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Leidos Holdings Inc
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Greetings and welcome to Leidos Q3 2018 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Kelly Hernandez, Senior Vice President of Investor Relations. Please go ahead.
Thank you, Brock, and good morning, everyone. I'd like to welcome you to our third quarter 2018 earnings conference call. Joining me today are Roger Krone, our Chairman and CEO; Jim Reagan, our Chief Financial Officer; and other members of the Leidos management team.
Today, we will discuss our results for the quarter ending September 28, 2018. Roger will lead off the call with notable highlights from the quarter as well as comments on the market environment and our company's strategy. Jim will follow with a discussion of our financial performance and our guidance expectations. After these remarks from Roger and Jim, we'll open the call for your questions.
Today's discussion contains forward-looking statements based on the environment as we currently see it and as such does include risks and uncertainties. Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially.
Finally, during the call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in the press release that we issued this morning and is also available in the presentation slides. The press release and presentation, as well as the supplementary financial information file are provided on the Investor Relations section of our website at ir.leidos.com.
With that, I'll turn the call over to Roger Krone.
Thank you, Kelly, and thank you all for joining us this morning for our third quarter 2018 earnings conference call. Our results in the quarter demonstrate a continued build of our growth trajectory, both in the short term and in the long term, as evidenced by revenue and bookings strength.
Revenues grew 1.8% sequentially and inflected to growth on a year-over-year basis as well, up 2.9%. Awards were very strong in the quarter, with $4.6 billion of net bookings in the quarter, resulting in a book-to-bill of 1.8, the highest level we've had in the last three years.
We ended the quarter with a record total backlog position of more than $20 billion, up 15% from the prior year quarter. Margins remained comfortably above our long-term target, with adjusted EBITDA margins of 10.8% in the quarter, bringing our year-to-date levels to 10.6%. Our commitment to translating our revenue and profit growth into cash, together with ongoing efforts to optimize our balance sheet assets allowed for a very strong quarter in cash generation, well ahead of our expectations.
This higher level of cash generation resulted in a strong ending cash and cash equivalents position of $515 million exiting the quarter, and has not only given us confidence to raise our expectations for cash from operations for the year, but also allowed us to return more excess cash to our shareholders.
During the quarter, we repurchased an additional $62 million of shares, bringing our year-to-date total to $162 million. Year-to-date, we have deployed close to $400 million of cash in a combination of share repurchase, dividend payment and debt payments. Of the cash deployed, nearly half was directed to share repurchases. We remain committed to deploying our excess cash in this thoughtful and disciplined manner as we have done in the past.
The macro environment has been mostly positive, with the end of the government fiscal year resulting in a strong level of awards across all of our segments. Some highlights include, a new $620 million single award IDIQ vehicle with United States Air Force to provide single-point integration services for F-16 fighter jet avionics shops. We're proud to serve as the non-manufacturing support integrator for the Air Force's avionics shops and look forward to supporting this critical mission.
We were also selected by the Social Security Administration to support its Office of Software Engineering programs, which has a mission to improve the ability to deliver better software faster and more economically. Under this task order, we will apply our technical expertise in support of full lifecycle software development and the Agency's IT Modernization efforts which will improve services to the American public.
Awards from our intelligence customers during the quarter were significant, as we were awarded about $2 billion on programs across the intelligence community, more in this one quarter than we were awarded in either full-year 2016 or 2017. The significant growth in awards for us in this area far outpaces even the robust budget growth levels indicated in the most recently available national intelligence and military intelligence program budgets.
Beyond the strength in award activity at the end of the government fiscal year, there were additional positive developments in the broader markets. Defense base funding increases for 2019 were approved for a 3.2% increase versus fiscal 2018 levels, with R&D up more than the overall increase. Our DoD exposure aligns more with the base budget R&D and O&M line items, and the approved levels further our confidence in our future growth.
In the broader market, although the defense budget levels are positive factors, the outlays for fiscal year 2018 which were more directly correlated to contract revenues ended the year below expectations, in that not all available budget authority was spent in the fiscal year. At year-end, DoD outlays were up 5.3% compared to fiscal year 2017 versus the 9% to 10% approved budget authority increases. In areas where we have notable exposure, defense outlays were up more than the average.
Federal civil agencies also underspent their approved budget authority levels by nearly $73 billion. Outlays at year-end for these agencies increased less than 1% over fiscal year 2017 levels. This did manifest in headwinds for us in the quarter as some expected program ramps occurred more slowly than we anticipated, slipping more revenue to the right. We view this largely as timing rather than a reduction in expected revenue on these programs.
Beyond this, we are still optimistic about the growth in our business, given our strong book-to-bill and backlog position, and the increased level of takeaway and new business wins that will continue to drive our revenue run rate higher. We have seen good success in hiring to support the ramp of our new business wins and takeaways, with close to 2,000 new hires added in the third quarter.
As we have discussed, hiring activity is critical to our ability to develop – to deliver on our growth plans. While we are pleased with the level of hiring, we have begun to feel some impact from the tight labor market as the structural unemployment across the country is at historic lows. This had a regulating effect on our growth in the third quarter and we expect likely into the fourth quarter as well.
To counterbalance this, we continue to focus on making Leidos the employer of choice in our industry, through a combination of creating the right culture, offering competitive compensation and benefits, and career advancement opportunities for our employees. To this end, we were honored to be included in Forbes inaugural America's Best Employers for Womens (sic) [America's Best Employers for Women] list which was announced during the quarter and recognizes our commitment to embracing talent with different perspectives and from various backgrounds.
As we regularly examine our organization to ensure that we are optimally structured to support our long-term growth strategy, we made the decision to reorganize internally effective the first day of fiscal 2019 into four business groups: Civil, Defense, Health and Intelligence. We have had a commitment to investing in our talent and growing leaders from within, and with that said, I am proud to reiterate the leaders of these groups whom I believe will lead their teams to excel in their served markets.
The Civil Group will continue to be led by its current President, Angie Heise. The Defense Group will be led by Gerry Fasano. Gerry was most recently the Chief Business Development and Strategy Officer and led the team to the improved success of our new business capture efforts. The Health Group will continue to be led by its current President, Jon Scholl. Vicki Schmanske has been appointed President of the new Intelligence Group. Vicki's more than 30 years of experience spans responsibilities across all four of our market areas, with roles in systems engineering, software and information systems development, program management, and enterprise IT services.
One other notable change, as Gerry Fasano has moved into a new role, we have appointed Roy Stevens in his place as the Chief Business Development and Strategy Officer. Prior to this, Roy served as the Senior Vice President of Business Development within the old Defense and Intelligence Group, working with our military and intelligence community customers both in the United States and abroad. We are confident that these changes will allow us to better execute the strategies in our core markets, increase our agility through increased focus on our customers, and improve our success in the market and ultimately drive value for our shareholders.
With that, let me hand the call over to Chief Financial Officer, Jim Reagan, for more details on the quarter and our guidance.
Thank you, Roger, and thanks, everyone, for joining us on the call today. I'll start by adding some context to our consolidated results, the highlights of which Roger has already shared with you. The sequential and year-over-year increase in consolidated revenues were driven by the ramp up of recent program wins, most notably ITEMS USF (sic) [ITEMS UFS], ACE-IT and the SENS3 takeaway programs. This growth reflects our ability to quickly capture and activate new hires to drive volumes on these new programs.
Adjusted EBITDA margin in the quarter of 10.8% was fairly consistent, decreasing just 10 basis points compared to both the prior quarter and prior year. The stable consolidated margins primarily reflect a higher level of program write-ups in our Civil segment, offset by lower margin levels on the new program ramps as we have discussed previously. On a year-to-date basis, our adjusted EBITDA margin of 10.6% keeps us comfortably above our guidance range and our long-term target of over 10%.
Net interest expense of $35 million was largely in line with our expectations. Non-GAAP diluted EPS from continuing operations was $1.14, up 20% from the prior year, primarily reflecting the lower corporate tax rate. Weighted average share count declined 1 million shares from the prior quarter to 153 million, reflecting our share repurchase activity. Share count exiting the quarter was 152 million fully diluted shares.
Cash flow from operations during the quarter was very strong at $371 million, reflecting 200% conversion of non-GAAP net income to free cash. In addition to higher profits, stable collections and some balance sheet monetization all drove the strong cash. Days sales outstanding remained in line with the prior quarter's level at 64 days, reflecting the strong collections at the end of the government fiscal year as expected.
Additionally, during the quarter and in conjunction with our term loan restructuring, we were able to monetize our outstanding interest rate hedges, replacing them with new instruments, which reflects the term extension. This generated $60 million in cash proceeds, which are reflected in cash flows from operations. We continue to hold a fixed floating debt ratio of 70/30 at the end of the quarter.
Additional cash items impacting the quarter include the receipt of $40 million on our outstanding promissory note which is reflected in cash flows from investing activities, as well as $15 million in payments on our outstanding debt, and $62 million of share repurchase activity reflected in cash flows used in financing activities.
As Roger detailed the strong bookings already, I would add some additional context here about the composition of awards that the comp – that the composition of awards has shifted notably from the prior quarter. Nearly a half of the awards booked in Q3 represent new work for Leidos. So these are either takeaway wins from competitors or new program wins. The weighting of these types of awards has increased notably each quarter throughout the year, which combined with the 15% increase in our total backlog position over the past year furthers our confidence in future growth.
Now, let me share some highlights from our segments. Note that the changes to our organization structure that Roger discussed will be effective starting the first quarter of FY 2019 and we don't anticipate an impact to our reportable segment structure.
First, revenues in the Defense Solutions segment were up 4% from the prior year, as ramping volumes from recent program wins offset completion of certain contracts. Sequentially, revenues were roughly flat as these ramps were offset by a lower level of materials volume on certain contracts.
Bookings in the Defense Solutions segment during the quarter were at the highest level since the formation of the segment, with $2.7 billion in net bookings, resulting in a third quarter book-to-bill of 2.2. Awards were particularly robust in our Intel business, with $2 billion in gross awards from our classified customers. On a trailing 12-month basis, the segment book-to-bill is 1.5, pointing to a nice growth trajectory in this business into next year.
Results in our Civil segment were particularly robust in the quarter both in terms of revenue growth and margin performance. Civil segment revenues increased 7.3% sequentially and 5.3% from the prior year, reflecting strength across the portfolio, including the ramp-up of recent new program wins, higher volumes on existing programs and a higher level of net profit write-ups from risk retirement and recoveries on certain programs.
Non-GAAP operating margins in our Civil segment hit a new high watermark in the quarter at 13.3%, up
300 basis points sequentially and more than 200 basis points from the prior year period. This increase primarily reflects the positive impact of the write-ups mentioned earlier, which more than offset the negative impact of the initial phase of new program ramps. Given the one-time nature of these write-ups and the higher expected mix of early phase program revenues, we don't anticipate this level of margin moving forward.
Our Civil segment generated roughly $850 million in net bookings during the quarter, leading to a book-to-bill of 1.0. These bookings were awarded from a diverse set of customers, including the Transportation Security Administration, the FAA and the IRS.
Now, on to our Health segment, revenues declined 4.3% year-over-year and 1.6% sequentially. During the quarter, we experienced customer-driven schedule delays on existing programs and procurement delays on other awards that we had expected would offset contract completions in the quarter. Now, while these effects were disappointing, we view these as timing items and expect to recognize these revenues throughout the fourth quarter and into 2019.
Non-GAAP operating margins in the Health segment decreased 220 basis points compared with the prior year and 350 basis points sequentially, reflecting the lower revenues as well as the mix shift within the business. The Health segment delivered a very strong book-to-bill of 2.3 in the third quarter, a robust leading indicator of the growth that we expect from this business.
Some of the procurement delays mentioned earlier were resolved late in the quarter, driving the $1 billion of net bookings which reflect wins within the Social Security Administration, the Defense Health Agency and the Centers for Medicare and Medicaid Services to name a few. Trailing 12-month book-to-bill for the Health segment of 1.2 positions us well to grow this business.
Now, onto guidance, after evaluating the third quarter results and the expected fourth quarter program activities, we are revising our guidance for 2018 as follows. We expect revenues for the year to come in between $10.1 billion and $10.3 billion, at the midpoint relatively flat with 2017. And while we're disappointed by the slower than anticipated ramp of some of our programs, we're still confident in our growth trajectory.
The midpoint of our revenue range implies a fourth quarter revenue run rate which is up 5.4% year-over-year. This accelerating growth combined with our strong book-to-bill year-to-date and particularly the heavy weighting of new business and takeaway wins in the third quarter give us confidence in stronger revenue growth in 2019.
We're narrowing our expected range for non-GAAP diluted EPS around the midpoint of our prior range at $4.20 to $4.40. This includes an estimate of interest expense of $140 million, which is at the higher end of our prior range of $135 million to $140 million. We're also narrowing our adjusted EBITDA margin range to 10.2% to 10.4%, up slightly at the midpoint.
And finally, we are increasing our operating cash flow guidance by $100 million to at or above $775 million. This increase is primarily driven by the strong cash performance year-to-date, as well as a $15 million reduction in expected cash flows for restructuring and integration costs related to the IS&GS acquisition.
We will continue to thoughtfully execute against our capital deployment philosophy that we've consistently indicated in the past: Balancing investment for growth, regular quarterly dividends, debt pay down and share repurchase to enable an optimal cost of capital, while also driving increased value for our shareholders. And as we've indicated more recently and in light of our strong cash position exiting the quarter, beyond our commitment to the dividend and investing internally for growth, we view share repurchase as the most likely avenue for incremental capital deployment, absent potential M&A.
In conclusion, we are pleased with our increased backlog, the most forward-looking indicator of our revenue growth, but we're also disappointed that the timing has shifted slightly to the right causing us to lower our revenue outlook for the full year. We will continue to focus on increasing value for our shareholders and we're working hard to deliver revenue growth, profitability and best-in-class cash flow generation.
With that, Brock, now let's open it up to take questions.
Thank you, sir. At this time, we will be conducting a question-and-answer session. The first question today comes from Cai von Rumohr of Cowen & Company. Please go ahead.
Yes. Thanks so much and great performance guys. So, maybe give us a little bit more color on the revenue delays, which programs it was, when you expect those to pick up, with specific reference perhaps to the GENESIS program?
Great. Hey, thanks, Cai. So our compliant – our guidance, as Jim said, sort of implies flat full year to full year. But as I'm sure you noticed, we're showing growth in Q3 and the implied guidance for Q4 is significantly higher, frankly above 5%. What we found is we've reached our inflection point, we've got growth in third and fourth quarter, but lower level of government outlays resulted in slower ramps on programs, all right, and those would be programs that were new, right, some scheduled delays on existing programs, and I know you're always interested in GENESIS, so I'll come back to that.
And then, as I said in my remarks, we probably are starting to see a little bit of tightening in the job market, although we're really being pleased with our hiring, we just need to think about that going forward whether we can hire, continue to hire at that rate. And that's why we elected to lower our guidance a bit.
On the DHS GENESIS program, we did begin the wave deployment in Q3 at new sites and I'm sure you read about that. But despite that, there have been some delays in the program as a result of customer decisions to ensure that the IT infrastructure in some of the DHA sites is ready for deployment. They're going to be thoughtful in creating their rollout schedule. They will convert all of their sites as they anticipated in the program.
The size of the program, the funding on the program is still intact. We're proud of our performance. There's always reports that come out, we had an IOT&E report that came out during the quarter, which is very similar to the report that we had earlier, which reiterated that change is hard and installing new IT systems in older environments is the challenge that we all thought it was.
Frankly, we really like getting these reports. It's good data for us, as we get ready to deploy more broadly across the DHA environment. And I would highlight it usually doesn't come out in these reports that the benefits and enhancements delivered to customers as a result of the GENESIS program, improved patient care, they're seeing more patients, improvement in clinical efficiencies.
For instance, there were 1,300 duplicative lab orders that were caught by the DHA's GENESIS system, and improvements in safety, which we're excited about. We increased the new fill on prescriptions in the pharmacies at those facilities. So again, Cai, we're confident about what 2019 looks like and excited about next year.
And although we didn't fully anticipate some of these changes in activities and slowdowns in the quarter, we do expect deployment on DHMSM to ramp up in 2019 and beyond, as we always have, and we expect the flow through of our book-to-bill and our backlog to give us a very, very nice fiscal year 2019. Thanks for your question.
Thank you.
The next question comes from Robert Spingarn of Credit Suisse. Please go ahead.
Hi. Good morning.
Good morning, Rob.
Thanks, Roger. Hi. Wanted to follow-up on Cai's question there. So what's the right way to calibrate 40% growth implied and the year-to-date 1.4 book-to-bill to revenue growth next year, if that's the right period for those bookings to fall, obviously, there's a longer duration to those awards, but what's the rule of thumb?
It's a great question. And, of course, we don't necessarily give that kind of detail guidance. And Rob, you're really good at taking our book-to-bill and making an estimate of what the duration is and building that into your model. I just like to point to the macro environment; you can't have a book-to-bill greater than 1 quarter-over- quarter and not print growth.
The average duration in our backlog is in the couple years, right, so again, you've got a great model and you flow it through. But I would, I think, emphasize maybe for some of those who haven't followed us, is it's not instantaneous. So we win a program and we're able to book it into backlog, especially if it's a new win or takeaway that we need to go, transfer people in the program, hire new people, often move into a new facility and the ramp-up can be six months to a year. And so, having a great third quarter implies things well beyond first quarter in 2019.
Yeah, and Rob, I would add to that the fact that – just to reemphasize, the second and third quarter in terms of just the trend of the makeup of the new awards that comprise book-to-bill have been increasingly moving away from some recompetes that were part of kind of the normal schedule award cycle, but more into new work to Leidos as well as takeaways from competitors. And that improves our own visibility into our growth targets for next year.
Previously, we have talked about our growth rates beyond 2018 being above 3%. And the numbers that we're looking at for Q3 awards and our year-to-date number certainly point to higher confidence in achieving or overachieving on those numbers. We'll have more details on that in our fourth quarter call. The one other thing I would tell you is that the duration of our backlog has shortened slightly which points to a bit of a faster burn rate on the existing backlog.
Yeah, I don't want to put pressure on you, because it sounds like a 3% hurdle at some point here is pretty doable. The other thing I wanted to ask you about the backlog and you've touched on this earlier, but from a margin standpoint, how do you think about the business you're putting into the backlog, and if you could reflect on the labor tightening element of that as well?
Yeah. So the work that's going into backlog, there is a lot of work that is confidently in the double-digit margin area. We are able to shape more contract awards into fixed unit price. But I would also – to be clear, there's still a lot of work that's being awarded in the high-single-digit margin area.
So when we take a look at the balance of existing and new work, we're still talking about work that on an EBITDA basis balances out to north of 10%. We're continuing our work around optimizing our cost structure, which will translate into continuing a pretty competitive cost structure for new bidding and also our ability to continue driving margins competitively above 10%.
Okay. And then just one quick housekeeping one, the $60 million interest rate swap expiration that you'd contemplated in your previous OCF guidance, is that the main driver of the increased guide?
Yeah. Well, that's one part of it, but we're also doing, I think, a great job of optimizing our billing process. As you know, I have to give credit to the people that run the back office and have done a great job of putting us on to a single billing platform from the four different platforms we had as we came together with IS&GS.
So good program performance means that customers pay you faster. And when you bill them faster, those things combine to good OCF performance. But I do have to tell you that monetizing that cash – the interest rate swap was not contemplated in our original guidance and that's part of the driver for the bump up of $100 million.
Right. Okay. Okay, thanks for clarifying.
Thanks, Rob.
The next question comes from Ed Caso of Wells Fargo Securities. Please go ahead.
Hey, good morning. It's Rick Eskelsen on for Ed. Roger, I was hoping you can go back and talk just a little bit more about your comment that clients kind of underspent the budgets and that the outlays have been a little bit slower, maybe you can just talk more broadly about client behavior and whether you think that changes now as we enter the next government fiscal year with the national budget in place and it seems like clients have been more confident entering this year than in past years?
Well, overall, they are more confident and they are upbeat. Rick, but I think you have to look at it customer by customer because it's really different within the Department of Defense versus outside the Department of Defense. And we found DoD probably more confident and more willing to spend to their authorized and appropriated levels. And we have been talking about this throughout the year. Those agencies outside of DoD, as they looked at the effect of sequester and are trying to predict what will happen to them in 2019 and frankly in 2020, I think they have been more reticent to spend to their fully obligated levels and indeed, we saw evidence of that in the third quarter.
Now, that means, they're spending about flat to past year, which is still good for us. And in the areas where we compete, modernization of infrastructure, IT, O&M, the spending has been solid, but not at the level of the top line growth in their budget. And we don't – I don't really expect to see a big change in that in 2019. We will all be informed a little bit here in two weeks as we get through the election and we understand what the administration is going to do as they look beyond 2019 to 2020.
The good news is we got a lot of bills passed at the end of fiscal year 2018, and so for many, many of our agencies, they've got certainty for 2019. So we don't have the CR overhang that we usually have. I think that will help, but we're trying to temper that enthusiasm with reality of how the budgeting process works for our customer.
Thank you. It's very helpful. Just a follow-up on the – also you've talked about the hiring impact, it sounds like you guys still feel like you're doing okay on the hiring, but you're seeing maybe signs of tightening. I'm, I guess, curious if that has anything to do with security clearances and maybe if you can go a little bit more into sort of what you're doing on the hiring front? I know in the past you've talked about external referrals and things like that. Thanks.
Yeah. Okay. A couple of questions there; let me start with the one that is an industry-wide initiative. This is on security clearances and we have engaged with AIA and PSC and our associated companies in open discussion with both OPM and the Department of Defense and the Intel community.
And I know that Deputy Secretary Shanahan is taking this on as a personal initiative. We are cautiously optimistic that certainly on renewals, if not on initial clearances, that things will get better. But it is still a problem and it takes a long time, especially like for a college hire to get them through the clearance process. And for many of our programs that require a clearance, it does make it more difficult to hire.
We would say, overall, we're still pleased with the number of people who want to come to work at Leidos. We're very pleased with our percentage of offers that are actually accepted, but it's a workflow process from when we write a requisition to when we actually have that person on site working on a program is a period of better than a couple of months. And so as we have got to get our reqs (00:37:48) written in anticipation of the programs, we've got to hand that to our staffing organization, by the way which does a great job.
And as you mentioned, we are looking at all opportunities, employee referrals, bonuses for hiring your friend and things like that, things that you're probably seeing in the industry writ large. And our hiring has continued even in October at a very, very nice clip. We just look at the economy writ large and what's going on to employment, and we want to pass on that. There is a bit of concern, we're about at structurally zero unemployment, and that's going to at some point make it more difficult for us to hire or hire at the rate at which we've been.
Thank you very much.
You're welcome.
Our next question comes from Krishna Sinha of Vertical Research Partners. Please go ahead.
Hi, thanks. So just to kind of simplify the math here, if I look at your guidance, your sales guidance, you pulled that down by about $250 million at the midpoint. Can you just talk about how much of that you're expecting to flow through in 4Q and how much of that overflows into 2019?
Well, hi, Krishna, this is Jim. The way we think about the fourth quarter is that – certainly a piece of that will flow into 4Q, although the run rate is a little bit lower than what was implicit in our prior guidance. With that said, about 5.5% year-over-year growth in Q4 is something that we're pointing at and what we're pleased with as well as the sequential growth that we're seeing there. Adding to that record backlog and book-to-bill for the past quarter, when we think about what we've said before, what our aspirations are for 2019, while we haven't been specific about what the growth rate is, saying that it's north of 3%, we're more than confident about being able to achieve that objective.
Yeah, Krishna, I think your question was of the $250 million, is that lost or is it deferred, and what we said in our prepared remarks and we reiterate here is it's primarily timing, is it's not associated with programs that we thought we're going to win, that we have lost, it might have been the case a couple of years ago. What we see here are slower ramps, customers who have the money, have the top line and are not spending it. And so we're pleased about the implication that that has for 2019. But I would also comment that although we have a lower top line, our bottom line has continued to stay very strong. And, of course, that's led to terrific cash generation in the quarter as well.
Okay. And kind of to that point, Roger, I mean, you talked about, I think last quarter you talked about a 7% go-get target to hit the revenue guidance for – that you had set out previously, obviously that didn't happen because of the timing. But how did you perform on that 7% go-get target through 3Q?
Yeah, I'll give a summary, and then Jim can touch on the numbers. I think on our go-get, our win, we actually exceeded that. I mean, I think we're really, really pleased that our capture efforts performed better than expected, where the disappointment is, we won the program, we had an expectation of when that program would start to turn into revenue and how fast it would ramp up. And in point of fact, although we may have won the program, the customer may have delayed by a couple of weeks when they want to start the program. And the – if you will, the rate of growth in the program. So we did talk about our need to win and we're very, very pleased with our team and their ability to win the programs. We are disappointed is that customers have not been as enthusiastic about starting those programs and increasing the level of spend.
Okay. And just one more question on cash flow, obviously, you had a good cash flow result and you pulled the guidance up for the year. It looks like some of that cash flow just dropped through to the balance sheet. And I'm wondering if it – it sounds like you're pretty aggressive on the buyback or you want to be, why didn't we see more buyback in the quarter since the cash flow was so strong in the quarter? And what's the kind of level of balance sheet cash that you want to maintain going forward?
Krishna, this is Jim. When we think about the amount of cash that we want to hold onto the balance sheet, for operations, it's a roughly $200 million number. And then as we think about – in addition to that, if we have near-term M&A targets in mind, we might squirrel away some of that.
With that said, I think that if we had stronger visibility into the cash flush that was going to happen at the end of the quarter from the government, if that had happened sooner, we probably would have had a little bit more buyback. And – but as you know, around the middle of September, we end up kind of going into a blackout on stock buyback. And with that said, we would have been precluded from doing anything at the end of September. I think that what you're hearing from us is that with the cash that we've got, we're confident that we will be able to get back into the market sometime during the fourth quarter.
Okay. That's great. I'll jump back in the queue. Thanks.
Thanks.
The next question is from Jon Raviv of Citigroup. Please go ahead.
Hey. Good morning, team.
Good morning, Jon.
Just on the cash flow, the new guidance, $775 million, you mentioned that it benefits from a couple things, the interest – the swap and also the AIT cost. Just sort of big picture, how do you see that? What do you think is sort of sustainable operating cash flow for this business going forward? To what extent should operating cash flow grow with earnings next year or not? And related to that is, how do you see CapEx trending going forward? Thank you.
Well, we'll certainly be very specific on what we're thinking of operating cash flow when we have our Q4 call. But the way to think about how to model that Jon is that, we'd like to think that 100% of the non-GAAP net income will end up in the operating cash flow number. And simply put, it's EBITDA less interest and CapEx, and the level of CapEx that we were seeing for 2018, we expect will come down in 2019, absent some potential one-time items relate to specific programs. We are always thinking about how to reduce the investment non-cash working capital, reducing our investment in real estate and things that aren't directly connected to generating new business.
And Jon, I would add to that and I'm sure you've read that in the press releases, we're pretty much through the integration cash.
Okay.
And that is really exciting for us. That ends up, if you will, accumulating now on the balance sheet. And so as we've tried to in past calls is to say IS&GS integration is behind us and we're now to more normative levels, which we would have talked about a couple of years ago, and our ability to convert our operations to cash from operations. And so we're really excited about what 2019 looks like.
Thanks. I'll stick to one.
The next question is from Noah Poponak of Goldman Sachs. Please go ahead.
Hey, so it's Gavin on for Noah. Good morning, everyone.
Hey, Gavin.
Just wanted to follow on Jon's questions there. Obviously, there are a couple of one-time tailwinds to free cash this year. You got the interest swap settlement. But I think you're building some working capital ahead of growth, looks like head count might even be up more than revenue, DSOs and DPOs are a little bit better, but not a ton. But you've got that $60 million of transaction and integration that doesn't repeat and higher level of CapEx. So kind of what if that doesn't reverse or kind of what of those a tailwind versus a headwind next year?
Well, in terms – did you say headwind instead of tailwind for next year?
Yeah. Which of those are headwinds versus tailwinds and it kind of seems like you'd have more tailwinds than headwinds going into next year?
Well, one thing we've been able to do through the back end of this year and will probably help us more into the early part of next year is continued optimization of our tax position. So, on a GAAP basis, you'll see that our effective tax rate is pretty low in the quarter. And some effective tax planning is helping us there. And so, you'll see us kind of moving some non-cash working capital out of the deferred tax accounts and into the bank account for the early part of next year, that's one tailwind.
We're also working and this will not be necessarily working capital, but as we continue to optimize our real estate portfolio, we'll be selling some assets there, and using that cash to consolidate real estate facilities in the Washington area, and fund some of the build-out of our new facility right here in Reston. So we're doing those things, then you won't see those in the operating cash flow number, you'll see those down in the investing cash flow numbers in Q4 and early into next year to help us, again, take less productive assets off the balance sheet.
Okay, great. And then on the government customer kind of hesitant to spend dollars, what does it take for them to actually really ramp up and spend more? And are they concerned about mid-terms or sequestration that they just not have the infrastructure to spend the dollars and kind of what does it take for them to actually really get to the authority increase amount?
Yeah, Gavin, it's I think a bit of all of the above. And I think it will – the appropriations will get released as they check off each one of those, let's get through the mid-terms, let's get an understanding of what 2020 is going to start to look like. The President will come out with a skinny budget right after the first of the year. If you're an agency head, you don't want to spend up in 2019 to see sequester comes back – sequester caps come back in 2020. So as becomes more clear what the 2020 budget will look like, then they will lead spend in 2019 into an expected budget in 2020.
And no, your last comment was do they have the infrastructure and look, they're happy to start a new program, they need to have a program manager and they need to step up a contracts office and things like that. There's probably a little bit of that. I think most of this is, they probably didn't completely anticipate with the raising of the sequester caps, the defense and non-defense would see the increase in budget. And so, they've been a little thoughtful in actually spending to that level to make sure that it was real and that it was sustainable through 2019 and 2020.
Do you get a bit of a sense that there is going to be a dollar shift from readiness towards modernization?
Not – I think it's going to continue to be balanced. I've heard – we concluded in the quarter the Air Force Association event and we just finished the Association of the United States Army and so we get to interface with the high level customers. And their mission-capable rate, the availability of their hardware to do mission on any given day isn't where they want it to be. And so, we are seeing increased spending in operations and maintenance, while they are thinking through their longer term recapitalization efforts.
And of course, in the Air Force, they're buying – they're going to be buying F-35s. They just released the contract for T-X. The Navy is going through their fleet modernization thoughts. They have a new submarine program which they're investing in, right, and the Army continues to look at their vehicle programs. So, I think they're going to balance that hardware with increased spend in O&M.
And the good news for us in that is where do they create obligation authority and they do it by making their operations more efficient, by spending on IT modernization, digital transformation and move to the cloud. And that's really good for us because that's in among the O&M and the other things we do in R&D helping our customers operate more efficiently is center in our wheelhouse.
Great. Thanks so much.
Thank you.
Our next question comes from Sheila Kahyaoglu of Jefferies. Please go ahead.
Hi. Good morning, guys.
Hi, Sheila.
Hi, Sheila.
Good morning.
Just one question, just make sure it has 15 parts to it. So, can you just touch upon the F-16 sustainment contract and Social Security win, were these part of the takeaway wins you mentioned earlier in your prepared remarks, and just given the fairly sizable task order value kind of the contract step up? And if you could just touch upon the two recompetes you have in 2019, please?
Sure. Sheila, this is Jim. I'll start with the SSA win. The SSA win is actually work that we are already doing. It was one that was targeted to be taken away by a competitor, we held onto it. We're pleased with that outcome. The F-16 work, that was a takeaway from a competitor, and it was a work for our Air Force customer and we're really pleased to be taking away something that really exploits our technical capabilities very, very well. In terms of what that means for next year, obviously, with that takeaway as well as the other ones, it points to, like I said before, better than 3% growth, and we'll get more specific about that.
Let me say one more thing, to foot stomp, the fact that we are continuing to be very pleased with the level of win rate, win rates that we're experiencing on these takeaways and new business awards, we are feeling like it's a proof point to the changes that we've made in business development, in our cost structure that we're getting what we think is probably at least, if not better than our fair share of these takeaways and new business. Thanks, Sheila.
Can you just touch upon the recompetes, is that possible?
Yeah. We do have a couple of large recompetes next year. As we've said before, probably our largest one is the work with the Department of Energy up at Hanford. That RFP is dropped. We're working on that proposal, and we're confident that given the past performance that we're experiencing there in our relationship with the customer that we'll be able to retain that work. But we're not taking anything for granted. We're working very hard to make sure that we're delivering innovation and competitive cost structure for that deal.
Great, thanks.
Okay.
The next question is from Joe DeNardi of Stifel. Please go ahead.
Hey, guys. This is Jon Ladewig for Joe DeNardi.
Hi, Jon.
First – hey, guys. Given some of the recent commentary from President Trump calling for lower government spending in FY 2020, both on the civilian and on the defense side, does that change your view on how long this defense cycle lasts? How do you guys kind of interpreted these comments?
See, appreciate the question, kind of one that we thought someone might ask. I think you need to do the math on what was base budget in OCO and what the administration is trying to do is to drive to a base budget without the OCO. But I think what he is trying to do, as much as I can interpret his words, is to set an expectation that it's – it can't grow at the level that it did in 2018 and 2019 forever.
And I would tell you from our standpoint, we've always sort of took that into account and a more metering of top line is what was in our expectations. If you do the math, you look at debt, you look at where the federal budget is going, being fiscally thoughtful I think is actually a good thing, it's a good thing for the country and by the way the budget is certainly significantly big enough for many companies like Leidos to be successful at the current funding level.
The only other question I would kind of ping you guys with is, what's your win rate?
We don't like talking about specifics on win rates. We're very happy to talk about what those trends look like, though, and especially in light of how many competitors that we see on some of these big programs that we've been awarded, you would think that those win rates on new or takeaway work would be in – on a good day in the 30s, but we're experiencing better than win rates – better than a number like that in both of those categories.
And certainly the trend, I think that the upward trend that we're seeing on win rates is what is translating into the book-to-bill that you're seeing here. And again, it comes back to first and foremost delivering a proposal with innovation in it and delivering a proposal that has – because we can innovate, we can provide a cost point that is also competitive.
All right. Thank you, guys.
Thank you.
Thank you, Jon.
Our next question is from Joseph Thompson of SunTrust. Please go ahead.
Hey guys. This is Joseph Thompson on for Tobey Sommer at SunTrust. I have one question about the platform and product related work. How much did this type of work contribute in the third quarter and how much do you expect they can contribute going into 2019? Thank you.
It is really hard to answer that question to be fair, Joe. I think I'm hearing you asked, well, what's related to platforms. We think of it more along our set of technical core competencies. And I think that, for example, the new work we're doing for the Air Force on the F-16 program is a little bit different from – and refreshingly different from kind of our biggest power alley in IT modernization. But clearly, our ability and our competitiveness in IT modernization is probably the biggest single driver of our growth prospects and book-to-bill for the coming year.
Roger, do you have anything to add to that?
No. I would just reiterate, Jim, what you said is that we tend to classify our work against our technical core competencies which are differentiators and we don't – unlike maybe one of the large OEMs that look at platform and services, we don't manufacture a lot of platforms. We do some. We tend to cut our business and think about our pursuits more from a capability standpoint, so. Thanks, Joe.
That's all the time we have for questions today. I would now like to turn the call back to Kelly Hernandez for closing remarks.
Thank you, Brock, and thank you all for your interest in Leidos. We look forward to updating you again on our next call. Thanks and have a great day.
This concludes today's conference. You may now disconnect your lines at this time. Thank you for your participation.