Leidos - Q2 2023

Transcript

Operator (participant)

Greetings. Welcome to Leidos' Q2 2023 Earnings Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone today should require operator assistance during the conference, please press star zero from your telephone keypad. Please note, this conference is being recorded. At this time, I'll turn the conference over to Stuart Davis from Investor Relations. Stuart, you may now begin.

Stuart Davis (SVP of Investor Relations)

Thank you. Good morning, everyone. I'd like to welcome you to our Q2 Fiscal Year 2023 Earnings Conference Call. Joining me today are, Thomas Bell, our CEO, and Christopher Cage, our Chief Financial Officer. Today's call is being webcast on the investor relations portion of our website, where you'll also find the earnings release and supplemental financial presentation slides that we'll use during today's call. Turning to slide two of the presentation, today's discussion contains forward-looking statements based on the environment as we currently see it, and as such, includes risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially. Finally, as shown on slide three, during the call, we'll discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in today's press release and presentation slides.

With that, I'll turn the call over to Thomas Bell, who'll begin on slide four.

Thomas Bell (CEO)

Thank you, Stuart, and good morning, everyone. I'm pleased to be with you today, leading Leidos into our exciting second decade. I'm also very happy to report that we closed a strong Q2. Driven by a healthy demand environment, we achieved revenue growth of 7% year-over-year, with strong organic growth across all segments. Margins, earnings, and cash flow rebounded from our Q1, driven by an improving business mix, a partial recovery in the security products business, and a series of fast-acting initiatives implemented across the business focused on costs and collections. Adjusted EBITDA margin of 10.9% was up 150 basis points from Q1, and non-GAAP diluted earnings per share of $1.80 was up 22% sequentially. Also, operating cash flow of $164 million was up $262 million from last quarter.

While putting this quality quarter on the books speaks to the underlying strength of the business, even more important to me, it reflects ability of the Leidos team to focus and deliver when expectations are clear. As this is my first quarterly call with you, I thought I'd share some of my initial observations of Leidos. Over these first months, I've met with customers, employees, and analysts, and I've conducted detailed operating and strategic reviews with all our business groups and each of our functional organizations. The headline from this work so far is clear: Our business foundations are impressive. I've come to think of these foundations in three distinct pillars. One, an incredible team, two, compelling technology creation, and three, the ability to act with pace while leveraging scale. These three elements in combination enable us to uniquely solve our customers' most vexing problems in differentiated ways.

Let me unpack that a bit. First, we're a company of exceptionally talented and dedicated individuals. Their breadth and depth of expertise is remarkable, and they are palpably connected to our customers' missions. That translates into a truly differentiated culture with deep customer insights. Also, the esprit de corps and genuine care for each other at Leidos creates an environment that embraces collaboration and entrepreneurship, critical to our continuing success. Our ability to effectively attract and motivate top talent is a distinct competitive advantage for us. In this regard, Forbes recently named us as one of the best employers for diversity, for new graduates, and for veterans. Ethisphere recognized us as one of the world's most ethical companies for the sixth consecutive year. Second, technological innovation at Leidos is impressive, broad, and deep. The advances we are pursuing across Leidos are world-class.

We leverage these key technology differentiators, what I refer to as golden bolts, across our entire portfolio, and we deploy these golden bolts in disciplines ranging from secure software to cybersecurity to signal processing, so as to bring extraordinary capabilities to our customers. A couple recent examples of delivering complex mission capabilities to our customer includes, the successful hypersonic test launch under our MACH-TB program, and the last major deployment wave in the continental U.S. of MHS GENESIS, the Military Electronic Health Record System. This was done on time and on schedule, also significantly enhancing system capability. We've also been at the forefront of unlocking the power of artificial intelligence for our customers for decades. We've developed and deployed trusted AI to tackle some of our nation's most challenging missions.

Our debut in applied AI was in 2004, when we built a self-driving vehicle as part of DARPA Grand Challenge. By 2016, we launched the first unmanned autonomous ship, and now we're deploying next-generation computer vision for automated passenger scanning in our ProVision 2 platform. Also recently, we've deployed large language models in our health group, designing a trusted AI solution where humans and AI work as partners to more rapidly align resources and improve our support to beneficiaries. Differentiated technology, including AI, created, unlocked, and responsibly controlled by our amazing people, is and will continue to be a unique attribute of Leidos. To continue to accelerate our technical innovation, we're investing to broaden and deepen our workforce capabilities. So far this year, we've upskilled well over 3,000 of our people in fields ranging from AI to cyber to software to digital engineering.

It's open to all our employees, not just our technical wizards, so that all can be conversant in our golden bolts. The third pillar I've found here is equally important, scale and agility. Every customer I've met with is feeling the stress about the pace of change. Hard, vexing problems are coming at them at speeds they've never experienced, and they're looking for partners with speed and scale to address these holistic problems. They need us to operate with a clock speed that matches their urgency. At Leidos, we lean into this environment by challenging ourselves to operate with a strong bias for velocity. For example, within the US Space Force, the Space Development Agency is focused on rapid delivery of space-based capabilities to the joint warfighter. This is an ideal fit for Leidos, an essential, technically challenging mission where standard procurement cycles aren't acceptable.

To that end, today, our satellite payload remains the only Tranche 1, Tranche 0 tracking layer asset in space, and we're on track to launch Tranche 1 assets soon that will serve as the foundation for the defense of our nation from hypersonic missiles. All these findings have strengthened my conviction in the potential of Leidos. However, also in my first months, I've identified some areas where we must improve. First, some recent acquisitions have fallen short of plan. While I believe those acquisitions offer us significant strategic benefits, we will redouble our efforts to achieve the value envisioned in our acquisition business cases. Second, all on this call recognize the fact that our financial performance has not always lived up to our investors' expectations.

The team and I have had a series of candid conversations in this regard, and as a result, we have agreed that together, when we make a commitment, whether to each other, our customers, or the street, Leidos will meet that commitment. I call this simply a promises made, promises kept philosophy. Third, recent business development metrics have not been up to par. While we have a healthy backlog, currently $34 billion, built over the last 5 years via a book-to-bill ratio of 1.3x, we can and must do better. I believe that for a business like us, total backlog is a more relevant measure of future revenue growth than quarterly book-to-bill ratios. We will be determined to grow our total backlog over time with quality wins.

As such, we will be candid with ourselves about where we have a differentiated capability that the market recognizes and resource it appropriately, and where perhaps we find we do not enjoy true differentiation, we will ask ourselves some honest, probing questions, courageously acting on their answers. Finally, I believe Leidos can benefit from a certain strategic sharpening. To propel this and to optimize our success going forward, we are now in the process of crafting a clear new North Star for Leidos. As we crystallize this new North Star, we will use it to guide all our strategic decisions, and over time, this will improve our win rates, drive margin enhancement, and better enable us to most successfully serve our customers' most important needs. While this North Star is currently a work in progress, I can give you a few initial indications of where we'll be going.

We will take steps to simplify our organizational structure to promote operational excellence, allow for faster decision-making, and more tightly align our business across our key technology differentiators. We will focus more on the bottom line via greater cost discipline and by refining our investment strategy toward those areas of best opportunity, best overall value to the enterprise. We'll be very thoughtful and disciplined on capital allocation, both internally and externally. In the near term, I will be laser-focused on improving execution, so I don't expect much in the way of additional inorganic growth. After we complete our next strategic plan and reach our targeted leverage ratio, select M&A will likely make sense for us again. At that time, though, we'll be crisp in our approach to ensure there is a clear opportunity to create value for Leidos and our investors.

Lastly, I believe that a regular and predictable program to return capital to shareholders drives better investment decisions across any enterprise. Be looking forward to that as well. As we progress this work, I'll look forward to updating you on how we plan to accelerate growth here at Leidos, especially on earnings and cash. To our 2023 guidance. Based on our strong Q2 and our revenue momentum halfway through 2023, we are raising the top and bottom of our revenue guidance to a new range of $14.9 billion-$15.2 billion, an increase of $150 million at the midpoint. Revenue growth has been a key feature for Leidos in the recent past, and I'm pleased to acknowledge that this element of our business will continue to deliver for us.

The delta in margin performance between the first two quarters of 2023 indicates to me variability in profit margin greater than that suggested by the prior 20 basis point guidance range. Today, this is primarily due to the variability in our security products business. The good news here is that the civil team is aggressively knocking down these challenges by leaning out the cost structure and strengthening the supply chain. Considering the practicalities of a company becoming slightly more tied to product delivery timing, we are widening our Adjusted EBITDA margin range guidance to 40 basis points. Therefore, our revised EBITDA range will be 10.1% to 10.5% for 2023.

Lastly, we're reaffirming our non-GAAP diluted EPS range of $6.40-$6.80. We're reaffirming our operating cash flow target of at least $700 million. In closing, I'm optimistic about our future as we set course for Leidos' second decade of growth. I look forward to meeting with you at upcoming conferences and roadshows. With that, I'll turn the call over to Chris for more detail on our financial performance and updated outlook. Chris?

Christopher Cage (CFO)

Thank you, Tom. Our Q2 financial results were indeed strong and put us on pace for a good year. Big picture, revenue continued its growth trajectory, and we rebounded nicely on earnings. As I said on the last call, the Q1 profit shortfall was temporary, concentrated, and recoverable. We had improvement in the security products business, and we worked together as an enterprise to deliver solid results across the entire portfolio. Turning to slide 5, revenues for the quarter were $3.84 billion, up 7% compared to the prior year quarter. Revenue growth was broad-based as each of our three reporting segments grew at least 5% organically. On to earnings.

Adjusted EBITDA was $420 million for the Q2, which was up 15% year-over-year. Adjusted EBITDA margin of 10.9% increased 70 basis points year-over-year. Non-GAAP net income was $252 million, and non-GAAP diluted EPS was $1.80. Non-GAAP net income and diluted EPS were up 15% and 13%, respectively, compared to the Q2 of fiscal year 2022. Earnings growth came despite a $6 million drag from net interest expense. Both share count and the effective tax rate were essentially unchanged from last year. Non-GAAP profitability was up from Q1 levels in all three segments, driven by improved business mix and program execution, as well as enhanced focus on indirect spending across the company.

Though there were some pickups from achieving milestones and truing up completed programs that won't necessarily recur in future quarters, we saw improvement along most key profit drivers. Specifically, EAC performance was strong, with net write-ups of $18 million. SG&A, as a percent of revenue, showed improvement as well. The year-over-year numbers paint a positive picture. The sequential improvement is even more encouraging. Total revenues were up 4%, Adjusted EBITDA margin was up 150 basis points. Non-GAAP diluted EPS was up 22%. Turning to the segment drivers on slide six. Defense Solutions revenues increased 7% year-over-year. The largest growth catalysts were in the areas of digital modernization, including Navy NGEN and Hypersonics, especially SDA Wide Field of View Tranche 1, as well as our Airborne Solutions Australia business.

For the quarter, Defense Solutions non-GAAP operating income margin increased to 9.3%, up 100 basis points from the prior year quarter, with maturing development programs, strong execution, and lower indirect spending. Health revenues increased 9% over the prior year quarter, driven by growth on the SSA IT work and increased demand for medical examinations. For VBA, we're seeing higher volumes from the PACT Act, and we're earning a higher work share as a result of our performance. Also, the Reserve Health Readiness Program is now building. Non-GAAP operating income margin came in at 17%, compared to 19.8% in the prior year quarter. The decrease was primarily driven by the $28 million equitable adjustment in the Q2 of 2022 to cover costs incurred as a result of the COVID-19 pandemic.

More important, Health non-GAAP operating income margin was up 110 basis points, sequentially bolstered by increased volume, solid program execution, and a positive outlook on incentive fee performance. Civil revenues increased 5% compared to the prior year quarter. The primary drivers of revenue growth were the NASA AEGIS program, increased demand for engineering support to commercial energy companies, and a partial recovery within the security products portfolio. Civil non-GAAP operating income margin was 9.1%, compared to 6.5% in the prior year quarter, which was unfavorably impacted by an adverse arbitration ruling and associated legal fees totaling $17 million. Sequentially, Civil non-GAAP margins improved by 270 basis points, which reflects partial improvement in the security products business. Consistent with expectations, the security products business is recovering but is not yet at peak levels.

For perspective, year-to-date, the security products business is actually up slightly year-over-year on revenue and down modestly on margin. As with last year, the back half of the year has the potential to be significantly stronger than the H1. We're seeing good traction in the business with the recent Leeds Airport award, and we've implemented the changes we talked about on the last call, including a leaner, more responsive cost structure and an improved supply chain. In addition, as part of the review of the business, we're looking at pruning the portfolio of products in geographies with lower returns. This work is ongoing. Taking a step back, we see security as an important and growing market, and we are positioning for success with our investment in the Charleston production facility and looking to expand into new areas such as data center protection.

Turning now to cash flow and the balance sheet on slide seven. We generated $164 million of cash flow from operating activities and $124 million of free cash flow. Net cash provided by operating activities benefited from strong collections and working capital management. DSO for the quarter was 59 days, a 3-day improvement from the Q1 of 2023. We are in the middle of a cross-functional review of cash generation to include harmonizing vendor payment terms and building in more favorable collection terms on our contracts where possible. We continue to expect to derive sustainably improved performance over time. During the quarter, we paid the remaining $320 million of principal on the 364-day term loan agreement that came due in May, taking on $200 million of commercial paper to do so.

These were the key movers of our $125 million net reduction in debt during the quarter. We expect to clear out the commercial paper during the Q3, which will free up capital to deploy. On to the forward outlook. Tom gave you the revised ranges. Let me provide a little more color. We expect revenue to remain near Q2 levels in the back half of the year, with some degradation from the Focus Fox loss and a move to a single wave of deployments on DHMSM by Q4. We have a large pipeline of opportunities pending decisions, and we aren't dependent upon significant new business wins to sustain our current revenues. On EBITDA, the expanded guidance range primarily reflects the range of outcomes on the security products business, as well as the volume of special project work on fixed price contracts and incentive fee determinations.

We've made our best assessment of the likely outcomes and are comfortable that our wider range conservatively incorporates the reasonable potential results. With a narrower range on revenue and a wider range on margin, we're comfortable with our EPS range, which also tracks well to our cash target for the year. As in prior years, cash generation is concentrated in Q3. With a strong Q2, we are ahead of our internal plan year to date. With that, I'll turn the call over to the operator so we can take some questions.

Operator (participant)

Thank you. We'll now begin the question and answer session. To ask a question, you may press star, then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Thank you. Our first question is from the line of Bert Subin with Stifel. Please proceed with your questions.

Bert Subin (Managing Director)

Hey, good morning, welcome, Tom.

Christopher Cage (CFO)

Hey, Bert.

Thomas Bell (CEO)

Thanks, Bert.

Bert Subin (Managing Director)

Thanks, Chris. Thanks, Tom. There was clearly a lot of concern coming out of Q1 earnings that weakness would persist in the securities product business. I mean, so far, that business seems to be recovering ahead of schedule. Can you just walk us through what changed in Q2 versus Q1? What changes in the back half and whether you think SCS can return to double-digit growth again next year?

Thomas Bell (CEO)

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

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

Christopher Cage (CFO)

Yeah, well, I mean, Bert, obviously, there were a number of areas we were focused on driving improvements into, and the team has made great progress in that regard. I would tell you that, you know, we're not to the end game yet. Let me hit on a couple areas. I mean, the customer-driven delays, that improved during the Q2. We're not back to the original plan, we see a path. Again, that was one of the reasons why we put the guidance forward that we did today. In sourcing, you saw the announcement on Charleston. We're excited about that. The team went through a very thorough evaluation of alternatives, we're full speed ahead to get that operational. We think it's a relatively modest investment with a longer-term payback. Then, you know, there were a lot of cost reduction actions that were taken.

Those are never easy. As part of that, one of the things that we did do is revector a senior resource to focus on strategic supplier obsolescence parts management. We're seeing improvements in that regard, helping our supply chain in that relationship. Pipeline remains strong, as we indicated, you know, looking at areas outside of the conventional airport and ports and borders. You know, we'll be selective on how we prosecute those bids for maximum benefit to the bottom line and cash flow going forward.

Bert Subin (Managing Director)

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

Thomas Bell (CEO)

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

Hypersonics, the MACH-TB launch that I mentioned, is one of our hypersonics pursuits, so we think that's a key area where we can be differentiated in the market. Last but not least, force protection and making sure that, as our forces are out there, we have products and services that protect our forces, when they're deployed. Those are the three areas that we're focusing on while we maintain the agility and entrepreneurship that has always defined Dynetics. With that, I'll kick it to Chris to see if he has any more color to add.

Christopher Cage (CFO)

Bert, the only thing I'd add there is, I mean, Tom's right. Our agility and expertise gets us in the door. Our front end, Leidos Innovations Center, we call it LINC, you know, with some of the brightest minds in some of these areas in the world, you know, have us access to the most important customer sets, but we have to perform. You know, that gets us in the door. The team has to perform and deliver, and that's what I'm most encouraged by, seeing progress that they're making on having improved discipline on bidding and execution, improved supply chain management, all those things that are critical as we ramp some of these programs up towards low-rate production, then full-rate production.

Bert Subin (Managing Director)

Thank you.

Operator (participant)

Our next question is in the line of Peter Arment with Baird. Please proceed with your question.

Peter Arment (Managing Director and Senior Analyst of Aerospace and Defense)

Yeah, thanks. Good morning, Tom and Chris. Hey, Tom, just to follow up on just kind of the, the products business in general, you kind of made some opening remarks on kind of, improving the execution there. Just, you know, the variability in margins now because of the timing on product deliveries. Just what's, what's your view on, just in general, you know, Leidos being in the products business and, you know, do you expect it to do more of this once you've kind of, I think you kind of said, integrate and kind of improve the execution? Just your overall view on the product side?

Thomas Bell (CEO)

Yeah, thanks. Thanks for that, Peter. Yeah, you know, I think having some diversity in our portfolio really makes sense for Leidos. I mean, after all, we're a 15 billion dollar company, in order to have counter-cyclical capabilities, you have to have some exposure to both the services and products. I like the fact that we're in a products business also. I also like that there is connective tissue in everything we currently do, that is poised in that thing I talk a lot about around how we solve our customers' most vexing, emerging problems. Whether it be products or services or software, it's really focused on how we lean into our customers' biggest challenge. I'm coming to understand our specific products and how they mix in with our services, business models and how that makes sense.

You know, at the core, whether it be a product or a service, remember that everything we do these days is at its core, IT services and algorithms and software and cyber, something that we are absolutely world-class in. I like the mix, and I think we'll be continuing the mix, and at the same time, we'll be very purposeful in how we exploit our advantages in each of those sides of the business.

Peter Arment (Managing Director and Senior Analyst of Aerospace and Defense)

Appreciate that. Then just, Chris, just quickly on the new EBITDA margin range, just puts and takes of what would make the difference between coming in and staying at the lower end or at the higher end. Is it all just tied to this aviation product deliveries, or are there any other, any other factors that you would call out?

Christopher Cage (CFO)

Yeah, thanks, Peter. I mean, first of all, obviously, the, the team here wants to deliver against the original commitment, but the wider range was prudent, given where we are and, and the volatility you'd seen in the first half of the year. I'm very encouraged about the H2 and very optimistic about how we'll progress from here. I would point to a couple things. Security products is an element of that, and as I said in my prepared remarks, we have the potential to have a significantly stronger H2 there. We've laid a lot of good groundwork to realize that. Not everything's within our control. On top of that, there are a couple other things.

In health, we had a great quarter in health. The team has done an excellent job. There is the opportunity to sustain that momentum as we move forward. Some of that is dependent upon not only our performance, but throughput and customer satisfaction, some variables on incentives that, again, we'll monitor closely. Our past performance suggests that those are fully attainable. That's another variable that we wanted to give ourselves some capacity for, because that incentive calculations is somewhat new.

Then, you know, lastly, just, some of our digital modernization programs continue to ramp up, and we're very pleased with the performance the team has executed against there, and there are some opportunities for more project work in the back half of the year, and depending upon how and when that comes to pass, could push us, you know, towards the higher end of that range.

Peter Arment (Managing Director and Senior Analyst of Aerospace and Defense)

Appreciate it. Thanks, Chris.

Christopher Cage (CFO)

Thank you.

Operator (participant)

Our next question is coming from the line of Matthew Akers with Wells Fargo. Please proceed with your questions.

Matt Akers (Senior Aerospace and Defense Services Analyst)

Yeah. Hey, guys. Good morning, and welcome, Tom. I want to ask about defense margins. You know, kind of the strongest margins here we've seen in a little bit. Could you just talk about sort of how sustainable that is, as we get into the back half and into 2024?

Christopher Cage (CFO)

Hey, thanks, Matt. Yeah, obviously, we're super pleased with the performance there. 9.3% OI margin, the highest in five years. A lot of that's led by, you know, progress we've seen on some of our big digital modernization programs. The team's done an excellent job there with NGEN, DES is continuing to ramp, there are others. There are some other things going on that are sustainable outside of that. Maturing development programs. Tom talked about Wide Field of View, especially Tranche 1, incorporating the lessons learned from Tranche 0. Better mix overall with the Australian airborne aviation business that we acquired last year, that's helping us. Then there's some variable items, I wouldn't say these are, you know, totally one-off, but we need to continue to perform well to realize these in the future.

Award fee scores were very strong. We reached certain program milestones, we did close out some older projects. We won't deliver 9.3 every quarter near term, but that's the expectation we're setting for ourselves and the team longer term. One thing that we will not take our eye off the ball on is, you know, underpinning focus on indirect cost management and program execution. So yeah, great progress in the Defense Solutions segment, and we're optimistic that there's more of that ahead of us.

Matt Akers (Senior Aerospace and Defense Services Analyst)

Okay, thanks. I wanted to ask about DES. We haven't talked a lot about just how you're thinking about the timing and does that ramp up here as we get into 2024?

Christopher Cage (CFO)

Yeah, it's a great question, very timely. In fact, we had a review internally with the team yesterday. We've got a really strong team on DES and working hand in glove with the customer. You know, this year it's still a modest contributor to the company in the order of $50 million of revenue. We just walked through a number of active task orders that are either in evaluation by the customer or some other ones that were coming up for bid and evaluation later this year. We're seeing the activity level increase, and there's a roadmap on, you know, migrations of more users onto the DoD net. Again, continue to think of that as something that will be a more, much more significant contributor in 2024 and 2025, really beyond that.

We'll have more to say as we get later in the year and have some clarity on when those get determined.

Matt Akers (Senior Aerospace and Defense Services Analyst)

Great. Okay, thanks.

Christopher Cage (CFO)

Thank you.

Operator (participant)

Our next questions are from the line of Jason Gursky with Citigroup. Please proceed with your questions.

Jason Gursky (Equity Research Analyst)

Yeah, good morning. Tom, I was wondering if we might double-click for a minute on the comment that you made about leveraging acquisitions. Maybe to better understand from your perspective, you know, kind of what went wrong, whether it was, you know, misalignment with expectations or execution, and what do you think it's going to take to fix, you know, what you've already acquired and what's going to change as you evaluate new acquisitions?

Thomas Bell (CEO)

Yeah, thanks for that. You know, I wasn't here, so I can't say exactly what went, quote, unquote, wrong. I don't know that anything went wrong, per se. I'm just looking at the current annual operating plan and the five-year plans for business against the original business case that was put forward to the board to approve the deals, and there's, there's a certain gap. Now, you know, I've been in this industry 40 years. I've frankly never seen an acquisition business case that doesn't have a gap. So that's not new, that's not novel to Leidos, and that doesn't say that we've made mistakes in the past.

That just means we've got the ball now, and it's our job to make sure we, we leverage the investments we've made and the capital we've deployed to ensure that the real cores of the acquisition business case come to pass. That's with focus, that's with resolve. That's obviously by getting deep dives into program executions, and also making sure that we go back to the basics of the original business case and say, what is the golden bolt that we were trying to buy, and how do we make sure we deploy it across the enterprise as effectively as possible? That's what I'm focused on, playing forward from here. As I suggested in my comments, I think the acquisitions that have been accomplished over the past seven, eight, nine years here at Leidos all make sense to me.

The key is just doubling down and making sure we make them make sense for our bottom line. Chris?

Christopher Cage (CFO)

Yeah, I mean, the one thing I'd add is, the playing off of Tom's words, the golden bolts example, I think our 1901 Group acquisition is a great example of that, right? You don't hear us talking much about that because it's embedded into the organization and providing capability broadly against a number of our digital modernization contracts, cutting across multiple sectors. That's the kind of leverage we want to see gained as we move forward with acquisitions. Dynetics, we talked about the Wide Field of View programs, and quite honestly, that is a combination of a legacy capability that Leidos brought to bear out of our Leidos Innovations Center, that Dynetics is now in the midst of executing that program and building the payloads. That is the leverage we want to see going forward.

We need to move more rapidly to link those capabilities together to get the full leverage out of future acquisitions.

Thomas Bell (CEO)

On the subject of future acquisitions, you asked about what's going to be the drive going forward. As I suggested in my prepared remarks, obviously, I think having a regular return of capital to investors makes sense to us. We're really focused on executing the work that we have on our plate now before we get back into the market to do M&A. However, when we do, in keeping with the North Star that I referenced, and a very clear articulation of where we want Leidos to be in 2028 and 2033, which are the two vistas we're setting out for ourselves, we'll have very clear articulations of what are the technologies that we see emerging?

What's the hypothesis of what the customer problems are going to be in the next five, 10 years? How might we either build those capabilities organically or acquire those capabilities inorganically? All of those will be tempered with a very clear articulation of affordability, hurdle rates, and a very clear strategic narrative. Premature to actually talk about what those are because we're still working out the North Star and the vision of what our customers are going to need us to be to serve them into the future, but those are the kind of things we'll be talking about.

Jason Gursky (Equity Research Analyst)

Okay, great. Then, as a quick follow-up here, your comments on backlog growth, and, you know, kind of maybe not necessarily being where you'd like it to be at this point. Can you talk a little bit about whether that is a market issue overall, and kind of the dynamics going on with your bid and proposal activity, and, and whether we're seeing either a, a slowing or acceleration? Just kind of what you might want to change internally if it's not a market issue.

Thomas Bell (CEO)

Yeah. The good news is, I don't think there's a negative market dynamic we're dealing with here. There's positive demand across all of our customers, and there's great opportunity for organic growth. As I suggested, we have a strong backlog, we have a strong pipeline, and I think the number is something like $26 billion in pending awards. The timing of those awards is unfortunate in that the fiH2 of the year has been light. Again, as I referred to in my comments, I think quarterly book-to-bill ratios can become quite a distraction and are actually quite unhelpful. What I'm focused on is building a quality backlog over time with quality wins that speak to long-term growth for Leidos. I don't think the BD process here is broken.

I know we know how to win. I'm passionate about winning. The whole ELT is passionate about winning, and I would not count us out just yet. Chris?

Christopher Cage (CFO)

Yeah. Jason, I would, you know, Tom said in his remarks that we need to be better. You know, that does imply there were some things where we swung and missed on some opportunities, and we would have liked to have won those. You rest assured, the team, you know, dissects those backwards and forwards anytime we have a loss, right? There's always lessons learned moving forward. We're not going to win them all. There's that combination, coupled with there are some things that are out there pending, and we're optimistic that those decisions will come here in the H2 of the year. Plus, the pipeline is strong, $135 billion. We expect to put another $20 billion of proposals through the back half of this year. Very active.

You know, again, our track record over, over the long haul has been strong. This is, you know, there's not a fundamental breakdown in our process. We've got great people in our business development organization, but we do need to, you know, land some of these ones that we have out there for decision right now.

Jason Gursky (Equity Research Analyst)

Great. Thank you, guys.

Christopher Cage (CFO)

Thanks, Jason.

Operator (participant)

The next questions are from the line of Sheila Kahyaoglu with Jefferies. Please proceed with your questions.

Sheila Kahyaoglu (Managing Director of Equity Research)

Thank you. Good morning, Tom, Chris, and Stuart. Tom, first one for you, please. I appreciate your comments in the opening remarks about margin enhancements. What are some of the steps on organizational structure and bottom-line financial discipline you plan to take? Because I was just under the impression that Leidos has pretty good margins, it just could be variable at times. Where do you see the potential opportunities on the profit margin side outside of the security business?

Thomas Bell (CEO)

Thanks for the question, Sheila. I think there is a slight reset in the culture that I've enjoyed putting out there, which is treating Leidos' money as if it's our own. As a result, Chris and I both talked about indirect spend and, you know, just, just tightening our belts a little bit and being a little bit more prudent with some of the indirect spend that is in any big bureaucratic organization. The reorganization I refer to is a tuning exercise. It's, it's not a fundamental reset of Leidos.

I do think it will add to the bottom line, because as Leidos has grown dramatically over the last five years, we've bolted on and fit in some of those acquisitions, such that there is replication and duplication of capabilities in different parts of our current value stream. I think there is opportunity for us to bring those capabilities together, better, bottle repeatability for customer solutions in some of those businesses, simplify the organization, promote better operational excellence around delivery for customer expectations, certainly speed up decision-making. Again, very key, align the organization around the key technology differentiators that set Leidos apart and define who we are in the markets that we serve. Again, this isn't a fundamental reset.

It's a tuning exercise to take advantage of the inorganic plays that have been made, rationalize the organization toward those goals, and then incentivize teams to actually deliver against very crisp goals for those businesses. Chris, anything to add?

Christopher Cage (CFO)

Yeah. No, Sheila, I would echo that. I mean, clearly, the primary objective here isn't to organize, to drive cost out of the business. That'll be a second order variable, and we always try to run lean, so that'll create, you know, some opportunity to reinvest, we're hopeful. Back to, you know, your question on where are there margin opportunities? Obviously, super pleased with health, moving up a bit from what we had said as an expectation. You see what's possible within the Defense Solutions segment of the business. I think some of that will come down to selectivity. You know, the teams will be more focused on which opportunities they have the ability to earn a quality return on. So we're, we're very optimistic that that'll pay dividends as we move into 2024 and beyond.

Sheila Kahyaoglu (Managing Director of Equity Research)

Great. Chris, one more specific one on health. Yeah, I thought the margins were very good at 17%. I think you mentioned a new incentive calculation on the VBA work. Can you provide additional detail around how we might think about that opportunity going forward? How do we think about the wind down on the single way that DHMSM impacting profitability in the H2?

Christopher Cage (CFO)

Yeah, thanks, Sheila. You know, on the incentive side, again, this was a change that went into effect earlier this year, so we're working through it, and we'll have more to say as, as we learn more. I would tell you that, you know, the incentive structure at the VBA was optimized from their point of view for all participants in order to better serve the veterans and to deliver better outcomes for VBA. It gives contractors, like Leidos, the opportunity to invest, to drive, you know, quality outcomes, better throughput, better patient experience, and, you know, be recognized and compensated potentially for those outcomes.

That's just getting started, and that, you know, creates an opportunity where we're a bit more optimistic that if we perform the way we have in the past, and you have to earn it, you know, every quarter, that, you know, the mid-teens margin has some upside to it than we previously communicated, and we'll just have to see how that goes. Obviously, the caseload volume from the PACT Act is still settling in. The other thing that's settling in is us, you know, earning more than our fair share, if you will, of the work share, because our performance has been so strong. Some of those variables will impact that as well. We're optimistic that, you know, that should create some sustainable upside.

Then on DHMSM, you know, obviously this is a little bit of a headwind on the growth side, and we'll see a bit of a moderation in Q4 and more so in 2024. From a margin perspective, I mean, it's a quality program, well run, but it is, you know, not one of the highest margin programs within the health portfolio. I don't think that's a negative as it relates to health margin, and the team is working hard and has a number of high-profile opportunities that they're pursuing right now that will help offset the revenue piece as we move forward. We talked about RHRP as another example of a program ramping that'll help offset that a little bit, too. A few dynamics going on there, but don't look at DHMSM as a margin headwind for us.

Thomas Bell (CEO)

Yeah, not to let that go without my commentary, too. I just want to say that we couldn't be more proud of Liz and the team there in health, because they, they are earning great margins because they have a differentiated offering that is serving our veterans and our customer in a differentiated way. It's really a joy to see that ecosystem come together.

Sheila Kahyaoglu (Managing Director of Equity Research)

Great. Thank you.

Christopher Cage (CFO)

Thanks, Sheila.

Operator (participant)

Our next question come from the line of Seth Seifman with JPMorgan. Please proceed with your questions.

Seth Seifman (VP and Equity Research Analyst)

Hey, thanks very much. Good morning, and welcome, Tom. I just wanted to follow up. I think there was an earlier question, you know, asking about, you know, Dynetics and the inflection that was expected there next year. I wonder, maybe zooming out to the whole business, there are some standing, you know, three-year targets out there in terms of organic growth, you know, that would point to some acceleration in 2024. I guess, you know, Tom, in the spirit of promises made, promises kept, should we, you know, should we still consider those, those targets to be operative?

Thomas Bell (CEO)

Yeah, well, I'll start and let Chris fill in some blanks. I certainly am very aware of the investor day we held a couple of years back and the, and the view toward 2024 that we gave at the time. I've started staring at 2024 lightly, but in all brutal honesty, Seth, I'm very focused on finishing 2023 strong and laying a strong foundation for Leidos over the next three, five, 10 years. I actually haven't done my own diagnostics of how achievable the 2024 targets are. Obviously, if we do hit the objectives in 2023, we're a step closer to achieving those objectives that we laid out in that industry day a couple of years ago. Chris, you want to?

Christopher Cage (CFO)

Yeah, Seth, the only thing I'd add, obviously, you know, Tom coming on board, we've got to get him, you know, even more deep into our detailed plans as we look ahead to 2024. One of the things that, you know, as a change condition, is ensuring that we are optimizing for the best bottom line and cash performance and the selectivity that'll come with that. Really being thoughtful around how our resources get allocated to pursue opportunities in technical investment and differentiation as we pivot into 2024. You know, some of those things will have near-term paybacks, and some of those things will have longer-term paybacks. More to say on 2024, as we progress through the year, but everybody's heads down on delivering this year as strong as we can and putting some wins on the board and positioning for the future.

Seth Seifman (VP and Equity Research Analyst)

Great. Thanks. I'll stick to one this morning.

Thomas Bell (CEO)

Thank you.

Christopher Cage (CFO)

Thanks, Seth.

Operator (participant)

Our next questions are from the line of Robert Spingarn with Melius Research. Please proceed with your question.

Robert Spingarn (Managing Director of Aerospace, Defense, and Space Equity Research)

Hey, good morning. Just following on that.

Thomas Bell (CEO)

Hello.

Robert Spingarn (Managing Director of Aerospace, Defense, and Space Equity Research)

Hey, good morning, everybody, welcome, Tom. On 2024, just with regard to the budget and the difference between, you know, the budget caps from the debt ceiling deal on the defense budget and then on non-defense, where there's going to be decreases. Given that you have a couple segments that point away from defense, do you just broaden the aperture there so that your pipeline can offset potential pressure on the budget?

Thomas Bell (CEO)

Yeah. You're right. There is a curious dynamic that's been set up as a result of the debt ceiling debate and resolution that occurred, that obviously, people on Capitol Hill are expressing optimism that they will solve before we're facing another government shutdown. At the same time, we're actively working with all of our customers on both sides of that equilibrium, if you will, to ensure that if there are things we can do this year to get them out of harm's way of any possible budget challenges they might face next year, we're engaged with them on that. We're also focusing on exactly what you suggest, Robert, which is, expanding the areas where we can help those customers and or customers like them.

I'm not overly concerned about 2024 and the law of unintended consequences, if you will. I'm very focused on the fact that the team is engaged with customers about all those eventualities, and we feel we're fairly insulated against, near-term impacts from any possible government shutdown. Chris?

Christopher Cage (CFO)

Yeah. Rob, I mean, there's certainly areas within our civil and health business that, you know, we've been positioning to make sure we're in priority areas for our customers. We just talked a bit about the, you know, the VBA side, and, you know, that's not going to change. Outside of the civilian agencies, I mean, you look at what we do in our commercial energy business and, you know, grid resiliency and critical infrastructure, and those are areas that you're going to see more spending dedicated to. The team's really been doing an excellent job there, and obviously, we've been talking a lot about security products in the pipeline and opportunities there. There are definitely parts of the portfolio that we will have, you know, strong budgetary environments, we believe, and we'll prioritize those in the near term.

As Tom mentioned, you know, we're optimistic that we'll weather any challenges in certain customer areas.

Robert Spingarn (Managing Director of Aerospace, Defense, and Space Equity Research)

Chris, just on that last part, when we think about healthcare and discretionary versus non-discretionary funding, so, you know, Medicare, Medicaid, and so on, what- is there a way to quantify what portion of your healthcare business gets funded out of those non-discretionary budgets?

Christopher Cage (CFO)

Well, a lot of the stuff that we're doing on, on the medical examination businesses is in that bucket, right? You know, that's well protected and insulated. Then, you know, obviously, the health record modernization programs are priorities for our customer sets and what we're doing on our reserve health readiness. You know, I think by and large, Rob, we're, we're in a good position there, but that'll be something we can, you know, come back with, you know, details on in the future.

Robert Spingarn (Managing Director of Aerospace, Defense, and Space Equity Research)

Great. Thanks so much.

Christopher Cage (CFO)

Thank you.

Operator (participant)

The next question is from the line of Tobey Sommer with Truist Securities. Please proceed with your questions.

Jasper Bibb (VP of Equity Research)

Hey, good morning. This is Jasper Bibb for Tobey Sommer. Just wanted to ask about the security products business and underperformance versus the acquisition case there. Would there be any way to quantify what getting that business back up to your targets might mean for civil segment revenue growth and margins over the next few years?

Christopher Cage (CFO)

Yeah, Josh, I think it's a little premature. Obviously, we all know that with the COVID pandemic and worldwide aviation travel, not where we thought it would be, that we're quite a bit under on the top line where that, you know, business was expected to be. The growth rates over the last couple of years have been improved, and we're optimistic as we look ahead, we'll continue to see that. Yeah, when you look at civil, I mean, what we're focused on is raising the floor of performance. Q1 was, you know, below our standards, Q2, much improved. You know, over time, we expect the civil business to be, you know, on average, a 10% plus margin business, and in the best quarters, we'll see it 11% above.

If we raise the floor of performance, which we're focused on in security products, you know, that'll allow us to do that and achieve, you know, significant upside, hopefully over time. Again, I think that just gives you a sense that there is room for that to grow going forward, and, you know, our job is to take out the variability that you've seen more recently.

Thomas Bell (CEO)

On the top line and bottom line expansion of our security business, as I have said, security is a vexing problem that's not going away. In fact, more and more civil customers don't think government, civilian customers are thinking about the security of their premises and the need for them to be more guarded on what goes in and what comes out. This is a great opportunity for market expansion for the team at very good margins. I like our bet on security, and I think it's going to be a good place for us to be as we prosecute the next five years.

Jasper Bibb (VP of Equity Research)

Thanks for that. I'll stick to just one question today, so we can get some more people on.

Christopher Cage (CFO)

Thanks, Josh.

Stuart Davis (SVP of Investor Relations)

Hey, Rob, it looks like we're coming pretty close to the top of the hour. I think we have time for one more question.

Operator (participant)

Sure. That question will come from the line of Noah Poponak with Goldman Sachs.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Hi, good morning, everyone.

Christopher Cage (CFO)

Hey, Noah.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Chris, last quarter with security products, you, you provided a lot of detail on where the challenges were. You talked about customer schedule delays, where they couldn't accept product, supply chain disruption, and then you said there were service agreement penalties and product investments. I was wondering if you could just quickly update each of those. I mean, how many customers are delayed and how many are on schedule? I guess, those other three, are they just, you know, kind of fully behind you or not?

Christopher Cage (CFO)

Yeah. Hey, thanks, Noah. I hit on this a little bit earlier on one of the questions, but, just to reiterate, on the customer, it's predominantly a large program with a single customer. It's a multi-year arrangement to deliver a number of products. We are still not on the original schedule that we had laid out with them, and the team is working hard to get units accepted, and progress was made in the Q2. That will continue to be something we'll work through the Q3 and the Q4 of this year. Again, you know, with the guidance range we gave you, we're comfortable that if we're not able to get all the way back, we're still, you know, solidly in our range. That is ongoing, improving, but not resolved.

You know, the supply chain side of things, you know, several things are going on there. Number one, setting up our capability to perform light manufacturing in the future. That commitment was made. We're full speed ahead on outfitting that, that Charleston facility, and we'll be well-positioned beginning in 2024. In the meantime, you know, we have improved our ability to get the component parts that we need. We've in-sourced certain circuit board repairs. We've seen OEMs step up with better response times, and as I mentioned, we've positioned one of our senior, you know, leaders in that organization to focus on critical supplier management, and part obsolescence. Again, that's shown improvements, which is, you know, not fully resolved, but significantly improved the service level penalty situation. I would say the R&D investments are on track.

The team has laid out a plan. We're not compromising there, ensuring that we have the full capability of our, you know, software with our hardware is critical as a differentiator for us. We like where that is trending. You know, we took out a lot of additional costs in the business to set ourselves up for more streamlined performance going forward. I think that'll actually yield, you know, better communication flow, you know, clear roles and responsibilities. As we optimize that with the, the, the team that we have in place going forward, we think we'll see some continued improvements in, in our performance.

Solid progress, not done, Noah, I think is the punchline, and, you know, that is an area that gets full visibility from Jim Moos, our Civil Leader, and the whole security detection team. They're all over it.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Okay. I guess, you know, it's a pretty good step up in the quarter sequentially, despite not being to the finish line on all of that. I appreciate the widening of the margin range and the volatility, you know, that's inherent in what we're talking about here. The guidance implies the margin is a decent amount lower in the back half, yet you're describing getting to the finish line on these civil items. Does the low end just incorporate the unlikely, but can't roll it out risk that customer delay takes a big step backwards? Is there something outside of, you know, the tail that could get you to the low end of that margin range?

Thomas Bell (CEO)

I'll take that, if you don't mind, Noah. If I could characterize the widening of the range, that is, in my mind, more applicable for a business like ours that does products and services and is subject to the timing thereof. I just think a 40 basis points guidance range is going to be the new normal going forward. Don't read into the 10.1 acquiescence or fatalism that that is the goal. It is certainly not the goal. The team is driving toward the high end, as you would expect the team to do. However, it is consistent with a promises made, promises kept philosophy, where I don't want to put out a range that later I'm not going to be able to hit.

10.1 to 10.5 is an adequate and realistic view of the entire range of possibilities we can see at this time, and we'll keep driving for the upper end of that range.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

I understand. If I might just quickly, Tom, appreciate all the color you've given here, and there's a lot of things you're talking about, working, working on. You've had these questions on the financials of the business beyond 2023 and the prior Investor Day-oriented midterm, long-term outlook. How are you thinking about eventually having another Investor Day, providing a fresh set of midterm financial goals, versus not doing that and just running the business and letting the results speak for themselves?

Thomas Bell (CEO)

The team is already talking to me about when we would have the next Investor Day, so, in my mind, it's a question of when, not if.

Noah Poponak (Managing Director of Aerospace and Defense Equity Research)

Okay. Thanks for taking my questions.

Thomas Bell (CEO)

Thanks, Noah.

Operator (participant)

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

Stuart Davis (SVP of Investor Relations)

Thank you, Rob, for your assistance on the call this morning. Thank you all for your time this morning and your interest in Leidos. We look forward to updating you again soon. Have a great day.

Operator (participant)

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.