Leidos Holdings Inc (LDOS) — Q3 2019 Earnings Call Transcript

Thank you, Rob, and good morning, everyone. I'd like to welcome you to our Third Quarter and 2019 Earnings Conference Call. Joining me today are Roger Krone, our Chairman and CEO; Jim Reagan, our Chief Financial Officer; and other members of the Leidos management team. Today, we will discuss our results for the quarter ending September 27, 2019. Roger will lead off the call with notable highlights from the quarter as well as comments on the market environment and our company's strategy. Jim will follow with a discussion of our financial performance and our guidance expectations. After these remarks from Roger and Jim, we'll open the call for your questions. Today's discussion contains forward-looking statements based on the environment as we currently see it and as such does include risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially. Finally, during the call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in the press release that we issued this morning and is also available in the presentation slides. The press release and presentation as well as the supplementary financial information file are provided on the Investor Relations section of our website at ir.leidos.com. With that, I'll turn the call over to Roger Krone.

Thank you, Kelly, and thank you all for joining us this morning for our Third Quarter 2019 Earnings Conference Call. We're pleased with the continued momentum in our business reflected in our third quarter results, which set new records for revenue, backlog, and bookings. Our results underscore our success in growing all segments of our business and demonstrate our ability to deliver our broad capabilities across our diverse customer base. Starting first with the growth engine of the company: Our business development efforts. Results in the quarter were strong even beyond typical seasonal levels. We booked a record amount over $5 billion of net new awards in the quarter, resulting in a book-to-bill of 1.8x. These results reflect several notable awards, including a $400 million contract in our defense business for the provision of aircraft intelligence surveillance and reconnaissance support services in support of the Army's Program Executive Office intelligence, electronics warfare, and sensors. We were also awarded a $900 million contract in our Civil business by the Transportation Security Administration to continue to provide Integrated Logistics Support services to sustain TSA passenger-screening equipment at hundreds of airports and other designated facilities across the U.S. and its territories. During the quarter, we won roughly $1.3 billion of awards from our classified customers, reflecting growth across each of our customers in the Intelligence Community. Our success reflects mission-enabled solutions across transformational software development, analytics, and digital transformation. Our success in executing against our pipeline allowed us to increase our backlog to a record level of $23.9 billion, a leading indicator of our future growth potential. Beyond that, we also have nearly $35 billion of submitted proposals awaiting decision. This still includes several large programs: GSM-O II, Hanford, and Navy NextGen, all of which we expect will be awarded in the next couple of quarters. Revenue growth continued to accelerate in the third quarter with year-over-year organic growth of 12%. This growth was broad-based across all our businesses and reflects the success of the scale and diversity of our portfolio. Underpinning our growth was another strong quarter for hiring as we added another 2,500 people, bringing our year-to-date total to over 7,500 new hires. While the market for talent continues to be tight, our success in hiring in our key growth areas reflects the investments we have made in our organization, our employees, and our culture in making Leidos a great place to work. We are proud that every day, nearly 34,000 people choose to work at Leidos, and we take very seriously our responsibility to make their work life more rewarding in order to maximize our ability to retain them and attract more top-performing talent. Strong margins and a continued resolute focus on cash conversion allowed us to generate nearly $350 million of cash from operations in the quarter, resulting in a quarter-end cash and equivalents balance of $635 million. During the quarter, we deployed our excess capital consistent with our stated capital deployment philosophy, which balances investments for growth, including organic and M&A, with returning capital to shareholders through dividends and share repurchases. We executed a $200 million accelerated share repurchase during the quarter, which resulted in the retirement of 2.4 million shares outstanding. Beyond this, our M&A pipeline continues to be very robust, and we have been evaluating opportunities across all of our business segments for acquisition targets, both big and small. While we routinely assess the market landscape for potential targets, we run a disciplined process for evaluating opportunities to ensure transactions that enable us to improve our strategic position and drive shareholder value. Many of the opportunities we have evaluated did not meet our criteria in these areas. However, we were pleased that one target did. We announced and closed the acquisition of IMX Medical Management Services during the quarter, and we are pleased to welcome IMX into the Leidos team. Our combined experience, footprint, and commitment to customer service positions us to be a significant player in independent medical evaluations in the commercial market as we are today in the federal space. In the quarter, we also divested our health staff augmentation services business in a sale to Alvarez & Marsal Capital. The business that was divested was a small, immaterial piece of our overall portfolio, which delivered staff augmentation services to commercial health care providers. This divestiture helps Leidos focus on what it does best: Providing solutions that meet the complex needs of our government or other highly regulated and complex industries. We recently completed a major milestone in one of our marquee programs in this area, the DoD Healthcare Management Systems Modernization program, or DHMSM, the largest IT transformation in the history of the military health system. The Leidos partnership for defense health successfully deployed MHS GENESIS to a new wave of military treatment facilities on September 7, 2019. Following the release, our customer, Program Executive Officer of the Defense Healthcare Management Systems, lauded us for what he called a very successful release at Wave Travis. As I said before, patients' safety is our #1 priority. We added 6 new technical capabilities to MHS GENESIS in advance of this wave, including CV Pax, a system that can be used to treat various heart conditions. Within the first 48 hours of go-live at Travis Air Force Base, a heart attack patient was successfully treated using CB Pax, a capability that did not exist at this hospital before MHS GENESIS. We also introduced enhanced training curriculum during this wave and noticed a significant increase in the speed of adoption at each site. We continue to make substantial progress on this program, and with this wave behind us, we are looking ahead to the next two waves, which have just kicked off pre-deployment activities right on schedule. These are Wave Nellis, which includes Nellis Air Force Base in Las Vegas, Nevada; and Wave Pendleton, which includes Camp Pendleton in San Diego, California. Wave Nellis is on track to go live in June 2020. Finally, turning now to the macro environment. Conditions continue to remain favorable. The two-year budget agreement, which provides top line spending amounts for both defense and non-defense spending accounts, creates a supportive foundation for the continued growth of our business. While we are starting the government fiscal year with the continuing resolution as we have for 19 of the last 20 years, we see no material impact from a CR that lasts potentially through the end of the first quarter and could even last through the full government fiscal year 2020. While we are optimistic that we will avert a government shutdown, we are also prepared for this scenario should it occur. As we look ahead, the strength of our results thus far in the year and the continued acceleration in revenue growth give us confidence to raise our expectations for the year across all guidance metrics. I'll now hand the call over to Jim Reagan, our Chief Financial Officer, for more details on third quarter results and our revised guidance.

Thanks, Roger, and thanks to everyone for joining us on the call today. In the interest of getting to your questions, I'm going to focus my comments on providing some context to the results disclosed in our press release and summarized by Roger. Revenue grew 10% and 12% organically when you normalize the effects of the commercial cyber and health staff augmentation divestitures. Organic growth was broad-based and driven by high levels of on-contract growth and increased contribution from new programs which ramped during the quarter. Adjusted EBITDA margins were 10.7%, reflecting strong margins in the core business as well as the following. First, the payment of an arbitration award relating to work performed for the Greek Olympics back in 2004. A big thanks to the significant effort by our legal team that resulted in the long-overdue receipt on this work. We collected $59 million in cash from the Greek government and recognized a net $54 million reduction of operating expenses on this item. And this was partially offset by a $19 million provision for certain other international receivables, and this was reflected in the Civil segment results. The net effect of these two items was a $35 million benefit. The second, revenues in the third quarter reflect a higher mix of material volumes, which put downward pressure on margins. And lastly, we incurred significant startup expenses on certain large new program wins, most notably in our Civil business, where we expect margins to revert back to normal levels in the fourth quarter. These items, along with a lower share count, help to drive non-GAAP diluted EPS of $1.36, an increase of $0.22 over the prior year. Operating cash flows of $349 million in the quarter reflects the seasonally strong government fiscal year-end as well as higher advance payments which reduced our accounts receivable and contributed to the reduction in days sales outstanding to 57 days. We expect much of these advances to reverse in the fourth quarter, getting us back to a more typical DSO level in the high 50s to low 60s. Bookings of $5.2 billion were strong across all segments and resulted in a 1.8 consolidated book-to-bill with an ending backlog of $23.9 billion. This is once again an all-time high for the company and reflects an 18% increase over the prior year. Now for an overview of our segment results. Defense Solutions grew 8.3% over the prior year quarter, driven by elevated levels of on-contract growth on our mature programs plus new program revenues. Non-GAAP operating margins of 8% declined 60 basis points sequentially and 50 basis points from the prior year primarily on higher materials revenues and lower write-offs. And despite elevated protest activity during the quarter, our Defense Solutions business booked over $2.7 billion of net awards, resulting in a book-to-bill of 2.0x for the quarter and 1.3x on a trailing 12-month basis. In our Civil segment, revenues grew 10.4% sequentially and year-over-year. Organic revenues grew 13.4% when adjusting for the sale of the commercial cyber business which closed in the first quarter. The primary driver of Civil revenue growth both sequentially and compared to the prior year was an increase in new program revenues. Non-GAAP operating margins in our Civil segment of 7.8% were uncharacteristically low, declining 210 basis points sequentially and 540 basis points from the prior year quarter. Margins reflect two unusual items in the period, which combined, resulted in 220 basis points of negative margin impact. Adjusting for this, the margins in the business were over 10.2%, up slightly from the prior quarter. And these two items were: First, the bad debt expense I referred to earlier is reflected within the Civil results and drove a $16 million charge in the quarter; and second, startup expenses associated with a new program ramp for a new program that involved a large materials buy component. Because the payment for these costs is made over time, the related profits are recognized over the next five years of the program, and this contributed to a margin headwind in the quarter. Civil segment bookings of $1.1 billion were once again strong and drove a book-to-bill of 1.2 for the quarter and 1.0 on a trailing 12-month basis. In our Health segment, revenue growth, bookings, and margins were all the best performers in the company during the quarter. Revenues there grew 14.4% over the prior year period. Growth was driven by a variety of factors: Strong levels of on-contract growth, increased revenue contribution for the ramp in the DHMSM wave deployments and revenues from other new programs. Non-GAAP operating margins of 14.8% were 40 basis points higher sequentially and 60 basis points higher than the previous year, driven by strong execution across a variety of mature programs in the portfolio. Health bookings were very strong in the quarter at $1.4 billion, largely driven by a mix of on-contract growth and recompete decisions. This resulted in a book-to-bill of 2.7x for the quarter and 2.1x on a trailing 12-month basis. With the strength of our Q3 results and the continued large pipeline of submits outstanding, we remain confident that we will continue along the growth path we've been on now for over a year. And as such, we are revising our 2019 guidance upwards as follows. We expect revenue for the year between $10.9 billion and $11 billion, a $150 million increase from the midpoint of the previous guidance and about a 7.4% increase at the midpoint over the prior year. Further, our results thus far in the year and our visibility into fiscal 2020 has further increased our confidence in our continued growth momentum into 2020. As always, we will provide more information on our fiscal 2020 guidance in our fourth quarter earnings conference call. We expect adjusted EBITDA margins for the year between 10.2% and 10.4%, a 30 basis point increase at the midpoint from the previous guidance. We now expect non-GAAP diluted earnings per share between $4.90 to $5.10, an increase of $0.38 from the midpoint of the prior guide. This reflects the higher expected net income and lower share count resulting from the ASR completed in Q3. Finally, we expect cash flow from operations to be at least $875 million, up from the prior floor of $825 million, reflecting the Greek arbitration award. One additional note related to free cash flow. We now expect capital expenditures for the year of approximately $125 million, which is $50 million lower than our prior guidance of $175 million, which is primarily driven by lower expected real estate spending. Now with that, I'll turn the call over to Rob so we can take some questions.

Great. Congrats here. I was curious about your cloud positioning, particularly in the wake of the JEDI decision. How does Leidos play in the whole, what we're hearing as an accelerating transition by the Defense Department to the cloud?

Thanks, Ed, and good morning. We tend to utilize the cloud as purchased by our customer. So think of our business as cloud transformation or moving applications from legacy to the cloud. And in some contracts, we will contract with AWS, Azure or whomever for cloud services as a pass-through, but typically, the actual provisioning of the provider of the cloud is not in our contract. So we tend to do the value-added of converting legacy to cloud. And that's true really across the board, whether it be in a DoD or in our Civil or Health business. So we call this sort of digital transformation, and it's one of the largest areas of our pipeline. And the decision by the Department of Defense to go with Microsoft Azure versus AWS is really immaterial to us. We won't be affected by that decision in any way.

I have a question regarding the continuing CR. It appears we are approaching at least a second one. When does the extension of the CR begin to influence the future outlook?

Yes. For us, really very little, if at all. We've looked at the situation multiple times, starting from the end of November, then considering the end of the year, and most recently analyzing it through the first quarter and for the full fiscal year. We don’t have many new starts in our pipeline for 2020, so I would say it's minimal. While it's prudent not to claim it's zero, it's really immaterial for us compared to our pipeline. It certainly complicates things for our customers who are trying to set budgets and plan long term. However, due to the increase we've experienced with the two-year budget, in light of the prior year's budget process for the continuing resolution, we are actually in pretty good shape.

So I wanted to ask a couple of things, if I might. Roger, I wanted to start with your commercial strategy as it stands today. Is this a business you're seeking to expand in light of the IMX acquisition? Or is that more specifically targeted for those assets?

Sure. Thanks, Rob. We've been successful in doing disability assessments for the VA. And as such, we have built what we think is a national capability to do medical exams and disability assessments. We believe there's a parallel for corporations, health care centers, private employers. And that industry is starting to consolidate and we just see it as an opportunity to take, if you will, sort of our back end and the process work we've done for the government and to apply that in the commercial marketplace. And the easiest way for us to get a foothold was through an acquisition, and we were pleased to be able to come to terms with the team at IMX.

Okay. And then at a higher level, I wanted to address the relationship between sales growth and record backlogs but also this idea that the duration of backlogs appears to be expanding across the industry. So meaning that if duration is extended, you might expect growth to slow a little bit. So I wanted to ask you how will you think about those two factors. Or is this double-digit-type growth just supportable for a while?

Let's see. A couple of quick comments. The duration in our backlog remains roughly the same. While I can't speak for the entire industry, we do not observe any significant stretching or contraction. Following the logic you presented, if we secure a high number of wins, we will increase our backlog and see organic growth, which should be sustainable given the current backlog. We've discussed this in previous calls: it takes considerable time for backlog programs to initiate, for them to progress through the PPBS system, and ultimately convert into revenue for us. This reflects a 2- or 3-year projection for our momentum. While we cannot predict the election outcomes or the subsequent budget impacts, we feel extremely confident about our prospects for multiple years ahead.

So a number of your competitors have kind of noted that bookings have been slowed by lots of protests, decisions happening late. And certainly in your case, GSM-O, Hanford, and NextGen have moved to the right. Two questions. One, what do you think is causing this phenomenon and maybe with some specifics on your three outstanding bids? And maybe update us on kind of the status of protests either of things you've won or things you've lost.

It's almost like a seasonal delay related to momentum, staffing, and programs going through peer reviews before getting awarded. I don't think these delays are unusual; sometimes we have programs that come out early, but typically we add around 90 days to the award dates provided by customers because it takes time to ensure everything is correct. They also want to handle the decisions carefully to avoid issues with protests. In terms of protests, a quarter or two ago, we had very few, but with the summer's awards—both ones we received and ones we lost—protests have increased, which is typical for award seasons as many contracts get issued at the end of the government fiscal year, leading to more protests. For our major programs, we expect updates on Hanford and GSM-O in the fourth quarter, and maybe NextGen in the first quarter or shortly thereafter. I did think Hanford would be awarded in July at one point, but we remain close to the customer, keep our bids updated, and hope they finalize their award process before the year's end.

Jim, you mentioned the adjustments in Civil. In defense, your margins appeared to be slightly lower due to increased materials costs. Can you provide more detail on these issues and the impact of the lower EACs?

Yes. We have secured an Army contract, Cai, where there have been some unpredictable fluctuations in the support-related materials purchases we make that resulted in lower margins. This was a margin challenge during the quarter. Additionally, as I mentioned, there were a higher number of Estimate at Completion write-ups in the same period last year. These are the two main factors contributing to the year-over-year change in defense margins.

I wonder, is there any more additional detail you can give about the charge in Civil? Sort of what contract that is and what gives you confidence that any issues are behind you, the $16 million bad debt.

Yes, I don't want to get into the specifics of the contract. However, I can share that the decision to take a provision for these receivables, which are linked to overseas contracts in the Civil group, was mainly influenced by the conditions we observed on the ground and the current status of our efforts to collect outstanding receivables. As we mentioned earlier regarding the recovery of the long-standing arbitration award in Greece, we will continue our collection efforts for these receivables, even though we've recorded a charge for them. It's entirely plausible that in the future, possibly several quarters or even a couple of years from now, we could see a recovery. For now, however, we believed it was prudent to establish a reserve for it.

And Seth, that was a $19 million charge. When you boil it all down between the recovery on the Greek arbitration award and the provision we took on those other overseas receivables, it's a net of about $35 million.

Right. And then just a follow-up. Looking through the year thus far, it looks like to reach the EBITDA margin guidance, we're looking at something in the 10.3-ish range for the fourth quarter. The last two years, we've seen the margin tick down in the fourth quarter. What kind of gives you the confidence in that fourth quarter margin?

Yes, I understand your question, Seth. I believe that the implied margins in Q4 are slightly higher than that. It largely relates to our strong visibility regarding the revenue mix for Q4. As I mentioned earlier, we expect the Civil margins to return to our typical levels, and there’s potential for them to be even stronger. Moreover, Q4 appears to have a favorable revenue mix of fixed price and unit price-related work, which should lead to margins that exceed our usual Q4 performance.

Just expanding maybe on the last question with regards to all three segments. You've had a bunch of new wins and strong revenue growth. How do you think about the margin mix, where it's been impacted most and how you think about that bridging into 2020?

I appreciate your question, Sheila, and we constantly consider this. As we mentioned before, the ramp-up of new programs is underway, and we are definitely observing some of this in Q3. During the initial stages of a program ramp, margins typically start lower compared to the program's overall lifespan. We incurred some upfront costs related to new program ramps in the Civil group, which is reflected in the Q3 results. We do not anticipate this occurring again. While revenue growth is surpassing our prior guidance, one might expect additional pressure on margins moving forward. However, we haven't experienced the level of pressure that we had previously discussed. This indicates strong program execution, which you can see across the program ramps in Civil. The margin dip we observed in the first quarter is expected to recover in future periods due to the accounting for some leased equipment on several programs. Regarding Health margins, we are confident that the robust margins achieved this quarter will continue to be sustainable, and we are pleased with the execution on both our newer and more established programs within the Health group.

Great. And then maybe just a question on Health to expand on that. Roger, thanks for the color on IMX earlier. How do you think about that portfolio? The margins have been quite strong, you're adding IMX, divesting the health augmentation business. Kind of how do you think about expanding that or what that business looks like over the next few years?

We are investing in the part of the business that's performing well, which gives us confidence in our margins. We sold a portion of the business that wasn't aligned with our portfolio, and it likely had lower margins for us. We believe it will thrive under someone who is more focused on that area. We remain very confident about the performance of the Health group, but we do not provide segment guidance. However, you can expect us to focus on the successful parts of the Health business and move away from those that do not align with our strategy and portfolio, and that's what we have done.

I wanted to ask if you could elaborate I guess a little bit on the M&A market, what you're seeing there. You mentioned a little bit in kind of the opening remarks, but sort of what have been the deals that you looked at so far? Where have they fallen short? Is it just the valuation or just kind of lack of something that's a good fit with Leidos?

We consider a wide range of factors. Our approach focuses on net present value rather than multiples. When evaluating mergers and acquisitions, we typically analyze five-year and ten-year forecasts and then discount those to determine value. Some others in the market rely on multiples, which is not our strategy. We're interested in the long-term value of a company, so we’ve missed out on some deals priced beyond our range. As you're aware, we often receive offering memorandums or management presentations, and everything appears promising at that stage. However, upon conducting due diligence, a company that seemed to add significant value might instead turn out to be underwhelming. We want to explore numerous opportunities, especially since there's ongoing consolidation in defense and civil sectors, and we aim to be part of that while ensuring alignment with our strategies. Consequently, we will engage in the early stages of many transactions, but we don’t anticipate completing very many.

Got it. And then I guess, I think you mentioned 2,500 headcount adds in the quarter. Was that the gross number? And if so, could you give us what the attrition was?

Yes, that's the gross number, and we don't typically recount the net number. However, the net number will naturally be lower than that. We have included the headcount in our release for tracking purposes from quarter to quarter. We remain confident in our ability to attract talent, especially those with the necessary security clearances, experience, and educational backgrounds. Our talent acquisition team is excellent. Additionally, the changes we've implemented and the positive image Leidos has cultivated in the workforce, along with our treatment of employees, have contributed to making this a desirable workplace.

Just to return to the margin question for a moment, you mentioned an implied fourth quarter in the mid-10s, and you described the health results as somewhat sustainable as you focus more on higher-margin areas. Now, for two consecutive years, we've achieved a 10% adjusted EBITDA. Is 10% still the target rate to consider going forward?

Yes, Jon, this is Jim. In the past, we've communicated that we aim for long-term adjusted EBITDA margins of 10% or higher. You are correct in your assessment of Q4. We anticipate sustained strong margins in Health and a promising recovery in the margin profile of the Civil group, which has been positioned for a favorable Q4 margin due to current orders in the pipeline. This reinforces our confidence in both Q4 and the full-year margins.

Small typically refers to companies with revenues between $50 million and $100 million, while big means over $1 billion. However, I want to clarify that we are not aiming for a large-scale deal like we did in 2016. Our M&A strategy focuses on two key aspects: capability and customer access. We evaluate whether we need certain capabilities to complete our portfolio for existing customers or if we lack access to customers or markets that we need to reach a part of the marketplace where we currently do not compete. Although it might appear that we are everywhere, there's still a significant portion of our customer base that we are not able to address at this moment. We assess these gaps using a specific set of criteria, which we discussed during our Investment Day in May, to guide our M&A decisions.

When we consider our investments in mergers and acquisitions, we can also view our investments in internal and organic growth in a similar manner. We have made substantial investments over the past few years, which are reflected in our top line organic growth for the third quarter and the full year. As long as these investments provide good returns, we will continue to prioritize this approach while also seeking strategic and financially beneficial acquisitions.

I was wondering if we could start. Roger, can you talk about constraints to growth? What are the limits to the company's ability to grow organically?

Well, okay. So we haven't found those yet. And you can kind of break it into a couple of categories. Access to capital markets probably has never been as good for us as it is today, the cost of borrowing is low. Because we're a people business, all of our strategies revolve around our people and our talent, and I would put that in two categories: Our business development team and our ability to develop those relationships with customers and to pursue procurements, which is a multi-year campaign for us. And so you have to have the customer relations people, the business development people, the proposal people. And those are probably the most rare commodity in our market today. And then on the backside, you don't want to bid on a program if you cannot staff post-award. And so we're really, really thoughtful about what we bid on and our ability to attract people. As we all know, it's very, very difficult to hire in the national capital region. And so as we look at things going forward, we're excited about opportunities where we can staff the program in places other than Virginia, Washington, Maryland, and Delaware. So if there was a program in Colorado Springs or Denver or St. Louis, then that would be a great place for us to look simply because of all the economic growth that has already occurred here in the D.C. area.

On the revenue guidance, it's the second raise this year. So just curious if you could talk a little bit more about what's surprising you kind of relative to your initial plan? If it's better new business wins, higher recompete win rate, more on-contract growth, faster movement by the customer, just any color there would be great.

I think you covered all the key points. To elaborate a bit further, Roger mentioned our ability to attract the necessary talent to convert backlog into revenue. We're satisfied with our HR and recruiting team's performance, as they are effectively meeting customer needs. Regarding our backlog this quarter, about one-third consists of new work, and another third pertains to the growth of existing programs through extensions or on-contract growth, much of which has been sold by our team directly interacting with customers. We have placed significant emphasis on on-contract growth. The final third comes from successfully acquiring recompete business. It definitely seems balanced, and the improvement in revenue beyond our expectations stems from strong execution on the program side, along with excellent people and processes, as well as a solid return on our investments in business development teams.

Got it. And then you mentioned no extension in the kind of backlog duration. The total book-to-bill has been great, but funded looks maybe a little bit soft on a trailing 12-month basis. Does that have any implications for kind of next 12-month growth relative to kind of the longer period that's supported by total backlog? Or is that just lumpiness here?

Yes, it really highlights some variability in how the backlog is funded. We're not concerned about the decrease in the funded portion of the backlog, Gavin. The other point regarding the duration of the backlog, which has not significantly changed, supports my earlier comment that we're feeling more confident about the growth rate we've forecasted for post-2019. We'll provide further details on our expected growth beyond 2019 when we share our guidance in the Q4 call.

Okay. Can I ask one more quick question? You mentioned that you're doing a great job with hiring. Are you able to bring people on contract more quickly or expedite their clearance process? Is there any operational leverage that still needs to be realized in the margins as you onboard these individuals?

Yes, Gavin, it's slightly improved. However, I don't think anyone in the industry is celebrating just yet. There's some hope that in about six months to a year, the process will continue to improve. One aspect of our business model is that the perception might be we have 2,500 college hires, but in reality, only about 10% of our hires are fresh from college. We typically focus on recruiting mid-career professionals, many of whom already possess clearances or have what we refer to as "secret" clearance. This allows us to complete the hiring and security clearance process more smoothly. Therefore, the time it takes from hiring to having them cleared and ready to generate revenue is usually shorter than what one might expect with new graduates, who often face an eight to twelve-month process with their paperwork. This is part of our strategy to attract those who have already navigated the adjudication process. While the clearance process has improved and the backlog is significantly reduced on both the contractor and government sides, the overall workflow is still too lengthy, currently taking a minimum of six months, and for some individuals, especially those with overseas experience, it could take up to eighteen months.

Roger, I was just wondering, we hear a fair amount from DoD these days about Fourth Estate reform. And I was wondering if that's something that you're kind of focused on at all and whether you think there's any potential impact on Leidos and on the services space.

Yes, there is a lot happening in that area. We understand that the new Secretary of Defense and the Head of Acquisition are reviewing the Fourth Estate. For those unfamiliar, the Fourth Estate refers to noncombat agencies in the Department of Defense such as DISA, DLA, and some three-digit intelligence organizations, which are not directly involved in combat. During the tenures of Secretary Shanahan and Secretary Esper, this was seen as an opportunity to leverage technology to create greater efficiencies, potentially freeing up budget to be allocated directly to combat organizations. We maintain a strong balance between the services and these support agencies and collaborate closely with them. Our focus is on driving efficiencies within these organizations, which is our core competency. In some contracts, we have reduced costs by approximately 20%. We see the current activity as an opportunity for us, both in existing contracts with these agencies and in new contract prospects at places like DLA. Recently, we successfully secured a program in the UK called LCST, where we have implemented digital transformation in commodity purchasing and distribution. Our compensation is tied to driving efficiency in their procurement system. We've gained valuable insights into running a procurement organization and modernizing processes, which we believe will be beneficial for the Defense Logistics Agency in the U.S. We are eager to respond to RFIs and RFPs and assist our customers in transforming some of the Fourth Estate organizations.

This is Jon on for Joe. Can you kind of update us on what's driving the success in your new wins and takeaways and how this kind of plays into your recompete win?

If I knew exactly what was working, I might have an even higher rate. You've all been on this call for several quarters, and a couple of years ago, we felt we weren’t winning as much as we had hoped. We took a step back and reevaluated our entire relationship with customers, how we qualify our pipeline, our decisions on bids and no-bids, and the entire business development process regarding how we create our offerings, set pricing, and write proposals. It was essentially a complete overhaul of the processes we inherited from both Leidos and IS&GS. We aimed to take the best elements from all those processes and rebuild our business development framework and, to some extent, our organization. The results you're seeing now reflect the time it takes to address issues and the duration for those changes to flow through the proposal process. If I implement a new proposal strategy, the wins don’t show up until about 18 months later due to the time required to pursue opportunities, engage with customers on their program work statements, navigate procurement, receive an RFP, write a proposal, and go through the evaluation cycle. The positive outcomes we’re seeing today are really a result of hard work done 18 to 24 months ago, which was in response to a few losses we experienced 2 or 3 years back. I hope that answers your question.

I wanted to ask about your work with the Army in the ISR sector, specifically regarding your COCO structure. It seems like a significant investment where you own the assets. How are you approaching the opportunities and risks associated with this? Is this a direction you plan to expand in?

We have been involved in the mission support business for a long time. Recalling the period when we had a significant amount of OCO work, there were many questions about our involvement in that area, particularly concerning aircraft on collection missions. Our goal is to be in a mission support role with various customers, and we are open to multiple business models, including GOCO and OCO within our ARL-E program. We will be providing an aircraft to the Army for the Army reconnaissance low enhanced program, which is a modern aircraft that we manufacture and deliver to the customer. Recently, we have had opportunities to invest in aircraft and capital, allowing us to operate more in a COCO model. This has enabled us to be more responsive and deliver capabilities to the field more quickly since it's within our control. However, this will be balanced and is just one part of our broader portfolio and mission support business. We are satisfied with the opportunities we've had to provide these capabilities. Additionally, if you were to visit our hangars, you would see other aircraft under different business models. We also have our Afghan support program where we provide support to the Afghan Air Force's Mi-17s through an Army contract, which is part of a direct support program. Overall, we have a diverse range of contracts in our Army and multiservice ISR business.

Would you say you've turned down opportunities for COCO work where the risk profile was just too high?

Well Rob, I think we've managed to shape the service profile in collaboration with our customer so that it meets their expectations with the right kind of return. What we're able to provide to our customer is, at a predictable cost, they pay us for availability, which fulfills their needs and gives us a satisfactory return on our COCO investment.

Yes. We have had some initial discussions with customers, and there are definitely edge opportunities that we are not pursuing. As you know, we prefer to maintain a capital-light approach. We are not in the aircraft leasing business and do not intend to enter it. Our investment strategy typically focuses on maintaining long-term relationships with customers for mission-critical tasks that we can execute effectively while ensuring a return on our capital investment. I want to clarify that our capital expenditures are not going to increase, and we will not become heavily invested in aircraft or surface vessels. This new opportunity complements our existing business and helps us reach a customer we might not have been able to engage otherwise. Our usual approach involves standard government contracts where the customer retains ownership of the asset.

Great. Thank you, Rob, and thank you all for your time this morning and for your interest in Leidos. We look forward to updating you again next quarter. Have a great day.