L3Harris Technologies Inc (LHX) — Q3 2019 Earnings Call Transcript

Thank you, Michelle. Good morning, everyone, and welcome to our third quarter fiscal 2019 earnings call. On the call with me today is Bill Brown, Chairman and Chief Executive Officer; and Rahul Ghai, Senior Vice President and Chief Financial Officer. First, a few words on forward-looking statements. Discussions today will include forward-looking statements and non-GAAP financial measures. These statements involve assumptions, risks and uncertainties that could cause actual results to differ materially from those statements. For more information, please see the press release, the presentation and Harris SEC filings. A reconciliation of non-GAAP financial measures to comparable GAAP measures is included in the quarterly materials on the Investor Relations section of our website, which is www.harris.com, where a replay of this call also will be available. With that, Bill, I will turn it over to you.

Thank you, Anurag, and good morning, everyone. Earlier today, we reported strong third quarter results, with non-GAAP earnings per share increasing by 30% to $2.11, alongside revenue growth of 11%, marking the highest top line growth we've experienced in 8 years. Overall, our company margin expanded by 80 basis points to 19.7%, and free cash flow improved by over $250 million compared to the same quarter last year. These results reflect our exceptional performance year-to-date, with non-GAAP earnings per share for the first three quarters up 26% on 10% revenue growth, and free cash flow rising by 75% to $788 million. The highlight this quarter was our accelerating top line growth, showing a double-digit increase after three quarters of high single-digit increases, with robust growth across all three segments and solid operating performance. We maintained strong momentum, achieving a book to bill ratio of 1.03 for the quarter and 1.1 for the first three quarters, with total company-funded backlog up 15% compared to last year. These results illustrate our team's unwavering focus on daily execution during the merger integration phase, and I want to commend their efforts. With approval from both L3 and Harris shareholders and Harris finalizing an agreement to divest our Night Vision business, we are on track to close the merger in mid-calendar 2019. I'll begin by detailing our quarterly performance before concluding with insights on the merger. Communications Systems revenue increased by double digits for the fourth consecutive quarter, up 19%, fueled by strong growth in DoD Tactical Communications and Public Safety. DoD Tactical reported another impressive quarter, with revenue up 55% from over $100 million in modernization revenue from the Army, Marine Corps, and SOCOM. This surge in modernization, coupled with strong demand for readiness in the first quarter, has driven year-to-date DoD Tactical revenue growth of 28%. With complete revenue and backlog for Q4, we now anticipate DoD revenue growth in the mid-20% range, surpassing our prior expectation of low-20% growth starting the year. International Tactical revenue remained flat this quarter as the ramp-up of the Australian modernization program, early adoption of multichannel products in Canada, and ongoing counterterrorism support in the Middle East were balanced out by a challenging comparison in Eastern Europe. With International Tactical revenue up 4% for the first three quarters and 70% of Q4 revenue in backlog, along with rising demand for multichannel products, we are optimistic that international growth will reach low to mid-single digits in fiscal '19. Our tactical radio strategy is progressing well, as we continue to win all DoD ground radio modernization programs, capitalize on platform investments to maintain our international leadership, and expand into network systems and airborne markets. In terms of DoD ground radios, we are at the beginning of the Army modernization ramp. With SOCOM and the Marine Corps closely following, we anticipate significant growth over the coming years, supported by the recent budget request from the President. In FY '20, the total tactical radio budget across the services exceeded $1 billion, with the Army requesting $504 million, roughly two-thirds more than in FY '19. We're expecting another LRIP on both the HMS manpack and the 2-channel radio this summer, indicating the Army's commitment to transitioning from low-rate to full-rate production following the Operational Test in 2020. For the SOCOM 2-channel handheld program, we completed the operational user acceptance test and received a $39 million production order this quarter as we move toward full-rate production. Additionally, we received an initial order from the Marine Corps for HF and multichannel manpack radios, cementing our leading position as they embark on their modernization efforts. All of these programs are well-supported by the tactical budget request, which is growing by over $1 billion to $7.3 billion over the next five years. The successful launch of our multichannel products and recent wins with the U.S. DoD have led to quicker international adoption than anticipated. During the quarter, we received an order from the Canadian Armed Forces as part of their multiyear modernization program and were chosen by the special forces of two NATO countries to supply 2-channel radios, ensuring standardization on Harris for NATO and U.S. coalition interoperability. We also have a strong pipeline of opportunities across Europe, Asia Pacific, and the Middle East, aiming to refresh their large base of approximately 350,000 Harris radios with next-generation products. For the third focus of our strategy, expanding into broader network systems, we achieved a win in New Zealand, taking advantage of our established position to modernize and upgrade their command and control network. This victory builds on previous successes in Australia, the UAE, and other regions as we widen our reach and provide comprehensive mission solutions. In March, we also received our first international order for airborne radios for the Apache platform from a Middle East customer, creating new market opportunities. This strategic win will enable us to expand into other air platforms in the region and increase our revenue share with international clients as we transition from ground to airborne radios. In total, for the first three quarters, Tactical revenue grew by 14%, and with a book to bill of 1.1, we achieved a 21% increase in backlog year-over-year, surpassing $1 billion. With continued strong growth in DoD Tactical and another quarter of double-digit growth in Public Safety, we are raising our revenue guidance for Communications Systems to approximately 12%, up from the previous guidance of 10% to 11%. In Electronic Systems, revenue rose by 7% due to sustained strong growth in avionics and electronic warfare, where we are executing well on long-term platforms including the F-35, F/A-18, and F-16. Order momentum has remained robust, with Electronic Systems recording its seventh consecutive quarter of a book to bill ratio exceeding 1. In electronic warfare, we secured a $212 million contract to enhance electronic countermeasure capabilities for U.S. Navy and Kuwaiti F/A-18s, marking our largest order to date on the F/A-18 platform and reaffirming our long-standing relationship. In avionics, we won a $129 million contract for the development phase of the open systems integrated core processor on the F-35. This strategic success, along with previous awards for the Aircraft Memory System and the Panoramic Cockpit Display, positions us as a crucial part of the Tech Refresh #3 program and primes us for future opportunities on the F-35 platform. We've also leveraged our open-architecture technology and have been selected to supply a processor for the newly redesigned trainer in the MQ-25 platforms. These wins position us ahead in open systems design, establishing a strong base as more platforms adopt nonproprietary solutions. In the C4I sector in the UAE, after successfully completing the initial operational capability phase of the ELTS program, we secured a contract to provide technical support and training to the Armed Forces. This is a significant milestone in the $1 billion-plus opportunity, which encompasses full operational capability across five army brigades, tactical radios, and networking systems for various military services. Year-to-date, Electronic Systems revenue increased by 7% with a book to bill ratio of 1.2. Given our strong backlog and progress in reducing cycle times within our factory and supply chain to enhance delivery capabilities, we're increasing our revenue guidance for Electronic Systems to approximately 8.5%, compared to the earlier guidance of 7% to 8%. Lastly, in Space and Intelligence Systems, revenue was up 7%, driven by mid-teens growth in our classified business from the expansion of small satellite exquisite systems and next-generation technologies that offset challenges in environmental programs. Order strength was widespread across classified, environmental, and other civil programs, leading to a segment book to bill ratio greater than 1. In classified, we secured over $400 million in orders, showing double-digit growth as we leverage our investment in innovation and strong customer relationships to solidify our incumbency and expand our share of business. In the civil sector, we reinforced our position as a trusted partner on established environmental programs and GPS. We also secured a $293 million contract extension for NOAA's GOES-R ground system program, raising the total contract value to $1.7 billion. This resulted in a book to bill ratio of 1.4 for environmental programs in the first three quarters and affirms our expectation for the environmental business to return to growth next year. For the GPS project, our investment in a 100% digital mission data unit has reinforced our standing as the partner of choice for over 40 years, leading to a $243 million award for the first two out of 22 space vehicles under the sole-sourced GPS III follow-on contract. Overall, Space and Intelligence Systems have seen strong year-to-date performance with revenue growth of 7%, and with nearly all of Q4 revenue in backlog and high confidence in follow-on opportunities, we now project revenue growth for the segment to be around 7%, at the higher end of our previous guidance range of 6% to 7%. Considering our strong year-to-date performance, improving business outlook, and growing backlog, we are once again raising our guidance across all metrics. Company revenue is now expected to rise by approximately 9%, compared to previous guidance of 8% to 8.5%, with earnings per share projected at $8.15 and free cash flow around $1.025 billion. Now, I will turn it over to Rahul to provide a more detailed overview of our financial results before I finish with a few comments regarding the merger. Rahul?

Thank you, Bill. Good morning, everyone. Discussions today are on a non-GAAP basis, excluding out the deal and integration costs and one-time adjustments in the prior year. Turning now to the total company results on Slide 5. Revenue was up 11% in the third quarter and earnings before interest and taxes increased 15% on higher volume and operational efficiencies, resulting in margin expansion of 80 basis points to 19.7%. EPS grew double digits for the sixth consecutive quarter to $2.11, and free cash flow increased 3x to $379 million as we reduced 12 days of working capital driven by structural improvements, resulting in a more linear cash flow through the year. We also repaid $300 million of debt in the quarter, completing the last tranche of planned debt repayment, enabling us to return future cash flow to shareholders through dividends and share repurchases. Year-to-date revenue was up 10% and earnings before interest and taxes increased 15% with margin expansion of 90 basis points to 19.6%. Free cash flow was robust in the first 3 quarters at $788 million, a 75% increase over the prior year and was approximately $1.25 billion over the last 12 months. Turning to the third quarter EPS bridge on Slide 6. Year-over-year, EPS grew by 13% or $0.49. Of this, $0.30 of growth came from higher volume and solid program execution, which was partially offset by product and program mix. A lower tax rate, including benefit from tax reform, contributed $0.19. Segment details on Slide 7. Communication Systems third quarter revenue was $568 million, up 19% versus the prior year. In addition to strong growth in Tactical, revenue was up double digits in Public Safety as the business continued to gain traction with federal and state agencies. Operating income for the segment was up 19% with strong margin at 30.3% from volume and operational efficiencies, partially offset by product and program mix. Year-to-date, segment revenue was up 15% with strong growth across all 3 businesses, and operating income increased 17%. Operating margin was up 80 basis points to 30.1% and year-to-date book to bill was 1.1. Historical information for Tactical orders, revenue and backlog is included as supplemental information at the end of this presentation. Electronic Systems on Slide 8. Revenue was up 7% driven by growth in avionics and electronic warfare partially offset by transition on the ELTS program from initial to full operational capability. Segment operating income increased 14% to $123 million, and margin expanded 120 basis points to 19% from increased volume and strong operational performance. In addition to strength on long-term platforms, F-35, F-18 and F-16, double-digit growth in weapons release systems led to year-to-date segment revenue growth of 7% and operating income increased 13%. Operating margin was up 90 basis points to 19.1% and year-to-date book to bill was 1.2. In Space and Intelligence Systems on Slide 9, third quarter revenue was $514 million, up 7%, and operating income grew 5% to $87 million from higher volume and strong program execution partially offset by higher investments in R&D and selling expenses. Year-to-date segment revenue increased 7% with continued growth in classified programs partially offset by a decline in environmental revenue. Operating income increased 6%, and operating margins remained strong at 17.5%. Year-to-date book to bill was 1.1. Moving to Slides 10 and 11 for full year guidance. As Bill mentioned, given a strong year-to-date performance, we now expect revenue to be up approximately 9% versus the prior guidance of up 8% to 8.5%, reflecting strength in all 3 segments. We're increasing EPS guidance to approximately $8.15 or by $0.20 from the midpoint of prior guidance of $7.90 to $8. Higher volume is expected to contribute $0.11 of this increase, with lower tax rate contributing the remaining $0.09. EPS now is expected to be up approximately 28% for the year, with about 60% of the growth coming from operations and a balanced 40% from lower share count and the benefit of a lower tax rate. We're also increasing free cash flow guidance to approximately $1.025 billion versus the prior guidance range of $1 billion to $1.025 billion driven by higher earnings. In fiscal '17 and '18, over 50% of free cash was generated in the fourth quarter. And as I mentioned earlier, we have made structural working capital improvements to smoothen cash generation through the year, resulting in about 25% of the expected fiscal '19 free cash guidance to be generated in the fourth quarter. We expect to end fiscal '19 with working capital of 43 days, a 2-day improvement over fiscal '18 and a 35-day improvement since the Exelis acquisition. Tax rate guidance is now approximately 15.5% versus approximately 16.5% previously, but half of the one-point reduction was due to lower international tax primarily from increased FDII benefits and the other half from additional tax planning. Switching to segment outlook. In Communication Systems, we now expect revenue to be up approximately 12% versus up 10% to 11% previously driven by strength in DoD Tactical and Public Safety. In Electronic Systems, we now expect revenue to be up approximately 8.5% versus up 7% to 8% previously driven by strong growth on long-term platforms. In Space, Intelligence, we now expect revenue to be up approximately 7%, at the high end of the previous guidance range of up 6% to 7% from continued momentum in the classified business. Margins for all 3 segments are expected to be at the midpoint of the previous guidance ranges, approximately 30% in Communication Systems, 19% in Electronic Systems and 17.5% in Space and Intelligence. And with that, I would like to turn it back to Bill for his closing remarks.

Okay. Well, thanks, Rahul. We're now in the homestretch of fiscal '19 and performing very well and better than our S-4 projections across all metrics: revenue, margin and cash flow, and we're on track for a record year. The President's budget request for GFY '20 and beyond is a real positive for Harris and the programs that we support, especially in strategic growth areas where we invested in R&D over the past several years and have strong customer positions. In addition to tactical radio budgets, long-term platforms like the F/A-18, the F-35 are well supported and classified space and other IC budgets continue to trend up. And with outlays continuing to lag budget appropriations by more than $100 billion in investment accounts, we expect growth momentum to continue in the medium term. Alongside our strong operating performance and execution, integration planning is progressing well. The team over the last 6 months has made significant progress in outlining an operational roadmap for the combined company to ensure a seamless transition on day one. They're also developing detailed capture plans to achieve the $500 million of cost synergies and, though still early, have identified more than 100 ideas on potential revenue synergies. Chris and I remain very closely connected with the integration team through our weekly meetings, and we're very pleased with the progress they have made to date. I'm also pleased with the outcome of the divestiture of Night Vision, which we proactively initiated to address potential regulatory concerns. You'll recall this business was operating at breakeven with declining revenue when we acquired it with Exelis. And through aggressive actions, we transformed it into a mid-teens margins business, growing at double digits, resulting in a $350 million sale price, well above the implied value when we bought Exelis. This same relentless focus on operational excellence is clearly demonstrated in a track record of margin expansion at Harris, and we expect to leverage and build on this OpEx muscle in a new L3 Harris to capture integration savings, improve underperforming businesses and drive long-term productivity gains. Overall, I'm increasingly encouraged and confident that this transformative combination will create substantial long-term value for employees, our customers and our shareholders. And with that, I'd like to ask the operator to open the line for questions.

Good results, guys. First question, I guess more broadly speaking, revenue guidance moved up but margin guidance was maintained. When we think about programs driving upside across the business, how does this convert to profit growth or operating leverage for standalone Harris?

So as we look at margin expansion driven by the revenue growth, clearly, we've said that before, that this year in Communication Systems is a transition year for us as we ramp three new products: the Army handheld, the SOCOM handheld and the Army manpack. So as we work up the production ramp and take out costs, which we've got a great track record previously, we took out 47% of costs, for example, in the 117G post introduction, we're confident that Communication Systems margins will continue to trend up. Same thing in Electronic Systems. We've done well taking out costs this year. We guided to 18.5% at the beginning of the year. We increased it to 19%. We had a plus sign in the guidance range. 80% of this business is fixed price. We will continue to drive margins in Electronic Systems as well, but the volume is a headwind especially as the growth is coming from long-term platforms. So I think Communications Systems and Electronic Systems should drive margin expansion in the future years.

If I may add, Sheila, we indicated earlier this year that we would see a slight margin expansion in fiscal '19, not due to segment margin improvement but mainly because of a shift towards higher-margin businesses, specifically Communications Systems and Electronic Systems, which are expected to grow at a faster pace. This year, we have experienced even more of that, along with some margin growth in Electronic Systems. As we approach the end of the year, we anticipate reaching a 20% margin in the fourth quarter and expect further margin expansion as we move into fiscal '20 and beyond.

And then just on Communication Systems, strong support for the Tactical business in the budget. How do we think about market share going forward, given upcoming orders for Army manpack and handheld on a best value basis and further implications for the overall tactical market?

Well, look, we're very pleased with the trajectory of the budgets. They continue to increase, and I'm very pleased to see the Army HMS budget going over $500 million in '20 from about $300 million this past year, $7.3 billion over the next 5 years, which is stronger than we had expected that the President would suggest it even about a year ago. Our market share has remained very, very robust. We're on all the contract vehicles. We continue to compete well. We're going to continue to win and gain share through the investments we make to continue to advance our radios, take costs out, add functionality, improve waveforms in the radios. And that's how we expect to win and continue to have a large share of market in DoD and perhaps gain some share over time. So the outlook is very, very strong in DoD radio, Sheila.

Bill, just a quick question on the merger situation here. When do you expect to announce the next layer of management for the combined company?

Rob, we will be fully prepared to announce the management structure several levels down, along with our Board, as we approach the closing, likely towards the end of June.

Okay. And then as a follow-up, again on the merger situation. You highlighted the very strong cash flow performance on the working capital days that you see. Do you see this achievement being applicable to the combined company? And what sort of scale are we now looking at there?

Yes, we've made significant progress since acquiring Exelis. We've reduced working capital days by 35, ending the year at 43, which is a very positive trend. On a combined basis, looking at the end of March with recent data, we're at 70 days. This presents a great opportunity for both companies. We're projecting a reduction of 6 to 7 days over the next few years, which equates to $35 million a day, but we believe there is potential for even more improvement. Chris and his team are diligently working on this and making good strides. We are focusing on the specifics of where the working capital is, and implementing plans accordingly. Overall, I feel more confident now than I did a few months ago about the improvements we can achieve in working capital.

Bill, could you comment on the recent book-to-bill ratio? It appears that the latest figures are lower than those from previous quarters, although budget activity has remained strong. Can you provide some insight into the opportunities in the pipeline that relate to the recent bookings and whether there's been any significant change compared to the past 18 months, which has seen robust performance?

Yes, that's a great question, Carter. There is no fundamental or material difference. Year-to-date, our book to bill ratio is very strong at 1.1, with five consecutive quarters above 1. As we mentioned, our backlog is up 15% year-over-year, with over a 20% increase in the Tactical business and a 25% rise over the last couple of years. The backlog is quite strong, and we expect the book to bill ratio for the year to exceed 1, which is encouraging. The pipeline for Harris as a whole is at $32 billion across the three segments, demonstrating resilience. Budget allocations are well-positioned to support future growth. We have raised our guidance three times this year, with $420 million above the S-4 revenues. All indications suggest that we will continue to see good growth opportunities moving forward.

And Carter, if I may add, the 1.03 book to bill that Bill mentioned in his prepared remarks, that's the funded book to bill. If you include the unfunded portion of the awards we received in the quarter, we are at 1.3 book to bill for the quarter. And given the only other data point I would throw out there is that the backlog is up 15% year-over-year, as Bill mentioned, and 12% since we started the fiscal year, so good growth in backlog.

That's great. And then just as a quick follow-up. Bill, you mentioned it quickly, but the thought process around revenue synergies. I just wonder as you get another quarter under your belt and we get close to closure, just if you could share your thoughts on the intersection of the Harris' capabilities and L3's capabilities and how that's evolving and what we should expect to see here, places you're excited about. Any color there would be helpful.

That's a very good question. Every day, as Chris and I engage with our teams during their discussions and brainstorming sessions, both in open and classified areas, we become increasingly optimistic about the opportunities before us. However, it's still too early to measure or quantify these prospects or estimate the time it will take to realize them. Some will necessitate R&D investment. From our experience with Exelis, it took a few years before we began to see significant revenue synergies. Currently, we are observing positive developments in several areas. We have established a strong position in small satellites, leveraging the expertise of both L3 and Harris in optical and RF payloads, SATCOM, mission knowledge, and L3's robust data link capabilities. By combining our strengths, we expect to create a more comprehensive and competitive offering in the small satellite market, which is very encouraging. We have previously discussed data links, where L3 excels in airborne systems while we lead in ground systems, which will be interesting to explore further. Additionally, L3 has a strong multifunction phased array capability, and we possess advanced open-system architecture in electronic warfare processing, along with solid capabilities in phased arrays. The combination of L3's multifunctional approach and our open architecture is potentially transformative. This applies not only to existing platforms but also to new and evolving ones. Furthermore, our small Size, Weight, and Power (SWaP) electronic warfare product has started to gain traction after being in the market for a couple of years, with numerous opportunities to integrate it into the unmanned systems from L3 and their system integrators. We have more than 100 different ideas in this area, and these are just a few that come to mind. The energy and excitement surrounding these discussions are tangible, and we are very optimistic about our prospects.

A couple of questions. First, Bill, I was hoping you could expand upon the airborne radio opportunity and maybe just more broadly speak about the foreign and domestic Tactical pipelines and how they may have changed with the airborne kind of opportunity now more clear.

The pipeline is very strong and resilient for the Department of Defense, remaining around $2.6 billion, which aligns with our results from the previous quarters. It has been stable. For the Department of Defense, about $1.6 billion is now shifting more towards modernization, resulting in an almost even split between base and modernization, reflecting a year-over-year increase of about 13%. The strong orders we've seen over the past year in Tactical and the resilience of the pipeline for that business are quite encouraging and a testament to our team's efforts. Regarding the airborne radio sector, I feel very optimistic. Our investments over the past three years, particularly with Exelis, have positioned us well in airborne platforms, despite their older product offerings. We are introducing new products, including two-channel options for ground use, which can also be adapted for airborne applications. Our partnership with ViaSat on the Small Tactical Terminal has yielded impressive growth this year in airborne radios. I see this as very encouraging. Moreover, securing our first opportunity with a Middle Eastern country involving a small number of Apaches—despite their large fleet—is a significant win for us. While it may not be substantial in terms of dollars right now, the potential for growth is considerable, and I believe it will expand over time. Although I cannot provide specific figures today, I anticipate continuous growth as we move beyond our traditional ground business, which we have been developing over the past several years.

Could you discuss how you have collaborated with L3 prior to the merger closing? Specifically, what operational assistance have you provided to L3, especially considering the traveling wave tube issue they faced a few quarters ago, which hasn’t recurred in the recent results? How have you been working together operationally to ensure a smooth transition once the merger is finalized?

Thank you for the question. Our integration teams are focused on realizing integration value by combining our spending and optimizing it. We have conducted several should-cost analyses and have a solid understanding of our purchasing, including suppliers and prices. The clean team is generating valuable ideas and negotiating packages so that we can execute from day one after the close. We see opportunities in indirect areas and facility consolidations. Our operational leadership teams are visiting various sites to identify these opportunities. Chris is deeply involved in addressing the traveling wave tube business and will provide updates later. He has allocated significant resources and attention to this area, and we are seeing some positive metrics. We're ready to provide guidance and support as needed, and Chris is effectively managing this situation, which should lead to stability and improvement. As a combined company, I believe the operational strength we bring, honed at Harris over the years, will allow the L3-Harris business to perform well, similar to what we have achieved at Harris in recent years. I'm very optimistic about this.

So I have a question, Bill, for you on growth that speaks a little bit to what we've already talked about, and then I have one for Rahul on cash. But Bill, you're now targeting 9% growth for this year. L3 is at 6%. You both had among the best numbers growth-wise this quarter, and you talked about the budgets supporting further growth in the medium term. But would you say that the new L3-Harris can be the sector top line growth later well into the future? Or is this a peak-ish kind of year, just given those strong budgets over the past couple of years?

I don't believe that fiscal '19 is going to be a peak year. It's a bit early to assess the growth potential of the combined companies. L3 has had exceptional results this quarter and raised their guidance for the year, just like we did. Together, we are exceeding our expectations by about $274 million to $275 million based on the S-4, and even more if we consider their new guidance for this year. Both companies are doing better than anticipated independently. The outlook for our budget is also more favorable than we expected. We are optimistic about our potential for revenue synergies. We will be more competitive as an enterprise, reduce costs, bid aggressively, pursue new business, and expand as a comprehensive solution provider. Overall, I'm feeling more positive about our growth trajectory beyond fiscal '19. I wouldn't consider it a peak year, but I do believe we will perform quite well as a merged entity once we finalize the deal and move forward. It feels promising.

Okay. And then on cash, Rahul, the two of you, the two companies have about $1.4 billion pro forma on the balance sheet, cash, and so you've targeted $2 billion for share repurchases in the first 12 months post-close. But given what's on hand and what you're going to generate in the meantime, it seems that you'll end that first year with a lot of excess cash. So I know you're limited in your ability to buy back even more stock in year 1. So should we think about this cash build as giving you more firepower for repurchases in year 2? Or might you do something else with that cash?

No, absolutely, Rob. We've mentioned this before. After closing, our focus has been to finalize the debt repayment. With the sale of our Night Vision business, as it closes, we plan to prefund the combined L3-Harris pension. This means the Harris standalone pension is prefunded until 2025, while the L3 pension should be funded until about 2022 based on our modeling. Therefore, the pension should be adequately funded with no immediate funding needs. As we have stated, M&A will only occur if absolutely necessary. All excess cash should return to shareholders, either through dividends or share buybacks. We anticipate dividends to be in the range of 30% to 35% of our free cash flow, which allows for significant share repurchase capacity. We also plan to maintain about $500 million on our balance sheet. So, the excess cash will be returned to shareholders.

And I would just add, I think you know our debt ratios quite well. So we don't have any debt payments in the near term either or the medium term, Rahul.

Generally, I'd like to ask you for defense. We're seeing a lot of programs transition from development to production, and I wanted to ask you about the DoD classified and unclassified contracting environment that you're seeing versus what you may have been expecting. For example, as programs transition to production, are you seeing a more favorable contracting environment? And if possible in your answer, could you comment directionally on how contracting may impact your margins going forward?

It's a broad question. Generally, we're noticing that opportunities are being put on contract a bit quicker than they were a year or two ago. The method of contracting hasn't changed significantly regarding the mix, cost-plus fixed price, and encouraging industry investment in IRAD. There's ongoing discussion about contract financing, which remains to be addressed. There was an attempt to change the financing structure last September, and that's still under consideration. However, I don't see any substantial changes that would affect the margin structure for classified or unclassified contracts going forward. Our margins in the classified sector are typically cost-plus and generally maintain cost-plus margins, which I expect to continue. Rahul, do you have any additional thoughts?

No. I think you're right. And I think even with everything else that's going on, I think we're growing margins this year. All segment margins are expanding in all 3 segments and, in response to Sheila's question, to kind of provide a little bit of forward-looking statements on our expected margins going forward.

Okay. Just a quick follow-up here, just on the classified backlog growth. I thought I'd ask if you could comment on how quickly you see classified revenues growing relative to unclassified part of the business. And on that part of the business, are you finding margins for classified wins at/or above standard margins? And do you think that the trends that you're seeing in the classified programs are going to impact you positively in '20?

The classified business has performed exceptionally well for us over the past few years. Our bookings remain strong, with a mid-teens growth rate, a book-to-bill ratio exceeding 1, and revenue increasing in the double-digit mid-teens range consistently. This success spans various areas, including exquisite systems, small satellites, and ground adjacencies, though we cannot disclose too many specifics. Our growth reflects years of investment in technology, transitioning from providing components to subsystems, and now to comprehensive mission solutions, which has been a multi-year journey. We're observing an increase in our growth, market position, and share as budgets evolve, which drives our positive growth. Regarding margins, while a portion of our business is fixed price, much of it is tied to advancing technology and will likely rely on cost-plus contracts, resulting in slightly compressed margins. However, I believe our Space business, where a significant portion of the classified work occurs, can maintain its margins as we continue to enhance productivity, reduce costs, and adapt to the evolving business mix. I'm not overly worried about margins; this is a robust business. Additionally, technology developed in the classified sector often benefits our unclassified operations in the long run, making it a strong area for us.

Bill, I think it sounded like you're kind of confident on the turn in the environmental headwinds Space, Intel. So I'm just curious, can you size kind of what you had to absorb this year in your fiscal '19 that you grew 7% in spite of that and then just confirm that you don't see that as a headwind year-on-year into '20 and maybe what that outlook is from there?

This year, our environmental business is around $270 million, slightly less than $300 million, and it's down in the mid-teens. We believe we've hit the bottom this year. The book-to-bill ratio, as I noted earlier, is about 1.4, which is a good sign. Our backlog is up, and we expect 2020 to at least match 2019 and possibly show some growth. We've faced budget pressures over the past couple of years, but we're seeing new orders from NOAA, particularly for GOES-R ground modernization. There are opportunities arising in both U.S. and international markets. We've launched five satellites and five instruments in the last year, and as we move through various phases of these launches, U.S. and international customers are looking at the development of next-generation instruments. We have sales in Japan, South Korea, and the U.S., and we see potential for growth in adjacent areas like RF spectrum management, DoD weather, and thermal detection. Overall, we're optimistic that 2020 won't be another downturn and that there should be opportunities beyond that, which gives us a clearer picture of that business's size.

So could Space and Intelligence be your fastest growing or at least the business that's accelerating the most into 2020?

I think it's too soon to say right now. We'll provide guidance in early August as we close the year. As you can see, it has been a challenge for us over the last couple of years and certainly into fiscal '19. However, we need to consider the entire portfolio, the outlook, the budgets, and how it will impact our business. I wouldn't say it will be the fastest growing segment, but it should experience healthy growth over the next several years. When we last offered medium-term guidance, we indicated it would be in the mid-single digits, and we'll revisit that in early August.

So I wanted to ask a little bit about the tactical radios. It looks like, probably on a DoD side, be up to somewhere in the $660 million or something like that range for this year. When you think about what the growth drivers are in terms of the key programs that we know that you're on, the key growth drivers in 2020 within DoD Tactical.

I believe that moving forward, the key growth drivers will be modernization, the Marine Corps ramp, and the Army ramp, particularly for handheld and manpack systems. SOCOM is also expected to continue growing. Your figures for fiscal '19 regarding the Department of Defense are in line with expectations. Looking back to '17, the budget has increased by about two-thirds during that time. The most encouraging aspect is that over the next two to three years, the budgets are projected to rise by another two-thirds, reaching around $1.5 billion to $1.6 billion. Even if we maintain our current market share, we anticipate significant business growth, potentially reaching nearly $1 billion in three years. Thus, we remain optimistic about the growth prospects in DoD Tactical.

Okay. In the Electronics Systems division, can you share your observations regarding any changes in the competitive environment? This sector includes many defense primes and others, with a significant amount of new work available. Some companies are experiencing rapid growth while others are slower, but everyone is aiming to expand. Can you detail any changes you have noticed in this competitive landscape?

Yes, things are changing, but these changes are not happening overnight; they are occurring over several years. We have invested in new technologies over the past several years, particularly in open-systems architecture, which has now matured. For example, we won the open-system mission processor for the F-35, which is a significant achievement because it's a long-term platform, and we feel confident about it. This victory was competitive. We're also applying our open systems technology to new platforms at Boeing, such as the T-X and MQ-25, as we move towards nonproprietary solutions. Next-generation platforms will definitely adopt open systems, and we have also utilized open systems for the F-18 a couple of years back. Additionally, we've invested significantly in electronic warfare over the past few years, transitioning to software-defined electronic warfare with enhanced capabilities. These investments are positioning us well for growth in long-term platforms, and we are advancing faster than others because we are gaining market share. Our teams are performing well and ensuring our success. As we merge with L3, the combined capabilities will open up new opportunities in areas we are not currently involved in. The competition is strong and the dynamics are changing, but I believe we are in a strong position.

This is Colin on for John. Can you just update your thoughts on the $3 billion free cash flow target, what you're seeing in existing budgets and combinations, international that could either buy us growth either upwards or downwards?

I think we're feeling as good today as we did before on $3 billion in 3 years. As Rahul mentioned, we're sort of over the last 12 months, over $2 billion of combined cash between us and L3. We see organic growth opportunities both internationally and domestically. We didn't really split those pieces, but we see organic growth driving cash generation. We see that the cash effect of cost synergies kicking in, another 6 or 7 days' worth of working capital, all of which gets us to that $3 billion range. And if anything, sitting here today, we're more confident about that than we would've been 6 months ago, just given the trajectory since the merger announcement on growth in the company, on working capital improvements, on the things that we're all talking about in terms of prefunding pension which eliminates cash flow contribution several years out. So if anything, we feel better today on achieving $3 billion three years out.

Got it. And then if you could just talk a little bit about modernization trends that you're seeing among NATO partners, in terms of both the NATO and U.S. interoperability. The social forces comment points to pretty constructive trend there. I just want to see in terms of the kind of larger forces what you're seeing.

That's a great question because we're observing positive trends. Typically, our international partners, starting with the 5 Eyes and expanding to others, are modernizing and upgrading their capabilities in line with the Department of Defense’s product upgrades. For instance, the 2-channel handheld device eventually makes its way into allied nations, beginning with special forces and later extending to regular services. We've noticed this trend over the first two quarters, particularly in the last quarter with Canada and some NATO countries in Europe, as well as in Australia. There's strong momentum for modernization. About 1.5 years ago, we secured a significant contract in Australia and are successfully executing that modernization. These developments seem to come in waves. I believe the U.S. DoD is at the forefront of a multiyear modernization increase, and we're now seeing similar patterns emerge in various countries globally. The U.K. is a bit further behind, likely 2 or 3 years out with the Morpheus program, which aims to upgrade the Bowman program; however, some Brexit concerns might have delayed that. Nonetheless, that remains a future opportunity. We anticipate competing strongly in these various projects due to the strength and maturity of our product offerings with the DoD.

Colin, the only thing I'd add there is that if you look at our radio business, our investment in Europe is up more than 50% this year primarily driven by the modernization and some of the allied nations buying our radio products.

A couple of quick questions. Bill, just to follow up on international radios. You gave a lot of great qualitative color. Any view directionally on how that business goes in fiscal '20? It's always kind of opaque for us, I think.

It's a bit early to predict what fiscal '20 will look like. I want to finish fiscal '19 first, and we will give more detailed guidance as we observe trends developing. This year is progressing as we anticipated, with an increase in the low to mid-single digits. The first half saw a 7% increase, while the second half is flat, resulting in a 4% year-to-date growth. For the full year, we expect growth in Asia Pacific to be in the mid-single digits, mainly driven by the ramp-up in Australia. Europe is also expected to grow in the mid-single digits, which is a positive result. As mentioned, developments in Western Europe are offsetting declines in Eastern Europe, which aligns with our expectations. The Middle East and Africa region is flat, but Africa has performed strongly for us this year, and we expect that trend to continue into next year. Central and Latin America, along with Central Asia, have shown relative weakness, but they are smaller markets, and we anticipate a rebound starting in '20. Positive indicators are emerging from Brazil and Mexico regarding growth. We're also seeing encouraging news from Afghanistan due to the anticipated U.S. pullout and the need to strengthen and equip their forces, which may lead to growth there as well. Overall, this year is unfolding as we expected, and we believe similar trends will continue into next year.

This year, it's down significantly as expected due to a gap between initial operating capability and full operational capability, which has transitioned from one brigade to five. We anticipate additional services, like radios, to come online, which should drive growth in fiscal '20. However, we faced some headwinds this year from that transition. The good news is that the team has performed exceptionally well, and the program has progressed positively. The mission readiness exercise conducted with one brigade at the start of our fiscal year was very successful, and our standing in the UAE is very strong. In fact, we feel more optimistic about the $1 billion opportunity in the UAE today than we did a year ago. We are managing a transition this fiscal year and expect to see growth in fiscal '20.

So you mentioned more open systems competitions going forward. Can you talk about your historical win rates on open platforms? Maybe JTRS comes to mind. But as the market evolves in that direction, just be curious to hear Harris' historical win rate in that environment.

It's challenging to define a win rate since the markets are quite different and constantly evolving. A significant example of open system competition was the F-35 program, which was a lengthy process that began with around ten competitors and ultimately narrowed down to three. We successfully won that competitive bid against very strong rivals. Our team excelled by delivering advanced technology, excellent execution, and a competitive cost structure, which has helped us extend our capabilities into other platforms. This began with some open-systems work we did over time on the F-18 with Boeing. Overall, I believe that we are performing well in the opportunities we are pursuing. If we consider the JTRS platform as an open system due to its software-defined protocols and waveforms, we’ve established a strong foothold in JTRS programs. Looking back five or six years, we weren't even part of the Program of Record and couldn't compete for program funding. Now, we are actively competing, holding contracts, and delivering radios successfully. This demonstrates our company's ability to succeed with nonproprietary solutions, reflecting both our agility and our commitment to investing in R&D ahead of market trends.

Helpful. And then I just want to ask one on your efforts in robotics. I believe you competed the T7 robot on the CRS program. Is this an area where you see Harris expanding its efforts? And then it would seem there might be some good cross-functionality with L-3. Are they already in your supply chain on the robotics side?

I don't think they're involved in the supply chain for robotics, but there may be some opportunities there. I won't specify further, but it's a possibility. I'm very satisfied with the progress we've made in robotics over the past three to four years. We secured the U.K. MoD contract for the T7, valued at £55 million or around $70 million. We've delivered between four to ten units in the U.K., all of which are performing exceptionally well. The U.K. MoD has provided strong support as we promote the T7 globally, and they are very impressed with the robot and its performance. We also have another opportunity called Dark Rose in the U.K., which is a smaller robot where we could be competitive. Additionally, we are shortlisted for the Common Robotic System-Heavy program in the U.S., which is expected to be awarded this summer, and we believe we are well positioned for that. On a global scale, we see the potential for robotics to be close to $1 billion. We're just starting in this area, and our early successes with a reputable MoD in the U.K. are very promising for our robotics efforts.

Rahul, you commented on the cash progression through the year. I just want to circle back on that. It looks like the free cash flow guidance assumes some pretty big step-down in Q4 relative to what you did in Q2 and Q3. It looks like it assumed some sort of working capital drag. Can you just elaborate a little bit on why free cash flow is off so much in Q4?

Yes, there are different aspects to consider, David. We are definitely improving our working capital performance throughout the year. If we compare to last year's Q4, when we generated half of our cash flow for the entire year just in that quarter, we saw an improvement of about 20 days in working capital. This year, however, we're seeing less than 10 days of improvement, which significantly impacts the cash flow we generated in Q4 last year compared to this year. Capital expenditures have increased slightly from last year and there’s also a rise from Q3. Additionally, there are timing issues with tax payments and some accrued expenses, including non-executive bonuses being paid out in Q4. Considering all of this, our Q4 performance is lower than last year and also lower than Q3 '19. That said, we did manage to deliver 10 days of working capital improvement in Q2 and about 12 days year-over-year in Q3, and we're aiming for an even better number in Q4. Therefore, there is potential for some upside in Q4 cash flow if we can enhance our working capital performance.

Okay, Bill, how are you thinking about the reporting of the combined company, particularly regarding the adjusted EPS number and potential exclusions? Can you provide an update on that? If the deal closes in late June or early July, would you provide guidance for the combined company right away, or would you wait until later?

David, I think if we close at the end of our fiscal year or thereabouts, Chris and I will work then in July as we close our books and report earnings early in August. My thinking at the moment, I think Chris is aligned with this, is that we would guide to the stub year, the 6-month back end of our calendar '19 and then maybe towards the end of the year or early in calendar '20, then guide to '20. And that's kind of what we're thinking at the moment. Again, we'll say more in the coming months. It all hinges on when we actually close the transaction. We're still contemplating cash EPS likely to exclude amortization expense. But any more detail on that in terms of exactly how we're going to report that, I think, is still going to be determined. And Chris and I with the CFO of the company will certainly give some thought to that and share more about that as we get closer to close.

Thank you, everyone, for joining the call today. If there's any questions, just get in touch with me. Bye, bye.