Ladies and gentlemen, good day, and welcome to the Leonardo DRS First Quarter Fiscal Year 2023 Earnings Conference Call. [Operator Instructions] 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 afternoon, 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. He 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 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?.

Thanks, Steve, and thank you all for joining us this afternoon. Our first quarter results surpassed our expectations and marked a solid start to 2023.

Although our key metrics on an as-reported basis were down year-over-year, when we normalize those metrics for the net divestiture impact in onetime items, our revenue, adjusted EBITDA, margins and adjusted diluted EPS in the quarter were largely stronger than last year.

As discussed on our last call, we expect growth to accelerate throughout the year, and that foundation is evident from the $749 million of funded bookings in the quarter. This translated to a book-to-bill of 1.3x and a backlog that stands at $4.3 billion, which is up 43% year-over-year.

We continued to enjoy healthy and broad-based customer demand for our mission-critical technologies. .

In the quarter, we saw particularly strong demand for our capabilities in electric power and propulsion, rotary wing survivability, dismounted in ground vehicle sensing, secure tactical terminals and advanced battle management. Shifting to the macro environment.

Global tensions in the threat environment remain high and do not appear to be showing any signs of easing in the near term. As a result, we think there is a clear need for continued defense investment to deter and counter-pacing threats.

Since our last call, additional details on the FY '24 President's budget request were released, which further supports the confidence we have in the long-term market position of DRS. The $842 billion request contains roughly 4% increases over enacted FY '23 levels for the investment accounts.

The request supports the core programs and the DRS portfolio. Furthermore, we are delighted to see growing requests for integrated sensing in the budget. This offers further validation of our acquisition thesis for rate. DRS is well placed to advance this initiative with our strong market positioning. .

Now to the operational highlights in the quarter. We continue to perform well and are seeing strength across the business. Long-term market expansion opportunities are becoming more visible in our electric power and propulsion business.

It was recently announced that the Navy has determined that the new surface combatant, DDG(X) will have an electric drive system. We're pleased with this development as it demonstrates the importance of electric drive technology to power and propel next-generation ships and submarines.

Our demonstrated capability in this area on the Columbia class submarine serves as a key differentiator. Additionally, we are seeing strategic initiatives from the Navy to expand the capacity of the submarine defense industrial base in order to support increased throughput for domestic and international requirements.

We are partnering with our customers to achieve this objective of expansion by shifting work to trusted suppliers like DRS. .

Shifting to innovation. I am humbled that DRS has received the prestigious 2023 Herschel award for our work in the development of advanced infrared detectors used in ground sensing applications. This is our fifth 2023 Herschel award and is a reflection of the strong culture of innovation at DRS.

Additionally, in our sensing business, we are seeing great traction for our new receiver technologies in the electronic warfare market as these technologies enable the fusion of Sign and Elin missions. We are energized by the momentum that continues to build in our space sensing business.

The value that DRS is bringing to the SDA tracking layer, Tranche 1 program is being recognized through increased market opportunities in space. We have established clear technology differentiation and are quickly building past performance through demonstrable program successes.

With respect to our technology differentiation, last call, I briefly mentioned that we had launched an uncooled sensor payload on a LEO satellite. I am pleased to announce that sensor is now returning remarkable imagery. .

This demonstrates the success of our patented image stabilization technology and more broadly, the viability of uncooled thermal imaging in the space market. In force protection, I'm excited to share with you that we recently demonstrated and tested a single vehicle counter UAS Stryker based solution.

This is an important step forward as current counter UAS solutions are either multi-vehicle or fixed site. We believe that this single vehicle solution will significantly enhance the effectiveness, mobility and affordability of this critical system.

Also in the force protection market, we are seeing strong adoption of our next-gen multi-mission Hemispheric Radar or MHR. This radar is providing upgraded range and target resolution, which is a key factor for success of any force protection system.

In Q1, we were awarded a contract to provide our Distributed Aperture infrared countermeasure system to enhance aircraft survivability on multi-service helicopters. Additionally, we are seeing requirements emerge from the unmanned and fixed wing markets for our aircraft survivability solutions. .

While we have been focused on driving innovation through accelerating R&D expenditures, we have also been working to develop strategic relationships with technology partners to accelerate our key initiatives.

As a result, we are advancing customer conversations with respect to our integrated sensing efforts and are working with partners to apply artificial intelligence and machine learning capabilities across our business.

Our agility and innovation is pushing demand to DRS from both our government and prime customers for critical capabilities needed for next-generation operations..

As an example, we are providing growing sensors and electronic content on JADC2 related efforts for the Navy through a strategic partnership with one of the primes to enable more integrated operations in a connected battle space.

We believe that the increased requirements around autonomy and interconnected systems will continue to drive long-term demand for our sensing and network computing technologies..

Overall, let me reiterate that we are excited about the strength we have shown across the business. Our agility, innovation and focus is allowing us to rapidly and effectively meet our customers' demanding requirements.

I want to thank the entire DRS team for their continued focus on excellence and their remarkable efforts to deliver our best technology to the war fighters. Let me now turn the call over to Mike to take you through the numbers in greater detail. .

Thanks, Bill. I'm pleased that our quarterly results were ahead of our expectations. The strong execution in the quarter increases our confidence in the ability to meet our commitments to shareholders.

As Bill discussed earlier, our reported numbers have a bit of noise with the divestiture of GES, the acquisition of Radar and the discrete Columbia class program item impacting Q1 of last year. Throughout my remarks, I will offer some directional commentary to help with a more normalized comparison to last year.

Q1 revenue was lower by 7% as compared to last year. Several factors drove this trend. First, the net divestiture impact, which is the contribution difference between our divested GES business for Arada acquisition was a headwind.

Second, recall that in Q1 of 2022, we recognized a discrete $25 million profit step-up related to our Columbia class program that had an equal impact to revenue. .

When excluding both of these factors, revenues would have otherwise been up low single digits over the prior year. Moving to the segment trends. Advanced Sensing and Computing segment revenues were down due to the net divestiture impact. Absent this, the segment would have grown organically.

In our Integrated emission Systems segment, revenues decreased primarily due to the Columbia class item. Excluding this item, segment revenues would have declined slightly. Now to adjusted EBITDA. Adjusted EBITDA in the quarter was $49 million, representing a decrease of 33% from last year.

Resulting adjusted EBITDA margins were 8.6%, down 330 basis points from Q1 2022. As expected, the discrete Columbia class item had a more meaningful impact at the adjusted EBITDA line.

When normalizing for this item, adjusted EBITDA would have been up low single digits and the year-over-year margin trend would have been flat despite the increased costs associated with operating as a public company and the investments in internal research and development. .

Moving to the segment trends. In Q1, ASC segment adjusted EBITDA increased and adjusted EBITDA margins expanded due to strong program execution and mix. At the IMS segment, adjusted EBITDA and margins were down primarily due to the Columbia class item.

The remaining decline is driven by the increased internal research and development investments to further enhance our electric power and propulsion technologies. The discrete profit item flowed down to the bottom line metrics as well. As anticipated, net earnings declined 67% and adjusted net earnings were lower by 52%.

Both metrics would have still declined, excluding the Columbia class item, but less significantly..

The remaining decline is largely caused by the relative impact of stable interest expense on a smaller operating earnings number. Diluted EPS and adjusted diluted EPS faced the incremental headwind of increased share count from the all-stock combination with Rada. As a result, diluted EPS decreased 61% and adjusted diluted EPS was down 73%.

Moving to free cash flow..

As expected and consistent with prior year trends, we experienced significant cash flow usage in the first quarter. This totaled $346 million in Q1 for 2023.

The incremental cash used in the quarter compared to last year was a result of higher working capital requirements the payment of taxes tied to the R&D capitalization through Section 174 and overall lower relative net earnings. .

Now to our guidance. We are reaffirming the guidance that we provided a little over a month ago. As a reminder, we are expecting revenue between $2.7 billion and $2.8 billion, which represents up to a 4% growth compared to 2022 on a total basis and implies an organic growth range between 2.5% and 6%.

We are expecting adjusted EBITDA between $315 million and $330 million. The range for adjusted diluted EPS is $0.64 to $0.69 per share. Our assumptions for tax rate at 24% and fully diluted shares of $263.1 million remain unchanged.

Consistent with our prior commentary, we are still expecting revenues for the remaining quarters to be stair-stepped as we progress throughout the year and a slightly steeper cadence for our profit metrics.

Before we open the line for questions, let me wrap up by stating that our focus remains on execution to drive long-term value for our customers, employees and shareholders. With that, we are ready to take your questions. .

Thank you. [Operator Instructions] Our first question or comment comes from the line of Robert Stallard from Vertical Research. .

I'll kick off with a couple of questions for Mike on the numbers. First of all, what's your expectation on divisional margins from here? Obviously, a good result, particularly in ASC.

If everything is going to be flat year-on-year, that theoretically, then that will be down for the rest of the year? And then also on free cash flow, how do you expect that to move from here? I know you said it's a Q4 weighting, but what are you expecting in the next 2 quarters?.

Yes, sure. So let me start with the segment margins. And as you know, we don't guide to the segments. So we're not giving that type of visibility in. But you can see that we're happy with the performance in the ASC segment in the first quarter. And the IMS segment is a tough compare with the onetime impact for MTD.

We think both of the segments are well positioned. They're dealing with the challenges that we mentioned in the previous quarter in terms of the inflation impact, and we do expect to be in that kind of flattish margin range overall when comparative to the prior year. But we like where we started, and we're confident that we can hit those commitments.

On the cash flow side, this is a typical trend for us in that we do have a lot of cash usage in Q1.Obviously, that was impacted again by the 174 tax payment.

We do expect to see the improvements as we kind of progress throughout the remaining quarters with a significant emphasis on the Q4 cash generation, not too dissimilar to what we've seen in past years. .

Okay. And then a couple for Bill, if I may. First of all, on Colombia. Are there any particular milestones that we should be looking for over the next 12 months or so that could have an impact on your booking rate? And then secondly, on capital deployment on the M&A environment.

One of your counterparts actually at Honeywell said that he was seeing one of the best environments you can remember for deals at the moment.

I was wondering if what your perspective is on the pipeline here and whether the government's regulatory environment could slow things down?.

Yes. Thanks, Rob. On Colombia, we're -- we had the bulk buy for ships 3 to 5 that we just announced.

And we're continuing to negotiate with our customer in the Navy about the future transactions in that kind of vein where we would bundle several ships together to get more stability and better pricing, but we don't have anything to announce at this point on that.

With regard to the M&A environment, I think we're still seeing -- prices are still somewhat elevated. The regulatory environment is, I think, stricter, although I think we're in a better position in that I think the government is somewhat focused on consolidation at the top tier among the primes. And I think they would like to see a stronger mid-tier.

So I think that gives us some leverage to pursue M&A transactions as it would really strengthen the competition in the sector rather than reduce it. .

Our next question comment comes from the line of Jon Tanwanteng from CGS. .

The first one is you outperformed a little bit in Q1. Was that coming from future quarters? Or does that just give you more cushion for the -- for getting to the full year guidance? Help me understand where that actually came from. .

Sure. I'll take that one, and thanks for the question. So I'll start by saying that we have confidence in the full year guide. That's why we kind of reaffirm that here. As you know, as we kind of looked at the weighting, a lot of it coming in the back half, and we have that kind of stair step in our output.

So the Q1 has derisked a little in terms of that back half weighting, but we're still focused on execution to meet the commitments. .

Okay. Understood.

And then what are you seeing from your supply chain today, both from an availability and inflation perspective as a trend of where you wanted to be, #1? And then #2, how are you pricing in your current orders and bids? Are you pricing that inflation in and getting the margin that you want?.

Let me start and then turn to Mike. On supply chain, as we said in the last call, what we're looking for and seeing is stability. We haven't projected real improvements in supply chain lead times until maybe 2024 but not really in 2023, but the stability is what we need to meet our revenue commitments.

And that's -- through the first quarter, that's what we're seeing. We're not seeing increased lead times. And then on inflation, the way we're handling inflation is to price it into our future contracts. We have about a 3-year turn on those contracts. In other words, we renegotiate the next tranche every 3 years or so on average.

And so with the inflation having started about a year ago, we're maybe 1/3 of the way through our contract bank. And so we are -- as we said in the last call, we're still seeing, I think, some headwinds from inflation in 2023. And as we get those new contracts renegotiated through the year, we think it will drop off fairly substantially in 2024.

Mike, do you want to add to that?.

Yes. The only thing I'll add is that we still see some bottlenecks from a supply chain and lead times perspective in pockets particularly in electronics and castings. We're still holding the view that we're going to see that stabilize, but there is some pressure on that front at the moment.

And as we kind of alluded to last call, that's part of the investments that we're making in the working capital to kind of pull some of those procurements left and make sure that we're investing in the right working capital in order to derisk the revenue on the back end given a little bit of the uncertainty in the supply chain still. .

Got it. And then, Bill, if you could, I was wondering if you could give us a little bit more theoretical economics of having your sensors up in lower orbit on potentially hundreds of satellites that are decaying and they have to be replaced.

Help us understand the time frame and the scale of that opportunity and what it could potentially be?.

Yes, sure. I mean we've always had a capability in the smaller payloads. Our technological advantage is really size, weight and power, which shows itself in those smaller payloads. That used to be really a niche capability for things like weather satellites that flew in those low earth orbit.

Now as more and more things like the space tracking layer is moving to low earth orbits, as you're talking about, where they -- it's a proliferation of satellites with a much smaller payloads and a faster turn time. We think that has the potential to move what was a niche market for us really into one of our core markets.

And we've already won a position on that space tracking layer. We've just demonstrated a capability with a NASA satellite in terms of imagery. So we think things are moving in our direction in terms of the timing you're asking, it's a 2-, 3-, 4-year timing as these constellations fill out.

And over that time, I think we're going to see some pretty substantial movement up for our products. .

Our next question or comment comes from the line of Jan Engebret from RW Baird. .

Bill, Mike and Steve. I'm on for Peter today. So I just had a question on Colombia. And you previously mentioned the revenue opportunity through 2032 at about $300 million.

Just curious if there's an opportunity to sort of add content given your power conversion capabilities? And is there any upside to this $300 million annual revenue given that there's sort of a 1 boat per year from 2024 onwards in the budget?.

I think we're going to see some increase in the Colombia as we get to kind of the full production level. We're still moving off of that development contract. So that's going to improve our margins, as we've talked about fairly extensively.

But it's also going to move the revenue base up, I think, above 300 as all of the content gets into the future, but -- So I think there's some opportunity there, some likelihood of improvement.

The larger opportunities are, frankly, for us, that are sort of game-changing opportunities are to use this technology for new classes of ships and submarines. The Navy, I think as I mentioned in the opening, has already made the decision that they're going to use electric drive technology in the next class of destroyers. .

That's the DGX.

That will initially, if we're able to win that based on our track record with the Columbia, that initially would be an R&D flow of money and then ultimately, they'll buy those ships at a more than 1 per year that's in the Columbia, although the package is a little bit smaller, but the scale of that kind of opportunity once we get to production is probably on the order of the same magnitude as the Columbia.

And then a little bit further down the road is the next-generation submarine, the SSN. There -- the Navy hasn't yet made a decision on the power propulsion technology.

but there are the same kinds of opportunities, the same operational advantages in terms of quietness, power density, efficiency are available to the submarine II, and they've already put it in the premier program, the Columbia.

So we're hopeful they'll see that were clear to do it with the next-generation attack submarine, which would again be another opportunity of that Columbia scale. .

Okay. Great. And then if I could just have a quick follow-up. Just on the internal R&D. How should we think about the rest of the year and how that sort of would impact the IMS segment margin? Just since you mentioned that it does have a margin headwind for this quarter. If you could just comment on that for the rest of the year. .

Yes, sure, sure. So I think that we made a comment in last -- the earnings call as well in terms of our desire to increase our R&D spend, and that was going to be a little bit of a headwind into the margin in around the 30 basis point range. That is kind of still what we're progressing to.

So the trend in the quarter is consistent with our expectation and where we project to be by the end of the year. .

Our next question or comment is a follow-up from Mr. Jon Tanwanteng from CGS. .

A little bit more color on the maybe philosophy around having these electric propulsion systems in the next generation.

Is it possible that they would want to source from someone else and have a dual source just to spread the risk around? Or does your incumbency in the Colombia just give you that much more of an advantage that they could go with you for the next generation as well?.

Well, I mean, I think the Department of Defense always likes competition. So you're right about that. But the -- this is a substantial investment that we've made in the technology that is hard both to match in terms of the progress we made on developing the technology as well as the desirability of paying twice that same R&D bill.

So yes, I think they'll look at competition. And yes, also to the other part of your question, I think the Columbia gives us a real competitive advantage in any competition. .

Okay. Great. Mike, just a follow-up for you. You mentioned having a steeper trajectory in earnings over the rest of the year.

Can you give us a little bit more detail as to what you meant by that, and kind of what you're thinking on the cadence as we progress?.

Yes. So I would think of it as with the revenue being stair-stepped in terms of our profile over the course of the year, it's really about the absorption of the G&A and the fixed costs. So think of it that way as that revenue enhances quarterly over the course of 2023, the margins will follow that on an absorption basis. .

Thank you. At this time, I will turn the floor back to Steve Vather for closing remarks. .

Thank you all for your time this afternoon and your interest in DRS. If you have follow-up questions, please don't hesitate to call or e-mail me, and we look forward to speaking with all of you again soon and enjoy the rest of your day. .

Ladies and gentlemen, thank you. This concludes today's conference. You may now disconnect. Thank you for your participation..