Q1 2023 Leonardo DRS Inc Earnings Call

Speaker 1: You it you.

Speaker 2: Ladies and gentlemen, good day and welcome to the Leonardo D.R.S. First Quarter Fiscal Year 2023 Earnings Conference call. At this time, all participants are no 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.

Speaker 2: 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.

Speaker 3: Good afternoon and welcome everyone. Thanks for participating on today's quarterly earnings conference call. With me today are Bill Lynn or Chairman and CEO and Mike DePold or CFL. We will discuss our strategy, operational highlights, financial results and forward outlook.

Speaker 3: Today's call is being webcasts 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...

Speaker 3: to update any of the forward-looking statements made on this call.

Speaker 3: 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 at the substitute for gap performance measures.

Speaker 3: 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?

Speaker 4: 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-to-vestiture impact in one-time items, our revenue, adjusted speed, margin, and adjusted deluded EPS in the quarter were largely stronger than last year.

Speaker 4: 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.

Speaker 4: 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 have 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.

Speaker 4: In force protection, I'm excited to share with you that we recently demonstrated and tested a single vehicle counter UAS striker-based solution.

Speaker 4: This is an important step forward as current counter UAS solutions are either multi-vehicle or fixed site.

Speaker 4: 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 NMHR.

Speaker 4: This radar is providing upgraded range and target resolution, which is a key factor for success of any force protection system.

Speaker 4: 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.

Speaker 4: As a result, we are advancing customer conversations with respect to our integrated sensing efforts.

Speaker 4: 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.

Speaker 4: 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 are not only to ensure that the

Speaker 4: We'll 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 warfighters.

Speaker 4: 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 RADA, and the discrete Columbia-class program item impacting Q1 of last year.

Speaker 5: 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 percent as compared to last year. Several factors drove this trend. First, the net divestiture impact, which is the contribution difference between our divestited GES business first or rata acquisition.

Speaker 5: What the head went. 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.

Speaker 5: 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.

Speaker 5: In our integrated emission system segment, revenues decreased primarily due to the Columbia class item. Excluding this item, segment revenues would have declined slightly. Now to adjusted EBITDA.

Speaker 5: Adjust the debitant in the quarter with 49 million, representing a decrease of 33% from last year.

Speaker 5: Resulting adjusted EBITDA margins were 8.6 percent down 330 basis points from Q1 2022.

Speaker 5: As expected, the discrete Columbia class item had a more meaningful impact at the speed.

Speaker 5: 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.

Speaker 5: Despite the increased cost associated with operating as a public company and the investments in internal research and development.

Speaker 5: Moving to the segment trends. In Q1, ASC segment adjusted EBITDA increased and adjusted EBITDA margins expanded due to strong program execution and mix.

Speaker 5: At the IMF statement, 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.

Speaker 5: The discrete profit item flowed down to the bottom line metrics as well. As anticipated, net earnings declined 67 percent and adjusted net earnings were lower by 52 percent.

Speaker 5: 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.

Speaker 5: diluted EPS and adjusted diluted EPS face the incremental headwind of increased share count from the all-stock combination with RADA.

Speaker 5: As a result, diluted EPS decreased 61%, and adjusted diluted EPS was down 73%.

Speaker 5: 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.

Speaker 5: The incremental cash use in the quarter compared to last year was a result of higher working capital requirements.

Speaker 5: The payment of taxes tied to the R&D capitalization through Section 174 and overall lower relative net earnings.

Speaker 5: 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 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%.

Speaker 5: We are expecting adjusted EBITDA between $315 and $330 million. The range for adjusted diluted EPS is 64 cents to 69 cents per share. Our assumptions for tax rate at 24% and fully diluted shares of $263.1 million remain unchanged.

Speaker 5: 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.

Speaker 2: With that, we are ready to take your questions. Thank you. Ladies and gentlemen, if you have a question or comment at this time, please press star 1 1 on your telephone keypad.

Speaker 2: If your question has been answered or you wish to remove yourself from the queue, simply press star 1 1 again.

Speaker 2: Again, to ask a question or comment, please press star-1-1 on your telephone keypad.

Speaker 2: Please stand by while we compile the Q&A roster. Our first question or comment comes from the line of Robert Stallard from Vertical Research. Mr. Stallard, your line is open.

Speaker 6: Thanks so much. Good evening.

Speaker 6: 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's going to be flat year on year, theoretically, then that would be down for the rest of the year.

Speaker 5: And then also on free cashflow, how do you expect that to move from here? I know you said it's a Q4 waiting, but what are you expecting in the next two quarters? Thank you. Yeah, 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 ASL.

Speaker 7: to the prior year, but we like where we started and we're confident that we can hit those commitments.

Speaker 7: 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.

Speaker 7: with a significant emphasis on the Q4 cache generation, not too dissimilar to what we've seen in past years.

Speaker 6: Okay, and then a couple of bills if I may. First of all, on Columbia, 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 he can remember.

Speaker 4: We had the bulk buy for ships three to five that we just announced. We're continuing to negotiate with our customer in the Navy about the future transactions in that kind of vein where we would bundle.

Speaker 4: 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.

Speaker 4: 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.

Speaker 4: as it would, you know, it would really strengthen the competition in the sector rather than reduce it.

Speaker 4: it would really strengthen the competition in the sector rather than reduce it. Okay, that's great. Thanks so much.

Speaker 2: Thanks, Rob. Thank you. Our next question, a comment comes from a line of John Tawanton from CGS. Mr. Tawanton, you may proceed with your question. Hi, good afternoon. Thank you for taking my question. The first one is you outperformed a little bit in Q1. And was that coming from future quarters?

Speaker 7: or does that just give you more cushion for the, for the, for getting to the full year guidance? Okay, help me, 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 reaffirmed that here.

Speaker 7: As you know, as we kind of looked at the waiting, a lot of it's coming in the back half, and we have that kind of stair step in our output. So the Q1 has de-risked a little in terms of that back half waiting, but we're still focused on execution to meet the commitments.

Speaker 2: Okay, understood. And then what are you seeing from your supply chain today, both from an availability and an inflation perspective as a trend of where you wanted it to be number one and then number two, how are you pricing in your current orders and bids? How are you pricing that inflation in and getting the margin that you want?

Speaker 4: 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 till maybe 2024, but not really in 2023.

Speaker 4: three year turn on those contracts. In other words, we renegotiate the next tranche every three years or so on average. And so with the inflation having started about a year ago, we're maybe a third of the way through our contract bank.

Speaker 4: 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'll drop off fairly substantially in 2024.

Speaker 7: Mike, do you want to add to that? 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 stabilized, but there is some pressure on that front.

Speaker 7: 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 de-risk the revenue on the back end, given a little bit of the uncertainty in the supply chain still.

Speaker 2: Got it. Thanks for that color. 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 then have to be replaced. Help us understand the time frame and the scale of that opportunity and what it could potentially be.

Speaker 2: Got it. Thanks for that caller. 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 orbits on potentially, you know, hundreds of satellites that are decaying and then have to be replaced. Help us understand the timeframe and the scale of that opportunity and what it could potentially be. Yeah, sure. I mean, I think, you know, I think the, the, the, the, the, the, the, the, the

Speaker 4: 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 orbits.

Speaker 4: Now is more and more things like the space tracking layer is moving to low Earth orbits as you're talking about, where it's a proliferation of satellites with much smaller payloads and a faster turn time. We think that has the potential to move.

Speaker 4: 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.

Speaker 4: So we think things are moving in our direction. In terms of the timing, you're asking, it's a two, three, four 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. Got it.

Speaker 8: Good luck in that in that venture. I'll jump back in queue. Thank you. Thank you. Thank you. Our next question or comment comes from the line of Jan Englebrandt from RW Baird. Ms. Englebrandt, your line is open. Ingrid, your line is open.

Speaker 9: Thank you. Good afternoon, Bill Michael Steve. I'm on for Pierre today. So just had a question in Colombia. And you previously mentioned the revenue opportunity through 2032 at about $300 million. This one's curious is there's an opportunity to add content given your power conversion capabilities.

Speaker 9: Is there any upside to the 300 million annual revenue given that you know there's sort of a One boat per year from 2024 onwards in the budget I think we're going to see some increase in the Columbia as we

Speaker 4: 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.

Speaker 4: gets into the future boat. 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,

Speaker 4: has already made the decision that they're going to use electric drive technology in the next class of destroyers. That's the DDGX. 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 more than one price.

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 too and they've already put it in the

the premier program, the Columbia. So we're hopeful they'll see the work clear to do it with the next generation attack submarine, which would again be another opportunity of that Columbia scale. Okay, great, thanks for the detail, Bo. 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 margins, 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. Yeah, sure. Sure. I think that we made a comment in last...

Okay, great. Thanks, Mike. I'll jump back in the queue.

Thank you. Our next question or comment is a follow-up from Mr. John Tawantin from CGS. Mr. Tawantin, your line is open.

A little bit more color around the Navy's philosophy around having these electrical 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 income and see in the Columbia just give you that much more of an advantage that they could?

go with you for the next generation as well? Well, I think the Department of Defense always likes competition, so you're right about that. But 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.

Okay, great. Mike, just to follow up for you, you mentioned having a steeper trajectory and earnings over the rest of the year. Can you give us a little bit more details to what you meant by that and kind of what you're thinking on the cadence?

as we progress? Yeah, so I would think of it as you know with the 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 of the G&A and the fixed cost. 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. Thank you. At this time I will turn the floor back to Steve Valor 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 email me. We look forward to speaking with all of you again soon.