Leidos Holdings, Inc. 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of Leidos Holdings, Inc.'s ("Leidos") financial condition, results of operations, and quantitative and qualitative discussion about business environment and trends should be read in conjunction with Leidos' condensed consolidated financial statements and related notes. The following discussion contains forward-looking statements, including statements regarding our intent, belief or current expectations with respect to, among other things, trends affecting our financial condition or results of operations, backlog, our industry, the impact of our merger and acquisition activity, government budgets and spending, our business contingency plans, uncertainties in tax due to new tax legislation or other regulatory developments and our ability to recover certain costs through the Coronavirus Aid, Relief and Economic Security Act ("CARES Act"). Such statements are not guarantees of future performance and involve risks and uncertainties, including uncertainties relating to the coronavirus pandemic ("COVID-19") and the actions taken by authorities and us to respond, and actual results may differ materially from those in the forward-looking statements as a result of various factors. Some of these factors include, but are not limited to, the risk factors set forth in our Annual Report on Form 10-K, as updated by the risk factor in this report under Part II, Item 1A. "Risk Factors" and as may be further updated in subsequent filings with the U.S. Securities and Exchange Commission. Due to such uncertainties and risks, you are cautioned not to place undue reliance on such forward-looking statements, which speak only as of the date hereof. We do not undertake any obligation to update these factors or to publicly announce the results of any changes to our forward-looking statements due to future events or developments. Unless indicated otherwise, references in this report to "we," "us" and "our" refer collectively to Leidos and its consolidated subsidiaries. Overview We are a FORTUNE 500 ® science, engineering and information technology company that provides services and solutions in the defense, intelligence, civil and health markets, both domestically and internationally. We bring domain-specific capability and cross-market innovations to customers in each of these markets by leveraging five technical core competencies: digital modernization, cyber operations, mission software systems, integrated systems and mission operations. Our customers include the U.S. Department of Defense ("DoD"), the U.S. Intelligence Community, the U.S. Department of Homeland Security, the Federal Aviation Administration, the Department of Veterans Affairs and many other U.S. civilian, state and local government agencies as well as foreign government agencies. We operate in three reportable segments: Defense Solutions, Civil and Health. Additionally, we separately present the unallocable costs associated with corporate functions as Corporate. COVID-19 For the three and nine months ended October 1, 2021, COVID-19 did not have a material impact to revenues and operating income. The full extent of the impact of the COVID-19 pandemic on our operational and financial performance, including our ability to execute on programs in the expected timeframe, will depend on future developments, including the duration and spread of the pandemic and the distribution of vaccines, all of which are uncertain and cannot be predicted. Section 3610 of the CARES Act, a $2 trillion coronavirus response bill providing widespread emergency relief, authorized the government to reimburse qualifying contractors for the cost of certain impacts of COVID-19. While a portion of the recoveries that we have made are a result of Section 3610 of the CARES Act, the Act expired on September 30, 2021. Effective October 1, 2021, we mandated a policy requiring all employees, vendors, subcontractors and visitors to be vaccinated or maintain proof of a negative COVID-19 test in order to enter a Leidos facility in the U.S. or to attend company business events outside of our facilities. On September 9, 2021, President Biden issued a series of executive orders to combat COVID-19, which requires us, as a federal contractor, to ensure that all of our employees are fully vaccinated by December 8, 2021, unless the employee is legally entitled to a religious or medical exemption. We are currently assessing the impact our policy will have on our workforce and operations. 24 Table of Contents LEIDOS HOLDINGS, INC. Business Environment and Trends U.S. Government Markets During the three and nine months ended October 1, 2021, we generated approximately 88% and 87%, respectively, of our total revenues from contracts with the U.S. government. Accordingly, our business performance is affected by the overall level of U.S. government spending, especially on national security, homeland security and intelligence, and the alignment of our service and product offerings and capabilities with current and future budget priorities of the U.S. government. Congress received the GFY 2022 President’s Budget Request on May 28, 2021 and passed a Continuing Resolution ("CR") before the GFY deadline of September 30, 2021. The CR will fully fund the federal government at current levels through December 3, 2021 and provides $28.6 billion in disaster relief and $6.3 billion to support Afghanistan evacuees. The House and Senate also voted to extend the debt limit waiver through December 3, 2021. International Markets Sales to customers in international markets represented approximately 8% of total revenues for the three and nine months ended October 1, 2021. Our international customers include foreign governments and their agencies. Our international business increases our exposure to international markets and the associated international regulatory and geopolitical risks. Changes in international trade policies, including higher tariffs on imported goods and materials, may increase our procurement costs of certain IT hardware used both on our contracts and for internal use. However, we expect to recover certain portions of these higher tariffs through our cost-plus contracts. While we evaluate the impact of higher tariffs, currently, we do not expect tariffs to have a significant impact to our business. 25 Table of Contents LEIDOS HOLDINGS, INC. Results of Operations The following table summarizes our condensed consolidated results of operations for the periods presented: Three Months Ended Nine Months Ended October 1, 2021 October 2, 2020 Dollar change Percent change October 1, 2021 October 2, 2020 Dollar change Percent change (dollars in millions) Revenues $ 3,483 $ 3,242 $ 241 7.4 % $ 10,246 $ 9,045 $ 1,201 13.3 % Operating income 305 258 47 18.2 % 882 699 183 26.2 % Non-operating expense, net (45) (44) (1) 2.3 % (137) (163) 26 (16.0) % Income before income taxes 260 214 46 21.5 % 745 536 209 39.0 % Income tax expense (52) (51) (1) 2.0 % (162) (104) (58) 55.8 % Net income $ 208 $ 163 $ 45 $ 583 $ 432 $ 151 Net income attributable to Leidos common stockholders $ 205 $ 163 $ 42 25.8 % $ 579 $ 431 $ 148 34.3 % Operating margin 8.8 % 8.0 % 8.6 % 7.7 % Segment and Corporate Results Three Months Ended Nine Months Ended Defense Solutions October 1, 2021 October 2, 2020 Dollar change Percent change October 1, 2021 October 2, 2020 Dollar change Percent change (dollars in millions) Revenues $ 2,009 $ 1,951 $ 58 3.0 % $ 5,971 $ 5,413 $ 558 10.3 % Operating income 140 145 (5) (3.4) % 429 359 70 19.5 % Operating margin 7.0 % 7.4 % 7.2 % 6.6 % The increase in revenues for the three months ended October 1, 2021, as compared to the three months ended October 2, 2020, was primarily attributable to program wins and $47 million of revenues from the acquisitions of Gibbs & Cox and 1901 Group, partially offset by the completion of contracts and a net decrease in volumes on certain programs. The increase in revenues for the nine months ended October 1, 2021, as compared to the nine months ended October 2, 2020, was primarily attributable to program wins, a net increase in volumes on certain programs and $97 million of revenues from the acquisitions of Gibbs & Cox and 1901 Group, partially offset by the completion of certain contracts. In addition, for the nine months ended October 1, 2021, there was a $66 million benefit in exchange rate movements. The decrease in operating income for the three months ended October 1, 2021, as compared to the three months ended October 2, 2020, was primarily attributable to a net decrease in volumes on certain programs and the completion of certain contracts, partially offset by program wins. The increase in operating income for the nine months ended October 1, 2021, as compared to the nine months ended October 2, 2020, was primarily due to program wins, a net increase in program volumes on certain contracts and the acquisitions of Gibbs & Cox and 1901 Group, partially offset by the completion of certain contracts. Three Months Ended Nine Months Ended Civil October 1, 2021 October 2, 2020 Dollar change Percent change October 1, 2021 October 2, 2020 Dollar change Percent change (dollars in millions) Revenues $ 792 $ 771 $ 21 2.7 % $ 2,357 $ 2,183 $ 174 8.0 % Operating income 58 54 4 7.4 % 187 191 (4) (2.1) % Operating margin 7.3 % 7.0 % 7.9 % 8.7 % 26 Table of Contents LEIDOS HOLDINGS, INC. The increase in revenues for the three months ended October 1, 2021, as compared to the three months ended October 2, 2020, was primarily attributable to program wins and a reduction of the negative impacts from COVID-19 experienced during the prior year quarter, partially offset by a net decrease in program volumes. The increase in revenues for the nine months ended October 1, 2021, as compared to the nine months ended October 2, 2020, was primarily attributable to a net increase of $62 million of revenues related to L3 Harris Technologies' security and detection businesses (the "SD&A Businesses") acquired in the prior year, a net increase in program volumes, program wins and a reduction of the negative impacts from COVID-19 experienced during the prior year. The increase in operating income for the three months ended October 1, 2021, as compared to the three months ended October 2, 2020, was primarily due to improved performance on certain programs and lower amortization of intangible assets related to the acquisition of the SD&A Businesses, partially offset by fewer product deliveries on certain programs. The decrease in operating income for the nine months ended October 1, 2021, as compared to the nine months ended October 2, 2020, was primarily attributable to a net decrease in volumes due to the timing of product deliveries on certain programs, partially offset by a $26 million benefit from an adjustment to legal reserves related to the Mission Support Alliance joint venture during the first quarter of fiscal 2021. Three Months Ended Nine Months Ended Health October 1, 2021 October 2, 2020 Dollar change Percent change October 1, 2021 October 2, 2020 Dollar change Percent change (dollars in millions) Revenues $ 682 $ 520 $ 162 31.2 % $ 1,918 $ 1,449 $ 469 32.4 % Operating income 130 75 55 73.3 % 339 149 190 127.5 % Operating margin 19.1 % 14.4 % 17.7 % 10.3 % The increase in revenues for the three months ended October 1, 2021, as compared to the three months ended October 2, 2020, was primarily attributable to a net increase in volumes on certain programs and program wins. The increase in revenues for the nine months ended October 1, 2021, as compared to the nine months ended October 2, 2020, was primarily attributable to a net increase in volumes on certain programs, program wins and an approximately $96 million reduction of the negative impacts of COVID-19 experienced during the prior year, partially offset by the completion of certain contracts. The increase in operating income for the three months ended October 1, 2021, as compared to the three months ended October 2, 2020, was primarily due to increased volume on fixed unit price programs. The increase in operating income for the nine months ended October 1, 2021, as compared to the nine months ended October 2, 2020, was primarily attributable to a net increase in volumes on higher margin programs, an approximately $63 million reduction of the negative impacts of COVID-19 experienced in the prior year and a net decrease in asset impairment charges of $8 million. Three Months Ended Nine Months Ended Corporate October 1, 2021 October 2, 2020 Dollar change Percent change October 1, 2021 October 2, 2020 Dollar change Percent change (dollars in millions) Operating (loss) income $ (23) $ (16) $ (7) 43.8 % $ (73) $ — $ (73) NM NM - Not Meaningful The increase in operating loss for the nine months ended October 1, 2021, as compared to the nine months ended October 2, 2020, was primarily attributable to an $81 million net gain recognized during the second quarter of fiscal 2020 upon receipt of proceeds related to the VirnetX, Inc. legal matter and a decrease in acquisition and integration costs. 27 Table of Contents LEIDOS HOLDINGS, INC. Non-Operating Expense, net Non-operating expense, net for the three months ended October 1, 2021 was $45 million, consistent with the three months ended October 2, 2020 of $44 million. Non-operating expense, net for the nine months ended October 1, 2021 was $137 million as compared to $163 million for the nine months ended October 2, 2020. The change was primarily due to $31 million of debt discount and deferred financing costs written off related to refinancing activities in the prior year. Provision for Income Taxes For the three months ended October 1, 2021, our effective tax rate was 20.0% compared to 23.8% for the three months ended October 2, 2020. The decrease in the effective tax rate was primarily due to a decrease in foreign taxes and an increase in research tax credits. For the nine months ended October 1, 2021, our effective tax rate was 21.7% compared to 19.4% for the nine months ended October 2, 2020. The increase in the effective tax rate was primarily due to a net decrease in benefits related to employee stock-based payments. Beginning in 2022, the Tax Cuts and Jobs Act of 2017 eliminates the option to currently deduct research and development costs for tax purposes and requires taxpayers to amortize domestic and foreign research costs over five years and 15 years, respectively. The House Ways and Means Committee has proposed tax legislation to delay the effective date of this change to 2026, but it is uncertain whether the proposed delay will ultimately be enacted into law. If the 2022 effective date remains in place, our initial assessment is our cash from operations would materially decrease in 2022 and our net deferred tax assets would increase by a similar amount. We are currently evaluating the potential impact on our cash flows from operations. Bookings and Backlog We recorded net bookings worth an estimated $4.7 billion and $12.3 billion during the three and nine months ended October 1, 2021, as compared to $4.3 billion and $14.5 billion for the three and nine months ended October 2, 2020. The estimated value of our total backlog was as follows: October 1, 2021 October 2, 2020 Segment Funded Unfunded Total Funded Unfunded Total (in millions) Defense Solutions $ 4,412 $ 15,160 $ 19,572 $ 4,115 $ 13,746 $ 17,861 Civil 1,713 7,702 9,415 1,521 7,028 8,549 Health 1,164 4,541 5,705 1,208 4,101 5,309 Total $ 7,289 $ 27,403 $ 34,692 $ 6,844 $ 24,875 $ 31,719 The increase in backlog includes $757 million of backlog acquired through business combinations in our Defense Solutions reportable segment. Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts, both funded and unfunded. Backlog does not include unexercised option periods and future potential task orders expected to be awarded under indefinite delivery/indefinite quantity ("IDIQ") contracts, General Services Administration Schedule or other master agreement contract vehicles, with the exception of certain IDIQ contracts where task orders are not competitively awarded and separately priced but instead are used as a funding mechanism, and where there is a basis for estimating future revenues and funding on future anticipated task orders. Total backlog at October 1, 2021 included a positive impact of $103 million when compared to total backlog at October 2, 2020, primarily due to the exchange rate movement in the British pound when compared to the U.S. dollar. Backlog estimates are subject to change and may be affected by factors including modifications of contracts and foreign currency movements. 28 Table of Contents LEIDOS HOLDINGS, INC. Liquidity and Capital Resources Overview As of October 1, 2021, we had $587 million in cash and cash equivalents. Additionally, we have an unsecured revolving credit facility which can provide up to $750 million in additional borrowing, if required. As of October 1, 2021, there were no borrowings outstanding under the revolving credit facility and we were in compliance with the related financial covenants. At October 1, 2021, and January 1, 2021, we had outstanding debt of $5.1 billion and $4.7 billion, respectively. On May 7, 2021, we entered into a Credit Agreement which provided for a senior unsecured term loan facility in an aggregate principal amount of $380 million. We made principal payments on our long-term debt of $27 million and $80 million during the three and nine months ended October 1, 2021, respectively, and $477 million and $705 million during the three and nine months ended October 2, 2020, respectively. This activity included required principal payments on our term loans of $24 million and $72 million during the three and nine months ended October 1, 2021, and $24 million and $48 million during the three and nine months ended October 2, 2020. During the nine months ended October 2, 2020, we made additional payments of $3,975 million, related to our refinancing activities. On September 1, 2020, we retired our $450 million senior unsecured notes due December 2020. The senior unsecured term loans and notes contain financial covenants and customary restrictive covenants. We were in compliance with all covenants as of October 1, 2021. On July 12, 2021, Leidos, Inc. established a commercial paper program in which we may issue short-term unsecured commercial paper notes not to exceed $750 million and have maturities of up to 397 days from the date of issuance (see "Note 6–Debt" ). As of October 1, 2021, we did not have any Commercial Paper Notes outstanding. We paid dividends of $51 million and $149 million during the three and nine months ended October 1, 2021, respectively, and $49 million and $148 million during the three and nine months ended October 2, 2020, respectively. During the nine months ended October 1, 2021, we sold $693 million of accounts receivable under accounts receivable purchase agreements. There were no sales of accounts receivable during the thee months ended October 1, 2021. During the three and nine months ended October 2, 2020, we sold $753 million and $1,866 million of accounts receivable under accounts receivable purchase agreements and received proceeds of $752 million and $1,864 million, respectively. Stock repurchases of Leidos common stock may be made on the open market or in privately negotiated transactions with third parties including through accelerated share repurchase agreements. Whether repurchases are made and the timing and actual number of shares repurchased depends on a variety of factors including price, corporate capital requirements, other market conditions and regulatory requirements. The repurchase program may be accelerated, suspended, delayed or discontinued at any time. During the three and nine months ended October 1, 2021, we made open market repurchases of our common stock, under the Company's share repurchase program, for an aggregate purchase price of $137 million and $237 million, respectively. The proposed legislation changes to the Tax Cuts and Jobs Act of 2017 and the potential for COVID-19 to affect the financial markets may impact our liquidity. We will continue to assess our liquidity needs as the proposed tax legislation changes and pandemic evolve. For the next 12 months, we anticipate that we will be able to meet our liquidity needs, including servicing our debt, through cash generated from operations, available cash balances, sales of accounts receivable and, if needed, borrowings under our revolving credit facility and commercial paper program. 29 Table of Contents LEIDOS HOLDINGS, INC. Summary of Cash Flows The following table summarizes cash flow information for the periods presented: Three Months Ended Nine Months Ended October 1, 2021 October 2, 2020 October 1, 2021 October 2, 2020 (in millions) Net cash provided by operating activities $ 565 $ 592 $ 821 $ 1,386 Net cash used in investing activities (53) (15) (693) (2,714) Net cash (used in) provided by financing activities (209) (517) (44) 1,353 Net increase in cash, cash equivalents and restricted cash $ 303 $ 60 $ 84 $ 25 Net cash provided by operating activities decreased $27 million for the three months ended October 1, 2021, when compared to the prior year quarter. The decrease was primarily due to the $92 million deferral of employer payroll taxes in the prior year and the timing of customer advance payments, partially offset by lower income tax payments of $34 million and other favorable working capital changes. Net cash provided by operating activities decreased $565 million for the nine months ended October 1, 2021, when compared to the prior year. The decrease was primarily due to lower sales of accounts receivable outstanding of $232 million, $92 million of deferral of employer payroll taxes in the prior year, higher income tax payments of $69 million, the receipt of $85 million of proceeds related to the VirnetX legal matter in the prior year and the timing of customer advance payments. Net cash used in investing activities increased $38 million for the three months ended October 1, 2021, when compared to the prior year quarter primarily due to an additional inconsequential acquisition made during the current quarter (see "Note 3–Acquisitions, Goodwill and Intangible Assets"). Net cash used in investing activities decreased $2,021 million for the nine months ended October 1, 2021, when compared to the prior year, primarily due to larger acquisitions made in the prior year for Dynetics and the SD&A Businesses compared to our material current year acquisitions, 1901 Group and Gibbs & Cox (see "Note 3–Acquisitions, Goodwill and Intangible Assets") and lower capital expenditures in the current year. Net cash used in financing activities decreased $308 million for the three months ended October 1, 2021 when compared to the prior year quarter. The change was primarily due to the early repayment to retire our $450 million senior unsecured notes in the prior year quarter, partially offset by $137 million of open market stock repurchases in the current year quarter. Net cash used in financing activities increased $1,397 million for the nine months ended October 1, 2021, when compared to the prior year. The change was primarily due to a decrease of approximately $1,206 million from the net change of proceeds received from the issuance of debt, principal payments and payments for debt issuance costs and by $237 million of open market stock repurchases in the current year, partially offset by a net $34 million increase in capital contributions received from our non-controlling interest. Off-Balance Sheet Arrangements We have outstanding performance guarantees and cross-indemnity agreements in connection with certain aspects of our business. We also have letters of credit outstanding principally related to performance guarantees on contracts and surety bonds outstanding principally related to performance and subcontractor payment bonds as described in "Note 10–Commitments and Contingencies" of the notes to the condensed consolidated financial statements contained within this Quarterly Report on Form 10-Q. These arrangements have not had, and management does not believe it is likely that they will in the future have, a material effect on our liquidity, capital resources, operations or financial condition. 30 Table of Contents LEIDOS HOLDINGS, INC. Guarantor and Issuer of Guaranteed Securities Leidos Holdings, Inc. has fully and unconditionally guaranteed the obligations of its subsidiary, Leidos, Inc., under its $500 million notes due May 2023, $500 million notes due May 2025, $750 million due May 2030 and $1,000 million notes due February 2031 (collectively, "the Notes"). The underlying subsidiaries of Leidos, Inc. do not guarantee these obligations and have been excluded from the financial information presented below. We have entered into registration rights agreements, pursuant to which we agreed to use reasonable best efforts to file registration statements to permit the exchange of the Notes and related guarantees for registered notes having terms substantially identical thereto, or in the alternative, the registered resale of the Notes and related guarantees under certain circumstances. Pursuant to these registration rights agreements, we filed a Registration Statement on Form S-4 with the Securities and Exchange Commission on May 6, 2021, which was declared effective on May 19, 2021. The summarized balance sheet for Leidos Holdings, Inc. and Leidos, Inc., net of eliminations, as of October 1, 2021 was as follows (in millions): Balance Sheet Total current assets $ 2,050 Goodwill 4,142 Investments in consolidated subsidiaries 4,912 Other long-term assets 1,414 Total assets $ 12,518 Total current liabilities $ 2,496 Long-term debt, net of current portion 4,614 Intercompany payables 1,451 Other long-term liabilities 899 Total liabilities 9,460 Total equity 3,058 Total liabilities and stockholders' equity $ 12,518 The summarized statements of income for Leidos Holdings, Inc. and Leidos, Inc., net of eliminations, for the three and nine months ended October 1, 2021 were as follows (in millions): Statements of Income Three Months Ended Nine Months Ended Revenues, net $ 2,369 $ 6,885 Operating income 171 517 Net income attributable to Leidos common stockholders 74 218 Contractual Obligations and Commitments We are subject to a number of reviews, investigations, claims, lawsuits, other uncertainties and future obligations related to our business. For a discussion of these items, see "Note 10–Commitments and Contingencies" of the notes to the condensed consolidated financial statements contained within this Quarterly Report on Form 10-Q. Critical Accounting Policies There were no material changes to our critical accounting policies, estimates or judgments during the period covered by this report from those discussed in our Annual Report on Form 10-K for the year ended January 1, 2021 except for the elimination of the Income Taxes critical accounting policy. 31 Table of Contents LEIDOS HOLDINGS, INC. Recently Adopted and Issued Accounting Standards For a discussion of these items, see "Note 1–Basis of Presentation and Summary of Significant Accounting Policies" of the notes to the condensed consolidated financial statements contained within this Quarterly Report on Form 10-Q. Item 3. Quantitative and Qualitative Disclosures About Market Risk. There were no material changes in our market risk exposure from those discussed in our Annual Report on Form 10-K for the year ended January 1, 2021.