Leidos Holdings, Inc. (NYSE:LDOS) Q3 2023 Earnings Call Transcript

Leidos Holdings, Inc. (NYSE:LDOS) Q3 2023 Earnings Call Transcript October 31, 2023

Leidos Holdings, Inc. misses on earnings expectations. Reported EPS is $-2.91241 EPS, expectations were $1.64.

Operator: Greetings. Welcome to Leidos’ Third 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. Stuart, you may now begin.

Stuart Davis: Thank you, Shamali, and good morning, everyone. I’d like to welcome you to our third 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.

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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. It’s really good to be with you today. I’m pleased to report another strong quarter for Leidos this morning, a quarter of record revenue, earnings, cash flow, bookings, and backlog. Revenue grew 9% year-over-year this quarter, our fastest (indiscernible) two years, and well ahead of the pace implied in our guidance. Customer demand remained robust across all three of our segments, and we are proud of the work that we accomplished with our customers to deliver on important missions. Non-GAAP EPS was up 28% year-over-year, with an adjusted EBITDA margin of 11.5%. Cash management and collections were even stronger. Operating cash flow of $795 million was already in excess of our existing full year guidance of at least $700 million.

As a result of this quarter’s strong performance and the momentum established in our second quarter, we are raising our 2023 financial guidance across all measures. This quarter’s results and our improved outlook were driven by the substantial progress the team has made delivering on our performance initiatives articulated during our last call. First, instituting a promises made, promises kept culture here at Leidos. Second, analyzing and improving acquisition performance. Third, enhancing business development performance and backlog quality. And fourth, sharpening Leidos’ strategy. Let me speak to each of these initiatives in turn. First, we’re executing well on creating a promises made, promises kept culture here at Leidos, challenging ourselves to consistently deliver on the expectations we set for ourselves, and ensuring that we’re having candid conversations about what is working and what can be improved.

We’re taking decisive actions to reallocate resources and course correct when needed. The team understands that creating this culture is not a one and done or twice as nice event, but rather a quarter-by-quarter disciplined drumbeat. Second, we’re taking definitive actions to enhance performance, drive predictability, and de-risk our Dynetics and security products or SES businesses. In Dynetics, we’re in the final stages of business integration across all financial contracts, supply chain, manufacturing, and HR systems. This will result in full proactive management visibility into the business, better business efficiency, and a better employee experience. We’ve added significant engineering and program management expertise to Dynetics to better serve our customers throughout critical programs of record.

The growth outlook for Dynetics is strong in the three priority areas I identified in our last quarter. In hypersonics, we’re ramping up production rates, while looking to improve effectiveness and lower costs. In small satellite payloads, we have all four Wide Field of View tracking layer Tranche 0 payloads in orbit. Moreover, we’re executing on Tranche 1, and recently submitted and recently submitted our proposal for Tranche 2. In force protection, we’re tracking toward government-level development testing of IFPC Enduring Shield in early 2024, and we’re making progress on the persistent surveillance needs of the Army and Marine Corps. In SES, we saw improvement in the quarter on revenue and margin, coupled with strong bookings. We bolstered our supply chain resiliency and took costs out of the business to create more predictability.

At the same time, consistent with the promises laid out last quarter, the team has critically evaluated the business to identify unprofitable product lines and unfavorable geographies, and we’ve updated our sales projections to better reflect current customer buying behavior. Based on these candid evaluations and proactive measures to right-size the business, we are taking a non-cash pre-tax charge of $688 million. As previously disclosed, the market has changed since the SD&A acquisition and won’t return to pre-pandemic levels as fast as previously expected. As a proof point, the TSA administrator testified to Congress recently that the rollout of CT at the checkpoint would not be completed until 2042 at current funding levels. Broadly, customers are delaying recapitalization decisions and holding onto existing machines longer.

With this as a backdrop, the team has moved to right-size the business, discontinue sales of an unprofitable product line, and exit numerous higher-risk, lower-return geographies. We remain committed to the overall security products market where we offer differentiated technology-driven solutions. Security concerns will be just as, if not more pervasive going forward, providing a long-term growth opportunity for Leidos. This includes the regulated aviation and ports and border markets, as well as commercial infrastructure security and loss prevention markets. The definitive actions we have now taken will better position our security business to grow from here in both margins and earnings. We also made progress on our third initiative, delivering exceptional business development performance in the third quarter.

$7.9 billion in awards is a new quarterly high watermark for Leidos. Our book-to-bill ratio in the quarter of 2.0 brings our year-to-date and trailing 12-month ratios to 1.2. But more important to me, our $38 billion of backlog is now $4 billion larger than last quarter’s, and supports our growth and margin objectives. This is what I was referring to last quarter when I mentioned growing our total backlog over time with quality wins. Let me touch on a few of those quality wins this quarter, which demonstrate the ways Leidos provides differentiated solutions to meet customer (indiscernible). The largest win was the Army Common Hardware Systems’ sixth generation, known as CHS-6, which is a single-award IDIQ with a potential value of $7.9 billion over 10 years.

Through technology, we’ll be streamlining and optimizing complex supply chains and transforming logistics to be resilient to supply chain disruptions and cyber risks. Because we offered the army a truly differentiated solution, this award was not protested, and task orders are already beginning to flow. Please note, because of the nature of IDIQ contracts, CHS-6 did not material – did not contribute to our record Q3 bookings and backlog that I mentioned earlier. We also had two large Recompete awards in our Intelligence Group that secure our portfolio for years to come. On a $900 million contract to support and enhance Department of Homeland’s security networks, we’ll enable cross-agency intelligence sharing and secure collaboration, while delivering capabilities like quantum resistant cryptography, AI operations, robotic process automation, and classified cloud service integration.

On a $700 million contract to provide prototype and technology development support to a longtime customer, we’ll identify emerging technologies and develop new tools, techniques, and cyber capabilities to enhance their mission. My final callout is a $125 million contract to defend army weapons systems from cyber electromagnetic activities. This award builds on the R&D and field testing we’ve been doing for years, and it’s another example of Dynetics’ ability to transition from prototypes to fielded capability. You’ll notice that cyber is a common theme on each of these wins. Cyberattacks are a persistent, vexing problem for our customers, and Leidos is a top provider of full spectrum capabilities and services. In keeping with our approach of anticipatory technology investment, we continue to focus on addressing the next generation of cyber threats, with emphasis in zero trust, quantum proof encryption, network Defense, and cyber physical systems.

We also anticipated the convergence of cyber and AI, what we call cognitive cyber, years ago. We’ve matured a number of technologies and capabilities in this area into pilots that defend against AI-based cyberattacks. As a key driver of our business development strategy, we’ll continue to invest in differentiators in areas of critical importance to our customers. Fourth, we’re executing a multi-phase, strategic sharpening under the effort we call Leidos Next, a robust journey to unlock the next level of technological innovation, the next level of execution and performance, and the next level of customer success. The goal of Leidos Next is to create a company with a much clearer and even more inspiring vision, our new North Star. We want to become the best company in the world that’s solving a core set of problems for our customers and the best employer in the world, hiring and retaining the most talented people in order to do this.

This is the essence of Leidos Next. As an enabler of Leidos Next, we will be simplifying our organizational structure to promote operational excellence, allow for faster decision-making, and more tightly align our business around key technology discriminators. This more focused, capability-oriented structure will better enable us to create clear, differentiated growth strategies for each market we serve, allow for more targeted and efficient investment in the highest areas of potential, and enable repeatable solutions to drive profitable growth. Each new sector has ample room for expansion, while benefiting from the collective strength and scale of our $15 billion company. Beginning in 2024, we’ll operate in five sectors that are focused on specific defined capability sets we bring to our customers.

Health and Civil will deliver customer solutions with unique capabilities in the areas of public Health, care coordination, life and environmental sciences, and transportation. National security will combine all our technology-enabled services and mission software capabilities for Defense and intel customers in the area of cyber, logistics, security operations, and decision analytics. Commercial and international will combine our existing SES commercial energy, UK, and Australian businesses. Digital modernization will bring together our IT operations and digital transformation programs. This will allow us to serve all our digital transformation customers with better scale and speed brought about by better repeatability of best-in-class solutions with greater efficiency.

And lastly, Defense systems will combine elements of Dynetics and our prior Defense business to develop and produce advanced space, aerial, surface, and subsurface manned and unmanned Defense systems. By streamlining the organization and encouraging decision-making at the appropriate levels, we’ll be more efficient and responsive to market changes and customer needs. I’m also upgrading several existing executive leadership team positions. We’ll centralize strategy, business development, marketing, communications, government relations, all in one value stream under a new Chief Growth Officer. As such, we’ll rejuvenate our customer-centric business approach. Our new Chief Performance Officer position will spearhead program execution to ensure that we keep our commitments to customers, as well as drive cost efficiencies through world class supply chain management, IT delivery, and real estate portfolio management.

Lastly, our Chief Technology Officer will now also lead LinC, the Leidos Innovation Center, adding even more emphasis on (technology) innovation and development, and making a profound organization-wide commitment to discovering, developing, and deploying market-differentiating technology, Golden Bolts. We’re placing technology innovation at the forefront of our sharpened Leidos Next North Star strategy. Later this week, we’ll announce our sector presidents and those who will serve in these key positions. Finally, as I mentioned on our last call, a key element to our approach going forward will be disciplined resource allocation both internally and externally. Internally, last quarter we acted to refine our investment strategy toward those areas of best overall value to the enterprise.

Our BD teams have removed opportunities that do not have a clear path to an acceptable market and are reallocating our resources and realigning our pipeline to better achieve top and bottom-line growth for Leidos. Externally, as promised, our team deployed capital during the third quarter towards debt reduction to reach and slightly surpass our previously announced target leverage ratio of three times gross debt to EBITDA. After reaching this milestone, and with near-term acquisitions not a priority for this business, I recommended, and the Board of Directors approved, the first increase in our dividend in over two years. Shareholders of record on December 15 will receive a dividend of $0.38 a share, a 6% increase over our past dividend. Our strong balance sheet enables us to deploy additional capital to shareholder returns.

With a stock price that does not fully capture our earnings and cash generation power, we expect share repurchase to be a primary focus for excess cash in the near term. And as we look to the future, we expect earnings and cash to grow, and remain committed to this disciplined capital management and deployment policy. In closing, we’re building momentum with two successful quarters as we work toward ending 2023 in a position of strength. Our Q3 results speak to our ability to focus, grow the business, grow earnings, and generate robust cash conversion. I’m very excited about our new organizational alignment for 2024, our new North Star coming into focus, and indications of the full potential of this business becoming evident. With that, I’ll turn the call over to Chris for more detail on our financial performance and updated outlook.

Chris Cage: Thank you, Tom. Despite our GAAP loss, our third quarter operating results were positive across the board, and speak to the underlying strength of the team, market position, and management discipline. Revenue growth, profitability, and cash conversion all improved not only year-over-year, but also compared to a very strong Q2. Our enhanced outlook puts us on track for an excellent 2023. Turning to Slide 5, revenues for the quarter were $3.92 billion, up 9% compared to the prior year quarter. Revenue growth has accelerated each quarter this year and was ahead of our long-term target in Q3. Growth was robust in all three of our reporting segments, especially in Health. Customers continued to expand scope on existing contracts ahead of an uncertain budget environment.

Adjusted EBITDA was 451 million for the quarter, up 21% year-over-year, and adjusted EBITDA margin increased 120 basis points to 11.5%. I’ll get a little more granular later, but big picture, Civil and Defense profitability were in line with the year-ago quarter, and Health was up substantially. Non-GAAP net income was $283 million, and non-GAAP diluted EPS was $2.03, both up 28% compared to last year. Below EBITDA, a lower effective tax rate added about $0.08 to EPS, which offset a $0.02 headwind from increased interest expense. Turning to the segment drivers on Slide 6, Defense Solutions revenues increased 7% year-over-year. The largest growth catalyst were in digital modernization, offensive and defensive hypersonics, and our Australian Airborne Solutions business.

Defense Solutions Non-GAAP operating income margin increased 30 basis points from the prior year quarter to 8.4%, with some milestone achievements and strong cost control. That said, we did have some unfavorable EAC adjustments as we wind down prototype developments on a couple of programs, which led to the 90 basis point sequential decline in margin. As we complete systems integration and add technical depth, we are committed to delivering better and more predictable returns at Dynetics. Civil revenues increased 6% compared to the prior year quarter, driven by continued recovery in security products, infrastructure spending at the FAA, and increased demand for engineering support to commercial energy companies. Civil non-GAAP operating income margin was 10.4% compared to 11% in the prior year quarter.

The year-over-year segment profitability decreased as a result of the mix of security product sales. The changes that we’ve implemented, including a leaner cost structure, improved supply chain and rationalized product and geographic portfolio, will stabilize and enhance the margin going forward, and did contribute to the 130 basis point sequential increase in Civil non-GAAP margins. Health revenues increased 18% over the prior year quarter, driven by higher levels of medical examinations and growth on our Social Security Administration’s IT work. Non-GAAP operating income margin came in at 20.4%, compared to 15% in the prior year quarter. The increase in segment profitability was driven primarily by the increased volumes from PACT Act and strong incentive fee performance in the medical examination business.

In addition, we received an equitable adjustment to cover costs incurred as a result of the COVID-19 pandemic. This adjustment added $14 million to both revenue and operating income, similar to the recovery incurred in the second quarter of 2022. We’ll operate in and report on these three segments through Q4, and then we’ll move to the five-sector structure that Tom described. For financial reporting segmentation, we’ll combine the national security and digital modernization sectors based on their similar economic characteristics. The remaining three sectors, Health and Civil, Defense Systems, and Commercial and International, will be their own reporting segments. We believe the new segmentation will enhance visibility and provide investors and analysts a clearer picture of Leidos going forward.

We’re still completing the contract-by-contract mapping into the new sectors. On our Q4 call, we’ll provide supplemental disclosure to help you with modeling, including revenue and operating income for the new segments for full year 2022 and 2023. Turning now to cash flow and the balance sheet on Slide 7. We generated $795 million of cash flow from operating activities, and $745 million of free cashflow. Cashflow benefited from strong collections and ongoing working capital improvement initiatives. In addition, we saw some benefit from our US government customers accelerating payment at their fiscal year-end. DSO for the quarter was 57 days, a two-day improvement from the second quarter of 2023. During the quarter, we paid off the remaining $200 million of commercial paper to reach our target leverage ratio of three times gross debt to adjusted EBITDA, actually achieving 2.9 times, which gives us flexibility to return capital to shareholders.

We ended the quarter with $750 million in cash and cash equivalents, and $4.7 billion of debt. Tom mentioned the non-cash charge recorded this quarter, so let me provide some additional details around that. There are three basic components that are add-back to net income from the statement of cash flows, a goodwill impairment of $599 million, asset impairment of $88 million, and $12 million of inventory and other assets associated with product lines we are exiting. Goodwill and asset impairments are both separate lines on the income statement and cash flow statements. The restructuring charge for inventory is included within the $19 million other line in the statement of cash flows, and then within cost to revenues on the income statement. The vast majority of the charges are associated with SES, but we also held a small unprofitable asset within Dynetics for sale, resulting in an $11 million impairment.

The sale has been completed and will be reflected in our Q4 financials. In both the SES and Dynetics impairments, we’ve taken action to improve the margin and earnings outlook, with no significant impact to current revenue projections. On to the forward outlook on Slide 8. Based on our strong Q3 and year-to-date results, we’re raising our 2023 guidance for all metrics. We now expect revenue between $15.1 billion and $15.3 billion, an increase of $150 million at the midpoint. Profitability has been a key focus area over the last two quarters, and the team has delivered. Our new adjusted EBITDA range is 10.5% to 10.7%, an increase of 40 basis points on the bottom, and 20 basis points on the top of our previous guidance. With an improving revenue and margin outlook, we’re raising our non-GAAP diluted EPS $0.40 at the low end, and $0.30 at the high end, to $6.80 to $7.10.

and we’re raising our operating cashflow target by $150 million to at least $850 million for the year, which is right at our year-to-date performance. Let me put some context around our guidance related to the current budget environment. We’re hopeful that Congress will be able to avoid a shutdown, but in the spirit of promises made, promises kept, our guidance explicitly includes our current assessment of the risk of a government shutdown. A potential full 45-day shutdown could put us closer to the bottom end of guidance for revenue in EPS. A shutdown’s impact on cash flow is harder to predict. We expect to generate operating cash flow in the fourth quarter, but our revised cash guidance reflects the possibility of a modest disruption associated with the potential government shutdown.

Our strong balance sheet positions us well to navigate this potential headwind. With that, Shamali, we’re ready to take some questions.

Operator: [Operator Instructions]. Our first question comes from the line of Matt Akers with Wells Fargo. Please proceed with your question.

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Q&A Session

Matt Akers: Yes. Hey, good morning, guys. Thanks for the question. I guess to follow up on SES, curious if you could give us an update on some of the insourcing activities and how that’s going, if you’re still on track for Charleston kind of early next year.

Chris Cage: Yes, Matt, thanks for the call and the question. Yes, definitely, the team has continued to make steady progress over the course of the last few quarters, and Charleston is really important to our future strategy. We are on track. It’s something that will go live, whether it’s late Q1, early Q2. We’ve launched our hiring campaign. We’re working on outfitting the facility. So, that’s still tracking to where we want it to be, and we’ve made other progress as it relates to various supply chain improvements over the course of the quarter. So, again, one of the reasons why the Civil margins trended up this quarter was the SES business showing some signs of improvement, and we’re really happy with that progress.

Tom Bell: I would just add, Matt, that while your question was tactical, so I wanted Chris to go first, I’m glad the first question was about SES, because while it’s unfortunate we have to take the impairment charge, the fact is, we’re all very bullish about the prospects of this business going forward. In fact, I referenced in my comments, changing customer buying behavior. Over in Europe at a major trade show, we recently unveiled two new products that directly speak to this changing customer buying behavior. A Pro:Vision 3 people scanner, which features wideband AI-based gender-neutral algorithms for higher quality imaging and detection, something that customers are asking for the technology to be faster and better. And more important to me, a product we call ProSight, which is a secure and scalable enterprise platform that integrates a customer’s diverse suite of screening machines and operations that allow them to create a system-wide view of their security operations at any airport or any lane.

So, very excited about not only the tactical decisions the team is making to right-size the business for the future, but also the forward investment in future products that will allow us to compete and win going forward in both the regulated market and the commercial market.

Matt Akers: Great, thanks. And then I guess as a follow-up, could you touch on kind of the cash flow? I guess the Q4 cash is implied a lot weaker. Is that just kind of timing of the working capital, like you mentioned? Is there anything else kind of one-time in there.

Chris Cage: Yes, no, Matt, nothing more than that. Obviously, we’re very pleased with the third quarter performance, and that allowed us to raise our full-year guidance by the $150 million. We’re navigating the risk around a shutdown and the potential challenges that may or may not pose. We’re hopeful to be able to exceed that performance level. And the other thing is, we did certainly experience some benefit, as I mentioned, of customers paying a few things early as we closed out Q3. So, team’s motivated to finish the year strong, but we’ll just be cautious as we navigate what our government customers do going into Q4.

Matt Akers: Great. Thank you.

Operator: Our next question comes from the line of Bert Subin with Stifel. Please proceed with your question.

Bert Subin: Hey, good morning, and congrats on the strong quarter. As we think about – hey, Tom, and Chris. This is probably for Chris. As we think about 3Q performance relative to future earnings, were there items in the quarter that you anticipate do not recur outside of the $14 million Health benefit you just mentioned? Your no-shutdown case for earnings in 4Q is expected to be closer to just shy of $1.80, which is still a step-down from 3Q when factoring in that benefit and the tax benefit. So, I’m just curious if there was pull-forward of security products or, something unordinary, or if the business is just performing really well.

Chris Cage: Yes. I’d say, kind of our base outlook, Q4 looks a little bit like Q2. Bert, there wasn’t anything other than the $14 million that we highlighted that was what I’d consider to be a one-timer. The Health business performed exceptionally well. When you normalize that one-time benefit out, the margins were still in the high 18% range. We did see strong performance from PACT Act’s caseload. We did see strong incentive fee performance around that as well. And those are things that could moderate a little bit quarter-to-quarter. But on the contrary, I also pointed to the fact that Defense stepped back a little bit due to some EAC adjustments, and those are things that we don’t expect to recur on an ongoing basis. So, Q4, hopefully, we’re right down the middle. We will see where the government shutdown risk takes us, but really pleased, quite honestly, with the progress we’re seeing across the business on margin and revenue growth.

Bert Subin: Yes. Great. Maybe just as a follow-up there, both on the Health and the Defense side, I guess there’s three big contracts to think about. There’s DES. there’s CHS-6, and there’s DHMSM. Can you just give us maybe some – a viewpoint on sort of how we should think about those contracts going forward? I know DHMSM was expected to be a headwind. It doesn’t seem like that’s happened yet. Maybe you’re repurposing some of that ceiling value. So, I’m just curious how you think those are going to – those two are going to ramp up and then DHMSM’s going to step down.

Tom Bell: Well, let me jump in first, Bert, if you don’t mind. I’ll talk about DHMSM first and then we’ll take them from there. Obviously, we’re very, very pleased and proud of the team and how they deployed DHMSM to great customer satisfaction to date. It’s about 91% deployed, with 7.3 million Conus beneficiaries out of 9.6 million that we envision full-time. And we’re on track to deliver to all the DoD locations by the end of this year. But what’s more exciting to me is, while most of us, and most of my first six-month conversations with analysts have been about what are we going to do when DHMSM trails off, what I learned this past quarter is, actually this program is just in the first phase of a three-phase program that the customer expects regarding the whole suite of programs around Health margins.

So, what is interesting to me is how our excellent customer satisfaction and performance to date positions us not only to continue to work on the program of DHMSM, but also puts us in a great position to compete for the follow-on efforts and the rest of the efforts that the customer is looking for. So, I’m actually very excited about where we’re going.

Chris Cage: Yes. Well, I am too, Tom, and I think that this definitely has a horizon, a next horizon to it, Bert. And we’ve talked about trying to, once the system got deployed, add more capabilities. And to that point, the team was very successful. We won a contract this quarter, not huge, but it’s a relatively shorter duration contract digital-first under the DHMSM umbrella. And that is starting on the next phase that Tom was just talking about, taking – digitalizing the information to digitalization and how patient benefits are extended and modernized. And so, that will help moderate the impact of the deployments coming to an end. It is lower in Q4 than it had been earlier this year because of the deployment phases, but we’re able to see line of sight to holding kind of at the Q4 level going into 2024, which is excellent.

And then quickly on the other two, DES, hey, it’s performing as expected and we’re seeing some ramp-up consistent with what we said last quarter. A couple of nice task orders are in the hopper right now, multi hundred-million-dollar task orders.

Tom Bell: Well, in fact, we just got a major award this quarter of $274 million in DES, and there’s likely another one even larger in the near term.

Chris Cage: That’s right. So, it will be a growth catalyst for us in 2024. And then finally CHS-6, Tom highlighted, very proud of the team to prevail without a protest. Won’t see any notable activity from that in 2023, but we’re positioned for it to be a growth catalyst in 2024. And too early to speculate until we get a little bit more clarity on what those task orders are, but we’re rounding out the catalog. Customer seems very motivated to use us to buy as much of the C5 ISR activity as they can to support their mission. So, really excited about getting that one up and running.