Leidos Holdings Inc (LDOS) — Q1 2015 Earnings Call Transcript

Thank you. Good morning, everyone. I'd like to welcome you to our first quarter fiscal 2015 earnings conference call. Joining me today are John Jumper, our Chairman and CEO; and Mark Sopp, our CFO; and other members of the Leidos management team. During the call, we'll make forward-looking statements to assist you in understanding the company and our expectations about its future financial and operating performance. These statements are subject to a number of risks that could cause actual events to differ materially, and I refer you to our SEC filings for a discussion of these risks. In addition, statements represent our views as of today. Subsequent events and developments could cause our view to change. We may elect to update the forward-looking statements at some point in the future, but we specifically disclaim any obligation to do so. I'd now like to turn the call over to John Jumper, our Chairman and CEO.

Thank you, John. Our first quarter results for fiscal year '15 and our second full quarterly reports since the separation reflect the continuing challenges we face in our various markets while also demonstrating some positive results from our actions to improve operational performance. We continue to make meaningful progress on mitigating the impact of government spending levels and shedding impediments to our future growth. We are cautiously optimistic about recent contract activity in some segments of the federal market, particularly federal health. However, our outlook and our experience in defense and intelligence budgets show outlays continuing to decrease through the government's fiscal year '15. We also believe that dramatic differences in priorities between political parties may result in another continuing resolution in the upcoming new government fiscal year, which starts October 1 of this year. Leidos continues to take actions necessary to become more competitive in both federal and commercial markets. I remain convinced that we're doing a good job improving upon these areas within our control and that we are extracting the value we envisioned in the separation. We saw our National Security Sector operating income improve, as well as an increase in the sector's funded backlog. And we continued on our journey to shape and optimize our portfolio, completing the sale of CounterBomber, our third divestiture in recent months. We also had success in our efforts to access markets that were either partially or fully conflicted before the separation, seeing strong new awards amounting to more than $400 million in airborne systems, command and control, and logistics. In addition, we have taken initial steps to build our international presence with both government and commercial business where we see demand for our demonstrated solutions. These steps are being taken in a small number of countries where we have existing footprint, relationships, and past performance credentials. In the area of capital deployment, we substantially completed a $200 million accelerated share repurchase program announced in March. As we have said, our goal is to avoid building excess cash on our balance sheet as we move forward. In the last 6 months, we have returned over $0.5 billion through our share repurchase program, and this represents about 17% of our current market cap. Our cash generation is typically lower in the first quarter, as our results show. That said, cash generation remains a clear priority for Leidos, and we remain committed to utilizing our expected strong cash flows to drive value for our shareholders. Now turning to our National Security Sector. Revenues decreased by $133 million, or 12% year-over-year, in the first quarter of FY '15. This represents a slight improvement in the rate of decline compared to the fourth quarter of last year. About $78 million of the decline was due to the continued reduction of U.S. overseas war-related, or OCO, business. We continue to expect that OCO-related revenues will be about $400 million in fiscal 2015, down from close to $750 million in fiscal 2014. We believe that we will eventually be able to turn about half of the remaining business into programs of record. It is our expectation that we continue to see a moderation in the rate of decline for our National Security Sector revenues as we move through the remainder of fiscal 2015, mainly driven by easing comparisons. Our National Security Sector operating income increased by $6 million to $77 million in the first quarter of FY '15. Our operating income margin was 8.2% for the quarter, up 160 basis points compared to the prior year. The improved margin performance reflects the ongoing impact of our cost reduction initiatives and solid program execution. I am pleased to note that these initiatives more than offset the overall impact of revenue decline. National Security Sector net bookings for the quarter were $474 million, resulting in a book-to-bill ratio of just over 0.5. Our funded backlog increased by 6% year-over-year and grew 7% on a sequential basis. One notable recent win was the Combatant Craft Medium contract, a specialized vessel for the U.S. Special Operations Command. We have been pursuing this program for several years, winning an aggressive competition to develop and field initial units using our vessel design and unique capabilities and leveraging the commercial shipbuilding supplier base. This win further solidifies our competitiveness in the DoD solutions space. Now on to Health and Engineering. Health and Engineering revenues decreased by $141 million, or 27% year-over-year. The revenue contraction reflects 4 main factors: first, the completion of 2 alternative energy power plant construction projects, Plainfield and Gradient, which boosted revenues by $63 million in the prior-year period; second, the timing of security product shipments. In the first quarter of fiscal 2015, we had a relatively low level of shipments due to the completion of a large international systems maintenance contract last year and due to our schedule for delivery of new security product shipments, which are concentrated in the remaining quarters of this year. Third, while we saw a sequential improvement in our commercial health revenues for the first quarter, we experienced a decline on a year-over-year basis. And finally, we had fewer new starts in our design-build engineering business. Overall, we believe our Health and Engineering revenues will build modestly as we move through the rest of the year, driven largely by higher levels of security product deliveries. Health and Engineering operating income decreased by $10 million in the first quarter, a result of the lower revenue volume, the low volume of security product deliveries and operating losses associated with the Plainfield biomass power plant. Excluding any unforeseen items, we would anticipate our sector operating income to increase as we move through the rest of the year, driven primarily by the expected increased volume in security product shipments in the remaining quarters and an improvement in the results from Plainfield operations. Our Health and Engineering business had a book-to-bill ratio of 1.0. Total backlog for this sector was $1.85 billion, up 5% compared to the prior year, while the funding backlog was $1.12 billion, up slightly year-over-year. Looking at our total company business development results, consolidated net bookings totaled $857 million for the first quarter and produced a book-to-bill ratio of 0.65. We ended the quarter with $8.8 billion in total backlog, $3.1 billion of which was funded. Total company backlog was down 6% year-over-year, while funded backlog was up 5% over that period. The value of bids outstanding at the end of the first quarter was $11.9 billion. Finally, before I turn the call over to Mark, I'd like to give you a quick update on the board's ongoing CEO search. We have identified a number of excellent candidates, both internal and external. The board is devoting considerable attention to the interview process, and I am optimistic that we'll be in a position to conclude the process in the near future.

Great. Thank you, John. Consolidated revenues were $1.3 billion for the first quarter, which represented a decline of 17% year-over-year and consistent with our expectations. Operating income margin was 6.7%. This is below our full year expectation of a low- to mid-7% range due to a higher-than-anticipated loss on our Plainfield energy plant operations and the timing of severance- and regulatory-related charges in our corporate sector. At the same time, I'd like to highlight progress on improving our margin profile. Our National Security Sector posted a margin of 8.2% in Q1, benefiting from strong program execution, and we generally expect this level of performance throughout the year. Our Health and Engineering Sector operating income margin was 6.6% in Q1, depressed by the Plainfield results and by low sales volume of our higher-margin security products, as John said. We expect improvement in these 2 areas for the rest of the year. These factors together drove operating income of $89 million for Q1 and a year-over-year improvement of 17% despite a reduction in revenues. Interest expense was $20 million in the quarter, tracking to our expected normalized level for the year. Our share buybacks reduced our diluted shares outstanding to 78 million, down from 84 million in the fourth quarter of last year. This should adjust down to 75 million to 76 million in Q2 as we get a full quarter's benefit from the $200 million buyback we launched in March. Diluted EPS from continuing operations was $0.59 for the first quarter, and our non-GAAP EPS was $0.60 per share, which excludes $1 million of separation and restructuring expenses stemming from an adjustment to a reserve for facilities' lease terminations. Operating cash flow was negative $8 million in Q1. The first quarter, as John said, is typically the low point for cash flow generation as we have one extra payroll cycle, and we also pay all annual incentives in the first quarter. We exited the quarter with $183 million of cash on hand. Now moving on to guidance. Today, we are reaffirming our fiscal '15 guidance for all measures, revenues, non-GAAP diluted EPS and operating cash flow, as we laid out on our last earnings call in March. Our fiscal '15 revenue expectation continues to be in the range of $4.9 billion to $5.1 billion. In terms of timing, from a sequential perspective, we expect revenues in the remaining quarters to be modestly below the result in Q1. This is primarily driven by ongoing reductions in revenues from our support of overseas contingency operations, OCO, and overall DoD and intelligence community budget cuts. Our expectation for operating margin implied in our guidance range continues to be in the low- to mid-7% range. We expect operating losses from Plainfield to be reduced in Q2 and contribute modestly to profitability in the second half. I will note we anticipate Plainfield to contribute positively to operating cash flow for the year due to favorable tax benefits associated with the biomass plant. Also, as noted earlier, our higher-margin security products business is scheduled to ramp up in the remaining quarters. In addition, we expect to benefit from further cost reductions. These factors are expected collectively to drive higher margin for the remaining quarters compared to Q1. As for other P&L items, there are also no changes to our original guidance. We continue to expect interest expense to be approximately $80 million for the year and our effective tax rate to be roughly 36%. With that, we expect fiscal '15 non-GAAP diluted EPS to be in the range of $2.35 to $2.55. Our guidance does not include the impact of any potential future share repurchases in the year. For fiscal '15 operating cash flows, we expect at least $350 million. This contemplates recovery from working capital outflows in Q1 and further working capital reductions of $50 million, as we set forth in our original guidance, as we work through the rest of the year. In addition to our operating cash flow outlook for the rest of the year, we anticipate that the proceeds from the Plainfield cash grant will be received in the latter half of fiscal '15, showing up in cash flows from investing activities and further adding to our cash deployment potential. Finishing up on the topic of capital deployment, our strategy is unchanged. As a reminder, our first priority on the deployment front is to maintain or increase our regular quarterly dividend. For excess cash, which we define as amounts above $200 million of cash on hand, our strategy is to deploy it to maximize shareholder returns. Given our $350 million operating cash flow outlook and the expected net inflows from investing activities, we anticipate generating significant, deployable excess cash as we progress through the year.

Thank you, Mark. As we report our second full quarter of performance under the Leidos banner, I have watched a resilient management team and a talented team of employees take on multiple challenges, sequestration, government shutdown, a new company name, and significant structural change. I am confident we are positioned better than ever to take on the uncertainties of our environment and to deliver to our shareholders the value that was envisioned when we created Leidos. Now let me turn the mic back over to John for your questions.

Thank you. Operator, we'd now like to open up the line for questions.

Could you provide some insight into the tone of bookings at NSS? Some of your competitors have mentioned they've begun to see an increase. Additionally, could you quantify the situation? You previously reported a decline of $78 million in OCO volume; what was that number in the first quarter?

Cai, this is John Jumper. We've got Lou Von Thaer here with us today as part of the management team. So I'm going to let him field that question.

$78 million was our first quarter impact on revenues due to a decline in actual OCO. A lot of this is related to timing, and our submissions for the quarter were a bit lower. However, in the next couple of quarters, we expect to see several bids over a billion dollars that have been delayed go out. Over time, things will balance out, and we anticipate a significant increase in our submission numbers. Historically, given the government budget challenges over the past few years, most awards tend to occur in what is typically our third quarter, and we expect this pattern to continue this year.

And then to my first question, the other question about the level of OCO revenues in the first quarter?

Cai, this is Mark. We're still on pace to have roughly $400 million for the year. It will modestly decline as we move through the year with some scheduled ramp-downs, but that overall $400 million expectation for the year is unchanged from our previous discussions.

Yes. I think it's pretty linear, Cai, but that's with some noise on it.

Got it. And then the last one, maybe you could update us in the commercial health IT area, how that did, what the order looks like, and whether we're starting to see any pickup there.

Cai, this is John Jumper. I think we're encouraged about commercial health, but we've had some ups and downs. As you know, the Meaningful Use in the ICD-10 decisions have been pushed out to the right again. So this has not had the impact that we saw previously with those decisions, but still, there's room for caution. So it's still too early to call a turnaround in that business, although we have seen some improvement.

I wanted to start with a high-level question. I'm trying to understand the implications of what's happening on the OCO side with troop drawdown compared to the broader sequestration. Can you clarify those for us and help us understand if you think things have bottomed out from a sequestration perspective, or is there still more to come?

Let me begin with a strategic budget outlook. It’s encouraging to have a budget agreement, but a close look at actual government outlays shows we may experience ongoing pressure and declines at least through the government fiscal year 2015. Therefore, we remain less optimistic about this situation. Regarding the impact of the Overseas Contingency Operations, we are anticipating continued troop drawdowns, but it is uncertain how this will affect businesses like ours in that context. We expect reductions, but the final impact remains hard to predict. I will let Lou expand on this further.

Yes, I think John got that just right. The only other piece I would add is within the overall government DoD budgets, if you look at the procurement and RDT&E sections of those budgets, they're under even more pressure because personnel costs, facilities costs, a lot of the non- or less-controllable costs continue to increase for the Department amidst the declines. And as a result, while we look forward to being more optimistic, we see more pressure on these budgets for a couple more years.

Okay. And then going back to your comment earlier, I think you said you derived about $11.9 billion in bids outstanding as of the end of the quarter. What percent of those would you estimate could be decisioned by the end of the government fiscal year, as well as by the end of the Leidos fiscal year?

Well, let me start. I'm going to say that one of the characteristics of the situation we're in is that decisions, in general, are being pushed to the right. So I've mentioned this on previous calls that the delays in decisions are probably one of the most harmful aspects of sequestration, and quite frankly, we don't see much improvement in that.

Okay. So no specific percentage that we should be thinking of?

I think it would be disingenuous of us to try and parse any answer to you on that.

Okay, okay. And then just last one, which sort of ties into this prior question, but as you think about the prospect for government flush in September, compared to what we saw or, for that matter, did not see last year, I mean, are you expecting it to be similarly tepid? Or could it be less tepid than it was last year?

Well, again, I think we're under a new set of rules as we try to figure out the real impact of sequestration, the delayed decisions, the delay in RFP, etc., all of the push to the right. It's difficult to say. I can only say that there's no reason to believe it won't look like last year. We don't see anything, quite frankly, that much different in the current environment. So while I think it's impossible to predict, I'd say that the logic would tell us it would look very similar to last year in the sort of sequestration ecosystem that we find ourselves in right now.

This is actually Joe on for Rob. Mark, you noted that Q1 is typically the low point for cash flow generation, and I just wanted to ask how should we think about the cadence for cash flow in the remaining 3 quarters and how you kind of get to the $350 million level that you're guiding to?

Okay. Thanks, Joe. I mentioned in my prepared remarks, we had an extra payroll and incentives in Q1. So those incentives won't happen again for the rest of the year. So you'll see improvement in the out quarters from that alone relative to Q1. We do have an extra payroll again in Q3, and so there will be a little bit of pressure there. So all other things being equal, I'd expect Q2 and Q4 to be better. We do expect to see DSO reduction over the course of the year. I expect that to be somewhat gradual, but specific initiatives and catalysts for that are well in mind and are of very, very high priority. So it will build over the course of the year, and there will be quite a bit in Q4. So it will come down to the wire, but I can assure you this team is laser-focused on it, and we're confident in our outlook.

It's actually Chris Sands on for Joe. I just wanted to follow up on the commercial health-care outlook. I know you said it remains uncertain, but can you say that it was profitable in Q1 and what your expectation for the full year is?

Mark?

Commercial health was profitable in Q1. It actually had a healthy margin. So we were really pleased to see that in both the absolute and relative to recent quarters. General outlook is relatively flat on the top line given the pipeline we see and the uncertainty that John referred to earlier. We expect to be profitable for the year. Margins will move around a little bit with the timing of investments, bids, and things like that. And so we're expecting to be, for the year, well above last year, which was not a great year. I would not say our margins are going to be optimized this year for that business. We still are making investments, and we don't quite have the volume we'd like to see to really get to what you might expect from a commercial consulting business. So we've got a ways to go there, but at least we're in the black relative to recent quarters, and we're pleased to see that progress. And hats off to the team for their progress there.

And so is that low- to mid-single digits? Is that reasonable for what you're expecting this year?

It's more in the mid, maybe a little plus.

Okay. And then when you said flat for the rest of the year, did you mean relative to Q1 on the top line?

Basically, give or take a little bit, it's sequentially flat, going out, is our current view.

Okay. And then switching over to the federal health outlook. John, in your prepared remarks, I believe you said that you'd seen some positive indicators there. Can you give us an update on the outlook and potential near-term opportunities you're going after?

Yes. One positive aspect of the federal budget is the notable increase in contracting activity in the federal health sector. We are anticipating the competition for the defense health medical records contract, which involves the re-digitization of the Department of Defense electronic health-care records system. We have successfully managed this system for approximately 25 years. This presents a great opportunity to leverage both commercial and federal efficiencies in the federal space. We believe we are well positioned for this, and the outlook appears very promising.

What's the timing on the DHMSM contract?

Well, they just released the final section of the RFP. So as I will refer back to my conversation previously about delayed decisions, I'm not going to predict when we might actually have a bid on this, but I think it's going to be in the months to come.

Mark, you mentioned, on NSS, the margins will be sustained, but when I back out the project adjustment, I get 100 basis points lower if I just take that off the operating income. So when you say that, do you expect additional project write-ups or that write-up to get offset by cost reductions kind of keeping that low-8s-type operating margin through the year in NSS?

We are looking at low-8s going forward, and I think that our performance on projects is reflected in some of those write-ups. I think the team has done a marvelous job stabilizing and improving our performance on our programs across the board. And so the write-ups do reflect that, but they also reflect the ongoing cost reductions that Lou and his team have engineered into the business. And cost reductions work their way favorably into contract adjustments, and there's an element of recurring nature in that. In addition to that, we do have some higher-margin specific projects that are either under our belt or within our visibility that also should fuel some improvement in the out quarters. So it's a combination of strong program performance on past and ongoing cost reductions and also some mix improvements going forward that are real drivers for our expected modest improvement moving forward.

Okay, great. Can you elaborate on the Plainfield cash grant? Is it included in your operating cash flow guidance, and what is the amount and source of that?

So the Plainfield Treasury cash grant is not part of our operating cash flow guidance because it will be a receipt into the investing activities category, and we expect it will offset our CapEx. And that is why I said we expect net inflows from investing activities for the year fueling more capital deployment opportunity. We filed our Treasury grant application early in the fiscal year, and it's going through its normal process. We are having a dialogue with the Treasury Department now, which I would categorize as normal. With that, we expect to receive proceeds in the second half of the year, as I said earlier. We've said before that that's nominally a $70 million number, which is part of the overall carrying value of the plant, which is at $275 million.

Any update on your potential sale of that?

We have filed for the cash grant and are currently working on the performance parameters of the plant. Our goal is to make the plant fully operational and to maximize value for our shareholders.

I'll just clarify. It's operational today.

Yes.

We're working on optimizing its performance. And once we have that well under our belt, it's when we can be better positioned to access the market to maximize shareholder value in a monetizing transaction.

I was curious in your thoughts on a recent commentary from President Obama, maybe a change in strategy here, and how that might impact areas that you're targeting going forward?

Which comments, Ed?

Primarily the ones at the naval base in West Point.

The talking about the global strategy?

Yes.

I think you're putting me on the spot here because the commentary on that speech has been rather critical in many cases. However, I believe that the speech has left us somewhat in the middle. The President discussed extremes of possibilities but ultimately positioned us in a balanced way, particularly regarding the importance of using allies and others to assist us in our global strategy. I don't anticipate that any of this will have an impact at the operational level on our future activities. When we consider our roles in intelligence, cyber efforts, and other areas of national security, it’s hard to see how anything he said changes our approach. In fact, it may increase the urgency to respond swiftly and remain adaptable to a rapidly evolving global landscape. As you know, Ed, that’s our strength as a company. We are prepared for whatever happens next.

And any thoughts on the turmoil over at the VA? Do you think that has the chance? And obviously, the VA is important to the federal health opportunity, whether that may cause some delays in any of these contract awards?

We are not involved in any of the major work at the VA, but we do have some minor roles and are proud to support our veterans. What we’re observing at the VA is specific to that organization. It doesn’t diminish the need for progress; in fact, it likely increases the urgency to advance with the Department of Defense's electronic health-care digitization initiative. This situation highlights the necessity to leverage our technology for functions that are still being performed manually in areas we expect to be technologically advanced, which indicates that we still have work to do. This situation emphasizes the need for change.

It seems that Congress is more than willing to use the OCO budget to do things that maybe aren't quite OCO work. Does this give you an added level of comfort that change will be more gradual?

Yes, this is Lou Von Thaer. And yes, I think we will see some of that. I think some of the places where we believe we'll be able to transition some of our OCO work into programs of record, I think, in transition through this, already some of those assets are being used in other continents today at small levels. And we think this will support our strategy. And the recent announcements that the President made on when we would potentially end the conflicts in Afghanistan, I think, are pretty consistent with our expectations of the plan that we have laid out.

And, Ed, this isn't new. I mean, we've seen this before with the OCO budgets not always being entirely focused on OCO activity.

Last question, can you discuss pricing and any recompetes you anticipate in the next 12 months? What is your current exposure to recompetes, and how have your win rates been lately? Additionally, what pricing trends are you observing for both takeaway and recompete activities?

So this is Lou. I'll take that one as well. So we're obviously seeing a very challenging pricing environment. At the same time, our recompetes are at about a normal level for us. We usually run about 20% of the business or so that we recompete for each year. Prices are tight right now, which is why we are being very aggressive in the cost-cutting activities that we're continuing to do, and quite frankly, our win rates have been great lately. Our win rate, actually, for the National Security Sector was up in the mid-60s, which is our highest in the last 5 quarters over the last quarters. These things are all kind of cyclical and ebb and flow. We believe we're still very competitive, and we believe we're continuing to rapidly adjust to these pressures.

Just a couple more. First, on the book-to-bill on Health and Engineering 1.0, I see that you highlighted 2 of the wins that totaled about $27 million, but what was the bulk of the rest of those to get to that 1.0?

Bill, it's Mark. There's no single factor that significantly impacts the landscape beyond what you've mentioned and a few other announcements we've made this quarter. The health business tends to have very fast turnover, which explains why we consistently operate at 1.0. We did see sequential revenue improvements, indicating progress. There's a lot of activity and rapid changes happening across both federal and commercial engineering, as well as in the health sectors. However, I can't identify anything specific that would substantially influence the overall outcome.

Okay. And then on cash use, you said excess cash is over $200 million. You have $1.3 billion in debt. What are your plans? It kind of sounds like you are leaning more towards special dividends or something of that nature, but what are your views on acquisition opportunities as well?

Bill, this is John. The strategy and priorities remain unchanged. The board reviews these matters at every meeting, and we have another meeting approaching. Therefore, I don't foresee any adjustments to the strategy you've observed previously.

So you would be comfortable if you've paid out all your cash? And your $200 million in cash, you've got $1.3 billion in debt. You would be comfortable leveraging up, potentially, several hundred million to go for an acquisition or...?

This is something the board considers every quarter. So I'm not going to be predictive in any way, Bill.

Okay. But you don't want to prioritize where the deployment would go at this time?

Well, we said that our regular dividend is the highest priority. We said that. We've laid out the other options that are considered duly on a quarterly basis.

Thank you very much, everybody, for joining us today. We look forward to updating you on our progress as we move through the rest of the year. Have a good day.