Leonardo DRS, Inc. (NASDAQ:DRS) Q3 2023 Earnings Call Transcript

Leonardo DRS, Inc. (NASDAQ:DRS) Q3 2023 Earnings Call Transcript November 4, 2023

Operator: Ladies and gentlemen, good day, and welcome to the Leonardo DRS Third Quarter Fiscal Year 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the company’s prepared remarks, there will be an opportunity to ask questions, and instructions will be given at that time. As a reminder, this event is being recorded. I would like to now turn the conference over to Steve Vather, Vice President of Investor Relations and Corporate Finance. Please go ahead.

Stephen Vather : Good morning, and welcome, everyone. Thanks for participating on today’s quarterly earnings conference call. With me today are Bill Lynn, our Chairman and CEO; and Mike Dippold, our CFO. They will discuss our strategy, operational highlights, financial results and forward outlook. Today’s call is being webcast on the Investor Relations portion of the website where you will also find the earnings release and supplemental presentation. Management may also make forward-looking statements during this call regarding future events, anticipated future trends and anticipated future performance of the company. We caution you that such statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict.

Actual results may differ materially from those projected in the forward-looking statements due to a variety of factors. For a full discussion of these risk factors, please refer to our latest Form 10-K and our other SEC filings. We undertake no obligation to update any of the forward-looking statements made on this call. During this call, management will also discuss non-GAAP financial measures, which we believe provide useful information for investors. These non-GAAP measures should not be evaluated in isolation or as a substitute for GAAP performance measures. You can find a reconciliation of the non-GAAP measures discussed on this call in our earnings release. At this time, I’ll turn the call over to Bill. Bill?

William Lynn : Thanks, Steve, and thank you all for joining us this morning. Let me begin by sharing our heartfelt concern and deep support for the people of Israel. The horrific attacks that occurred last month demonstrate the dangerous and unpredictable nature of global threats that face us and our allies. We are thankful that our team and operations in Israel remain resilient, but we are closely monitoring the ongoing conflict with the priority on keeping our employees and their families safe. In the face of an elevated global threat environment, we are confident that there remains broad bipartisan support recognizing the critical need to maintain defense investment as well as the need to support our allies. The growing sophistication of our adversaries is driving increased customer demand for advanced technologies to deter and counter global threats effectively and efficiently.

DRS broad and relevant technology portfolio, coupled with our agility and innovation continue to be key assets in supporting our customers’ most challenging missions. This is exemplified by our most recent $3 billion plus contract award for the rest of Columbia-class electric power and propulsion systems. The contract award covers most of the components for the remaining 7 Columbia class submarines previously not under contract and is additive to our Q3 total backlog. In the near term, we look forward to seeing progress and clarity with respect to the timing of FY ’24 appropriations and supplemental funding. Moving to an update on the quarter. I’m pleased to report that we delivered another quarter of strong results, which were ahead of our expectations for the third quarter.

In Q3, our revenue growth accelerated considerably to 10% organically. We secured $1.1 billion of bookings in the quarter, translating to a robust 1.5 book-to-bill ratio. Throughout the year, we have seen demand strength come from varying parts of our broad and diverse portfolio. This quarter, customer demand was most evident for our advanced solutions in ground and dismounted soldier sensing, force protection, tactical communications and naval computing. The steady flow of bookings continues to push our backlog higher. Backlog now sits at $4.7 billion, which is up 50% year-over-year and is also up sequentially. Q3 bookings and revenue momentum was matched by excellent quarterly profit generation and growth across key metrics, including solid adjusted EBITDA margin expansion in the quarter.

I want to sincerely thank the team for their steadfast focus and hard work and executing with excellence for our customers and shareholders. Their strong performance in the quarter and throughout the year has allowed us to drive incrementally better linearity and increase the line of sight to meeting our financial commitments for the full year. And while there is another stair to climb for the fourth quarter, we are clearly focused on driving the necessary acceleration to a strong finish for the year. Moving to an update on the operating environment. Supply chain continues to be a key operational focus. The good news is that the aggregate impact to our business from supply chain complexities remains fairly stable. However, we are still seeing shifts of where specific issues reside.

Throughout 2023, we have observed more stability in microelectronics, but as discussed on prior calls, castings continue to be a challenge and now specialty alloys and raw materials are emerging as a new area of concern. That said, with every evolution on the supply chain front, our team has been proactive and aggressive in working to implement the appropriate mitigations to reduce and contain the operational impact as much as possible. Bottom line, the supply chain complexities that we have faced over the past few years and continue to face, we’ll keep our bookings to revenue conversion cycle elongated and our working capital above historical norms. Lastly, let me offer a quick comment with respect to labor availability and inflation. While both of these factors continue to linger, they are progressing on a slow but improving trajectory.

Our expectations for both variables remain fairly static. And while they will continue to service slight headwinds as we close out the year, they show promise of flipping to potential tailwinds over the medium term. Now shifting to some business highlights from the quarter. Our strong results continue to reflect strong program execution across the business. The improving dynamics in our Columbia class program remain evident in our overall financials. However, we are also seeing better execution from other smaller development programs as well. That said, we are maintaining steadfast focus on execution as we work to fully migrate those programs to production over the coming year. Moving to growth. We are experiencing strong customer demand for our broader capabilities in advanced sensing, electric power and propulsion, network compute and force protection as evidenced by our robust quarterly and year-to-date bookings.

Additionally, key growth opportunities remain clear across the business. We have several proposals in electric power and propulsion and advanced sensing that remain outstanding and under evaluation with expected adjudications over the next 12 months. We are also continuing to innovate and advance our capabilities. On prior calls, I have discussed our vision for integrated sensing. I am pleased to report that we recently received a small but important contract award from the Army to further that initiative to enable the integration of AI-capable computing into sensors. On the force protection front, we are seeing domestic requirements emerge for active protection systems, and we are also experiencing steady global demand for our multi-mission tactical radar technologies.

As we approach the 1-year anniversary of acquiring RADA, our investment thesis has been validated by the macro environment. Furthermore, strong synergies and opportunities with the rest of our business are visible and our teams are routinely working together to respond to customer requirements and propose integrated solutions. We are excited about the diversity of organic growth opportunities across our business. We are regularly evaluating how to best position DRS through thoughtful investments, whether these manifest as incremental R&D or capital expenditures. We look forward to sharing more detail on this and on our overall strategy at our Investor Day in New York City on March 14. Overall, I am pleased with our performance to date, but we are maintaining a focus on operational execution to meet our commitments to both customers and shareholders.

Now I’d like to turn the call over to Mike so that he can walk you through our financials in more detail.

Michael Dippold : Thanks, Bill. Let me begin by also thanking the DRS team for their incredible effort to deliver another excellent quarter. As usual, I will walk through the key financial metrics and trends for the quarter at both the company and segment level and then discuss our updated guidance. Total revenue growth for Q3 accelerated 11% year-over-year, which represented 10% organic growth in the quarter. The bulk of the growth was on the back of our naval power programs, namely Columbia Class, but we also saw a very healthy contribution from our naval and ground network compute businesses. Moving to the segment view. ASC segment revenues were up 6% due to solid growth in network compute and tactical communications as well as the slight inorganic tailwind from RADA.

Our IMS segment delivered another impressive quarter of organic revenue growth of 21%. Now to adjusted EBITDA. Adjusted EBITDA in the quarter was $82 million, representing a remarkable growth of 41% from last year. Our adjusted EBITDA was also up meaningfully on a sequential basis. This is driven by the fact that we period expense G&A, which means greater volume will largely drop to the bottom line. Historically, this has been most evident in our fourth quarter results, and we expect a similar cadence this year as we look to next quarter. In Q3, our adjusted EBITDA margins expanded 250 basis points to 11.7%. Strong program execution across our business, better mix and higher volumes, all bolstered profitability. On a segment basis, our ASC segment adjusted EBITDA increased by 33% and margins were up 230 basis points due to better program execution in our network compute and laser programs, favorable mix and slightly higher volume.

At our IMS segment, adjusted EBITDA was up 55% and margins were 270 basis points higher than last year due to continued momentum on naval power programs led by Columbia Class. Moving to the bottom line metrics. Third quarter net earnings were $47 million and diluted EPS was $0.18 a share, both down considerably over last year due to the $270 million net gain recorded last year for our GES and AAC divestitures. Our adjusted net earnings of $53 million and adjusted diluted EPS of $0.20 a share, which normalized for the onetime gain and other non-operational items were up 112% and 67%, respectively. Strong operational execution, along with a healthy tax tailwind related to research and development credits flowed to these metrics. However, the compares for our EPS metrics still reflect a headwind from a significantly higher share count as a result of the stock combination with RADA.

Moving to free cash flow. Cash collections continued to improve sequentially and also trended favorably year-over-year. We generated $21 million of free cash flow in the third quarter. Despite continued supply chain constraints, we are focused on driving more efficient working capital and enhancing cash conversion. We have been fairly consistent in pointing to the fourth quarter as the dominant source of our annual cash flow. And as such, we are very much focused on accelerating that cash generation. Now to our forward outlook. Based on the strength of our year-to-date performance, we are narrowing the guidance ranges for revenue and adjusted EBITDA and raising the guidance for adjusted diluted EPS. We are tightening the expected revenue range to between $2735 million and $2785 million.

At the midpoint, this still reflects approximately 4% organic growth. That said, the largest variable factor in achieving fourth quarter and full year results will be the timing and level of material receipts. Our revised view on adjusted EBITDA is between $319 million and $325 million. As discussed earlier, revenue volume will heavily influence our profit output given our period expensing of G&A. The other important factor that will drive variability within the range will be the program mix driving revenue. We are increasing our expectations for adjusted diluted EPS to between $0.70 and $0.72 per share. Our underlying assumption for the tax rate for the year is now 13%, thanks to the continued benefit from the R&D tax credit. However, we are still holding a long-term tax rate of 23% for the fourth quarter as well as for 2024 and beyond.

We are also maintaining our fully diluted share count of $266 million for the year, given the pacing of option exercises realized in the year-to-date. With respect to 2024, it is our intent to provide you color and our official guidance on our fourth quarter call in late February. As we quickly approach a year of being public, we are pleased with how the business has performed and have confidence in the opportunity ahead. We have a clear strategy, a strong portfolio and a unique market position to create value. We remain focused on execution and meeting the critical needs of our customers as well as delivering for our shareholders. With that, we are ready to take your questions.

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Q&A Session

Operator: Thank you. At this time, we will conduct the question-and-answer session. [Operator Instructions] The first question comes from Robert Stallard with Vertical Research.

Robert Stallard : Bill, I’ll start with you. A couple of questions on what you might call the macro environment. Quite a lot of uncertainty down in D.C. at the moment with regard to getting the budget through the system. What sort of contingencies have you put in place in case there is a government shutdown or even a repeat of sequestration later this year?

William Lynn : I mean there’s always a fair amount of turmoil in Washington at this point in the year. And this — I think we’ve seen a little bit more extreme version this year. But the big picture of CRs through the quarter is what we anticipated when we built the plan, almost over this Congress pass bills on time by October 1. So that’s built into the plan. A shutdown isn’t built into the plan, but if there is a shutdown, which I think is getting less likely, it would be quite short and doesn’t have a material impact on us. We think what we’ll see is a CR through probably into January and then they’ll go to passing the bills either individually or more likely through some sort of Omnibus.

Robert Stallard : Okay. And then regarding the supplemental request, which is in the Congress at the moment, there’s an amount in there for investment in the defense industrial base. Is there anything there that could ultimately come through to DRS?

William Lynn : Yes, it’s possible. I mean the industrial base money, in particular, the money that would be for the submarine industrial base certainly touches us. There’s a great impetus to increase the throughput of the shipyards and to have the supplier base support that to move it up to 3 submarines per year. And we are in active discussions with the Navy and the yards about how we could expand our capacity and our capabilities to support that. The funding that was — that came before and the money that’s in the supplemental are certainly candidates to support that expansion. What the eaches are going to be remains to be seen until after Congress passes the money.

Robert Stallard : Yes. And then maybe a couple for Mike. First of all, what’s your expectation for free cash flow for the year, has that changed at all versus what you said 3 months ago? And then also, where do you expect the working capital situation to be within that? And how is that likely to track heading into next year?

Michael Dippold : Sure. And thanks for the question. So from a free cash flow perspective, we still anticipate driving a cash conversion of 90% of our adjusted net earnings. Obviously, adjusted for the $174 million tax payment that was made earlier in the year. We’re still kind of on that trajectory and feel confident with our ability to deliver that commitment. With regards to working capital, what that means is that a lot of the investment we put into working capital throughout the year in order to maintain schedule for the customers and maintain our financial commitments you’re going to start to see that pay off here in the fourth quarter as we kind of outsize the cash conversion in Q4 versus prior quarters. So you’re going to see the trend unwind a little bit from our working capital, and that’s going to assist us in delivering the cash commitment for the year.

Robert Stallard : Okay. And then next year, do you expect a similar sort of seasonal pattern the working capital build through the year and then you deliver it all in Q4?

Michael Dippold : Yes. We’re obviously focusing on getting kind of our procurement set for the revised lead times in the current supply chain. We think that there is a stabilization there. So we’ll see our focus continued to be on improving that trend. But if you look historically, this has been — the large portion of our cash generation has been in Q4. That won’t change, but we are focusing on improving that seasonality.

Operator: Next question comes from Michael Ciarmoli with Trust Securities.