Leonardo DRS Q2 2023 Earnings Call Transcript

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Provided by Quartr
August 2, 2023

There are 8 speakers on the call.

Operator

Ladies and gentlemen, good day, and welcome to the Leonardo DRS Second Quarter Fiscal Year 2023 Earnings Conference Call. At this time, all participants are in a listen only mode. Following the company's prepared remarks, there will be an opportunity to ask questions instructions will be given at that time. As a reminder, this event is being recorded. And I would now like to turn the conference over to Steve Vather, Vice President of Investor Relations and Corporate Finance.

Operator

Sir, please go ahead.

Speaker 1

Good morning and welcome everyone. Thanks for participating on today's quarterly earnings conference call. With me today are Bill Lynn, our Chairman and CEO Mike DePold, our CFO. They will discuss our strategy, operational highlights, financial results and forward outlook. Today's call is being webcast on the regarding future events, anticipated future trends and the anticipated future performance of the company.

Speaker 1

We caution you that such from those projected in the forward looking statements due to a variety of factors. For a full discussion of these risk factors, please refer to our latest Form 10 ks and our other SEC filings. We undertake no obligation to update any of the forward looking statements made on this call. During this call, management will also discuss non GAAP financial measures, we believe provide useful information for investors. These non GAAP measures should not be evaluated in isolation or as a substitute for GAAP performance measures.

Speaker 1

You can find a reconciliation of the non GAAP measures discussed on this call in our earnings release. At this time, it is my pleasure to turn the call over to Bill. Bill?

Speaker 2

Thanks, Steve, and thank you all for joining us this morning. I am pleased to report that we delivered strong results in line with our expectations for the Q2. In Q2, our revenues accelerated and organic growth increased to the mid single digits. We also continue to see momentum in customer demand and secured nearly $700,000,000 of funded bookings in the quarter, representing a 1.1 book to bill ratio. Backlog now stands at $4,400,000,000 which is up 43% year over year and is also up sequentially.

Speaker 2

Demand was evident across our diverse technology portfolio With Q2 bookings being led by requirements for our electric power and propulsion, network computing and Tactical Radar Technologies. We also generated healthy profitability as demonstrated by our solid adjusted EBITDA, Margins and adjusted diluted EPS for the quarter. Mike will walk through the details and trends a bit later in the call. Overall, our year to date performance continues to track to the stair step trajectory necessary to achieve our 2023 guidance. We remain confident in our ability to continue to increase our revenue and profit performance Up this quarterly staircase as planned based on our solid business fundamentals and demonstrated ability to execute.

Speaker 2

Shifting to the macro environment, the bipartisan agreement reached a few months ago to raise the debt ceiling resulted in a framework for future defense spending levels. For FY 2024, the agreed upon levels indicate a growth of 3%, which is consistent with the President's budget request. For FY 2025, the growth is lower at 1%. However, supplemental spending including U. S.

Speaker 2

Military support for Ukraine is exempt from these agreed upon levels. Overall, we expect that there will be an upward long term bias to defense budgets given the bipartisan recognition of the elevated global threat Furthermore, our platform agnostic business model, alignment to customer priorities, Differentiated technology offering and strong pipeline gives us continued confidence in our growth prospects. Moving to operational highlights, the team has done a great job managing through the complex operating environment. However, supply chain inflation and labor availability all remain as factors with varying levels of impact to the business. Of these three factors, supply chain continues to pose the biggest challenge.

Speaker 2

Consistent with our prior commentary, We are not relying on any material improvement in the back half of 2023. Furthermore, We expect the potential improvement in 2024 will likely be gradual and incremental. With respect to inflation, we are seeing better price stability in our material inputs. As we work through our own normal course repricing We remain cautiously optimistic that inflation will become less of a headwind next year. On the labor front, we are seeing improvement in retention rates, which is helping the pacing of our net hiring.

Speaker 2

That said, There are still some pockets where hiring remains challenging. All in all, we are pleased that the operating environment is trending positively, But we will remain vigilant and focused on execution, particularly as we continue the transition of several programs from development to production over the coming quarters. Moving to some programmatic highlights from the quarter. We are continuing to execute well on the Columbia Class program, which is reflected in our overall results. We remain excited about the near term growth opportunities for our electric power And Propulsion Technology.

Speaker 2

International interest in this technology continues to build and we are closely tracking The competitive domestic opportunities. Shifting to space for a moment, we recently secured 2 strategic wins to help develop Space payloads for civilian LEO satellites. These wins are important strategic market footholds. We are encouraged by our continuing traction in this market as we expand our presence and build on our reputation as a go to provider for differentiated sensing capabilities optimized for size, weight and power. Additionally, we submitted several new business Proposals in the quarter that offer the potential to further expand our space business for both civilian and defense applications.

Speaker 2

We're carefully optimistic that customers will find value in our differentiated solutions amidst a competitive field. Moving to innovation, last quarter we discussed our single vehicle counter UAS solution. I am delighted to report That the customer reaction to date has been quite favorable. This is a validation of our agility and our ability to make strategic R and D investments to quickly meet the critical needs of our customers. Over the past few years, we have thoughtfully increased our research and development investments to further expand and differentiate our technology portfolio.

Speaker 2

This quarter, we announced innovation in the sensing arena With a new 8 inches gimbal for small to midsize UAS platforms that will deliver improved intelligence, surveillance, Reconnaissance and targeting capabilities. There is a rich opportunity for DRS to expand its presence on unmanned platforms With our sensing, platform survivability and our broader electronics capabilities, bringing all of DRS to bear across Programs, platforms and customers is a fundamental part of our strategy. And I'm excited to see that expand to include RADA. We are actively pursuing pipeline opportunities on a joint basis and are looking to drive the revenue synergies that underpinned our transaction rationale. Lastly, I wanted to highlight that the Defense Counterintelligence and Security Agency Has awarded us a 2023 Cogswell Award for Outstanding Industrial Security Achievement at our facility in Bridgeton, Missouri.

Speaker 2

We received 1 of the 20 awarded this year from a field of 12,000 facilities. This marks our 21st Cogswell award in the past 10 years reflecting our utmost commitment to maintaining the highest standards for security. Overall, I am pleased with our performance to date, but we are maintaining a steadfast focus on operational execution to meet our commitments to both customers and shareholders. Now, I'd like to turn the call over to Mike, So, Dheep can walk you through our financials in more detail.

Speaker 3

Thanks, Bill. I want to thank the broader DRS team in helping deliver another Quarter of solid results. Let me step through the key financial metrics and trends for the quarter and then discuss our updated guidance. Q2 revenues were essentially flat year over year. Excluding the net divestiture impact, our revenues for the quarter were up mid single digits versus Q2 of the prior year.

Speaker 3

Just as a reminder, this is the last quarter where we had the full net divestiture impact. We will anniversary the divestiture in early August, resulting in a smaller and partial quarter impact to Q3. Moving to the segment trends. Advanced Sensing and Computing segment revenues were down 9%, mostly due to the net divestiture impact. Excluding this factor, the decline was roughly a couple of points as supply chain challenges continue to elongate the conversion of bookings to Overall, supply chain challenges have been more impactful to our ASC segment.

Speaker 3

Our Integrated Mission Systems segment enjoyed impressive organic growth 21% as our Columbia class program revenues move incrementally towards the production stream. Now to adjusted EBITDA. Adjusted EBITDA in the quarter was $62,000,000 representing a decrease of 8% from last year. Resulting adjusted EBITDA margins were 9.9%, down 90 basis points from Q2 of 2022, but up 130 basis points sequentially from last quarter. The year over year adjusted EBITDA decline and margin contraction was driven by increased public company costs and higher investments in research and development.

Speaker 3

In the quarter, we reversed a $10,000,000 legal reserve for an aged environmental liability. This liability came via an acquisition several decades ago and recent facts drove us to reassess the risk related to this matter as no longer probable. Please note, we have excluded this one time benefit out of all of our non GAAP financial metrics. Moving to the segment trends. In Q2, ASC segment EBITDA decreased and adjusted EBITDA margins declined due to the higher investments in internal R and D and increased public company costs allocated to the segment.

Speaker 3

Despite increased operating expenses, the IMF segment adjusted EBITDA and margins were up, primarily due to strong program execution and higher volume in our naval power business, particularly on the Columbia Class program. Moving to the bottom line metrics, There were a couple of discrete factors that drove performance and trends. Our solid execution translated to the bottom line, but was aided by a net 8,000,000 Tax benefit primarily related to research and development credits. Additionally, our GAAP metrics reflected a $10,000,000 legal reserve reversal that was discussed earlier. The resulting net earnings in the quarter were $35,000,000 up 40% over the prior year and adjusted net earnings of $39,000,000 were up 13%.

Speaker 3

As expected, the trending was a little lower at the EPS line given the increased share count in 2023, resulting from our all stock combination of RADA. Diluted EPS was $0.13 a share, up 12% and adjusted diluted EPS was $0.15 a share, representing a $0.01 decline as compared to the prior year. Year to date strength in our stock price performance also drove higher than expected option exercises and ticked up our diluted share count. Moving to free cash flow. Cash remained a little sluggish with an outflow of $10,000,000 in the second quarter.

Speaker 3

Driving working capital lower and optimizing cash conversion remains a top priority for us. Please remember that our typical cash flow strength is most evident in the 4th quarter. Now to our forward outlook. Halfway through the year, we are updating our guidance by narrowing the ranges for revenue, Adjusted EBITDA and adjusted diluted EPS. We are now calling for revenue between $2,725,000,000 and 2,800,000,000 At the midpoint, this still reflects approximately 4% organic growth.

Speaker 3

Our updated view on adjusted EBITDA is between $318,000,000 $328,000,000 The range for adjusted diluted EPS is now $0.66 to $0.69 per share. Our underlying assumption for the tax rate for the year is now 19%, thanks to the benefit of the R and D tax credit. We should see a recurring benefit from R and D tax credits in future periods and we anticipate our rate to drop. For modeling purposes, you should leverage a 23% Effective tax rate moving forward. Our strong year to date stock performance led to a higher than expected option exercises.

Speaker 3

And as a result, we are now assuming a higher fully diluted share count of 266,000,000 for the year. As discussed previously, we continue to expect the driven by the absorption of fixed costs and free cash flow. Let me close by saying that we have solid momentum in our year to date results, We are focused on accelerated performance for the balance of the year. Longer term, we are excited about the growth opportunities in front of and are working aggressively to sharpen our competitive positioning. With that, we are ready to take your questions.

Operator

Thank you. At this time, we will begin the question and answer session. Our first questions come from the line of Robert Stallard of Vertical Research. Please proceed with your questions.

Speaker 4

Thanks so much. Good morning.

Speaker 2

Good morning.

Speaker 4

I'll kick off with a couple for Bill. First of all, On the DoD budget, we could see another CR for the start of the fiscal year. Historically, what sort of impact has that had on DRS? And what sort of implications could there be in 2023? And then also to follow-up on your comments on export interest in electric propulsion.

Speaker 4

I wonder if you could elaborate where this could be, what sort of programs your export customers are looking at there? Thank you.

Speaker 2

Yes. Thanks, Rob. On the first point, that we're almost sure to see a CR. I think it's been 15 years The defense bill was passed on time, so we're not really expecting that to happen this year. So that's built into our numbers.

Speaker 2

Generally, you see a defense bill at the very end of the calendar year, the very beginning of the next calendar year. That's about what we'd expect This year and that's how we've planned. So I don't anticipate great disruption from that. We don't have a lot of New start programs, which is what's most impacted by CRs and that you can't spend new fiscal year money on a new Start until you actually have the bill. With regard to your interest on electric power internationally, We've said earlier, we put in a proposal for a Korean destroyer.

Speaker 2

That's in evaluation right now. We Expect to hear in the next months. We don't have a specific date. And then there I don't have other countries, but there's other Interest in a couple of other countries that it's not as far along.

Speaker 4

Okay. Maybe just a couple of quick follow ups for Mike. First of all, on the restructuring charge in the quarter, dollars 8,000,000 I was wondering if you could elaborate what that was related to? And then secondly, Which might be for Mike or maybe for Bill. On capital deployment, why not use some of the anticipated free cash flow this year to offset the share count increase?

Speaker 4

Thank you.

Speaker 3

Okay. I'll start here. The restructuring charge, We constantly assess our kind of our overall footprint and our cost structure. We saw the opportunity here to rationalize some facility expenditures and condense our manufacturing footprint to a lower cost center of excellence. So That's what we implemented during the quarter.

Speaker 3

We think that will have some benefit in the long run, and that's what we did there on the capital deployment piece. So on the capital deployment piece, Rob, with the share count where it is and the float Kind of offsetting that incremental share count is not something where we think our money would be best suited in terms of reducing that float from a buyback. We're focused on generating that cash flow first of all and then putting that cash to use in other methods.

Speaker 4

Okay. Thanks so much.

Operator

Thank you. One moment please for our next question. Our next question will come from Peter Arment of Baird. Please proceed with your questions.

Speaker 5

Thanks. Good morning, Bill, Mike, Steve. Hey, Bill, On the Advanced Sensing margins, the kind of the pressure that you mentioned from the internal R and D step up Spending, does that continue throughout this year? How should we just think about how you think about the impact of margins when we're thinking about the whole year?

Speaker 3

Sure. I'll actually jump in and take that one, Peter. So first of all, with the ASC segment, the first thing I'll point you to Q1 actually got off to a hot start, which was primarily attributed to a little bit of a mix that unwound a little bit. We did indicate when we gave the guide that we were going to see the Public company costs and increased IRED, that is what we anticipated in terms of some cost which we're going to keep the margins kind of flat year over year. But ultimately, the way I would think about the ASC segment is as we continue down This process of kind of stair stepping the revenue volume, that's going to absorb these fixed costs.

Speaker 3

The fixed The G and A, the iRED is going to stay relatively stable and you're going to see the volume increase in the back half of the year and that's going to drive the margins higher And it's kind of tracking towards our expectation for the segment.

Speaker 5

I appreciate that color. Thanks, Mike. And then just Bill, maybe the one for you. Are you seeing any step up in terms of bookings related to force protection for in Ukraine or other countries in Europe? Thanks.

Speaker 2

Yes. Peter, Ukraine certainly has emphasized the importance of force protection both Against airborne threats drones in particular as well as ground based things like shoulder launched missiles and grenades, Seeing all those YouTube videos of the vulnerability of the Russian forces. The way that interest has been reflected has been there has been some Movement into Ukraine, in particular the U. S. Has moved its Avenger, some of its Avenger systems To Ukraine, and I think there have been some direct sales.

Speaker 2

The impact for us has been more in terms of backlog than in revenue. And by that I mean what happens here is ultimately the U. S. Is going to backfill those Avengers Probably with SHORAD by the short range air defense, a more modern system. So that will add to our backlog, but it's not happening immediately.

Speaker 2

It doesn't happen contemporaneous with the move of the equipment to Ukraine. So over the next couple of years, we do expect to see a tick up In those programs, but it doesn't happen in the current year.

Speaker 6

Appreciate all the color. Nice results. Thanks. Thanks. Thanks, Peter.

Operator

Thank you. And one moment please for our next question. Our next question will come from Jon Tanwanteng of CJS Securities. Please proceed with your questions.

Speaker 6

Hi, good morning. Thank you for taking my questions. My first one is, are you hearing any update on the new naval programs domestically? I think I heard You're moving forward in the KDDX, but I was more wondering about the destroyer and the subs and the industrial base expansion here stateside.

Speaker 2

Yes. Thanks. Thanks, John. On the domestic programs, The first step for the new destroyer, the DDG X is a testing facility. The Navy is Wants to proceed in a path where they design and test the new propulsion system before they start the new destroyer.

Speaker 2

So the testing The next step and we have submitted a proposal for the DDGX testing facility this past quarter And we'll see the results in the next few months. You never know exactly when you're going to see an award, but it's the proposals submitted. SSNX, the next submarine is behind that. They're still evaluating what kind of propulsion system. I should say at DDG X they have decided on an electric permanent magnet motor which is what we put into the Columbia Class submarine.

Speaker 2

On the SSNX, they're still doing that evaluation. It's running a couple of years behind the destroyer. In terms of the facility expansion, the demand is there. The U. S.

Speaker 2

Wants to move and there's Congressional pressure to move from our current capability in the submarine industrial base of about 1.5 per year, which is even under the current demand of about 2 per year and we expect that demand to grow. And so the overall the Navy and the shipyards are working With the supplier base including ourselves to try and see how do you accomplish that doubling over the next several years and we're in active discussions with our customers into how we would accomplish that capacity increase.

Speaker 6

Okay, great. Thank you. 2nd, I know you mentioned a little bit more supply chain challenge in ASC in Q2. I was wondering if you're actually seeing the progress in your efforts to help your suppliers recover their Recipes, their yield and their quality, just help me understand what's going on down in the supplier level?

Speaker 2

Let me start and then let Mike expand. Overall, we're seeing greater stability In the supply chain, we're not seeing lead times increase the way we saw in past years, but we're not yet seeing them contract either. So that's why when we say we're not seeing improvement, we're seeing stability, but not a contraction of those lead times. The other thing we're seeing is some movement. I would say last year the biggest problem was in microelectronics.

Speaker 2

This year we're more seeing it there's more stability there. But in electromechanical components, castings, just Contract Manufacturing generally, we're seeing some issues. As you indicated, we're working actively with our suppliers To address those issues and keep our schedules on track, but it's a series of moving challenges that we have to pay Constant attention to it.

Speaker 1

Let me let Mike add a

Speaker 2

little more color in terms of the segment.

Speaker 3

Yes. The only thing I'll add to That John is that, the efforts that we've been making in terms of improving the quality and kind of relearning the recipe, if you will, from some of the casting houses and other vendors that we're dealing with, they are showing some improvements. It's really aiding in that stability comment that Bill just alluded to. We're starting to get more confidence In the timing of the deliveries because of those efforts and because of the quality improvements. So that is moving along, again, not contracting Lead time is not accelerating our backlog conversion, but stabilization continues to be the word that we use and that's what we're seeing.

Speaker 3

The other thing that we've been doing is where we're not seeing those improvements is working to second source certain vendors that You have had some difficulties and that is making progress as well and we're starting to get those qualified and ready to be part of our solution. So In all, I think we're taking another step forward this quarter from a supply chain perspective, but it's still focused on stability, not yet contracting the lead times.

Speaker 6

Okay, great. Thanks. One more for me. Just Leonardo, the parent, reported recently with the new management, they mentioned there might be more opportunities for synergies With DRS, I was wondering, is there room for upside to you at DRS? Or would that be something that accrues more at the parent level?

Speaker 6

Is that too early to think about? Just help me understand what they're thinking up in Italy?

Speaker 2

I think it's probably the latter, John. It's A little too early to think about. The new CEO, Roberto Cingolani is very interested in looking for synergies as are we. I think his focus is on the areas he highlighted in his call, space in particular. As We've talked about we have real opportunities to expand in space and I think that's where the new CEO wants to go as well.

Speaker 2

So I think that's An area we want to mine, but I think it's too early to give you any sizing or thought on the opportunities.

Speaker 6

Okay, understood. I'll jump back in queue. Thank you.

Operator

Thank you. And one moment please for our next question. Our next question will come from Michael Ciarmoli of Truist. Please proceed with your questions.

Speaker 7

Hey, good morning guys. Thanks for taking the questions.

Speaker 6

I guess, Bill, just maybe a

Speaker 7

little bit more color on bookings. I think You've called out ACS as maybe being ahead of expectations. Can you give us any more detail around where maybe some of the upside And then I know you mentioned sort of the status of the DoD budget, but any implications And you did mention Ukraine, but anything from overall increases in NATO spending or kind of the trajectory of what you're expecting for international revenue growth here?

Speaker 2

Yes. Thanks, Michael. On the European Sai, we continue to utilize Leonardo's good offices to seek opportunities In Europe and certainly Ukraine has offered some direct opportunities on the smaller side And it's also bringing a general increase in the European budgets as the NATO members More and more of them are moving to hit that 2% target. So that is moving. That was the first On the bookings side, I'll take

Speaker 3

the bookings. But on the bookings, as you know, we don't officially give any guide on bookings, But we target to beat that kind of 1 to 1 book to bill ratio and our first half performance has come out of the gate well. So we're sitting at about a 1.2 Book to bill ratio year to date, our backlog has grown not only year over year due to the Columbia funding, but also Sequentially, so we're increasing to that record backlog we put out last quarter. The demand seems to be there across all of our product lines are performing well in those Four key markets. So we think we're building a nice foundation as we look out into the future.

Speaker 7

Okay, perfect. And then Mike, I guess just on maybe Status of repricing some of these contracts, how much further Do you have to go to get some of these contracts, I guess, in balance or maybe to offset some of the inflationary headwinds? Just Any color you could provide there, discussions with customers or what's happening on that side?

Speaker 3

Nothing really new on that front. We have a very diverse portfolio. So obviously, there's puts and takes between each of the different programs. But in total, we've talked about this kind of 3 year repricing cycle on average for our contracts, and we're still in the middle of that. This will Still be the year that I think is most impacted from the inflation pressures because it is kind of that year 2 of that 3 year cycle in which we priced programs before the global environment changed.

Speaker 3

So nothing new based upon what we said from our guide. We're seeing those pressures on the profit, which is driving a relatively flat EBITDA margin year over year. So we're seeing that, but we are also seeing The repricing efforts be successful as we look out into the future and hopefully that will provide the tailwind and some margin expansion opportunities as we look forward.

Speaker 7

Got it. And then just last one for me on free cash flow. It looks like it's going to be another heavy 4Q weighting, but Maybe can you give us I know you didn't provide guidance for it, but any color on maybe the magnitude of cash generation for the year or a conversion rate that you could help us with?

Speaker 3

Yes. We're still targeting that 90% conversion of adjusted net earnings with the one And caveat of the Section 174 R and D tax payment that we had to make. So no change there. It is back end loaded You said, and we have a path to get there, and are tracking that accordingly.

Speaker 7

Perfect. Thanks, guys. I'll jump back in queue.

Operator

Thank And we have a follow-up from John Cameron Kang of CJS Securities. Please proceed with your question.

Speaker 6

Hi. Yes, I was just wondering about the restructuring charge. I think you addressed a little bit earlier, but I was wondering what kind of run rate cost savings that's generating on an annual basis. Is that part of your guidance for this year or does that more impact the 4 years from here?

Speaker 3

Yes. The majority of the cost savings is going to be forward looking. We look for a 1:one ratio at a minimum for these restructuring efforts annually. And that's the expectation that we had set with this effort with the facility rationalization.

Speaker 6

Okay. And is that a one time Q2 event or is there more that we saw in Q3 and Q4?

Speaker 3

The majority of it is here in Q2. We're going to because of the accounting And when the timing of the recognition, we'll have some water drips in, but the lion's share of it is in Q2.

Speaker 6

Okay, got it. Thank you.

Operator

Thank you. One moment please. I'm seeing no further questions in the queue. So at this time, I will turn the floor back to Steve Vather for closing remarks.

Speaker 1

Thank you all for tuning in this morning and your continued interest in DRS. As always, please don't hesitate to reach out if you have any follow-up questions. We look forward to speaking to all of you again soon. Enjoy the rest of your day.

Operator

Thank you. This concludes today's conference. You may now disconnect. Thank you for your participation and have a pleasant day.

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