Leidos Holdings, Inc. (NYSE:LDOS) Q4 2022 Earnings Call Transcript

Leidos Holdings, Inc. (NYSE:LDOS) Q4 2022 Earnings Call Transcript February 14, 2023

Operator: Greetings. Welcome to the Leidos Fourth Quarter 2022 Earnings Call. At this time, all participants will be in listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. At this time, I’ll turn the conference over to Stuart Davis, from Investor Relations. Mr. Davis, you may now begin.

Stuart Davis: Thank you, Rob, and good morning, everyone. I’d like to welcome you to our fourth quarter and fiscal year 2022 earnings conference call. Joining me today are Roger Krone, our Chairman and 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’re using today. 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, does include 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, 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, let me turn the call over to Roger Krone, who will begin on Slide 4.

Roger Krone: Thank you, Stuart and thank you all for joining us this morning. , by the way, Happy Valentine’s Day. The fourth quarter marked a strong finish to a banner year for Leidos with record revenue and non-GAAP diluted EPS driving us to the top end of our revenue guidance range and beyond our EPS guidance range for the year. Our performance validated that our diversified and resilient portfolio and our investments in technology and innovation are positioning us for growth in key customer missions including digital modernization, cyber, hypersonics and force protection. Each and every day, our 45,000 people are helping our customers execute on important missions and meet the world’s most complex challenges. Against the challenging backdrop in 2022, we delivered on our financial commitments, allocated capital to deliver value for our shareholders, won multiple franchise programs that position us for future growth and significantly grew our talent base.

So let me provide more detail on each of these points. Number one, our strong financial performance in the fourth quarter enabled us to deliver on our financial commitments. Record revenue of $3.7 billion for the quarter and $14.4 billion for the year, we’re up 6% and 5% respectively. Adjusted EBITDA margin of 10.7% in the quarter was up 40 basis points year-over-year, which helped drive adjusted non-GAAP diluted EPS to a record $1.83, which represents growth of 17%. For the year, adjusted EBITDA margin of 10.4% helped lead to non-GAAP diluted EPS of $6.60, which was well above our guidance. We generated $105 million of cash flow from operations in the quarter and free cash flow of $52 million. For the year, that translates to nearly $1 billion of cash flow from operations and $857 million in free cash flow, which were right at guided levels.

These results came despite multiple headwinds, most notably a protracted continuing resolution to start the year inflation, supply chain disruptions and labor constraints. Even at industry leading scale, we’re nimble enough to pivot as needed. And I’m proud of how well the team pulled together and weather these challenges. Number two, in 2022, we allocated capital to deliver value for our shareholders. Over the year, capital deployment was heavily weighted towards return to shareholders, while still layering in strategic acquisition of the Australian airborne business and investing to grow our core business through capital expenditures and internal R&D. With our asset light model, CapEx was just under 1% of revenues with large investments in airborne ISR and Dynetics and we’re seeing those investments payoff in additional aircraft performing valuable missions and key wins in hypersonics, which takes me to number three, business development.

This year, we won franchise programs in each segment that position us for growth. Programs like DES in Defense, Social Security Administration, IT in Health, and AEGIS in Civil, contributed to performance in 2022 and have built the foundation for 2023 and beyond. They demonstrate our ability to take away work and target brand new opportunities. In the fourth quarter, which is typically the weakest in our industry, we booked $3.7 billion of net awards for our book-to-bill ratio of 1.0. For the year, our book-to-bill ratio was 1.1. Total backlog at the end of the quarter stood at $35.8 billion of which a record $8.4 billion was funded. Total backlog is up 4% and funded backlog is up 13% year-over-year. After a relatively slow start to the year across the industry, contract activity is improving.

Most importantly, our submit volume picked up dramatically in the fourth quarter with $23 billion in submits of which 92% was for new business. Taken together, the two Social Security Administration IT task orders that we spoke of last call were the largest award in the quarter. GAO dismissed the competitor’s protest earlier than expected and that program has fully ramped. We also won more than $0.5 billion in hypersonics awards, including Mayhem, our first major contract on the air breathing side and wide field of view Tranche 1, which is the backbone of the nation’s hypersonics defense capability. We’re pleased that so many of you were able to join us in Huntsville last December to get a clear picture of the opportunities that we see at Dynetics.

Our Independent research and development investments were critical to procuring these awards just as they were for our landmark wins in digital modernization. In 2022, we invested $116 million in IR&D and IRAD (ph) has grown at a compound annual rate of 23% over the last five years. We continually invest to develop proprietary tools and unique processes to drive competitive advantage. We’ve already deployed workflow transformations using the latest generation of AI-based on large language models and we’re at the leading edge of combining artificial intelligence and cyber to enable our customers to achieve security levels that are beyond compliance. Speaking of cyber, earlier this month, we announced the latest version of our Zero Trust Readiness Level tools suite that simplifies Zero Trust adoption for government organizations, consolidating a six month to nine month planning process to less than 60 days.

We drive digital innovations by working tightly with our product partners. For example, we’ve partnered with Intel Corp. to demonstrate confidential computing through a hardware-based independently attested trusted execution environment. And just last month, we were recognized as the 2023 ServiceNow America’s Premier Partner of the Year. Number four, we significantly grew our talent base. We hired more than 2,400 people in the fourth quarter and more than 11,000 in 2022. Headcount was up 6% for the year and attrition rates continue to subside. We’ve seen great synergy between our people engagement and technology investment initiatives. Employees in our technical upskilling programs have significantly higher retention, and we more than doubled participation in 2022 compared to 2021.

Our technical upskilling programs are aligned with our technology strategy and broad participation is enabling us to enhance our competitive position and deepen our culture of innovation. If you want to build your technical skills over a fulfilling career, Leidos is a great place to work. In 2022, we offered courses in artificial intelligence and machine learning, software, cyber, cloud and digital engineering. In 2023, we’re expanding with new offerings in cyber operations, secure rapid software development and specialized learning pass in AIML. We also take learning and engagement beyond the classroom. Two weeks from now, we will launch our seventh annual AI Palooza challenge (ph), where employees around the company will engage with some of the newest AIML techniques in a creative and collaborative competition.

Perpetual learning is part of our culture and we make it fun. Before turning it over to Chris, I’ll touch on the current budget environment. Demand trends are very positive for our business. Late last year, Congress overwhelmingly passed and the President signed the Omnibus Appropriations bill, funding the government through September. Budgets across the board saw healthy increases, including defense spending, which was up about 10%. The budget address the critical challenges we’re facing as a nation, including national security concerns arising from China and Russia and Leidos is well-positioned to respond. Amidst a highly partisan backdrop, President Biden’s calls in the State of Union address to support Ukraine, protect our country and modernize our military to safeguard stability and deter aggression received strong bipartisan support.

That said, we’re anticipating a series of noisy debates over the coming months around the debt ceiling and the 2024 appropriations given the razor-thin majorities and the deep divisions in Congress. As a matter of prudence, we are preparing contingency plans around a potential government shutdown. But we built our 2023 guidance, assuming a continuing resolution beginning in October and extending through the rest of the year with no government shutdown. We believe this is the most likely outcome. In summary, I’m pleased with the performance and the momentum of the company. In the fourth quarter, we posted record levels of revenue, non-GAAP diluted EPS and funded backlog as well as the highest adjusted EBITDA and adjusted EBITDA margin and lowest attrition rate for the year.

We anticipate that 2023 will be another good year for Leidos, marked by strong hiring, important new wins, solid growth in revenue and operating income. With that, I will turn the call over to Chris for more details on our results and our 2023 outlook.

Chris Cage: Thanks, Roger, and thanks to everyone for joining us today. Let me echo Roger and express my gratitude to the entire Leidos team for how we executed in 2022. We navigated many challenges throughout the year, including an unexpected adverse arbitration ruling in Q2 to deliver at the top end of our revenue guidance range and above our EPS guidance range for the year, all while delivering for our customers. Turning to Slide 5. Revenues for the quarter were $3.7 billion, up 6% compared to the prior year quarter. For the year, revenues were $14.4 billion, which was up 5% compared to 2021, despite a $107 million headwind from foreign currency movements, primarily from work in the UK and Australia in our Defense Solutions segment.

2022 revenue performance was in-line with the targets that we laid out 16 months ago for ’22 through ’24. Turning to earnings. Adjusted EBITDA was $397 million for the fourth quarter for an adjusted EBITDA margin of 10.7%, our highest margin of the year and above expectations based on higher growth on more profitable programs, better performance on some large programs and disciplined cost management. 2022 adjusted EBITDA was $1.49 billion for a margin of 10.4% or right at the midpoint of guidance that we’ve held all year. Non-GAAP net income was $255 million for the quarter and $919 million for the year, which generated non-GAAP diluted EPS of $1.83 for the quarter and $6.60 for the year. Non-GAAP diluted EPS was up 17% for the quarter and essentially flat for the year as a result of some one-time events that we’ve talked about in the past.

Looking at the key drivers below EBITDA. The non-GAAP effective tax rate for the quarter came in at 20.1%, which was below our expectation and added about $0.09 to EPS. The tax rate benefited from certain international tax credits and limitations, increases in our federal research tax credit and higher than planned stock compensation deductions. In addition, net interest expense in the quarter increased to $51 million from $46 million in the fourth quarter of 2021. Finally, the weighted average diluted share count for the quarter was 138 million compared to 142 million in the prior year quarter, primarily as a result of the $500 million accelerated share repurchase agreement implemented in the first quarter of fiscal year 2022. Now for an overview of our segment results and key drivers on Slide 6.

Defense Solutions revenues in Q4 of $2.07 billion were essentially flat compared to the prior year quarter. 2022 Defense Solutions revenues of $8.24 billion were up 3% for the year. Civil revenues were $938 million in the quarter, up 17% compared to the prior year quarter and 2022 revenues were $3.46 billion, up 10% compared to 2021. The primary driver for growth in the quarter and the year was the ramp on the NASA AEGIS program. In addition, we had good growth within our commercial energy business as well as increased security products, sales and maintenance. Health revenues were $691 million for the quarter, an increase of 10% compared to the prior year quarter, driven primarily by performance on DHMSM and our new work on SSA IT. Health revenues were $2.69 billion for the year, up 5% over 2021, with the same drivers that I cited for the quarter plus strong performance on the Military and Family Life Counseling program.

On the margin front, on Slide 7, Defense Solutions and Civil posted their highest margins in more than a year based on mix and some excellent program performance. For the quarter, Defense Solutions non-GAAP operating margin came in at 8.6%, up 40 basis points compared to the prior year quarter; and Civil came in at 11.2%, up from 10% in the prior year quarter. Defense Solutions non-GAAP operating margin for the year was 8.3%, which was down 30 basis points from 2021, primarily from investments in new program startups. Civil non-GAAP operating margin for the year was 9.2%, down from 10.2% in the prior year, driven by legal matters that we’ve addressed in prior calls, a $26 million gain in 2021 and a $19 million expense in 2022. Health non-GAAP operating margin for the quarter was 14.3%, consistent with what we’ve been talking about for some time.

Health non-GAAP operating margin for the year finished at 17.1%. Turning now to cash flow and the balance sheet on Slide 8. Operating cash flow for the quarter was $105 million, and free cash flow, which is net of capital expenditures was $52 million. For the year, operating cash flow was just shy of $1 billion and free cash flow was $857 million for a 94% conversion rate. In the fourth quarter, we completed the acquisition of the Australian airborne business, which provides maritime surveillance operations for the Australian border force and search and rescue response capability for the Australian Maritime Safety Authority, purchase consideration was approximately $190 million, net of $6 million of cash acquired. During the fiscal year 2022, Leidos returned $741 million to shareholders, including $199 million as part of its regular quarterly cash dividend program and $542 million in share repurchases.

As of December 30, 2022, the company had $516 million in cash and cash equivalents and $4.9 billion in debt. Roughly $1 billion of that debt will come due in this year. Most of it in May. We expect to fully repay the remaining $320 million on the short-term loan originally tied to the Gibbs & Cox acquisition and then rolled over in support of the ASR program. We’ll refinance the $500 million of maturing bonds as well as the bank term loan A still tied to LIBOR in an efficient and flexible manner, but interest expense will increase given the current rate environment. As we approach the debt market, we’re pleased with the recent upgrade from Moody’s to BAA2 credit rating, which signals their confidence in our financial stability and outlook. We’re already benefiting from improved terms on our commercial paper borrowing and expect that to carry through on the debt transactions.

As we close out the year, we remain committed to a target leverage ratio of 3 times. Our long-term balanced capital deployment strategy remains the same and consists of being appropriately levered and maintaining our investment grade rating, returning a quarterly dividend to our shareholders, reinvesting for growth, both organically and inorganically and returning excess cash to shareholders in a tax efficient manner. Onto the forward outlook on Slide 9. For 2023, we expect revenues between $14.7 billion and $15.1 billion, reflecting growth in the range of 2% to 5% over fiscal year 2022. Demand remains strong as our customers execute robust budgets, and we enter 2023 with a number of programs that are ramping, but the procurement process is still protracted.

We expect 2023 adjusted EBITDA margin between 10.3% and 10.5%. The midpoint of the margin range is the same as 2022. And the top end is consistent with the target that we laid out at our October 2021 Investor Day. We’re committed to long-term margin expansion, and we’ll pull multiple levers to offset the impact of inflation and supply chain on our cost structure, as we demonstrated in the back half of 2022. We’re closely managing our corporate cost with a special focus on real estate. GAAP net income in the quarter reflected impairment charges of $37 million from exiting and consolidating underutilized lease spaces. Since beginning our journey to optimize our real estate footprint post-COVID, we’ve exited over 2 million square feet, which is about 25% of our office space.

Getting out of that space improves our competitiveness and keeps corporate costs in check. We expect non-GAAP diluted earnings per share for 2023 between $6.40 and $6.80 on the basis of 138 million shares outstanding, which is unchanged from fourth quarter levels. To provide some context around that range, we expect 2023 net interest expense of approximately $225 million and a non-GAAP tax rate between 23% and 24%. These two items amount to an EPS headwind of about $0.20 for the year. Finally, we expect operating cash flow of at least $700 million. This guidance reflects approximately $300 million of additional cash taxes compared to fiscal year 2022, primarily related to the Tax Cuts and Jobs Act of 2017 provision requiring the capitalization and amortization of research and development costs.

As we’re awaiting potential congressional action, we didn’t make any Section 174 related tax payments last year. So we’ll need to make payments this year to cover both ’22 and ’23. We paid the 2022 Section 174 taxes in January, and we expect to pay the 23 taxes in quarterly installments throughout the year. From a free cash flow perspective, we’re targeting capital expenditures of approximately 1.5% of revenues based on the timing of some investments in Australian and U.S. airborne surveillance as well as in-sourcing some of the security product supply chain. As is our usual pattern, cash generation will be back end weighted in 2023, along with the tax and debt payments in Q1 and Q2, this limits the ability to deploy capital for shareholders in the first half of the year.

As a result, the EPS guidance range does not account for any repurchases, and we’ll update you as we go throughout the year. With that, I’ll turn the call over to Rob, so we can take some questions.

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Q&A Session

Operator: Thank you. At this time, we will be conducting question-and-answer session. Thank you. And our first question comes from the line of Robert Spingarn with Melius Research. Please proceed with your question.

Robert Spingarn: Hey. Good morning.

Roger Krone: Good morning, Rob.

Chris Cage: Good morning, Rob.

Robert Spingarn: Chris, about the guidance, I wanted to ask you if you might not give us some more detail on a segment basis for the — what drives the 2% to 5% growth across the segments and then how do the margins look relative to the ’22 performance on a segment basis?

Chris Cage: Well, Rob, you know that we don’t guide by segment, but I’ll give you a little additional color commentary. First of all, we’re planning on growth across all of our segments. And our leaders have signed up to that. We feel good about that. We’re seeing strong demand and pipeline and bid opportunities really across all three segments: Defense Solutions, Civil and Health. On the margin front, we’ve been communicating this for some time. Health margins were overheated in ’20 and ’21. Those started to moderate down. You saw that in the fourth quarter that they’re coming to a place that we believe is sustainable, and then we can build off of that going forward. So what I would tell you is that’s how we see health playing out is in the mid-teens as we’ve communicated.

But we’re very focused in the other two segments about continuing to drive margin expansion, Defense Solutions and Civil. So that’s generally how we see the year playing out. And hopefully, that gives you enough additional color commentary.

Robert Spingarn: Yeah. And then, Roger, going back to the security products business and the supply chain there, what parts of that might you bring in-house?

Roger Krone: Some of the manufacturing. We’ve had — we’ve used a contract manufacturer for — if you think about it for some of the lower level parts and then final assembly of some of the pieces of equipment. And with the Dynetics organization and the expertise we now have — we’re very, very comfortable with doing more of those operations internally. We have more control. We can manage the supply chain. Frankly, we think we can drive the cost down. And that’s been part of our strategy, and we are having the conversations about a manufacturing center of excellence which I think really is a great part of the evolution of the company. And so we can look at, if you will, larger manufacturing like the provision system, which I’m sure you all go through and be very confident that we can build that well in-house.

Robert Spingarn: Thanks so much.

Roger Krone: Yeah. Thanks, Rob.

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

Sheila Kahyaoglu: Good morning, everyone and thank you.

Roger Krone: Good morning.

Sheila Kahyaoglu: Just a follow-up maybe on health, and I know you don’t guide on a segment basis, but can you give us the moving pieces as we think about your growth rate. You mentioned SSA in the quarter starting to contribute RHRP. How do we think about that incremental contribution in 2023? And what you’re seeing from burn pit and then the offset from DHMSM?

Chris Cage: Well, you nailed all the big players there, Sheila. So you’re on top of it. First of all, I mean, the SSA team did an outstanding job, and couldn’t be happier with the transition, the fact that the customer did the right thing. Let us get started in the fourth quarter, we’re off and running, and we expect that to be a significant contributor to growth in 2023, so that is solid. RHRP, finally, we feel very confident that, that will start to ramp up here really at the tail end of the first quarter. There’ll be some activity in March, but think about that as building from Q2 onward through the rest of the year. So that gives us solid growth momentum. is still again early. I’d say the team is doing excellent work in QTC.

The story got a little complicated last year because some of the pre-discharge work went to multiple competitors. We also have the international work that we won that’s ramping up this year. So I’d say that’s — we expect growth in that area, but more color on that as we get a quarter or two down the road. And then, finally, DHMSM, this year, there’s, I would say, towards the tail end of the year, we’ve got to continue to work to offset that ramp down on the deployment side, but the teams have been doing excellent work to expand the capabilities within the software that’s been deployed. And so we’re continuing to find opportunities to do that. I don’t know, Roger, if there’s anything more you’d add there.

Roger Krone: No, not really. Although, Sheila, I’m sure you’ve heard in the state of union address that the President talked about burn pits and making sure that we took care of veterans. And so it has been slow, but solid and we would expect that momentum to continue throughout the year. That’s more likely to affect volume than margin. But we’ve seen, again, our volume hold up well in our exam business and look forward to another strong year.

Sheila Kahyaoglu: Okay. No, that’s helpful. And then I wanted to talk about margins as well, defense was solid in the quarter, but I think it was mainly stable that in Q3 and Q4 have seen really good performance there. So what’s sort of going on? You mentioned larger programs, but I didn’t think you had anything in particular there. So how do we think about Civil margins going forward and what’s the driver of the better performance in the second half of the year?

Chris Cage: Well, Civil — again, we talked a little bit on the prepared remarks about the security products area seeing some ramp up. And that will — certain quarters will have more volume there. Certain quarters will have less, but that is always a nice contributor. Steady performance in our commercial energy business that has grown nicely quarter-over-quarter. It’s higher margin work. Team does an excellent job there. And then just on the digital modernization side, AEGIS coming in, not one of our higher-margin programs, but it’s a great base. A lot of employees go into work that helps absorb costs elsewhere, helps make other programs more profitable. And so we like the pipeline of additional digital modernization IT opportunities that we see in that unit as well.

And lastly, everybody has been focused on cost management, Sheila, that was kind of the mantra across the company in the back half of the year, the civil team got to give them kudos. They went above and beyond and finding opportunities where they could drive efficiencies sustainably into the organization. And so we like how that performance is trending.