Greetings. Welcome to L3Harris Technologies Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mark Kratz, Vice President, Investor Relations. Thank you. You may now begin.

Thank you, Rob. Good morning and thank you everyone for joining us to discuss third quarter results. Joining me are Chris Kubasik, our CEO, and Michelle Turner, our CFO. Yesterday, we published our investor letter detailing our results, guidance, and key company updates. So this morning's call will be focused on answering questions. As always, we may discuss certain matters that constitute forward-looking statements. These statements involve risks, assumptions, and uncertainties that could cause results to differ materially. For more information, please reference our provision found in our investor letter and our SEC filings. We will also discuss non-GAAP financial measures, which are reconciled to comparable GAAP measures in the investor letter. I'd now like to turn it over to Chris for some brief remarks.

Okay. Thank you, Mark, and good morning, everyone. I know you've all had a busy week, and we appreciate you joining us this morning. The current events in the Middle East remind us that what we do at L3Harris matters. The industry in which we operate is more critical than ever before. As a national security technology-focused company, we remain committed to supporting the U.S. and its allies to deter aggression and foster stability around the world. As we embark on our fifth year since the merger of L3 and Harris, I'm proud of our achievements. We built a diverse and seasoned team that is integrating our company. L3Harris is viewed as a disruptive competitor that is reshaping the U.S. Defense industrial base. Meanwhile, underpinning our strategy is a focus on operational excellence, delivering quality products on time, driving costs out of our system, and focusing our portfolio as a national security company. This ultimately benefits our customers and creates long-term value for our shareholders. While the macro environment has been challenging, we are making considerable progress. The business is on solid footing, and we are building operational momentum. In the third quarter, we reported 16% top-line growth, the second consecutive quarter of sequential margin improvement and strong cash generation, resulting in more than 100% free cash flow conversion. This extends our trend of generating positive free cash flow in each of the quarters since the merger. The team and I look forward to providing more details on our strategy and our 2024 outlook at our Investor Day in December. And with that, Rob, let's open the line for questions.

Thank you. We'll now be conducting a question-and-answer session. Thank you. Our first question is from Kristine Liwag with Morgan Stanley. Please proceed with your question.

You know Chris, Michelle, after owning Aerojet Rocketdyne now for a few months. Are there any surprises to the positive or negative that you've seen?

Okay, well, I expected an Aerojet question. Let me take this one and try to answer your question and maybe give a little more insight on Aerojet Rocketdyne. To refresh everyone's memory, we signed and announced the deal back in December. We're able to close it in seven and a half months, which I think is pretty impressive in this environment. There was support or probably no objections from industry and in the Department of Defense to allow the acquisition to go through. We hit the ground running on day one. Deployed the L3Harris leadership team to run the business which I thought was critical to our success. From an integration perspective, all is going well, we're clearly on track to get the $40 to $50 million of cost savings that we discussed previously. We've shut down the Aerojet Rocketdyne headquarters in California. We're ready for January 1 to transition all the employees to L3Harris payroll system and benefits. The IT team is already connected to all the networks. Communication is working well. We have a little longer term IT strategy to optimize the business from that perspective. I will say the workforce, we conducted a survey of the workforce about a month ago, and the results were outstanding. I was more than pleased to see the enthusiasm of the workforce, their confidence in being part of L3Harris, and their alignment with being a part of a larger company focused on defense and national security. That's encouraging. We've been clear that our number one priority is to increase deliveries, specifically in the rocket motor sector. Everything we're doing is focused on increased deliveries. We developed the plan, and the leadership team reviewed it, and we're off executing it, including having Centers of Excellence. We've supplemented the existing leadership teams at key locations in Alabama, Arkansas, and Virginia with resources and experience that I believe will start showing immediate results. We've also deployed resources to our sub-tier suppliers. That is a challenge in the munitions and rocket motor business. The Defense Production Act, over $200 million that was awarded earlier this year, is focused on three main products. We have a plan and we're starting to execute that. We just leased a building in Alabama to modify and order equipment to increase capacity at that facility. We will use that as a framework to revitalize the business. We've had discussions with our customers, and they are very excited to have L3Harris own this asset. They see us as the solution to the challenges they and the industry have faced relative to rocket motors and we have their full support. The space engine business of Aerojet Rocketdyne, which may represent about one third of Aerojet Rocketdyne, is operating well. The RL10 engine, which is the upper stage, is performing flawlessly. The successes in that area go back decades without a failure. We're excited to be part of the United Launch Alliance's first Vulcan launch and subsequent launches. We have over 150 engines in backlog, providing us with good visibility and stability in the space sector. That's operationally where we are with Aerojet Rocketdyne, Kristine. I want to also address the strategic rationale for the acquisition. Even though it hasn't been quite a year, people still ask questions. At L3Harris, we are building a defense-focused, technology-based company. We're taking a portfolio approach, looking to acquire businesses that align with our nation's defense strategy and growing markets. Aerojet Rocketdyne is growing faster than the legacy L3Harris business. Since we signed the deal in December, the demand for these products has increased significantly both in the U.S. and the world, which is why we need to focus on an increase in output. The DPA money and our ability to focus on three particular lines will help us increase capacity, move production lines, and optimize engineering. The tailwinds are there. I feel better about the acquisition today than I did in December, to be honest. It highlights some of the industry's challenges. Going back to the '80s and the peace time dividend, the industry and our capacity contracted. For the last several decades, we've had a peace time mentality, but we need to ramp up to more of a wartime footing. Money and focus must go towards the sub-tier suppliers feeding not just us but other industry partners. I appreciate the longer response, Kristine.

Our next question is from the line of Gautam Khanna with TD Cowen.

I actually wanted to switch subjects and ask about Tactical RF. Maybe if you could talk about book-to-bill in the quarter where backlog stands and give us some pipeline color, both domestically and internationally? Also, can you answer the supply chain questions, how that's evolved in that business line? Thanks.

Yes. Thanks for the question. From an overall perspective, we continue to be on track to deliver to our guidance, which was double-digit growth across the business, including the supply chain challenges. We continue to see significant support from the DoD budgetary perspective, and we're about 40% through that modernization program. Internationally, we continue to see strong demand. Overall, I'd say we're in a good place from a perspective. For supply chain specifically, we are experiencing hiccups like you are hearing across the industry, but our tactical communication business has seen significant improvements over the last 18 to 24 months. The efforts made by our team have enabled us to pivot when we experience these hiccups, allowing us to continue to deliver for our customers and shareholders. Notably, our overall deliveries have actually risen from Q2. We're seeing the results of those sustained efforts.

Our next question comes from the line of Noah Poponak with Goldman Sachs.

Chris, you alluded to the competing inputs for national security spending. When you think about what's evolving geopolitically versus the deficit battle in the U.S., what is your medium-term end market growth rate? What is your latest thinking on the L3Harris spread versus that growth rate?

Yes. Thanks for the question, Noah. As I step back, I think it’s implied that the budget and what's going to happen with the supplemental plays a role. We now have a speaker of the house; that’s step one. I believe it feels like it is an even more dangerous world than it has ever been. Look at what’s going on in the Middle East, Ukraine, South China Sea; national security needs to be a top priority. I'm concerned that a government shutdown would weaken our national security as does a continuing resolution. The industry and our customers hope that a budget emerges in the next couple of weeks so that the money can flow to the industrial base. There’s been a lot of discussion about a supplemental budget potentially exceeding $100 million split between state and DoD, Ukraine, Israel, and the southern border. We feel confident about the supplemental but uncertain about the specifics. When looking at our product portfolio, we are in a good position, especially given the products that can be quickly deployed like radios, night vision goggles, sensors, and cameras. The midterm relies more on continued budget growth and investment in advanced technologies for peer threats. Our strategic portfolio positioning, particularly in the space sector, can't be overstated. Our performance as a trusted disruptor has been evident, as it’s noteworthy that at the date of the merger, L3Harris had no satellites in orbit as a Prime. Looking at our backlog, we could see around 50, L3Harris Prime satellites in orbit in the next 3 to 5 years. I feel well positioned there. We aim for mid-single-digit growth based on historical industry trends. Lastly, I believe that we need infrastructure investment to increase industrial base capacity, especially considering the budget dynamics and worldwide events.

Next question is from the line of Scott Deuschle with Deutsche Bank.

I have two quick questions, both for Michelle. The first is on the difference between the $56 million of M&A expense add-backs on the P&L and the $215 million of add-backs for M&A on adjusted free cash flow. So that’s my first question. And then my second question is what would drive CS margins to the 26% range in the fourth quarter, which is what’s implied in the guidance. Thanks.

Thanks for that, Scott. I'm going to start with the margin question and take a step back. We think of this as managing our portfolio. We're encouraged with the overall margin results in the quarter. We saw improving margins at 15% across our segments, including two months of Aerojet. Starting with our Space and Airborne Systems business, it delivered a record operating profit with 12.5% margins thanks to effective management of costs and contracts. Looking ahead to Q4, there will be a step-down due to some one-time contract modifications successful in Q3. From the Integrated Mission Systems perspective, this segment had sequential margin improvement of 180 basis points from Q2. Despite earlier programmatic challenges, John Rambo's team is seeing positive results in Q3, and we expect the worst is now behind us. In our Communication Systems business specifically, it matched our expectations for the quarter. We anticipated that heavier DoD shipment mix would lead to lower margins due to a high volume of tactical radios. As I noted earlier, we delivered more radios this quarter, showcasing efforts in building a resilient supply chain. In terms of Aerojet, we expect some margin contraction in Q4 given Q3 benefiting from purchase price accounting adjustments. The difference between M&A expense and cash impacts primarily derives from Aerojet acquisition cash flowing out post-closing compared to what was originally booked on Aerojet's books.

Our next question comes from the line of Jason Gursky with Citi.

I just wanted to go back to the Space business for a minute. There have been some contracting changes occurring in the aerospace business this quarter. Can you help provide insight into your space portfolio, specifically its fixed price versus cost plus mix, and discuss the associated execution risks and benefits moving forward?

Great question, Jason. The mix between fixed price and cost-plus contracts in our space portfolio is about 50-50. This is a significant change as historically, space contracts leaned more toward cost-plus. Many challenges in the industry stem from supply chain issues; however, we've been able to adjust and manage expectations as we maintain biddable margins. For longer-cycle programs such as space, we're experiencing pricing and workmanship quality challenges. We've been doubling down on our bidding discipline to factor in risks, ensuring we won’t bid to lose money. We’re conducting regular independent reviews of our key programs, which helps identify risks early. I believe we’re managing our margins solidly compared to our peers, without major write-offs. We have planned fixed-price contracts for missile tracking, notably for the Missile Defense Agency. These contracts are completed and awaiting launch. We continue to seek to mitigate risks by securing appropriate contracting terms. Our goal is to sacrifice growth for profitability through careful management of our program portfolio. Ultimately, our aim is to attract new talent and optimize margins as we navigate through these challenges.

I'd like to add that alongside our SDA and NDA work, we also have a stable business in civil weather that has brought in about $1.5 billion, showing growth opportunities in decades of business.

Our next question comes from the line of Richard Safran with Seaport Global Research.

Chris, I heard your remarks about 2024 during the Investor Day, but could you provide a qualitative assessment of which segments have the most room to grow in '24? Any color on this would be helpful.

Are you planning to visit us in December for our Investor Day, Rich? Great to hear! I can’t provide a fully satisfying answer, as we are currently reviewing our 2024 plan, but it appears that all four of our segments will see growth. We will reveal specific details about segment growth in December. However, we must work through the next month or two to see the outcomes surrounding budget uncertainties and geopolitical events. For now, it seems likely that all segments will experience top-line growth. On a consolidated basis, we expect growth in cash, operating income, and EPS, despite challenges like pension headwinds. This is encouraging.

Our next question comes from the line of Ken Herbert with RBC Capital Markets.

Chris, following up for Michelle, can you discuss how you view CAPEX across legacy L3Harris versus Aerojet Rocketdyne as we think about 2024? Do you need to accelerate CAPEX in Aerojet to address any of the issues you highlighted, particularly in relation to cash growth next year?

We'll continue to prioritize our R&D and CAPEX based on business needs. Aerojet Rocketdyne had projected $50 to $60 million in CAPEX, and I expect that to remain the same as we evaluate all investments. The market for Aerojet shows high growth potential, and we aim to accelerate due to DPA funds and any potential funding from states. The overall CAPEX target will need to accommodate these investments, and if more is needed for Aerojet, it will likely come at the expense of other projects in the legacy portfolio without near-term ROI.

In terms of free cash flow for next year, we expect increased income to provide a tailwind, alongside a benign impact on working capital. Keep in mind our initial model for Aerojet projected free cash flow accretion in year two due to the program cycle they are currently in. Historically, we run around 2% CAPEX and do not expect that to fundamentally shift going into next year.

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

Could you elaborate on LHX NeXt? Specifically, regarding the $500 million benefit you mentioned, how much of that impact does L3Harris retain? Is there any expectation of shared offsets with your customer?

I’m glad to expand on that. LHX NeXt represents the next phase of our merger evolution. The initial integration savings delivered several hundred million in benefits alongside some associated offsets. Now, in this more difficult phase, we are targeting operational efficiencies. To clarify your specific question, we anticipate that while there will be investments associated with this phase, the bottom-line impact will be a nominal tailwind and not flow entirely to profit. Examples include renegotiated benefits to support employees while maintaining their costs, along with streamlining our communications process. The material opportunities on the direct and indirect side, leveraging the scale of L3Harris, will help drive value for our shareholders.

The next question comes from the line of Seth Seifman with JPMorgan.

If you could discuss the path to deleveraging and how much cash you need to have on the balance sheet? I believe there's some more debt coming due, and the company will need to consider how to manage repayments versus terms.

Absolutely. We're focused on debt repayment. First, we will prioritize our commercial paper and higher interest variable rates. Currently, post-acquisition, we stand at $13.5 billion in debt, and our target is to lower this to about $13 billion by year-end. In terms of leverage ratio, our goal is to get below 3 over the next couple of years.

Our next question comes from the line of Sheila Kahyaoglu with Jefferies. Chris, this will be our last question this morning.

Just stepping back, big picture, your margins are at 15% today. How do we think about expanding them? Is it even possible? Could you discuss that for Communication Systems margins? Can you shake off some of these supply chain issues?

I’ll take this, Sheila. Thank you for your question. Yes, we are proud of our 15% margins, which lead the industry. Even with this high standard, we are dedicated to finding ways to grow margins. Our communication systems benefit from a commercial business model beyond tactical radios, and we’re also increasing prices to counter cost increases. The reality is that prices are going up all around us, so we need to adapt. Our plans are directly related to ensuring we manage our supply chain properly while also seeing improved profitability by leveraging procurement with combined buying approaches. We have shown evidence of strengthening margins through negotiations across all segments, looking at direct material effectively. We haven’t seen significant write-offs, which has been fortunate and contributed positively to margins. We will avoid bidding in projects that lead to losses and work towards solidifying our profitability. I agree that we need to focus on building a resilient supply chain while also managing challenges in contracting to ensure we maintain strong profitability. Lastly, mitigating supply chain issues is a key part of our strategy moving forward. In conclusion, I want to thank everyone for joining the call this morning. I also want to recognize our employees for their hard work in delivering a robust third quarter. We are looking forward to Q4 and seeing everyone at our Investor Day in early December. Thank you, and we will sign off.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.