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spk12: Greetings. Welcome to the Leidos third quarter 2021 earnings call. At this time, all participants will be in listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero from your telephone keypad. Please note, this conference is being recorded. At this time, I'd like to turn the conference over to Stuart Davis with Investor Relations. Stuart, you may now begin.
spk04: Thank you, Rob, and good morning, everyone. I'd like to welcome you to our third quarter fiscal year 2021 earnings conference call. Joining me today are Roger Krohn, our chairman and CEO, and Chris Cage, our chief financial officer. Today's call is being webcast on the investor relations portion of our website, where you'll also find the earnings release and supplemental financial presentation slides that we'll use during today's call. Turning to slide two of the presentation, 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, as shown on slide three, during the call we'll discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in today's press release and presentation slides. With that, I'll turn the call over to Roger Krohn, who will begin on slide four.
spk11: Thank you, Stuart, and thank you all for joining us this morning. The third quarter marked another strong quarter for Leidos, with record levels of revenue, adjusted EBITDA, non-GAAP diluted EPS, and backlog. Our success is the direct result of building a business portfolio focused on vital missions and a workforce that is motivated to enhance those missions through technology, engineering, and science. As we described at our October investor day, we see continued success ahead based on our scale, positioning, and talented people. To organize my remarks, I'll address four messages. First, our financial results demonstrate our ability to grow organically, drive earnings, and generate cash. Second, our business development engine delivered large and important awards that speak to our differentiated position in the market. Third, we're effectively deploying capital to create shareholder value. And fourth, we are investing in our people and building a company that we can all be proud of. Number one, our strong financial performance was highlighted by outstanding earnings and cash performance. Revenue of $3.48 billion were up organically 6% year over year ahead of the market. Non-GAAP diluted EPS for the quarter, was $1.80, which was up 22% year over year, driven by strong operating performance as reflected in our adjusted EBITDA margin of 11.6%. Finally, we generated $565 million of cash flow from operations and free cash flow of $541 million for a free cash flow conversion ratio of 211% of non-GAAP net income. With an asset light model, an ability to take EBITDA and to convert it to cash, and a lean balance sheet, cash generation is a hallmark of Leidos. Number two. Business development continued the momentum that is driving our industry-leading organic growth this year. We achieved net bookings of $4.7 billion in the quarter, representing a book-to-bill ratio of 1.4, our 15th consecutive quarter with a book-to-bill ratio of 1.0 or greater. As a result, total backlog at the end of the quarter stood at a record $34.7 billion, which was up 9% on a year-over-year basis. I'll now touch on four of our key wins. We were awarded a $600 million prime contract to continue to support the Army's geospatial center, Buckeye Mission. We're providing mission-critical, unclassified high resolution color imagery and digital 3D terrain over all operationally relevant areas of the world. Our scale enabled us to invest in aircraft that we own and operate and a cadre of professionals to support the mission. Through this program, we provide our war fighters with a decisive advantage on the battlefield and given the unclassified nature of the Buckeye data, support partner nations as well as humanitarian assistance and disaster relief. The National Security Agency awarded us a $300 million prime contract to develop and modernize the agency's technical signals intelligence mission. Under the contract, we provide the technical services to develop, deploy, and sustain a wide range of enhanced TechSIGINT collection, production, and analysis capabilities that provide our nation's leaders and military troops with actionable intelligence and critical information to protect and defend our country. The U.S. Army awarded our Dynetics subsidiary a $237 million, two and a half year contract for the Enduring Indirect Fire Protection Capability, or IFPIC, to produce a transportable system to engage and defeat cruise missile and unmanned aircraft system threats. Our solution uses an open system architecture that provides both flexibility and growth as well as full integration with the Army's integrated air and missile defense battle command system. Under this initial contract, we'll deliver 16 launcher prototypes and 60 interceptors. I view this as the seed corn. If we do it right, IFPIC can grow into a billion-dollar-plus program. The contract includes options for follow-on production of 400 launchers with associated interceptors. Finally, Customs and Border Protection awarded us another important multi-award IDIQ for non-intrusive inspection. So far this year, we've received two IDIQs with a total of $870 million in ceiling value and $200 million in tasking on those contracts. safeguarding our nation's ports and borders is a critical priority. And CBP has set a goal of 100% screening of cars and cargo at the border versus the single digit percentages that we achieved today. Congress has appropriated a significant amount of money for more screening. So we see this as a great opportunity for us. Number three. I view capital allocation as one of my key functions as CEO, and we're deploying capital to create shareholder value. During the quarter, we bought back $137 million of our stock through open market repurchases. At our investor day in October, we shared a target of $3.5 billion in cash flow from operations from 2022 through 2024. after considering capital expenditures, some debt pay down, and our dividend program will have approximately $2.2 billion to deploy across M&A and share repurchases. We're always looking at technology add-ons, and so that pipeline is pretty active. In Q3, we added a small strategic acquisition to our Dynetics subsidiary to accelerate some of its growth opportunities. Beyond that, there's currently nothing major on the horizon. We've built a portfolio that we're proud of and we think we're well positioned to grow. We'll pursue large M&A only if we find a property along the way that could really help accelerate our strategy. Number four, People are at the heart of what we do, and this quarter demonstrated our ability to attract the talent that we need. During the quarter, we hired more than 2,900 people, and at the end of the quarter, we were more than 43,000 strong. Our head count grew 2% sequentially and 12% year over year. Still, recruiting is an evergreen challenge. We have about 1,400 funded vacancies, and recruiting and retention remains areas of strategic focus for the leadership team. One of the reasons we're attractive to job applicants is that we invest in upskilling our people and building an innovation culture. As an example, in Q3, we held our first ever Leidosphere. a 24-hour virtual technology conference that brought together employees from around the world to share technical solutions. CTOs, solutions architects, and other technologists streamed presentations live from the US, Australia, Israel, and the UK. I personally saw the clear value for participants with real-time answers to questions and lively chat discussions. In a time of increasingly complex global challenges, our global network of customers and colleagues working together to address those challenges is a competitive differentiator. Another part of what makes Leidos so attractive is that we're a values-based company. This leadership team is committed to Leidos being a great corporate citizen. We're mindful of our opportunities and responsibilities to our many stakeholders, especially as we grow. With our mission to make the world safer, healthier, and more efficient, we believe we can build a future where our people and technology make a real impact. Having achieved our legacy greenhouse gas emissions reduction goal, We have now set new environmental goals as well as social and governance goals for 2030. Our new next level Leidos ESG goals highlight key efforts related to cultivating inclusion, advancing environmental sustainability, and promoting healthier lives. We believe these efforts will not only sustain and enrich our culture at Leidos, but they'll also have a positive impact on all of our stakeholders. We'll report our progress annually in our corporate responsibility report, which we've been publishing for more than a decade. Through this effort, we're committed to continue transparency in how we're doing from a diversity and environmental standpoint, as well as making the lives of our employees and communities better. And so you'll see that in our disclosures. Before turning the call over to Chris, I'd like to address the current budget environment as it gives important context for the guidance that he will be providing. As expected, Congress enacted a continuing resolution and suspended the debt ceiling to avoid a shutdown and economic turmoil. Each is now set to expire on December 3rd. The current thinking is that Congress will try to package the spending bills together into an omnibus spending bill for the president to sign before December 3rd. Or they may kick the can down the road and pass another CR that could last until next March. In addition, The House has indicated that it plans to attempt to pass two large legislative items this week or maybe this month. The first the 1.2 trillion bipartisan infrastructure framework to improve the country's roads, bridges, broadband and other critical infrastructure priorities has already passed the Senate, so it would head to the president. It would head to President Biden's desk for signature. The second. The $1.75 trillion Build Back Better proposal to overhaul the nation's health care, education, climate, and tax laws would head to the Senate for debate. The fate of both bills is still unclear, as is the path forward on the spending bills and the debt ceilings. In the face of this uncertainty, some of our customers have tamped down their normal spending patterns. Given the mission-critical nature of our work, we expect only a modest impact to our results while the budget issues remain unresolved. I'll now turn the call over to Chris Cage.
spk09: Thanks, Roger, and thanks to everyone for joining us today. As Roger said, Q3 was an outstanding quarter for earnings and cash, and I'm proud of the team for delivering such strong operating performance. Let's jump right into the third quarter results, beginning with the income statement on slide five. Revenues for the quarter were $3.48 billion, up 7% compared to the prior year quarter. Excluding acquired revenues of $47 million, revenues increased 6% organically, with organic growth across all three reportable segments. We're pleased to continue to outpace the market, but revenues were below our expectation. The main driver of the shortfall was in lower margin material purchases due in part to supply chain issues for computers and technology components and due to reduced activity levels due to concerns over the predictability of funding that Roger just mentioned. We were able to deliver strong earnings despite these factors. Adjusted EBITDA was $403 million for the third quarter, which was up 16% year-over-year. And adjusted EBITDA margin increased from 10.7 to 11.6% over the same period. This was primarily due to strong program management, higher volumes on some of our fixed-price programs, and better direct labor utilization. Non-GAAP net income attributable to Leidos common stockholders was $257 million for the third quarter, which was up 21% year over year. And non-GAAP diluted EPS for the quarter was $1.80, up 22% compared to the third quarter of fiscal year 2020. Now for an overview of our segment results and key drivers on slide six. Defense Solutions revenues increased by 3% compared to the prior year quarter. Excluding the acquisitions of 1901 Group and Gibbs & Cox, organic revenue was up 1%. The largest growth driver was the engine ramp, which more than offset the completion of the human landing system base contract within Dynetics. Civil revenues increased 3% compared to the prior year quarter, and all of the growth is now organic. The revenue increase was primarily driven by volume growth on existing programs, including the Antarctic support contract, our managed IT services support to the Bureau of Alcohol, Tobacco, Firearms, and Explosives, where we're leveraging our 1901 group acquisition, and our engineering support to commercial energy providers. Health revenues increased 31% compared to the prior year quarter, and all of that growth was organic. We continue to see a nice ramp on the military and family life counseling program, and DIMSOM had a large year-over-year increase based on deployment timing. Like last quarter, the largest year-over-year increase was in the disability examination business in our QTC subsidiary. On the margin front, Defense Solutions non-GAAP operating margin for the quarter came in at 8.8%, which was unchanged compared to the prior year quarter. Civil non-GAAP operating margin declined from 10.5% in the prior year quarter to 9.6%, as we had fewer deliveries of airport screening systems. Importantly, Margins for both defense and civil were up sequentially, consistent with our long-term view for these segments. Health non-GAAP operating margin for the quarter was at 20.7% compared to 16.3% in the prior year quarter. This quarter's strong margin performance benefited from the significantly increased revenue volume on fixed unit price programs and the higher direct labor utilization. Turning now to cash flow and the balance sheet on slide seven. Operating cash flow for the quarter was $565 million, and free cash flow, which is net of capital expenditures, was $541 million. The exceptional operating cash flow was driven by strong operational performance across the enterprise and higher customer advance payments and came despite the $62 million cash tax headwind from last year's CARES Act deferral. During the quarter, we paid down $27 million of debt and repurchased 1.4 million shares. In total, we returned $188 million to shareholders through our quarterly dividend program and share repurchases. As of October 1, 2021, we had $587 million in cash and cash equivalents and $5.1 billion of debt. As we close out the year, we remain committed to a target leverage ratio of three times. Our long-term balanced capital deployment strategy remains the same and consists of being appropriately levered, maintaining our investment-grade rating, returning a quarterly dividend to shareholders, reinvesting for growth, both organically and inorganically, and returning excess cash to shareholders in a tax-efficient manner. On now to the forward outlook. As shown on slide 8, we're updating our guidance for fiscal year 2021. Let's walk through the drivers for each metric. We now expect revenues between 13.7 and 13.9 billion, which is the bottom half of our previous range. Supply chain delays and customers holding back spending due to concerns over the predictability of funding are the primary drivers here. But some protests have also pushed revenue out of this year, and we're also mindful of the potential impact of vaccine mandates on our workforce. At the midpoint of revenue guidance, revenues in Q4 would increase about 70 million compared to Q3, driven by the continued ramp on new programs like NGIN, offsetting moderation in the volume of our medical exam business. At the revenue midpoint, organic growth for the year would be 9% and total revenue growth would be 12%. We expect 2021 adjusted EBITDA margin between 10.9 and 11.1%, which is above the previous range as a result of our Q3 outperformance. As the revenue composition shifts in the fourth quarter, we expect EBITDA margins will come back in and land in the mid 10% range. We expect non-GAAP diluted earnings per share for the year between $6.55 and $6.75. So we've increased the midpoint of the range by 15 cents based on our Q3 outperformance. Share repurchases in the third quarter will also add about a penny to Q4 non-GAAP diluted EPS. Finally, Our expectation for cash from operations is unchanged at $875 million or greater. Our strong Q3 performance increases our confidence in meeting or exceeding $875 million for the year, but the advanced payments in Q3 will be a headwind to Q4 cash generation. Before I close, I want to highlight the three-year targets we laid out at Investor Day last month. From 2022 through 2024, we're targeting an organic revenue CAGR of 5% to 6%. adjusted EBITDA margins of 10.5% or greater by 2024, free cash flow conversion of approximately 100%, and cumulative cash flow from operations generation of approximately $3.5 billion. Our market positioning, industry-leading scale, and technology differentiation support our position and ability to deliver on these targets. With that, I'll turn the call over to Rob so we can take some questions.
spk12: Thank you. At this time, we'll now be conducting a question and answer session. If you'd like to ask a question, please press star 1 on your telephone keypad, and a confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants who are using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we poll for questions. Thank you, and our first question comes from the line of Peter Arment with Baird. Please proceed with your questions.
spk06: Yes, good morning, Roger and Chris. Good morning, Peter. Nice results. Hey, Roger, you mentioned some customers tampering down kind of their spending plans just given the uncertainty. Maybe you could just give us a little more color on what specifically you're seeing. Thanks.
spk11: Yeah, you know, what typically happens, so we end up with a contract as IDIQ. We work on task orders. And then we always anticipate, especially in the next fiscal year, that those customers will come forward with projects which will expand our revenue base. And it's discretionary money on their part, but it's below the IDIQ ceiling. And I'm thinking in my mind primarily about three or four agencies, and those projects just haven't materialized. And the base program is running fine, but we always anticipate maybe 10% on some of these IDIQ kind of test quarter contracts that will come in. And a couple agencies specifically just haven't been spending their project money. And so it's something we sort of plan on. It's not unusual. We've seen it before when the budget uncertainty gets as bad as it is today. And, you know, pretty much eventually they'll spend that money. It'll be in it next year or the year after. So the work still needs to get done. It's just not getting done in third and fourth quarter.
spk09: And, Peter, the only thing I'd add is we're not really seeing that in our civil and health customers. It's pretty much in our defense solutions segment between the intel and some defense customers where we're seeing that activity.
spk06: Okay, appreciate that. I'll leave it there at 1. Thanks.
spk12: Great. Thanks, Peter. The next question comes from the line of Seth Seifman with J.P. Morgan. Please proceed with your questions.
spk02: Hey, thanks very much, and good morning, everyone.
spk11: Hey, good morning, Seth.
spk02: So, Chris, I wonder if you could help level set us with the health business. I guess from, you know, from 2017 to 2019, we had adjusted EBIT pretty regularly in, like, the $275 million range in that business. 2020 included the COVID impact, so obviously it would have been much higher. This year we're looking at something considerably higher than that, maybe even something approaching $500. And so when we think about the headwind that's obviously going to be there next year, as the outsized exam revenue comes off. Can you help us to size the sales and margin impact of that?
spk09: Well, I mean, first of all, I want to congratulate our team. I think our team has done an exceptional job running that business and continuing to optimize performance along the way. Clearly, this was a banner quarter with the growth and the margins above 20%. I would tell you, and we have told you, You know, that is not where we see this being sustained. And we have worked down the backlog that came about through the pandemic, and we're seeing, you know, a level of referral volume continuing to stay fairly high. So there's some reasons to be a bit optimistic there. But it will come back down. And what we said before is when the business was running at a normal level, it was in the mid-teen margin. And while we don't guide by segment, I would tell you somewhere at that level is certainly – the bottom end of what we feel comfortable with, but with the improvements in the business operations and the growth, I think there's opportunity to, you know, do better than that over time. So we're preparing for a scenario where health is not performing at these levels, that we've communicated that at Investor Day, and we're, you know, driving the rest of the business to make sure we're driving margins up over time. But again, couldn't be more happy with the performance of the health team, and we're going to sustain that performance as long as we can.
spk11: Yeah, and Seth, as you know, we've got a couple fairly large programs starting up, the Military Family Life and Counseling Program and the Reserve Health Readiness Program, and they will be, you know, fully ramped next year. And those are more towards our normative levels that you might see in our defense group. And so, you know, it's a great business. We're really proud of the team. But next year should look more normal. This COVID has created swings in our business that we saw last year, and now it's, as we had predicted, it's swinging back this year.
spk02: Okay, great. That's very helpful on the margin. And then maybe just to follow up on the sales, you know, I assume that the exam business will be down on the top line next year. But, you know, to your point, there's been some nice wins and some programs ramping. Can health grow next year, top line?
spk09: Well, so we'll obviously get into those details in our fourth quarter call with you. In fact, we're going to be with our team here in a couple weeks going through the bottoms-up annual plan. But I would say, yes, our expectation is the health business can grow next year, and that's certainly the way we're approaching it. So more to come on the details around that, but we're actively working that, and there's a healthy pipeline that we're pursuing at all times.
spk02: Great. Thank you very much.
spk12: Thanks. Our next question comes from the line of Gavin Parsons with Goldman Sachs. Please proceed with your questions.
spk07: Hey, good morning.
spk11: Hey, Gavin.
spk07: I was hoping you'd help to quantify some of the impacts of the delays or impacts you cited and then you know, some of the other businesses that may not be kind of running at a normal level, right? Health might be a little high, but I think SDNA is a little low. So if you could help to quantify the impacts of chip shortages, Intel delays, things like that, that would be really helpful.
spk09: Yeah, I'll take a stab, Gavin. You know, so we took down the midpoint of our guidance to $100 million. So that's kind of the size of the pie, if you will, is how we think about potential headwinds that we're facing. And You know, on the material side, which is kind of tied up in, you know, some of the chip shortages, we've seen lack of material availability. Most are on the computing side, but some technology components impacting like our Dynetics or our ISR, airborne ISR business. You know, think of that as, you know, roughly a third of the impact, right? And then we've got the budgetary headwinds where we expected certain projects to come through. We're not seeing that activity from customers. You know, that's another issue. You know roughly third of the impact and then there's this protest bucket, so we had a couple programs that we won and, in fact, we had another program that we won last quarter on the tsa side. The ted's and said, which is an OEM underneath that protested so we're not able to do some of the work so there's this bucket of protest activity that cost us. You know some of the revenue miss as well, so there's a few of those things going on, we didn't talk about. Afghanistan drawdown, but I would just add that in. That's certainly probably at the higher end of our previous estimates on what that impact would be. So there's a little bit of, you know, we expected or hoped that we would have some over-the-horizon support that's not really materializing. So all those things added together kind of are the $100 million-ish guide down on the midpoint of our revenues.
spk07: Got it. And then maybe on civil margins, you know, I appreciate that can be pretty lumpy with timing of hardware delivery, but I'd say two below average quarters in a row here. Anything that's changed structurally there, or is there just a lot of timing going on there as well? And would you expect that to normalize itself?
spk09: No, I would tell you again, I was pleased to see the sequential improvement from Q2. You know, that's our expectation going into next year as we'll continue to see that tick up. The team's done an excellent job getting the SD&A business, you know, ready for growth in the future when that market rebounds. A lot of new talent's been added to the team. We're happy about that. But, you know, there's a lot of other things going on civil. When I highlighted the growth in our commercial energy customer business, which is above the segment average on margins, that'll continue to see expansion, we believe, going into next year, which will help us. So, again, the civil business should be above the corporate average margins. It's slightly below right now, but that's a quarter-to-quarter thing that we see trending up.
spk07: Thank you.
spk12: Our next question is from the line of Sheila Kaigu with Jefferies. Please proceed with your questions.
spk00: Hey, thank you. Good morning, everyone. Good morning, Sheila. Can we think about profitability? Adjusted EBITDA margins are in the 10.3% range in Q4. versus 11.2 year-to-date, what are the sort of the drivers of the contraction as we head into Q4? And I think consensus looks at, you know, 10.5% margins for next year. So maybe can you talk about the puts and takes for the last quarter of the year and, you know, what we should be considering if health margins are mid-teens next year?
spk09: Well, that's one of the – first of all, she lost art, and Roger can add in. You know, health, as we've been signaling, there was the expectation that Q4 will start to see a bit of a ramp down on the medical exam business. You know, that might not be the case, but we're preparing for that to be the case. And that clearly will put some dampening on margins overall. I would also point to the execution in Q3 was quite strong on the program performance side. You'll see when you get into the Q that we had an excellent quarter on net write-ups, you know, and that helped us in the third quarter pick our margins up to 11.6%. But we're absolutely targeting kind of that mid-10 rate. And as we paid it in Investor Day, that's kind of our longer-term view on where the business should be. So, you know, all things considered, in Q4 with the holiday season and uncertainty in health, we feel pretty good about landing in that area.
spk00: Okay. And then maybe one more question. Roger, in the release, you said you're gaining share. You know, what areas do you find that you're gaining the most traction?
spk11: Well, you know, we've always been strongest in this area if you look at our technical core competencies called digital transformation. And this is move to the cloud, IT as a service, helping our customers operate more efficiently. And what has been exciting for us is that line of business crosses really all five business units. And we've got some major wins that we've talked about. We've got some things in the pipeline. We've actually moved forward even in the health group with some commercial health care providers. And so overall, that's a real strong business for us. Another area that's really been nice, and again, we've talked about this already, is the new wins in the health group, which has allowed us to grow our health group faster than the rest of the business. And in order to do that, things like the military family life and counseling was a takeaway. The Reserve Health Readiness Program was a takeaway from other people. And we have... As we said at our investor day, and Sheila, we've been talking about for years, we want to have that balanced portfolio. And so we're investing in health and civil to grow. And to grow, it's great to go after new business, but sometimes we have to go after re-competes as well and to take business away from others in our industry.
spk00: Thank you.
spk11: Yep.
spk12: Our next question is from the line of Kaivon Rumert with Cowan. Please proceed with your question.
spk05: Yes, thanks so much for taking the question. So kind of as we look at the full year and actually the third quarter also, while you say, you know, the guides come down 100 million, it's basically very mixed. Clearly health looks like it's 200 million or so better for the year. And the big miss is really in defense. So Could you basically drill down a little bit more on the programs? For example, it looks like Dynetics, you know, might have been short. So we can understand which programs are, you know, contributing to the shortfall.
spk09: Sure, Kai. Well, obviously, health being up 200 million is against your estimates. We don't give the guidance by segment, but we're pleased with the health growth. And in defense, you know, clearly, is where we're seeing the preponderance of some of the impacts that we've talked about. You know, the Afghan drawdown, that was a headwind for the team this year and has hurt what would ordinarily be a growing airborne business. The material shortages, a lot of that in our intel customer space have been an impact. We previously talked earlier this year on the intelligence customer award delays having some impacts on the business as well. So, you know, those things are all factors. that are driving that, and, of course, the human landing system program. While we had never put that follow-on in our plan, clearly the $240 million that we executed on that 10-month program, you know, that's gone, and that becomes a growth headwind. Now, Dynetics, you know, Roger featured the IFPIC program in the quarter, and we're very bullish on, you know, the growth from that over time into the future. So we're excited about that. some of the programs that they're winning and executing on, but it is a different business model where you're not going to see some of those large franchise program wins in each and every quarter. So there's some variability on how the growth plays out. But if you pull human landing system out of Dynetics Performance, they're still on a very nice growth trajectory.
spk11: Roger, anything you want to add? Yeah, Kai, I would also add, you know, in the third and fourth quarter, we tend to buy a lot of material in our contracts, and then we kind of spend the spring installing it. And the chip shortage has affected the type of, and we say material, yeah, we buy raw material, but we buy a lot of computer equipment, you know, PC laptops, servers, routers, switch gear, and what have you. And we really have seen those supply chains lengthen. A PC we could use to get maybe in four months or in four weeks now probably takes 20 weeks. A server... probably the same, maybe if not longer, some of the networking equipment about the same. And so normally we would place the orders, we'd get through the fiscal year, we'd get into the next year of funding, we'd place these orders, we'd get the equipment delivered before the end of the year, and we'd book revenue against it. Now we're placing those orders, we're on backlog like everyone else in the industry, and it will arrive in the first quarter. And those programs are primarily in our defense segment.
spk05: Okay. Thank you very much.
spk11: Okay.
spk12: Next question is coming from the line of Matt Akers with Wells Fargo. Please proceed with your questions.
spk03: Hi. Yeah, thanks. Good morning. Can you comment on CAPEX? I mean, it's running a little bit lower year to date. Is that Something we should expect to pick up next year, and I think you've talked about kind of 1.5% of sales. Is that kind of the right way to think about it in the future?
spk09: Hey, Matt. Thanks for the question. So you're right. It has been running a little bit lower than our expectations. We do expect a modest ramp up in Q4 from what we've been running at. And 1.5%, I would say, that's kind of what we see as the upper bound, right? And our job is to make sure that each and every capital expenditure request pass as muster as it relates to returns that we expect to generate from that, and we'll go through the detailed scrub of that in our AOP. As you can imagine, there's some things from a supply chain issue also impacting us on the capital expenditure side. Roger mentioned airborne assets and some of the planes that we're outfitting, we're not able to get some of the technology components to get those in operation, so that's taking longer than expected. And some of the facilities, especially on the Dynetics side, for fabrication and some of our new wins, you know, getting contractors, getting materials to get those things out there is taking a little bit longer. So a little bit of uptick is what I would expect for the fourth quarter, and then as we head into next year, you know, 1.5% I'd say is the upper bounds, and we'll kind of see how things play out as far as what the opportunity space looks like. when we go through our planning process.
spk11: You know, and Matt, we just completed a big hypersonic facility in Huntsville, so that's mostly in our history. And then when we moved into the new headquarters here in Reston and we had a new building in Gaithersburg and refacilitated Campus Point, we went through, you know, although we lease our facilities generally, we have to buy the capital equipment and do capital improvements. So that's... going to be down next year. And, you know, Chris said, yeah, well, I'm not sure we've ever been at 1.5%. But somewhere between 1 and 1.3 is probably a working number. And just to reiterate what Chris mentioned, I can think of a couple projects in the building that we're in which we have put on hold because we can't get the material to finish it. You know, there's something on the floor above us that we just had to wrap up. and leave fallow and probably get it finished probably next year. So it's just, it's amazing how far-reaching the supply chain is. And if you look at the pictures of Long Beach Harbor, you know, there's a lot of material out there in connexions.
spk03: Great. Thank you. That's really helpful. And I guess just one more on NGEN is that, you know, I think last quarter you had mentioned that was sort of one of the kind of reasons to be cautious on the guidance, that it was a new program and you sort of weren't sure of the order patterns. Is that sort of fully ramped up now, and is that kind of flowing through kind of at the run rate that you had expected?
spk11: Yeah, I'll give you some details, and if I don't cover it sufficiently, Chris will jump in. We are fully staffed on the program, so nominally 4,000 people, give or take a little bit. From a revenue standpoint, though we won't hit full revenue until next quarter first quarter so it's still got some room to go from a revenue standpoint if you're looking for a full year. Then it's probably next year, or maybe even 23 until we're at the absolute run rate, but the great news is we've taken over the network. We own it now. We have starting the transformation part of the program, which is to move the Navy into, if you will, the next generation of a shore network. And the program is actually running really, really well, and we literally amazingly went from, award to fully staffed in literally just a quarter or two, and that's almost unprecedented. So really great stuff on the program. We're not at the max revenue this quarter, but we've got a good shot to be close next quarter.
spk09: I mean, the team, I think it's a highlight across the company of how quickly they staff that thing up and the executive management attention to get there. Roger mentioned earlier some of our customers have special projects, and NGIN would be a program that would have budget for special projects. So Again, we're learning this customer. We're ready to execute on those as those orders come through, but that's a variable demand signal that we have to be prepared to respond to. But we're pleased with where that sits right now with room to grow. Great. Thank you very much.
spk12: Yep. Our next question comes from the line of David Strauss of Barclays. Please proceed with your question.
spk08: Thanks. Good morning. Good morning, David. I wanted to ask you how are your recent acquisitions, 1901, Gibson-Cox, doing? The acquired revenue in the quarter was a little lighter than what I was expecting based on kind of what you had indicated Gibson-Cox would contribute this year.
spk11: Well, it's still early on both of those. Let me talk more strategically. The 1901 has been just a real energizer for our digital transformation work. We have used the talent in 1901 really to de-risk our engine ramping and staffing. They have an as-a-service platform and have a culture that just attracts people. And so we were able to set up a call center literally in a month using the people in 1901, and that has really allowed us to get ahead and provide that level of customer service that we wanted to get on engine. And it's the top-line growth. There's a lot of work on 1901 that happens through the other units, and so the way we account for it, if they facilitate a sale in our civil group, you'll see that revenue in our civil group. And the way we account for acquisition revenue is the standalone 1901. On Gibbs and Cox, on a standalone basis, which is probably not all that relevant even today because we've combined our heritage link, Leiter's Innovation Center Maritime Group with Gibbs and Cox, but you don't see that in the way we account for the revenue and the cross-linkages, the synergies between the heritage maritime business where we would have Sea Hunter and our TRAPS program and some other classified program and what goes on at Gibbs and Koch. You're not going to get that visibility in our GAP reported financials, but the naval architecture work and the relationships at NAVSEA and in the Navy that now complement our autonomy business and the work that we do under the water has been terrific. And then Gibbs and Cox, on a standalone basis, continue to have strong support from the Navy on the new frigate contract and the new destroyer contract. And they continue to grow and to staff. And it's really been exciting. They bring, you know, a level of systems engineering and platforms that we have wanted to have for a long time. And that knowledge and that culture really we're using across the whole organization.
spk09: The only thing I'd add on what we love about the Gibson Cox team is they're so close to the customer, so important to the customer's mission, and they're going to support that mission even in advance of a contract award. So, for example, just as they become part of a bigger corporation, making sure that we're getting out with the right contractual arrangements so we can recognize revenue on some of the work they're doing. But they're in a good position to continue to grow and deliver. And as Roger mentioned, the 1901 group is contributing a lot internally on other programs which are adding value and will ultimately be accretive to our performance, and that doesn't show up in the external report that you see.
spk08: Okay, that helps. And then, Chris, I wanted to ask, you know, on working capital, so it looks like, you know, to get down closer to the 875 or a little above that, you know, you're baking in, I would guess, something like a couple hundred million-dollar working capital headwind in the fourth quarter. So can you talk about that? And then, you know, in terms of your long-range forecast, I know we have the 3.5% you know, billion in operating cash flow that you forecast. But what specifically do you have baked in there in terms of working capital? Do you expect working capital to kind of be a net drag over that period? Thank you.
spk09: Sure, David. So let me, you know, first address the fourth quarter. And we signaled, you know, a couple main things that are going to go on in the fourth quarter. We talked about advanced payments. And so one of our large programs, Customer funds us in advance at the end of their fiscal year. We get that money in our third quarter. There are some material subcontractors and other payments that will go out in the fourth quarter, right? So we get paid. We pay some of them. So that will be an outflow that's already planned and programmed. And then we talked a lot about NGIN, and that's, again, a new customer with new buying behavior for us. And one of the things that we'll be in a position to do in the fourth quarter is procure a number of software licenses that they use and execute on and You know, as you can imagine, some of those arrangements are paying advance to the software license providers. The way the Navy funds those is kind of an overtime model. So there's some of that that's built in in our expectations of working capital usage. Big picture overtime, I would tell you this. I mean, I like the way the team is managing working capital today. I think we're having an excellent year. We're programming in improvements where we can make them. We're thoughtful about certain particular business areas that might need a little bit of investment, but that's modest. And so generally speaking, you know, our DSO this quarter at 60 days is something that I see as being able to be sustained, perhaps improved in certain spots. And right now, you know, the way we're going to manage inventory, I think there's ability to continue to tighten that down and drive improvements into that. So I don't see a big change in our working capital usage to execute our growth plan over the next three years. All right, great.
spk08: Thanks very much.
spk09: Thank you.
spk12: Next question is coming from the line of Mariana Perez-Mona with Bank of America. Pleased to see you with your questions.
spk01: Thank you. Good morning, everyone. Good morning. Good morning, Mariana. So supply chain, you gave us color on what's going on, but could you please discuss the actions you are taking to mitigate the headwinds and how much of these headwinds could actually slip into next year?
spk11: Well, we're doing what everybody else is doing. Our purchasing organization is out having discussions with all of our supplier partners. We're trying to place orders ahead of need. We would be willing to own and hold stock if we can get it. We are trying to substitute what's in inventory for what's not in inventory. We are having discussions frankly with our customers about would they rather wait, you know, would you rather have the, you know, the X laptop now or the Y laptop tomorrow. By the way, most of our customers are saying now we'll wait another month to get the Y laptop. We've got really good visibility into our supply chain. We tend to have, you know, from a system standpoint, material resource and planning, Our major suppliers connect into our system, so we sort of know where the supply is. We know when it's going to arrive. And as such, we don't want to get ahead of the arrival of the equipment. But like everybody in the industry, we see this as a delay, not a long-term problem, something that will For most of us, we'll correct early next year. I don't think we have the same issues that you might see in the auto industry or in others. And these are supplier partners that we've got 10-year, 20-year relationships with, and we buy a lot of volume. And so we have a preferred position when they get in the the server, the router, we are near the top of the list in getting our fair share. But there's only so much you can do, which is why we talked about it this morning, is if the chips aren't there, they're not being put on the boards, they're not being put into the equipment, and we can't put the equipment in the customer and take revenue credit.
spk01: Okay, makes sense. And then if I may, switching gears to vaccine mandates, I know the White House is already hinting some flexibility, and you mentioned no significant impact, but it will be really helpful if you can give us some color on the workforce vaccination rate, what are the most exposed businesses, and what are your actions to prepare for early December?
spk11: Yeah, well, we almost got through the call, so I could spend an hour on this. I'll try to give you a summary so that you have a good sense of where we are and what we're doing. First of all, we had a sweepstakes, what we call the carrot, where we encouraged our employees to get vaccinated, and we gave 10 employees a year's salary. That was very, very, very successful. We think a lot of people went and got vaccinated, kind of came off the fence because of the, we call it the move, the needle sweepstakes. OK, we are now looking at by way our current status is to enter our facility. You have to be vaccinated today or you have to have a recent 72 hour COVID test and that's all of our facilities and then customer facilities. We have to follow whatever rule the customer is put in place and it varies by it varies by customer, varies by state and varies by county. We all know there's an executive order 14 oh 42. that says everyone needs to be vaccinated by the 8th of December. We are working with the customers really down to every contract officer and every contract on what that looks like. I'm sure you know that it allows for exceptions because of the ADA and the Civil Rights Act, which means there is a health exception and a religious exception. We are processing exceptions through a relatively rigorous process. We have if you will, forms you have to fill out, and then we have a group of people who adjudicate that. You asked me what is our current vaccination status. I can give you a range. We think we're in the mid-90s today, all right, and because that's PHI data and the requirement to verify your vaccination is not in place here until the 8th of December, you know, we don't know for sure But based upon all the data we've got, the number of people who have already updated, uploaded their vaccination card, we think we're in those mid-90s. We worry about a small percentage number of people who won't apply for an exemption, won't get vaccinated, and simply say, hey, you know, I just don't believe it. I'm a non-vaccinator. We think that number is in the single-digit percentages. were concerned, which is why we talked about it on the call. It could have an impact to revenue. If an employee, if the mandate stays in place as it's written, and there's a lot of discussion, even yesterday, that the firm requirement of December 8th may be relaxed, but it has not yet been, although there's a lot of rhetoric from the White House. But if an employee were not to be vaccinated, then we would treat that like any disciplinary action where we go through an oral and then a written, and then they have to go through our employee disciplinary board, and that will take literally months, as it would if you parked in somebody else's parking spot or something like that. It is unlikely that we would involuntarily separate employees early, but there is a possibility that at some point we're going to have to lay off some people because they don't get vaccinated. We don't want to do that. And we're working with the legislators and with the White House on a sensible implementation of the executive order. But I would tell you right now it's fluid. There have been lawsuits filed. There are some states who have said, you know, you can't comply. And so we're trying to understand state law versus federal law. Like I said, this explanation could go on at length, but what we want to do is to keep COVID out of our facilities and out of our customer facilities. And the EO gives us a great opportunity to do that, and we're going to do everything in our power to keep COVID out and be compliant with the rules and the laws and the executive order. But we care about our employees, and we are a people company, and our workforce is really, really important. and we're gonna do all we can to maintain jobs for our employees. One other benefit that we have, and then I'll cut this off, Mariana, as I said, it's probably longer than you wanted. Because of our diverse portfolio, we have parts of our business that are not subject to the executive order. We do work for some commercial customers, actually a considerable amount of work for commercial customers. If it's possible, based upon skill set and geographical location, if we have people who don't want to get the vaccine and they have a skill set that we can use in our civil business and our civil health business and some other businesses, we can actually move those people to open jobs in other parts of the business and maintain their employment with Leidos. Now, that's not going to be true in every case. But the strength of having a diverse portfolio that we do have allows us to move people back and forth. And in this COVID world, a fair amount of people are working at home. So that adds to our flexibility that we could take someone who maybe was on a defense contract and move them to a civil commercial infrastructure program. And we do have a process set up to do that. We are encouraging those non-vaccinators if they would like, to take one of the jobs that we have in the commercial segment. Like I said, I could go on, but that's probably more than you wanted to know. But I appreciate the question.
spk01: No, and I appreciate the caller. Thank you.
spk04: And, Rob, I think we have time for one more question.
spk12: All right. That question will be coming from the line of Toby Sommer with Truist Securities. Thank you.
spk10: Thank you. I was hoping that you could give us some perspective on what an increase in wage inflation over the next year or two could mean to your different businesses, whether that would, you know, crowd out some new contract starts because existing programs may need to be, you know, kind of plussed up to keep the staffs and accomplish their mission. Thanks.
spk11: Well, let me give you a quick overview, and then Chris can talk about the numbers. So we have yet to see the wage inflation, but we are being thoughtful about that. And with the hiring that we're doing, especially in some geographical areas and some skill sets, the fight for talent is something that we are being very thoughtful about. Toby, you know we have forward pricing rates. There's an escalation assumed in the forward pricing rates. If we hire ahead or above that, then on our cost type contracts, that makes us a little less competitive, but we flow it through the customer. On our fixed price contracts, it lowers our fee. The numbers, as we look at 22 and 23, are really small. You know, because, you know, we procure about half of what we sell and our labor content, you know, is a percentage of that. And then you have to start seeing where we are on a labor category by labor category. So, you know, it's a risk item for everyone, for everyone in the industry, but it is not yet a significant risk for us. It's literally, I mean, and Chris can probably give you some colors here, in the single or double digit millions. But it's something we're being thoughtful about and it's why in our labor strategy you have heard us talk about building centers of excellence in areas that are outside some of the large geographical metropolitan areas like the 1901 group gave us a large footprint in Blacksburg, which we love. By the way, Blacksburg is a fantastic place, a great place to work. The people who work there love it. They're big. Virginia Tech fans, and it is a very different economic environment than trying to hire someone in Reston, Virginia. And our strategy for the past few years have been to be in places like Morgantown, West Virginia, and Blacksburg, and even St. Louis, which with the movement of the second headquarters of NGA has become a pretty exciting place for us to hire people and to grow.
spk09: Toby, it's certainly something, as Roger said, we're being very thoughtful about, we've been thinking about for some time, and actually just had some discussion on this as a leadership team yesterday as part of our planning process, so went through the analysis, and I would tell you that the budget that we're establishing for our merit increases for next year will be higher than what it's been the last several years. We're very cognizant of the fact that that's reality, but it's affordable to do so, and as we've talked about margin levers longer term, we understand that That's an area we're going to be making a little bit more investment. There's other areas we're going to de-emphasize. So I don't see it as something that puts a big headwind on us. We know how to do this. We know how to attract talent, retain talent. And I think ultimately, you know, doing the right thing on the front end with paying our people, you know, can offset costs elsewhere, such as retention or other things that, you know, you have to put in place. So again, big picture, I don't think it's a material driver for near-term margin impacts. And It's something we're certainly planning for.
spk11: Yeah, Toby, I would just add, and I know you've thought through this, is the rehire cost, the recruiting cost, kind of far exceeds the risk of wage inflation. And so paying at market or slightly better has always been our philosophy, and we want to keep up with market. And we would pay more to lose an employee and then go have to recruit a replacement than a small percentage in wage increase. And, you know, our focus, frankly, has always been about making this a great place to work, attracting people, having them build their career here, and stay with us over the long term.
spk12: Thanks, Toby.
spk11: Thank you. Thanks.
spk12: Thank you. At this time, we've reached the end of the question and answer session. I'll turn the call over to Stuart Davis for closing remarks.
spk04: Rob, I want to thank you for your assistance on this morning's call, and thank you to all the listeners and questioners for your time this morning and your interest in Leidos. Have a great day.
spk12: Thank you, everyone. This concludes today's conference. You may now disconnect your lines at this time. Thank you for your participation.
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