L3Harris Technologies Inc (LHX) — Q1 2022 Earnings Call Transcript

Thank you, Rob. Good morning, and welcome to our first quarter 2022 earnings call. On the call with me today are Chris Kubasik, our CEO; and Michelle Turner, our CFO. First, a few words on forward-looking statements and non-GAAP measures. Forward-looking statements involve risks, assumptions, and uncertainties that could cause actual results to differ materially. For more information, please see our investor letter and SEC filings. A reconciliation of non-GAAP financial measures to comparable GAAP measures is included in the Investor Relations section of our website, which is l3harris.com, where a replay of this call will also be available. And as a reminder, at the start of the year, we began reporting our results in our realigned three-segment structure that shifts pension items to the corporate level. With that, I'll turn it over to Chris for a few comments.

Okay. Well, thank you, Rajeev, and good morning, everyone. As you saw, we released our results after the market closed yesterday in our new streamlined format. We're always looking at ways to improve and challenge the status quo. So instead of issuing a press release at 7:30 this morning, and have Michelle and I read prepared remarks, which were very similar to the press release and maybe with some added color, and then having you follow along with our web charts, which are just a graphic depiction of what we were going to say anyway, we thought we'd try something new and come out with what we're calling our investor letter and putting everything in one document. And that allows us all the time today to focus on the questions and talk about what's on your mind. So just real quickly, the first quarter results are consistent with our prior commentary of a back half 2022 weighted revenue and margin plan. This will also be the case with our free cash flow as well. And for the full year, we're reiterating our guide across the board as we continue to advance our strategy in a dynamic environment, whether it's from the pandemic or the global threats in Eastern Europe and elsewhere. So before opening the line to questions, I'd like to express our steadfast support for the people of Ukraine. I think we all agree their unwavering strength and resilience are a motivating force behind our mission here at L3Harris. So with that, Rob, let's open the lines for questions.

Good morning. I wanted to ask you really a general question, to just elaborate on your Agile Development Group and the strategy behind the partnership with Shield Capital. And then something more specific on the flight test status for your integrated core processor for the F-35 Tech Refresh 3 and the possibility that delays on TR3 might push Block 4 out to fiscal '29 and how all this impacts the revenue backup that you previously talked about between TR2 and TR3?

Okay. Why don't I take F-35 first, and then I'll ask Michelle to give you some of the financial numbers on F-35, then I'll come back and do ADG and Shield. So yeah, we talk about F-35 each quarter appropriately. And I'll say this last quarter is probably the best quarter we've had in a while. We're progressing through the integration and test, which we all know is the most challenging part of any development program. And the integrated core processor did begin safety of flight testing earlier in March. So that is a good sign and progressing well. I do want to highlight, we also have the Panoramic Cockpit Display, which just completed its safety of flight, and then the Aircraft Memory System completed its full qualification test. So everything is tracking well to the first flight. We just provided this to Lockheed, and I think in 2023 is going to be the first flight of the aircraft. So all seems to be going well. On the contractual side, we secured a contract for ICP for Lot 16 and for AMS and PCD on Lot 16 and 17. So we're getting to production contracts, and we're going to be ready to hit the ground running as we complete these tests. As you'd expect, we're investing R&D and capital to continue to support the program and find more efficient ways to meet these commitments. And I do want to recognize the team because we are working effectively three shifts and weekends. This is the highest priority for everyone. We've had customer visits and they've been very complementary of the workforce and the progress that we're making. So Michelle?

Yeah. Good morning, Rob. So just to add a little bit of color from a financial perspective. So our overall Mission Avionics sector is going to be down mid-single digits, consistent with what we shared before. The F-35 development is going to be down low-double digits before we get into the ramp from a production perspective. So we anticipate going into next year that we'll be flattish to up a couple of percent.

Yeah. So let me go back to the first question about the Agile Development Group and our investment in Shield. So you've heard us talk about our strategy of being a trusted disruptor, investing more in R&D as a percentage of revenue than most, trying to prime more contracts and embracing the new entrants that are disrupting the marketplace and the DoD. So we set up the Agile Development Group. It is an entity that had previously existed, so some of this is just kind of branding it and giving it the recognition it deserves. We have a couple of thousand engineers in this group. Their R&D is double digits as a percentage of revenue. They are really the front end of the business, and they've been working with speed, agility, and innovation. Most of the focus has been on modular open systems, which has been embraced by our customer. It's hard to give examples because a lot of what we're doing is in the classified arena, initially focused on the air domain. We're also doing some interesting development on new and creative weapon systems. So they're the front end. And as we get these contracts out of development and into production, they'll hand these off to another entity that is world-class at producing them. I don't think it's the most unique thing in the industry, but it's something we thought made sense. They're off to a pretty good start. I've spent a lot of time in D.C., and the customers have been excited about it. They have even come down and visited our facilities and are generally very impressed with how we're moving along. Now Shield Capital is a venture capital firm. They raised $125 million. We're the largest strategic partner. The thought process there was to try to find a way to get these new startup technology companies, which I differentiate from small businesses. Small businesses are about compliance -- contractual compliance and usually apply to service contracts. These are mainly Silicon Valley high-tech startup companies that have great commercial technologies that want to support the Department of Defense. It's hard for these companies to get programs of record. So we're embracing and working with them. We will make investments, either co-invest or through Shield in these companies, which is secondary to the goal of making this strategic investment to get this technology into our systems quicker, faster, more affordably, and meet the warfighter need. So very excited about that. We'll keep you updated as that progresses in the years ahead.

Good morning, Chris, Michelle, and team. Thanks so much for the bold new efficient format. I like it. I think Slide 16 or Page 16 is my favorite though. Chris, since the last time we spoke, there's been a lot of change. The budget came out. It was more robust of an outlook than we thought, coupled with NATO members stepping up defense spending. So given your ability to be perhaps more nimble than others, what are you seeing in terms of incremental opportunities? And how do you think that could impact the intermediate growth profile of LHX?

Okay. Well, thanks, Sheila. We'll obviously welcome all feedback on the new investor letter, but I think we got a lot of positive feedback, giving you 15 hours to read it instead of one hour. So hopefully, that was helpful. Yeah, on Ukraine -- and I'll just say Ukraine in the whole region. The breaking news yesterday was you saw the White House asked Congress for an additional $33 billion of funding. When you look into the details, which I know will evolve over time, $20 billion is for defense. Of that, $6 billion is the US AI, which is the Ukraine security assistance initiative, and $6 billion is FMS. Those are two vehicles and processes that we're very familiar with, and we've used over the last several years or decades in supporting Ukraine. I think we understand how that process works, which, of course, is very important. The $6 billion compares to $300 million last year. This is a significant increase, and we just need to see how long it's going to take to get this bill passed. As we read it, it appears to have a lot more flexibility for acting quickly to get these contracts moving. As you would imagine, we're in discussion with several customers in the region and here in the U.S. There are lots of opportunities for L3Harris. When you think of secured communications, I think it's been publicized the importance of having secured communications. That's worked well. With Ukraine, they have been a longtime customer of ours. You can read and see that the Russians are having difficulty with the communication. That positions us well. We just, under the whole ISR, situational awareness, whether it's space ISR, air ISR, even the EO/IR turrets out of WESCAM, are examples of things that I think could be needed, and of course, night vision goggles. We're really not able to give a lot of details, as you would imagine. But I think broadly, we're well situated, and many of these capabilities are in our sweet spot, including electronic warfare. Over the midterm, we continue to believe low to mid-single digits is the right guide at this point in time. We are starting to get demand signals. We're responding to RFIs. I like the tailwinds. More to come over the next several quarters. I will say relative to being more agile or nimbler, I can't give you specifics, but within 15 days from receiving a request, we were able to ship product to help with the conflict. A lot of this is reprioritization; right? We have other customers who are willing to give up their products to get them over in the region. We have to backfill those as well. I don't know if that addressed all your points, Sheila, but I think we're well situated.

Thanks so much. Good morning.

Good morning.

Chris, I'd reiterate the -- thanks for this new format, and the timing especially is very helpful. In terms of my question, inflation obviously is a big issue across the world at the moment. In relation to defense, there's been some concern about how this could flow through on fixed-price contracts. So I was wondering if you could comment on that, and what sort of alleviation L3Harris might have to this issue.

Okay. Thank you. No, inflation is a challenge for all of us, and I think all industries. A lot of people immediately jumped to the traditional supply chain and materials, which obviously gets attention, but I also believe we need to plan for wage and labor inflation as well as the job market gets tighter. We look at it more broadly. When I look at our backlog and our portfolio, we have about 25% of our contracts that are cost-plus cost reimbursement. The way those are designed, the added cost will flow through to our end user. That's one of the reasons you see the budget increased; although I don't think anyone believes it's large enough to absorb all the inflationary headwinds. We have about 25% of our business through not only commercial products but the commercial business model we’ve discussed, whether it's our WESCAM turrets or TACOM radios. At the right time, you increase your prices. The real risk, if you will, is the 50% that’s firm fixed price. We don't have a lot of multiyear backlog, but we do have a little over 12 months of backlog. In that case, it is a headwind. In many of those contracts, there are escalation clauses. The reality is those indices are probably less than the real inflation, but that does absorb some of the headwind. We’ve talked about E3 and some of the initiatives we're taking there. We've doubled down on that effort, and are going to continue to find ways to be more efficient. We are really embracing and rolling out digital engineering, investing in more machinery and tooling to be more efficient. So that's going to be the challenge. On new bids, which seem to come in several times a day for Michelle and me, we have to factor those costs into the bids going forward. This has given us a little bit of headwind as you see here in the quarter. I don't know, Michelle, if you want to quantify it?

Yeah. So I would just characterize it's very consistent with what we shared in our previous guidance. The other thing I would say is that from a 2022 perspective, we've locked in most of our supply pricing. We've mitigated most of the risk consistent with what we put into the guidance. Although I will say that this environment is becoming more elongated. As we think about our strategic planning, this is certainly going to be a headwind considering 2023.

Good morning, guys. And thank you for the very efficient format both last night and on your opening comments. I had a couple of questions related to one another. First, if you could just broadly characterize how LHX fared in the fit-up forecast? Secondly, if you could talk about radios? You've won a number of IDIQs, night vision, and what have you. So take it as far as you'd like, but talk to us about the fit-up and how you guys are positioned?

Okay. Did you have more? Or just -- is that your only question?

Meaning the lives and other questions as well. We can defer that.

Okay. Yeah. I mean, as we saw -- the good news is we did get a '22 budget finally. We've talked at length about challenges. It's taken 165 days to get a budget. But nonetheless, we do get a budget. Now we're starting to see some contracts and activity pick up at a quicker pace. For '23, I think we've all seen focused on the top-line, the $773 billion top line. In discussions with several customers and members of Congress, I believe that number is going to go up during the conferencing process. We’ve seen about $20 billion on the Unfunded Priority list, and I think the majority of that is going to be rolled into the final 2023 budget. Relative to -- I'll just go to the Unfunded Priority list first. You did mention night vision. That was in the budget as zero. It was zeroed out. Ourselves and our competitor are aggressively working the hill to get that funding back in, with the support of the army. We generally don't go to the hill without our customers' support. The fact that is on the UP list is a positive. That was probably the one thing that caught our eye on the negative side. On the positive side, I'll let Michelle talk a little about the IDIQ. Everything we've looked at aligns well with our goals. We track all our current programs and are looking for new opportunities. We're very aggressive in bidding and opening the aperture. We want to ensure those opportunities are funded, even if they’re competitive, because over the long run, we think we’re positioned to win some of those. I'd also mention beyond DoD is NOAA. I mentioned that we're well-positioned with the next-gen weather satellites. The NOAA budget went up 17% from '23 to '22. NASA is up 8%. Even the FAA, where we do a lot of work, is up 4%. When I look at DoD, NOAA, NASA, FAA, plus trends in international budgets, especially in NATO countries, I see a lot of positive tailwinds that put us in a good position to continue to grow for the foreseeable future. I'll give it to Michelle to provide more color.

Yeah. No, I agree. I think often in recent discussions, our radio business has been overshadowed by our supply chain challenges. But when you look at the predictive indicators, whether we’re talking about budgets with double-digit growth on our handheld or the IDIQs that we've received within first quarter. $10 billion of IDIQ is really a strong predictive indicator on the overall growth within this business. We're excited about the near term. Going back to Sheila's question around the immediate opportunities we're seeing from the conflict environment as well, all macro indicators suggest a tailwind for this business. We're excited about what's to come. However, we do need to get through the hurdle with immediate supply chain challenges.

Yeah. Good morning, Chris and Michelle. Thanks for your time. I appreciate the new format like everyone else. Chris, I guess my question is just leading off from what Michelle just mentioned about the supply chain. Just your comfort level around kind of things improving in the second half? And then also just how it relates to maybe you taking a more cautious approach and carrying more inventory as we look towards this kind of building budget environment and just kind of adjusting case supply versus targeting your working capital days that you have been highly focused on? Thanks.

Yeah, thanks. No, that's a great question. Clearly, that's the number one risk we're all following and have been discussing for at least the last nine months, maybe longer. To put it in perspective, since our last conversation, I would say it feels about the same. We seem to be making progress, but every day is different. We get two steps forward and one step back. The only thing that might change in my mind is the length of the recovery. There's a belief that this would be behind us in 2022, but I think it's going to extend into 2023. With respect to supply chain, I categorize it into three buckets: inflation, materials, and labor. Based on prior questions about inflation, we're in the mid-to-high single-digit rates, but it’s expected to come back down to lower single digits later this year. The materials mainly involve electronic components. We invested in tools, data analytics, and those processes are paying off in terms of better visibility. However, lead times are extending, and freight and shipping challenges add to the complexity of delivering products into the country. The labor shortage, the attrition is high across our industry. We need to address this. The labor shortage is particularly significant within the supply chain. Despite the challenges, we've been successful in recruiting new college grads. I would summarize it by saying I feel the same as I did 90 days ago, just that the recovery might take longer.

Yeah. So I can add a bit from a numerical perspective. In the first quarter, we expect the impact to be slightly under $100 million in terms of the top-line impact. We expect that to be fairly consistent in Q2, with recovery happening in the second half and into 2023. This aligns with our previous outlook for 2023.

Good morning. Thank you. I'd like to continue on the tactical radio side. Because when I think of the products that you've got here, I mean, this is sort of the -- I think of it kind of post-jitters world where you're trying to have common waveforms. So it means you have to outfit large portions of the military. When you think about the IDIQs you've gotten, can you talk about how those -- how you expect those to play out in terms of, in a sense, completing the deployment over time of the radios that the Army, the Marines, that they need over time? How do you think about the conversion of those IDIQs into revenues in terms of your share, in terms of the timing of individual awards?

Yeah. No, Doug, great question. Yes. So we can -- let me take the first part, maybe at a higher level, and Michelle can give you some of the actual numbers that show you what we're doing relative to orders and revenue quarter-by-quarter and the outlook. You're absolutely right about the importance of these radios and resilient communications. A lot of our R&D goes into new waveforms. The modernization is still in the early phases. We talk about the SOCOM two-channel multiband handheld. That's a nearly $400 million IDIQ, and it's a little over halfway utilized, which means there are still a couple of hundred million dollars of opportunity. SOCOM is a great customer, and a lot of our radios start there and then migrate into the other services and even internationally. That was the handheld. We also have a single award for the Manpack of about $550 million, which is also about halfway through the spend. So clearly, lots of opportunities in SOCOM. When we go into the tactical radios for the Marine Corps, we had a two-channel handheld opportunity that was competitive, winner-take-all. Again, it was a single award for $750 million. That is just getting started. We’ve seen tens of millions of dollars on that so far. The dual awards, such as the Army rifleman, is where we're one of two competitors; same with the Manpack. Those ceiling limits go over a decade, just shy of $4 billion and $12.7 billion, respectively. The first step is to win the IDIQ, which you can think of as the hunting license. Then, you go task order by task order year by year. We're in a really good position overall. The modernization process will continue, and secured communications and situational awareness are two key needs in any conflict. Despite some of the headwinds and volatility in our tactical comm revenue, we have still not missed a customer delivery. Our team effectively manages a range of parts and schedules. We increased our inventory by about $30 million just in TACOM as we try to get more electronic components in sooner rather than later, although lead times are currently 6 to 12 months, much longer than they used to be. So Michelle, would you like to provide more detail?

Yeah. And just to put some context around the inventory builds. We did build inventory across the enterprise by about $100 million, what we call smart inventory, in terms of solidifying the second-half revenue growth. That's a good callout, Chris. But on the IDIQs, we did have four substantial IDIQs from the radio perspective within the first quarter. The first one was a $6 billion, ten-year dual-source IDIQ. Based on history and how that plays out, we would expect to get half of that as the funding comes in. Just a reminder: our backlog does not assume these IDIQs until they're funded. What we saw within Q1 on the book-to-bill being right around one did not include any of the funding upside that we would anticipate as funding is added to these IDIQs. We booked a $3.7 billion five-year Navy multiservice, which is a sole-source IDIQ coming 100% to L3Harris, along with a $750 million ten-year award with the Marine Corps, which was a competitive award, and a $300 million SOCOM award that is another sole-source. So, of the four booked, all were sole-sourced except for the first one, which was dual-source. We continue to have really strong predictive indicators in terms of our demand for radios.

Chris, Michelle. Good morning. I wanted to ask you about the bookings. Book-to-bill was about one in the quarter. Your comments about continuing to grow - it just seems understated to say you're optimistic about demand, given the global increases in defense spending and the upward trajectory of new awards. What does it say about book-to-bill for the -- how book-to-bill for '22 ends up? Are we talking about an improving outlook here? Do you see international as a bigger driver of your bookings now? Any comment on how you're thinking about now what '23 bookings might look like? Anything you could offer there would be helpful.

Okay. Well, good morning. Richard, it's always good to hear from you. The first quarter was 0.98 book-to-bill, and that's really funded book-to-bill as Michelle explained. Maybe a little more conservative than the way others look at it. We're looking at a plan of about 105 book-to-bill. So we're aiming for over 1 in each of the next three quarters. We may be slightly conservative, but we did have a continuing resolution through mid-March. Now we have to convert these into actual contracts. That's the process we're going through. I see international as a tailwind as well. We have some great opportunities for international ISR. We have our EO/IR turrets. We just need to navigate the process, including congressional notifications and managing foreign governments. We think we're in a good position; many of these are sole-sourced contracts that we're working on. I would expect those to close as planned. Hopefully, we remain in the 105 range for this year. We haven’t provided extensive insight into '23, but we might use a similar benchmark due to tailwinds we keep discussing. Everything appears positive relative to the demand signals we are receiving. Winning contracts is the key to moving forward. In fact, we are excited about some recent awards, such as Spear, the shipboard panoramic electro-optical infrared system. It's $200 million EMD with options just under $600 million, intended for 21 ships for the U.S. Navy. We believe it could extend to around 100 ships, and, of course, we have the international market as well. This builds on investments made six years ago by establishing our IR&D or R&D investments across different segments in L3Harris, collaborating effectively. This opportunity aligns with our strategy and represents a significant potential growth area.

Yeah. And just to add a couple of additional words to that because this is part of our second-half growth. We anticipate international ISR missionization programs in the second half as well. To summarize, we landed within Q1 with a book-to-bill over one at 1.08 from an international perspective with 4% growth. This is another predictive indicator demonstrating that our strategy is working. The space sector continues to function as a growth engine, and we anticipate announcements for awards on SCCA tracking Tranche 1. That’s another competitive award we expect in the second half of the year.

Thanks. Good morning.

Good morning, David.

Mix, I wanted to touch on it. I think it was -- it sounds like it was a benefit to IMS in the quarter, but a negative on SAS. I think for the full year, it may be a headwind to both of those segments. If you could just touch on kind of the big moving pieces and how mix impacts margins?

Yeah. David, so I'll start, and then Chris can jump in. From an overall mix perspective, to your point, our segment margins came in at 16%. Our guide is 16% to 16.25%, so we came in on the low end of that. The IMS segment had a strong quarter at 14.8%, compared to our guide of 13.5 to 13.75% due to excellent execution. This is the fourth consecutive quarter of double-digit growth in our commercial aviation sector, and we anticipate continued growth in the second half. We expect that to moderate as we get into the second half to align with our previously provided guidance. Conversely, SAS landed at 11.9% versus a guide of 12.5 to 12.75%, indicating increased expectations for productivity and mix.

Yeah, and regarding Commercial Aviation, we're targeting approximately $500 million in revenue this year. Pre-pandemic, that was closer to $900 million for our commercial training business. We’re patient and anticipating a rebound soon. While we have divested some military training, we're continuing to watch and capitalize on the rebound, which should be forthcoming. The space sector is thriving, delivering well over $2 billion in revenue, and it's achieving double-digit growth. We believe we are in an advantageous position, be it prime in responsive space opportunities or classified work.

Hey. Good morning, guys. Thanks for taking my question. Love the new format. Chris, just -- and perhaps, Michelle, back to the international and demand environment. If we look at the growth trajectory in the industry pre-war, it was really driven by U.S. DoD modernization next-generation programs in the R&D phase, shifting to production. Given the increases in NATO spending plans as a percent of GDP, are you seeing more tangible evidence? And you pointed out that 1.08 book-to-bill; is there potential for higher-margin legacy systems as you move forward? Could this provide structural margin tailwinds in kind of the medium term if these European NATO countries need to recapitalize their business or their industrial base?

Yeah. Michael, that's a great question about legacy systems. I think we're all learning that if the system is out of production, it’s almost impossible to restart. Being able to restart something that's currently operational, potentially an older version, might be easier to deploy. The supply chain headwind is a challenge; not many products are lying around in warehouses. Demand signals are focused on restocking rather than new production. I'm optimistic about international opportunities because we have a mixture of products and a global distribution network. We're making strong connections in critical markets, and international segments are growing as a larger percentage each quarter. To close, I want to thank everyone for the positive feedback on our new format. We’re excited to do it again and see if we can innovate further. We know our customers are under pressure, and we are working hard to support them. I credit our customers with their requests for new entrants and innovation, which we've responded to. And, of course, I want to thank all our employees for their dedication and hard work. They're inspiring, and we feel a lot of momentum and excitement heading into 2022 with solid plans in place. I will note we will continue our humanitarian efforts for the people of Ukraine, working with DoD, NATO allies, and others as we navigate current challenges. Thank you for joining today’s call. Have a great weekend. Talk to you in a couple of months. Bye.