but it's been maybe a little lumpier than I would have expected and you pared back in some of your products there. What are you seeing broadly, is that improved?

Sure. Well, I mean, commercial and international, first of all, putting some pieces together that we're strictly our commercial and international businesses, I think, was a great move by Tom. It allowed the team to, first of all, take some of those distractions away for other parts of the business and then really think about do we want to prosecute work internationally, whether it's our legacy U.K. and Australia-based businesses or SES, which has got a global footprint. And so SES specifically, yes, a lot of work is still going on to optimize the inner workings of how we manufacture the equipment, how we do the service, combining our ports and borders and aviation business. I think the team has made nice gains there, but there's still work ahead of us. And then it's investing in the innovation for the next series of products. You're right that air traffic travel has certainly bounced back. We've all experienced that. But sometimes it doesn't immediately translate into new procurement opportunities, whether that's with TSA or global customers. There are some that we're competing for. And -- but there is really optimizing how we deliver the service, it provides a more near-term path towards consistent profitability. And so we're certainly focused on driving that. Some of that was supply chain challenges on part shortages, et cetera, et cetera. A lot of those things have improved, and we'll see continued improvement as we get through this year. But beyond SES and commercial and international, we're very excited to our energy utility business. It's been an excellent performing business for us. The utility markets, there's a ton of demand for critical infrastructure the engineering services work we do for those utilities is expanding. That demand signal is very high. ultimately, tying and cyber protection into grid resiliency. We think there's a long-term play there because that's a capability Leidos standout in and some utilities have prioritized that more than others. But -- so seeing that particular subseg of the market has a growth catalyst over the next several years is something we're excited about too.

I guess the only thing that's been a little confusing here is the margin profile because I would have expected this would have been at least in the low double-digit range has been, correct me, if I'm wrong, with mid-8s. Is there -- is this the biggest margin opportunity this segment?

Well, it's one of the biggest, right? Where if we have time, we might talk about different systems. Yes, so it's not where it should be. And there's a couple of areas we talked about SES and driving that products and services component. We think there is room to run there over the next few years. Energy is doing well. I'm very proud of the team's performance there. But even in the U.K. and Australia, there's opportunities to mature parts of those parts -- business portfolio as they grow and scale up a little bit more. There's margin potential to unlock. So the team has got a bogey. I mean, Tom has been very clear around what the expectations for margin improvement are there. And they're building their plan to execute that. And so I am bullish that we'll see this as a part of the portfolio that's a margin tailwind over time.

So I guess maybe then wrapping up the business conversation on defense systems. I mean, Dynetics feel like there was a lot of enthusiasm for that business several years ago. And there's been some interesting programs, just haven't gotten off the ground quite yet. Margins, like you mentioned, maybe this is one of the larger opportunities, sort of the mid-8 range. I think you think it's talked about it improving this year. And used to signal that, correct me if I'm wrong, that was maybe like a 12-plus percent margin business, not just not defense systems, but Dynetics. What's going on in Defense Systems? Is that -- if commercial and international isn't as defense system's biggest opportunity?

Well, it certainly -- again, we're excited about the prospects there. And putting -- you mentioned Dynetics. That was an acquisition in 2020. And now we've surrounded it by some of our more hardware platform-oriented piece of the business in airborne and airborne autonomy in the maritime and maritime autonomy. And so those things are integrated. And each one of those has some compelling growth threads for them. I think the engineering discipline program execution discipline of bringing that together will help the organization find the next year. We're actually only 5 months into finally integrating Dynetics into all of our Leidos enterprise systems rates. There's a lot more sharing and collaboration and resource allocation that can happen more seamlessly now than they could last year. So we're excited about that unlocking more value and then kind of the mix of programs, right? We've seen we're much, much closer to some transitioning from development stage into low-rate next phase of production where lessons learned can be applied and you can really move up the value ladder. So yes, there are several irons in that fire that '24 is a margin improvement a year, not a huge growth inflection year. I expect '25 to be better, but that's what the strategy work is for, it's for us to get conviction around where that part of the portfolio is going, but I think they've got multiple prospects for growth?

Is the big growth driver there going to be a [ pick ]. And is that program? I mean I think the expectation turn of the year that might start to -- you see some production there. Is that -- could that be a big tailwind in '25? Is that more '26?

I think that -- I would expect it to be a multiple year tailwind. I don't think it's going to ramp from 0 to 60 in 1 year, but I think there is a -- that's the one where we hear the most consistent, compelling demand from our customer around how do we get some of that capability fielded depends on Guam and other areas. It's still in a critical testing phase, but that's not stopping discussion around the next phase of orders and ramp up, and we're ready for that to happen. So this one has a multiple year journey that we're still excited about the indirect fire protection capability is the choice. Assuming it can deliver the capability that they're expecting, there's a robust demand signal over multiple years there.

Maybe just to wrap up, if we went back 5 quarters, our book-to-bill on a trailing basis was below 1. You're back above 1. The environment should be fairly robust with appropriations happening, supplemental spending packages, so you have a good setup as you think through the next several months. We've had some in the industry that have maybe there's been mixed setups in terms of business development and the pipeline. Can you just tell us maybe what you're seeing and if those signals improved, do you feel good about the pipeline as you sit here in June '24.

I do. I do feel good about the pipeline. The whole energy and our business development function, bringing that under Gerry Fasano's leadership again. Gerry is relentless. He drives the organization. He made things happen. So the ton of energy, our proposal pits are jampacked. We've got 2/3s of the pipeline is new and takeaway work. So there's a lot of growth expansion opportunities there. And yes, I think it sets us up well. The activity level has been elevated, and I think it will continue that way up through government fiscal year-end. Obviously, we had an election year, and then we'll see, but I like to set up going into the back half of the year and positioning us for growth.

Great. Well, Chris, thanks so much for being with us.

Bert, appreciate it.