Leidos Holdings, Inc. (NYSE:LDOS) Q2 2023 Earnings Call Transcript

Leidos Holdings, Inc. (NYSE:LDOS) Q2 2023 Earnings Call Transcript August 1, 2023

Leidos Holdings, Inc. beats earnings expectations. Reported EPS is $1.59, expectations were $1.57.

Operator: Greetings. Welcome to Leidos’ Second Quarter 2023 Earnings Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. Please note, this conference is being recorded. At this time, I’ll turn the conference over to Stuart Davis, from Investor Relations. Sir, you may now begin.

Stuart Davis: Thank you, and good morning, everyone. I’d like to welcome you to our second quarter fiscal year 2023 earnings conference call. Joining me today are Tom Bell, our CEO, and Chris Cage, our Chief Financial Officer. Today’s call is being webcast on the Investor Relations portion of our website, where you’ll also find the earnings release and supplemental financial presentation slides that we’ll use during today’s call. Turning to Slide 2 of the presentation. Today’s discussion contains forward-looking statements based on the environment as we currently see it, and as such, includes risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially.

Finally, as shown on Slide 3, during the call, we’ll discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in today’s press release and presentation slides. With that, I’ll turn the call over to Tom Bell, who will begin on Slide 4.

Tom Bell: Thank you, Stuart, and good morning, everyone. I’m pleased to be with you today leading Leidos into our exciting second decade. I’m also very happy to report that we closed a strong Q2. Driven by a healthy demand environment, we achieved revenue growth of 7% year-over-year, with strong organic growth across all segments. Margins, earnings, and cashflow rebounded from our first quarter, driven by, an improving business mix, a partial recovery in the security products business, and a series of fast-acting initiatives implemented across the business focused on costs and collections. Adjusted EBITDA margin of 10.9% was up 150 basis points from Q1, and non-GAAP diluted earnings per share of $1.80 was up 22% sequentially.

Also, operating cashflow of $164 million was up $262 million from last quarter. While putting this quality quarter on the books speaks to the underlying strength of the business, even more important to me, it reflects ability of the Leidos team to focus and deliver when expectations are clear. Now, as this is my first quarterly call with you, I thought I’d share some of my initial observations of Leidos. Over these first months, I’ve met with customers, employees, and analysts, and I’ve conducted detailed operating and strategic reviews with all our business groups and each of our functional organizations. The headline from this work so far is clear, our business foundations are impressive. I’ve come to think of these foundations in three distinct pillars.

One, an incredible team, two, compelling technology creation, and three, the ability to act with pace while leveraging scale. These three elements in combination enable us to uniquely solve our customers’ most vexing problems in differentiated ways. Let me unpack that a bit. First, we’re a company of exceptionally talented and dedicated individuals. Their breadth and depth of expertise is remarkable, and they are palpably connected to our customers’ missions. That translates into a truly differentiated culture with deep customer insights. Also, the esprit de corps and genuine care for each other at Leidos, creates an environment that embraces collaboration and entrepreneurship, critical to our continuing success. Our ability to effectively attract and motivate top talent is a distinct competitive advantage for us.

And in this regard, Forbes recently named us as one of the best employers for diversity for new graduates and for veterans, and Ethisphere recognized us as one of the world’s most ethical companies for the sixth consecutive year. Second, technological innovation at Leidos is impressive, broad, and deep. The advances we are pursuing across Leidos are world-class. We leverage these key technology differentiators, what I refer to as golden bolts, across our entire portfolio. And we deploy these golden bolts in disciplines ranging from secure software to cybersecurity to signal processing, so as to bring extraordinary capabilities to our customers. A couple of recent examples of delivering complex mission capabilities to our customer includes, the successful hypersonic test launch under our MACH-TB program, and the last major deployment wave in the continental US of MHS Genesis, the Military Electronic Health Record System.

This was done on time and on schedule, also significantly enhancing system capability. We’ve also been at the forefront of unlocking the power of artificial intelligence for our customers for decades. We’ve developed and deployed trusted AI to tackle some of our nation’s most challenging missions. Our debut in applied AI was in 2004 when we built a self-driving vehicle as part of DARPA’s Grand Challenge. By 2016, we launched the first unmanned autonomous ship. And now, we’re deploying next-generation computer vision for automated passenger scanning in our ProVision 2 platform. Also, recently, we’ve deployed large language models in our Health group, designing a trusted AI solution where humans and AI work as partners to more rapidly align resources and improve our support to beneficiaries.

Differentiated technology, including AI, created, unlocked, and responsibly controlled by our amazing people, is and will continue to be a unique attribute of Leidos. Now, to continue to accelerate our technical innovation, we are investing to broaden and deepen our workforce capabilities. So far this year, we’ve upskilled well over 3,000 of our people in fields ranging from AI to cyber, to software to digital engineering, and it’s open to all our employees, not just our technical wizards, so that all can be conversant in our golden bolts. The third pillar I’ve found here is equally important, scale and agility. Every customer I’ve met with is feeling the stress about the pace of change. Hard, vexing problems are coming at them at speeds they’ve never experienced, and they’re looking for partners with speed and scale to address these holistic problems.

They need us to operate with a clock speed that matches their urgency. At Leidos, we lean into this environment by challenging ourselves to operate with a strong bias for velocity. For example, within the US Space Force, the Space Development Agency is focused on rapid delivery of space-based capabilities to the joint war fighter. This is an ideal fit for Leidos, an essential, technically challenging mission where standard procurement cycles aren’t acceptable. To that end, today, our satellite payload remains the only Tranche 0 tracking layer asset in space, and we’re on track to launch Tranche 1 assets soon that will serve as the foundation for the defense of our nation from hypersonic missiles. All these findings have strengthened my conviction in the potential of Leidos.

However, also in my first months, I’ve identified some areas where we must improve. First, some recent acquisitions have fallen short of plan. While I believe those acquisitions offer us significant strategic benefits, we will redouble our efforts to achieve the value envisioned in our acquisition business cases. Second, all on this call recognize the fact that our financial performance has not always lived up to our investors’ expectations. The team and I have had a series of candid conversations in this regard, and as a result, we have agreed that together when we make a commitment whether to each other, our customers or the Street, Leidos will meet that commitment. I call this simply a promises made, promises kept philosophy. Third, recent business development metrics have not been up to par.

While we have a healthy backlog, currently $34 billion built over the last five years via a book-to-bill ratio of 1.3 times, we can and must do better. I believe that for a business like us, total backlog is a more relevant measure of future revenue growth than quarterly book-to-bill ratios. We will be determined to grow our total backlog over time with quality wins. As such, we’ll be candid with ourselves about where we have a differentiated capability that the market recognizes and resource it appropriately. And where perhaps we find we do not enjoy true differentiation, we will ask ourselves some honest probing questions, courageously acting on their answers. Finally, I believe Leidos can benefit from a certain strategic sharpening. To propel this and to optimize our success going forward, we are now in the process of crafting a clear new north star for Leidos.

As we crystallize this new north star, we will use it to guide all our strategic decisions, and over time, this will improve our win rates, drive margin enhancement, and better enable us to most successfully serve our customers’ most important needs. While this north star is currently a work in progress, I can give you a few initial indications of where we’ll be going. We’ll take steps to simplify our organizational structure to promote operational excellence, allow for faster decision-making, and more tightly align our business across our key technology differentiators. We will focus more on the bottom line via greater cost discipline and by refining our investment strategy toward those areas of best opportunity, best overall value to the enterprise.

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And we’ll be very thoughtful and disciplined on capital allocation, both internally and externally. In the near term, I will be laser focused on improving execution, so I don’t expect much in the way of additional inorganic growth, but after we complete our next strategic plan and reach our targeted leverage ratio, select M&A will likely make sense for us again. At that time though, we’ll be crisp in our approach to ensure there is a clear opportunity to create value for Leidos and our investors. Lastly, I believe that a regular and predictable program to return capital to shareholders drives better investment decisions across any enterprise, so be looking forward to that as well. As we progress this work, I’ll look forward to updating you on how we plan to accelerate growth here at Leidos, especially on earnings and cash.

Now to our 2023 guidance. Based on our strong Q2 and our revenue momentum halfway through 2023, we are raising the top and bottom of our revenue guidance to a new range of $14.9 billion to $15.2 billion, an increase of $150 million at the midpoint. Revenue growth has been a key feature for Leidos in the recent past, and I’m pleased to acknowledge that this element of our business will continue to deliver for us. The delta in margin performance between the first 2Quarters of 2023 indicates to me variability in profit margin greater than that suggested by the prior 20 basis point guidance range Today, this is primarily due to the variability in our security products business. Now, the good news here is that the Civil team is aggressively knocking down these challenges by leaning out the cost structure and strengthening the supply chain.

But considering the practicalities of a company becoming slightly more tied to product delivery timing, we are widening our adjusted EBITDA margin range guidance to 40 basis points. Therefore, our revised EBITDA range will be 10.1% to 10.5% for 2023. Lastly, we’re reaffirming our non-GAAP diluted EPS range of $6.40 to $6.80, and we’re reaffirming our operating cashflow target of at least $700 million. In closing, I’m optimistic about our future as we set course for Leidos’ second decade of growth, and I look forward to meeting with you at upcoming conferences and roadshows. With that, I’ll turn the call over to Chris for more detail on our financial performance and updated outlook. Chris.

Chris Cage: Thank you, Tom. Our second quarter financial results were indeed strong and put us on pace for a good year. Big picture, revenue continued its growth trajectory and we rebounded nicely on earnings. As I said on the last call, the Q1 profit shortfall was temporary, concentrated, and recoverable. We had improvement in the security products business, and we worked together as an enterprise to deliver solid results across the entire portfolio. Turning to Slide 5, revenues for the quarter were $3.84 billion, up 7% compared to the prior year quarter. Revenue growth was broad-based, as each of our three reporting segments grew at least 5% organically. Onto earnings, adjusted EBITDA was $420 million for the second quarter, which was up 15% year-over-year, and adjusted EBITDA margin of 10.9% increased 70 basis points year-over-year.

Non-GAAP net income was $252 million, and non-GAAP diluted EPS was $1.80. Non-GAAP net income and diluted EPS were up 15% and 13%, respectively, compared to the second quarter of fiscal year 2022. Earnings growth came despite a $6 million drag from net interest expense. Both share count and the effective tax rate were essentially unchanged from last year. Non-GAAP profitability was up from Q1 levels in all three segments, driven by improved business mix and program execution, as well as enhanced focus on indirect spending across the company. Though there were some pickups from achieving milestones and truing up completed programs that won’t necessarily recur in future quarters, we saw improvement along most key profit drivers. Specifically, EAC performance was strong, with net write-ups of $18 million, and SG&A as a percent of revenue showed improvement as well.

The year-over-year numbers paint a positive picture, but the sequential improvement is even more encouraging. Total revenues were up 4%. Adjusted EBITDA margin was up 150 basis points and non-GAAP diluted EPS was up 22%. Turning to the segment drivers on Slide 6, Defense Solutions revenues increased 7% year-over-year. The largest growth catalysts were in the areas of digital modernization, including Navy NGEN and hypersonics, especially SDA Wide Field of View Tranche 1, as well as our Australian Airborne Solutions business. For the quarter, Defense Solutions non-GAAP operating income margin increased to 9.3%, up 100 basis points from the prior year quarter, with maturing development programs, strong execution, and lower indirect spending. Health revenues increased 9% over the prior year quarter, driven by growth on the SSA IT work, and increased demand for medical examinations.

For VB A, we’re seeing higher volumes from the PACT Act, and we’re earning a higher work share as a result of our performance. Also, the Reserve Health Readiness Program is now building. Non-GAAP operating income margin came in at 17% compared to 19.8% in the prior year quarter. The decrease was primarily driven by the $28 million equitable adjustment in the second quarter of 2022 to cover costs incurred as a result of the COVID-19 pandemic. More important, Health non-GAAP operating income margin was up 110 basis points, sequentially bolstered by increased volume, solid program execution, and a positive outlook on incentive fee performance. Civil revenues increased 5% compared to the prior year quarter. The primary drivers of revenue growth were the NASA Aegis program, increased demand for engineering support to commercial energy companies, and a partial recovery within the security products portfolio.

Civil non-GAAP operating income margin was 9.1% compared to 6.5% in the prior year quarter, which was unfavorably impacted by an adverse arbitration ruling in associated legal fees totaling $17 million. Sequentially, Civil non-GAAP margins improved by 270 basis points, which reflects partial improvement in the security products business. Consistent with expectations, the security products business is recovering but is not yet at peak levels. For perspective, year-to-date, the security products businesses actually up slightly year-over-year on revenue and down modestly on margin. As with last year, the back half of the year has the potential to be significantly stronger than the first half. We’re seeing good traction in the business with the recent Leeds Airport award, and we’ve implemented the changes we talked about on the last call, including a leaner, more responsive cost structure and an improved supply chain.

In addition, as part of the review of the business, we’re looking at pruning the portfolio of products and geographies with lower returns. This work is ongoing. Taking a step back, we see security as an important and growing market, and we are positioning for success with our investment in the Charleston production facility, and looking to expand into new areas such as data center protection. Turning now to cashflow and the balance sheet on Slide 7, we generated $164 million of cashflow from operating activities, and $124 million of free cashflow. Net cash provided by operating activities benefited from strong collections and working capital management. DSO for the quarter was 59 days, a three-day improvement from the first quarter of 2023.

We are in the middle of a cross-functional review of cash generation to include harmonizing vendor payment terms and building in more favorable collection terms on our contracts where possible. We continue to expect to drive sustainably improved performance over time. During the quarter, we paid the remaining $320 million of principal on the 364-day term loan agreement that came due in May, taking on $200 million of commercial paper to do so. These were the key movers of our $125 million net reduction in debt during the quarter. We expect to clear out the commercial paper during the third quarter, which will free up capital to deploy. On to the forward outlook. Tom gave you the revised ranges. Let me provide a little more color. We expect revenue to remain near Q2 levels in the back half of the year, with some degradation from the (Focus Fox) loss, and a move to a single wave of deployments on DHMSM by Q4.

We have a large pipeline of opportunities pending decisions, and we aren’t dependent upon significant new business wins to sustain our current revenues. On EBITDA, the expanded guidance range primarily reflects the range of outcomes on the security products business, as well as the volume of special project work, on fixed price contracts, and incentive fee determinations. We’ve made our best assessment of the likely outcomes and are comfortable that our wider range conservatively incorporates the reasonable potential results. With a narrower range on revenue, and a wider range on margin, we’re comfortable with our EPS range, which also tracks well to our cash target for the year. As in prior years, cash generation is concentrated in Q3. With a strong Q2, we are ahead of our internal plan year-to-date.

With that, I’ll turn the call over to the operator so we can take some questions.

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Q&A Session

Operator: [Operator Instructions]. And our first question is from the line of Bert Subin, Stifel. Please proceed with your questions.

Bert Subin: Hey, good morning and welcome, Tom. So, there was clearly a lot of concern coming out of 1Q earnings that weakness would persist in the securities product business. I mean, so far, that business seems to be recovering ahead of schedule. Can you just walk us through what changed in 2Q versus 1Q? What changes in the back half and whether you think SES can return to double-digit growth again next year?

Tom Bell: Yes, thanks Bert. Well, first, before I turn it over to Chris to give some specificity on the latter part of your questions, let me say how proud I am of Jim and the team as they’ve been driving progress against that recovery plan. One of the first meetings I had with Jim was about the recovery plan and how we were going to get that ship righted. And as Chris said, the guidance that we’ve articulated incorporates the range of likely outcomes. The market is improving, as Chris suggested, with the Leeds award. We believe we have a superior product offering. We believe the customer continues to show confidence in our solutions, and the team is out there aggressively prosecuting the market. So, we feel very good about the fundamentals internally and the market externally.

And also, the team is very focused on expanding the market that we serve with less traditional security solutions that are needed by a different set of customer sets. Chris, anything you’d like to add?

Chris Cage: Yes. Well, I mean, Bert, obviously, there were a number of areas we were focused on driving improvements into, and the team has made great progress in that regard. I would tell you that we’re not to the end game yet. Let me hit on a couple of areas. I mean, the customer-driven delays, that improved during the second quarter. We’re not back to the original plan, but we see a path. Again, that was one of the reasons why we put the guidance forward that we did today. In sourcing, you saw the announcement on Charleston. We’re excited about that. The team went through a very thorough evaluation of alternatives, and we’re full speed ahead to get that operational. We think it’s a relatively modest investment with a longer-term payback.

And then there were a lot of cost reduction actions that were taken. Those are never easy. As part of that, one of the things that we did do is revector a senior resource to focus on strategic supplier obsolescence parts management. We’re seeing improvements in that regard, helping our supply chain in that relationship. So, pipeline remains strong. As we indicated, looking at areas outside of the conventional airport and ports and borders, and we’ll be selective on how we prosecute those bids for maximum benefit to the bottom line and cashflow going forward.

Bert Subin: Great. That’s super helpful. Thanks. And just as a follow-up, Tom, so Leidos has been talking about a Dynetics inflection being on the horizon for a little while now, and previously the expectation was organic growth was going to ramp pretty materially in 2024 for that business. As you’ve come into Leidos over the last three months and got a greater assessment of sort of where things are going, can you just walk us through how you’re thinking about Dynetics and what you see as the growth path there.

Tom Bell: Sure, Bert. Well, my first trip as CEO was to Huntsville to visit with the Dynetics team down there, and I was just thrilled to see what we have there in Alabama. Great facilities, great people, and really importantly, great customer connectivity. Steve and the team down there are bringing focus to what defines them. They’re always going to be a place, I hope, that the customers believe they can get stuff done cleverly and fast. I think that’s a real dynamic for Dynetics. And at the same time, Steve and the team are refocusing their attention on three primary areas. They’re really focused on differentiating themselves in the markets of small satellite payloads. So, the success I referred to with Tranche 0 and Tranche 1, tracking layer assets.