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

So as we think about that program, is it fair to say it's a $350 million contributor today, and it will transition in next year and it could be going to 0 with no software and $50 million to $100 million if there's a software element?

I don't see a scenario where it's 0. I mean there's a need for sustainment and support, and they're looking for that, right? So there's absolutely work scope where they're going to need a key provider, supplier by their side to help them sustain it, modernize it, upgrade it, patch it, what have you. So that's a meaningful amount of activity in some future scenario. Now whether that is something we have to compete competitively for or what have you, that's unknown. But -- so there's always -- there's a work -- there's a role to play here supporting this customer in this mission, and we expect to be part of that. Yes, if they do pull some of the software into a direct procurement model, that puts some downside pressure on the number that you cited, which is not far off. And whether that's $100 million, $150 million TBD depending upon who they can negotiate with directly, right? Not everybody is going to want to play ball that way and what terms and conditions they get and what time they pull that out. But I think the main thing to focus on is there's still a substantial role to play supporting the software application and being part of the modernization of it into the future, and that's Leidos' sweet spot.

Great. Turning to your defense business. It represents 22% of sales, $3.6 billion of revenue. You grew 6% in the quarter, 2.2x book-to-bill. How do we think about your defense? First of all, I guess, what helped drive that 2.2x book-to-bill outside of IFPC? And how do we think about this business going forward?

Well, first of all, Sheila, I mean, you're just wizard with the facts and figures there. I'm uber impressed by all what you've got your fingertips here.

I have an iPad.

Okay. All right. Well, you've done your homework. And so yes, the defense business, everything you cited there, we're proud of.

And you have a good IR guy.

Well, he helps too.

He's helpful.

So this is what we love about the business. It's been hitting on all cylinders and whether it's a nice award that we secured in the space domain to continue that franchise of what we're doing with the Wide Field of View family of programs. You're right, IFPC and follow-on orders to expand that capability. ABADS, the customer is talking about -- they gave us a nice award. They're already talking about increasing the scope and scale on that particular program. And so there's been any number of things. But the big activity in Q2, specifically for that book-to-bill was tied to the IFPC volume. And so the integrated air defense demand signal continues to be robust. It does not yet include what we're expecting to see ultimately in our munitions franchise, right? The framework agreement that we've talked about for our low-cost containerized munitions, none of that's in a book-to-bill number yet. None of that's in backlog yet. And that's potentially north of $1 billion type of activity that we ultimately expect to realize. So the defense team has got a lot of great things going on. There are several areas of that, that are continuing to accelerate. And most near term that we're excited about and hopefully, maybe have something to celebrate if we're successful in Q3 is on the maritime side. Can we secure our position on the maritime unmanned surface vessel opportunity that we're auditioning for as we speak?

Do you mind if I ask you, if I'm sounding ignorant, what is that program? And it kind of came back from nowhere. So how do we think about that opportunity?

Yes. Well, I mean, so we've talked about maritime clearly is an area that the Leidos has robust capabilities. And we've got a nice set of capabilities in the undersea domain. We obviously, many years ago, bought kind of the premier architecture engineering firm in Gibbs & Cox. So our ability to design the vessels and whether it's the Trump battles -- class battleship or what have you, second to none. But also Leidos has invested for decades in the autonomy arena, right? And we knew that, that was where this was going. That's what we needed to position for. And so Leidos has been invited to this competition. The Navy is looking to procure, hopefully, up to 30 medium-sized unmanned surface vessels. We were 1 of 7 people invited to the competition to -- and those trials are ongoing as we speak. And the expectation is the Navy has got money that they want to obligate here before the end of the government fiscal year. That's not to say it will definitely happen, but they are up against the clock and stand to potentially lose a portion of that if they don't get that under contract. So there's an urgency to move. There's a competitive process going on right now to demonstrate that you've got the goods. We've partnered with the shipbuilder because that's not what we do, but we bring so much else to the table here. And like I said, we're hopeful and no guarantees that we will be one of the awardees. There'll be multiple awardees as part of this, for this first set of vessels that they procure. But it really kind of paves the way for a future franchise position. And then you think about the O&M that goes around with this, too, there's a real potential here for the long game to increase the scale of what we do in the maritime domain. So I think that's something that bears watching here, certainly at the end of the government fiscal year or worst case into the early part of our fourth quarter.

And can you update us on the $869 million Army MACRO award that you won? What is that? And how does that drive the long-term profile of the segment?

Yes. I mean that gives us an opportunity to compete in an area, probably more in the software domain than anything else than we haven't in the past. So it does, it creates new capacity for us, what that vehicle does. I wouldn't say it came with any immediate work that we're turning on day 1, but I'd say it's a very important positioning with our customers to demonstrate Leidos' bona fides and what we can do in the command and control C5ISR domain where we've got some real expertise. So that's what I would view MACRO II as is one more important vehicle that gives us access to a customer area for work that we should be able to scale up into '27. I don't view it as a significant catalyst for us in the near term, but one of many areas that will provide a modest tailwind into next year.

Homeland represents an equal size, about 21% of sales to defense. And you've actually grown quite a bit in that business. I think revenue growth of 32%, but organic of 15%. How do you think about outside of Entrust, what the drivers of that growth were in Homeland?

Well, some of it comes back to the conversation on the FAA side that we were having earlier. They have been looking to accelerate some programs that we had been executing on. And so they had some more funding. They were getting after it, and our team was stepping up and helping them accelerate mission outcomes. So that's certainly been going on. We've had good success. Part of homeland includes the homeland defense of some of our critical partners in Australia and the U.K. and the Australia team, in particular, has seen some acceleration on the work they're doing. We had won a nice position in the Counter-UAS domain. We won an important contract in the health arena. So we're really expanding our presence beyond the legacy IT business in our Australian customer. And then there's the TSA. So that's an important customer for us, too, and we do a lot of logistics support for the TSA today, even outside of what we do on manufacturing some of the equipment that's ultimately going to move to a joint venture. But the logistics side of the work stays with Leidos. So we've just seen some acceleration across several of those areas. Very pleased to see the Homeland organization not just show that strong growth, but improvement in profitability. So the margins are ticking up, and we think there's more room to go up from here.

Can you talk about Entrust? What's kind of going on with the business today? What have you learned since the acquisition? And kind of what are revenue opportunities?

Yes. So Entrust, I mean, this was a big move. We had built a very nice kind of organically grown energy infrastructure, energy transmission engineering distribution business. And it was performing exceptionally well. Entrust gave us an opportunity to basically double the size of that business and significantly scale up our capability. We're about 5 months into that acquisition, right? So right now, the team is doing a great job on very detailed integration. And so by the end of the year, we'll have completed the -- kind of think of all the back-office systems and put them on a common set of infrastructure, and that will help them gain some efficiencies in how they execute the business. Before that, in the near term, really getting the combined organization aligned, right? The leadership, the segments underneath that leadership sales, go-to-market, those kinds of things. So we've -- rather than operating it as 2 complementary businesses, have that fully aligned, and that work will be done here in short order. So great progress by the team on positioning that for future success. What we're pleased with is, first of all, their receptivity and uptake on us bringing technology and training their engineers on the tools that we had built out that had proven to be significant efficiency drivers for Leidos. So that's been very welcome and been well received. And then our customers' acknowledgment, right? So getting invited to some larger opportunities. We had signaled an opportunity at a Canadian presence and some bigger, more meaty things with some of our existing utility clients. They were in the gas domain, which was not an area that we participated in the past. So there are some opportunities there with some of our legacy utility customers that also operated in the gas arena, like, for example, Duke Energy that we weren't participating in projects for them in that regard. And now we have an opportunity to bid on some of those. So I like what I'm seeing. I think the teams are highly aligned and motivated. We've expanded our addressable market collectively, probably by 3x from where it was with just the business that we were executing before. So no shortage of opportunities to pursue, and I expect that growth momentum to continue as we pivot into '27.

And just to -- how do we, I guess, think about what Entrust offers? Is it just a complete software solution? Is there a product that aligned with it? And what's the growth rate of the business now that you've 3x the addressable market?

Yes. It's less about software or products. It's -- we are using our software proprietary tools to help our customers deliver engineering packages for major -- whether it's a modest upgrade or a new transmission line, the engineering design drawings, et cetera, that we have to deliver, that's still highly people dependent, but augmented by technology. And that's the work that we do as a trusted provider to the utilities and the demand signal, as you can imagine, right, trying to bring more power online the boom that AIs and data centers are providing, it's like how do you get the power to where it needs to be? And how do you help them as a trusted provider that has this capacity to scale up for these mega engineering projects. And we've expanded our reach too, into the front end of that process with new generation assets and how do we play inside the fence on some of the engineering. So that's where we touch and the value that we bring to the table. Where does it go from here? I mean, again, I think that momentum taking 30% roughly is where we benchmark it of the manpower out of the equation, given technology deployment allows us to operate more profitably and more competitively as we compete for a tremendous demand signal coming from utilities directly or some of the data center developers that are looking to make sure that they've got power to meet their needs.

Maybe one on margins before I forget. You talked about second half margins, at least in health stepping down 200 bps as you have suspension of incentive payments. I guess how do we think about margins for the overall company as well in light of what happens with health?

Well, I mean, we're very proud of the margins that we've been delivering over the last several years. And -- but we have signaled that even this year, when we went into the year, they were a little bit elevated to where they were going to settle in for the long haul. And now with the changes that we've faced in health, we've signaled that those margins will moderate down, averaging about 20% for the Health segment for the back half of the year. But you think about what's going on elsewhere in the portfolio, and I was very pleased to see -- I mentioned Homeland earlier, doubling our energy presence. It's proving out that, that's a margin-accretive line of business, and you will continue to see that show up in Homeland's results. In the defense space, where we're maturing our product offerings and quantities, the throughput is elevated. You'll continue to see that show up in nice margin improvement over time. And I think both of those businesses have good runway ahead of them to continue to grow margins into '27 and into '28. And the other part, in digital and intel, I mean, the team is doing great work. I would say there's a little bit more range bound on the margin potential in those businesses. We're harvesting what we can. The area that has potential to help margins over time there is if the customer does continue to shift to more fixed price outcome-based contracting. We've had some opportunities to have conversations with customers about converting programs from a cost-plus arrangement to fixed price. Nobody's pulled trigger on anything substantial yet. But as those conversations take shape and more opportunities present themselves, there could be longer-term ways that we can drive margins higher in that part of the portfolio, too. So too soon to put specificity around what '27 looks like, given all the puts and takes. I think, obviously, with health moderating down a little bit, that will bring the enterprise margins down somewhat going into next year. We're going to work hard to get uplift in other parts of the portfolio, but that's going to take a little bit more time to fully offset the health piece.

That makes sense. Maybe one on shifting gears to capital allocation. How do we think about Entrust was $2.4 billion acquisition, potentially higher CapEx needs. I think they're doubling year-over-year. What you're looking to spend your capital on and free cash flow conversion?

Well, thanks for that. I'd say that, first of all, yes, we're well positioned. We did Entrust. We very quickly paid down some of the short-term borrowings that we took on as part of that. So exited Q2 with a leverage ratio that's at the low end or even below our comfort zone, right, in our target. So we've got capacity. But that being said, we're working hard to be -- continue to be a great cash-generating business. Went into this year expecting that we would elevate our CapEx number. We signaled up to as much as $350 million. Last quarter, we pulled that back to $250 million. So it's still up from where it was last year, but kind of more in the high end of a range that we've signaled that we're comfortable operating in. That gives us an opportunity to invest in a little bit more capacity to modernize some of our classified facility space because the demand signal that we're seeing with some of our intelligence customers and that business has grown nicely. It's a good return on investment to position that part of the business to grow and scale. Heading into the future, again, the good news is our facilities footprint is largely in a good spot. There might be some opportunities to selectively scale up in certain locations. I mentioned on the maritime side, there might be a bigger presence we need in our Long Beach, Mississippi facility, for example, to execute on a program like that or in Huntsville, it's a high-class problem when you're potentially growing out of some of your production footprint. But we're in a good spot right now. We'll probably be at the margins increase tooling, things like that to help ensure that we stay ahead of the game. I think cash flow conversion will continue to be a strength of the business. But the meanwhile, we're putting our energy into optimizing some of our back-end processes. It's not glamorous, but our enterprise transformation office is helping us get after our billing cycle, as an example, and our payable cycle, deploying more technology and AI into the solution space. And ultimately, we'll see that take a day or so out of our DSO, which will be a nice cash conversion for us.

Last one, just to end. I think as we head towards NorthStar 2030, what do you think investors underappreciate about Leidos here?

I think the power of the portfolio, again, coming off of Q2, where you think about it, we signaled a couple of headwinds in the health business that were outside of our control, pausing of incentives, et cetera. But we were able to raise guidance through all of that because of the strengths of other parts of the portfolio. So I think we've got a very robust defense business, defense technology business within that, that is underappreciated and accelerating. I think the beauty of the energy part of our portfolio, low capital intensity, low care and feeding, high return are underappreciated and Leidos has -- and then on top of all that, our digital backbone where we're in the most impactful, most consequential missions that our customers have to execute on and increasingly, that cyber protectiveness, digital connectedness is going to be paramount to help them execute their mission successfully, and Leidos is positioned across all of those domains.

That's great to hear. Well, thank you so much Chris for being here.