Leonardo Spa Ord

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

Good morning and welcome, everyone. Thanks for participating on today's quarterly earnings conference call. With me today are Bill Lynn, our chairman and CEO, and Mike DePold, our CFO. They will discuss our strategy, operational highlights, financial results, and forward outlook. Today's call is being webcast on the investor relations portion of the website, where you will also find the earnings release and supplemental presentations. Management may also make forward-looking statements during this call regarding future events, anticipated future trends, and anticipated future performance of the company. We caution you that such statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Actual results may differ materially from those projected in the forward-looking statements due to a variety of factors. For a full discussion of these risk factors, please refer to our latest Form 10-K and our other SEC filings. We undertake no obligation to update any of the forward-looking statements made on this call. During this call, management will also discuss non-GAAP financial measures, which we believe provide useful information for investors. These non-GAAP measures should not be evaluated in isolation or as a substitute for GAAP performance measures. You can find a reconciliation of the non-GAAP measures discussed on this call in our earnings release. At this time, I'll turn the call over to Bill.

Bill? Thanks, Steve, and thank you all for joining us this morning. Let me begin by sharing our heartfelt concern and deep support for the people of Israel. The horrific attacks that occurred last month demonstrate the dangerous and unpredictable nature of global threats that face us and our allies. We're thankful that our team and operations in Israel remain resilient, but we are closely monitoring the ongoing conflict with the priority on keeping our employees and their families safe. In the face of an elevated global threat environment, we are confident that there remains broad bipartisan support recognizing the critical need to maintain defense investment as well as the need to support our allies. The growing sophistication of our adversaries is driving increased customer demand for advanced technologies to deter and counter global threats effectively and efficiently. DRS's broad and relevant technology portfolio coupled with our agility and innovation, continue to be key assets in supporting our customers' most challenging missions. This is exemplified by our most recent $3 billion-plus contract award for the rest of Columbia-class electric power and propulsion systems. The contract award covers most of the components for the remaining seven Columbia-class submarines previously not under contract and is additive to our Q3 total backlog. In the near term, we look forward to seeing progress and clarity with respect to the timing of FY24 appropriations and supplemental funding. Moving to an update on the quarter, I'm pleased to report that we delivered another quarter of strong results, which were ahead of our expectations for the third quarter. In Q3, our revenue growth accelerated considerably to 10 percent organically. We secured $1.1 billion of bookings in the quarter, translating to a robust 1.5 book to bill ratio. Throughout the year, we have seen demand strength come from varying parts of our broad and diverse portfolio. This quarter, customer demand was most evident for our advanced solutions in ground and dismounted soldier sensing, force protection, tactical communications, and naval computing. The steady flow of bookings continues to push our backlog higher. Backlog now sits at $4.7 billion, which is up 50% year-over-year and is also up sequentially. Q3 bookings and revenue momentum was matched by excellent quarterly profit generation and growth across key metrics, including solid adjusted EBITDA margin expansion in the quarter. I want to sincerely thank the team for their steadfast focus and hard work in executing with excellence for our customers and shareholders. Their strong performance in the quarter and throughout the year has allowed us to drive incrementally, better linearity, and increase the line of sight to meeting our financial commitments for the full year. And while there is another stair to climb for the fourth quarter, we are clearly focused on driving the necessary acceleration to a strong finish for the year. Moving to an update on the operating environment, supply chain continues to be a key operational focus. The good news is that the aggregate impact to our business from supply chain complexities remains fairly stable. However, we are still seeing shifts of where specific issues reside. Throughout 2023, we have observed more stability in microelectronics, but as discussed on prior calls, castings continue to be a challenge, and now specialty alloys and raw materials are emerging as a new area of concern. That said, With every evolution on the supply chain front, our team has been proactive and aggressive in working to implement the appropriate mitigations to reduce and contain the operational impact as much as possible. Bottom line, the supply chain complexities that we have faced over the past few years and continue to face will keep our bookings to revenue conversion cycle elongated and our working capital above historical norms. Lastly, let me offer a quick comment with respect to labor availability and inflation. While both of these factors continue to linger, they are progressing on a slow but improving trajectory. Our expectations for both variables remain fairly static, and while they will continue to serve as slight headwinds as we close out the year, they show promise of flipping to potential tailwinds over the medium term. Now shifting to some business highlights from the quarter, Our strong results continue to reflect strong program execution across the business. The improving dynamics in our Columbia-class program remain evident in our overall financials. However, we are also seeing better execution from other smaller development programs as well. That said, we are maintaining steadfast focus on execution as we work to fully mitigate those programs, excuse me, fully migrate those programs to production over the coming year. Moving to growth, we are experiencing strong customer demand for our broader capabilities in advanced sensing, electric power and propulsion, network compute, and force protection, as evidenced by our robust quarterly and year-to-date bookings. Additionally, key growth opportunities remain clear across the business. We have several proposals in electric power and propulsion and advanced sensing that remain outstanding and under evaluation with expected adjudications over the next 12 months. We are also continuing to innovate and advance our capabilities. On prior calls, I have discussed our vision for an integrated sensing. I am pleased to report that we recently received a small but important contract award from the Army to further that initiative to enable the integration of AI-capable computing into sensors. On the force protection front, We are seeing domestic requirements emerge for active protection systems, and we are also experiencing steady global demand for our multi-mission tactical radar technologies. As we approach the one-year anniversary of acquiring RADA, our investment thesis has been validated by the macro environment. Furthermore, strong synergies and opportunities with the rest of our business are visible, and our teams are routinely working together to respond to customer requirements and propose integrated solutions. We are excited about the diversity of organic growth opportunities across our business. We are regularly evaluating how to best position DRS through thoughtful investments, whether these manifest as incremental R&D or capital expenditures. We look forward to sharing more detail on this and on our overall strategy at our Investor Day in New York City on March 14th. Overall, I am pleased with our performance to date, but we are maintaining a focus on operational execution to meet our commitments to both customers and shareholders. Now I'd like to turn the call over to Mike so that he can walk you through our financials in more detail.

Thanks, Bill. Let me begin by also thanking the DRS team for their incredible effort to deliver another excellent quarter. As usual, I will walk through the key financial metrics and trends for the quarter at both the company and segment level, and then discuss our updated guidance. Total revenue growth for Q3 accelerated 11% year over year, which represented 10% organic growth in the quarter. The bulk of the growth was on the back of our naval power programs, namely Columbia class, but we also saw very healthy contribution from our naval and ground network compute businesses. Moving to the segment view, ASC segment revenues were up 6% due to solid growth in network compute and tactical communications, as well as the slight inorganic tailwind from RADA. Our IMS segment delivered another impressive quarter of organic revenue growth of 21%. Now to adjusted EBITDA. Adjusted EBITDA in the quarter was 82 million, representing a remarkable growth of 41% from last year. Our adjusted EBITDA was also up meaningfully on a sequential basis. This is driven by the fact that we period expense G&A, which means greater volume will largely drop to the bottom line. Historically, this has been most evident in our fourth quarter results, and we expect a similar cadence this year as we look to next quarter. In Q3, our adjusted EBITDA margins expanded 250 basis points to 11.7%. Strong program execution across our business, better mix, and higher volumes all bolstered profitability. On a segment basis, our ASC segment adjusted EBITDA increased by 33%. and margins were up 230 basis points due to better program execution in our network compute and laser programs, favorable mix, and slightly higher volume. At our IMS segment, adjusted EBITDA was up 55%, and margins were 270 basis points higher than last year due to continued momentum on naval power programs led by Columbia Class. Moving to the bottom line metrics, third quarter net earnings were 47 million and a diluted EPS with 18 cents a share, both down considerably over last year due to the 270 million net gain recorded last year for our GES and AAC divestitures. Our adjusted net earnings of 53 million and adjusted diluted EPS of 20 cents a share, which normalized for the one-time gain and other non-operational items, were up 112% and 67% respectively. Strong operational execution along with a healthy tax tailwind related to research and development credits flowed to these metrics. However, the compares for our EPS metrics still reflect a headwind from a significantly higher share count as a result of the stock combination with RADA. Moving to free cash flow, cash collections continue to improve sequentially and also trended favorably year over year. We generated $21 million of free cash flow in the third quarter. Despite continued supply chain constraints, we are focused on driving more efficient working capital and enhancing cash conversion. We have been fairly consistent in pointing to the fourth quarter as the dominant source of our annual cash flow, and as such, we are very much focused on accelerating that cash generation. Now to our forward outlook. Based on the strength of our year-to-date performance, we are narrowing the guidance ranges for revenue and adjusted EBITDA and raising the guidance for adjusted diluted EPS. We are tightening the expected revenue range to between $27.35 and $27.85 million. At the midpoint, this still reflects approximately 4% organic growth. That said, the largest variable factor in achieving fourth quarter and full year results will be the timing and level of material receipts. Our revised view on adjusted EBITDA is between 319 and 325 million. As discussed earlier, revenue volume will heavily influence our profit output given our period expensing of G&A. The other important factor that will drive variability within the range will be the program mix driving revenue. We are increasing our expectations for adjusted diluted EPS to between 70 and 72 cents per share. Our underlying assumption for the tax rate for the year is now 13%, thanks to the continued benefit from the R&D tax credit. However, we are still holding a long-term tax rate of 23% for the fourth quarter, as well as for 2024 and beyond. We are also maintaining our fully diluted share count of 266 million for the year, given the pacing of option exercises realized in the year to date. With respect to 2024, it is our intent to provide you color and our official guidance on our fourth quarter call in late February. As we quickly approach a year of being public, we are pleased with how the business has performed and have confidence in the opportunity ahead. We have a clear strategy, a strong portfolio, and a unique market position to create value. We remain focused on execution and meeting the critical needs of our customers, as well as delivering for our shareholders. With that, we are ready to take your questions.

Thank you. At this time, we will conduct the question and answer session. To ask a question, you will need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, please press star one one one again. And please stand by while we compile the Q&A roster. The first question comes from Robert Stallard with vertical research. Your line is now open.

Thanks so much. Good morning. Good morning. Bill, I'll start with you. A couple of questions on what you might call the macro environment. Quite a lot of uncertainty down in D.C. at the moment with regard to getting the budget through the system. What sort of contingencies have you put in place in case there is a government shutdown or even a repeat of sequestration later this year?

I mean, there's always a fair amount of turmoil in Washington at this point in the year, and I think we're seeing a little bit more extreme version this year. But the big picture of CRs through the quarter is what we anticipated when we built the plan. Almost never does Congress pass the bills on time by October 1st, so that's built into the plan. A shutdown isn't built into the plan, but if there is a shutdown, which I think is getting less likely, it would be quite short and doesn't have a material impact on us. We think what we'll see is a CR through probably into January, and then they'll go to passing the bills either individually or more likely through some sort of omnibus.

Okay. And then regarding the supplemental request, which is in the Congress at the moment, there's an amount in there for investment in the defense industrial base. Is there anything there that could ultimately come through to DRS?

Yeah, it's possible. I mean, the industrial base money, in particular the money that would be for the submarine industrial base, certainly touches us. There's a great impetus to... increase the throughput of the shipyards and to have the supplier base support that to move it up to three submarines per year. And we're in active discussions with the Navy in the yards about how we could expand our capacity and our capabilities to support that. The funding that came before and the money that's in the supplemental are certainly candidates to support that expansion. What the eaches are going to be remains to be seen until after Congress passes the money.

Yeah. And then maybe a couple for Mike. First of all, what's your expectation for free cash flow for the year? Has that changed at all versus what you said three months ago? And then also, where do you expect the working capital situation to be within that? And how is that likely to track heading into next year?

Sure. And thanks for the question. So from a free cash flow perspective, we still anticipate driving a cash conversion of 90% of our adjusted net earnings, obviously adjusted for the 174 tax payment that was made earlier in the year. We're still kind of on that trajectory and feel confident with our ability to deliver that commitment. With regards to working capital, what that means is that a lot of the investment we put into working capital throughout the year in order to maintain schedule for the customers and maintain our financial commitments, you're going to start to see that pay off here in the fourth quarter as we kind of outsize the cash conversion in Q4 versus prior quarter. So you're going to see the trend unwind a little bit from our working capital, and that's going to assist us in delivering the cash commitment for the year.

Okay. And then next year, do you expect a similar sort of seasonal pattern that working capital builds through the year and then you deliver it all in Q4?

Yeah, we're obviously focusing on getting kind of our procurement set for the revised lead times in the current supply chain. We think that there is a stabilization there, so we'll see. Our focus continues to be on improving that trend, but if you look historically, this has been the large portion of our cash generation has been in Q4. That won't change, but we are focusing on improving that seasonality. That's great.

Thank you.

One moment, please, while we prepare the next question. Next question comes from Michael Carmoli with Trust Securities. Go ahead. Your line is open.

Hey, good morning, guys. Thanks for taking the questions here. Bill, maybe just on supply chain, you know, it sounds like something's getting better, but you clearly flagged, I think, specialty alloys, raw materials. I mean, how are you looking at that? You know, I guess, you know, access to material availability as you think about moving into 24. I mean, just trying to get a frame of reference as to, you know, how concerning this is.

Yeah, I mean, I think the overall theme here, Michael, is stability. We are seeing more stability in the supply chain. But that said, we're seeing kind of the, it's a little bit of a whack-a-mole. We're, you know, the microelectronics have stabilized and now the specialty metals have popped up. We have learned to be very proactive. And so we are, you know, buying well ahead of need and stockpiling to anticipate any disruptions. And we think those steps are enabling us to meet our revenue commitments, meet our customer commitments. And we will be able to do that not just through 23, but through 24 as well.

Okay. Okay. I guess back to kind of Rob's question. Does that maybe keep some upward pressure on working capital, just if you're carrying more inventory than normal, or do you kind of have that contemplated into the plan?

It absolutely does increase the working capital. We've built that into the plan, but these kinds of steps, there is a cost to them, and that cost is really reflected in the elevated working capital. As Mike said, it'll wind down some in the fourth quarter, but We'd be above where we would otherwise be, but for those steps, I guess, is the way to look at it. Got it.

Got it. And then just on the Columbia booking, and I think even that the cadence of Columbia work as we move into 24 and into the out years, I think there was an expectation of better pricing there, growth on sort of the annual run rate. Any surprises with the booking that you got or negotiations with the Navy, or should we continue to expect that program to kind of grow in terms of annual revenues and be additive to margins?

It will do both. It will grow and be additive to margins. That's built into the contracts that we've negotiated. The thrust of this is the Navy and the shipyard gets stability in terms of delivery and pricing. And we get the assurance of those bookings going on for a decade. That lets us work through the supply chain, work with our suppliers to get better pricing, to get them to absorb some of the risk because they're getting more of the benefits. So it's a win-win for everybody. And what it really does is reflect the stability of the Columbia program in the defense budget. Everybody is completely convinced this program is going to go forward As planned, and so what we're trying to do is do it in the most efficient way possible.

Got it. Last one for me, just labor. You've obviously got RADA. You've got facilities in Israel. Any potential risk there of labor disruption, you know, potential employees, you know, called into reservist duty or, you know, just in terms of how are you kind of framing, you know, as you look at your operations there, given the current environment?

Yeah, thanks for the question. We're obviously very attentive to the Israeli operations. They are operating fully right now. There have been some reserve call-ups, as you would expect, but we're managing that and working with the Ministry of Defense. Obviously, the products that we produce are very important in terms of the conflict that Israel faces at this point. So everybody's interested in keeping our facility going at maximum capacity. a capacity. We also have a backstop in that we have basically a largely duplicative U.S. facility that can do a lot of the same things. So we can adapt if there's disruption, but there hasn't been any disruption to this point. Perfect. Thanks, guys. I'll jump back in the queue.

One moment while we prepare the next question.

next question comes from andre madrid with bank of america go ahead your line is open hey everyone good morning uh maybe to follow up on michael's question on columbia does the booking that you received after the quarter end do you think that the risks in any way the kind of margin expansion profile that you guys were projecting through the out years i think you guys said something maybe closer like 70 to 100 basis points of margin expansion company-wide on Columbia repricing. So if you can give any clarity on that.

I'll let Mike answer.

Yeah, I think that the negotiation and where we landed on a price commitment perspective will continue to aid in our ability to be more efficient. So what Bill said I think is the right way to think about this is this has given us clear visibility. It's helping us work our supply chain. It's helping us maintain our labor force in a continuous production environment, all of those are going to create efficiencies that will help us in driving that margin expansion that we have been leaning on, Andre.

Gotcha, gotcha.

And then another one on IMS more broadly. It looks like book to bill came in a little soft for the quarter at 0.8 times. Could you maybe talk about the demand profile across that business broadly. I know a lot of it's driven by Columbia. So could we expect some lumpiness on that front moving forward? Is that just kind of the nature of the business?

Yeah, looking at book-to-bill in a quarterly cadence gets a little difficult. You're right, it was 0.8 times from a book-to-bill in Q3, but that was on the heels of a Q1 book-to-bill of about 1.8 times. So you really got to look at it a little more holistically throughout the course of the year. And within our IMS segment, you know, even outside of Columbia, we're getting a lot of demand from the macro environment and the tensions we're seeing in our force protection arena. So the demand coming through from IMS is very robust, and I think you'll see that in your results.

All right, perfect. That's very helpful. I think I'll take that, guys.

Great.

One moment while we prepare our next question.

Next question comes from John Tanwantag with CJS Securities. Go ahead, your line is open.

Hi, this is Justin on for John. Good morning. Was just wondering, was there any pull orders into Q3 and then following that? What's, you know, can we get a little color on what's driving the increased adjusted EPS outlook?

Sure, sure. So the increase in the adjusted EPS outlook is really driven by some of the benefits that we saw from the R&D tax credit. So that's certainly a tailwind into the adjusted EPS metric. And as you know, from an operational standpoint, we continue to have a little bit more conviction. Hence, we tightened the guide rein on both the revenue side as well as on the adjusted EBITDA side. But the increase is largely the flow through of the benefit from the tax. R&D tax credit offset in part by a little bit higher, you know, kind of share count that we've been seeing through the increased option exercises from some of the employees.

Okay. That's helpful. Thanks. And then just quickly a follow-up. Can you give an update on your low Earth orbit efforts?

Yeah, in space, generally, we have moved more into low Earth orbit, as that's really where the demand is. We've won a weather satellite in that venue, as well as a position on the space tracking system for the Space Development Agency. And then we're doing a demonstration for NASA of uncooled technology. which has the potential to really lower the weight that you would have to put onto a payload because the cooling technology is quite a weight burden. We think those are opening opportunities that over the next 12 to 24 months give us the chance to take what really has been a niche capability for us and pull it really more into our core business. And we'll see over the next 12 to 24 months as other opportunities open and we're able to take advantage of those.

All right. That's helpful. Thanks for taking the question.

Thanks. Thanks, Justin.

Okay. One moment while we prepare the next question. Our next question comes from Jan Franz Engelbrecht.

Go ahead. Your line is open. Yann Frantz with Baird, are you there? I will go to the next question.

Hello, I'm here. Hello, you're there. Okay, great.

Thank you. Go ahead. So good morning, both Mike and Steve. I'm on for Peter today.

Morning.

Morning. So I just want to quickly return to Columbia. I think you've delivered about two ships, two ship tests to the Navy today. And I was just wondering if you could highlight some initial lessons that you've learned on the program from both just a technical perspective as well as labor, and then sort of when you expect to achieve sort of steady state profitability on that program, or would it be sort of a gradual improvement over that 12-boat lifetime?

Yeah, I'll let Mike take the financial question. Let me just, you know, what we've been able to do is, developed through the first contract, which was the first ship set, as well as the development of the system. I think we've been able to develop a scaled-up electric propulsion system, which was unavailable to the Navy before. We've delivered that. We're now working on the production ship sets. I think we are seeing the lessons that we – the hard-won lessons that we learned in the development show up in the production. We're not seeing surprises. I think we've worked through – it was a very thorough development program, five years with an enormous amount of testing. And we're feeling very good about the predictability of the production capacity. And we think that where this leads is we're going to be able to transfer this technology to new classes of ships, both foreign and domestic. And that's really an enormous opportunity over the next several years.

And I'll take that from the financial side. I think what Bill hit is also why we're confident in this new proposal that we're going to be able to drive the margin expansion. And that is Yes, we've built the prototypes. We've tested it. We built the first production ship set. But I'll just remind you about the rigor that goes through in the testing and evaluation for the submarine community. So we have learned a lot of lessons through those efforts. We are very confident in our ability to execute. And obviously, it's mandated and demanded by the customer. So we feel good there. We also bid this program in today's economic environment, so we're de-risked from that aspect, and we do believe that this gives us some opportunity to move from that development program, which is where you had a little drag on margins, and as the content of our revenue begins to become more and more from the production side and the margins associated with that production, that's where you're going to see the margin lift. You're going to see it as we become less dependent on the revenue contribution from the development and first production ship set and moving into these newly negotiated contracts that will afford us the opportunity for additional marginality.

Perfect. Thank you. That's really helpful. And then just a quick follow-up. Are there any specific areas where you're seeing sort of elevated foreign demand, just given the geopolitical backdrop, Ukraine, Middle East, Europe in general? I'd imagine it would show up in DRS land systems, but if you could just give some additional color there.

Yeah, I mean, land systems certainly. I mean, what we're seeing, you know, on a mission area is force protection has been highlighted by the Russian experience in Ukraine and the vulnerability of their platforms, their vehicles to both attack from the ground, rocket-propelled grenades and anti-tank weapons, as well as attack from drones. Obviously, the Ukrainians are experiencing particularly that attack from drones. So that's really highlighted the force protection capabilities, which really had atrophied in the post-Cold War era, and this has really highlighted the importance of that set of systems. We're also seeing kind of more generally a demand in Europe, particularly those states that border Russia, for increases in ground systems and force protection systems. And so you're seeing an acceleration of things that looked like they were several years out in Poland and Romania are now being pulled into the current timeframe. So that's an upward push on demand as well.

Perfect. Thank you. I appreciate taking the questions. I'll jump back in the queue.

Okay. One moment, please. I see we have another question from Robert. Robert, stand by while I bring you back in.

Hello?

Robert from Vertical Research. If you have another question, go ahead. Your line is open.

Yep. Thanks so much. Just a couple of quick follow-ups here. First of all, given the share price performance here today, have you seen any sign from Leonardo that they might be interested in maybe bringing down their stake and realizing some cash here. And then secondly, again, this might be for Bill actually, on capital deployment, what sort of M&A opportunities are you seeing out there in this defense environment?

Sure, Rob. Thanks for the question. On Leonardo, I think probably the best thing for me to do is point you to Leonardo is going to have their earnings call a week from today. And so I think that that's the place to look for an update on any update they might have on their plans. In terms of what was the second? Capital deployment. Oh, on capital deployment, we're actively looking. We're focused on the four market areas that we have with force protection, network computing, advanced sensing, electric power, and propulsion. We've seen opportunities in all of them, and we've pursued some to further steps, but we're not at this point in a position to move or announce on anything. And I would say the valuations are still fairly elevated, which doesn't mean we can't move, but we do have fairly strict financial criteria as well as strategic criteria. So it's going to be a process that's going to take months through 24 or so is the timeline we're looking at for these kinds of examinations.

Okay.

Thanks, Bill. Okay. At this time, I see no further questions, so I will turn it back to Steve. for closing remarks.

Awesome. Thank you. And thank you all for tuning in this morning and your continued interest in DRS. Please don't hesitate to reach out if you have any follow-ups, and we look forward to speaking with you all again very soon. Enjoy the rest of your day.

Thank you. This concludes today's conference. You may disconnect now. Thank you for your participation.