Leidos Holdings Inc (LDOS) — Q3 2021 Earnings Call Transcript

Thank you, Rob. And good morning, everyone. I would like to welcome you to our third quarter fiscal year 2021 earnings conference call. Joining me today are Roger Krone, our Chairman and CEO, and Christopher Cage, our Chief Financial Officer. Today's call is being webcast on the Investor Relations portion of our website, where you will also find the earnings release and supplemental financial presentation slides that we'll use during today's call. Turning to Slide 2 of the presentation, 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, as shown on slide 3, during the call we'll discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in today's press release and presentation slides. With that, I will turn the call over to Roger Krone who will begin on slide 4.

Thank you, Stuart, and thank you all for being here this morning. The third quarter was another strong period for Leidos, with record revenue, adjusted EBITDA, non-GAAP diluted EPS, and backlog. Our achievements stem from a business portfolio focused on essential missions and a motivated workforce dedicated to enhancing those missions through technology, engineering, and science. As we discussed during our October Investor Day, we are optimistic about our future success due to our scale, positioning, and talented team. I will outline four key messages. First, our financial results showcase our capacity for organic growth, profit generation, and cash flow creation. Second, our business development efforts have secured significant awards that highlight our unique market position. Third, we are wisely allocating capital to enhance shareholder value. And fourth, we are investing in our workforce and developing a company that we can all take pride in. To start, our strong financial performance was underscored by impressive earnings and cash generation. We achieved revenue of $3.48 billion, reflecting a 6% organic increase year-over-year, surpassing market expectations. Our non-GAAP diluted EPS for the quarter was $1.80, marking a 22% year-over-year increase, thanks to robust operating results, evidenced by an adjusted EBITDA margin of 11.6%. Additionally, we generated $565 million in cash flow from operations and $541 million in free cash flow, resulting in a free cash flow conversion ratio of 211% of non-GAAP net income. Our asset-light model, combined with our ability to convert EBITDA into cash and maintain a lean balance sheet, positions us strongly for cash generation. Moving on to our business development, we continued to build on the momentum that supports our industry-leading organic growth this year. In the quarter, we recorded net bookings of $4.7 billion, giving us a book-to-bill ratio of 1.4. This represented our 15th consecutive quarter with a book-to-bill ratio of at least 1.0. Consequently, our total backlog reached a record $34.7 billion at the end of the quarter, up 9% year-over-year. Let me highlight four critical wins. We were awarded a $600 million prime contract to continue supporting the Army's Geospatial Center, BuckEye mission, which provides essential unclassified high-resolution color imagery and digital 3D terrain across important global operational areas. Our scale has allowed us to invest in aircraft and skilled professionals to back the mission, providing advantages on the battlefield and assisting partner nations as well as disaster relief efforts. The NSA also awarded us a $300 million prime contract to enhance its Technical Signals Intelligence mission, where we will offer technical services to develop and sustain a wide array of advanced collection, production, and analysis capabilities for actionable intelligence essential to the defense of our country. Our Dynetics subsidiary received a $237 million contract with the Army for the enduring Indirect Fire Protection Capability to develop a system designed to counter cruise missile and unmanned aerial threats. Our flexible open system architecture will allow integration with the Army's Integrated Air and Missile Defense command system. With this initial contract, we will supply 16 launcher prototypes and 60 interceptors, potentially leading to a program exceeding $1 billion in value, with options for full-scale production of 400 launchers. Lastly, we were granted another significant IDIQ contract by Customs and Border Protection for non-intrusive inspection, accumulating two IDIQs this year with a ceiling value of $870 million and $200 million in tasking. Ensuring our ports and borders are secure is a top priority, and CBP aims for complete screening of vehicles and cargo at the border, compared to current single-digit screening levels. There is significant funding from Congress for expanded screening, presenting a favorable opportunity for us. Regarding capital allocation, I consider it a crucial responsibility as CEO, and we are actively allocating resources to drive shareholder value. In the quarter, we repurchased $137 million of our stock on the open market. At our October Investor Day, we set a cash flow target of $3.5 billion from operations between 2022 and 2024. After accounting for capital expenditures, debt repayment, and dividends, we will have around $2.2 billion available for M&A and stock buybacks. We are always exploring technology acquisitions, and that pipeline remains active. In Q3, we made a small strategic acquisition to enhance growth prospects at our Dynetics subsidiary. Aside from that, we are not anticipating any major deals in the near future. We are confident in our current portfolio and believe we are well-positioned for growth, pursuing large acquisitions only if we identify opportunities that align with our strategy. People are central to our operations, and this quarter showcased our ability to attract top talent. We welcomed over 2,900 new hires and ended the quarter with a workforce exceeding 43,000. Our headcount rose by 2% sequentially and 12% year-over-year. However, recruiting remains a consistent challenge. We currently have about 1,400 funded vacancies, emphasizing our focus on recruitment and retention as key strategic objectives. One reason we are appealing to job seekers is our commitment to upskilling employees and fostering an innovative culture. For instance, in Q3, we hosted our inaugural Leidos Sphere, a 24-hour virtual technology conference where employees worldwide shared technical solutions, with live presentations from various locations. This format provided immediate answers and interactive discussions, showcasing our collaborative approach in tackling complex global challenges, which sets us apart competitively. Additionally, being a values-driven organization is a significant attraction. Our leadership team is dedicated to ensuring Leidos is a responsible corporate citizen, balancing opportunities and responsibilities to our stakeholders as we expand. Our mission to enhance safety, health, and efficiency motivates us to build a future where our people and technology can effect meaningful change. Having achieved our previous greenhouse gas emissions reduction targets, we have now established new environmental, social, and governance objectives for 2030 that emphasize inclusion, environmental sustainability, and healthier lifestyles. We believe these initiatives will sustain and enrich our Leidos culture while positively impacting all stakeholders. We will consistently report our progress in our Corporate Responsibility report, which we have published for over ten years. Through this initiative, we are committed to transparency regarding our diversity, environmental efforts, and the well-being of our employees and communities, which will be evident in our disclosures. Before handing over the call to Chris, I want to discuss the current budget environment as it provides important context for his guidance. As anticipated, Congress has passed a continuing resolution and suspended the debt ceiling to prevent a shutdown and economic disruption. Both measures are set to expire on December 3rd. Currently, there are expectations that Congress will attempt to package spending bills into an omnibus bill for presidential approval before this expiration or potentially extend the timeline by passing another continuing resolution lasting until next March. Additionally, the House plans to push through two significant legislative items soon, including a $1.2 trillion bipartisan infrastructure plan, which has already passed the Senate and is ready for the President’s signature, and the $1.3 trillion Build Back Better initiative aimed at overhauling healthcare, education, climate, and tax policies, which is set for Senate debate. The outcomes of these bills and the ongoing spending and debt ceiling discussions remain uncertain. As a result of this instability, some of our customers have scaled back their usual spending patterns. Nonetheless, we anticipate only a minor impact on our results given the essential nature of our work during this budget uncertainty. I will now turn the call over to Chris Cage.

Thanks, Roger. And thanks to everyone for joining us today. As Roger said, Q3 was an outstanding quarter for earnings and cash, and I'm proud of the team for delivering such strong operating performance. Let's jump right into the third quarter results, beginning with the income statement on slide 5. Revenues for the quarter were $3.48 billion, up 7% compared to the prior-year quarter. Excluding acquired revenues of $47 million, revenues increased 6% organically with organic growth across all three reportable segments. We're pleased to continue to outpace the market, but revenues were below our expectations. The main driver of the shortfall was lower-margin material purchases, due in part to supply chain issues for computers and technology components, and due to reduced activity levels due to concerns over the predictability of funding that Roger just mentioned. We were able to deliver strong earnings despite these factors. Adjusted EBITDA was $403 million for the third quarter, which was up 16% year-over-year. And adjusted EBITDA margin increased from 10.7% to 11.6% over the same period. This was primarily due to strong program management, higher volumes on some of our fixed-price programs, and better direct labor utilization. Non-GAAP net income attributable to Leidos common stockholders was $257 million for the third quarter, which was up 21% year-over-year, and non-GAAP diluted EPS for the quarter was $1.80, up 22% compared to the third quarter of fiscal year 2020. Now for an overview of our segment results and key drivers on Slide 6. Defense Solutions revenues increased by 3% compared to the prior-year quarter. Excluding the acquisitions of 1901 Group and Gibbs & Cox, organic revenue was up 1%. The largest growth driver was the engine ramp, which more than offset the completion of the Human Landing System base contract within Dynetics. Civil revenues increased 3% compared to the prior-year quarter, and all of the growth is now organic. The revenue increase was primarily driven by volume growth on existing programs, including the Antarctic support contract. Our managed IT services support to the Bureau of Alcohol, Tobacco, Firearms, and Explosives, where we're leveraging our 1901 Group acquisition and our engineering support to commercial energy providers. Health revenues increased 31% compared to the prior-year quarter, and all of that growth was organic. We continue to see a nice ramp on the Military and Family Life Counseling program, and there was a large year-over-year increase based on deployment timing. Like last quarter, the largest year-over-year increase was in the disability examination business in our QTC subsidiary. On the margin front, Defense Solutions non-GAAP operating margin for the quarter came in at 8.8%, which was unchanged compared to the prior-year quarter. Civil non-GAAP operating margin declined from 10.5% in the prior-year quarter to 9.6% as we had fewer deliveries of airport screening systems. Importantly, margins for both Defense and Civil were up sequentially consistent with our long-term view for these segments. Health non-GAAP operating margin for the quarter was at 20.7%, compared to 16.3% in the prior-year quarter. This quarter's strong margin performance benefited from the significantly increased revenue volume on fixed unit price programs and higher direct labor utilization. Turning now to cash flow and the balance sheet on Slide 7, operating cash flow for the quarter was $565 million, and free cash flow, which is net of capital expenditures, was $541 million. The exceptional operating cash flow was driven by strong operational performance across the enterprise and higher customer advance payments, and came despite the $62 million cash tax headwind from last year's CARES Act deferral. During the quarter, we paid down $27 million of debt and repurchased 1.4 million shares. In total, we returned $188 million to shareholders through our quarterly dividend program and share repurchases. As of October 1st, 2021, we had $587 million in cash equivalents and $5.1 billion of debt. As we close out the year, we remain committed to a target leverage ratio of three times. Our long-term balanced capital deployment strategy remains the same, and consists of being appropriately levered, maintaining our investment-grade rating, returning a quarterly dividend to shareholders, reinvesting for growth both organically and inorganically, and returning excess cash to shareholders in a tax-efficient manner. Now to the forward outlook, as shown on Slide 8, we are updating our guidance for fiscal year 2021. Let's walk through the drivers for each metric. We now expect revenues between $13.7 billion and $13.9 billion, which is the bottom half of our previous range. Supply chain delays and customers holding back spending due to concerns over the predictability of funding are the primary drivers here. Some protests have also pushed revenue out of this year. And we're also mindful of the potential impact of vaccine mandates on our workforce. At the midpoint of revenue guidance, revenues in Q4 would increase about $70 million compared to Q3, driven by the continued ramp on new programs like NGEN offsetting moderation in the volume of our medical exam business. At the revenue midpoint, organic growth for the year would be 9% and total revenue growth would be 12%. We expect 2021 adjusted EBITDA margin between 10.9% and 11.1%, which is above the previous range as a result of our Q3 outperformance. As the revenue composition shifts in the fourth quarter, we expect EBITDA margins to come back in and land in the mid-10% range. We expect non-GAAP diluted earnings per share for the year between $6.55 and $6.75. So we've increased the midpoint of the range by $0.15 based on our Q3 outperformance. Share repurchases in the third quarter will also add about a penny to Q4 non-GAAP diluted EPS. Finally, our expectation for cash from operations is unchanged at $875 million or greater. Our strong Q3 performance increases our confidence in meeting or exceeding $875 million for the year, but the advanced payments in Q3 will be a headwind to Q4 cash generation. Before I close, I want to highlight the 3-year targets we laid out at Investor Day last month. From 2022 through 2024, we're targeting organic revenue CAGR of 5% to 6%. Adjusted EBITDA margins of 10.5% or greater by 2024, free cash flow conversion of approximately 100%, and cumulative cash flow from operations generation of approximately $3.5 billion. Our market positioning, industry-leading scale, and technology differentiation support our position and ability to deliver on these targets. With that, I will turn the call over to Rob so we can take some questions.

Good morning, Roger, Chris.

Hey. Good morning, Peter.

Nice results. Hey, Roger, you mentioned some customers tampering down their spending plans just given the uncertainty. Maybe you could just give us a little more color on what's specifically you're seeing? Thanks.

What typically happens is that we secure a contract, this IDIQ. We work on a few projects, and we always expect that, especially in the next fiscal year, those customers will bring forward projects that will increase our revenue. This is discretionary spending on their part but remains below the IDIQ ceiling. I am primarily thinking of three or four agencies. However, those projects have yet to emerge. The base program is performing well, but we generally anticipate around 10% from some of these IDIQ, or test quarter contracts, to come in. A couple of agencies have specifically not been utilizing their project funds. This is something we plan for; it’s not unusual. We have observed similar patterns before when budget uncertainty reaches levels like it is today. Eventually, they will spend that money, whether it be next year or the year after. The work still needs to be completed; it’s just not happening in the third and fourth quarter.

And Peter, the only thing I'd add is we're not really seeing that in our civil and health customers; it's pretty much in our Defense Solutions segment between the intel and some defense customers where we're seeing that activity.

Okay. I appreciate that. I'll leave it there. Thanks.

Thanks very much, and good morning, everyone.

Good morning, Seth.

So Chris, I wonder if you could help level set us with the health business. I guess from 2017 to 2019, we had adjusted EBIT pretty regularly in that business at around the $275 million range. 2020 included the COVID impacts, so obviously it would have been much higher. This year we're looking at something considerably higher than that, maybe even something approaching 500. When we think about the headwind that's obviously going to be there next year as the outside exam revenue comes off, can you help us to size the sales and margin impact of that?

First of all, I want to congratulate our team. I think our team has done an exceptional job running that business and continuing to optimize performance along the way. Clearly, this was a banner quarter with the growth and the margins above 20%. I will tell you and we have told you that is not where we see this being sustained. We have worked down the backlog that came about through the pandemic, and we're seeing a level of referral volume continuing to stay fairly high. So there are some reasons to be a bit optimistic there, but it will come back down. What we said before is that when the business was running at a normal level, it was in the mid-teen margin. While we don't guide by segment, I would tell you somewhere at that level is certainly the bottom end of what we feel comfortable with. But with the improvements in the business operations and the growth, I think there is opportunity to do better than that over time. So we're preparing for a scenario where health is not performing at these levels that we've communicated at Investor Day, and we're driving the rest of the business to make sure we're driving margins up over time. But again, couldn't be more happy with the performance of the health team, and we're going to sustain that performance as long as we can.

Yeah. And Seth, as you know, we've got a couple of fairly large programs starting up. The Military and Family Life Counseling Program and their Reserve Health Readiness Program will be fully ramped next year. Those are more towards our normative levels that you might see in our defense group. It's a great business; I'm really proud of the team, but next year should look more normal. COVID has created swings in our business that we saw last year, and now it's as we had predicted, swinging back this year.

Okay, great. That's very helpful on the margin, and then maybe just a follow-up on the sales. I assume that the exempt business will be down on the top line next year, but to your point, there have been some nice wins and programs ramping. Can health grow next year top line?

Well, we'll obviously get into those details in our fourth-quarter call with you. In fact, we're going to be with our team here in a couple of weeks going through the bottoms-up annual plan, but I would say yes. Our expectation is that the business can grow next year, and that's certainly the way we're approaching it. So more to come on the details around that, but we're actively working that, and there's a healthy pipeline that we're pursuing at all times.

Great. Thank you very much.

Thanks.

Good morning.

Good morning, Gavin.

There's something you had to quantify some of the impacts of the delays or impacts you cited. And then some of the other businesses that may not be kind of running at normal level, right? Health might be a little high, but I think SD&A is a little low. So do you have to quantify the impacts of chip shortages, intel delays, things like that, that would be really helpful.

I'll take a stab, Gavin. So we took down the midpoint of our guidance by $100 million. So that's kind of the size of the pie, if you will, how we think about potential headwinds that we're facing. On the material side, which is tied up in some of the chip shortages we've seen, lack of material availability is mostly on the computing side, but some technology components are impacting our Dynetics or our airborne ISR business. Think of that as roughly a third of the impact. Then we've got the budgetary headwinds where we expected certain projects to come through, but we're not seeing that activity from customers. That's another roughly third of the impact. Then there's this protest bucket; we had a couple of programs that we won, and in fact, we had another program that we won last quarter on the TSA side, but there was an OEM underneath that protest. So we're not able to do some of the work. There’s a little bit of a learning curve, I mean, we expected or hoped that we would have some over-the-rise and support that's not really materializing. All those things added together are the $100 million guide down on the midpoint of our revenue.

Got it. And then maybe on civil margins. I appreciate that can be pretty lumpy with timing of hardware delivery, but it's to below-average quarters in a row here. Anything that's changed structurally there, or is there just a lot of timing going on there as well? When would you expect that to normalize?

I would tell you again, I was pleased to see the sequential improvement from Q2. That's our expectation going into next year; we will continue to see that tick up. The team's done an excellent job getting the SD&A business ready for growth in the future when that market rebounds. A lot of new talent has been added to the team, and we're happy about that. But there are a lot of other things going on in Civil. When I highlighted the growth in our commercial energy customer business, that will continue to see expansion we believe going into next year, which will help us. So again, the Civil business should be above the corporate average margins. It's slightly below right now, but that's a quarter-to-quarter thing that we see trending up.

Thank you.

Hey. Thank you. Good morning, everyone.

Good morning, Sheila.

Can we think about profitability? Adjusted EBITDA margins are in that 10.3% range in Q4 versus 11.2% year-to-date. What are the drivers of that contraction as we head into Q4? Consensus looks at 10.5% margins for next year. So maybe, can you talk about the puts and takes in for the last quarter of the year and what we should be considering if health margins are mid-teens next year?

Well, Sheila, I'll start and Roger can add in. Health-wise, we've indicated that we expect a slight decline in the medical exam business for Q4. However, we are preparing for that possibility. This will likely have a negative impact on margins overall. I also want to highlight that our performance in Q3 was quite strong, particularly in program performance. We had a remarkable quarter with net write-ups, which helped elevate our margins to 11.6%. Our goal remains to target mid-10% margins, as we discussed at Investor Day, which reflects our long-term outlook for the business. Considering everything in Q4, including the holiday season and health uncertainties, we feel optimistic about achieving those margin targets.

Okay. And then maybe one more question. Roger, in the release, you said you're gaining share. What areas do you find that you're gaining the most traction?

We've always been strongest in this area, our technical core competency is called digital transformation. This is the move to the cloud, IT-as-a-Service, helping our customers operate more efficiently. What has been exciting for us is that line of business crosses really all five business units. We've got some major wins that we've talked about. We've got some things in the pipeline. We've actually moved forward even in the health group with some commercial healthcare providers. Another area that's really been nice, and again, we talked about this already, is the new wins in the Health group, which allowed us to grow our Health group faster than the rest of the business. In order to do that, we’ve taken business away from others in our industry.

Thank you.

Yes.

Yes. Thanks so much for taking the question. So as we look at the full year, and actually third quarter also, while you say the guides come down $100 million, it's basically very mixed. Clearly, Health looks like it's $200 million or so better for the year, and the big miss is really in Defense. Could you basically drill down a little bit more on the programs? For example, it looks like Dynetics might have been short. So we can understand which programs are contributing to the shortfall.

Sure, Cai. Obviously, Health being up $200 million is against your estimates. We don't give the guidance by segment, but we're pleased with the health growth. In defense, clearly is where we're seeing the preponderance of some of the impacts that we've talked about. The Afghan drawdown, that was a headwind for the team this year, and it's hurt what would ordinarily be a growing airborne business. The material shortages in our Intel customer space have been an impact. We've previously talked earlier this year on the Intelligence Customer Award delays having some impacts on the business as well. Those things are all factors driving that, and of course, the Human Landing System Program while we had never put that follow-on in our plan, clearly, the $240 million that we executed on that 10-month program is gone, and that becomes a growth headwind.

Yes, I would also add that in the third and fourth quarter, we can procure a lot of material under our contracts and spend the spring installing it. The chip shortage has affected the types of materials we use. While we buy raw materials, a significant portion includes computer equipment such as PCs, laptops, servers, routers, and switch gear, and we have really seen those supply chains lengthen. A PC that we would typically receive in four weeks now likely takes around 20 weeks. A server takes about the same amount of time, if not longer, and the same goes for some networking equipment. Normally, we would place orders to ensure delivery before the end of the fiscal year so we can book revenue against it. Now, we are placing those orders and experiencing backlogs, similar to others in the industry, and the equipment is expected to arrive in the first quarter. Most of these programs are concentrated in our Defense segment.

Okay. Thank you very much.

Yes.

Thanks, Cai.

Hi. Yes, thanks. Good morning. Could you comment on Capital Expenditures? I mean, it's running a little bit lower year-to-date. Is that something we should expect to pick up next year? And I think you've talked about kind of 1.5% of sales. Is that kind of the right way to think about it in the future?

Thank you for the question, Matt. You're correct that our capital expenditures have been running slightly below our expectations. We anticipate a modest increase in Q4 compared to our current levels. The 1.5% figure is what we consider to be the upper limit. Our responsibility is to ensure that every capital expenditure request meets our return expectations, and we will thoroughly review this in Rio P. Additionally, we are facing supply chain challenges that are affecting our capital expenditures. As Roger mentioned, we have airborne assets and some aircraft that are delayed in receiving the necessary technology components for operations, which is taking longer than expected. We're also experiencing delays in outfitting some facilities, particularly on the Dynetics side, as we work to secure contractors and materials for our new projects. Therefore, I expect a slight uptick in Q4, and as we move into next year, I would again view 1.5% as the upper limit, and we will evaluate how the opportunities evolve as we progress through our planning process.

We have just finished a significant hypersonic facility in Huntsville, which largely reflects our historical efforts. Since relocating to our new headquarters in Reston and our new building in Gaithersburg, we have typically leased our facilities but need to purchase the necessary capital equipment and undertake capital improvements. I expect spending on that will decrease next year, and based on Chris's input, we're likely aiming for a range between 1% and 1.3%. In line with what Chris previously mentioned, we have paused a few projects in our current building due to material shortages that prevent us from completing them. There's an unfinished project on the floor above that we had to leave aside, but we anticipate completing it next year. The extent of supply chain issues is remarkable, as evident from the pictures of Long Beach Harbor, where a lot of material is currently stranded.

Great. Thank you. That's really helpful. And just one more on NGEN. I think last quarter, you had mentioned that was one of the reasons to be cautious on the guidance. It was a new program, and you weren't sure of the order pattern. Did that fully ramp up now and is that flowing through at the run rate that you had expected?

Yes. But I'll give you some details, and if I don't cover it sufficiently, Chris will jump in. We're fully staffed on the program. Normally 4000 people give or take a little bit. From a revenue standpoint, though, we won't hit full revenue until next quarter or first quarter. So it’s still got some room to go from a revenue standpoint. If you’re looking for a full year, it’s probably next year or maybe even 2023 until we’re at the absolute run rate. But the great news is we've taken over the network. We own it now. We have started the transformation part of the program, which is to move the Navy into, if you will, the next-generation of a short network. The program is actually running really, really well; we went from an award to fully staffed in literally just a quarter or two, and that’s almost unprecedented. So really great stuff on the program. We’re not at the max revenue this quarter, but we’ve got a good shot to be close next quarter.

I think the team is a highlight across the Company of how quickly they staffed that thing up. Roger mentioned earlier some of our customers have special projects in NGEN that will have budget for special project. So again, we're learning this customer. We're ready to execute on those as those orders come through, but that's a variable demand signal that we have to be prepared to respond to. We're pleased with where that sits right now with room to grow.

Great. Thank you very much.

Yes.

Thanks. Good morning.

Good morning.

Good morning, David.

I want to ask you how your recent acquisitions, 1901, Gibbs & Cox are doing? The acquired revenue in the quarter was a little lighter than what I was expecting based on what you had indicated Gibbs & Cox would contribute this year.

It's still early for both of those acquisitions. Looking at a strategic perspective, 1901 has really energized our digital transformation efforts. The talent from 1901 has helped us mitigate risks in our engine ramping and staffing. They have an as-a-service platform and a culture that draws in talent. We managed to establish our call center in just a month with the help of the 1901 team. This has enabled us to enhance our customer service for NGEN. Regarding top-line growth, there’s significant work with 1901 that contributes through other units. Revenue from sales facilitated by them in our Civil Group will appear in that group, while acquisition revenue from 1901 is reported separately. Concerning Gibbs & Cox, on a standalone basis, it's worth noting that we've integrated our heritage Leidos Innovation Center Maritime group with Gibbs & Cox, which may not be reflected clearly in our revenue accounting. The synergies between our maritime heritage business and Gibbs & Cox are not visible in our GAAP financials. However, the naval architecture work and relationships at NAVC and within the Navy are complementing our autonomy efforts and underwater projects successfully. Gibbs & Cox is continuing to grow and expand their team, which is exciting. They provide a level of systems engineering and platform expertise that we have sought for a long time. We are leveraging that expertise and culture throughout the entire organization.

What we love about the Gibbs & Cox team is they are so close to the customer, so important to the customer's mission. They are going to support that mission even in advance of a contract award. For example, just as they become part of a bigger corporation making sure that we're getting out with the right contractual arrangements so we can recognize revenue on some of the work they are doing, they are in a good position to continue growing and delivering. As Roger mentioned, the 1901 group is contributing a lot internally on other programs which are adding value and will ultimately be accretive to our performance. That doesn't show up in the external report that you see.

Okay. That helps. And then, Chris, wanted to ask on working capital. It looks like to get down closer to the 875, or a little above that, you're banking in, I would guess, something like a couple hundred million working capital headwind in the fourth-quarter. So can you talk about that and then in terms of your long-range forecast? I know we have the $3.5 billion in operating cash flow that you forecast, but what specifically do you have baked in there in terms of working capital? Do you expect working capital to be a net drag over that period? Thank you.

Sure, David. Let me first address the fourth quarter and we signaled a couple of main things that are going to go on in the fourth quarter. We talked about advanced payments, and so one of our large programs customer funds us in advance at the end of their fiscal year - we get that money in our third quarter. There are some material, subcontractors, and other payments that will go out in the fourth quarter, right? So, we get paid; we pay some of them, so that will be an outflow that's already planned and programmed. Then we talked a lot about NGEN and that’s a new customer with new buying behavior for us. One of the things that we’ll be in a position to do in the fourth quarter is procure a number of software licenses that they use and execute on. Some of those arrangements are pay-in-advance to the software license providers. The way the Navy funds those is kind of an overtime model. So there’s some of that built in our expectation of working capital usage. Big picture over time, I would tell you this. I like the way the team is managing, working capital today. I think we're having an excellent year. We're programming improvements where we can make them. We're thoughtful about particular business areas that might need a little bit of investment, but that's modest. Our DSO this quarter at 60 days is something that I see as being able to be sustained, perhaps improved in certain spots. Right now, the way we're going to manage inventory, there’s an ability to continue to tighten that down and drive improvements into that. So I don’t see a big change in our working capital usage to execute our growth plan over the next three years.

Alright. Great. Thanks very much.

Thank you.

Thank you. Good morning, everyone.

Good morning.

Good morning, Mariana.

So supply chain, you gave us color on what's going on, but could you please discuss the actions you are taking to mitigate the headwinds and how much of these headwinds could actually slip into next year?

We're taking the same approach as everyone else. Our purchasing team is actively in discussions with our supplier partners. We're aiming to place orders in advance of our needs and are open to owning and holding stock if possible. We're working to substitute available inventory for what we don’t have on hand. We are also communicating with our customers to understand their preferences—whether they'd like to wait for a specific laptop or receive another one sooner. Many customers are opting to wait an additional month for what they want. We have strong visibility into our supply chain; our major suppliers are integrated with our system, so we know the supply status and arrival times. We don’t want to overcommit before the equipment arrives. Like many in the industry, we view this as a temporary delay rather than a long-term issue, expecting improvements early next year. Our situation differs from industries like automotive, as we have long-standing relationships with our suppliers and purchase in significant volumes, which gives us a favorable position. When it comes to servers or routers, we are prioritizing our orders. Ultimately, there are limitations to what we can do, which is why we discussed this earlier. If the necessary chips aren't available, they can't be assembled into the equipment, and we cannot recognize revenue from that.

Yeah, that makes sense. And now if I may, switching gears to vaccine mandate. I know the White House is already hinting at some flexibility and you mentioned no significant impact, but it will be really helpful if you can give us some color on the workforce vaccination rates, what are the most exposed businesses, and what are your actions to prepare for early December?

We are nearing the conclusion of the call. I could elaborate on this for a while, but I'll summarize where we stand and our actions. Recently, we held a sweepstakes, referred to as The Carrot, to motivate employees to get vaccinated, awarding ten individuals a year's salary. This initiative was very successful, and we believe it encouraged many employees to get vaccinated. Currently, anyone entering our facilities is required to be vaccinated or present a negative COVID test taken within the last 72 hours. This applies across all our locations. For customer facilities, we must adhere to their specific rules, which can differ by customer, state, and county. There is an Executive Order in effect requiring vaccinations by December 8th, and we are actively collaborating with our customers to address this requirement for each contract. The order does allow for exceptions based on health or religious reasons, and we are processing these requests through a careful evaluation process. Regarding our vaccination rates, we estimate they are in the mid-90s. Although we cannot confirm this precisely until the verification requirement begins on December 8th, the data from those who have uploaded their vaccination cards suggests we are in that range. We are aware a small percentage of employees may not seek exemptions or vaccinations. We estimate this group could be in the single-digit percentage range, which is concerning since it could potentially affect our revenue. If the mandate remains in place as currently stated, an unvaccinated employee would face disciplinary measures similar to other policy violations, but it is unlikely we would separate employees early. However, layoffs could be a possibility if vaccination compliance becomes mandatory, which we want to avoid. We are engaging with legislators and the White House to effectively implement the executive order, but the situation is dynamic. Legal challenges have emerged, and some states are resisting compliance with federal law. We aim to protect our employees and maintain a conducive working environment, attentive to the rules and the executive order. Our workforce is vital, and we are committed to preserving jobs. One advantage we have is our diverse portfolio; parts of our business are not under the Executive Order. We work with numerous commercial customers, allowing us, when feasible, to reassign unvaccinated employees to different roles and retain their positions within the company. While this may not apply to everyone, our diverse operations permit flexibility. With many employees working from home, we have the ability to transition personnel between projects. We do have a system for this and encourage unvaccinated employees to consider available positions in our Commercial segment. I could discuss this further, but I appreciate your question.

No, I appreciate the details. Thank you.

And Rob, I think we have time for one more question.

Thank you. I was hoping that you could give us some perspective on what an increase in wage inflation over the next year or two could mean to your different businesses, whether that would crowd out some new contract starts because existing programs may need to be kind of plussed up to keep the staffs and accomplish their mission? Thanks.

Let me give you a quick overview, and then Chris can talk about the numbers. We have yet to see the wage inflation, but we are being thoughtful about that with the hiring that we're doing, especially in some geographical areas and some skill sets. The fight for talent is something that we are being very thoughtful about. Tobey, you know we have forward pricing rates. There’s escalation assumed in the forward pricing rates. If we hire ahead or above that, then on our cost-type contracts, that makes us a little less competitive while we flow through the customer on our fixed-price contracts, it lowers our fee. The numbers, as we look at '22 and '23, are really small because we procure about half of what we sell and our labor content theory is a percentage of that, and then you have to start seeing where we are on our labor category by labor category. It’s a risk item for everyone in the industry, but it is not yet a significant risk for us. It’s literally, I mean, and Chris can probably give you some colors in the single or double-digit millions. It’s something we’re being thoughtful about, which is why in our labor strategy, you’ve heard us talk about building centers of excellence in areas that are outside some of the large geographical metropolitan areas like The 1901 Group gave us a large footprint in Blacksburg, which we love. Blacksburg is a fantastic place, a great place to work. The people who work there love it; they’re big Virginia Tech fans and they're in a very different economic environment than trying to hire someone in Reston, Virginia. Our strategy for the past few years has been to be in places like Morgantown, West Virginia, and Blacksburg. Even St. Louis, especially with the movement of the second headquarters of NGA, has become a pretty exciting place for us to hire people and to grow.

Tobey, it's certainly something, as Roger said, we're being very thoughtful about. We've been thinking about it for some time. In fact, just had some discussion on this as the leadership team yesterday as part of our planning process. I went through the analysis, and I would tell you that the budget we’re establishing for our merit increases for next year will be higher than what it’s been the last several years. We’re very cognizant of the fact that that's reality but it's affordable to do so. As we’ve talked about margin levers longer term, we understand that this is an area where we're going to be making a little bit more investment. There are other areas we’re going to emphasize. I don't see that something that puts a big headwind on us; we know how to do this, we know how to attract talent, retain talent, and I think ultimately doing the right thing on the front end with paying our people can offset costs elsewhere, such as retention or other things that you have to put in place. So again — big picture, I don’t think it's a material driver for near-term margin impacts and it’s something we're certainly planning for.

Tobey, I would just add — and I know you've thought through this — the rehire cost, the recruiting cost far exceeds the risk of wage inflation. Paying at market or slightly better is always been our philosophy, and we want to keep up with the market. We will pay more to lose an employee and then go have to recruit a replacement than a small percentage in wage increase. Our focus has always been about making this a great place to work; attracting people and having them build their career here and stay with us over the long term.

Thanks, Tobey.

Thank you.

Rob, I want to thank you for your assistance on this morning's call, and thank you to all the listeners and questioners for your time this morning and your interest in Leidos. Have a great day.