Greetings. Welcome to the Leidos Second Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, that today's conference is being recorded. At this time, I'll now turn the conference over to Stuart Davis, Senior Vice President, Investor Relations. Mr. Davis, you may begin.

Thank you, Rob, and good morning, everyone. I'd like to welcome you to our second quarter fiscal year 2022 earnings conference call. Joining me today are Roger Krone, our Chairman and CEO; and Chris Cage, our Chief Financial Officer. Today's call is being webcast on the Investor Relations portion of our website, where you'll also find the earnings release and supplemental financial presentation slides that we'll use during today's call. Turning to slide two of the presentation. 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, as shown on slide three, during the call we'll discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in today's press release and presentation slides. With that, I'll turn the call over to Roger Krone, who will begin on slide four.

Thank you, Stuart, and thank you all for joining us this morning. Leidos remains on track for another year of solid organic growth and core business profitability. The affirmation of our Defense Enclave Services contract award by the Government Accountability Office demonstrates our leadership in digital modernization across the federal government, with strong demand for our technology solutions and services across our diversified business portfolio. We continue to execute on our disciplined and balanced capital allocation strategy to drive shareholder value. And we are proving our ability to compete successfully for talent with another quarter of robust hiring. I'll now expand on these four points. Number one, our financial performance for the quarter was strong, ahead of consensus at both the top and bottom lines. Revenues of $3.6 billion were up 4.3% in total and up 4% organically year-over-year. Non-GAAP diluted EPS for the quarter was also up 5% to $1.59, with an adjusted EBITDA margin of 10.2%. We also generated $40 million of cash flow from operations and are on track to generate at least $1 billion of operating cash flow this year. Number two, our business development results demonstrate our strong positioning in the government technology marketplace. We achieved net bookings of $2.2 billion in the quarter, representing a book-to-bill ratio of 0.6. Over the past 12 months, net bookings are $15.4 billion and book-to-bill is 1.1. Total backlog at the end of the quarter stood at $34.7 billion, which was up 4% year-over-year with funded backlog of $7.5 billion, up 5%. On a constant currency basis, backlog was $268 million higher. You can read about some of our awards in the press release, but let me highlight a few developments in the quarter. Most importantly, the GAO affirmed the $11.4 billion DES award to Leidos. We'll support DISA's mission by consolidating enterprise IT services at a global scale and by providing standardized responsive and cost-effective solutions. This program should have a several-year runway of growing revenue and expanding profitability, but will not add materially to the 2022 revenue or earnings. We also had an outstanding outcome on our Social Security Administration position. The SSA recompeted all of the work under its primary IT services IDIQ known as ITSSC-2 in two task orders. And we significantly expanded our role. We were the sole large business awardee on both task orders. On the first, we'll modernize and manage the SSA's IT infrastructure, including data center, data operations, networks telecommunications, cloud, and user services. And all of this is new work for us. On the second, we'll now perform all of the software development and mission application work that we previously split with other providers. As expected, both of the awards were protested last week. But should we prevail, we could double our revenue at SSA and make ITSSC2 a top 10 program. Finally, we've seen some initial indications of an improving airport screening landscape. We were selected by the Dominican Republic's Punta Cana International Airport to upgrade both people and baggage screening at all security lanes within the Terminal B checkpoint. In addition, bid volume and bid scale has increased meaningfully when compared to the first half of 2021. And we're getting great feedback on our ability to differentiate our offerings by bringing broader Leidos capabilities like cyber protection. Although, we're not expecting a full recovery in the airport screening business until 2024, it's good to see some positive trends here. That said, the overall bookings environment has been challenging, as procurement timelines continue to extend. DoD outlays for example are down 2% this government fiscal year-to-date compared to fiscal year 2021, despite a higher budget. Still, our book-to-bill ratio understates the true strength of the business development performance in the quarter, as it includes nothing for DES, and the protested SSA awards. Our win rates and summit volumes remain high and we expect procurements will pick up to match the improved budget environment. Number three. Our approach to capital allocation is a core part of our investment thesis. We've talked about being appropriately levered and maintaining our investment-grade rating, returning a quarterly dividend, reinvesting for growth, both organically and inorganically and returning excess cash to shareholders in a tax-efficient manner. And we're doing all of that. In Q1, we executed a $500 million accelerated share repurchase. And we've just entered into a definitive agreement to acquire Cobham Aviation Services, Australia's Aviation Special Mission business for about US$215 million. The transaction is subject to regulatory approval and other customary closing conditions and we expect to close by the end of the year. We expect the acquisition to be immediately accretive to non-GAAP EPS. The business owns and operates 14 modified aircraft, providing border force airborne surveillance and maritime safety search and rescue to the Australian Federal Government and a critical element of Australia's national security. This acquisition diversifies our Australian portfolio into capability and mission services work, with both the Defense Maritime and Homeland Affairs programs. Finally, integration risk is manageable, because airborne surveillance is what we know how to do well and we already have strong local leadership and infrastructure to support success. Number four, Leidos is an attractive destination for talented people. In the second quarter, we hired nearly 3,600 people, a number we've only surpassed once in five years. And that's when we were simultaneously staffing the Navy NGEN program and the Military and Family Life Counseling program. Year-to-date, we've hired more than 6,200 people. Quarter-after-quarter, we demonstrated that talent acquisition is a core strength of Leidos. On the Q1 call, we talked about challenges around retention. Competition for talent remains high as critical skills for us, such as software engineers and developers are in demand by both tech and non-tech companies. Even though voluntary attrition seems to have peaked, we remain focused on keeping engaged with our people. In fact, our June leadership offsite was focused on retention and we're now implementing many of the ideas that came out of that session. Before turning it over to Chris, let me touch on the federal budget landscape. The House and Senate Armed Services committees approved versions of the Fiscal Year '23 National Defense Authorization Act, both of which recommended healthy increases to the President's request. Congress fully recognizes the urgency of investing in our national security in the face of global security threats. The fiscal year '23 appropriations process is also underway which should result in significant nominal increases to 2022 levels, but we expect that the government will begin the fiscal year with a continuing resolution that should be resolved before the end of the 116th Congress. And finally, I'm pleased to announce that we'll be hosting an investor site visit at Dynetics in Huntsville, Alabama this fall. Dynetics is an important part of our value proposition for investors and a key differentiator for us in the marketplace. The event will start with a dinner with the leadership team on November 30th with a mix of briefings, tours of the production facilities and Q&A with the team on December 1. Expect to come away with a much better understanding of the culture and key growth drivers for Dynetics including the Hypersonics, Indirect Fire Protection Capability and space-based missile defense programs. Please reach out to Stuart if you're interested in attending. I'll now turn the call over to Chris.

Thanks Roger and thanks to everyone for joining us today. Second quarter results were very positive overall. And there are a number of moving pieces I want to cover this morning, starting with the income statement on Slide 5. Revenues for the quarter were $3.6 billion, up 4.3% compared to the prior year quarter. Revenues grew organically across all three reportable segments, given robust hiring and our recent program wins. Adjusted EBITDA was $366 million for the second quarter, which was up 1.9% year-over-year and adjusted EBITDA margin decreased from 10.4% to 10.2% over the same period. Non-GAAP net income was $220 million for the second quarter, which was up immaterially year-over-year. And non-GAAP diluted EPS for the quarter was $1.59, up 5% compared to the second quarter of fiscal year 2021. The performance of the base business is solid and stable. A couple of factors below EBITDA that drive EPS are worth noting. Net interest expense increased to $50 million from $46 million in the second quarter of fiscal 2021 with higher borrowing and the rise in interest rates. The weighted average diluted share count for the quarter was 138 million compared to 143 million in the prior year quarter. The current share count benefits from the retirement of 300,000 shares as part of the final settlement of the ASR program. Now for an overview of our segment results and key drivers on Slide Six. Defense Solutions revenues increased by 2.4% compared to the prior year quarter. The largest growth drivers were the NGEN and IFPC ramps which more than offset the end of our Afghanistan support contracts and reduced material purchases supporting hypersonics programs. In addition, the strengthening dollar represented about a $24 million year-over-year headwind for our UK and Australia businesses which lowered the segment growth rate by about a point. Defense Solutions non-GAAP operating margin for the quarter came in at 8.3%, which was unchanged compared to the prior year quarter. Civil revenues increased 7.3% compared to the prior year quarter, primarily driven by the start-up of the NASA AEGIS program and increased demand on existing programs, including the support to Hanford and our engineering support to commercial energy providers. Civil non-GAAP operating income margin was 6.5% compared to 9.1% in the prior year quarter as a result of an adverse arbitration ruling which led to $17 million of additional expense related to a dispute arising out of the acquisition of the IS&GS business from Lockheed Martin in 2016. Excluding this arbitration write-down, Civil margins would have been up sequentially to 8.5%. Health revenues increased 6.7% over the prior year quarter. We continue to benefit from the ramp on the Military and Family Life Counseling program and DHMSM had a nice year-over-year increase based on the deployment timing. In addition, we had a $28 million equitable adjustment to cover costs incurred as a result of the COVID-19 pandemic which caused non-GAAP operating margin to improve to 19.8% from 17.8% in the prior year quarter. We had originally anticipated to receive this payment in the second half of the year, so we're pleased to resolve this matter earlier than expected. Turning now to cash flow and the balance sheet on Slide 7, operating cash flow for the quarter was $40 million and free cash flow which is net of capital expenditures was $19 million. While DSOs in the quarter came down two days sequentially to 61, $110 million of collections that we anticipated in Q2 came in during the first week of July. We're targeting another three days of DSO improvement over the back half of the year which is consistent with our historical pattern. During the second quarter, we returned $51 million to shareholders, primarily through our ongoing dividend program. We also rolled over the $380 million term loan related to the Gibbs & Cox acquisition that came due in May. At the end of the quarter, we had $339 million in cash and cash equivalents and $5.2 billion in debt, including $150 million of commercial paper notes outstanding. The purchase price for the Cobham Aviation Special Mission acquisition was AUD310 million, which we hedged to lock us in at the $215 million purchase price that Roger quoted. With that acquisition, we expect 2022 will follow our standard capital allocation approach with the balance of organic and inorganic growth investments, dividends, and share repurchases against the backdrop of a leverage ratio trending towards three times. On to the forward outlook, as shown on slide 8, we're maintaining our guidance ranges for fiscal year 2022. The guidance does not include the impact of the Australian Aviation acquisition which should be relatively small for this year. Taking a big picture view, when we put together our plan for 2022, we had expected to build momentum through the year. Our guidance calls for the second half to be more in line with the first half from a revenue, EPS, and EBITDA perspective. Part of that shift is driven by over-performance in the first half. But there are a number of other factors that I'll address as I walk through the individual guidance elements. On revenues, we're ahead of where we expected coming into the year, stemming from the build-out of our recent wins and on-contract growth through trusted customer relationships. This gives us increased confidence in being in the upper half of the revenue range. Increased legal expenses and the unexpected arbitration ruling are pressuring EPS and EBITDA margin. And we're experiencing a larger-than-expected headwind from broader economic issues including foreign exchange rates and interest expense. In addition, we've had more margin dilution than anticipated from the start-up of some newer programs. Accordingly, it will be challenging to perform at or above the midpoint of the EPS and EBITDA margin ranges. Even though most of the cargo factors are transitory in nature we're taking actions on items within our control. We haven't changed our long-term view of margins. Finally, we're maintaining our operating cash flow guidance of at least $1 billion. The arbitration ruling will result in a $25 million cash payment. We'll have to offset that payment, but I have confidence in our team's ability to deliver on the cash commitment. We continue to monitor the potential for Congress to act on the new tax research cost capitalization rules. At this time, we do not expect to make any federal tax payments related to the amortization of research costs this year. If the 2022 effective date of the Tax Cuts and Jobs Act research cost capitalization provision remains in place, we expect our income taxes payable and net deferred tax assets will each increase by approximately $150 million in fiscal 2022 and the related negative impact to cash will be realized in fiscal 2023. With that, I'll turn the call over to Rob, so we can take some questions.

Thank you. We'll now be conducting a question-and-answer session. Thank you. Our first question comes from the line of Peter Arment with Baird. Please proceed with your questions.

Good morning, Roger and Chris. Roger, you provided some high-level insights on the budget earlier. I'm curious about your long-term outlook and whether the recent successes you've had could lead to an acceleration in revenues moving forward. While I understand you're not providing guidance for 2023, any additional insights would be appreciated. Thank you.

Yeah. We're still really optimistic about the out years. We made the comment I think both Chris and I that long-term, we don't see anything that changes the conversation that we've had in the past. And frankly since we were all together in New York last fall, the budget environment actually has gotten better and better in the areas where we're focused and differentiated. So I am still very bullish on the future.

Can you provide any highlights regarding the outlook of the Dynetics program of record? It seems to be attracting a lot of attention.

It's really exciting across the board. The hypersonic program has strong support. We currently have three Enduring Fires programs: one focused on lasers, another on missiles, and a third on high-powered microwaves, all of which are well-supported. In the space business, there are developments that we hope to discuss next quarter, and we're very pleased with how things have progressed. This is one of the reasons we chose it for the visit in the fall. I look forward to showing you the plant and introducing you to some of the team there; I think you'll be quite excited as well.

Appreciate the detail. Thanks.

The next question comes from the line of Sheila Kahyaoglu with Jefferies. Please proceed with your question.

Hey, good morning and thank you.

Hi. Good morning, Sheila.

Good morning. Roger I appreciate your comments on talent hiring and your retention focus. When we look at your headcount it was up 10% I believe year-over-year with organic growth of 4%. So maybe if you could square that disconnect for us a little bit.

We recognize that this is somewhat complex, but I'll simplify it. Direct labor is crucial for us as it allows us to manage a significant portion of our costs. Therefore, an increase in direct labor within the same revenue category is beneficial for us. We are working to enhance the Leidos' contribution to our projects across the board. It's important to note that there will be fluctuations on a quarterly and monthly basis. However, we have a long-term goal to boost our contributions. As you know, a major part of our contribution relies on the excellent work done by our dedicated team every day. So, having our headcount grow at a rate faster than revenue is actually a positive sign for us. It indicates that we are successfully executing our strategy and are effective in attracting and retaining the talent necessary for our success.

Okay. Thank you. And then I wanted to ask about how the business has been very good. And maybe on two specific opportunities with burn pit currently facing some hurdles in the Senate, how do you think about that and how it could be potentially incremental to your VA medical business? And then the second with Cerner and their EHR Modernization program, it's currently paused again. What are your thoughts there and the opportunity for Leidos?

Yeah. Sheila this is Chris. I'll get started. Maybe Roger can comment on the VA program. Obviously, we're very pleased with the Health team and their ongoing performance. And we had told you in Q1 that we had won a recompete successfully that was critically important, although there was an increased amount of competition introduced on that program. We also won some new work on international. So both of those dynamics are shaking their way out and we'll continue to see international ramp-up and we might see some pressure on the legacy side on the pre-discharge work. You talked about burn pit that's something we're watching very carefully. The team believes there is a significant increase in demand that will come from that. Obviously, we had hoped and expected that legislation would have passed by now. We're monitoring that daily, hourly and we hope to have some good news soon. So that's something that there is a modest amount of increased volume in the back half of the year associated with that coming through. And we think hopefully we'll be in a position where we could do better than that if things work through quickly. And Roger might comment on the VA.

Yes. And thanks Sheila. Obviously, we watch the VA program very closely. We have a relatively small role in supporting Cerner on the program. The movement of Cerner to Oracle, I think is going to be a positive for the program. Oracle is a real strong company, very strong software and data management. There's the Oracle Cloud. I think that will all be favorable for the VA. I know that they are paused while they reassess their go-forward plan. We stand ready to support Oracle, Cerner, the VA, any one of those organizations with the best of Leidos and frankly, members of our DHMSM team, and we'll just have to sit back and see how it develops. Again, I know they're paused. But the VA needs a single electronic healthcare record system and they need the interoperability with the active military, and we're strongly supportive of both of those.

Thank you very much.

You’re welcome.

Our next question is from the line of Robert Spingarn with Melius Research. Please proceed with your questions.

Hey, good morning.

Good morning.

Good morning. Hey, Rob.

Roger, one thing we are noticing in your numbers today and also with Booz is that there were flat sequential sales in defense. I wanted to ask why we didn't see a sequential increase from the March quarter to the June quarter, especially since the CR concluded in March. What is going on? Is it simply slow acquisition activity out of the Pentagon? And why?

Yes, acquisition activity is slow, and the ramp-up on the programs we've secured is gradual. Some programs have been delayed due to protests, pushing them further into the year. Spending has actually decreased. While we engage with officials at the Pentagon, including those in Acquisition and Research, I can't pinpoint the exact reasons for the acquisition slowdown. They do intend to spend the authorized funds. It seems many experienced personnel have retired, and the workforce is still largely remote, leading to longer timelines. Another vital aspect for us is the special project work on various contracts. This typically occurs when we have a base contract, and the customer asks for additional tasks while we’re already engaged. This work is important for our revenue and profitability, but it faced delays due to budget uncertainties. We are hopeful for an increase in such work during the second half of the year, though we are cautious in our forecasts, as Chris mentioned. Overall, there is positive news, but in the short term, we need to restart the spending process.

Well, just on the back of that, is there anything particular about the types of awards that are being delayed or the size that are being delayed? Is it more common for larger awards and task orders to be delayed?

It was a good question. I'm kind of thinking of looking at Chris and...

I think that's typically what we would see, the larger and more complicated evaluations with multiple competitors lead to a longer evaluation process. Where we perform best is in contract growth on existing vehicles because there's no competition. There's hope that we will see more of that in the fall quarter leading up to the government's fiscal year-end. However, more complex procurements vary by agency, and we have observed a trend towards consolidation into larger vehicles, which often extends the procurement cycle.

Yes. Okay.

Yes. And Rob, I would comment. And this is an absolute, but if a program is over $1 billion, I think the customer runs the acquisition process with the knowledge that there'll be a protest. So I think in both peer review and in writing the acquisition opinion and the sourcing letter, I think they're taking more time to get it right to either avoid the protest, which obviously hasn't been happening or to ensure that the award will be upheld. We've got protested again. It happens to us almost every quarter now in our large social security win. And I think in the government that they are now kind of like a protest is almost the normal and the bigger the program, the more likely the protest.

Okay. That's very helpful. I just wanted to ask you a clarification on the hiring. You said attrition is coming down. Is that because fewer people are going into the tech – that tech hiring is slowing I guess the best way to ask it?

Yes. Of course, I mean you and I are both speculating on why. I think there's a concern about the economy. Some of big tech has slowed their hiring. Some big tech has actually announced some layoffs. It's the summer and just a lot of people are on vacation or not. There is sort of a cycle and a seasonality to when people leave and when people stay. Very few people leave before like incentive awards are made in March. And I hope we're seeing a change in our long-term trend. But we've all been here before. It could spike back. We are still not back to pre-COVID levels. So although, we have started to see some moderation in attrition which I view as favorable but I do worry a little bit about the economy. And I'm not forecasting recession but I am forecasting maybe a little toning down in growth. So – and I think for a lot of people we have great jobs. We have great work. I mean we pay really great salaries. We have really cool stuff to do and we're able to attract some really great people. And I think once they get here and they start doing some of the fantastic stuff that we do, they go gosh, I want to do that. And that has that message has gotten through to our employees and I think we benefited from that.

Very helpful. Thank you.

Yes.

Our next question is from the line of Gavin Parsons with Goldman Sachs.

Hey, good morning.

Good morning, Gavin.

Roger, I think you said you didn't book anything for DES. But just any update on your expectations for what that ramp could look like or how much that could contribute in the future and whether or not that could ultimately be a top 10 program?

Yes. And DES, we've been turned on for the first task order which is very small. We are – let me spend at least 15, 20 seconds to describe the program. So in DES, we work with DISA to create a common architecture called DoD ONE-Net. And once we've established that architecture, then we will migrate 20-some-odd federal agencies to the new architecture. So the first thing we have to do is partner with our customer and define the architecture. And that is really hard work but a small number of people working in partnership with a DISA customer. And that's going to go on for months. So it's going to be really low. I don't think we put numbers out. But as I think I said not significant impact to top line or bottom line. Next year right, we started to do migrations. And then in the third year we do even more migration. So – and again I think we said this last quarter is that when we clear it – it was going to be a very slow ramp. But then it will ramp into a significant program. Whether we'll ever achieve the IDIQ value of $11.5 billion I guess we'll have to tune in 10 years from now. It has the potential to do that because we believe the architecture and the cost savings and the increased cybersecurity and the efficiency of this new DoD ONE-Net will be so advantageous to the government customers that people will want to migrate maybe even more agencies over time. But it's going to take a while to get there.

Okay. That's helpful. And maybe just in terms of margins. It looks like it was 9.9% in the quarter excluding the charges. Maybe if you could just give us kind of around the horn by segments what that looks like through the rest of the year with Health, down from these elevated levels maybe Defense and Civil, what those trajectories look like?

Yes, Gavin. We won't go into too much detail about margins by segment, but I believe you have the right idea. We've indicated that we expect moderation in the Health sector. We still anticipate that will happen, but we appreciate the team's performance. Earlier, we mentioned burn pit legislation, which could introduce some helpful dynamics. However, we won't maintain current levels due to a couple of one-time events in the first and second quarters in Health. In Civil, the AEGIS program has just started, and we anticipated it would have lower margins at the beginning of this multiyear program, which will gradually improve. Civil has also absorbed many of the legal expenses I previously mentioned, so we expect those margins to get better. Roger mentioned improvements in our security products business, and while I don’t want to predict too far ahead, I believe the second half will show stronger profitability and margins compared to the first half. Overall, Civil is a well-managed business, and I expect its performance to improve slightly. As for Defense, it will likely be higher over time. Whether that will happen in the second half of this year is still to be determined. The special project work Roger mentioned is something we hope will increase in volume. Currently, we aren't seeing that and don't expect immediate changes. There has been some transition, as work in Afghanistan has decreased, but there are promising airborne opportunities that the team is chasing, which we hope to discuss in the future. Those could be catalysts for growth and margin improvement. For now, I would say we're likely to stay on the current trajectory regarding defense margins in the short term.

Okay. Thank you.

Thanks, Gavin.

The next question is from the line of Colin Canfield with Barclays. Please proceed with your question.

Hey, good morning. Tying together perhaps Peter and Rob's question. Can you just discuss some of the bigger drivers of next year's growth acceleration? It sounds like the defense hardware pieces of Dynetics seem to be adding outsized lift. And obviously, I understand it takes time to get all the headcount added and commercial aero are going to returns in 2024. I guess it's still a TBD given the kind of exposure that you guys have to widebody traffic. So maybe if you could tie together kind of what are your biggest uplifters into next year?

Yeah. I mean, Colin, we're early to get in detail about 2023, right? And we'll certainly speak about that more as we get to next year's guidance. But again, I think Roger talked about the budget backdrop is a foundational starting point and that's favorable. Therefore, the volume of things that we're seeing and bidding on continues to be strong and favorable. And so, defense activity is one that we've seen a lot of throughput in opportunities more Dig MOD opportunities more C4ISR opportunities. I mentioned hopefully some airborne opportunities where we've demonstrated a great capability that the customer is interested in seeing more of. Dynetics in the defense hardware side, absolutely, there are some programs that will be ramping up. There's also some programs that will be moderating, as we transition towards proof of concept, completing demos and getting into hopefully a production cycle award which will probably be more likely 2024. And so those things all should do fine. Civil again, would probably be the aviation hardware accelerating growth, but not back to pre-COVID levels, but the trends are positive there. And more civil agency digital modernization opportunities we continue to see and bid on that we're pursuing. And the wildcard is Health. Now the one big catalyst that we've been waiting on is the Reserve Health Readiness program. We spoke about that for over a year now. That had been delayed. It was originally in this year's expectation. It's now fully out of any contribution for 2022. But we see that as a big program that we've already won and should ramp up nicely in 2023. So those are a few things that come to mind. But again, we'll talk in more detail about 2023 as we get to that time of the year.

Got it. And then a longer-term strategic question. But can you just talk about how you're preparing the business for a structurally impaired headcount environment? Both you and Booz are kind of talking about IT cyclical benefits and a softer economy freeing up headcount. But if you look at the population statistics, labor force participation isn't coming back and the US population growth is almost close to shrinking. So if you think about how you guys are structuring the business around kind of that environment?

Hey, Colin, I'll touch on it a little bit. I'm not sure we have enough time on the call to talk about all the things we're doing. But I think we all realize that we are in an era where there are going to be more jobs than people. I mean, it's just a fundamental structural problem. If you look at college grads and where we can source. And so that from a long-term standpoint, talking with our HR and our leadership team, it's about okay, what can we automate, how can we put RPAs into our administrative and functional organizations and free the talent up, so that they can provide value-added goods and services to our customers? And then what is our new knowledge worker work look like in this industry? And then how do we hire them retain them upskill them right and grow them over time? And so we have a long long-term view of our labor strategy and how we want to take people and create multiple gates and multiple steps in their career. So, they graduate from college, they come here they pick up some stretch Thunkable credentials. They add another computer language. They pick up Python. They get a master's degree. We continue to invest in them. They continue to grow and move professionally. And they go wow I'm doing great work. I'm making competitive salary. And I see my career advancing at the company opportunities for growth and management. We're growing. And that's a terrific place to be where we're growing and hiring people. But we do realize that the world that I grew up in is no longer here. And we have to be very thoughtful about where we want to put our people and frankly maybe what we want to do with partners and what we want to do with automation.

And the only thing I'd add to that is again we've been talking about some of these businesses. But clearly we see as growth catalysts some of our businesses that are less headcount-dependent. What's happening in Dynetics what's happening with the security products business. So, again, they're not a huge part of the portfolio but they'll become an increasingly larger part of the portfolio over time.

Got it. Thanks for the color.

Thank you. Good questions.

Our next question comes from the line of Cai von Rumohr with Cowen. Please proceed with your question.

Yes. Thank you. So, you and Booz had some trends that were very similar; strong sales a very anemic bookings although very strong fundings which I don't understand how you get those two together; and very weak cash which slips into the next quarter. Maybe give us some color on how we could get the incongruity of bookings and funding. And then looking forward, we've got all that funding is there are we going to have the super blowout September quarter in bookings that we could, or is that still going to be slowed by the issues you discussed Roger?

Yes. I believe the next quarter will show improvement, but I don't expect a significant increase. All of us in the industry, including competitors like Booz, are encountering similar acquisition challenges. From my perspective at Leidos, our win rates have remained consistent, and we didn't lose many programs in the first or second quarter, nor were there many canceled opportunities; things just got delayed. We've observed this throughout our entire value stream. Some cash payments we anticipated for the quarter were actually received in the first week or two of July, which Chris mentioned totaled over $100 million. The customer process is slow, and we faced a couple of protests that negatively impacted our book-to-bill ratio. While we account for these surprises, we usually expect protests. The social security bid may not improve until the fourth quarter if we win the protest, which means it won't provide much support for the third quarter. Overall, while the third quarter should be stronger, the recovery will be gradual due to the budget challenges we experienced earlier this year and late last year.

And I think Cai is increasingly we're talking about the mega awards the larger awards those just don't often line up with the government fiscal year-end third quarter cycle. So, you could see the bigger quarters any time like we had a great first quarter. On the funding side, I mean again I think that's conversion of previous prior awards unfunded to funded. That's not always going to follow the same cycle. It's easy for a contract officer to make that action on something they've already awarded and give you incremental funding dollars versus a whole new procurement decision process. So, to me, it's great. We like to see our funded backlog improving. But I don't think you can read too much into the cycle around when those activities take place versus brand-new award decisions.

Yes Cai. I think a good example is this program we call FENS, which is sort of a network infrastructure program for the FAA. A year ago, we thought it would have happened in first quarter and first quarter it got delayed to the second half of the year. Now it's a little bit uncertain, even when they're going to make the award, I think we can almost count on a protest. So if they make the award in the third quarter or fourth quarter, that could be extended well into 2023. And we just have that kind of uncertainty. And we've seen more of that trend, and more of that behavior perhaps than we have over the past couple of years.

Thank you. And can you give us just some quick color, on what are you seeing in July? Is there being any pickup, or is it still at the same level? What are you seeing there?

Well, cash was good in July. From a war...

We have a couple of strategic wins. We'll be able to talk about that happening.

Yes, we did have some wins, but they're not ready to announce yet. I believe that every month brings great achievements, though the ones I’m most excited about are often strategic and involve technology, which might not get published. We had some of those in July that we can discuss in the next quarter. However, there wasn't a major win in July. Our next significant opportunity could be a couple of programs, particularly a substantial IDIQ that may be awarded, but we need to compete for the scores, likely related to the FAA FENS program.

Thank you very much.

Thank you.

Our next question comes from the line of Matt Akers with Wells Fargo. Please proceed with your question.

Hi. Good morning, guys. Thanks for questions.

Good morning, Matt.

Could you provide some insights on your international business? You've recently acquired a company in Australia, and many of our allies are discussing increased defense spending. I'm interested to know if this could become a more significant aspect of your business in the future.

We're really pleased with our international work, which represents just under 10% of our revenue from outside the US. We aim to be selective in our expansion and typically follow the US market, particularly in the UK and Australia, where we have a strong presence. Growing in Australia is a priority for us due to its longstanding alliance with the US. We believe in expanding country by country and ensuring that we have the infrastructure and critical mass necessary before moving regionally. Unlike some competitors, we do not plan to have offices in every country. However, we see a diverse international presence as a valuable addition to our portfolio, providing potential stability alongside our US operations. Our security business operates globally, with products that are transportable and meet uniform specifications. While we have a presence in around 125 countries, our organization in those countries might be small, consisting of a few field service technicians or maintenance staff. Our SES business is already global and will remain so, as we engage in every country where it's appropriate for us to sell. The recent acquisition in Australia is a positive move, aligning with our strategy to grow larger in that region, which is crucial for the Australian government's mission.

That's great. I have one more question regarding DES and the long-term targets presented at the Investor Day last fall. How much does DES factor into those targets, particularly in terms of growth and margins? Should we also consider any potential dilution from that contract as the program scales up in the coming years?

Well, Matt, I want to clarify that in the short term, we don’t anticipate the margins from that program to meet or exceed the corporate average. We understand there is some initial investment involved. This year, while we are in the protest process, the team has been expanding the PMO staff and proactively working on the transition. We are investing in DES and plan to continue doing so because we have a long-term perspective on it. I expect 2024 to contribute significantly more than 2023. As Roger mentioned, there's a ramp-up, and it's still early, so we can't provide precise details on timing and customer adoption. However, by 2024, it should play a more substantial role in our growth narrative.

Great. Thank you.

Thank you.

The next question is from the line of Bert Subin with Stifel. Please proceed with your question.

Hey, good morning and thank you for the time.

Hey, good morning.

Good morning, Bert.

Roger you noted that SD&A will not recover until 2024. You had previously guided that business, I guess, if we go back to early 2020 to low teens, annual sales growth with expanding margins back when you did that deal with L3. How should we think about the path forward for SD&A now? Does it get back on to that track, or are you really just sort of thinking about it in terms of pro forma 2019 sales? No. We see it as having a clear plan when we acquired the business and finalized the deal before COVID. Then we experienced a significant decline in our revenue, which impacted margins, although it still remains a profitable venture. We reached the lowest point, and now we're observing a recovery with double-digit growth in that segment compared to last year. Our projections indicate that by 2024 we will return to pre-COVID revenue levels and will continue to expand as airports in the US and worldwide upgrade their equipment, driven by both age and new threats from emerging chemicals like fentanyl that older machines can't detect. The demand for touchless technology at airports is growing, and we anticipate that in a decade, most airports will provide a touchless experience for passengers, which we believe will boost demand significantly. Personally, I would choose a touchless lane over one that is not.

Well, I think look at improved throughput right which is a huge deal.

We have been investing heavily in technology during this challenging period so that we are prepared to compete when the business picks up.

Just a clarification question on that. Where does border security fit in? I know you have some products there and that seems like there's going to be a lot of future demand. Does this acquisition in Australia have any relation to what you might be doing in that business, or are they completely separate?

Yes, they are completely separate. The Australia business focuses on airplanes with sensors flying over blue and littoral waters to search for boats in distress or unauthorized vessels. In contrast, our other business involves ground operations where vehicles like cars and trucks pass through our systems. We also have a rail operation at the Mexican border where railcars go through our machines for personnel screening. These two businesses are very distinct. While the top-level customer is similar in Australia, it likely belongs to a different department within that organization. We are not pursuing the carbon business due to its overlap with our SES business.

Got it. And then just a quick follow-up if I may. The appropriations process is likely to yield. I think you mentioned earlier Roger defense budget is higher than the initial request. But that's likely to put pressure on non-defense just in terms of thinking about total spending. Is that a good outcome in your view? I know you have pretty similar exposure to both.

Yes. First of all, I want to share my perspective on what I believe will happen. I anticipate that the non-defense budget will move in tandem with the defense budget. Historically, we haven't seen an omnibus without adjusting the non-defense budget in a similar direction, and I expect this trend to continue this year. Whether this occurs during the lame duck session, which I believe it will, I think there will be a push to align non-defense and defense funding closely, leading to an omnibus that will be finalized before the new Congress takes over, allowing us to move forward. I see this as a positive outcome for Leidos across all our sectors, including Defense, Intel, Health, and Civil. In my opinion, this is beneficial for the company, its employees, and shareholders. I have young children, and at times I ponder the future implications of our financial decisions, such as potential tax increases or other revenue sources for the federal government. However, from Leidos' perspective, I foresee a robust budget environment favorable for us for many years to come.

Thanks, Roger. Thanks, Chris.

Okay, Bert.

Our next question is from the line of Seth Seifman with JPMorgan. Please proceed with your questions.

Hey, thanks very much and..

Hi, Tobey.

Hi. Its Seth. Just a quick one from me this morning keep it short. But the release mentions the reduction in materials intake at Dynetics as a driver for defense. Does that have to do with sort of scheduled changes in activity there, or is that more of a supply chain issue kind of as we've seen across the industry including at some companies in similar areas like Raytheon and Aerojet?

Yes. So Seth it – obviously, supply chain is a factor that we're seeing here and there. But the particular issue in hypersonics was kind of planned, the cycle production schedule for that program. It's following course that we expected it to. Now we're hopeful for some more authorizations from a funding perspective that could help the program. As a growth catalyst in 2023 that's something we're paying attention to. But right now there's not a big issue from a supply chain bottleneck, although I would say that we're still not out of the woods on that as it relates to certain component parts in various parts of the business. But it hasn't been a major factor for us this quarter.

Right. Okay.

Thank you.

Thank you. The final question is coming from the line of Tobey Sommer with Truist Securities. Please proceed with your question.

Hi. Good morning. This is actually Jasper Bibb on for Tobey. Thanks for taking our questions. So I just wanted to ask about margins in the Civil segment. I think you highlighted SG&A and the contract ramps there. But can you provide a bit more color on when you expect that segment to return to more normalized 2018-2019 profitability level?

Yes, we are actively discussing this with the leadership team. There are several drivers in the Civil business, with SES being a significant component of our long-term margin strategy. I've noted some recent program wins, particularly in digital modernization, which may have lower margins in the short term. However, our commercial energy business is performing well and contributes positively to margins, even though it comprises a smaller portion of our overall portfolio. Our transportation and aviation segments are doing well, especially with the FAA, although this is influenced by the FAA budget and new program initiations. Additionally, our MNO support contracts and mission operations, whether with DOE or other clients, generally experience lower margins. Looking ahead, returning to those previously established margins will likely take several years as we focus on winning and executing more projects in the digital modernization area and see a rebound in SES. We are also aiming for small improvements in other parts of the portfolio alongside our team. That's our current perspective regarding the near-term situation.

Okay. I appreciate the detail. Thanks for taking my questions, guys.

Okay. Great. Thank you.

Thank you. We reach the end of our question-and-answer session. And I will now turn the floor back to Stuart Davis for closing remarks.

Thank you, Rob and thank you for your assistance on today's call. And thank you all for joining us this morning and your interest in Leidos. We look forward to updating you again soon. Have a great day.

This will conclude today's conference. You may disconnect your lines at this time. Log off your webcast and have a wonderful day.