Leidos Holdings, Inc.

Greetings, and welcome to the Leidos fourth quarter 2018 conference call. At this time, all participants are in listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Kelly Hernandez, Investor Relations for Leidos. Please go ahead, Kelly.

Thank you, Kevin, and good morning, everyone. I'd like to welcome you to our fourth quarter and full year 2018 earnings conference call. Joining me today are Roger Krohn, our chairman and CEO, Jim Reagan, our chief financial officer, and other members of the Leidos management team. Today we will discuss our results for the quarter ending December 28, 2018. Roger will lead off the call with notable highlights from the quarter, as well as comments on the market environment and our company strategy. Jim will follow with a discussion of our financial performance and our guidance expectations. After these remarks from Roger and Jim, we'll open the call for your questions. Today's discussion contains forward-looking statements based on the environment as we currently see it, and as such, does include risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially. Finally, during the call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in the press release that we issued this morning and is also available in the presentation slides. The press release and presentation, as well as the supplementary financial information file, are provided on the investor relations section of our website at ir.leidos.com. With that, I'll turn the call over to Roger Krohn.

Thank you, Kelly, and thank you all for joining us this morning for our fourth quarter and full fiscal year 2018 earnings conference call. 2018 was a continuation of our great execution and was a year of transition as we pivoted the organization to focus on growth. We saw many successes, and I'm proud of our employees for driving these achievements. The government shutdown had a negligible effect on our fourth quarter results, and is expected to have an immaterial effect to our first quarter 2019 results as well. Now, I'd like to start this morning by discussing four key highlights from our results, bookings, growth, profitability, and cash generation, before focusing on what we see going forward in 2019 and beyond. First, 2018 was a record year for us in bookings and backlog. We booked $13.7 billion in net awards into backlog, resulting in a 1.3 book-to-bill for the year and a record backlog of $20.8 billion. These bookings, along with other single-award IDIQ positions we've won, will drive our growth this year and beyond. The strong momentum in our business development results has continued into 2019 with NASA's recent award of the NASA End User Services and Technology Program to Leidos. This is new work for us, a competitive takeaway, furthering our market share gains, although it is still subject to a protest. NEST is a single award, firm fixed price, IDIQ contract, with a potential value of $2.9 billion over 10 years. Second, in terms of growth, the improving win rates and ramp of revenues from our new awards allowed us to close out the year on a strong note with year-over-year revenue growth in Q4 at the highest pace we've had in two years. For the third quarter in a row, revenues grew year-over-year as new awards increasingly contribute to the expansion of our base business. Third, profitability was also a highlight for the year, as we again exceeded our target of 10% or higher for long-term adjusted EBITDA margin and delivered margins of 10.4% for the year. We continue to balance margin and growth as we drive to our long-term targets in both areas with revenue growth of 3% or more while maintaining adjusted EBITDA margins at 10% or higher. Finally, we continue to maximize the cash generated from the organization through the fourth quarter. For 2018, we generated more than three-quarters of a billion dollars of operating cash flow. a 46% increase from the prior year's level, despite the revenue growth in the fourth quarter. Driving cash collections from the business is truly a cross-functional effort. These results show that our teams across the organization did a great job in driving cash conversion. Throughout the year and continuing into the fourth quarter, we've benefited from many initiatives to monetize our balance sheet. We'll continue to explore additional such opportunities in 2019. Cash generation is important, and smart deployment of that cash is essential to driving shareholder value. In 2018, our performance allowed us to return over $600 million to our shareholders, or nearly 90% of our free cash flow through dividends and share repurchases. We returned $200 million to our shareholders through regular quarterly dividends and nearly $420 million as share repurchases, which allowed us to retire 6.5 million shares during the year. We also repaid $59 million of debt. These actions are consistent with our stated capital deployment philosophy. Now, we look forward to 2019 as we are focused on accelerating growth while continuing to execute our book of business. To drive this growth, we will leverage the strong defense budget and outlays, ramp-ups from our new program wins, and a strong pipeline of submitted bids, waiting decisions. We've entered the year with roughly $28 billion of bids outstanding. This pipeline includes several multibillion-dollar bids, such as our Department of Energy Hanford Mission Support Contract Recompete, our DISA Global Solutions Management Operations Program Recompete, as well as the NASA Nest bid, which I mentioned earlier. We're also submitting proposals on several other large new business and takeaway bids during 2019 and expect decisions on many of these large programs during the year. We've analyzed what's driven our improving win rates and our success in capturing new work. While it's clear that no single factor has led to this success, the three most prevalent areas are the strength of our technical solution, the competitiveness of our cost structure, and our past performance credentials, all made possible by our talented and dedicated employees. Further, it's clear that customers have confidence in our ability to solve their large, complex problems because of our size, scale, and depth. We continue to strengthen across all of these areas, including investing in our internal R&D so we can offer increasingly advanced technical solutions. One particular area where we have seen strong customer enthusiasm is in the application of artificial intelligence and machine learning. These technologies drive efficiencies in our customers' mission through automation and also provide deep analytical insight at speed. We also invest in AI ML security to make all of our data-rich information technology offerings the most reliable and secure in the industry. Our AI ML capabilities have already been instrumental to several recent program wins with our defense and intelligence customers. With our anticipated growth, we'll need more people to join the company. I'm pleased to say we have seen improvement in our hiring statistics as our recruiting and HR teams have implemented innovative methods to improve our success and efficiency in hiring new employees, as well as improved retention rates of our existing employees. We are also optimistic on the potential for a more efficient security clearance process with the renewed focus on this effort by the Department of Defense, which recently assumed the function from the Office of Personnel Management. When in place, this increased efficiency will mean that our employees spend less time waiting to start work on classified programs. Refining the process is a complex undertaking that will take time to implement, but we are encouraged by the initial progress. Now, we all continue to watch what is going on in the federal government. We are pleased with the last week's budget agreement that averts another shutdown. Even a partial shutdown impacts a broad array of vital government services that touch millions of Americans and impacts the important mission of our customers. While there is still uncertainty on the debt ceiling limits and the sequester caps, we remain optimistic about the actual budgets that will be agreed upon and the spending priorities in government fiscal 2020 and beyond. As we analyze the budgetary activity beyond the headlines, we are encouraged that the government spending priorities align well with our strategy and our areas of technical strength keeping us well positioned to drive growth. Finally, I'm pleased to announce that we have set May 14th as the date of our Investor Day, which will be held in New York City, as well as being webcast. The leadership team and I look forward to sharing our vision for the company and more details about our strategy at the event. I hope you will find time to join us. With that, I'll turn the call over to Jim Reagan, our Chief Financial Officer, for more details on our 2018 results and our 2019 outlook.

Thank you, Roger, and thanks, everyone, for joining us today. We're pleased with our full year 2018 results, and I'll start by highlighting a few of our accomplishments for the fourth quarter and the full year. Fourth quarter revenues increased 5.2% from the prior year and 2.8% sequentially, our third consecutive quarter of growth and another proof point in our growth trajectory. In 2018, our adjusted EBITDA margins of 10.4% again exceeded our long-term target of 10% or higher. Fourth quarter margins were 9.7%, in line with our expectations and reflects typical seasonality in the margin profile due to a higher proportion of materials revenues compared with other quarters. This strong operational performance, coupled with lower than expected tax rate, drove a non-GAAP diluted EPS of $1.10 in the quarter. Non-GAAP diluted EPS for the year was $4.38 at the upper end of our guidance range. Operating cash flows for the full year of $768 million increased 46% from the prior year and resulted in 104% free cash flow conversion of non-GAAP net income in line with our long-term goal. The slight miss versus our guidance target was driven by unexpected timing slips in the fourth quarter due to year-end payment system transitions at a couple of our key customers. During the fourth quarter, we continued to monetize our balance sheet by selling our old headquarters building in San Diego for net proceeds of $79 million. The cash proceeds from this were received and recognized in two tranches, $14 million in financing inflows in Q4 of 2018 and $65 million in investing inflows that will be in Q1 of 2019. In addition, just after the close of the year, we also closed on the sale of the old IS and GS headquarters in Gaithersburg for $31 million. Proceeds will be recognized as a cash flow from investing item during the first quarter of 2019. And these two transactions are an extension of our focus on monetizing non-core assets and increasing our return on invested capital. Now, let me share some comments on our segment results. Revenues in the Defense Solutions segment increased 3.6% in the fourth quarter compared to the prior year period, driving the third consecutive quarter of growth in the business. This growth largely reflects new program activity that expands our revenue base. Non-GAAP operating margins in our Defense Solutions segment decreased 160 basis points from the prior year quarter to 7.7%, reflecting a lower level of net profit write-ups. As a reminder, there's typically a fair amount of variability in the quarterly timing of profit write-ups. For the full year, the segment's margins were 8.4%, flat with the prior year, reflecting a similar level of profit write-ups. Awards activity was a highlight in the defense solutions segment. That bookings were over $7 billion in 2018, a 56% increase from 2017. Book to bill for the year was $1.4, a substantial increase over the prior year level of $0.9. In our civil segment, the new program wins and on-contract growth contributed notably to fourth quarter results, driving revenue growth of $3.6 over the prior year period. The startup of new programs was the primary cause of the roughly 100 basis point decline in non-GAAP operating margins to 9.7%. Overall, we are pleased in the growth in this business and are confident in our ability to drive margins higher over time in this segment. Bookings in our civil business increased in the fourth quarter with roughly a billion dollars in net bookings, which resulted in a 1.1 book-to-bill for the quarter and 1.0 for the year. Turning now to our health segment, fourth quarter results were again very strong across all metrics, revenue growth, margins, and bookings. Revenue grew nearly 13% over the prior year and roughly 12% sequentially. This growth largely reflects the slippage of some revenues from the third quarter into the fourth quarter, as we discussed in our third quarter call. margins in our health business expanded in tandem with the revenue growth. Non-GAAP operating income margins of 16.1% in the fourth quarter increased more than 400 basis points from the prior year and 190 basis points sequentially. For the full year, non-GAAP operating margins of 15.2% increased 30 basis points from the prior year. The margin expansion reflects a greater mix of on-contract growth in certain quick-turn, fixed-unit price contracts. The health segment also had a very strong year in awards activity, with full-year net bookings of $3.2 billion, roughly 75% higher than the prior year level, resulting in a 1.7x book-to-bill for the year. During the fourth quarter, we booked $1.1 billion into backlog in the health segment, resulting in a book-to-bill of 2.2. Overall, all of our businesses demonstrated solid progress in the fourth quarter towards our growth targets, and we expect all segments to grow in 2019. So before I talk about 2019 guidance, I want to comment on the government shutdown and its impacts to our business. For fiscal year 2018, the shutdown was in effect for four working days, at the very end of the year where we typically see heavy vacation usage, so there was minimal impact to our business. The shutdown did, however, force the closure of the Committee on Foreign Investments in the United States, or CFIUS, which was the last approval needed to allow for the closure of our commercial cyber sales. We continue to work the process and we expect that deal to close within the first quarter of 2019. For 2019, the shutdown impacts to our business are also relatively immaterial, but given the volume of questions we've received on this, I'll provide some context. First, we estimate our aggregate revenue impact resulting from the shutdown to be approximately $11 million. This effect is largely isolated to our civil segment, where some of our work for the FAA and the Department of Homeland Security were deemed nonessential, causing us to furlough some employees. We realized the effect that this had on those employees, and it was not a step taken lightly. We may be able to recover some of this revenue loss throughout the year, but it is too early to estimate any recovery now. The shutdown also caused some delays in the billing and collection cycle, as well as with award decisions, but these effects are more timing-related, and we don't expect any permanent impacts to our business from those delays. Now, on to our guidance for 2019. We expect revenue in the range of $10.5 to $10.9 billion, reflecting growth of 3% to 7% from 2018. We expect 2019 to be a year in which we will exceed our 3% long-term revenue target growth due to the strength of our backlog entering the year and our focus on driving on-contract growth and winning new business throughout the year. Although we do not guide on a quarterly basis, I would like to provide some context on the quarterly phasing of revenues for the year and particularly for the first quarter. Similar to 2018, we expect revenues to build sequentially throughout the year, starting from a low point in the first quarter. Historically, Q1 revenues declined sequentially due to the lower level of material volumes compared to Q4. This year, however, we expect a greater sequential decline in the high single-digit range due to the combined effects of low materials buying in the first quarter, program transitions in our health segment, and the shutdown. From the first quarter low, however, we expect revenues to grow sequentially throughout the year and to drive to our full-year revenue guidance. We expect adjusted EBITDA margins of 9.9% to 10.1% for the year, a slight decrease compared to 2018. And as we've said in the past, there is a trade-off between margin and revenue growth, and the ramp-up of our new awards will drive slightly lower margin levels in the near term. We expect non-GAAP EPS between $4.25 and $4.60. We expect operating cash flow of at least $725 million, a slight increase from 2018 levels after adjusting for the interest rate swap monetization and the unusually low cash tax rate we experienced in 2018. Following the fourth quarter sale of our San Diego building, we will move into the more material phase of our real estate consolidation activities in 2019. We will continue to streamline our footprint and reduce owned facilities, allowing us to work more efficiently and increase the level of collaboration across our functions. As a result of these actions, we expect a lot of moving parts to the different components of our cash flow statement this year. We've added a slide, slide 10, in our earnings deck, which is available on our website, to help you with some of the details. Some of the real estate action increased CapEx and therefore reduced the free cash flow metric, while others result in inflows in cash in investing and financing activities. At the end of the day, the net of all of our balance sheet monetization activities and our real estate investments will yield a positive cash inflow for the company. We will continue to deploy our excess cash from those transactions consistent with our stated capital deployment plan. All that said, we expect 2019 capital expenditures of between $135 and $140 million. Roughly $60 million of that is related to real estate investments and leasehold improvements, which will drive better asset utilization. As we've said earlier, between the San Diego and Gaithersburg real estate sales, we have already closed on transactions that will drive 95 million inflows to cash from investing in the first quarter. These inflows will more than offset the one-time 60 million capex item that I referred to earlier. Beyond leaning out our real estate portfolio, we will continue to look for opportunities to monetize the balance sheet, which increases our flexibility and drives value for our shareholders. Now a couple of other comments to help you with modeling 2019. We expect net interest expense between $135 to $140 million and a non-GAAP tax rate between 23% and 24%. To wrap up, We closed the year on strong footing. We generated over three-quarters of a billion dollars of cash from operations. Our margins were, again, over target for the second year in a row, and we exited the year with a revenue growth rate of 5.2% and record backlog. We remain focused on continuing this momentum into 2019 by driving profitable growth and generating cash that drives long-term value. With that, I'll turn the call over to Kevin so we can take some questions.

Thank you. And I'll be conducting a question and answer session. If you'd like to be placed in the question queue, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Once again, that is star one to ask a question at this time. One moment, please, while we poll for questions. Our first question today is coming from Kai Von Rumer from Cowan & Company. Your line is now live.

Yes, thank you very much. Good quarter. Maybe you can help us understand what is in your guide for 2019. Does it include anything for Nest? Does it include the commercial cyber business that you hope to close? And then maybe some color on the adjusted EBITDA margin, which looks like it's at the bottom of your expectations.

Good morning, Kai. Thanks for joining us. Yeah, first, the guide does include our expectations for the ramp-up of NASA NEST. The guide does not include the commercial cyber business. And in terms of our EBITDA margin expectations for the year, it reflects the fact that In 2019, we've got a number of programs, the Army Corps of Engineers program and S&S, just to name a couple of them, where the ramp-up of those programs typically has lower margins than for the life of the program, and we've been historically pretty conservative in setting those profit take-up levels early in the program as we plan on some contingencies. As programs reach the end of their lives and we start to wind them down, that's typically when you get more liquidation of risk, and we pick up some write-ups, as you've seen us historically have in the past.

Terrific. And then for a last one, maybe update us on where you are with Genesis.

Yeah, great, Kai. I'll be happy to take that one. We're really pleased with the program, our relationship with the customer, solid support in DHA for moving forward, a lot of enthusiasm over what's happened at the IOC sites and how we've learned from our initial deployments. We have agreement on a full schedule for deployments. We're currently working on what we call Wave 1. We've identified the different groups of hospitals we're going to deploy to. We expect wave one to go live in the fall. The next wave, not to confuse you, is actually going to be wave four. And we'll expect to start that later in the year. And then we should be running a new wave about every six months at any one time we will be in deployment of two waves concurrently. A lot of great discussions with our customers. We've got agreement on the go-forward plan. We should be fully deployed by 2025, and Kai, as you know, the program is expected to extend to about, excuse me, 2023 fully deployed, and the program runs through 2025. I know you've often asked in the past about sort of a ramp-up in revenues, and we expect to see that this year that maybe will give us sort of a point at the top line, something like that. And, again, very enthusiastic about the program, a great relationship with our customer at DHA, their strong commitment to put this technology in place to increase the healthcare for our active military.

Thank you very much.

Thank you. Our next question is coming from Krishna Sinha from Vertical Research Partners. Your line is now live.

Hi, thank you. On your operating cash flow guidance for the year, obviously I see the slide about the real estate, but I'm just talking about the operating cash flow. Can you just give us some puts and takes there about what you're expecting, what's not being included or not recurring from 2018 to 2019 and just kind of what we can expect from the forward trajectory, maybe beyond 2019 in terms of cash flow for the business on an underlying basis?

Sure, Krishna. Thanks for the question. The The two big things that occurred in 2018 which are not recurring in 2019, and that's reflected in the go-forward guide. First, as part of monetizing the balance sheet, we took $60 million of cash for interest rate swaps that we could monetize in conjunction with extending the term of our term loan facility. The second thing is we had some opportunities to monetize some deferred tax assets. Now, these were tax assets that were fully reserved anyway. But that was $65 million of cash that we pulled in. That's also reflected in the gap effective tax rate of about 4.5%. So those things aren't recurring, although we're always looking for opportunities to improve on our tax rate. So those are the big things. And then There are also a couple of items, and they're primarily program-related. One of the large contracts that we just won will require us to buy some assets, and that's a roughly $40 million cash flow headwind that we will end up recouping over the life of the program.

That's great. Thank you.

Sure.

Thank you. Our next question is coming from Robert Springard from Credit Suisse. Your line is now live.

Good morning.

Good morning.

I wanted to ask a high-level question about the guidance from a segment perspective. In other words, how you're thinking about the growth across the segments. And then the same for the margins. And this has to do with just some of the movement that we see, you know, in 2018, especially sequentially with regard to the margins. So, Jim, if you could give us some understanding, some color there by segment.

Sure. Well, Rob, I'll remind you we don't guide by segment, but what I can give you some color on is, first of all, because we're expecting all of the segments to be growing with some fairly large program wins, as I mentioned when I was answering Kai's question, some of these larger programs tend to have margin profiles that ramp up as we increase the operating efficiency of these contracts. We're probably expecting a little bit more growth in the health segment and in the defense segment as compared to the other segments of the business because of the large program wins that we've had and the pace of the ramp-up in both defense and in health. As Roger mentioned, we're getting a full point of growth just off of the DIMSOM program. So I think that that helps you with kind of setting up what the growth profile is like of the segments.

And what are the biggest swings in your revenue guide, that $400 million program-wise? Or how do we think about what you're assuming at the low and high end?

Well, you mean – I think that what I'm understanding, you're wondering, well, what could give rise to the low end? What could give rise to the high end? Well –

Yeah, the 10-5 versus the 10-9.

Yeah, I mean, we've got a lot of bids that are $28 billion of bids outstanding at the end of the year. One of them we've already pulled in from bids outstanding and into backlog, and that's the NASA NEST program, which was a takeaway, meaning it's obviously additive to our growth profile. That's reflected in our guide. And I think that the high end would be achieved if we kind of ran the table on the big ones and set us up for, you know, a 2020 that is growing at or, you know, potentially above what we're guiding to now. On the low end, it would be a significant drop in our win rates. And, you know, for the last year, we've been experiencing win rates that reflect first a very competitive cost position and that is now showing up in the velocity of new awards. The second, it is we have a well-defined set of technical differentiators that is probably more prominent in our win rates than the cost competitiveness. And third, the efficiency of our business development process is not only yielding great technical scores, but it is reducing the cost that we need to put into winning X dollars of new backlog. So, I mean, those three things are really bearing out what I think gives us the confidence of at least the midpoint of our revenue guide, if not a little bit more. Okay.

Roger, just a quick follow-up on the NASA program. We're still in that kind of unique period between announcement and debrief and the protest period. So we have a couple more days to go to see whether one of the competitors is going to file a protest. So we haven't exactly booked that into backlog yet. And when we do, it's a single award IDIQ, and we'll probably book the first task order just so that people don't go out and put $2.9 billion in backlog. It's probably likely... in the order of in the hundreds of millions, not in the billions, but just a technical point. I wanted to make sure that I was clear in my comments that it's still subject to protest. Thanks.

And Roger, just on the back of that, are there any specific awards that you would call out as being within the revenue synergies that at the time of the deal you weren't yet ready to talk about, but you know, now a few years in here, what are you seeing revenue synergy-wise?

Well, Rob, that's a great question, but it's one we haven't had for a while. But wait, NASA-NASA is clearly one. That is a program that really has come out of capabilities that came across in the merger with IS and GS and, you know, the combination of some of the things that we had done on the technology side and the cyber and the relationships that IS and GS had with the end user at NASA is part of that. I would say I think our probability of win on Hanford is enhanced by bringing the company together. Clearly that was a Heritage IS and GS contract, but I think we added more innovation in our offering. You can look at Navy Next Gen, I think with the same view. A program we might or might not have bid as standalone Leidos, but clearly felt we had a compelling offering to bring forward to the program. And just to kind of round out, the Sense3 program and the Department of Homeland Security, one that we won last year, I think I would put in synergy, we won an ABIS contract, which is an Army biometrics win, which is a collection of sort of IT and technology be able to recognize individuals based upon biometrics. And there's a whole host of classified wins. I talked to AIML in my comments, and that has been of particular interest in the intelligence community, and it's led to some wins there as well. So really a lot of, again, we don't talk a lot about synergy, but a lot of cross-linkages of the two business and a lot of strength in things that we can go after that we couldn't have gone before, and then overall increase in RP win.

Thank you both.

Thank you, Rob.

Thank you. Once again, ladies and gentlemen, that's star one to ask a question. And when we ask you, please ask one question and one follow-up, then return to the queue for further questions. Our next question is coming from John Raviv from Citi. Your line is now live.

Hey, good morning.

Good morning.

Jim, can you... Jim, can you walk us through just a little bit more on the risks and opportunities in this year's sales guidance? And I'm thinking about it specifically in relation to a year ago where, you know, obviously you fell a bit short in 18. I just want to make sure that, you know, the bias is really more to the upside in this year's guidance versus last year's guidance. Thank you.

Sure. Well, you know, we always like to hit the guidance down the middle of the fairway. The – The NASA nest win certainly gives us a little bit more confidence as it's yet another takeaway win, which builds the revenue volume and adds to our growth. So just to put a little bit more color on my comments of just a minute ago, I will repeat, you know, continuing to run at high win rates on takeaway wins and new business work, new contract awards that are kind of new to our peer group, that's one. And we continue to see really great results in win rates that reflect the execution in our business development teams. Going back to what are the things that could be a dampener of our growth rate, and that would be – if the clearance process slows down, uh, or if the handoff from OPM to DOD doesn't go as, as I think DOD or we would expect, I think that that could be one risk factor to revenue growth. And then the second one would be, um, uh, you know, a kind of a change in, um, the success that we've been experiencing in business development. you know, um, That and our hiring processes, so far we're pleased with what we're seeing out of our recruiting teams, but if the labor market has a sudden tightening from where we see it today, that could slow down our ability to hire people needed to execute on contract backlog.

Okay, and then in terms of some of the bigger re-competes this year, can you just potentially give a little more color or perhaps even quantify some of that exposure in terms of sales, but also in terms of profits, and the docs make it look like Hanford, big on sales, but doesn't add much income. Could you just level set us on those, please?

Yeah, well, you just mentioned Hanford, and probably the other large recompete that we have is GSMO, which, you know, we don't disclose the dollar values of both the revenue run rate or the margin details at the contract level. But, you know, clearly GSM-O, Gizmo, would be one that we're planning on re-winning. And if we get surprised on that one, that could be a dampener. Not so much for 2019, though, but more for 2020 as, you know, that contract, regardless of the outcome, is going to continue to run well into 2019 for us. Thanks.

I'll stick to the two.

Okay. Thanks, Sean. Thank you. Our next question is coming from Noah Poppenack from Goldman Sachs. Your line is now live.

Hey, good morning, everyone. It's Gavin on for Noah.

Hey, Gavin. Hey, Gavin.

Hey, guys. Nice to see booking strength translating to revenue growth, but I think the margin pressure is maybe kind of right in line with that 10% plus you were talking about, which maybe seems like a lot of pressure just on the rate of growth you're experiencing. So I was wondering if you could talk a little bit about your strategy to grow EBITDA dollars. And Roger, I appreciate the color that the, you know, earlier on the contracts have lower margins and later on you can book them at a higher margin. But, you know, whether or not these will be accretive on average over the life of the contracts and how you think about bidding when the margin initially is this low.

Well, okay, complex question. Let me see if I can unpack it a little bit and I'll look to Jim. Let's see, we have a pipeline and we kind of filter against the pipeline and we look at the structure of the contract and our ability to generate at or our target over the life of the program. We are in a fortunate position where we can decide what to bid and what not to bid. We've talked in the past about staying away from what we used to call lowest price technically acceptable because it traditionally has lower margin. And frankly, it's probably not the work that we are best equipped to do. We become more interested in a program where we can create a point of difference through our discriminators, our technology, our cost structure, and our size, and as such, we hope over the life of the program, right, to be accretive to our long-term EBITDA margin. You know, I think it was John who talked about Hanford. There are some programs just by their nature are going to be lower. You know, Hanford is one of them, has always been. That particular customer just – views the programs differently. Hanford's a very important program to us. We use it for a lot of past performance quals. By the way, it's a hugely important program for the nation, and cleaning up the 600-square-mile site in southeast Washington is really, really important work. But generally, we are looking at the portfolio and the pipeline with an eye to 10% or better on EBITDA, I think, you know, you reemphasize is that often when we get started, we're more thoughtful about our booking rate and how we ramp up. And if programs are going to have transition issues, it's usually in the first year or so. So it behooves us, and I think everyone in the industry does this, to be more thoughtful about our earnings rate in the early contract. But You know, because of our technological differentiators, we have the luxury to go after higher value-added work, which typically carries more margin with it.

Got it. And then, Roger, you talked about, you know, the DOD budget aligning well with your portfolio. Can you give us a little bit more color on kind of how you expect those priorities to go between hardware and kind of your addressable market?

Well, you know, there – Secretary Shanahan is, I think in the first year or two, they were looking at operational capability rate and getting the fleet and other hardware back up to a higher operational tempo. We certainly benefited from that. They're now focused towards buying end items, ships and tanks and airplanes, but not necessarily at the expense of their operational tempo. What really excites me is the digital transformation that's going on, not only in the Department of Defense, but across federal space writ large. They have got to operate more efficiently, to open up more total obligation authority to buy hardware and to pay troops and to defend the country, and that's right in our sweet spot. You know, we're really, really good at digital transformation, move to the cloud, software-defined networks, and, you know, that gets us excited. But we're also seeing a bit of a shift in how I think the department views the threat, and a lot of discussion, if you read the national security strategy, is what we call the physical and the kinetic threat is still important, but the virtual threat is becoming even more important. What's going on in cyberspace, some of the newer technologies, and that fits really well with where we are. We're not necessarily a company that builds tanks and big aircraft carriers and things like that. We are much more in the soft technologies, software, cyber, areas like that, electronic warfare, and we see increased spending in those areas.

Thank you.

Thank you. Our next question is coming from Greg Conrad from Jefferies. Your line is now live.

you know, a really strong booking year and quarter. Can you maybe talk about some of the initiatives outside of Dim Sum and Place that's supporting, you know, both the improvement in bookings and, you know, the revenue outlook for next year?

Yeah, I think so. So this is Roger. And if you've been following our story for a while, you know that about two years ago we had lost some programs that we thought were franchised. And it really caused us to go back and look at our whole business development process from cradle to grave. And we looked at what we call our win plan, how we write proposals, the staff that we had, how we view the competitive discriminators. And, you know, as we've said previously, frankly, often on this call over the past several quarters, we kind of started over. We took a clean sheet and Jerry Fasano and now Roy Stevens in business development and we looked at why we were winning and why we were losing and how we presented our competitive discriminators, even down to what bids that we were bidding on and whether we really felt we had a compelling point of difference on those bids and I would say I think we've gotten better across the board, better in identifying the opportunity, putting it in the pipeline, working early in the bid process with the customer to understand what their compelling needs actually were, and then just the way we go about actually structuring and writing a proposal how we deal with the proposal center, how well we represent our capabilities in between the front cover and the back cover of the proposal. Another point that we made really all the way through this journey from the acquisition is there was, I think, a thought that IS and GS, the Lockheed business, had become less cost-competitive. in some of the bids that they had made kind of being tucked inside a large OEM. And, you know, we had huge emphasis on bringing their overhead and SG&A, therefore their wrap rates, down to where we have been historically. And we look at our wins and our losses. We do a lot of forensics. And, you know, I wouldn't say we have not lost any bids historically. based upon price, but the number of bids that we have lost based upon our cost structure is down to just a very, very few. And so we are pleased with how we have used our cost structure to solve that problem, and that has allowed us to focus on superior technical offerings that create a point of difference for the customer.

Thank you. And just a follow-up on your commentary. around employees and employment. Is there any way to think about headcount growth for the year? And are you seeing any signs of any type of wage inflation?

Yeah, Greg, we don't provide headcount targets. I can tell you that compared to what our internal targets are, we're doing well in growing our direct employees compared to our plan. And And then the other thing on wage inflation, we do put a plan in place for growth in market salaries that is consistent with the benchmarks that we see published externally. And so far, we're not seeing any pressure on those assumptions that we have in our plan. The market's obviously pretty competitive for the kinds of people we're hiring. But given our scale and given The breadth of different things that people can work on here and a competitive salary and benefit structure, so far we're able to achieve our hiring numbers.

Thank you. Our next question today is coming from Rick Eccleson from Wells Fargo Securities. Your line is now live.

Hi, good morning. Thank you for taking my question. Just to clarify on the guidance commentary, for the dim sum contract, it's one point to growth throughout the guidance or is it a one-point addition at the high end? And then also, can you talk about any grow-over amount for the commercial cyber, which I believe you said was not in the forward guidance? Thank you.

Yeah, so the way, first of all, we think about DIMSOM is that one point of growth is inclusive of the, you know, our guidance implies 5% growth. That number includes roughly a point for DIMSOM. The second point to commercial cyber is The commercial cyber number, that midpoint of growth would be higher if you backed the commercial cyber number out of our 2018 results. But at this point, we have to keep those numbers confidential for terms of our agreement with the buyer.

Thank you.

Thank you. Our next question is coming from Toby Summer from SunTrust. Your line is now live.

Thanks. With respect to your comment on the budget and having a constructive outlook, does your commentary for the defense and intelligence budget hold true for the whole budget, including civil? And could you comment if currencies take a little bit of the edge off of your revenue growth guidance for 19?

I'll do the first one. I think it was a foreign exchange question on the second one. Let's see. Here's a comment that I want to make sure everybody understands is that, so I think we're all comfortable with what's going on in the Department of Defense. Clearly, there's been a lot of attention in what's going on in the Department of Homeland Security. We are optimistic in the parts of border security in which we operate, our VACUS system, what we do relative to vehicle inspections. We believe that has a significant role to play in the vision of this government in securing the borders. And so not only are we pleased with what we're seeing out of the Department of Defense, in those areas in our civil business where we have visibility into the budget, we are also quite pleased. We think there was a large demand. amount of fentanyl that was used at the Porter a couple weeks ago. And it is those technologies which we think we will be able to provide to the government and they will fuel our top line growth. By the way, we kind of feel the same way about what's going on in DOE and FAA and a lot of the other civil organizations.

Yeah, and then relative to the currency question, we don't see currency as being a material headwind or tailwind for 2019. There was a little bit of a headwind in 2018, but I wouldn't call it material with respect to the overall number. Just a reminder that international or foreign-denominated contracts are roughly 10% of our overall business.

Thank you. Our next question is coming from Joseph Denardi from Stiefel. Your line is now live.

Yeah, good morning. Jim, I think you've talked in the past a little bit about your M&A focus and not having much of a desire just to acquire pure play services businesses and maybe want to increase your exposure to products and hardware. I'm wondering if that means looking at services business that may have a product or hardware component to them or whether you'd be willing to acquire or look at pure play hardware and products businesses?

Joe, great question, and the short answer to both parts of your question is yes. For us, we have less interest in a pure play services business, especially one that looks, in terms of its customer footprint, a lot like us. We don't need more of what we've got. We can compete and expand the business that we have just fine on our own. The things that we're looking for to build the company inorganically would be the kind of company with both the services and product, a product differentiator that bolts in well with the kind of work that both the target company and we do. A pure product company could also be of interest to us. And although I would say that the ones that we've been interested in to this point tend to have some kind of service element to them, but I wouldn't say that we're not interested in it. I wouldn't say we'd shy away from a pure product business if it was strategically, you know, if it fit our strategic criteria.

Thank you. Our next question is a follow-up from John Ravie from Citi. Your line is now live.

Hey, thanks for taking the follow-up. Roger, in your prepared remarks, you had mentioned 2019 and beyond. Could you talk a little bit more about that beyond by any chance, maybe a small preview for the event in May, especially now that the combination is done?

A little bit. We kind of came out of the merger, and we talked about 3% growth and 10%. Of course, now we're printing a little bit better than that And as you know, we are a long-cycle business, and with $28 billion, if you take the $2.9 billion out for NASA-NESS, $25 billion in unawarded. Most of that is going to impact beyond 2019. You know, the way things work, if they make an award to us this year, we ramp up. You really don't see those revenues until 2020 and beyond. And as excited as we are about 2019, If you just run your model as we do and you all run similar models, you can see that the submits on awarded is going to have a larger impact on 2020 than it will on 2019. And it's the government's need for the types of solutions that we provide that gives us enthusiasm about the future and our strong A balance sheet and cash conversion gives us the currency, if you will, to invest in the future and to grow the business. And so as excited as I was, you know, five years ago when I came, as excited as I was about the merger with IS and GS, I look at the budget prospects and the needs of the government. And 2019 is going to be an exciting year for us, but I think 2020 will be even better.

And to pile on there, John, you know, about two-thirds – of our pipeline is either new work or what I call OPB, other people's business. And so with two-thirds of that representing things that are other than just keeping and re-competing our existing work, to Roger's point, I think that the profile of the pipeline certainly speaks well for some growth opportunity.

Thank you. Our next question is a follow-up from Krishna Sinha from Vertical Research Partners. Your line is now live.

I just wanted to get an update on capital deployment. Obviously, you've made some comments that you're going to try and maintain the dividend at a kind of steady rate, but just focusing more on the buybacks and the M&A opportunity and how you're thinking about those in 2019. I mean, are you close to any sort of bolt-on deals or have any in the pipe that you think could close within the next 12 months or that we should be aware of? Or since you'll be generating cash here, should we think about the buyback sort of staying at this pretty high cadence that you've been generating in the last two quarters?

Yeah, Christian, I think that if you compare where we sit today and looking at the M&A pipeline, I wouldn't say anything different about it compared to what I said last quarter or the quarter before that. We've got an M&A team internally that is looking at ideas that are consistent with our strategy. But, you know, we're very focused on doing good deals, not just deals for the sake of prosecuting a pipeline. So a couple of other factors that I would point out to answer your question. We're very comfortable with our leverage today, and we have plenty of dry powder and ability to take on more leverage, particularly at today's rates. to buy the right kinds of assets. But with that said, we're also not going to sit around waiting for something to come under contract before we make a decision on whether to deploy. So you could see a year, you know, we could be looking back on 2019 as being a year when we made a couple of acquisitions or an acquisition. but we also were able to deploy capital with some buyback and the normal level of debt buyback.

Thank you. Our next question is coming from Joseph DiNardi from Stifel. Your line is now live.

Yeah, my follow-up was going to be if, Roger, you could just talk about the sensitivity to a CR in 2020 and maybe just the mechanics of how that would look. I think kind of the impact to spending would be more pronounced because the budget would get set at the sequestration level, whereas FY19 just got set at FY18's level. So maybe I'm wrong. Can you just kind of walk us through what your expectations there would be if there is a CR to start FY20? I know it's a long way away, but just wanted to get your thoughts. Thank you.

Yeah, Joe, you have it. just about right if we end up with a CR, we could snap back, and if we don't do this right, we could be back to the sequester caps, and I touched on that in my remarks. I'm not the best person to predict what's going to happen in the government. I will tell you I have been encouraged by what the Department of Defense has done and their ability to cross the river and talk to the hill and explain to our elected officials how important it is to get a budget. I've been optimistic before about the ability of the department to actually get a budget passed. I'm also optimistic moving into what is going to be a presidential election season that people are not going to be distracted by a continuing resolution which snaps us back to the sequester caps and requires the department to curtail programs. And so If I was a pundit, I would tell you I think it's more likely that we're going to get some kind of a negotiation and we will get a budget rather than a CR. But the mechanics of what happens in a CR, you have about right. And if we went all the way back to the sequester caps, I think the department would have to take some significant measures to be able to get their budget back underneath that. As you know, once they start spending on aircraft carriers and F-35s and things, there's a future bill to be paid. And when they commit to, like, a bulk buy of two aircraft carriers, that's with the assumption that they're going to get most of what they ask for in their budget request in the future. If you snap the budget back to sequester caps, they're already committed to build those aircraft carriers, and it creates a real planning issue. dilemma for the department. And because of that, because I think our elected officials understand the importance of defending the country and they don't want this to become a topic in the presidential debate, I think we'll probably end up with a budget.

Thank you. We've reached the end of our question and answer session. I'd like to turn the floor back over to Kelly for any further closing comments.

Thank you, Kevin, and thank you all for joining us this morning, as well as for your interest in the company. Have a great day.

Thank you. That does conclude today's teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.