L3Harris Technologies Inc (LHX) — Q4 2022 Earnings Call Transcript

Thank you, Rob. Good morning, and welcome to our fourth quarter 2022 earnings call. We published our investor letter after the market close yesterday. So today's call will primarily be focused on answering your questions. Joining me for the call are Chris Kubasik, our CEO; and Michelle Turner, our CFO. 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. Before going to questions, Chris will make some brief comments.

Okay. Thank you, Rajeev, and good morning, everyone. As we reported yesterday, our fourth quarter came in ahead of expectations, and our 2023 guidance points to steady or improving trends. We've also been active on the M&A front, consistent with our strategy as opportunities present themselves. Let's start with Q4. The team delivered a solid top line, up 6% organically, with Communications leading the way as we saw improvements in electronic component availability within tactical communications. This contributed to the second consecutive quarter of organic growth for our company. Segment margins were about what we expected, with ongoing pressures from macro factors, including inflated costs for material and labor. The net of this is EPS just above our recently guided midpoint and free cash flow at our $2 billion outlook. Turning to 2023. We're consistent with what we said on the last call: Expanding our revenue in the 2% to 4% range, including the Link 16 acquisition while holding our industry-leading margins steady at about 15.5%. EPS adjusted for pension headwinds points to stable operating results, and we're expecting an improving cash flow profile. Lastly, on recent M&A activity, we've previously discussed an opportunistic approach within our balanced capital allocation framework. We had opportunities to acquire two unique assets in ViaSat's Tactical Data Link business and Aerojet Rocketdyne. We closed TDL in 13 weeks and are off to a strong start with integration. In fact, our newest employees are already on the L3Harris payroll system and participating in our 401(k) and benefit programs. This acquisition positions us well to play a central role in networking and resiliency for global defense customers and fills in a needed capability as we develop our JADC2 solutions. Regarding Aerojet Rocketdyne, it's a national asset critical to future warfare that has a leadership position in propulsion, adding exposure to new growth markets for us with munitions, space exploration and hypersonics. It brings nearly $7 billion of backlog and tailwinds driven by global demand. With both of these acquisitions, we'll utilize our recent experience from our merger of equals. We expect much of the integration work for TDL to be complete once we bring Aerojet Rocketdyne into L3Harris. We'll hold an Investor Day later in the year to talk more about the strategy and outlook for our growing company. So we're building momentum with our strategy and look forward to executing on our performance-first initiative in 2023. With that, let's open the line for questions.

Good morning. Thank you.

Good morning, Doug.

Yeah. Well, this question is going to have a few parts, I'm afraid because I want to understand a little bit more about your case for Aerojet Rocketdyne. I mean, you've talked a lot about it being a valuable asset. It diversifies your portfolio. But as you've also said, it's been a merchant supplier. So trying to understand, there are a few things here. When you look at it, what are some of the specific parts of the company that have potential for revenue synergy? Second, are there some areas of cost reduction there beyond just corporate costs? Because I know the facilities are difficult to move, for example. Third, are there things that you can do to improve operations and better performance for the end customers? And then last, when you're in this pre-close period, how do you ensure that the value of this asset doesn't deteriorate over time?

Okay. Well, thank you. Let me see if I can hit all of those. I'm sure there'll be several Aerojet Rocketdyne questions, but maybe I'll give a longer answer than usual and try to preempt some of those. So when we look at acquisitions, I'd like to start with the market. And when we're looking at the market data outside of platforms, the three largest global markets for defense are command and control, sensors, and weapons. So I'm very comfortable with how we're positioned on the first two, especially after the TDL acquisition. Our weapon presence in this $75 billion market is practically nonexistent. So we believe that weapons, munitions, missiles, whatever you want to call them, are absolutely aligned with the current and emerging customer demand. It is a growth market for the future fight. And solid rocket motors, especially for products like Javelin, STINGER, many that we know and hear about regularly, are a great way to position us in the missile and missile defense market. So I look at that from the munition side. On the space front, we have a long history of working with NASA and NOAA, so relative to space exploration and observation, we already have these relationships. We're honored to be able to support SLS and Artemis, and there's visibility there for several years to come. And then the RL10 is a premium upper stage engine with well over 100 engines under contract with the ELA for the new Vulcan launch vehicle. I think hypersonics doesn't really get the attention it deserves, and the other day someone said hypersonics is the future. The reality is hypersonics is now. I believe this could be the crown jewel of the acquisition, and we believe there are significant growth opportunities that are well supported by the budget and the customers. So when I look at those three markets, I see growth. If I jump to the financials, as it relates to Aerojet Rocketdyne and what we can do, I mentioned the $7 billion of backlog, which provides us with more visibility. I believe this will grow faster on the top line than our current portfolio. I believe we have the ability to improve margins and align them more closely with what we're doing on a consolidated basis now over time. And there are several multi-year programs that will be coming up for renegotiation in the next year or two. As we continue to negotiate milestone payments, we'll be cash favorable. I throw that out there to answer a couple of your questions. On the cost synergy, we believe there's something in the $50 million range easily from eliminating the public company costs and some of the duplicative overhead. You're right; we have no plans to move facilities, but I look at the footprint. We both have offices in D.C. and Huntsville. There's some low-hanging fruit there, and we really didn't anticipate or plan at this point any synergies relative to the supply chain. So we need to dig into that and, of course, take the power of the new enterprise into account. I think that gets us to your question, Doug, on cost synergies. On the operations front, I think we have great opportunities here to bring our skill set and enhance the performance of Aerojet Rocketdyne. I look at what we did at L3Harris before the merger, looking at the TR3 program as an example, and maybe our Waco facility. Both of those locations are – the TR3 program was over budget and late. The Waco facility was losing money. With the scale of the new company, more talent, processes, policies, controls, and the ability to attract new people, we were able to turn not only that program but that business around. Those are the capabilities that we'll be able to bring to Aerojet Rocketdyne. Regarding pre-closing exposure, I don't think there's anything unique compared to other acquisitions. The integration team meets regularly. I think we will start having people on-site at some of these facilities as part of the integration process next week or the week after. As you would expect, Eileen Drake and I meet regularly, and we had a call yesterday and meet every week and sometimes more. That's how we're going to stay in touch, and we can do whatever we can to help them. I'm optimistic that this is going to be a very accretive and successful acquisition. We're excited. The employees are excited, and I apologize for the long answer, but I wanted to try to address all five or six of your questions, Doug.

Thanks so much. Good morning.

Good morning.

Good morning.

Chris, I'll keep it to one following up from Doug's question though. When you looked at Aerojet and you look to the other levers you could pull on capital deployment, why did you think this is the best option for shareholders to go with versus continuing with the share buyback? Thank you.

All right. Well, thank you. First of all, it's consistent with our strategy. I think I've been talking for several years. We're building a new company to provide more competition within the industry and to give the DoD alternatives. I've been pretty consistent in saying we want to grow organically and inorganically. Different companies have different portfolios. When I looked at the market and the team looked at the markets and saw the focus and growth on munitions, it seemed to be a gap. We think over the long term to mid-term, you're going to look back on this and see why this makes so much sense. I tried to lay out for Doug some of the strategy and some of the trends. This company has some amazing employees and great technologies, with a great legacy, and I think there's going to be continued growth in munitions and space and hypersonics for the long term. Relative to capital deployment, yes, it was a -- I don't want to say it was a pretty easy decision, but it was consistent with what we wanted to do. There aren't that many assets available in this industry, and when they come available, you have to make a decision and act on them. I'm excited that we got TDL done in 92 days, and the integration is already underway. If you look at the investor letter, I think it's page 14, it has a nice pie chart that lays out our capital deployment over a five-year period, showing a fair amount of balance. I don't foresee us doing any acquisitions for a couple of years, as you would imagine. We have some non-core assets that we're going to sell, and we're going to use those proceeds to bring down debt over the next few years. We'll continue annual dividend increases and remain competitive. Then we'll repurchase shares—probably at least $500 million a year to absorb any dilution, and depending on cash flow and other dynamics, that number could increase as we go forward. Hopefully, that answered your question.

Thank you. Good morning, Chris and Michelle. Chris, just on your last point, you've clearly been busy augmenting the portfolio with TDL and Aerojet. But how do you think about IRAD spend in 2023 versus 2022? You noted in your EPS bridge us $0.10 of internal investment headwinds and input costs. So, what are some of the products that you're focused on and these technologies accelerators that you're working on? And how do they contribute to your top line returning to mid-single-digit growth?

Yes. Good morning, Sheila. And yes, IRAD is something that we have been investing in year-over-year. We have industry-leading IRAD, kind of in the 3.5% range. We've significantly increased what we call ERAD, our external R&D from customers. When I look at the two together, we're well over $2 billion. We have a pretty good process to prioritize how we spend that money. Some exciting things—if I start in space, we're excited about the investments made in new optics we refer to as replicated composite optics. This is a replacement for glass mirrors in telescopes made out of carbon graphite. This is exciting because it’s about half the weight, takes about two-thirds of the time to manufacture, and it's significantly less expensive. We're going to be launching the first-ever replicated optics in the middle of the year. I think this could reduce risk. We'll see how it performs, but this could be a game changer for our satellite business. In the air and land domains with ViaSat, we're investing in the advanced Tactical Data Link with a lot more resiliency. That's part of the overall strategy to modernize Link 16. We have the largest library of waveforms, so we're very excited about that. And on the maritime front, I'm pretty excited that our Iver vehicle has recently achieved the first-ever repetitive submerged launch and recovery from a torpedo tube. This is a significant step for our company, and I think it gives us an opportunity to enhance the nation's autonomous undersea capabilities considerably. Those are tangible examples, and each will result in new business programs of record and gives insight into what's coming from all the money we're spending, whether it's IRAD or ERAD. As you may have seen in the letter and other releases, we have two new segment presidents who joined us this year, and I can speak for them, saying as they went through our portfolio and looked at the IRAD and some of the things we're working on, both John and Sam were excited about the potential. So thank you, Sheila.

Hey, good morning and congratulations on the progress this quarter. It's great to see.

Good morning.

Michelle, are there any large ISR missionization contracts and the guides that haven't been finalized yet, particularly on the international side? I'm just trying to get a sense of whether there's any timing-related downside risk from that or if that's more just an upside opportunity if one or more contracts do go your way? Thank you.

Yes. No, I appreciate the question, Scott, and thanks for this, because it is important to note that, as we think about our guide for this year, we did take a different approach on a couple of things. Our ISR missionization business is one of them. To directly answer your question, no, there are not any large international ISR pursuits in the plan. We do have one domestic pursuit, which we're anticipating in the first half of the year. We already have the aircraft, so that's minimizing the risk, and it's funded from a budgetary perspective. It's our C3D program. We have four aircraft tied around that. It's important, because as we walk through the guide, this, along with supply chain, were the two key components influencing how we’re thinking about our guide for 2023. I'll hit supply chain upfront, because I'm assuming we're going to get the question. I'd be disappointed if we didn't. When we look at our guide for the current year, we're assuming something consistent with what we did in the second half of 2022. Coming off of the strong Q4 results, we're incredibly proud of all the teams across our product-based businesses, particularly. I want to shout out to our Tactical Communications team, WESCAM, PSPC, along with commercial aviation. We had a really strong finish to the year. As we're building on that momentum coming into 2023, we assume that we're continuing to have consistent results in the second half of 2022 throughout the full year of the 2023 guide. To your point, Scott, around using what we learned in 2022 and influencing our 2023 outlook, there are really two key components. One was around ISR missionization demand. Although we're continuing to pursue a handful of those programs with budgets being up, we're optimistic that we will land a contract. We thought it was prudent at this point not to put that into our guide and see it as upside.

Hey good morning guys. Thanks for taking the questions. Maybe just to go back to Aerojet and thinking about these cost synergies, I know they had previously executed on a $240 million cost takeout program. It seems like all of those savings went to the customers. I’m thinking about maybe the lack of margin expansion we've seen there. There have been challenges in the rocket motor supply chain. I think Raytheon has been pretty outspoken there. Northrop is picking up the entire GMLRS motor production this year. What's the status of their production system? Do you think you have to make any investments? Is that contemplated in the cost synergies? And I guess maybe your level of confidence in margin expansion at that entity?

Yeah. Thank you, Michael. We do have confidence in margin expansion. I think when you look at the customer or the portfolio mix they have, it's a combination of cost-plus and fixed-price contracts. I'm not sure all of it would go back to the customer; it should remain on the fixed-price contracts. But that’s in the past. I'm looking forward. Like any of these acquisitions, there are systems that are fragmented or maybe older technology just like when we put L3 and Harris together. Our IT organization knows how to convert these. I used my reference to ViaSat; those employees are already on our systems, and it hasn't been a month. Most of the challenges seem to be at one facility. We'll have people down there in the next week or two. Everything has been contemplated in our business case. One of the benefits of being part of a larger organization—again, this is an acquisition, not a merger, an important distinction—we're buying them. They're about one-tenth of our market cap, and this will be a quick integration relative to decisions needing to be made. A lot of their systems will migrate onto ours, whether it's benefits, payroll, etc. On the ERP manufacturing execution systems, they've been implementing those. We're familiar with those and with the technology. All of that has been taken into account. With our scale, we have the capital. We have the IRAD. We prioritize it, and we have the ability to invest as they have been doing to make them world class.

Hey. Thanks very much, and good morning.

Good morning.

I wonder if you could talk a little bit about the kind of the medium-term outlook for the Communications business. We recently saw a management change there, and the details of the management change suggest that you're looking for some really fresh and different thinking in a business that's been kind of the core of the earnings for the company. We've seen some good growth in the radio budgets in recent years. But when we look out to the middle of the decade and beyond, it doesn't necessarily look as good. So, can you tell us about your medium-term thought process for communications?

No. Absolutely, Seth. Yeah. I mean, Sam joined us at the beginning of the year. When I look – I know a few people were asking questions relative to Sam and the business. CS is a short-cycle business with a global footprint, a lot of Army and Marine business. When I hired Sam, I look first and foremost for someone who's a leader versus a manager. Everywhere he's been, he's had success strategically, operationally, and financially. Whether it’s Collins, Sikorsky, UTC, he’s led production and programs. He’s familiar with foreign military sales, direct commercial sales, and has global experience. I have no doubt he will add value to the corporation. When I look at the medium term on communications, I don’t want to underestimate the significance of the ViaSat acquisition and the focus on JADC2 and the ability to connect networks, which the customer has been talking about for a decade. There’s frustration on their part that we haven’t been able, as an industry, to get that across the goal line. The tactical radio business continues to see growth in the low to mid-single digits, not only domestically, where modernization will continue. Internationally, in the fourth quarter, we got another contract from Australia, a great customer. The visibility we see continues to look good as modernization continues and the need for resiliency continues. I think there’s ability for more of a soldier as a system that’s been talked about but never quite brought across the goal line. We have the ENVG goggles, radios, and connectivity at the soldier level and networks at a higher level. It’s a key part of our business. Anything over the past year, you look at the war in Ukraine, the ability to communicate is critical to executing the fight of the future. Our resiliency and capability are unique, and I think it's going to continue to grow for the foreseeable future.

Hi. Good morning, guys.

Good morning.

Good morning.

I was curious, Chris, if you could talk to where you guys are in the L3 kind of integration journey. Meaning a couple of years ago, you talked about $250 million of annual cost out for several years moving from a holding company to an integrated business, etc. I’m just curious where you think you are on that journey? And then if you could just comment also on the supply chain and the pace of healing within it assumed in the guidance and what you saw in Q4? Thanks.

Okay. Let me take the first part. I'll ask Michelle to talk about the supply chain. As part of our E3 continuous improvement initiative, I'd say we're never complete. We talked about a three-year plan to take out $500 million, and we took out $660 million. We're going to stop trying to call out separately the one-time costs and the savings as we move into the next cycle of acquisitions. But I assure you it’s an ongoing journey. We got the low-hanging fruit. We made a lot of progress. I'd say maybe we're two-thirds of the way through the integration. When I look at the IT systems, the ERP systems have come down substantially. I think we used to have about 100; by the end of the year, we’ll be in the 20s. That’s good progress. We’ve got consistent manufacturing execution systems. The ones in Greenville should be done this year. We’ve done a good job on shared services and completed the facility moves. The team is looking at each function and process and continuing to optimize them. We did the easy stuff and are now going function-by-function, relooking at policies, procedures, and systems to optimize the business, making it faster and ultimately taking cash out. So I’d go with two-thirds of the way through. I’ll pass it to Michelle and see if she agrees with me, and have her give some supply chain insight.

I always agree with you, Chris. Just to add a little more color, I think a great example of where we're continuing on this next phase is around our real estate and footprint consolidation efforts. We've taken the low-hanging fruit in the first couple of years. Byron Green and his real estate team have focused on what's the next phase of that. We're in the middle of a two-year plan to reduce an additional 10% of our overall sites as a result of this current operating environment where we have more of a hybrid workforce. It’s an evolution that will continue to pay dividends for us. It’s really helping to offset some of the macro inflationary challenges that are permeating across the industry. Just to give a bit more color from a supply chain perspective about our 2023 guide, I’d describe it as a balanced approach. This guide assumes consistency with our second half 2022 performance. To make this more tangible, let’s think about what’s different in 2023 versus what remained the same at the start of 2022 or at the end of 2021. What’s the same? We continue to see hiccups from an overall supply chain perspective. This is consistent across our industry and has become a new norm. We continue to be on a 90-day allocation process with our microelectronic chip manufacturers. This is important because insights about our chip supply are good for only about 90 days. When we look at our portfolio, 25% is tied to product deliveries. If we’re short on chips or washers, we can’t deliver our products. What’s different is the proactive actions we took last year. Engineering redesigns were a big focus; we’re seeing the full benefit of that in 2023. Our alternate part bank for Tactical Communications Systems is up to 1,000 parts, compared to 100 in 2021. Our overall revenue base in terms of DPAS coverage has increased double digits, aiding the prioritization of supply and material availability. The most important predictive indicator is the number of critical parts; we’ve dropped from hundreds to the 10s in terms of impact. We see sequential improvement from a supply chain perspective. We’re not out of the woods, and we’re taking a balanced approach reflected in our guide.

Hi. Thank you. So Michelle, just on the back of all of that, it seems like the positives may support higher margins in 2023. Now I know the guidance range allows for that. But what would cause the downside?

Yeah. No, great question. I’ll start from the overall enterprise. To your point, Rob, we assume flattish margins, around 15.4, 15.5. From a headwind perspective, we're assuming continued macro inflationary challenges of about $400 million or about 2.5% of our overall revenue. We also have some headwinds from a mix perspective. Chris talked about where we're investing in space. While Kelly and her team are doing phenomenal in terms of growing the business, it will be a drag on our margins as we book these new programs at lower rates. As we mitigate the risk, profitability should improve over time. Inflationary challenges and mix are offset by our strong E3 savings program. Real estate is a great example of that. Another great example is the voluntary retirement program announced at the end of Q3 last year, which will help offset merit increases. We've also assumed some level of commercial pricing. Specifically, Rob, the downside is the unknowns related to inflationary challenges; 2022 felt more reactionary. We are controlling the controllables and managing through 2023.

I’ll just add that when we last talked, I mentioned the importance of keeping our workforce engaged and motivated and focusing on attrition. In October, we discussed some initiatives unique to our workforce. We’ve increased budgets for spot awards to recognize performance, all of which has resulted in significant investments of over $100 million that will provide a drag in 2023 but are the right thing to do. I’m confident it’s going to pay off.

Hey. Good morning, guys. Chris, earlier you mentioned that the ViaSat deal closed 90 days ahead of expectations. Was this something that you did differently with this acquisition to help speed up the regulatory review? And how much of that playbook is applicable to the Aerojet Rocketdyne deal?

Yes. Great question and good morning, Kristine. Yes, I said we closed it in 92 days. We forecasted mid-year closure and made all the appropriate filings for HSR. We responded to all the questions within the 30-day period for ViaSat. There are some international approvals. It made a lot of sense, and we weren’t sure how that process would play out. For Aerojet Rocketdyne, mid-January, we made our HSR filing. We’re aware the FTC is reviewing it. We’ve been responsive in answering their questions. Eileen and I met with key customers in the Pentagon to explain the rationale and answer their questions, so transparency and responsiveness are the focuses. We’ll see how the process plays out, but so far everything is tracking.

Good morning, Chris, Michelle. Hey, Chris, the TD acquisition seems like it's a great fit, as you kind of highlighted that you had two capabilities. Maybe you could just talk a little bit about if you see a big product upgrade cycle or what kind of opportunity it is for L3?

Yes. Thanks, Peter. We’ve talked about Link 16 being on 20,000 platforms. That really gives us the ability to upgrade and modernize. When I mentioned the IRAD we’re spending on the advanced data tactical link, that’s an obvious fit. One of the things we focused on in the negotiation was this being a carve-out, which is a little unique regarding what we buy and don’t buy. We really wanted to get access to a relatively small piece of the business, which was the Link 16 to space and Link 16 and Viasat's on the SDA transport. Later this year we’ll launch the first-ever Link 16 capability in space, and I think that’s the hidden jewel of this acquisition. There’s going to be Link 16 in space, and connectivity from space to air is a game changer for focusing on resiliency. Relative to revenue synergies, we’re very excited about the potential with ViaSat. The upgrade is going to happen, and we’re investing in new product production that's going well. We’ll look back on this one and see it as quite successful and off to a good start.

Thanks. Chris, Michelle, Rajeev, good morning.

Good morning.

Chris, last year, I'm going to try two, because I think they're quick. Your letter indicates you're getting compensated for inflation on new contracts. I was just wondering on existing fixed-price contracts, is the government allowing you any adjustments based on higher unforeseen costs? If so, would that be upside to your guide? Second question is Chris, just given your knowledge on – I asked this of your competitors. It seems to be just a general view that, as we move into a deficit reduction, defense is going to be the bill payer. I was curious about your sentiment on the Hill for continued defense spending and funding modernization? Thanks.

Yeah. Thanks, Rich. On the first one, we have not received any compensation for inflation on fixed-price contracts, nor have we asked for any. Similar to COVID expenses and other factors, we've absorbed it as part of the business. I'm confident we’ve survived these past three years and that everything is looking much better on the upside. If we received money, that would be upside, but as of now, we're focused on new contracts. If something changes or if the DoD encourages us to bring forward a claim of some sort, we’ll certainly do it, but clear documentation is necessary. On deficit reduction, it’s something we’re all watching. I referenced the letter. We’re excited to have a defense budget to start our fiscal year, thanks to everyone in the lame-duck session for getting that done. It’s a significant deal for us and the industry, and even a bigger deal for the Department of Defense. This gives us confidence in the future. It’s hard to predict how that will play out. I’m not in the camp that thinks the DoD will be the bill payer. There’s some rhetoric around that, and people say things to gain leadership positions in Congress. However, with the current threats, it’s hard to justify flattening or reducing the defense budget in this dangerous world. This relates back to these acquisitions and looking at what will matter in the end—the future fight, situational awareness with ISR, resilient communications, and munitions. I like where we are regarding those positions, Rich. With that, we'll wrap up. I appreciate everybody calling in. I'm a big believer in momentum, and I feel we're beginning to see it with two consecutive quarters of growth and some acquisitions. I don’t know if you can hear it in my voice and Michelle’s, but we’re really excited about the future and what it brings. The initial feedback from the ViaSat and Aerojet Rocketdyne employees has been all positive. We've heard from many former Aerojet Rocketdyne employees who are excited about the transaction. We’ll focus on the closing, get this deal done, and once it’s closed, we’re looking forward to connecting with any former Aerojet Rocketdyne employees who are passionate about the mission. It’s going to be an exciting couple of years, but I wanted to recognize and thank Dana Mehnert for his 38 years of service. As you know, Dana announced his retirement in Q4 and is assisting with a smooth transition. We appreciate that, Dana, and wish you all the best in your future endeavors. I want to turn it over to Michelle real quick.

So, thank you, everyone, for joining the call today and for your continued interest in our company. Before we disconnect, I just want to take a minute. Many of you know, this will be Rajeev's last earnings call with us. I want to thank you, Rajeev, for your contributions to our Investor Relations function, overall L3Harris, and for me personally for my transition over the last year. We all wish you the very best in this next adventure. So, thank you.