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Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Yeah, so we'll get started. Good afternoon, everyone. I'm Christine Liwag, head of aerospace and defense equity research here at Morgan Stanley. I'm very excited to have the CFO of L3 Harris, Michelle Turner, here with us.
Michelle Turner
Chief Financial Officer of L3 Harris
Michelle, welcome. Thank you, Christine. And I'm so excited to be back here at Laguna. Last year, this was my first conference, I think, as part of the company. So I'm excited to be back here for this event. And I appreciate you letting me take a couple minutes up front here to share a little bit about where we're at from a company perspective, where we're at in terms of our evolution, where we've been, but more importantly, where we're heading. So for those that aren't familiar with our story, we're about to embark on our fifth year anniversary of the merger of equals of L3 Technologies and Harris Corporation. These were two companies that were, on their own, too small to compete with the large defense companies. but then also too large to be considered a small player. We just talked about choking right before this, didn't we, Christine? I think I had that same thing happen beforehand.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Well, great. And before we start, I'll just read this disclosure then, Michelle. So, you know, for important disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com forward slash research disclosures. If you have any questions, please reach out to your Morgan Stanley representatives.
Michelle Turner
Chief Financial Officer of L3 Harris
So where did we land kind of post this merger? We effectively became the new entrant within the industry. We offer competitive alternatives for our DoD customers. And more importantly, it's aligned with our DoD budgets in terms of where they're growing from an overall budgetary perspective. So since the merger, we've been quite busy over the last four years. We've delivered on over 700 million of integration savings in four years. We've also done a ton of portfolio shaping. And what does that mean? That means we sold some non-core assets, becoming much more of a focused defense portfolio. And we also made two recent acquisitions, strategic acquisitions that are aligned with our DoD customers' priorities, but more importantly for this group, for our shareholders and our investors, aligned with where we are seeing growth in the DoD budgets. So we're excited about the results that were driven to date. And we're also excited about the fact that our trusted disruptor strategy has really permeated across our entire portfolio within the company. And we're excited that it's starting to deliver results. In the first half of 2023, we've seen record backlog. So we ended the first half with $25 billion of backlog. We saw our book to bill end at 1.2 for the first half of the year. And all three of our segments are growing their top line. Actually, all four. With the recent acquisition of Aerojet Rocketdyne, they too are growing their top line. So we're really proud of all the accomplishments we've had over the last four years. And we're equally as excited about where we're heading next. So what should you expect from us over the next couple years? It's really two things. Two things grounded in doing what we said we would do and meeting our commitments. The first is around prioritizing performance. Performance and execution across our portfolio. It's doing what we said we would do in terms of meeting our commitments for our customers, our employees, and our shareholders. So what does that mean for you in terms of shareholders and investors? It means committing and meeting our financial commitments. It means continuing to deliver on industry-leading margins. and it means delivering on positive free cash flow. The second is around our capital allocation strategy. Consistent with our recent commentary, we are going to be prioritizing paying down debt after our two recent acquisitions, getting back to a 3.0 debt ratio consistent with where we've been from a history perspective. We will achieve this through our cash from operations, and also continuing our portfolio shaping using proceeds to continue to pay down debt. So over the medium term, looking beyond the debt reduction, you should expect us to get back to a balanced and shareholder-friendly capital allocation strategy, which includes increasing our share repurchases along with having a competitive dividend. So I'll just wrap before we jump into the questions, Christine, and note that We recognize that our stock is trading at a discount to our peers, and we recognize that we've been touted as a bit of a show-me story. We look forward to the results that we've driven over the last couple quarters, and we continue to expect to do so. We recognize that we've got to deliver consistently quarter on quarter. We're going to share a little bit more of that as we go through the questions today, but I'd also like to invite you to our Investor Day in December, December 11th and 12th. in Melbourne, Florida, where we're going to share a little bit more in terms of what we should expect over the next couple years.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Great. Looking forward to being in Florida, Michelle. So maybe let's start with a budget environment. You know, the debt ceiling negotiations were resolved this summer, but the defense spending were capped at Fiscal Year 24 at 3% and 1% for Fiscal Year 25. And we're going into an election year. So can you talk about the budget environment and what this means for your growth outlook?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, so we like to talk about it in terms of macro dollars, right? And so I know on the surface, nobody gets overly excited about a 3% number and a 1% number. You're probably a little bit unsatisfied by that. But when you think about the overall DOD budget at $850 billion and how that compares to just a few years ago, What, 700 million? What would you say, Christina, around that same dollar amount? That's a huge increase in terms of the prioritization of defense spending within the U.S. So you take that and you couple it with the supplemental budgets that continue to happen. There's another one that was just teed up a few weeks ago that's not part of those growth rates, along with the recognition across the globe that the world is an unsafe place and it just continues to get unsafer. I'm optimistic around the recognition that there's going to continue to be a need for defense investment prioritization. And so when I think about how do you win in this environment, then it all comes down to if you recognize that defense investment matters and will continue to invest there, then it comes down to do you have the best portfolio, right, to outcompete your competitors. And so when I think about our LHX Next portfolio, I'll start with the recent acquisition of Aerojet Rocketdyne. This is an area that's growing double digits within the DOD budgets. We expect it's going to continue to grow when you look into the near term. Missiles and munitions is an area we haven't played in historically, so that is going to help in terms of us being able to outgrow the overall average DOD defense budget growth. Our second domain is our space domain. This is the second fastest growing area within the DOD budget. And when you couple the acquisition of Aerojet Baracadine with our existing legacy space portfolio, about 20% of what we do is within the space domain. We expect that that's going to continue to grow at high single digits. So those are the growth areas within our portfolio that are going to continue to outpace the overall defense budgets. And then when you look at the other domains that we play in, maritime, intel and cyber and land, all of these areas are well positioned for low to mid single digit growth. And then the area that we think is gonna be flattish with the pivot from air to space and the war fighting domain is the air part of our overall portfolio. So when I think about how do we play and how do we measure up against the DOD budgets, we think we're gonna outpace it in kind of that low to mid single digit growth area.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Michelle, what you talked about for the macro environment, I think that's well supported by government spend. We've got the cost of sovereignty and security really increasing. With that said, you couple that in the near term headwinds, continuing resolution had been more of a norm in US budgeting process. On top of that, this year there's an incremental risk that if Congress can't pass all the spending bills by calendar year end, there's an automatic 1% cut on the budget. So how do you think about the risk of a normal continued resolution or a prolonged continued resolution or the possibility that we don't get these spending bills passed by calendar year end and we have a 1% cut? How do you manage that short-term risk?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, I think it's a great question, Christine. And I think, to your point, continuing resolution has been a part of the defense industry for years. I think if you look at the last 23 years, 18 of the 23 years had some level of continuing resolution on average lasting about 100 days. So I think the industry has been conditioned, L3Harris has been conditioned to ensure that we are planning appropriately and being prudent how we're thinking about, especially the near term. What we try to do and what we focus our teams on internally is focusing on the things you can control. going back to focusing on performance, executing on the programs that we have, because the way you grow your business is by delivering on the commitments that you've already been afforded. And so for us, it's about focusing on that strong backlog that we're going to be entering the year with, and also the recognition that in any given year, most of the defense industry, 70% of what you deliver on in the next year is already sitting within your backlogs. And so we're just trying to monotonously focus on program execution, delivering on what we have, and we'll continue to influence and shape the budgets as we can in the background.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Pivoting to Aerojet Rocketdyne, you closed the deal late July. And the initial deal rationale was to expand into weapons systems, space, so like missiles and space. and you highlighted earlier, these are two fast-growing portions of the defense budget. The fiscal year 23 budget request was up over 20% for both categories, and the top line's only up 3%. So can you tell us, now that you have closed Aerojet Rocketdyne, has the deal rationale changed, and how do you think about the strategic value of having this asset with the growth trajectory of those specific budget items?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, it's a good question, and I really like this question. I would say it's reaffirmed with a plus plus and another plus. It's a lot of pluses, and we're excited about having Aerojet Rocketdyne as part of our portfolio. To your point, right, it puts us into a space that we don't currently play in, right? So missiles and munitions, double-digit budget growth, who wouldn't be excited about having that as part of their portfolio? It also gives us greater backlog visibility. One of The knocks on our portfolio historically is that we tend to be more of a shorter cycle business. This provides us visibility into a three-year type of program time horizon versus our historical legacy portfolio being closer to 18 months. So that's a plus as well. But what I'm really excited about is when I think about what has changed from when we announced the deal back in December to where we are today. To your good point, Christine, the budgets are up even more. So not only were we excited about this to begin with, but the budget, $30 billion within the FY24 budget for missiles and munitions, we're super excited about that piece of it. The other thing that is new since we signed on the deal back in December is about $200 million of Defense Production Act funding that Aerojet Rocketdyne has received to help in modernizing and increasing capacity within their factories. This was not known whenever we signed the deal or agreed to the deal back in December. And then my third plus, and I know you're going to struggle with how do I put this into my models, but the addition of the 5,000 Aerojet Rocketdyne employees into our portfolio, I think, is a significant plus. And why I say this is we just completed an employee survey a week ago, and in that survey, 85% of those 5,000 employees said that they are excited and engaged and really bringing a level of increased energy aligned with our mission as a result of being a part of L3Harris. And again, I know you can't put that into your models in terms of spitting out a number, but I'm a big believer in engaged employees drive productivity, and in the end, this is going to help us with this operational excellence journey we're going to be on with them. Maybe following up on some numbers questions.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
You plan to initially operate Aerojet Rocketdyne as its own independent segment. How should we think about cost synergies and revenue synergies? And when you guys first laid out the plans for the deal, the expectation was EPS accretive year one, free cash flow accretive year two. Are these still the targets?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, so you're absolutely right. So day one, we announced Aerojet Rocketdyne as our fourth segment. We like to call them AR now. And just for context, for those that aren't as familiar with our portfolio, we have three other segments. We have our SAS segment, Space and Airborne Systems. We have our IMS segment, our Integrated Mission System segment, and our CS segment, Communication Systems. So we've got SAS, IMS, CS, and AR as a result of this. We announced it day one along with a diverse leadership team who's being run by our new president, Ross Niebergall, who is a former member of our L3Harris executive team. Well, he continues to be a member of the team as the new president, but he also has background with the large prime. So he's bringing a diversity of experience along with the leadership team that he announced, which is a mix between the legacy Aerojet Rocketdyne leadership along with L3 Harris. And I think what's important to note is in this leadership team, there is representation around the large defense prime, particularly within Raytheon and Lockheed, which are two primary customers of the Aerojet Rocketdyne business. Specific to your question around synergies, 50 million of synergies is what we've talked about in terms of the initial combination of Aerojet as a part of the L3 Harris portfolio. We are well on our track to that. On day one, we recognized the synergies associated with the public company costs of Arrowjet Rocketdyne before. That has now gone away with things like the board costs. We've closed on our 30-day milestone, and we're well on track to several milestones that are as of the end of this year, which includes things like payroll, pension assets, the combination of benefits and things like that. So we continue to see line of sight to those initial synergies. And then to your point about the EPS and the free cash flow accretion, we're continuing to track to that. We do expect as we start to get under the hood, we're going to give a little bit more in terms of guidance in our Q3 earnings call. We are going to update our guidance for the five months that Aerojet Rocketdyne will be part of our portfolio. And then as we get into Investor Day at the end of the year, we expect to lay out some operational milestones tied to that. And the only other thing I would add is just, because we've gotten the question, and I think it's important to put it out there, is around revenue synergies. We are being very maniacal in terms of focusing our efforts, our leadership energy, and our team's priorities on the operational roadmap ahead. So right now, it's all about performance first, ensuring that we're delivering on the commitments that we've made to all of our customers, and that includes getting Aerojet Rocketdyne back on that track as well.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Following up on that, Prime customers have been pretty vocal about the spotty execution Aerojet has historically had, especially with the strong demand for missiles and their inability to deliver. Can you talk about the operational roadmap of how you're going to get to turnaround operations, meet the strong demand for missiles, and how much it's going to cost? You highlighted the $200 million that Aerojet received from the DoD. Do you need more, and would L3Harris need to invest more? more and how much to turn around Aerojet Rocket9's operating performance. Okay, was that like seven questions?
Michelle Turner
Chief Financial Officer of L3 Harris
Okay, I'm going to try to take them one at a time. I'll start from a macro perspective. Our plan is to lay out the operational milestones as part of our investor day, and Ross and his team are doing a phenomenal job of really getting under the hood, understanding some of the program challenges, and starting to lay out a road map so we have an appreciation for what are the things we can do right away and we are identifying some quick wins I talked about the cost synergies but we're also implementing our operational rigor we call it our E3 performance initiative but it's really around driving a commercial mindset think about it as manufacturing flow within kind of a commercial entity within this historically defense program office space and so we're already bringing Predictive indicators those kinds of KPIs that you're used to in a commercial environment into this defense world And so these are some of the quick wins that we're putting in place today But we're also recognized that some of these fixes are going to take a little bit longer particularly in regards to the supply chain there is some opportunities there as we think about leveraging the scale of L3 Harris in a different way and Aerojet Rocketdyne is a great company with a long legacy, but they truly are a $2 billion company. And so using the resources and the expertise that we have within the company, particularly across our supply chain, within a space that has been plagued with supply chain challenges, will matter in terms of being able to deliver on more resilient commitments. And so that is one that I think will take a little bit longer, but we're already seeing some opportunities there for us to have an impact. And then specific to the question around kind of investment and what's needed, this $200 million, I can't overemphasize why this matters to a company of this size. And to put this into context, Aerojet Rocketdyne spends about $50 million a year on CapEx. So $200 million of investment is about four years of capital to them. And so that's a significant amount of investment being placed into an organization from the DOD with the recognition that we need that additional capacity to be able to meet the growth in the budgets that I talked about at the beginning. And so I don't anticipate we're going to have to add a significant amount of additional investment and I expect that within Althea Harris's portfolio that we will continue to run our CapEx below the industry average which for us is about 2 percent. Overall industry average is about 3.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Thanks Michelle. And moving on to just operational headwinds in general, I think what we've seen in the past few quarters across the defense industry has been that the margins have been a little bit more under pressure than what others may have expected going into this high inflationary environment. So when you look at IMS, the IMS segment has faced some headwinds operationally and also some of the mix from fixed price programs. Can you talk about the bridge to how to get to the steep margin expansion through the second half, what you're doing to get there, and how you're tracking?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, so to your point, let me take a step back and just talk about the overall industry. Margins have been challenged. The macro environment has been a challenge, whether you're talking about attrition, labor inefficiencies, supply chain, inflation, all of those things coming together to create a perfect storm. What I think is important is the good news for the L3 Harris portfolio is even with these challenges, we continue to deliver on industry-leading margin performance. Our margins are about 300 basis points higher than the rest of the industry. So I think that's important context as we start to deep dive into the segments within our portfolio. The other good news, just from a macro perspective, is we do tend to have a shorter cycle business. And as a result of that shorter cycle business, that means we're going to work through that backlog that was priced prior to this higher input cost environment faster than a lot of our peers. So those are two tailwinds when you think about L3 Harrison comparative to our peers. I think it's important to keep in the context. Specific to your question around the ramp that has to happen in the second half, there's really two drivers there. One is around continuing to see the supply chain stabilize. We've seen this stabilize over the last three quarters. Where we sit today, we're continuing to see that stabilize. And what we've assumed in the second half of the year is that our product-based deliveries, which is where we have more accretive parts of our portfolio, will continue to see the benefits of that stabilization. That, coupled with the increased volumes, will help our margins in the second half. The second piece is around overall EAC performance, and this is, Christine, what you were talking about, kind of industry-wide. And we are starting to see the performance start to rebound with where we sit in the second half. A key indicator for everybody to watch is overall EAC performance, which gets reported in the defense industry in the 10Qs. Within Q2, this was the first quarter that we actually start to see that improve from where we've been the last four quarters. And so I think that's an important predictive indicator that you should expect to see margins continue to sequentially improve. And where I would tell you where we sit here within Q3, we expect this to be our second quarter of sequential margin improvement.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
You said a term earlier that continues to catch my ear, trusted disruptor. And I think space is one area where, in addition to the Aerojet Rocketdyne deal, you have made a lot of inroads in being a credible prime in space through organic investments, and inorganic as well. Can you talk about where you've been most successful at gaining market share within space? And also, we've now been in a long period where space is already 20% budget request versus 3%. How long can that outside growth in space sustain, especially in a period where that's what the Department of Defense has highlighted as one area where the US is behind the other nation states?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, you just teed up our thesis perfectly, Christine. And I think it continues for a while for that very reason. With the recognition that the warfighting domain is shifting from air to space, it is the acknowledgement, particularly here within the U.S., that we've got to continue to outsize our investments within that space. We're particularly proud of the inroads that we've made within our space domain. This is an area that's grown 30% for us since the merger. So just in four years, we've grown this space by 30%. And we continue to see success. Our book to bill, the first part of this year in 2023, 1.7. So I talked about the overall portfolio being at 1.2. The space domain itself is at 1.7. So it says that we continue to be successful in winning in these different pursuits that we're pursuing. And you're absolutely right, Christine. This is the prime example within our portfolio where the teams have fully embraced being a trusted disruptor What we show up and how we show up in terms of these competitive awards is enabling our ability to win. And I would say, the other thing I would say about our space domain is it's actually in three different pockets, if you will. There's the traditional SDA that everybody talks about in support of the MDA. We're having huge success there. The Tranche 2 RFP just came out. We expect a bid on that in Q4 with an award expected the first half of next year. So that's a growth area for us. We also have a strong position within the weather recapitalization programs that are occurring. We've booked over a billion three associated with just weather programs in the first half of the year. And we had our first success earlier this year around a space international award. And so we feel like every part of our strategy within space, knock on wood, is working right now. And so I'm excited about continuing to see this growth.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Presumably a lot of that growth comes from lower margin, either from a development program or some sort of investment bid. How should we think about long-term margin potential at SAS? And at some point, should we expect some of these development margins translate to higher margins? And when would that occur?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, I think this is another area I'm just going to tout our performance. The SAS portfolio low double-digit margins, if you compare that to our peers who, and you know this space very well, Christine, you know that those are single-digit margins, and so this is another example where we are driving industry-leading margins. Now, we continue as the CFO to have aspirations to have expanded margins, and we do expect that this space will continue to grow for us for the reasons that you just talked about. But I'd also highlight the fact that we are doing things differently as a result. The international bid that I talked about is an example where we're using capabilities that we're building here in the U.S. that tend to be at lower margins, and we are converting those into international pursuits that will help the overall accretion of the portfolio.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Moving to the supply chain, the CS segment was under pressure in 2022 for margin because of supply chain disruptions. We've seen some recovery in the first half of this year. Where are you now with the supply chain struggles and how far along are you in fixing them or addressing them? And at some point when that normalizes, where could CS margins go?
Michelle Turner
Chief Financial Officer of L3 Harris
Oh, you cut that one off like really quick. Okay.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Sorry, we're like two minutes and I want to be able to ask the audience for a question, so.
Michelle Turner
Chief Financial Officer of L3 Harris
Okay, so I'm gonna quote our new CS president who likes to use the terminology, paramanoid optimism, in terms of our supply chain. Where we are at today is a fundamentally different place than where we were just a year ago. I would say it is much more bound in terms of the fluidity that we're seeing in terms of our supply chain, and we're much better positioned to deal with disruptions when they happen. I think we've built a muscle about being much more resilient, And so when challenges do happen, we have an alternate part bank of over 1,000 parts now that allow us to be able to react, to be able to meet the commitments to our customers. And so I think what we're seeing is that's starting to flatten off, and we're excited to see that continue to permeate in terms of the margins that we delivered within Q2, which, by the way, were one of our strongest quarters since we closed, since the merger.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
On capital deployment, you highlighted earlier target leverage of three times. How should we think about divestitures to get there? And then also, once you get to your target three times, how should we think about capital deployment priorities?
Michelle Turner
Chief Financial Officer of L3 Harris
Yeah, no, thank you for this question, because I think it's an important one for everyone to have an appreciation for how we're thinking about our capital allocation strategy. So divestments would be used to the extent that we continue to shape our portfolio. And again, our aspiration is to have a very focused defense portfolio. So to the extent that there are non-core assets not aligned with that aspiration, we're going to continue to look for portfolio shaping opportunities. To the extent that we have proceeds associated with that, we will be leveraging that to help get back to our 3.0 debt leverage ratio. In terms of go forward, you think about a couple years out as we get back to that 3.0, our expectation is we return to a much more balanced approach, increasing our share repurchases while offering a competitive dividend consistent with what we've done prior to these recent acquisitions.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Great. Thank you, Michelle. So we'll open up the Q&A to the audience. If you have a question, raise your hand and we'll give you a microphone. Anybody? Great, so maybe last for me. I am a person with many questions. So in the next 12 to 24 months, what keeps you up at night?
Michelle Turner
Chief Financial Officer of L3 Harris
So I'm gonna go back to my opening comments. We're really proud of the work that we've done over the last four years. If you compare us to our industry peers, we've done a lot, right? We've integrated to companies, We've divested some non-core assets. We've made some strategic acquisitions. And we're excited about the impact that we're having with our trusted disruptor strategy in terms of how we're winning and how we're deriving financial results. When I think about the go forward, there's two things that we're prioritizing. One is a maniacal focus on performance, doing what we said we would do. meeting our financial commitments, and building our track record quarter on quarter to be able to deliver for our shareholders. The second is around the capital allocation strategy, focusing and prioritizing the debt repayment over the next couple years and then returning to a more balanced approach following that debt repayment.
Christine Liwag
Head of Aerospace and Defense Equity Research at Morgan Stanley
Well, great. Well, thank you very much, Michelle. This concludes our presentation on L3Harris, and stay tuned for our next Best Ideas panel.
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