Leonardo DRS Inc

NASDAQ:DRS

Earnings Call Transcript 2023-Q2

[Operator]

Ladies and gentlemen, good day. And welcome to the Leonardo DRS Second 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.

And I would now like to turn the conference over to Steve Vather, Vice President of Investor Relations and Corporate Finance. Sir, please go ahead.

[Steve Vather]

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 Dippold, 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 find the earnings release and supplemental presentation.

Management may also make forward-looking statements during this call regarding future events, anticipated future trends and the 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, it is my pleasure to turn the call over to Bill. Bill?

[Bill Lynn, Chairman and CEO]

Thanks, Steve, and thank you all for joining us this morning. I am pleased to report that we delivered strong results in line with our expectations for the second quarter. In Q2, our revenues accelerated and organic growth increased to the mid-single digits.

We also continue to see momentum in customer demand and secured nearly $700 million of funded bookings in the quarter, representing a 1.1 book-to-bill ratio. Backlog now stands at $4.4 billion, which is up 43% year-over-year and is also up sequentially.

Demand was evident across our diverse technology portfolio with Q2 bookings being led by requirements for our electric power and propulsion, network computing and tactical radar technologies.

We also generated healthy profitability as demonstrated by our solid adjusted EBITDA, margins and adjusted diluted EPS for the quarter. Mike will walk through the details and trends a bit later in the call.

Overall, our year-to-date performance continues to track to the stair stepped trajectory necessary to achieve our 2023 guidance. We remain confident in our ability to continue to increase our revenue and profit performance up this quarterly staircase as planned based on our solid business fundamentals and demonstrated ability to execute.

Shifting to the macro environment. The bipartisan agreement reached a few months ago to raise the debt ceiling resulted in a framework for future defense spending levels. For FY 2024, the agreed upon levels indicate a growth of 3%, which is consistent with the President’s budget request. For FY 2025, the growth is lower at 1%.

However, supplemental spending, including U.S. military support for Ukraine, is exempt from these agreed upon levels. Overall, we expect that there will be an upward long-term bias to defense budgets, given the bipartisan recognition of the elevated global threat environment.

Furthermore, our platform-agnostic business model, alignment to customer priorities, differentiated technology offering and strong pipeline gives us continued confidence in our growth prospects.

Moving to operational highlights. The team has done a great job managing through the complex operating environment. However, supply chain inflation and labor availability all remain as factors with varying levels of impact to the business. Of these three factors, supply chain continues to pose the biggest challenge.

Consistent with our prior commentary, we are not relying on any material improvement in the back half of 2023. Furthermore, we expect the potential improvement in 2024 will likely be gradual and incremental.

With respect to inflation, we are seeing better price stability in our material inputs. As we work through our own normal course repricing exercise, we remain cautiously optimistic that inflation will become less of a headwind next year.

On the labor front, we are seeing improvement in retention rates, which is helping the pacing of our net hiring. That said, there are still some pockets where hiring remains challenging.

All in all, we are pleased that the operating environment is trending positively, but we will remain vigilant and focused on execution, particularly as we continue the transition of several programs from development to production over the coming quarters.

Moving to some programmatic highlights from the quarter. We are continuing to execute well on the Columbia Class program, which is reflected in our overall results. We remain excited about the near-term growth opportunities for our electric power and propulsion technology. International interest in this technology continues to build and we are closely tracking the competitive domestic opportunities.

Shifting to space for a moment. We recently secured two strategic wins to help develop space payloads for civilian LEO satellites. These wins are important strategic market footholds. We are encouraged by our continuing traction in this market, as we expand our presence and build on our reputation as a go to provider for differentiated sensing capabilities optimized for size, weight and power.

Additionally, we submitted several new business proposals in the quarter that offer the potential to further expand our space business for both civilian and defense applications. We are carefully optimistic that customers will find value in our differentiated solutions amidst a competitive field.

Moving to innovation. Last quarter, we discussed our single-vehicle counter UAS solution. I am delighted to report that the customer reaction to-date has been quite favorable. This is a validation of our agility and our ability to make strategic R&D investments to quickly meet the critical needs of our customers. Over the past few years, we have thoughtfully increased our research and development investments to further expand and differentiate our technology portfolio.

This quarter, we announced innovation in the sensing arena with a new 8-inch gimbal for small to midsized UAS platforms that will deliver improved intelligence, surveillance, reconnaissance and targeting capabilities.

There is a rich opportunity for DRS to expand its presence on unmanned platforms with our sensing, platform survivability and our broader electronics capabilities. Bringing all of DRS to bear across programs, platforms and customers is a fundamental part of our strategy.

And I am excited to see that expand to include RADA. We are actively pursuing pipeline opportunities on a joint basis and are looking to drive the revenue synergies that underpinned our transaction rationale.

Lastly, I wanted to highlight that the Defense Counterintelligence and Security Agency has awarded us a 2023 Cogswell Award for outstanding industrial security achievement at our facility in Bridgeton, Missouri.

We received one of the 20 awarded this year from a field of 12,000 facilities. This marks our 21st Cogswell Award in the past 10 years, reflecting our utmost commitment to maintaining the highest standards for security.

Overall, I am pleased with our performance to-date, but we are maintaining a steadfast 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.

[Mike Dippold, Chief Financial Officer]

Thanks, Bill. I want to thank the broader DRS team in helping deliver another quarter of solid results. Let me step through the key financial metrics and trends for the quarter and then discuss our updated guidance.

Q2 revenues were essentially flat year-over-year. Excluding the net divestiture impact, our revenues for the quarter were up mid-single digits versus Q2 of the prior year. Just as a reminder, this is the last quarter where we had the full net divestiture impact. We will anniversary the divestiture in early August, resulting in a smaller and partial quarter impact to Q3.

Moving to the segment trends. Advanced Sensing and Computing segment revenues were down 9%, mostly due to the net divestiture impact. Excluding this factor, the decline was roughly a couple of points as supply chain challenges continue to elongate the conversion of bookings to revenue. Overall, supply chain challenges have been more impactful to our ASC segment.

Our Integrated Mission Systems segment enjoyed impressive organic growth of 21% as our Columbia Class program revenues move incrementally towards the production stream.

Now to adjusted EBITDA. Adjusted EBITDA in the quarter was $62 million, representing a decrease of 8% from last year. Resulting adjusted EBITDA margins were 9.9%, down 90 basis points from Q2 of 2022, but up 130 basis points sequentially from last quarter. The year-over-year adjusted EBITDA decline and margin contraction was driven by increased public company costs and higher investments in research and development.

In the quarter, we reversed the $10 million legal reserve for an aged environmental liability. This liability came via an acquisition several decades ago and recent facts drove us to reassess the risk related to this matter as no longer probable. Please note, we have excluded this one-time benefit out of all of our non-GAAP financial metrics.

Moving to the segment trends. In Q2, ASC segment adjusted EBITDA decreased and adjusted EBITDA margins declined due to the higher investments in internal R&D and increased public company costs allocated to the segment.

Despite increased operating expenses, the IMS segment adjusted EBITDA and margins were up, primarily due to strong program execution and higher volume in our naval power business, particularly on the Columbia Class program.

Moving to the bottomline metrics. There were a couple of discrete factors that drove performance and trends. Our solid execution translated to the bottomline but was aided by a net $8 million tax benefit primarily related to research and development credits. Additionally, our GAAP metrics reflected a $10 million legal reserve reversal that was discussed earlier.

The resulting net earnings in the quarter were $35 million, up 40% over the prior year, and adjusted net earnings of $39 million were up 13%. As expected, the trending was a little lower at the EPS line, given the increased share count in 2023, resulting from our all-stock combination of RADA.

Diluted EPS was $0.13 a share, up 12% and adjusted diluted EPS was $0.15 a share, representing a $0.01 decline as compared to the prior year.

Year-to-date strength in our stock price performance also drove higher than expected option exercises and ticked up our diluted share count.

Moving to free cash flow. Cash remained a little sluggish with an outflow of $10 million in the second quarter. Driving working capital lower and optimizing cash conversion remains a top priority for us. Please remember that our typical cash flow strength is most evident in the fourth quarter.

Now to our forward outlook. Halfway through the year, we are updating our guidance by narrowing the ranges for revenue, adjusted EBITDA and adjusted diluted EPS. We are now calling for revenue between $2.725 billion and $2.8 billion. At the midpoint, this still reflects approximately 4% organic growth.

Our updated view on adjusted EBITDA is between $318 million and $328 million. The range for adjusted diluted EPS is now $0.66 per share to $0.69 per share. Our underlying assumption for the tax rate for the year is now 19%. Thanks to the benefit of the R&D tax credit.

We should see a recurring benefit from R&D tax credits in future periods, and we anticipate our rate to drop. For modeling purposes, you should leverage a 23% effective tax rate moving forward.

Our strong year-to-date stock performance led to a higher than expected option exercises, and as a result, we are now assuming a higher fully diluted share count of 266 million for the year. As discussed previously, we continue to expect the second half to have a stair stepped trajectory with the fourth quarter contributing disproportionately across all metrics, but particularly profit driven by the absorption of fixed costs and free cash flow.

Let me close by saying that we have solid momentum in our year-to-date results, but we are focused on accelerated performance for the balance of the year. Longer term, we are excited about the growth opportunities in front of us and are working aggressively to sharpen our competitive positioning.

With that, we are ready to take your questions.

[Operator]

Thank you. [Operator Instructions] Our first questions come from the line of Robert Stallard of Vertical Research. Please proceed with your question.

[Robert Stallard, Vertical Research]

Thanks so much. Good morning.

[Bill Lynn, Chairman and CEO]

Good morning.

[Robert Stallard, Vertical Research]

I will kick off with a couple for Bill. First of all, on the DoD budget. We could see another CR for the start of the fiscal year. Historically, what sort of impact has that had on DRS and what sort of implications could there be in 2023? And then also to follow-up on your comments on export interest in electric propulsion. I was wondering if you could elaborate where this could be, what sort of programs your export customers are looking at there? Thank you.

[Bill Lynn, Chairman and CEO]

Yeah. Thanks, Rob. On the first point, we are almost sure to see a CR. We -- I think it’s been 15 years since the defense bill was passed on time, so we are not really expecting that to happen this year.

So that’s built into our numbers. Generally, you see a defense bill at the very end of the calendar year, at the very beginning of the next calendar year. That’s about what we would expect this year and that’s how we have planned.

So I don’t anticipate a great disruption from that. We don’t have a lot of new start programs, which is what’s most impacted by CRs and that you can’t spend new fiscal year money on a new start until you actually have the bill.

With regard to your -- what -- interest on electric power internationally, we have said earlier, we put in a proposal for a Korean destroyer. That’s in evaluation right now. We expect to hear in the next months, we don’t have a specific date. And then there, I don’t have other countries, but there’s other interest in a couple of other countries that is not as far along.

[Robert Stallard, Vertical Research]

Okay. Maybe just a couple of quick follow-ups for Mike. First of all, on the restructuring charge in the quarter, $8 million, I was wondering if you could elaborate what that was related to. And then secondly, which might be for Michael, maybe for Bill. On capital deployment, why not use some of the anticipated free cash flow this year to offset the share count increase? Thank you.

[Mike Dippold, Chief Financial Officer]

Okay. I will start here. The restructuring charge, we constantly assess our kind of our overall footprint and our cost structure. We saw the opportunity here to rationalize some facility expenditures and condense our manufacturing footprint to a lower cost center of excellence. So that’s what we implemented during the quarter. We think that will have some benefit in the long run and that’s what we did there.

On the capital deployment piece, so on the capital deployment piece, Rob, with the share count where it is and the float kind of offsetting that incremental share count is not something where we think, our money would be best suited in terms of reducing that float from a buyback. So we are focused on generating that cash flow, first of all, and then putting that cash to use in other methods.

[Robert Stallard, Vertical Research]

Okay. Thanks so much.

[Operator]

Thank you. One moment please for our next question. Next questions will come from Peter Arment of Baird. Please proceed with your question.

[Peter Arment, Baird]

Thanks. Good morning, Bill, Mike, Steve. Hey, Bill.

[Bill Lynn, Chairman and CEO]

Hi, Peter.

[Peter Arment, Baird]

On the advanced sensing margins, the kind of the pressure that you mentioned from the internal R&D step-up spending. Does that continue throughout this year? How should we just think about -- how you think about the impact on margins when we are thinking about the whole year?

[Mike Dippold, Chief Financial Officer]

Sure. I’d like to jump in and take that one, Peter. So, first of all, with the ASC segment, the first thing I will point you to is Q1 actually got off to a hot start, which was primarily attributed to a little bit of a mix that unwound a little bit.

We did indicate when we gave the guide that we were going to see the increased public company costs and increased IRAD. That is what we anticipated in terms of some cost growth, which were going to keep the margins kind of flat year-over-year.

But ultimately, the way I would think about the ASC segment is as we continue down this process of kind of stair stepping the revenue volume, that’s going to absorb these fixed costs. The fixed cost, the G&A, the IRAD is going to stay relatively stable and you are going to see the volume increase in the back half of the year and that’s going to drive the margins higher and it’s kind of tracking towards our expectation for the segment.

[Peter Arment, Baird]

I appreciate that color. Thanks, Mike. And then just, Bill, maybe one for you, are you seeing any step-up in terms of bookings related to force protection for -- in Ukraine or other countries in Europe? Thanks.

[Bill Lynn, Chairman and CEO]

Yeah. Peter, Ukraine certainly has emphasized the importance of force protection, both against airborne threats, drones in particular, as well as ground based things like shoulder-launched missiles and grenades, seeing all those YouTube videos of the vulnerability of the Russian forces.

The way that interest has been reflected has been -- there has been some movement into Ukraine. In particular, the U.S. has moved its Avenger -- some of its Avenger systems to Ukraine and I think there have been some direct sales.

The impact for us has been more in terms of backlog than in revenue. And by that, I mean, what happens here is, ultimately, the U.S. is going to backfill those Avengers, probably, with SHORAD, by the short-range air defense, a more modern system.

So that will add to our backlog, but it’s not happening immediately. It doesn’t happen contemporaneous with the move of the equipment to Ukraine. So over the next couple of years, we do expect to see a tick up in those programs, but it doesn’t happen in the current year.

[Peter Arment, Baird]

Appreciate all the color. Nice results. Thanks.

[Bill Lynn, Chairman and CEO]

Thanks. Thanks, Peter.

[Operator]

Thank you. And one moment please for our next question. Our next question will come from Jon Tanwanteng of CJS Securities. Please proceed with your question.

[Jon Tanwanteng, CJS Securities]

Hi. Good morning. Thank you for taking my question. My first one is, are you hearing any update on the new naval programs domestically? I think I heard you are moving forward on the KDDX, but I was more wondering about the destroyers and the subs and the industrial base expansion here at state side?

[Bill Lynn, Chairman and CEO]

Yeah. Thanks. Thanks, Jon. On the domestic programs, the first step for the new destroyer, the DDGx is a testing facility. The Navy is wants to proceed in a path where they design and test the new propulsion system before they start the new destroyer.

So the testing facility is the next step and we have submitted a proposal for the DDGx testing facility this past quarter and we will see the results in the next few -- you never know exactly when you are going to see an award, but the proposal is submitted.

SSNx, the next submarine is behind that. They are still evaluating what kind of propulsion system. I should say at DDGx, they have decided on an electric permanent magnet motor, which is what we have put into the Columbia Class submarine. On the SSNx, they are still doing that evaluation. It’s running a couple of years behind the destroyer.

In terms of the facility expansion, the demand is there. The U.S. wants to move and there’s congressional pressure to move from our current capability in the submarine industrial base of about one and a half per year, which is even under the current demand of about two per year and we expect that demand to grow.

And so the overall, the Navy and the shipyards are working with the supplier base, including ourselves to try and see how do you accomplish that doubling over the next several years and we are in active discussions with our customers into how we would accomplish that capacity increase.

[Jon Tanwanteng, CJS Securities]

Okay. Great. Thank you. Second, I know you mentioned a little bit more supply chain challenge in ASC in Q2. I was wondering if you were actually seeing the progress in your efforts to help your suppliers, call it, recover their recipes, your -- call it, their yields and their quality. Just help me understand what’s going on down in the supplier level?

[Bill Lynn, Chairman and CEO]

Let me start and then let Mike expand. Overall, we are seeing greater stability in the supply chain. We are not seeing lead times increase the way we saw in past years, but we are not yet seeing them contract either. So that’s why when we say we are not seeing improvement, we are seeing stability but not a contraction of those lead times.

The other thing we are seeing is, some movement. I would say last year the biggest problem was in microelectronics. This year, we are more see it -- seeing it -- there’s more stability there, but in electromechanical components, castings, just contract manufacturing generally, we are seeing some issues.

As you indicated, we are working actively with our suppliers to address those issues and keep our schedules on track. But it’s a series of moving challenges that we have to pay constant attention to. Let me let Mike add a little more color in terms of the segment.

[Mike Dippold, Chief Financial Officer]

Yeah. The only thing I will add to that, Jon, is that the efforts that we have been making in terms of improving the quality and kind of relearning the recipe, if you will, from some of the casting houses and other vendors that we are dealing with, they are showing some improvements. It’s really aiding in that stability comment that Bill just alluded to.

We are starting to get more confidence in the timing of the deliveries because of those efforts and because of the quality improvements. So that is moving along, again, not contracting the lead times, not accelerating our backlog conversion, but stabilization continues to be the word that we use and that’s what we are seeing.

The other thing that we have been doing is, where we are not seeing those improvements is working to second source certain vendors that have had some difficulties and that is making progress as well, and we are starting to get those qualified and ready to be part of our solution. So, in all, I think, we are taking another step forward this quarter from a supply chain perspective, but it’s still focused on stability, not yet contracting the lead times.

[Jon Tanwanteng, CJS Securities]

Okay. Great. Thanks. One more for me. Just Leonardo, the parent reported recently new management. They mentioned there might be more opportunities for synergies with DRS. I was wondering, is there room for upside to you at DRS or would that be something that accrues more at the parent level? Is that too early to think about, just help me understand what you are thinking of it -- with?

[Bill Lynn, Chairman and CEO]

I think it’s probably the latter, Jon. It’s a little too early to think about. The new CEO, Roberto Cingolani, is very interested in looking for synergies as are we. I think he -- his focus is on the areas he highlighted in his call, space, in particular.

As we have talked about, we have real opportunities to expand in space and I think that’s where the new CEO wants to go as well. So I think that’s an area we want in mind, but I think it’s too early to give you any sizing or thought on the opportunities.

[Jon Tanwanteng, CJS Securities]

Okay. Understood. I will jump back in queue. Thank you.

[Operator]

Thank you. And one moment please for our next question. Our question will come from Michael Ciarmoli of Truist. Please proceed with your question.

[Michael Ciarmoli, Truist]

Hey. Good morning, guys. Thanks for taking the questions. I guess, Bill, just maybe a little bit more color on bookings. I think you called out ACS as maybe being ahead of expectations. Can you give us any more detail around where maybe some of the upside surprises were and then I know you mentioned the sort of the status with the DoD budget? But any implications and you did mention Ukraine, but anything from overall increases in NATO spending or kind of the trajectory of what you are expecting for international revenue growth here?

[Bill Lynn, Chairman and CEO]

Yeah. Thanks, Michael. On the European side, so we continue to utilize Leonardo’s good offices to seek opportunities in Europe, and certainly, Ukraine has offered some direct opportunities on the smaller side and it’s also bringing a general increase in the European budgets as the NATO members, more and more of them are moving to hit that 2% target. So that is moving. That was a first step.

[Mike Dippold, Chief Financial Officer]

On the bookings side, I will take the bookings. But on the bookings, as you know, we don’t officially give any guide on bookings. But we target to beat that kind of 1:1 book-to-bill ratio and our first half performance has come out of the gate well. So we are sitting at about a 1.2 book-to-bill ratio.

Year-to-date, our backlog has grown not only year-over-year due to the Columbia funding but also sequentially. So we are increasing to that record backlog we put out last quarter. The demand seems to be there across all of our product lines are performing well in those four key markets. So we think we are building a nice foundation as we look out into the future.

[Michael Ciarmoli, Truist]

Okay. Perfect. And then, Mike, I guess, just on maybe the status of repricing some of these contracts. How much further do you have to go to get some of these contracts, I guess, in balance or maybe to offset some of the inflationary headwinds? Just any color you can provide there, discussions with customers or what’s happening on that side?

[Mike Dippold, Chief Financial Officer]

Yeah. Nothing really new on that front. We have a very diverse portfolio. So, obviously, there’s puts and takes between each of the different programs. But in total, we have talked about this kind of three-year repricing cycle on average for our contracts and we are still in the middle of that.

This will still be the year that I think is most impacted from the inflation pressures, because it is kind of that year two of that three-year cycle in which we priced programs before the global environment changed. So nothing new based upon what we said from our guide. We are still seeing those pressures on the profit, which is driving a relatively flat EBITDA margin year-over-year.

So we are seeing that, but we are also seeing the repricing efforts be successful as we look out into the future, and hopefully, that will provide a tailwind and some margin expansion opportunities as we look forward.

[Michael Ciarmoli, Truist]

Got it. And then just last one for me on free cash flow, it looks like it’s going to be another heavy 4Q weighting. But maybe can you give us -- I know you didn’t provide guidance for it, but any color on maybe the magnitude of cash generation for the year or a conversion rate that you could help us with?

[Mike Dippold, Chief Financial Officer]

Yeah. We are still targeting that 90% conversion of adjusted net earnings with the one asterisk and caveat of the Section 174 R&D tax payment that we had to make. So no change there. It is back-end loaded like you said and we have a path to get there and are tracking that accordingly.

[Michael Ciarmoli, Truist]

Perfect. Thanks, guys. I will jump back in queue.

[Operator]

Thank you. [Operator Instructions] One moment please for our next question. And we have a follow-up from Jon Tanwanteng of CJS Securities. Please proceed with your question.

[Jon Tanwanteng, CJS Securities]

Hi. Yes. I was just wondering about the restructuring charge. I think you addressed it a little bit earlier, but I was wondering what kind of run rate cost savings that’s generating on an annual basis? And is that part of your guidance for this year or does that more impact the forward years from here?

[Mike Dippold, Chief Financial Officer]

Yeah. The majority of the cost savings is going to be forward-looking. We look for a 1:1 ratio at a minimum for these restructuring efforts annually and that’s the expectation that we had set with this effort with the facility rationalization.

[Jon Tanwanteng, CJS Securities]

Okay. And is that a one-time Q2 event or is there more at least over into Q3 and Q4?

[Mike Dippold, Chief Financial Officer]

The majority of it is here in Q2. We are going to because of the accounting treatments and when the timing of the recognition, we will have some order drips in but the lion’s share of it is in Q2.

[Jon Tanwanteng, CJS Securities]

Okay. Got it. Thank you.

[Operator]

Thank you. [Operator Instructions] I am seeing no further questions in the queue. So, at this time, I will turn the floor back to Steve Vather for closing remarks.

[Steve Vather]

Thank you all for tuning in this morning and your continued interest in DRS. As always please don’t hesitate to reach out if you have any follow-up questions. We look forward to speaking to all of you again soon. Enjoy the rest of your day.

[Operator]

Thank you. This concludes today’s conference. You may now disconnect. Thank you for your participation and have a pleasant day.