Leidos Holdings Inc (LDOS) — Q2 2020 Earnings Call Transcript

Thank you, Rob, and good morning, everyone. I would like to welcome you to our second quarter 2020 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 July 3, 2020. 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 will 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 supplementary financial information file are provided on the Investor Relations section of our website at ir.leidos.com. With that, I will turn the call over to Roger Krone.

Thank you, Peter, and thank you all for joining us this morning for our second quarter 2020 earnings conference call. As we continue to navigate through these difficult times as a country and as a global community, I hope each of you are well and your families are safe. Leidos' second quarter results demonstrate the resiliency of our business model, the value of our market diversity, and the strength of our team as we delivered on commitments through the most challenging quarter I have seen in my career. We exited 2Q with a strong business capture win rate, record-setting backlog, resilient cash position, and improved capital structure. These factors galvanize our optimism for the future, despite the extended effects of the current pandemic. In the quarter, the business delivered revenue of $2.91 billion, reflecting 6.8% growth from the prior year. Adjusting for acquisition and divestiture activity and effectively taking into account a full quarter's worth of COVID-19 impacts in specific areas within the business, organic revenue contracted by 3% over the same period. We recorded our non-GAAP diluted earnings per share of $1.55, up 34% from the prior year. In addition, we generated $422 million of cash from operations, ending the quarter with a solid cash balance of $588 million. Net bookings of $4.6 billion yielded a book-to-bill of 1.6 for the quarter, as well as 1.6 on a trailing 12-month basis. These impressive business capture measurements do not yet reflect material contributions from several notable single award IDIQs that were competitively won over the past several months. Upon receipt, those task orders will be captured in our bookings metrics in subsequent quarters. Adjusted EBITDA margin of 11.8% was greater than the prior year. The primary factor was the net gain resulting from the VirnetX legal settlement for patent infringement, which was largely offset by a full quarter of the anticipated COVID-19 impacts we discussed during last quarter's earnings call. The impact of COVID-19 in the second quarter was approximately $222 million in revenue and $78 million in non-GAAP operating income. While some of the Q2 impacts will be recovered in the second half of 2020, we expect more of the recovery to push into 2021 as the pace of reopenings began both later and slower in the second quarter than previously estimated. Additionally, the security clearance processing timeline for new employees continues to lengthen, and some programs such as Navy next gen remain affected by ongoing protest activity. In the meantime, due to the critical nature of our work, all of our Leidos facilities have remained open and each has implemented safe workforce plans to protect the health of our returning colleagues. For our guidelines, occupancy remains below 25% at this time, while more than half of our employee base continues to productively telework. Other than a small percentage that remain home in a ready state capacity, the remainder of our workforce reports to customer sites or other performance locations. From a subcontractor and supplier perspective, our business partner network remains resilient and in good health. We engage and monitor this important ecosystem daily. Lead times have improved during the course of the quarter and our teammates continue to perform across all of our programs. Equally important, during the second quarter, recruiting and talent acquisition remains strong as evidenced by nearly 8% growth in new hires compared to Q1. This metric excluded additions from M&A. Our ability to attract top talent in this manner is important as we staff up to successfully execute the new programs in our growing backlog, which now stands at a record $30.7 billion. This core competency will also prove critical as we prepare the business for continued growth given the ongoing high pace of business capture activities across the diverse markets we serve. When we compare mid-March through June of 2019 versus the same period in 2020, we found that we submitted more proposals during the pandemic with an aggregate approximate value of $8 billion. Now turning to several notable awards. Leidos was awarded the Traveler Processing and Vetting Software contract by the U.S. Customs and Border Protection. Under this new blanket purchase agreement, we will provide a full range of software development lifecycle services to support CBP's mission to safeguard America's borders and enhance the nation's global economic competitiveness. This single award BPA has a 1-year base period of performance followed by four 1-year option periods and a total estimated value of $960 million. The company was also awarded the Enterprise Standard Architecture V, also referred to as ESA V task order to provide managed IT services for the Department of Justice Bureau of Alcohol, Tobacco, Firearms and Explosives. The single award hybrid task order has a one 10-months and two 1-year base periods of performance followed by six 1-year option periods. It includes a ceiling value not to exceed $850 million if all options are exercised. Finally, our Dynetics subsidiary was awarded a sole-source contract for the production and sustainment of foreign radar simulators known as the Laboratory Intelligence Validated Emulator or LIVE family of products. The contract has a total estimated value of $356 million for production and sustainment for the next 10 years. On the M&A front, we remain focused on the successful integration of both Dynetics and the former L3Harris security detection and automation businesses. Both are progressing on schedule. Since the Dynetics deal closed in late January, our integration has focused on combining our legacy Leidos Innovation Center, which we call the LInC, with our new Huntsville-based business. The LInC has a great track record of executing early-stage R&D for DARPA and the Air Force Research Lab, and through the combination with Dynetics, we see opportunities for rapid prototyping and producing a higher conversion rate of research projects to programs of record. Other early collaborations led to important wins such as NASA's Human Lander Systems contract under the agency's Artemis program. If down-selected, the follow-on contract to place the first woman on the lunar surface and return man could exceed $4 billion. With security detection and automation, key business systems integration decisions have been made that further our confidence that the annual cost synergies of at least $20 million can be captured by 2022. Additionally, we are pleased with the expansion of our checkpoint solutions that will promote the safety and health of the traveling public and those entrusted to provide security services. To that end, in the quarter, we received an award at Edinburgh airport in Scotland to upgrade the airport's security tray return systems with antimicrobial tray technology. Also, the business was recently shortlisted for a 5-year opportunity at Munich Airport for the manufacturing, installation, and service of explosive detection systems for cabin baggage. This work would represent an important step in our strategy to grow in the airport security solutions market. Turning now to the macro environment. Despite a likely continuing resolution in the fall, we expect minimal overall impacts to our business sector as the fiscal year 2021 budget levels are already set under the Bipartisan Budget agreement. Additionally, DoD has almost $125 billion in unobligated balances as of fiscal year 2019. Therefore, if budget authorities are flat, these balances can allow higher rates of outlay to address our customers' ongoing critical mission requirements. Looking through the Leidos lens, we are encouraged by our continued alignment with DoD's top 10 technology priorities. The ongoing execution of our long-term business strategy further mitigates potential future headwinds for our business as does our portfolio diversity, as approximately half of our business is aligned with the federal, civil, and health customers. With regard to our Health business, I'd like to reiterate that yesterday we announced the appointment of Liz Porter as the new Health Group President. Liz has held that position in an acting capacity since early March. Prior to this role, she served as the operation manager for the civil groups' Federal Energy and Environmental business. Liz's demonstrated leadership experience in program management, engineering, and business development will continue to position Leidos for growth in the expanding health markets. Before I hand the call over to Jim, I want to acknowledge the pain over the continued injustice and violence suffered by the African American community. Over the past few months, we have seen this pain and more tragedy. We all saw the killing of George Floyd in May, and the tragedy in June as Rayshard Brooks in Atlanta was unnecessarily killed. I said this to our employees on our website and our social media platforms. And I want to say this again to you, racism and social injustice have no place in our society or at Leidos, nor does any form of discrimination. Equality and justice must be a universal experience, and we must take action. And at Leidos, we are working to find new ways to engage on these critical topics in order for us to move forward together in unity. To start, we are partnering with the Equal Justice Initiative, which fights against racial injustice and poverty and promotes equal treatment in our criminal justice system for the most vulnerable. We have made a large donation in support of their important work, and I am moved by their focus on progress, education, and equal justice under law. Also, we are implementing inclusion training across our company and working to launch a Leidos diversity and inclusion council. And we are hosting listening sessions with management for our employees across the enterprise. As CEO, I strongly embrace this responsibility and I want to share that with you today. I will now turn the call over to Jim Reagan, our Chief Financial Officer, for more details on our second quarter results and guidance.

Thanks, Roger, and thanks to everyone for joining us on the call today. As expected, Q2 has been a challenging quarter. However, our quarterly results reflect our team's agility to respond to the fluid environment. Let me start by sharing our quarterly results, an update on our recent financing activity, followed by an update to remaining year guidance, including COVID-19 impacts and assumptions. Second quarter revenues grew 6.8% over the prior year period and contracted 3% organically. The increase in top-line revenue was driven by the recent acquisition of Dynetics and the L3Harris security detection and automation businesses. These increases were offset by approximately $132 million of COVID-19-related impacts. In addition, expected growth on existing programs was reduced by $91 million due to COVID-19. Without these pandemic-driven headwinds, our second quarter organic growth would have been about 5% over the prior year period. Adjusted EBITDA margins of 11.8% increased by 180 basis points from the prior year quarter driven by the following items: the first was the $81 million net gain related to the VirnetX legal matter. The second was volume reductions on existing and new programs directly attributable to the COVID-19 pandemic of approximately $78 million. And after adjusting for these discrete items and the related revenue impact of $222 million, adjusted EBITDA margins would have been 10.9%, reflecting strong program performance and reduced indirect costs for our business. Non-GAAP diluted EPS for the quarter increased $0.39 over the prior year to $1.55, driven by increased volume, strong program performance, and lower share count. The net gain from the VirnetX legal matter and COVID-19 impacts largely offset one another. Operating cash flows of $422 million reflect a one-time VirnetX litigation payment of $85 million, the incremental accounts receivable monetization of $74 million, and lower tax payments. As mentioned during our last earnings call, we remain committed to our long-term balanced capital deployment strategy. In the quarter, we completed two actions toward our path to an adjusted net leverage target of 3.0x. At the end of the quarter, the metrics stood at 3.4x. First, we've refinanced $1.75 billion of loans associated with the acquisition of Dynetics and the L3Harris security detection and automation businesses. The deal marked our strong return to the investment-grade bond market as evidenced by an oversubscription of approximately 12x, which facilitated lower rates compared to the initial price indications and simplified our debt covenant structure. The transaction extended our debt maturities resulting in three tranches of senior unsecured notes, including a 3-year, a 5-year, and a 10-year with a blended coupon rate of 3.75%. Second, we used the VirnetX proceeds of $81 million coupled with strong cash generation from operations during the quarter to pay down approximately $226 million of our debt. We had another solid quarter in business development, resulting in bookings of over $4.6 billion, bringing our book-to-bill for the quarter to 1.6x and an overall backlog position of $30.7 billion. Large new business wins in the defense solutions segment and the Human Lander System program contributed to the record backlog number. Let me now take a moment to recognize the outstanding work by our business development and capture teams in submitting a world-class winning proposal for the $7.7 billion Navy next gen competitive procurement. As you are aware, the award was protested and in June the U.S. Government Accountability Office decisively denied two separate protests, including one from the incumbent. These decisions reaffirm the outstanding rating assigned to Leidos by the customer across the most critical technical and management evaluation factors, and also recognized our substantially lower price. We remain confident that we will prevail on the US Court of Federal Claims, and we look forward to ramping up the important work for our customer later this year. Until then the award will be excluded from our reported backlog. I'll speak more to the ongoing protest later when we discuss our updated FY '20 guidance. Before turning to our segment results, I'd like to provide an update on our hiring, given its importance to the growth of the company. I'm pleased to report that we welcomed approximately 1,000 employees from the security detection and automation businesses that we just acquired. And we also onboarded nearly 2,000 additional new hires in the quarter. Second quarter average weekly hiring has exceeded pre-pandemic levels, demonstrating our ability to attract top talent during a tight labor market. The year-to-date annualized voluntary attrition rate has declined by approximately 230 basis points compared to the prior year, and we continue to invest in our people to drive our attention and attract new employees. Now for an overview of our segment results. Defense Solutions revenue grew 12.6% on a year-over-year basis. The primary driver for the growth was the acquisition of Dynetics. From an organic perspective, the segment contracted 0.6% due to $18 million of contract volume reductions directly related to COVID-19. In addition, expected on-contract growth was reduced by about $19 million due to COVID-19. Non-GAAP operating margins of 8.1% declined 20 basis points from the prior year quarter, primarily attributable to COVID-19 impacts, which were partially offset by program wins. Defense Solutions booked over $3.5 billion of net awards, including two large new business wins with our intelligence customers, resulting in a book-to-bill of 2.0x in the quarter and 1.5x on a trailing 12-month basis. In our Civil segment, revenue grew 13.6% from the prior year quarter. This growth was primarily driven by the $80 million contribution from the acquisition of the L3Harris security detection and automation businesses, and increased contribution from new programs, partially offset by $18 million of reduced volumes on programs impacted by COVID-19. Furthermore, the pandemic caused a reduction of $34 million in expected growth on existing contracts and delays to the ramp-up of new programs. On an organic basis, the segment grew 1.6% from the prior year. Non-GAAP operating margins in the Civil segment were strong at 12.9%, reflecting a 180 basis point increase over the prior year period. This increase was driven by the acquisition of the SD&A business, program write-ups, and performance on new programs. Civil generated nearly $1 billion in net bookings in the quarter, reflecting the successful resolution of a protest on a new business award and the ESA V recompete award mentioned earlier. The result was a book-to-bill of 1.3x for the quarter and 2.1x on a trailing 12-month basis. And finally turning to our Health segment. Revenues were uncharacteristically low, declining 20.4% from the prior year period due to $96 million of COVID-19 impacts and the sale of the Health Staff Augmentation business in the third quarter of 2019. In addition, expected program growth reflected in our previous guidance was lower by $38 million due to COVID-19. These negative impacts were partially offset by contributions from new programs and the acquisition of IMX in the third quarter of 2019. After adjusting for the COVID-19 impacts and the acquisition and divestiture activity, revenues would have increased 11% year-over-year. Non-GAAP operating margins for the Health segment were 5.3% for the quarter. This lower than normal margin was the result of COVID-19 driven volume reductions on certain managed service contracts with fixed-cost infrastructures. Our Health segment saw approximately $150 million of bookings in the quarter, driving a book-to-bill of 0.4x with a trailing 12-month book-to-bill of 0.9x. Moving now to the remainder of the year. We're updating our guidance across all metrics to account for our second quarter results, additional COVID-19 impacts, and increased visibility for the second half of the year. We're adjusting our revenue guidance to a range of $12.2 billion to $12.6 billion, which is a reduction of $300 million or 2.4% from the prior range midpoint and represents a 12% increase over 2019 results. This $300 million reduction includes additional COVID-19 impacts, which reflect the slower than anticipated customer reopenings, the delayed ramp-up of the Navy next gen contract, and various other program delays and volume changes. As the NGEN protest has moved from the GAO, where it was fully decided to the Court of Federal Claims, we remain confident that this protest will be resolved in our favor. However, this does delay the full transition until late in the fourth quarter, continuing into 2021. Note that in our previous guidance, we expected our COVID impacted programs to begin to ramp up back to normalized run rates during the second quarter. However, with slower customer openings, we now expect programs to return to their normalized run rates in the fourth quarter, and then continue unimpacted into 2021. We anticipate that the majority of the 2020 impacts will be recovered in 2021, reinforcing our confidence in the ability to grow more than 10% organically next year with margins at or above our 10% adjusted EBITDA margin target. In terms of margins, we expect adjusted EBITDA margins of 10.0% to 10.2% for the year. This 20 basis point increase at the midpoint from the prior range reflects the net gain from the VirnetX litigation and the reduced indirect rates, partially offset by the impact of lower margins within the year in our Health segment. As a result of these new ranges for revenue and margins, we are updating our non-GAAP diluted EPS guidance range to $5.25 to $5.55. This increase of $0.25 at the midpoint from the prior guide reflects the net gain received from the VirnetX litigation, a slightly lower tax rate, and reduced interest expense for the year offset by the COVID-19 impacts discussed earlier. Finally, we expect cash from operations to be at least $1.2 billion for the year, up from the prior guide of $1.0 billion, reflecting the proceeds from the VirnetX litigation and an anticipated $100 million increase in net receipts from the accounts receivable monetization facility. The two additional items to note to help you with modeling. We expect lower net interest expense for the full year of $176 million, a decrease that reflects lower interest rates due to our debt restructuring and a slightly lower non-GAAP tax rate in the range of 21% to 22%. With all that, I'll turn it over to Rob, so we can take some questions.

Hi, good morning.

Hey, good morning, Rob.

Just on the back of what Jim just went through and Roger, you talked about this, so I just want to be clear on the pressure, particularly in the Health segment. Are you saying that's mostly timing-driven and that you're going to recover a lot of that next year or?

Yes. Yes, it has to do with some of the medical exam work that we do. Think about it as fixed infrastructure. Because of COVID, a lot of facilities were shut down and we have moved some of that to telehealth and some of that through review of existing medical records, but the vast majority of the work that we do requires a medical exam. And those are medical exams that have to be done, whether it be worker's comp or a disability benefit. And those have rolled, if you will, into backlog. So you'll think of it as a simple inventory. Those need to get done and they're not getting done. And the individuals who need that benefit need a medical exam. So if they didn't get it in the second quarter, then they're in the backlog now for third quarter and fourth quarter, but it's just going to take time to work through the backlog. So it literally is a timing and what we have seen in the past, Rob, when we have seen the backlog, we will surge and conduct more exams than normal to catch up. So this is not a permanent timing difference. It literally is just a delay and then we will surge and then sometime probably late in '21, we'll come back to normal.

I see. And it's not that they can get the exam elsewhere or that it's somehow lost share or anything like that? It's ...

No.

... they come back to you.

And the offers of these exams, whether it be worker's comp or disability are in the same boat. We've all been shut down and the backlog has unfortunately grown. We're now 85% open, something like that as of earlier this week. And so it's just going to take time now to work through the backlog, and we're committed to go do that.

Okay. And then the other thing I wanted to talk about, I think it's very interesting, but your role on Skyborg as the system design agent. And wanted to see if you could talk about the scope, perhaps of that contract. And if the work scope there is kind of a won and done, or if you have any kind of recurring revenue stream from Skyborg long-term?

Well, we are essentially the systems engineering contractor for the customer. And as you know, I think you may have written that there are a handful of other companies that are working on the concept and the vehicle, and our job on that program is to assist the customer in doing technical assessments and systems engineering at the concept level. And it's a nice program for us. We're obviously very, very pleased with it. It is not our largest program and probably won't grow to be because of our systems engineering role. We stand more along with the customer and the user than we do with the companies who may be designing and building the vehicle.

But that makes you somewhat agnostic on how this plays out. Your role ...

Absolutely.

... is there. And does this help you with autonomy efforts down the line?

I believe it benefits us significantly in areas related to autonomy and systems engineering. It enhances our previous performance and qualifications in this field. When we evaluated it, we realized that we didn't have an airborne offering, and it made more sense for us to take on a systems engineering role alongside the customer. This serves as a strong qualification for us.

Right. Thank you very much.

You're welcome. Good morning.

Hi, good morning, Roger, Jim, Peter.

Hey, good morning.

Roger, in relation to Rob's question, there's an aspect of being a guiding force as the organic leader in the growth sector, especially with your recent successes like NGEN. During COVID, you provided an excellent explanation in May regarding its impacts on programs like DHMSM and Antarctica. However, it's clear that the effects of COVID reached beyond those areas. Why do you think those businesses were affected? You briefly touched on this, but how do you see things normalizing? Additionally, how should we approach 2021, considering you mentioned in the slides that normalization is expected in Q4 regarding revenue growth and margin mix?

Yes, I will get started and then let Jim finish. The Defense Health program's electronic records initiative for DHA is affected only very slightly. We would like to emphasize that the completion schedule remains on track for the '23 timeframe. Most of our digital transformation efforts in the healthcare business are quite near schedule. Thus, we haven't observed any significant changes. The main impact this quarter has been in the exam business we just discussed, where a few months have passed during which we were unable to conduct exams. I’ll let Jim elaborate on our perspective regarding the fixed and variable costs related to our examination business.

Yes, Sheila, I think Roger said it well, but to just emphasize the point on what's changed from when we talked about the expected impacts a quarter ago, the real change has been that the impact of the pandemic in a number of geographies has been more prolonged and perhaps more severe than we had visibility to 90 days ago. And that has caused some of our customer sites and some of our examination sites to be closed longer than expected, and they returned to work in some of our customer sites, whether it's our intelligence customers within the Defense Solution segment, or the places where we serve patients for these medical exam services, all of those have had a longer and more prolonged return to opening than we expected just three months ago.

Sheila, your comment about '21, I think was right on. We expect to come back to a normative level in the fourth quarter and then therefore exceed that level in the exam business in 2021. So, obviously, optimistic about what '21 will look like.

Great. Thank you.

Thank you.

Yes. Could you please give us a little insight into recovery under the CARES Act, for example, the areas in which you expect recovery? Is that medical exam? And do you have any hope, and is it in your bookings that you would get recovery of these?

Yes. I'll begin, and Roger may add more. The CARES Act is assisting us in maintaining a portion of our workforce in the Defense Solution segment, particularly within the Intelligence Agency customer group. We are able to recover full costs for these employees, though not the fees. This accounts for no more than 5% of our total employee base. However, the CARES Act does not enable us to recover costs associated with ready state employees or facilities related to our health solutions contracts for two main reasons. First, a portion of that revenue is derived from commercial customers, such as insurance companies for disability exams. Second, our government clients operate on a fixed unit price basis, which means we incur significant fixed costs, such as lease and staffing expenses for processing exams. Typically, these costs are not covered by the CARES Act provisions. This is the main impact we are discussing in the Health business.

Thank you.

Thanks very much. I was curious about the incremental impact of 300. Should we consider that mainly related to the Health business? On the defense side, I see the main challenge for federal service providers during COVID-19 as being facilities that aren’t open. How should we view the incremental impact divided between these two areas?

Seth, I think about roughly half of the 300 as being incremental impact from COVID-19 with a little under half of it being the delay of the NGEN ramp-up because of the ongoing protest activity there. And then the balance of it would be COVID-19 impacts in other parts of the business, such as the Civil business and other parts of the Defense Solutions segment.

Okay. It sounds like then you don't really see that on the intelligence side and the impact of the pandemic on secure facilities. It sounds like you don't see very much incremental impact there.

Not much additional impact is observed. The main portion of the incremental effect is noted in the Health business.

Okay, great. Thanks very much.

Okay.

Good morning, Jon.

Hey, good morning.

Hi, Jon.

Thank you very much for that. Sorry about that. Just, Jim, some of those cash moving pieces heading from this year into next year, I think you've got some sort of almost one-time transient items helping you get to the 1.2 or greater this year. Can you just help us think about what the moving pieces are going forward? Some of those tax items, perhaps that go back, how sustainable the AR factory is, et cetera, et cetera. Thank you.

We plan to maintain the AR monetization program, which offers us additional funding options as needed. It's an inexpensive tool that we can access at any time. The other factors contributing to the increase from $1 billion to $1.2 billion in our guidance include the current funds from the VirnetX impact and some favorable effects from the CARES Act regarding our tax payments. We've been able to postpone both income and payroll tax payments, mainly deferring payroll taxes into next year. The deferral on income taxes merely shifts those payments to Q3 and Q4. Overall, the tax benefits anticipated for next year are over $100 million, while the remaining changes are primarily influenced by COVID-19 effects, balancing the positive cash flow trends we're experiencing.

Understood. Should we expect operating cash flow to decline year-on-year in 2021, or is it possible that we can actually increase from the $1.2 billion in 2021 as the effects of the CARES Act are balanced by COVID?

Some of the tax benefits will be offset next year and into 2022. The only other challenges we anticipate from a cash flow perspective are related to business growth, which we expect to be solid in 2021. Previously, we mentioned high single digits, but given our significant backlog in the Health business and other areas of the Defense Solutions business that will carry into 2021, we are confident in achieving 10% or better growth in our top line next year.

Thank you.

Thank you.

Yes. Good morning, Roger, Jim, Peter.

Hi, Peter.

Good morning, Peter.

Hey, Roger, without getting into specific dollar amounts, how do we assess the revenue profile of security detection and automation now that you have more experience in this area and have discussed its effects with customers? As we move into 2021, is this a growing business, and could you provide some insight into its overall health?

I'd be happy to provide an update. They are actually ahead of our expectations. We had an internal plan for the combined business, including the Tewkesbury operations and our U.K. tray return systems. This past quarter exceeded what we anticipated, and we believe this trend will continue. In our previous call, we discussed the impact of airport activities, speculating that this period would allow airports to focus on capital improvements. That has indeed been the case, with many airports seeking to enhance social distancing and health safety at screening checkpoints. Implementing 6-foot spacing requires changes to the layout, potentially increasing the number of lanes and necessitating additional standing areas. Innovations like antimicrobial trays, ultraviolet light in return pans, touchless screening, and ID verification create significant growth opportunities beyond what we originally projected when we developed our business case for the acquisition last year. The team, led by Maria Hedden, is doing an excellent job of reaching out to customers globally, and we are now operating in over 150 countries. There's considerable interest in capital improvements across the board. We observe that the recovery seems to be stronger outside the United States, while we continue to navigate the effects of a resurgence this summer. Many foreign markets experienced stricter lockdowns, resulting in smaller case numbers and an accelerated implementation of biometric technologies at their airports. We are very encouraged by our progress, and the integration is proceeding well, surpassing our initial business case expectations.

Appreciate the color. Thanks.

Hi. Good morning. Can you talk a little bit about your recompete exposure for the rest of this year, as well as 2021, please? Thanks.

Yes, thanks, Ed. We have three main items we are working on. First is our NASA NEST program, which has already been submitted. The other two have not yet been submitted. One is at NGA, which we call our user-facing and data services contract, and it is likely the largest one up for recompete at around $4.4 billion, with submission planned for the end of summer. The other is the IT services work we do for the Army Corps, referred to as ACE-IT, which we will also submit at the end of summer, estimated to be over $1 billion. The only one already submitted is our FAA/NISC contract, which is the National Aerospace Systems Integration Support Contract, and we are the incumbent for all three contracts.

And is 2021 a normal 20%, 25% year or is there anything unusual there?

Yes, very normal. And no, there is not a Hanford out there.

Okay. And you mentioned, you were seeing issues in clearances. We hadn't really been hearing that from some of your competitors. Is there anything unique about the mix of your business that's challenging you more?

Well, I think what may be unique for us, by the way, is primarily in our intel business. So, it's the very high-end clearances often requiring a polygraph. I think the background investigation seems to be going okay. I think the problem is, I don't want to get into too much detail but if you've ever been through a polygraph, you know it is a very COVID unfriendly process in how that's conducted. The throughput that the agencies have on getting polygraphs done has slowed down. So it's uniquely in our intel business. And I think, why it affects us maybe more than others is because of the wind and the growth that we've had. So we're not trying to maintain staff. We are actually trying to significantly increase the staff in our intel business because of our wins. And that means, we have to get new people through the clearance process in order to be able to support our growth. And not reflecting on some of the others that have reported. Our clearance process is not about our current workforce or really predominantly and what we call our collateral clearance, which you might see in our Defense group like a secret or a top secret, it really is in that high-end group.

Great. Thank you.

Yes. Good morning.

Hi, Joe.

Hi, Joe. Good morning.

Hey, guys. Jim, just in terms of 2021, is the thinking maybe that half of the growth is NGEN and half is all else, just in the context of you are sitting on a trailing 12-month book-to-bill of 1.6x ex NGEN, which would speak to really strong maybe double-digit growth by itself? So why can't growth be better than 10%, or do you see kind of a multi-year period beyond 2021 with really strong growth given the backlog? And can you just update us on the pipeline of bids that you're expecting? Thank you.

Sure. First of all, Joe, thanks for the question. The pipeline of new business opportunities continues to expand. Interestingly, it is growing with numerous programs, including quite a few that are $1 billion in size, but there is also increasing growth in programs that are in the hundreds of millions of dollars. This gives us more diversity and greater opportunities. In response to your query about whether half of the growth is from NGEN, the answer is no, as the NGEN program will require some time in 2021 to gain momentum. While your point is valid that growth could exceed 10%, we tend to be cautious and conservative in setting targets this early in the cycle. Lastly, as we move beyond COVID, and as our customers become more comfortable with the safety protocols we have implemented to protect patients and individuals undergoing these exams, we anticipate returning to the health group's previous level of being the segment of our business with the highest margins and growth rates. Although the Defense Solutions segment will experience good growth from the NGEN program, we look forward to the health group regaining healthy margins and growth rates in 2021.

Yes. That's helpful. And then just along those lines, in terms of the expectation that the business kind of gets back to normal by 4Q. Do you have visibility into that or is that more kind of hopeful in nature at this point? I understand things are fluid, are you having customer conversations that give you confidence around that, or are you able to kind of change certain processes that lessen your exposure to kind of what you've been facing the past few months? Thanks for the time.

It's more of the latter. We are currently in a better position where both commercial and government customers have allowed us to reopen clinics. We have implemented social distancing and non-contact measures. People are returning to the clinics, and we are witnessing an increase in volume. However, it did not rise in the second quarter, and due to our use of PPE, we are having patients wait in the parking lot before entering for exams. We are not seeing the same number of daily exams as we did before COVID, and it will take another quarter or so to reach full capacity on a clinic-by-clinic basis. Currently, about 85% of the clinics are open, and we expect to be fully operational this quarter. We need to increase our capacity, and we can only do so much overtime to complete the daily exams. We are all adapting to be more efficient in this COVID-19 environment. Post-vaccine, we aim to be either back to where we were or even better, as we are learning to be more efficient and are now incorporating telehealth for some exams, which was not a significant part of our business before. This change allows us to increase capacity at each location. Customers—including corporations and government agencies—are eager to collaborate with us because the backlog is challenging for them. Our goal is to complete these exams so that we can process claims and ensure reimbursements for individuals.

Hey, Joe, one other point, aside from the Health business, in the Defense Solutions segment, and in particular, our Intelligence Agency customers, they've seen very real mission impacts because of the need to partially close their work locations, and they are eager to work with us to get people back in those work locations, and that is a process that's currently underway. Last point that I would make is, and one of the things that we've learned from how we've had to operate, we've reduced our cost structure. When you take the VirnetX settlement and when you take out the COVID-19 impacts to the business that are arguably temporary, the business had a 10.9% EBITDA margin in the quarter, and while EBITDA margins go up and down from quarter to quarter, we do feel confident that on an ongoing basis, what this has done is we've leaned out the business even further than we have, which gives us strong visibility into good margins into 2021 and beyond.

Very helpful. Thank you.

Thank you, Joe.

Hey. Good morning, guys. Thanks for the question.

Hey. Good morning.

I wonder if you could comment on what you're seeing in early Q3, which is typically the big order quarter for the year. Are there any signs that this will be slower than prior years, or is customer demand holding up?

There should be no reason for this year to differ from previous years. I want to highlight that due to our achievements, we have experienced a significant amount of protests and adjudications in the Court of Federal Claims, which has influenced our third quarter outcomes. We have a few programs currently under protest. Once they conclude, they require corrective action, and we must resubmit our proposals. This has led to some of our expected activity in the third quarter being somewhat spread out. We anticipate that the oral arguments for next-gen programs will take place in October, but resolution may take an additional month. One of our key initiatives, the Reserve Health Readiness Program, which provides services to the military reserve, is also undergoing corrective action. We have submitted the necessary updates, and the adjudication and award process will follow. While this could potentially impact the third quarter, predicting outcomes in the protest environment is often challenging. However, nothing indicates that this year's third quarter will be any different from our historical performance.

Got it. That's helpful. I have one more question about tax. Regarding the change from expensing R&D to amortizing it over multiple years, which I believe started in 2022, can you explain the potential impact of that change on Leidos?

Yes, we are exploring ways to ensure that despite the changes in the law, we can recognize a greater portion of our work as eligible for the R&D tax credit. While I don't have a specific figure to share, we don't anticipate this having a significant impact on our effective tax rate. This year, we've successfully identified various eligible expenditures for the R&D tax credit, and more importantly, in relation to our acquisitions, we are able to allocate part of the assigned value of these businesses as tangible personal property, which qualifies under the accelerated depreciation rules established by the recent Tax Reform Act. Therefore, we see an opportunity to enhance our cash tax position not just by optimizing R&D but also by gaining added benefits from our acquired companies.

Got it. All right. Thank you.

Thank you.

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