Leidos Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
October 31, 2023

There are 11 speakers on the call.

Operator

Greetings. Welcome to Leidos' Third Quarter 2023 Earnings Call. 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 begin.

Speaker 1

Thank you, Shamali, and good morning, everyone. I'd like to welcome you to our Q3 fiscal year 2023 earnings conference call. Call. Joining me today are Tom Bell, our CEO and Chris Cage, our Chief Financial Officer. Today's call is being webcast slides on the Investor Relations portion of our website, where you'll also find the earnings release and supplemental financial presentation slides call that we'll use during today's call.

Speaker 1

Turning to Slide 2 of the presentation. Today's discussion contains forward looking statements call based on the environment as we currently see it and as such includes risks and uncertainties. Please refer to our press release call for more information on the specific risk factors that could cause actual results to differ materially. Finally, call. As shown on Slide 3, during the call, we'll discuss GAAP and non GAAP financial measures.

Speaker 1

A reconciliation between the two call. With that, I'll turn the call over to Tom Bell, who will begin on Slide 4.

Speaker 2

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 for the Q2 of fiscal year 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.

Speaker 2

Non GAAP EPS was up 28% year over year With an adjusted EBITDA margin of 11.5%. Cash management and collections were even stronger. Operations operating cash flow of $795,000,000 was already in excess of our existing full year guidance of at least $700,000,000 As a result of this quarter's strong performance and the momentum established in our 2nd quarter, We are raising our 2023 financial guidance across all measures. This quarter's results and our improved outlook were the first, instituting a promises made, promises kept culture here at Leidos second, analyzing and improving acquisition performance 3rd, enhancing business development performance and backlog quality and 4th, sharpening Leidos' strategy. Let me speak to each of these initiatives in turn.

Speaker 2

First, we're executing well on creating a promises made, promises kept culture here at Leidos, the 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 1 and done or twice as nice event, directions to enhance performance, drive predictability and derisk 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.

Speaker 2

We've added significant engineering and program management expertise to Dynetics to better serve our customers throughout critical programs of record. For SONICS, 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 the and recently submitted our proposal for tranche 2. In force protection, we're tracking toward government level the testing of IFPIC Enduring Shield in early 2024 and we're making progress on the persistent surveillance needs of the Army and Marine Corps.

Speaker 2

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. Presentation. At the same time, consistent with the promises laid out last quarter, the team has critically evaluated the business to identify unprofitable product lines financial results. Based on these candid evaluations and proactive measures to right size the business, we are taking a non cash pretax charge call of $688,000,000 As previously disclosed, the market has changed since the SD and A acquisition and won't return to pre pandemic levels as fast as previously expected.

Speaker 2

As a proof point, the TSA administrator testified to Congress recently that the rollout of CT at the checkpoint would not be completed until 2,040 2 at current funding levels. Broadly, customers are delaying recapitalization decisions and holding on to existing machines longer. With this as a backdrop, the team has moved to right size the business, discontinue sales of an 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 call as well as commercial infrastructure security and loss prevention markets.

Speaker 2

The definitive actions we have now taken We also made progress on our 3rd initiative, delivering exceptional business development performance in the 3rd quarter. The $7,900,000,000 in awards is a new quarterly high watermark for Leidos. The our book to bill ratio in the quarter of 2.0 brings our year to date and trailing 12 month ratios to 1.2. The But more important to me, our $38,000,000,000 of backlog is now $4,000,000,000 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.

Speaker 2

Let me touch on a few of those quality wins this quarter, which demonstrate the ways Leidos provides differentiated the solutions to meet the challenges. The largest win was the Army Common Hardware Systems 6th generation, formal presentation, known as CHS VI, which is a single award IDIQ with a potential value of $7,900,000,000 over 10 years. The Through technology, we'll be streamlining and optimizing complex supply chains and transforming logistics to be resilient the to supply chain disruptions and cyber risks. Because we offered the Army a truly differentiated solution, this award was not protested CHS-six did not material did not contribute to our record Q3 bookings and backlog that I mentioned earlier. We also had 2 large recompete awards in our intelligence group that secure our portfolio for years to come.

Operator

On a

Speaker 2

$900,000,000 contract to support and enhance Department of Homeland Security Networks, we'll enable cross agency intelligence sharing and secure collaboration while delivering capabilities like quantum resistant cryptography, the AI operations, robotic process automation and classified cloud service integration. On a $700,000,000 contract to provide prototype and technology development support to a long time customer, My final call out is a $125,000,000 contract to defend Army weapon systems from cyber electromagnetic activities. This award builds on the R and D and field testing we've been doing for years, and it's another example of Dyntik's ability to transition from prototypes to fielded capability. You'll notice that cyber is a common theme on each of these wins. Cyber attacks are a persistent vexing problem for our customers and Leidos is the top provider of full spectrum capabilities and services.

Speaker 2

In keeping with our approach the presentation. We continue to focus on addressing the next generation of cyber threats with emphasis in 0 trust, quantum proof encryption, network defense and cyber physical systems. We also anticipated the convergence of cyber the presentation and AI, what we call cognitive cyber years ago. We've matured a number of technologies and capabilities in this area into pilots the that defend against AI based cyber attacks. As a key driver of our business development strategy, we'll continue to the differentiators in areas of critical importance to our customers.

Speaker 2

4th, We're executing a multi phase strategic sharpening under the effort we call Leidos Next, the robust journey to unlock the next level of technological innovation, the next level of execution and performance 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 at 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 organization structure to promote operational excellence, allow for faster decision making and more tightly align our business around key technology discriminators.

Speaker 2

The This more focused, capability oriented structure will better enable us to create clear, differentiated growth strategies for each market we serve, the allow for more targeted and efficient investment in the highest areas of potential and enable repeatable solutions to drive profitable growth. Beginning in 2024, we'll operate in 5 sectors that are focused on specific defined capability sets we bring to our customers. The call. Health and Civil will deliver customer solutions with unique capabilities in the areas of public health, care coordination, the 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, U.

Speaker 2

K. And Australian businesses. Digital modernization will bring together our IT operations and digital transformation question programs. This will allow us to serve all our digital transformation customers with better scale the and speed brought about by better repeatability of best in class solutions with greater efficiency. The.

Speaker 2

And lastly, Defense Systems will combine elements of Dynetics and our prior Defense business to develop and produce advanced space, the aerial surface and subsurface manned and unmanned defense systems. By streamlining the organization and encouraging the decision making at the appropriate levels will 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.

Speaker 2

Our new Chief Performance Officer position We'll 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 the 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. 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.

Speaker 2

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 Q3 towards debt reduction to reach and slightly surpass our previously announced target leverage ratio of 3x 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 2 years. Shareholders of record on December 15 will receive a dividend of $0.38 a share, a 6% increase over our past dividend.

Speaker 2

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 2 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.

Speaker 2

I'm very excited about our new organizational alignment for 2024, our new North Star coming into focus the following slides 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.

Speaker 3

Thank you, Tom. Despite our GAAP loss, Our Q3 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.

Speaker 3

Revenues for the quarter were $3,920,000,000 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 continue to expand scope on existing contracts call ahead of an uncertain budget environment. Adjusted EBITDA was $451,000,000 for the quarter, up 21% year over year And adjusted EBITDA margin increased 120 basis points to 11.5%.

Speaker 3

I'll get a little more granular later. A big picture, civil and defense profitability were in line with the year ago quarter and health was up substantially. Non GAAP net income was $283,000,000 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.

Speaker 3

Defense Solutions revenues increased 7% year over year. The largest growth catalysts 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% the the call as we wind down prototype development 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 the increased demand for engineering support to commercial energy companies.

Speaker 3

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 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 and 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 IT work. Non GAAP operating income margin came in at 20.4% compared to 15% in the prior year quarter.

Speaker 3

The increase in segment profitability was driven primarily by the increased volumes from PactAct and strong incentive fee performance in the medical examination business. In addition, we received an equitable adjustment to cover the costs incurred as a result of the COVID-nineteen pandemic. This adjustment added $14,000,000 to both revenue and operating income similar to the recovery incurred in the Q2 of 2022. We'll operate in and report on these three segments through Q4 the call and then we'll move to the 5 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.

Speaker 3

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 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 20222023. Turning now to cash flow and the balance sheet on Slide 7. We generated $795,000,000 of cash flow from operating activities and $745,000,000 of free cash flow.

Speaker 3

Cash flow benefited from strong collections and ongoing working capital improvement initiatives. In addition, we We saw some benefit from our U. S. Government customers accelerating payment at their fiscal year end. DSO for the quarter was 57 days, a 2 day improvement from the Q2 of 2023.

Speaker 3

During the quarter, we paid off the remaining $200,000,000 of commercial paper the To reach our target leverage ratio of 3 times gross debt to adjusted EBITDA, actually achieving 2.9 times, call, which gives us flexibility to return capital to shareholders. We ended the quarter with $750,000,000 in cash and cash equivalents the financial results and $4,700,000,000 of debt. Tom mentioned the non cash charge recorded this quarter, so let me provide some additional details around that. The financial results. There are 3 basic components that are add back to net income statement of cash flows: a goodwill impairment of 599,000,000 asset impairment of $88,000,000 $12,000,000 of inventory and other assets associated with product lines we are exiting.

Speaker 3

The financial statements. The restructuring charge for inventory is included within the $19,000,000 other line in the statement of cash flows and then within cost of 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 $11,000,000 impairment. The sale has been completed and will be reflected in our Q4 financials. In both the SCS and Dynetix We've taken action to improve the margin and earnings outlook with no significant impact to current revenue projections.

Speaker 3

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 $15,100,000,000 $15,300,000,000 an increase of $150,000,000 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.

Speaker 3

The With an improving revenue and margin outlook, we're raising our non GAAP diluted EPS $0.40 the at the low end and $0.30 at the high end to $6.80 to $7.10 And we're raising our operating cash flow target by $150,000,000 to at least $850,000,000 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 and EPS. The shutdown's impact on cash flow is harder to predict.

Speaker 3

We expect to generate operating cash flow in the 4th quarter, but our revised cash guidance reflects the possibility of a modest disruption associated with the potential government shutdown. Our strong balance positions us well to navigate this potential headwind. With that, Shamali, we're ready to take some questions.

Operator

Our first question comes from the line of Matt Akers with Wells Fargo. Please proceed with your question.

Speaker 4

The Yes. Hey, good morning, guys. Thanks for the question. I guess to follow-up on the SCS, just to give us an update on some of the in sourcing activities and how that's going, if you're still on track for Charleston kind of early next year.

Speaker 3

The Yes. Matt, hey, 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 the And Charleston is really important to our future strategy. We are on track. It's something that will go live whether Late Q1, early Q2, we've launched our hiring campaign.

Speaker 3

We're working on outfitting the facility. So the That's still tracking to where we wanted to be and we've made other progress as it relates to various supply chain improvements over the course of the quarter. So call. Again, one of the reasons why the Civil margins trended up this quarter was the SCS business showing some signs of improvement, and we're really happy with that progress.

Speaker 2

The 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 2 new products that directly speak to this changing customer buying behaviors, the a ProVision 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.

Speaker 2

And more important to me, a product we call ProSight, which is a secure and scalable enterprise platform the that integrates the customer's diverse suite of screening machines and operations that allow them to create the and a system wide view of their security operations at any airport or any lane. So very excited about not only the tactical the 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.

Speaker 4

The 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?

Speaker 4

Is there anything else kind of one time in there?

Speaker 3

Yes. No, Matt, nothing more than that. Obviously, we're very pleased with the Q3 performance and that allowed us to raise our full year guidance by the 150,000,000 We're navigating the risk around the 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.

Speaker 3

The Team is motivated to finish the year strong, but we'll just be cautious as we navigate what our government customers doing going into Q4.

Speaker 4

The Great. Thank

Speaker 3

you. Thank you.

Operator

Our next question comes from the line of Burt Zubin with Stifel. Please proceed with your question.

Speaker 5

The Hey, good morning and congrats on the strong quarter. Thanks, Bert. 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 the For outside of the $14,000,000 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 call really well.

Speaker 3

Yes. I'd say our kind of our base outlook Q4 looks a little bit like Q2. Bert, there wasn't anything other than the $14,000,000 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.

Speaker 3

The margins were still in the high 18% range. We did see strong performance from PackAct'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. The But on the contrary, I also pointed to the fact that defense stepped back a little bit due to some EAC adjustments and And those are things that we don't expect to recur on an ongoing basis. So Q4, hopefully, we're right down the middle.

Speaker 3

We'll see where the government shutdown risk takes us, but really the Please, quite honestly, with the progress we're seeing across the business on margin and revenue growth.

Speaker 5

The Great. Maybe just as a follow-up there, both on the health and the defense side. I guess there's 3 big contracts to think about. There's DAS, there's CHS 6 and there's DHMSM. Can you just give us maybe some viewpoint on sort of how we should think about those contracts going forward?

Speaker 5

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 2 are going to ramp up and then DHMSM is going to step down?

Speaker 2

Well, let me jump in first, Bert, if you don't mind. I'll talk about the 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 today. It's about 91% deployed with 7,300,000 Conus beneficiaries out of 9,600,000 that we envisioned full time. And we're on track to deliver to all the DoD locations by the end of this year.

Speaker 2

But what's more exciting to me is, while most of us and most of my first 6 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 3 phase program that the customer the specs regarding the whole suite of programs around health margins. So the 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.

Speaker 3

Well, I am too, Tom. And I think that this definitely has a horizon, an extra horizon to it, Bert. And the 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.

Speaker 3

And so that will help moderate the impact of The deployment is coming to an end. It is lower in Q4 than it had been earlier this year because 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 2, DES, 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 $100,000,000 task order.

Speaker 2

Well, in fact, we just got a major award this quarter of $274,000,000 in debt, and There's likely another one even larger in the near term. That's right.

Speaker 3

So it will be a growth catalyst for us in 2024. The And then finally, CHS-six, 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 the call. And too early to speculate until we get a little bit more clarity on what those task orders are, but we're rounding up the catalog. Customer seems very motivated to use us the to buy as much of the C5ISR activity as they can to support their mission.

Speaker 3

So really excited about getting that one up and running.

Speaker 2

Yes. And just to pile on that one, Bert, if you don't mind. So proud of the team. The RFP asked for a transition plan of 60 days. The team accomplished it in 19, 19 days to be fully up and running for the customer in this important part of their value stream.

Speaker 2

So just so super excited about the team that was able to the Lean into that and satisfy the customer quickly out of the blocks.

Speaker 5

Super helpful. Thank you, Tom and Chris.

Speaker 6

The Thanks, Bart.

Operator

Our next question comes from the line of Mariana Perzumora with Bank of America. Please proceed with your question.

Speaker 7

Good morning, everyone.

Speaker 3

Hi, good morning.

Speaker 7

I have two questions. First one is more like big picture. How should we think about the organizational structure in terms of timing, how long, How much it's going to cost and how should we think about the cost structure once and workforce once this is done?

Speaker 2

The call. Yes. Thanks, Mariana. So first of all, we will operate in the current structure through the rest of this year. So in fact, In all of my communications to the Leidos team, I've been hammering home, the stay focused on the current organizational structure.

Speaker 2

Our customers rely on us, and I'm relying on the team to deliver on our promises this year to our customer. The new organizational structure that I articulated will take place on January 1, And frankly, it's not a reorganization. It's simply a realignment of the existing Leidos business In a post pandemic fresh look at the organization for efficiency and effectiveness, And that's really the main goal. How do we increase repeatability, increase our prowess going to the markets? How do we satisfy customers with better products across customers where they tended to be siloed in the last organizational the construct we had.

Speaker 2

And so it's my expectation that the new organization is going to unlock all sorts the revenue and profit opportunities. In that regard, one of the first things I'll be doing in the New Year is challenging the new executive leadership team to create full potential growth plans for each of the new five businesses. The And in those full potential growth plans, we'll be looking at the marketplace, the competition, the whole suite of technologies and capabilities we need to compete and win effectively, and I expect that we'll see growth plans for each business that are unlocking growth that is currently squelched or squandered in the current environment. So I'm very hopeful about it. In terms of costs, Chris?

Speaker 3

Less is better. But Listen, that's not the primary motivation to do this as Tom talked about. I do see each of these businesses having the different objectives as it relates to that in the example of Defense Systems. Hey, we have been investing and we will continue to invest more in engineering and technical depth. That is not a cost driven exercise to get those businesses aligned effectively.

Speaker 3

But in the case of digital modernization, this repeatable solutions, this automation, obviously, those can lead to more efficient delivery structures, back office structure of those types of things. So we're very excited to get to the full potential and we'll have a lot more to share on that, Mariana, as we get to that next call at Q4.

Speaker 7

Thanks so much. And then my follow-up is more specific to healthcare. Incentive fee performance on the medical examination was strong once again. Could you please measure that for the quarter and give us a sense of how are your expectations for that the Like in the near term to come down or not?

Speaker 3

Yes, Mariana, Absolutely. This is an area where the customers always had both incentives and disincentives associated with these contracts. And earlier this year as the Packback volume was ramping up, they modified some of those and the team has been doing An excellent job not only on throughput, volume, but customer satisfaction, timeliness, etcetera. The customer is motivated to raise the bar yet again because they want to make sure we're continuing to deliver against the high volume of demand. So we'll continue to recalibrate on what that full potential looks like.

Speaker 3

But I would just say that we're excited about the prospect the of those incentives continuing to contribute not only in the Q4, but as we look ahead in 2024.

Speaker 2

Yes. And just if you don't mind, Mariana, me piling on. So proud of the team and frankly, as a taxpayer, proud of the customer. The customer should be challenging us to raise our standards and raise expectations each contract. And so the They did.

Speaker 2

We performed. We threw strikes. They changed the strike zone and tightened it up a little the And so I have every expectation that the team can throw strikes even better in 2024 than they did in 2023.

Speaker 3

The

Speaker 7

Thanks so much.

Speaker 1

Thank you.

Operator

Our next question comes from the line of Cai von Rumohr with with TD Cowen. Please proceed with your question.

Speaker 8

Yes, terrific. Thank you very much. Great results, guys.

Speaker 6

Thanks, Scott.

Speaker 8

To maybe follow-up On Mariana's question, so if we take out the $14,000,000 COVID, which was kind of prior period, you did $18,600,000 which is Terrific and help. Could you quantify how big were the incentive accords in that quarter? The And give us some sense if they've tightened it up, I mean, are they going to tighten it so those margins go down? Because I think at one point, the You were hoping to do mid teens. It now looks like you're doing 18.5%, 18.6% this quarter.

Speaker 8

So the Where is that likely to go? And what impact do you see from potential government shutdown? Because you mentioned that as a potential issue going forward.

Speaker 3

The Yes. Cai, let me get going here and Tom wants to add on. He can. Look, we're not going to quantify specifics around the incentives. I would just say that this year, if you look at 2023, we will not have a full year worth of those incentives in our results.

Speaker 3

So the good news is 24, we expect that to be something that can contribute for a full year. The But also we'll have to step up our game relative to the customer increasing the standards because we all want to make sure the veterans are being well served, the that our time limit stays high, that the throughput stays high and the quality stays high. So it is a it's been a nice benefit. We have incentive fee structures across a variety of contracts and our objective is to deliver exceptional service and try to maximize those. These ones just happen to be call.

Speaker 3

But big picture on health, we had previously said a mid teens was a good margin level for the business. Obviously, we think We can do better and we are doing better than that now and whether that's in the 17%, 18% zone, we'll endeavor to sustained that level of performance. On the shutdown, this is an imperfect science, but we've spent a lot of work because we got so close at the end of September. Big picture, we think on the order of $100,000,000 ish of revenue potential risk, the $10,000,000 to $15,000,000 of OI risk that we're managing through. I mean, the most important thing is we work hand in glove with our customers right up to the deadline And that we work with our employees to make sure they understand what they're to do if they're unable to perform on the customer mission.

Speaker 3

And hopefully, we'll find an opportunity to get back to work quickly if it were to happen. But that's kind of our current assessment, but it's one that we will continuously refresh as we work through the Right up to a potential deadline.

Speaker 1

But again,

Speaker 2

just to put stop it a little bit, Cai, as Chris mentioned in his comments, The risk of a full 45 day shutdown is included in our the lower end of our guidance. So Consistent with promises made, promises kept, given the risk of a full 45 day shutdown is the possible, the guidance incorporates that risk.

Speaker 3

I mean, the good news, Kai, is we have a lot of funded backlog. We have a lot of essential programs the And we're well positioned to navigate these headwinds.

Speaker 8

So just to be clear, as a follow-up, the The $100,000,000 and the $10,000,000 to $15,000,000 in OI, that is for health or that is across the company?

Speaker 3

No, no, no, no. The Across the company, Cai. As it relates to health, that's probably one of the least impacted areas. So that's across the company.

Speaker 2

Veterans is an essential service. That's right.

Speaker 8

The Okay. Thank you very much.

Speaker 2

Thank you. Thank you, Kai.

Operator

Our next question comes from the line of Sheila Kahyaoglu with Jefferies. Please proceed with your question.

Speaker 9

The Good morning, guys. Thank you for the time.

Speaker 7

Hi, Sheila.

Speaker 9

Hey, guys. So, I wanted to ask about the dynamics and just how comfortable you guys deal with the development programs there and what sort of hurdles you're looking to get through to

Speaker 1

Yes. Thanks, Sheila, and good to speak to

Speaker 2

you again. The On Dynetics, I'm convinced and we're convinced that the best days are still ahead of us. We've got a great management team down there. And as I alluded to in my comments, we're adding technical and financial expertise the 2 Dynetics to ensure its success going forward. So feel really good about the team and feel really good about the people who are eager to go help us find success and be successful at Dynetics and in our defense business.

Speaker 2

The team down there is really focused on those 3 major markets that I have spoken to now for 4 or 5 months, which is small satellite payloads, hypersonics and force protection. And on each of them, we are tracking, Sheila, biweekly. The The actual burn down plan and the tasks that we have to hit to find success, not only as we turn the page from 2023 into 2024, but through 2024. So we have got a complete roadmap that the team is knocking down purposefully 1 by 1. Are there challenges?

Speaker 2

Always. Supply chain challenges, testing challenges, customer focus challenges. There There's all sorts of challenges that the team is having to wrestle to ground, but they're on it. We're engaged Both at the Pentagon and at the operational level, the customer demand for the solutions in those three spaces is acute. And frankly, world events that are happening right now only heighten their desire for these solutions that we're providing.

Speaker 2

So We feel very good about them. And I think that Dynetics is going to benefit from being a part of this new bigger defense business in the organization of 2024 where even more broad engineering, program management and technology capabilities will be brought to bear for the benefit of Dynetics and our Huntsville teammates.

Speaker 3

The Yes, Sheila. I mean, obviously, it's a high priority item. We're putting all the right resources on it and very excited about the long term prospects there. In any event, Dynex will be a growing business for us in 2024. The higher steeper ramp inflection point On related to IPCIC moving to fuller volumes could be later in the year, could trend into the 25, but all signs point to that continuing to be the capability the Army is focused on deploying.

Speaker 9

Okay. I'll follow-up on that later. But on the backlog, Tom, I wanted to Ask about this since you mentioned it in your prepared remarks. I think you said it grew $4,000,000,000 In the last time we chatted, you mentioned you added a criteria about the EBITDA margins to potential wins. So can you talk about how you think EBITDA margin should be on some of these the new wins that you have in the pipeline now.

Speaker 2

Well, you're right, Sheila. What I'm doing as we talk about the pipeline for business development opportunities across all businesses is we're adding the criteria of, well, what is the expected margin. That's why in my comment, I talked about not only the increase in the backlog, but that increase supporting our margin and cash expectations for Leidos. So you could assume that the general health of the pipeline has increased in has been accretive in the margin potential and

Speaker 9

the Great.

Speaker 7

Thank you. Thanks, Sheila.

Operator

Our next question comes from the line of Tobey Sommer with Truist. Please proceed with your questions.

Speaker 4

Yes, good morning. This is Jack Wilson on for Toby. Could you dig down a little bit more into that reallocation of business development resources sort of in light of pursuing those that higher margin work?

Speaker 2

The Sure. I mean it's not really rocket science. It's simply looking at the pipeline, Jack, and making sure that Where we are spending the talents of our people are on the opportunities with the highest pwin And the highest benefit to Leidos. It was that Each business area in Leidos was given a general growth target, which was generally the same for each businesses, And that's not my philosophy. My philosophy is we're running one company called Leidos.

Speaker 2

We're trying to grow the top line and bottom line of Leidos. And as opportunities ebb and flow between the 5 businesses that we have today or the 5 businesses businesses that we'll have in 2024. The key is that we aggregate business development resources and talent to those areas that are going to have the biggest bang for the buck. And so that's really all it is. Instead of attriting resources chasing low margin work because Each business was incentivized to grow no matter what.

Speaker 2

I am interested in growing Leidos as a whole, And sometimes that means some businesses will grow disproportionately to others. Chris kind of touched on this a little bit. In the future, not all five businesses for Leidos will have the same top line and bottom line goals. I'll be measuring those and putting them out there for the team commensurate with the market that they're in, the potential flow of that market and the competitions and the opportunities that present themselves in that market for the next year, 2 years, 3 years, 4 years. The And that's the whole philosophy of redeploying the business development time and talent to those areas of greatest return for Leidos, therefore our customers and by extension our shareholders.

Operator

Call. Thank you very much.

Speaker 2

Thanks, Jack.

Operator

Our next question comes from the line of Seth placement with JPMorgan. Please proceed with your question.

Speaker 4

Thanks very much and good morning everyone.

Speaker 3

Call. Hey, Seth.

Speaker 4

Hey. Just maybe to follow-up a little bit on that question about relative growth rates and kind of the new sectors that you laid out, not expecting any kind of numerical targets or anything like that. But just in a relative sense, the How should we think about the growth rates in those different sectors that you laid out relative to each other and also how it fits in, Tom, with your internal capital deployment plans.

Speaker 2

Yes. Thank you, Seth. Great question. And you're right, I'm not going to get to specifics because frankly, we don't have them yet. But I have hypotheses.

Speaker 2

And so the hypotheses If you look at the 5 businesses, some of them are positioned for top line growth because of customer demand and interest the And solutions that they can provide. Other businesses, we're going to be calling them sectors going forward. They are Each business over time, over 5, 6 years, top line growth and bottom line growth Maybe countercyclical in businesses, but that doesn't mean I ever think any business is not also a top line growth story and also a bottom line growth story. So we'll be using 2024 to have a very purposeful strategic planning exercise around what is the full potential of each business, where are they in the customer's ecosystem, how does the customer's buying behaviors, how do we predict they'll unfold in the coming year, and therefore, what are the goals and objectives for that business in the near term and the long term. And business development resources, Technology resources will be deployed according to those plans.

Speaker 2

It's simply going to be the money is going to follow the plans that have survived the scrutiny of the strategic planning process and therefore have the most merit for investment of our capital. That's it in a nutshell. And as Chris suggested, we're excited about 2024 and going through that strategic planning process and sharing more results with you over time as those come to fruition.

Speaker 4

Great. Thanks very much. And maybe just the For a quick follow-up, a little more model focused. As we think out and we think about uses of cash and capital the appointment. Other than that, I would assume that there would be an intention to repay the $500,000,000 that's due in 2025, just given that it's a pretty low coupon and would probably need to be replaced with something higher.

Speaker 4

And other than that, should we think about the potential the For most cash to be returned.

Speaker 3

Yes. I mean big picture Seth, I think you're thinking of it right. We hit our leverage target. We're happy with where we are. The interest rate environment could be vastly different in 2025.

Speaker 3

So that's something we'll pay close attention to. But I think you've got it right. We've got a dividend program. Tom just Talked about an increase that uses a little over $200,000,000 a year of cash, a CapEx program at around 1% to 1.5% of revenue. And then we've got a lot of excess cash tip to the interest rate environment.

Speaker 7

It will

Speaker 2

be a nice problem to have.

Speaker 3

Thank you.

Operator

Our next question comes from the line of Louie DiPalma with William Blair. Please proceed with your question.

Speaker 6

The call. Tom, Chris and Stuart, good morning.

Speaker 3

Louie, good morning.

Speaker 6

Within Healthcare, You referenced how DHMSM could be stable going into 2024. How should we think about the VA health CARE exam volumes going forward with the tailwind of the PACS Act. And has there been any changes in the competitive dynamic there?

Speaker 3

The Yes. Hey, Louis, again, just a clarification on DHMSM, stable relative to our Q4 kind of exit rate, right? It will be It's been trending a little lower as deployments have ramped down, but the good news is we at this time don't see a significant of a step down in 24 as we once did. So that's great news. On the VA side, listen, I mean, you always have competitors that are highly motivated to ensure they are stepping up their game to capture as much of the allocation as possible.

Speaker 3

And the VA wants a robust competitive dynamic because we need to keep the throughput high and get veterans the benefits that they deserve. At this time, it's hard to predict 24. We'll have more color in a few months, but we see that stable and it's been a growing part of the portfolio. There's other good things going on in the VA too. The RHRP program sorry, in health, the RHRP program will continue to be a growth catalyst for us as well.

Speaker 3

So it's not just the Packback volume, but right now that's trending very favorably and we're very pleased with the performance of the health leadership team the And really delivering great results.

Speaker 7

Excellent. Thanks.

Speaker 1

Thank you. Shamali, it looks like we have time for just about one more question.

Operator

Our last question comes from the line of Ken Herbert with RBC Capital Markets. Please proceed with your question.

Speaker 10

Tom and Chris and Stuart, thanks for squeezing me in. Hey, Tom, maybe just to take a step back, I appreciate all the detail you've outlined here in terms of the sharper focus and obviously reflected in the backlog and the wins and everything else. But as you think about the business now transitioning into 2024, What do you think are the biggest opportunities from a cost standpoint as we think about sort of the margin opportunity? Obviously, not looking for specifics in guidance, But how much of a cost standpoint do we think there is in the business, which obviously should support what you're doing in terms of the higher quality bids and business opportunities.

Speaker 2

Yes. Well, I can't put a the number on it because we're only now at the point where we can start to imagine the opportunities that are in front of us. But I'll call your attention to the 3 functional leaders that I talked about enhancing their positions. 1st and foremost, the Chief Technology Officer. Bringing Link into our Chief Technology Officer for the benefit of all of our businesses.

Speaker 2

I'm really excited about focusing our R and D pipeline the on those areas of technology that will propel our current business, enable us to compete the and when and insert technology in those businesses and when new business going forward. So I think there's great opportunity for us in the CTO office. In the CTO office, the Chief Performance Officer, That is the internal wheelhouse of everything that makes Leidos an efficient, effective corporation. I mentioned real estate, procurement, the IT, program management are all going to be in that. The new leader of our Chief Performance Officer We'll have the responsibility to not only make sure we are best in class when it comes to the quality of the product we put on the field to make Leidos as effective as possible, but I'll also be asking that individual to ensure we are world class as a cost of doing business at the corporate level.

Speaker 2

And then last but not least, aggregating the complete value stream of growth, strategy, sales, marketing, communications, government relations, all in the Chief Growth Officer will put us in a prime position to ensure we have unparalleled customer understanding for where the customer is going and how we're going to skate to the puck of where it's going to be as opposed to just chasing RFPs. So the The net sum of all of that, Ken, I believe will make us a more efficient and effective corporation. But again, as Chris said, it's not This isn't a cost cutting exercise, this realignment. This is a aggregate the capabilities of Leidos the In a better way to make us more effective and efficient.

Speaker 3

Yes. And I'd only say, I mean, We're already seeing and feeling kind of a leaner ongoing operating environment now and that's showing up in our results. The Clearly, we're focused on next year's 10.5% plus margin target. That's an area that I I think we're demonstrating that we have line of sight to delivering on that and that's still a goal the corporation is rallying behind.

Speaker 10

The Great. I'll leave it there. Thanks for the color and nice quarter.

Speaker 3

Thank you.

Operator

And this concludes our question and answer session. I would now like to turn the conference back to Stuart Davis for any closing remarks.

Speaker 1

Well, thank you, Shamali, for your assistance on this morning's call. And thank you all for your interest in Leidos this morning. We look forward to updating you again soon. Have a great day.

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Earnings Conference Call
Leidos Q3 2023
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