DRS - NASDAQ

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 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 also find the earnings release and supplemental presentation. 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 are 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 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 7 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 FY '24 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% 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 and 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, we'll 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 service 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 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 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 1-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 14. 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 a 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 diluted EPS was $0.18 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 $0.20 a share, which normalized for the onetime 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 continued 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 $2735 million and $2785 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 million 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 $0.70 and $0.72 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. [Operator Instructions] The first question comes from Robert Stallard with Vertical Research.

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 this -- I think we've seen 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 over this Congress pass bills on time by October 1. 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?

Yes, 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 3 submarines per year. And we are in active discussions with the Navy and the yards about how we could expand our capacity and our capabilities to support that. The funding that was -- 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.

Yes. 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 3 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 million 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 quarters. 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 the working capital build through the year and then you deliver it all in Q4?

Yes. 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 continued 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.

Next question comes from Michael Ciarmoli with Trust Securities.

Bill, maybe just on supply chain. It sounds like some things getting better, but you clearly flagged, I think, specialty alloys, raw materials. I mean, how are you looking at that, I guess, access to material availability as you think about moving into '24, I mean just trying to get a frame of reference as to how concerning this is?

Yes. 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 where the microelectronics have stabilized and now the specialty metals have popped up. We have learned to be very proactive. And so we are 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. 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 will 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. 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. That is -- it will grow and be additive to margins that's built into the contracts that we've negotiated. And 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 benefit. 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, the potential employees called into reserves duty or just in terms of how are you kind of framing as you look at your operations there given the current environment?

Yes, 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 it's -- we're managing that and working with the Ministry of Defense. There are obviously -- the products that we produce are very important in terms of the conflict that Israel faces at this point. So everybody is interested in keeping this -- our facility going at maximum capacity. We also have a backstop in that we have a 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.

Next question comes from Andre Madrid with Bank of America.

Maybe to follow up on Michael's question on Colombia. Does the booking that you received after the quarter end, do you think that derisks 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 to like 70 to 100 basis points of margin expansion company-wide on Colombia repricing. So if you can give any clarity on that?

Yes. 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 it's 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.

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

Yes. Looking at book-to-bill in a quarterly cadence gets a little difficult. You're right, it was 0.8x from a book-to-bill in Q3, but that was on the heels of a Q1 book-to-bill of about 1.8x. So you really got to look at it a little more holistically throughout the course of the year. And within our IMS segment, even outside of Colombia, 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 the year results.

Next question comes from Jon Tanwanteng went with CJS Securities.

This is Justin on for Jon. I was just one morning. Was there any pull orders into Q3? And then following that, 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 rate on both on 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 kind of share count that we've been seeing through the increased option exercises from some of the employees.

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

Yes. 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 on to a payload because the cooling technology is quite a wake burden. And 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.

Our next question comes from Jan-Frans Engelbrecht.

I just want to quickly return to Colombia. I think you've delivered about 2 ships 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 the 12 but lifetime?

Yes. I'll let Mike take the financial question. Let me -- what we've been able to do is develop 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 one 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 of 5 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 this 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 the 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 it's -- 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 it's -- obviously, it's mandated and demanded by the customer. So we feel good there. We also did this program in today's economic environment. So we're derisked 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 shipset and moving into these newly negotiated contracts that will afford us the opportunity for additional marginality.

Perfect. 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?

Yes. I mean land systems, certainly -- I mean, what we're seeing 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 propel grenades and anti tank weapons as well as attack from drones. Obviously, the Ukrainians are experiencing partially that attack from drones. So that's really highlighted the force protection capabilities, which really had atrophy 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 you look like they were several years out in Poland and Romania are now being pulled into the current time frame. So that's an upward push on demand as well.

Robert Stallard from Vertical Research, if you have another question your line is now open.

Just a couple of quick follow-ups here. First of all, given the share price performance year-to-date, 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. On capital deployment, we're actively looking -- we're focused on the 4 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 is -- doesn't mean we can't move, but we do have -- we 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. So is the time line we're looking at for these kinds of examinations.

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

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.