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

Good morning, everyone. It's still morning, I think. My name is Sheila Kahyaoglu with the Jefferies' Aerospace Defense team. Thank you so much to the Leidos team for supporting us. We have Megan Fisher in the audience, Stuart Davis, and of course, Chris Cage, who's CFO of Leidos. Chris, thank you for being here once again.

My pleasure, Sheila.

You've done a few of these. And so you're always a good support about it. Leidos has had a phenomenal year on all aspects, whether it's revenue growth or profitability, amazing for a defense organization.

So maybe if you could talk about what's unique to Leidos and obviously, under Tom's current leadership, how things have changed.

Sure. Well, great. Thanks again for having us out. We always enjoy coming out to Jefferies, first-class conference that you put together here. And so Leidos, for those that aren't as familiar, a $16 billion-plus government technology company. And we have had an excellent year, halfway through 2024, have been able to increase our full year outlook twice now after the first and second quarter. And so growth trajectory has been good and above our initial expectations. Margins have been an area of strength. And we're just getting started. As you mentioned, Tom Bell is now 15, 16 months into the job. He's come in, really helped, first of all, align the organization to a new construct this year, which has helped unlock our full capabilities across a number of domains, but more importantly, putting in a lot of cycles, thinking about the future this year of deep strategic thinking that we're undertaking. And that's not -- we're certainly not taking our eye off the ball in the present. I think the teams are locked in and executing, and we're doing our fair share to drive growth and profitability and cash conversion. But it's been refreshing to think about our customers' needs 5 and 10 years down the road, how we're positioned to meet those needs and which areas we want to continue to be more intentional about in the future. And so that's what you'll see from us next is really going after the areas of the market and our capabilities that offer the best promise for the future, and I'm excited about that next chapter for Leidos.

Great. And maybe if we could start on the financials. First half growth is running well ahead of a full year guidance, 4% to 6%, growth is 8% in the first half. How are you thinking about the biggest risks as we enter the second half and any impact from elections?

Well, certainly, we've been down this road before on election cycles and potential administration changes, things like that. But every year, the government has to get a budget in place. And unfortunately, it's something that they rarely get done on time. So we're anticipating that process will look like it has in the past, continuing resolution budgets, hopefully, late in the year or early into 2025. I think as it relates to this year's outlook, there's not as many things in the -- up in the air that could impact us significantly one way or the other. There's 4 months to go essentially in the year. We're fairly locked in. It's really how are those things going to set us up for growth in 2025. And there is a lot of bid activity that we've been working on. So there's a good pipeline of submitted bids and actual new bids that are going in. So it's really do we see the decision cycles continuing to hold a good pace of government award activity. I think we've got plenty of things we're excited about could be growth catalysts in the future. Some things like, for example, an award we had earlier this year that got protested. Hopefully, that will resolve itself favorably and that will be a growth catalyst for us in a classified customer setting. So to me, again, it's next year positioning, and we're optimistic that we can keep the momentum up that we've been showing so far this year.

I'll stick to the revenue question. So maybe if you could talk about book-to-bill as it relates to growth. You've had a 1x book-to-bill in Q2, 1.2x over the last 12 months. How do we think about backlog and conversion of your $36 billion into 2025 revenues?

Right. So we've been focused on backlog and building quality backlog over time. And that discipline around which things are being bid on in our pipeline, that journey started. And certainly, when Tom came on board, but even before that, really focused on high-quality work and generating a good return for Leidos. And I think you're seeing that manifest itself in some of the margin performance that we see today and the outlook around margin growth in some of our lines of business into the future. $36 billion of backlog, and that really understates the amount of activity we have visibility into because we have a number of single award IDIQ vehicles on top of that, that we've only scratched the surface on as far as initial tasking from customers. So you layer that on top, where we can see many of those continuing to be a growth catalyst for us over the next multiple-year time horizon, we think we're set up well with good visibility. And how do we build on that? We build on that by the pipeline, the front-end engine, the account management model we put in place to kind of accelerate our growth. But as it relates to backlog and book-to-bill, we're in a good position. I would expect the back half of the year. I mean, our expectation is that it will be more robust in the first half of the year. We do aspire to a book-to-bill greater than 1.0, but we're not fixated on point in time book-to-bill, but are the trends over time, what we want to see and are we building quality backlog over time, and I think we've been doing that.

And looking back over the past few years, Leidos has really had a track record of winning large programs. How do we think about sustaining that track record and also any approach to bidding on new work from here?

Right? So one of the things that Leidos has done exceptionally well is how we run a capture in our win plan model and the gate reviews and how we dissect what customers are really asking for and how we're responding to that. And again, understanding if we're in a situation where we're not as well positioned as we would like to be, how do you make that determination and move on to something that can be more productive. So the capture engine has been successful for us. I think what we're trying to do to enhance that even further is, I mentioned account management, how do we get increased visibility into our customers' environments early? And we have much of that today, but there are areas that we weren't as well positioned in that we've added capabilities and people to increase that level of unparalleled customer understanding because oftentimes, the ingredient to winning is not just responding to what the customer asked for with a compelling proposal, but also understanding what they didn't ask for in the RFP, but they really need to meet their mission requirements. And if you've got that, that you can respond to that's the secret ingredient to having a lot of success. So I like keeping the things that have been working really well for us, accentuating those, adding more front-end account management. And the other thing we've done is really enable a lot more of our solutions architects to be positioned on the growth side. So you'll win when you have a differentiated technical offering for a customer. And oftentimes, the people are the scarcest commodity of the really smart solution CTO-type that can dissect the winning strategy and solution for our customers. So we've been intentional and invested more resources and partnering up a lot more people on the solution architect side with our growth team, and I think that's a recipe for a lot of success.

We're going to turn to the individual businesses, starting with Health & Civil. This is the one where I have the most questions. It represents about 30% of your sales. You have this upcoming VA medical exam recompete. How do we think about the range of possibilities that are coming out of the recompete on District 6?

Sure. So the -- we do a number of things in our Health & Civil business, but certainly, we're a big supporter and partner to the Veterans Benefits Administration and running the disability examination contracts for them. And so we've been a long-term partner in that arena. And so there are multiple different contracts that provide support for them, CONUS, OCONUS, active duty that are transitioning to a veteran status, et cetera. Some of those are up for recompete at this time, and they should go through a process and be resolved most likely in our fourth quarter. This has been an excellent year, but there's been multiple excellent years of support in this particular area. We see the demand trends as being staying elevated for a period of time. So we look at the horizon and you look at the veterans that need to come through and have these disability determinations made and be supported by Leidos and other contractors, we think that signal is strong. It's still a recompete. So you still have to attack it the way you would with any piece of work, where you can't rest on your laurels and the success you've had, you really have to understand how do you continue to provide incremental value to the customer. And most importantly, serve this critical mission of getting veterans the disability benefits that they are entitled to. So that's our primary mindset. We have every expectation, though, that we'll continue to be an important contractor in the future for the VA. We've made a significant amount of investments over time to position ourselves to meet the demands of that contract with high quality, high throughput, great customer satisfaction scores. We've invested in things like being able to reach rural veterans, mobile clinics and things like that. So the fixed investments that Leidos has made are an area that it will be difficult for the VA to move away from those things. But again, we'll attack that head on as a recompete, and we look forward to winning that work. This range of outcomes, you could win some or all the work you have today, you can get bigger shares. Our expectation is the future will look similar to the recent past, right? Volumes are high. We're a great provider. We'll continue to be in that ecosystem. And therefore, that's an area that we're excited about the future prospects in.

I have a few more questions on the topic, if it's okay, just because I'm curious myself. So when we think about your VA business, correct me if I'm wrong, I believe it's $1 billion of revenue and is divided into 4 tranches. I might be making that up, so correct me if I'm wrong there. And so is the RFP out? And do we think about all 4 recompeted in Q4?

So I won't get the specifics as far as the size of that business, but it's been an excellent growing business. It's very important to us. And again, it's an area that we see strong growth prospects into the future. There are 4 regions contracts that exist. That's how they dissect the United States into these various regions and then there's an international program and there is a pre-discharge program. Not all of them are up for recompete, but the regions are. And so the RFP is out. We're evaluating how we respond to that and attacking it like we would for any proposal, right? going through our normal win and bid gates and the team is heads down on the proposal making sure we put a compelling proposal forward for the VA.

And Leidos has been so successful on the program, both from a profitability perspective, but with the customer, given the investments you've made, how do we think about the trajectory of profitability? Does it dip down on a new contract? Or are the investments in place? Or will there be additional investments required?

Well, again, it's a little premature to signal what the near-term expectations are post recompete. I mean every time there's a recompete, even if you're continuing the work that you do today, there's typically some change conditions that you have to assess, and evaluate and we'll do that. But until that award cycle plays out, it's hard to know exactly what those look like. Our expectation, again, as we've made investments, we're continuing to invest not just in physical locations and mobile locations and provider network, but technology, AI, how do we help the whole cycle from appointment scheduling through throughput, through record review, et cetera, to the end product of getting the better in their actual disability benefit through the VA process. Those investments will continue, and we expect to get returns on the investments that we make. So I think our profitability more recently has been very strong. I think it will continue to be strong, whether it stays at this elevated level we've seen in the first half, too early to say. But I feel good that relative to our historical experience, we're able to continue that or improve on it.

And just putting numbers on that, it's been 22% margins in the first half versus, I think, 14.5% in '23. So what's kind of accounted for that profitability improvement? How much of it has come from the incentive structure? And how do we kind of think about that into next year?

Yes. So exceptional numbers. Again, there's more going on in our Health & Civil business than just the VA work. So it's a collection of programs that we're performing on, and each of those have opportunities to provide excellent service and generate rewards. We -- that's one of the things we like about this customer set broadly in the Health & Civil arena is they tend to share upside, right? If you can innovate and you can deliver outcomes for them at a more affordable pace or leverage technology to do it, there's opportunities to participate in the savings that are generated, and we've done that. So -- and then back to the VBA, yes, there's the opportunity to earn incentive fees on top of your base performance. So as volumes stay elevated, that's great. That means more veterans are being seen and evaluated and ultimately getting disabilities. But if you do that against set schedule criteria with excellent customer satisfaction, with good accuracy and timeliness, then you can participate in incentive fees. And at the same time, you could have disincentives happen too. So it's not just a one-way street of only upside. You have to perform or you have the risk of earning less than you originally contracted for. We prioritized all those areas to provide excellent service and throughput and invested in technology, so we hope to continue to enjoy those incentive fees going forward.

Makes sense. And before VA was all the talk, it used to be DHMSM. So when we think about DHMSM, it's nearing the completion of its final deployment, I believe it accounts for about $400 million of revenues. How do we think about that program from here?

Yes. DHMSM has been a great success story for Leidos and the DHA customer. I mean, on schedule, on budget, a 10-year program to deploy a new electronic health record capability globally through the military health system. So we're proud of the work we've done for them over that period of time, and the team has built an excellent relationship with the customer and has been able to add capabilities not envisioned in the original contract because that's continued to evolve over time. It does have a horizon ahead of it next year, where there's life after that original contract. We know that there will be the need to sustain and maintain the installed system. That's work that Leidos, we believe, is best positioned to perform on, and we're going to compete for that very hard. And if we're fortunate, maybe perhaps there's not a competition and the customer can take a different route. But our expectation is there's a follow-on contract, we've been win on that. And the expectation and hope is they use that as a vehicle to continue to innovate and modernize and add capabilities now into the installed environment. And we've done some of that with things like Digital First helping the customer find [ RevX ]. There's all kinds of additional capabilities that, that provides a platform to embed. And so -- but it really starts with unparalleled customer understanding, exceptional customer service, being a contractor that they trust, and hopefully, that positions us to sustain DHMSM at levels that are similar to what we see today.

They're removing [ op ] health, I promise. So defense systems, that's about 12% of your sales, a focus there has been the Dynetics acquisition. You progressed on [ IFPC ] delivering 14 of 16 prototypes, I believe, and some progress on hypersonics. Can you talk about revenue and profitability inflection in this business and where it stands today on Dynetics?

Sure. So Dynetics was an acquisition that Leidos did in 2020. So 4 years later, actually, this year, we've fully integrated that business, and we've now combined it with a couple of legacy pieces of the portfolio to make up our defense systems sector. So that's a $2 billion-plus organization, a lot of heritage, Dynetics capabilities underpin that. We're very excited about a couple of key thrusts there. They've been slower than we would originally like to see as far as gestation period to go from development stage programs and now some of them are migrating into low-rate production type programs and have the opportunity to ramp up into full rate production, one of which being our space sensing satellite payload business, and that's an area that Leidos had a compelling capability on the algorithm development side, and now we'll leverage that into multiple tranche payload development under the Space Development Agency as a key subcontractor to a couple primes that provide the satellite. That's one area that we see future growth opportunities for Leidos. You mentioned [ IFPC ], and that's a program that has been challenged in the early phases. We're near the finish line on the development stage program. And in fact, we're very bullish on the fact that the customer actually procured a few additional units here over the summer for the integration test and evaluation phase of the program, and we're actively in getting dialogue with them around defensive Guam and then ultimately, the low rate and full rate production. So still have more testing to complete, but the strong signals around that being an under -- a key pillar of their defense strategy in Guam and elsewhere is really important. And so that could really turn into a sizable program for us over time. Hypersonics is a third one where Leidos has a number of individual programs in the family of hypersonics, whether it's testing, whether it's the subcontractor on the launcher system and/or the common hypersonic glide body key component of that weapon system. So that has a lower risk part of the portfolio because it tends to be more cost plus, but stable with growth prospects into the future. So I think all of those, we're excited about where [ '25 and '26 ] take us more broadly on profitability for Defense Systems, a lot of this was how do we continue to shore up our capabilities on program execution, our bidding discipline, really understanding these programs and where they were going. And I think we've made strong gains in those areas. And so I'm very confident the team is got a portfolio now that we can more consistently drive margins higher on, and we saw some of that in Q2 with above 11% performance. I wouldn't say we're there yet where that's -- we're going to print that every time. But this is one that we definitely feel like there's room to move margins up significantly over the next few years.

So Defense Systems is on stable footing and Dynetics has a baseline profit level at this point?

Yes, I'd say that's where I see things. There's a baseline level of profitability, inflections will come in some of these new programs transition into higher volumes, and those will give us the opportunity to step margins up higher. I didn't mention even the maritime piece of that business to kind of a legacy Leidos coupled by an acquisition, maritime autonomy, especially undersea is an area that we've got some exciting capabilities into, and believe that will be a really important need for our country going forward, especially in the great power competition. So that's one that we're expecting big things over the next multiple year time horizon.

And then your new segment structure, National Security and Digital represents about half of your revenues. [ DES ] is one of the programs in that. You just received a task order in July for $823 million. I believe the program is generating about $110 million of revenues this year. How do we think about that getting to that $500 million mark for that program?

Sure. Well, you're right. I mean, National Security and Digital, it's huge portion of the company in our Digital Modernization business at large has got several mega programs. Defense Enclave Services was the most recent win, and it was a little bit different because we didn't take over established program that already had a baseline level of activity. We had to help the customer build out the network environment for the future to migrate other DoD for the state agencies on to. And you can imagine, there is a level of getting that designed and implemented and getting a test bed with [ DISA ] customer 0 essentially before you could be positioned to entice other agencies to come into this improved, more secure network environment. We're finally at that juncture. So we're excited about this most recent task order award, $823 million, the [ DISA ] task order, we call it. And that positions us with a discrete number of users that will migrate on to the network over the next couple of years. So that is the key catalyst to the growth inflection we've been looking for. I still think we're on a couple year journey to get this ramped up to its full potential. But our expectation is '25 will show growth certainly over '24, and then there's additional room to run beyond that. So a well-run program, great partnership with the customer, and I think the team is ready to execute.

The last segment you have is Commercial and Industrial, about 13% of sales. You completed the Cobham Aviation Services acquisition almost 2 years ago. Can you talk about the trajectory of your ISR business since that acquisition and your progress in Australia?

Sure. So Commercial and International, to correct you Sheila, not industrial. But -- and you wanted to feature the international component. So Australia is a key portion of the business there. And we had -- we still have an excellent business in Australia, heavily focused on digital modernization for Australian government agencies, well run, been a nice growth driver for us with good margin performance. A couple of years ago, we added an airborne ISR capability. We had one -- we do have one in the States that we perform missions mostly for the Army, and this was a natural adjacency to extend the capability down in Australia. I'd say the business is performing well. There's always challenges. Certainly, getting pilots and those types of things could be a challenge in some of the geographies where you have to operate. But we're excited about the returns that have been generated. Australian government's looking to the future and how do they continue to evolve the mission requirements and look for ways to increase their surveillance and awareness of threats as their border, they're kind of in a tough neighborhood of the world potentially. So we'll look to how Leidos responds to those growing mission requirements in the coming years. But very pleased with our Australian business more broadly in Commercial and International has got some excellent pieces in the portfolio, but there's also some areas that there's work to do to continue to drive margins higher in and I'm very bullish on the prospects of bringing the whole C&I organization up to margin levels that are strongly in the double digits going forward.

And maybe on that, last year, the Security Enterprise Solutions business, SES within Commercial and International, made a lot of headlines. What's the size of that business today? How do you think about that business growing internationally and the profitability markers?

Sure. Yes. I think in retrospect, the Security Enterprise Solutions probably got a little bit more airtime than it could have relative to the size and impact to Leidos overall. But I get it. We had a tough first quarter in 2023, where that business ran in some challenges. We've spent the back part of '23 getting that shored up, and I like the progress that's been made. It's roughly 1/4 of our Commercial and International segments. So on a Leidos scale, it's certainly less than 5% of our top line. So it's important. All of our businesses are important, but it's not the critical driver for our success and profitability. That being said, we do like the business. We recognize that we've got a suite of products, several of which are franchise products that are installed with a huge footprint, both domestically and some internationally. And our job is to make sure that those -- we continue to innovate for the future product offerings, but we also support those installed products with excellent service and maintenance. And that's been a hallmark of Leidos at times that can be challenged. It was challenged a bit with supply chain back when COVID disrupted some things, I think we're mostly through that. And the trajectory has been positive. So we're looking for consistent sustained level of profit performance and then being selective on the growth drivers of the top line, making sure that we're focused on the geographies where it makes sense for us to do business for the long term because a lot of that business as we look to customer demands are international opportunities, Middle East, Asia, et cetera. And so like I said, not every geography is one that we want to be in, but we do think there's plenty of opportunities for growth as we look at the future of that business.

And then given you're the man who controls the balance sheet and capital deployment, you've deployed $300 million for share repurchases in the first half. How do we think about that as we head into the rest of the year?

Well, certainly, I'd say that Leidos has been focused on cash generation and in our capital deployment priorities more recently have featured share repurchases. We made a commitment as part of our original guidance this year that we expected to repurchase up to at least $500 million of shares. We're well on our way, but not done with that commitment, as you just pointed out, Sheila. So I think you can expect that we'll continue down that path as we progress in the second half of the year. And the way our business works with government cycles and government fiscal year-end, the second half of the year tends to be the strongest cash generation part of the cycle for us. So I'm expecting a robust cash generation in Q3 and 4. And we'll continue that journey. We don't want to short-change investment in the business. We certainly prioritized capital expenditures when we saw great opportunities that could generate exciting returns for Leidos. And today that's fit comfortably within the 1% to 1.5% of revenue sizing. And I think that's the sweet spot that we'll stay in for the near term. And we haven't been active per se in the M&A arena because it's been a year of deep strategic thinking, and we want to finish that work and make sure we're intentional about any moves we'd make if we are going to make any moves in the M&A arena. So you'll hear about that in the future. We're heading towards a big Investor Day early next year, talk more about the strategy development, talk more about the future as we see it and then feature the capital deployment priorities as part of that. But I like where we're sitting today, I like having optionality. We've been deleveraging the balance sheet at the same time. So we're in a very comfortable spot there on leverage, which is a good place to be. So it gives us plenty of capacity for share repurchases and other investments.

And just to be able to deploy that capital, how do we think about free cash flow conversion getting back to that 100% mark?

Yes, we set that objective, and I look at it over a multiyear time horizon, I think over the 3-year horizon that we focused on, we'll be able to hit that 100% conversion. Year-to-year, there are certain circumstances, depending upon growth or new contracts or what have you that could create small headwinds for us. But we've got a great customer broadly in the U.S. government. They pay their bills. It's our job to make that as automated as possible to do great work, invoice timely, collect cash with good terms, make sure that we're fair with our supplier network and our vendors, but also negotiate industry standard terms on payment cycles too, and I think we've been able to do that. So I believe that multiyear 100% conversion is a good number for us. If we were to dip a little bit below that, it's because we see exciting investment opportunities that could generate compelling returns, and I think that's something that you'd want the Leidos management team to be focused on and our shareholders would benefit from. So we're not afraid to dip into that if need be to finance good growth prospects. But broadly speaking, I think you'll see us stick to our knitting with customers that we understand with strong payment terms and just focus on doing good work and generating cash.

So just to sum it all up, revenue growth, mid- to high single digits, margins sustained at these levels and conversion getting back to 100%?

Well, you're not going to get me to comment on '25 or longer-term horizon, yes, but we're on track for a great year, with growth in the mid-single digits or better and certainly 12%-ish margins for the year. So we're very proud of that performance, and we look to sustain that momentum going forward.

Great. Thank you so much.

Thanks, Sheila.

Thanks, Chris.