L3Harris Technologies, Inc.

Hi, good morning, everyone. I'm Christine Liwag, Morgan Stanley's Aerospace and Defense Analyst. Thank you for joining our next session at 8.10 with L3 Harris, and welcome Ken Benningfield. He's SVP and CFO, and John Rambo, who's president of the Integrated Systems segment. So before we begin the disclosures, for important disclosures, please see the Morgan Stanley Research Disclosure website at www.morgansanley.com. forward slash research disclosures. If you have any questions, please reach out to your Morgan Stanley representative. So with that, I know, Ken, you've got your own set of disclosures to redo.

I've got an equally exciting reference to forward-looking statements. So today's comments will include forward-looking statements. And for risks and uncertainties related to those, just please refer to our SEC filings. And with that, it's great to be here. Thanks for having us. And we look forward to the conversation.

Great. So maybe, Ken, you know, L3 and Harris came together about five years ago. And during the integration, you've captured $650 million of cost savings, divested 10 assets, bringing the two companies together for a combined $2.9 billion in proceeds. Last year, there's also an announcement of a company transformation, the LA Checks Next campaign. I guess the question that we're fielding from investors is, What's the impetus behind this new initiative after you've gone through five years of integration? And why now? And what are really the key achievements that need to be accomplished at this point?

Thanks for the question. Let me start just by saying, you know, you point out it's been about five years since the company came together. And in fact, we just celebrated the five-year anniversary of L3Harris. And we're proud of the work that we've accomplished in that time. You mentioned some of the portfolio shaping, and I think we've done a great job of really building a national security-focused portfolio, exiting some of the areas of the business that were less focused in defense and national security, and then obviously adding some assets that are closely aligned with that critical area of focus for us. So I think we really have a strong portfolio today. you know, focused on defense and, you know, the Viasat acquisition of the TDL product line with the Link-16 capability, and obviously the critical acquisition of Aerojet Rocketdyne and what they're doing for our nation and our allies in terms of, you know, production of solid rocket motors as well as launch, space launch, and, you know, I think really doing some good work to talk about how we're solving some of that critical need and the demand that we see relative to where the supply has been. And I know we'll talk about that a little bit later. But I think what's really exciting, before I get into kind of the integration initiatives, what's really exciting is I'm getting on to a year with the company. You know, for me, really seeing how we're integrating the capabilities across the company And yes, we did some great work around integration and some of the cost savings at the time of the acquisition. But as I look at some of our programs and some of our opportunities and some of the wins that we've had, it really is kind of the ability to look across what we do as a company, take some of the best out of SAS, some of the best out of John's business at IMS and even CS, put that capability together and provide an integrated solution you know, mission solution to our customer. And I'm seeing that more and more. I think there's some great opportunities, one of which John's got a program called Armed Overwatch, close-air support for the special operations community. John's got the Prime on that, but it brings CS communications and other areas of the business together to provide an integrated solution. I was just in a classified space yesterday, and so I can't talk about specifically what it was, but there's a lot of really great work that we do for the classified community that, again, integrates across legacies of both L3 and Harris, brings that together, and we're doing some really amazing things for our country and for our allies that are, I think, game-changing and really differentiated And things that we couldn't have done alone as L3 and as Harris. And, you know, so I think that's great, great work. And I think it's just opening up opportunities. As an example, we are now a prime in space. I think we've mentioned we've got over 40 satellites in backlog. And we had zero at the time of the merger. And, you know, so that's just, I think, a great example of where we've brought the capabilities together, made some investments, and really started to grow into a new business area. So to the question about, you know, the integration and now why LHX Next and why now, I would say we did a great job of the initial integration generating some of the cost savings. And then unfortunately, you know, when the pandemic came on, it sort of put that program on pause a little bit. We started working through dealing with some of the supply chain challenges and some other things that were popping up, workforce issues and concerns and how to move work remote and things like that. And it just sort of got us a little bit off the path that we were on from an overall integration perspective. So as we got that behind us, we thought this was the right time to really, I'll say, kind of finish the program. And so we identified a program that we call LHX Next. which is to generate a billion dollars of gross annual run rate savings by 2026. And really it's a commitment to increasing our margin. So it has two benefits. Number one it'll increase our competitiveness as we go after new bids and we return some of those savings to the customer. But it'll also enable us to realize cost savings that accrue to us and to our shareholders to increase our margins to a commitment we've made of at least 16% margins by 2026. We're already seeing those, you know, savings kick in and provide benefit again as we look at new bids, but also as we're performing on our business. And I think John will talk about that a little bit more and what he's seen in his business. So it's really starting to pay off. I think we are ahead of schedule in terms of getting to our cost savings and Now we're trying to figure out how we over-deliver to the billion dollars and see if we can work to get to at least 16% and if we can get to a durable industry-leading margin at or above that rate 2026 and beyond.

So are you on track for that $1 billion of synergies by 2026?

We absolutely are on track. I would say we're ahead and we'll be driving for seeing if we can do some more I'm not going to put a number on it today, but we've got our Q3 earnings call coming up here before long, either at Q3 or by year end. We'll give a more substantive update with all the numbers and any target revisions if there are some.

Great. And, you know, before we move to John on IMS, maybe we'll pause for a second. I mean, Ken, you've been, before L3 Harris, you had a longstanding career at Northrop Grumman. John, you were at Lockheed Martin. When you guys, you know, you've seen L3Harris as a competitor over the years or as a supplier. Now that you're at L3Harris, are there anything that surprised you either in the positive or negative that just came out of your, you know, that stood out to you that you want to share with us?

Sure. I can start with that and then turn it over to John. I would say, you know, Chris has talked about the trusted disruptor strategy and, you know, You know, what I would say is you can see it and you can feel it within the company. It's real. We really try to do things with less bureaucracy, a bit more agility. Make good decisions, but make them faster. You don't need a room of 30 or 40 people to make a decision. So if it's something for John's sector, you know, John, Chris, and I, and maybe a couple other folks get in a room, talk about the issues, get the data. make a decision and move and I think the other thing that I see is you know we really try to listen to our customer and help them solve their mission needs at speed you know we are platform agnostic I like to say we are the honest broker in the industry because we're not you know beholden to specific platforms and that enables us to really focus on what are our customers challenges and what are our capabilities and how can we solve those at pace. And I think there's some great examples of where we've done that. John has a program called Vampire that's doing some very quick work in solving some counter UAS challenges, as an example. That was, you know, listen to the customer, bring some capability together and get it out there in a number of months, not years. So that's, you know, some of what I see is differentiating. And I'll just say, you know, I've been here, again, coming on a year. It's exciting. It's a lot of fun. I think Chris has built a great team from, you know, some, you know, within Legacy L3 Harris, some leaders in the organization. And I would say we are absolutely, you know, growing into our, you know, position as a large player in the defense industry rather than kind of two midsize players.

Yeah, I guess I just build on that a little bit. Having come from a 26-year career at Lockheed Martin, I guess there are two things that really struck me when I joined the business. One would be culture, and one would be capability. From a culture point of view, I'd echo what Ken said. The strategy of being the trusted disruptor in the industry really puts us in a unique position of having those relationships that give us that prime-level capability, but also the disruptive gene and our ability to partner within the company, as well as with small business, academia, other primes and really pulled together best of breed solutions and to make decisions about those quickly and to deliver quickly for our customers. And Vampire is a great example of having full capability from across the company, integrated that in a matter of months and delivered 12 systems to support Ukraine in less than a year. So that's something that I think is unique from a culture point of view. Capability-wise, I think I knew L3Harris best for the products that I think are across the portfolio, whether it's the communications capabilities, some of the space capabilities, a number of things in my portfolio, particularly in the maritime domain. I hadn't realized the maturity of the integration capability that we have, and so being able to stitch those capabilities together, again, back to sort of that best-of-breed integration approach, do that quickly and to deliver more quickly and more affordably for our customers.

Great. Thank you for answering that. I mean, you guys are in a unique seat, you know, having been at the competitors before. Right. Yeah. So maybe, John, like digging into IMS, you know, with the how LHX Next is manifesting in your business. You've talked about you've announced three facility consolidations in this quarter. I think your target is to get down to 70 sites by 2026. You're at around 100 today. Can you talk about what the priorities are for integration and how we think about cost savings?

Yeah, there's a significant opportunity for optimization in IMS, and our blueprint for LHX Next is very similar to what Chris and Ken have outlined at the corporate level. We started off by looking at our workforce, and we took some difficult but necessary labor actions earlier this year. We've seen some lift from that that's really helped build confidence in our guidance for 2024. And we've also looked at infrastructure. So we had talked at our investor day in December about our plans to consolidate 10 of the reporting units within IMS into a single reporting unit to sort of streamline that infrastructure and along with that a migration to a new SAP ERP system, which has allowed us to get some additional cost savings out of the business and drive more alignment in how we operate. From a facility's point of view, You're correct. We continue to work on that incrementally. Since the beginning of 2023, we've had 16 facility closures. So we're continuing to chip away at that target of 70. And we have about another, call it an equivalent number, that we think will be coming out in the next 12 months here. So that'll get us pretty close to the 70. The next wave of facilities projects, we'll be looking at some more, call them More complex longer term projects that would include perhaps the manufacturing consolidation, so we have a couple of candidate projects we're working through now. walking Ken through some of those business cases and setting some priorities for when we can get those underway again probably kick in one or two of those off in the next 12 months. And then the final piece we're attacking is supply chain more than half of the revenue we deliver. is pulled through our supply chain to our customers. And so getting more strategic about how we look at our top suppliers and getting into longer-term supply agreements with them that'll reduce prices and improve the confidence that we have in availability of components. And then also starting to work on a category management strategy, some that we'll do within the segment. And then also at the corporate level, we're looking at categories of material that are common across all the segments. So think electronic components or mechanical assemblies, for example, how we aggregate demand across the company and get negotiated long-term supply agreements that'll bring down cost and improve our certainty of supply. So I think there's a pretty broad range of projects there across those categories that'll continue to allow us to meet and hopefully exceed the targets that Chris and Ken have set for us.

Thanks. And maybe sticking to IMS, you know, IMS margin had been under pressure with some fixed price development programs, especially in the ISR business. Can you talk about, you know, so far year to date, The segment margins have been pretty strong. Can you talk about what's changed in your bidding practice? How do you manage risk? And what's your overall approach to return thresholds? How is it different?

Yeah, I'm excited about the progress we made with respect to performance in IMS. You know, we had some challenges last year. And just, again, tying back to Investor Day, we talked about going through a period of stabilization with the goal to get more into optimization performance. by the midpoint of this year, and we are on that trajectory. So you've seen the margin improvement, and it's really coming from three things. Number one is focus on bid rigor, starting out with, excuse me, with making sure the proposals that are going out the door are well-reviewed, particularly for the larger, more complex pieces of work, that we're confident that our estimates are accurate, and then making sure that the margins we're applying to those bids are appropriate for the type of work that we're doing, for the contract type that we're bidding, and that we're not taking on too much risk with the bids that we're sending out. The second piece that we're focused on is just the basic blocking and tackling of program management. We've done a lot of work to strengthen the leadership team of IMS. My entire leadership team has turned over over the last 18 months. We've pulled some top talent from other parts of L3 Harris. We've pulled some top talent from other areas in our industry. And I feel much better about the caliber of the leadership in the segment than I did 18 months ago and that's really starting to manifest itself in more consistency and how we oversee our programs we've strengthened our central program oversight organization so more independent reviews of ongoing programs. We're standing up an analytics group within my my program management organization that will be looking at predictive metrics across our programs to start to understand what things might be getting to a point where there could be a problem so we're getting ahead of those versus reacting to them. And then we're deploying earned value management more broadly across the organization. And we're deploying a training and certification program for our program managers. So a number of things we're doing to show our program performance, and that's coming through in improved EAC performance on a quarter-by-quarter basis. The last thing I would mention is, you know, it's not enough to just put a good quality bid out the door. As we get into performance on these contracts, it's almost inevitable that something will change. Something in the design requirements will change. Something in the customer's expectations or mission requirements will change. And we have to move in a slightly different direction. And making sure we are very methodical in how we react to those changes contractually to make sure the contracts are keeping up with the work that we're going to be doing is really important. I've elevated the reporting of contracts within my organization to be a direct report on my staff. We brought in a very strong and seasoned industry leader to the contracts function in IMS, and she's really bringing a lot more discipline to how we're just, not just getting the right initial proposals out there, but managing over the life cycle of those programs. So those are really the three things that we're doing from a performance point of view, and then obviously LHX Next is the other piece that's contributing to improve margins.

Thanks, John, and apologies for putting you in the hot seat, but I've got more IMS questions, I think, from investors. IMS revenue and IMS margins have been probably, what, 80% of our conversation. So since we have you, we'll take advantage of that. So another IMS question for you, John. So look, IMS today, 65% of the business is related to the air domain, 25% maritime. And you've got some profound changes in these areas regarding DOD strategy. You've got manned and manned teaming. You've got passive sensing. Can you talk about how you're positioned for these trends and also what opportunities do they present and any sort of dollars and cents you could share would be helpful too.

Yeah, I guess I'll start with some of the most significant opportunity in the air domain since that's the largest wedge of the portfolio. I guess the most exciting trends there continue to be in the missionized aircraft and particularly missionized business jets. I think that L3 Harris and our legacy company L3 Technologies was really insightful in recognizing that as we were seeing larger and more powerful business jets come to market, there was an opportunity for military customers to move from more costly, more customized military airframes for those special missions and start to migrate some of those capabilities to these business jet platforms that offer affordability benefits, both in terms of the acquisition cost and the support cost because of the broad commercial installed base. And so we invested pretty significantly early on to, I think, get ahead of where things were headed to help our customers shape their thinking on how we could migrate some of these mission systems. And I think we really did a nice job of catching that wave to be a market leader with these missionized business jets. And so we have about 60 of those either on order or in backlog right now. We have a number of other opportunities that we're engaged in. Some of those will come to fruition in the near term. So dollars-wise, we see about $5 billion in the you know, call it near to intermediate term of those business jet programs. And we continue to feel good about our odds to secure a portion of that for our company. We just took on about a $300 million international business jet order in the first quarter of this year for a key NATO ally. So those continue to come in incrementally. There's also international opportunity for the Skywarden aircraft. That's the aircraft that we're selling to Special Operations Command for armed overwatch. And so we see opportunities in Europe, in the Middle East, in Africa, and in the Asia-Pacific region. And we think that we could start to see small quantities of those international procurements coming in as early as next year, but certainly by 2026, we think we'll see some initial orders coming for the international skyward. And so I think in the, you know, call it the airborne missions area, a lot of opportunity for us for growth. If we pivot to the C domain, that's where a lot of the investments we've been making in surface and subsurface autonomy I think are really going to start to come to fruition in the, call it the intermediate term. Our customers right now, both domestic and international, are starting with some small quantity buys. They're doing experimentation with the unmanned systems and how those are going to work with the manned systems so they can effectively integrate those capabilities together. And I think the investments that we've made and the contracts that we have today, while not all large in all cases, are strategic in nature. And as our customers start to mature their thinking and acquire larger quantities of systems, we'll be well positioned to ride that curve as it spins up. In the passive sensing area, if you think about the difference passive versus active sensing, the easiest analogy for active is just to think about radar. We put energy out into the environment. bounces off things, comes back, we can identify and track objects. Radar systems are good. The downside of radar systems with a sophisticated adversary is they can identify the source and pinpoint the location of the radar system, and then you can become a target. So it's increasingly important for our customers to be able to rely on passive sensing systems as well that don't put out energy, but that can use energy that's already out there in the environment, whether that's you know, other radar signals, whether that's, you know, visible light, you know, across the spectrum of wavelengths to be able to detect and track objects without emitting energy. And I think L3Harris has had a tremendous pedigree of passive sensing technology from space to, you know, decades in the airborne work that we do with the U.S. Air Force to land systems and naval systems. The work that we do in undersea sensing, acoustic work, whether that's attached to a submarine or other undersea networks that we work on in the classified domain. I think there's opportunity there for us in all of those domains. Perhaps the most exciting is for our surface Navy customers, where historically they've relied heavily on radars for their sensing needs. As they need to have an alternative system, we've been there to provide a couple of different approaches to allow them to detect and track objects with passive sensors. So one of those programs is in development. The program's called SPEAR. We're doing that with the integrated warfare system part of the US Navy. That's a program that'll start to field in the coming years. And then we have some other work that we're doing that we can't really talk about even nearer term. So that's an exciting area for us. And I'd be remiss if I didn't talk a little bit about Westcam. Wescam is a really exciting part of the portfolio. It's a commercial business located up in Canada. They have a subsidiary that operates out of the U.S. to support domestic customers. And that is an electro-optical passive sensing capability that's usually sold as a turreted system that can drop onto just about any aircraft. The Wescam products have been fielded on hundreds of aircraft around the globe. typically sold through a commercial business model. The margins are accretive to IMS, and we see continued year-over-year growth as we look forward over the next several years.

Great. Thank you. Thank you, John. Now, Ken, maybe moving to Aerojet Rocketdyne. I mean, look, the deal's been closed a little over a year ago. You've increased your investment internally for Aerojet by 40%, and deliveries for solid rocket motors are up 50%. But customers still highlight that there's still a shortage of solid rocket motors Can you put into perspective, like, what's going on and what kind of, what more improvements and operations could you do to boost output for all the demand that we're seeing?

Yeah, we're really excited about the work that's being done at Aerojet. And, you know, we've got a new leadership team there that's got great experience in missiles. You know, some of it coming out of legacy L3 Harris, some of it coming out of other parts of the industry, kind of similar to what John talked about in terms of new leadership. And I think they've done a great job of really focusing on what are the challenges that need to be solved to increase the output to address not just the opportunity that we see in front of us, which is continuing to grow, but when we acquired Aerojet, there was a set of, let's say, delinquent deliveries that they had committed to in delivering solid rocket motors and were behind. In just a year, we've burned down those delinquent deliveries by about 50%. That's through making smart, think of it as like industrial engineering type of investments. We also worked closely with a customer to get one of the largest Defense Production Act awards of about $215 million. to make improvements in the facilities and the production lines to increase output for smaller solid rocket motors to support missile programs. So I think it's going really well at Aerojet. We're making good progress in productionizing some of those lines. And we look forward to getting to the end of the year. And then as we look at 2025, we will have had Aerojet integrated into the company for about 18 months. And as we look at 25, we look forward to sharing a little bit more about the growth profile there. When we looked at acquiring Aerojet, and then even when we closed the deal, the demand has just continued to build and build. And I think we've been working closely, again, not just with the internal team, but closely with our customers, whether that's the missile primes or our allies or, you know, the DOD to make sure that we understand kind of how to prioritize and where to prioritize that production for the critical needs. And, you know, we just see that as a huge growth opportunity for Aerojet. We've talked about, you know, it's roughly 2.5 billion of sales today, and we see that growing to at least $4 billion by the end of the decade. significant opportunity for us and really think the team's doing a great job. And, you know, maybe just bear with us till the end of the year, and then we'll be able to provide a more kind of solid set of 2025 guidance, a bit more integrated with a full year under our belt as we look at where we go with that business from a financial perspective.

Thanks, Ken. And the free cash flow, you're guiding to $2.2 billion this year, and you're getting to $2.8 billion by 2026. Can you parse out for us what's the incremental driver of those pieces and is 2.8 billion conservative?

You know, I guess I've been accused of being a little conservative over the years, but, you know, here's the way I think we look at it. We did $2 billion of cash flow in 23, 10% increase to 2.2 in 24. and growing to 2.8 in 26. I think we've got building confidence in that profile. And, you know, it's really about growing the top line to $23 billion. While we're growing, we're increasing our margins to at least 16%, turning that growing profitability, solid working capital management, solid deployment of capital, enabling us to get back into, you know, we're currently in somewhat deleveraging mode. We'll get back to our three times target leverage ratio that'll enable us to take some of that cash and deploy it I think in a more you know shareholder friendly manner you know continued dividend increases back into I'll say a creative share repurchase more than offsetting any dilution from you know incentive programs so you know really that's that that's I think where it comes from grow the business increased margins, effective working capital management. We'll get to 2.8 billion and then we'll deploy it effectively.

Thanks. And maybe touching on divestitures, you've announced about a billion dollars of divestitures in the past 12 months. How are you thinking about the portfolio from here? Do you identify other non-core assets? Could this accelerate debt pay down? How do we think about your priorities?

Look, I think, you know, as you've seen, we're active managers of our portfolio. And, you know, we certainly think about what the opportunities are, you know, both from an acquisition and a divestiture perspective. And we've been, you know, pretty active in both. In terms of as we look forward, I guess I would say we've taken some actions to support, you know, the acquisitions that we've done and to support the deleveraging and generate some cash to get there. As we look forward, you know, it'll really be a matter of thinking about the value creation opportunity. I don't think there's a burning platform for additional divestitures at this point. But if we've got an asset there's a better owner of and if they're willing to pay a fair price and we think there's value to be created, we'll certainly look at that as they come.

Great. And, you know, in terms of time, I just want to ask one last question. In the next 12 to 24 months, Ken, What are you most excited about for L3 Harris, and is there anything that keeps you up at night?

You know, really, nothing keeps me up at night. I think it's really about what gets me up in the morning. And, you know, as we look forward, I'm really excited about, you know, the continued integration of the business, you know, the ability to continue to bring the best of L3 and Harris together and provide those capabilities to our customers, move in an agile manner. you know, really continue to execute on the trusted disruptor strategy. And I think it's just exciting to grow the business while increasing our margins and generating more cash. And, you know, I think there's just a lot of opportunity for us. And it's just, it's an exciting time to be at L3Harris, and I'm really happy to be a part of the team.

Well, great. Well, thank you very much, Ken. Thank you very much, John. This concludes our presentation on L3Harris.