L3Harris Technologies Inc (LHX) — Q4 2019 Earnings Call Transcript

Thank you, Dena. Good morning, everyone, and welcome to our fourth quarter fiscal 2019 earnings call. On the call with me today is Bill Brown, CEO; Chris Kubasik, COO; and Jay Malave, CFO. First, a few words on forward-looking statements. Discussions today will include forward-looking statements and non-GAAP financial measures. Forward-looking 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 our 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, where a replay of this call also will be available. As supplemental information for investors, discussions also will include selected L3 and Harris combined financial information, which combines the historical operating results as if the business had been operated together on the basis of a newly announced four-segment structure during prior periods, but excluding the operating results of Harris’ night vision business and L3’s divested businesses. With that, Bill, I will turn it over to you.

Thank you, Anurag. Good morning, everybody. I’m excited to welcome you to our first-ever L3Harris Technologies earnings call. I’m also pleased to welcome our new Chief Financial Officer, Jay Malave, who joined us on July 1 from United Technologies, where he most recently was CFO of Carrier. Prior to that, Jay spent more than 20 years at the aerospace businesses, including as CFO of United Technologies Aerospace Systems and working on the integration of the Goodrich acquisition. Many of you know Jay from his time leading the Investor Relations function at United Technologies, and I’m thrilled to have him on board and confident he will be a strong business partner to me, Chris, and the rest of the management team. As you are aware, on June 29, in fact just minutes after we ended Harris’s fiscal ‘19, we successfully completed the transformative merger, establishing L3Harris Technologies. We really hit the ground running. On the first working day after closing, we consolidated headquarters activities between Harris and L3 and announced our new organizational model, creating four mission-focused segments that combine the top talent of both companies. In the first week, we completed 115 Town Halls with senior leadership, touching 80% of all employees. In the second week, we held a multi-day leadership meeting where Chris and I shared our joint vision, values, and operating philosophy with nearly 100 executives and then set out our initial game plan. I have to say that the level of energy and excitement across the company is extraordinary. So we are off to a good start as a combined company. We’ll talk more about that in a few minutes. But let me first begin by providing an update on Harris’s fourth quarter and fiscal ‘19 results, followed by Chris with L3, Q2, and first half results, and then Jay with combined L3 and Harris financials and guidance. So starting with Harris on slide three, we ended fiscal ‘19 on a high note with fourth-quarter non-GAAP earnings per share of 39% and revenue growth of 12%, the highest top-line growth we’ve seen in eight years. Overall, the company margin in the fourth quarter expanded by 80 basis points to a record 20.2%. These results cap an exceptional year in which we accelerated revenue growth and had margin expansion in all three segments. We outperformed on all guidance metrics, and we delivered a record earnings per share of $8.29, up 30%, and free cash flow of $1.055 billion. Total company book-to-bill was 1.1, driving funded backlog growth of 12%, and setting us up for continued top-line growth. All three segments contributed to our strong performance, driven by their top-line growth, which continued to exceed expectations. Let me take a few minutes to recap some of the highlights of the year on slides four and five, with additional segment detail in the appendix.

Thank you, Bill, and good morning, everyone. Let me take a moment to thank and congratulate the L3 and Harris teams for their hard work this past quarter. Today’s results from both companies are due to everyone’s focus and the uncertain times leading up to the close of this historic merger. As Bill mentioned, day one was seamless. We rolled out new email addresses to all L3 Harris employees, launched a new website and portal that connected to 50,000 employees across the globe, and installed new signage at our 50 largest sites. On the operational side, in the first week, we issued nearly 40 RFPs to our supplier base totaling $900 million in annual spend to start leveraging the purchasing power of the combined enterprise and to work towards our cost synergies goal. Shifting now to L3 results, we had a solid second quarter, highlighted by our consolidated margin and free cash flow, both outperforming the second quarter guidance we discussed on our May earnings call. Margins expanded by 160 basis points to 12.2%, and free cash flow was up 38% to $220 million. Non-GAAP EPS was up 18% to $2.91 on 2% revenue growth. These results capped a strong first half with EPS up 21% on 8% revenue growth. Total company margins expanded by 130 basis points to 11.9%, and free cash flow was $365 million, or five times last year’s first half, as we executed on working capital improvements that resulted in a 12-day reduction over the past 12 months. Orders were up 8%, resulting in a book-to-bill of 1.11, and funded backlog increased by 16%. Turning to the segments on slide six, ISR revenue grew by 2%, driven by a ramp-up in WESCAM turret systems and the strength of our ISR missionization business, as several key programs accelerated, including the Australian Peregrine and the Presidential Aircraft recapitalization program. This growth was partially offset by lower deliveries of night vision products due to export timing, and operating income was up 50%, resulting in margin expansion of 460 basis points to 14.3%. In the first half, ISR revenue was up 12%, and operating income grew by 45%, with margin expansion of 280 basis points to 12.3%. In the Communication Segment, revenue was flat in the quarter, with higher production volume for UAV Communication Systems offset by lower volume in the Integrated Maritime and Microwave product sectors. Margins declined by 130 basis points to 7.9% due to the dilutive mix impact of the Maritime Developmental Programs and the continued investment in Unmanned Undersea Vehicles. For the first half, segment revenue was up 5%, with margin expansion of 20 basis points to 9.3%. Lastly, the Electronics Segment second-quarter revenue was up 3%, with strong growth in Precision Engagement Systems, including the fuzing and ordnance business, F-35 Display Systems, and Airport Security Equipment, more than offsetting the expected headwind in Defense Training Solutions due to last year’s competitive loss of the C-17 training contract and lower volume from Commercial Flight Simulator sales. Margin expanded by 10 basis points to 13.6%, and in the first half, segment revenue was up 3%, with margin expansion of 10 basis points to 14.1%. Overall, L3 had a strong first half, tracking above the guidance set at the beginning of the year and ahead of the amounts disclosed in the S4.

Thank you, Chris, and good morning, everyone. It’s an honor to join the L3 Harris team, and I look forward to working with the analyst investor community once again. In a moment, I will discuss L3 Harris guidance for the second half of calendar year 2019, and as a reminder, we have transitioned to calendar year reporting. But beforehand, in order to provide context and support for the guidance, I will walk through the L3 and Harris combined financials for the first half of calendar year 2019, which we prepared on the basis that Anurag described at the start of the call, and I’ll also note various drivers in year-over-year comparisons in those results. Similarly, all comparisons included in the guidance discussion are to the comparable prior year period L3 and Harris combined financials. Okay, starting with results. In the second quarter, revenue was up 7%, and EBIT increased by 16% on higher volume and operational efficiencies, resulting in margin expansion of 140 basis points to 16.3%. EPS grew by 27% to $4.65, and free cash flow was slightly above $1 billion, up more than 50% from last year. First-half book-to-bill was 1.07. Turning to our new segment structure on slide eight, Integrated Mission Systems revenue for the quarter was $1.25 billion, up 3%, driven by strong growth in Electro-Optical Airborne Imaging Systems and continued strength in the ISR Aircraft Missionization business, including the Australian Peregrine program. Operating income for the segment was up 14% to $150 million from higher volume and improved program performance. Operating margin expanded by 110 basis points to 12.6%. For the first half, segment revenue was up 12%, and operating income increased by 17%, with margin expansion of 50 basis points to 12.1%. First half book-to-bill was 1.16. Next in Space and Airborne Systems on slide nine, revenue for the quarter was $1.2 billion, up 17%, driven by double-digit growth in avionics and electronic warfare from a production ramp and new contact on long-term aircraft platforms, as well as continued strength in classified space. Segment operating income increased by 25% to $225 million, and margin expanded by 120 basis points to 18.8% from higher volume, stronger program performance, and operational efficiencies. For the first half, segment revenue was up 16%, and operating income increased by 19%, with a margin of 18.2%. First half book-to-bill was 1.13. Switching to Communication Systems on slide 10, revenue for the quarter was up 6% from strong growth in DoD Tactical and Public Safety, partially offset by lower deliveries of L3 night vision products due to timing and the transitional impact to full operational capability of the UAE Land Tactical System program. Segment operating income was up 10%, and margin expanded by 80 basis points to 21.6%. Strong program execution offset the mix impact from the ramp in Tactical Radio Modernization programs. For the first half, segment revenue was up 12%, and operating income increased by 18%, with margin expansion of 100 basis points to 21.5%. First half book-to-bill was 0.96, and that’s coming off a book-to-bill of 1.27 in the last six months of 2018. Lastly, in Aviation Systems on slide 11, revenue for the quarter was up 2% as growth in precision engagement, airport security equipment, and FAA programs was partially offset by the expected headwind in Defense Training Solutions due to last year’s loss of the C-17 training contract and lower volume for Commercial Flight Simulators. Segment operating income was up 11%, and margin expanded by 90 basis points from better cost management. For the first half, segment revenue was up 1%, and operating income increased by 9%, with margin expansion of 90 basis points to 10.5%. First half book-to-bill was 0.99.

Thank you, Jay, and that’s a lot to take in. So let me wrap up with a few comments on the budget and our strategic priorities going forward. In regard to the budget, I’m very encouraged by the recent bipartisan deal raising the BCA caps over the next two years and removing the threat of sequestration. We continue to believe the House and Senate will support increased funding to meet the national security demands, which are well aligned with our core franchises. With budget outlays continuing to lag budget appropriations, we expect growth momentum to continue in the medium term. A few weeks ago, Chris and I aligned with our leadership team on our top strategic priorities, first and foremost being integration and accelerating the capture of cost synergies. We now expect to hit our gross run rate of $150 million by the end of calendar ’19, putting us on track to meet or exceed 40% or $200 million of gross savings in calendar 2020. We are off to a great start on segment and headquarters consolidations and supply chain activities, and we are growing increasingly confident in exceeding $500 million in gross cost synergies in calendar ‘22. Other priorities include driving operational excellence to our new program called E3: Excellence Everywhere Every Day, establishing a new performance culture, building on the strengths of both companies, investing smartly and aggressively in technology to grow revenue and increase share, reshaping our portfolio to focus on high-margin, high-growth, technology-differentiated businesses, and maximizing cash flow that will be returned to shareholders through repurchases and dividends. Overall, the progress and alignment in the first 30 days has exceeded our expectations, and we feel even more confident in the strategic combination and our ability to deliver shareholder value. So with that, let me turn to the operator to open the line for questions.

Thanks so much. Good morning.

Hey, good morning Robert.

Maybe a quick first question for Bill. There was some commentary at the Paris Air Show that the combined company might be looking at some post-merger disposals, and I wonder if there had been any further thought or development on that front?

Rob, thanks for the question. Yeah, it’s definitely a key priority as I mentioned in my closing remarks in terms of top priorities for the management team. Certainly as we’ve talked about before on this call and other venues, a broader mix of businesses gives us an opportunity to take a fresh look at the combined company portfolio and really think about what fits, what doesn’t fit, certainly gives us optionality to deal with businesses that we no longer consider strategic. We continue to look at this through a couple of different lenses. Certainly, one is, does the business have technology that’s required by differentiation? Can we deliver good returns? Can we grow and gain share, etc.? We are going to evaluate what businesses based on those metrics. We continue to have this dialogue; Chris and I are working very hard on this. We are engaging our new board on this as well. We are not going to deliberate decisions and discussions in public, but it’s really top of mind for us, Rob.

Okay thanks, and then maybe as a follow-on Jay and welcome back. In the free cash flow guidance, that’s around $400 million worth of adjustments, and I was wondering how many of these one-off items for 2019 won’t be repeating themselves in 2020 and beyond? Thanks.

Are you talking about the back half, Rob?

Yeah, it’s in the release. There’s a reconciliation of the guidance for the full year. We’ve got 1875 to 1925, and then the number of adjustments gets you to 2.3 to 2.35 adjusted free cash flow for the year.

Right, so when you look at that, we will continue to expect some of the integration costs. We’ll still see it going into next year from a cash basis. But let me just take you back to the second half of free cash flow because we expect, you know, an uptick in net income. There will be a little bit of an outflow related to our working capital within one or two days improvement, but we’re going to try to hold that flat, and we’ll see a little bit of a benefit in cash taxes. So we feel good about the second half, specific to your question in terms of what we see going next year. As I mentioned, there will be some continued costs related to the integration, restructuring type level of costs and those types of items, but beyond that, I don’t expect there to be other significant items that will repeat going forward.

I mean just in a nutshell, I think for the year, Rob, it’s $260 million of free cash impact from deal and integration cost. We had about $25 million or so in the first half. The $235 million will be in the back half. About $100 million of that, 95, are going to be deal costs; that’s going to be behind us by Q3. You know the balance is integration costs, and we’ll see some little drag forward into calendar ‘20 on integration costs as well.

That’s very helpful. Thank you.

Thanks. Good morning Bill and Chris and welcome Jay. On the deal closing, you guys increased share repurchases in your dividends. How are you maybe thinking about your overall free cash flow target and targeting returns to shareholders?

We are confident about our cash generation this year. We are still aiming for $3 billion in three years, which corresponds to calendar year 2022, and we will ramp up to that goal. We've had a strong start in cash generation during the first half of this year. Our LTM cash reflects our projections for this year, and everything appears positive. As of June, our balance sheet showed $1.7 billion on a pro forma basis, and we anticipate generating about $2.5 billion in the next 12 months, bringing our total cash available for deployment to around $4.2 billion. Our dividends amount to approximately $700 million, which includes the 10% increase announced on July 1, effective in August. We will reassess this in January. Additionally, we expect to incur about $300 million in deal and integration costs in the next year. Although we need to fund the surf and deferred compensation programs, this leaves us with about $3 billion available during that time. Of that, around $2.5 billion is expected to be used for buybacks, and about $0.5 billion will remain on the balance sheet for routine working capital needs.

Sure. Thanks, and then maybe just on the margins, the pro forma margin guidance for the total company implies second half margins are up 80 basis points over the first half. But just a decent acceleration, can you maybe talk about the moving pieces, how much of that is coming from synergies versus the underlying business profitability?

Yeah, so you’re right Sheila, the first half on a pro forma basis was up 90 basis points, the second half up 170, so it’s up subsequently as well, 16.7. For the year about 130 basis points of margin expansion, so 16 too, a little bit better than we had though when we put the deal together in the S4, so we feel good about the trajectory. You know, as we mentioned on the call about $40 million on the back half is coming from net cost synergies. There’s a road map in the back on the EPS bridge which indicates the absence of L3 intangibles and pension amortization for another $40 million, $43 million. We see an operational improvement year-over-year in a couple of businesses from L3, including EDD. We see operational excellence savings which offset some mix, grow some investments in the back half, all of which gets us to about that 170 in the back half and we feel it’s pretty well calibrated.

Hey, good morning, gentlemen.

Good morning.

Just a couple quick ones. One, I realize it’s hard because we didn’t have a, you know, a Harris guide for the next, you know, sort of fiscal year out there. But it looks like on a pro forma basis the top line that you’ve put forth for the second half is a little bit ahead of where we may have been on a pro forma basis coming in. Can you just verify that and maybe help us size it? And then as a follow-on, you know I wondered as part of the many decisions you made in getting the deal closed and whatnot, where you shook out on things like incentive compensation, not necessarily for the executive team, but as you go a layer down in terms of, you know, driving this sort of behavior that you want and so was there anything useful or notable to speak about there that will help us understand, you know, where your points of emphasis are? Thanks guys.

Yeah, sure Carter, thanks. So really on the first point, first of all Harris is feeling a little bit backtracking, a bit better on our calendar ‘19 in terms of versus the S4 and a combined company basis. For calendar ‘19 we are about $0.5 billion better. So you know it’s quite a bit stronger than we envisioned late last year when we put out the S4, but again as we mentioned at that time, the S4 was related to strategic plans that were put together earlier in the year over the summer. You know when the markets guide a bit better, we want some strategic opportunities, so we feel good about where we are at in calendar ’19, a bit better than we started. You know ‘20 is looking pretty good as well, certainly with the budget backdrop, you know a strong funded backlog at the beginning – at the midpoint of the year, up 15%. So a lot of this tracking I think for really good top line progress. On the comp program, you know we are still in discussions with our Board in terms of what we do going forward, but you know Chris and I, you know obviously there’s a short-term plan and a longer-term plan. On the short-term basis, it will be some combination of revenue op-income and free cash. And since we all know the importance of cash generation, the impotence of driving working capital improvements, you know there’s probably a slight tilt towards free cash, much like we did a number of years ago at Harris. You’ll note Chris mentioned about the big step up in the first half in free cash generation, a 5x over the first half of last year. I think 50% of the short-term comp for the L3 executives came on free cash, and we all know when you incentivize for something you get results. So that’s kind of what we are thinking on a short-term basis. Longer-term, it will be performance-based equity, you know that will be tied to the targets we are discussing with shareholders. You bet Carter.

Yeah thanks. Good morning Bill, Chris, Jay. A question Jay, I guess on CapEx you mentioned $190 million for the second half of the year, about 2% of revenues. Just thinking about longer term as we think over the forecast period and thinking about your integration period, is that still a good number to go off of, about 2% of sales?

Yeah, I believe it is, Peter. I mean 2% this year on a full-year basis, that’s $380 million, $190 million in the first half, $190 million in the second half. I think going forward it feels like that’s the right place to be to fund and be prepared for growth, and yeah, I think 2% is where we should go with.

Okay, and just as a quick follow up. I know you are not talking about quarterly guidance here, but just thinking about the second half guidance that you put out. Is there anything you’d call out regarding 3Q versus 4Q either on the EPS or free cash flow, just thinking from a modeling perspective for the street? Thanks.

Nothing material, Peter. There’ll be additional non-GAAP charges in Q3 because of some of the deal and integration expenses, but on a non-GAAP reported earnings per share, revenue growth should all look pretty stable, Q3 versus Q4.

Thanks. Good morning. Thanks for all the information and welcome Jay.

Thank you, David.

Bill, you used to have – in the Harris deck you had a slide that showed the medium term outlook by segment. I want to see if you might offer, since we are new to the combined company segment, so I wanted to see if you would offer your thoughts on kind of how the growth rates relative to each other among the segments might look going forward and also from a margin opportunity, beyond what we’re looking at for the second half of ’19.

Well, David, I mean it’s still a bit early. I mean obviously we just put the company together, and it took enormous work to put together pro forma guidance in the back half. So it’s a little bit premature to get out beyond that, but maybe just some high-level comments without getting into the segment-by-segment looks here. You know for us, looking at 10% growth in a calendar year in the industry that happens to be in, it’s pretty special. You follow us; you follow others in the space. You know looking at 10% in the back half feels pretty good as well. So, you know I mentioned the S4 is a little dated. We are doing a lot better than the S4, about $0.5 billion stronger this year. So we’re coming off a stronger starting point. You know in the S4 I think L3 numbers were growing at 5% to 6% in that range. We are a bit, a little bit higher than that. You know I see us continuing to grow in that mid to high single-digit range into ‘20 and maybe a little bit beyond that. It comes from a good bipartisan budget deal. You know the topline budget is not growing that much, 3% and then basically flat the year after, but the certainty that provides, the funding lines that we see tactical, F-35, other plays that affect the business look very, very good and very positive. It features a $122 billion worth of appropriations that are out there, that are exceeding the outlays. So those outlays have to catch up. There’s a lot of dry powder in the system that should keep all of the boats moving in the water and we feel pretty good about the medium term outlook. On the margins side, look, ending at 16.2 this year will be a great result. You know we’re at the front end of our ramp on synergies. Only $40 million this year getting to $300 million several years out, that’s another 170, 180 basis points. So if you could kind of run the math and get to 18% pretty quickly a few years out, and we’ll ramp to that as quickly as we can. So as we look out in the back end of the year, we feel great and I think the outlook into calendar ‘20 also looks pretty good too.

Hey, good morning everybody.

Morning.

In the three, the $3 billion, three-year free cash flow target, what is the underlying organic business segment? So you know putting aside anything below the line, putting aside the working capital opportunity in the synergies, just the core newly combined business segment EBITDA growth rate on that three-year basis that you are assuming in the $3 billion.

Yeah, I think topline is around 5%, 6%, a little bit higher than that on an EBITDA growth. When we – it yields about $0.5 billion of incremental net income, incremental cash coming from growth over the three-year period.

Right, so there’s $40 million of net synergies in the back half, net synergies in the full year as well, and that drops through generating cash on an after-tax basis. The 150 is the run rate we’ll be added in terms of cost synergies by the calendar year. So that’s the run rate we’ll be at – which gives us confidence that we can be at $200 million, so in calendar ‘20 gross savings dropping through. It’s about 75 days on a pro forma basis in June. As Jay pointed out, we're expecting one to two days of improvement, sequentially through the back end of the working capital, so anything around 74, 73 days.

Okay, so I should be kind of in the zone of maybe call it $100 million of the $500 million that you had for the – in that free cash flow bridge of net after-tax energy plus capital efficiency, maybe $100 million of the $500 million is happening in 2019.

I’m not sure. I mean we’re looking at each other here, not sure…

Well, if it’s $40 million to $50 million of synergy and then one or two days of working capital, I guess, that would be.

The one – two ways of working capital on a full-year basis is probably on the order of $30 million to $60 million in that range. So it will be half that over the course of the back end of the year.

Thanks guys.

You bet.

Hey, good morning. Thanks for taking the time for the last question here. You are just given the success with the Exelis combination and maybe using that as a benchmark, can you talk about how the experience so far with L3 has then maybe similar to that integration and then maybe where it's been a little more dynamic?

Well, certainly it’s a much bigger scale, you know clearly and there's a lot of complexity within L3. It was a company built over 20 years through a lot of M&A and Chris has talked about the desire to move from a holding company to an operating company and we server one that journey. So getting information, getting it, you know, consistently across businesses is a bit of a challenge, but the reality is we’ve out of the gauge very, very quickly; we've got a great seasoned integration team; people that are very experienced, they've done this before. There are a lot of people from the Exelis integration. We're getting data very quickly; you know the enthusiasm and energy across the company is very good. You know it's gone from my vantage point certainly better than we would have imagined and better than we did with Exelis. You know we're going faster on supply chain. That was an area that took a little time to ramp up too on Exelis, so we’re acting a lot faster this time. Obviously with the segments and the headquarters, we made those decisions, we execute on that on day one here, which is very important. You know the revenue opportunities ahead of us are quite significant, something that Chris is spending a lot of time on and we’re very encouraged. So we're going to get on that probably a lot faster this time than we do with excels. Keep in mind we're in a different market space, we’re in a different sort of part of the cycle. Back with Exelis, we're still coming out of sequestration. The visibility and the budgets weren’t very strong, you know so we focused much more on cost side. This time it’s different, you know and Chris and the team are really putting a lot of time and effort into making sure we understand what the revenue opportunities are and then making sure that we fund them. So you know I'm optimistic about the trajectory that we’re on here and clearly we want a great path to deliver $0.5 billion of gross cost synergies and hopefully a bit more than that over time, Josh.