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, interest rates and uncertainties in tax due to new tax legislation or other regulatory developments. 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 ® technology, engineering, and science 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, foreign government agencies and commercial businesses. 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 The COVID-19 pandemic is affecting major economic and financial markets, and effectively all industries and governments are facing challenges, which has resulted in a period of business disruption, the length and severity of which cannot be predicted. The pandemic has resulted in travel restrictions, government orders to “shelter-in-place”, quarantine restrictions and disruption of the financial markets. We have acted to protect the health and safety of our employees, comply with workplace health and safety regulations and work with our customers to minimize disruptions. For the three months ended April 1, 2022, the COVID-19 pandemic 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. On September 9, 2021, President Biden issued a series of executive orders to combat COVID-19, one of which requires us, as a federal contractor, to have our employees fully vaccinated unless the employee is legally entitled to a religious or medical exemption. This vaccine mandate is currently under a nationwide injunction, while courts adjudicate constitutional challenges to the executive order. We are prepared to comply with the executive order in the event the injunction is lifted. Business Environment and Trends U.S. Government Markets During the three months ended April 1, 2022, we generated approximately 87% 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. 21 Table of Contents LEIDOS HOLDINGS, INC. On March 15, 2022, President Biden signed the 2022 Consolidated Appropriations Act into law, funding the federal government through the remainder of GFY 2022. The Consolidated Appropriations Act includes $782 billion in defense spending and $730 billion in non-defense spending. The legislation also includes the 2022 Ukraine Supplemental Appropriations Act, which provides $14 billion in humanitarian and military aid for Ukraine. On March 28, 2022, Congress received the GFY 2023 President’s Budget Request totaling $5.8 trillion. The request includes $813 billion in defense spending and $769 billion in non-defense spending for GFY 2023 beginning on October 1, 2022. International Markets Sales to customers in international markets represented approximately 8% of total revenues for the three months ended April 1, 2022. 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. Results of Operations The following table summarizes our condensed consolidated results of operations for the periods presented: Three Months Ended April 1, 2022 April 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 3,494 $ 3,315 $ 179 5.4 % Operating income 271 308 (37) (12.0) % Non-operating expense, net (49) (46) (3) 6.5 % Income before income taxes 222 262 (40) (15.3) % Income tax expense (45) (57) 12 (21.1) % Net income $ 177 $ 205 $ (28) Net income attributable to Leidos common stockholders $ 175 $ 205 $ (30) (14.6) % Operating margin 7.8 % 9.3 % Segment and Corporate Results Three Months Ended Defense Solutions April 1, 2022 April 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 2,049 $ 1,958 $ 91 4.6 % Operating income 133 152 (19) (12.5) % Operating margin 6.5 % 7.8 % The increase in revenues for the three months ended April 1, 2022, as compared to the three months ended April 2, 2021, was primarily attributable to program wins and $27 million of revenues from the Gibbs & Cox acquisition. This was partially offset by the completion of contracts, a net decrease in volumes on certain programs, $11 million related to unfavorable exchange rate movements and contracts that were reassigned from the Defense Solutions reportable segment to the Civil reportable segment during the third quarter of fiscal 2021. The decrease in operating income for the three months ended April 1, 2022, as compared to the three months ended April 2, 2021, was primarily attributable to the completion of certain contracts, net profit write-downs on certain programs, a net decrease in volumes and increased amortization expense. The decrease was partially offset by program wins. 22 Table of Contents LEIDOS HOLDINGS, INC. Three Months Ended Civil April 1, 2022 April 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 795 $ 766 $ 29 3.8 % Operating income 43 74 (31) (41.9) % Operating margin 5.4 % 9.7 % The increase in revenues for the three months ended April 1, 2022, as compared to the three months ended April 2, 2021, was primarily attributable to a net increase in program volumes and contracts that were reassigned from the Defense Solutions reportable segment to the Civil reportable segment during the third quarter of fiscal 2021. The decrease in operating income for the three months ended April 1, 2022, as compared to the three months ended April 2, 2021, was primarily due to a $26 million benefit in the prior year from an adjustment to legal reserves related to the Mission Support Alliance joint venture. Three Months Ended Health April 1, 2022 April 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 650 $ 591 $ 59 10.0 % Operating income 118 102 16 15.7 % Operating margin 18.2 % 17.3 % The increases in revenue and operating income for the three months ended April 1, 2022, as compared to the three months ended April 2, 2021, was primarily due to a net increase in volumes on higher margin programs and net profit write-ups on certain programs. Three Months Ended Corporate April 1, 2022 April 2, 2021 Dollar change Percent change (dollars in millions) Operating loss $ (23) $ (20) $ (3) 15.0 % The increase in operating loss for the three months ended April 1, 2022, as compared to the three months ended April 2, 2021, was primarily attributable to an increase in legal costs. Non-Operating Expense, net Non-operating expense, net for the three months ended April 1, 2022, was $49 million as compared to $46 million for the three months ended April 2, 2021. The increase was primarily due to higher interest expenses driven by changes in interest rates and the short-term senior unsecured term loan incurred in the second quarter of fiscal 2021 to fund the acquisition of Gibbs & Cox. Provision for Income Taxes For the three months ended April 1, 2022, our effective tax rate was 20.3% compared to 21.8% for the three months ended April 2, 2021. The decrease in the effective tax rate was primarily due to excess tax benefits related to employee stock-based payment transactions and federal research tax credits. Beginning in 2022, the Tax Cuts and Jobs Act of 2017 eliminated the option to deduct research and development costs for tax purposes and requires taxpayers to capitalize and amortize research costs over five years. Although it is possible that Congress may defer, modify, or repeal this provision, potentially with retroactive effect, we have no assurance that Congress will take any action with respect to this provision. If the 2022 effective date remains in place, based on the law as currently enacted, our initial assessment is that our cash from operations will decrease by approximately $150 million in fiscal 2022 and our net deferred tax assets will increase by a similar amount. The actual impact on fiscal 2022 cash from operations will depend on the amount of research and development costs we will incur, on whether Congress modifies or repeals this provision and on whether new guidance and interpretive rules are issued by the US Treasury, among other factors. 23 Table of Contents LEIDOS HOLDINGS, INC. Bookings and Backlog We recorded net bookings worth an estimated $5.4 billion during the three months ended April 1, 2022, as compared to $3.8 billion for the three months ended April 2, 2021. The estimated value of our total backlog was as follows: April 1, 2022 April 2, 2021 Segment Funded Unfunded Total Funded Unfunded Total (in millions) Defense Solutions $ 3,919 $ 15,068 $ 18,987 $ 4,142 $ 14,393 $ 18,535 Civil 1,812 9,516 11,328 1,531 6,857 8,388 Health 1,360 4,670 6,030 1,310 4,348 5,658 Total $ 7,091 $ 29,254 $ 36,345 $ 6,983 $ 25,598 $ 32,581 The increase in backlog includes $685 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 April 1, 2022, included a negative impact of $33 million when compared to total backlog at April 2, 2021, primarily due to the exchange rate movements in the British pound and Australian dollar 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. Liquidity and Capital Resources Overview As of April 1, 2022, we had $297 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 April 1, 2022, there were no borrowings outstanding under the revolving credit facility. We had outstanding debt of $5.1 billion at April 1, 2022, and December 31, 2021. We have 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. As of April 1, 2022, we had $75 million of Commercial Paper Notes outstanding. We made principal payments on our long-term debt of $27 million and $26 million during the three months ended April 1, 2022, and April 2, 2021, respectively. This activity included required principal payments on our term loans of $24 million for both the three months ended April 1, 2022, and April 2, 2021. Our credit facilities, the 2021 credit agreement, commercial paper notes, senior unsecured term loans and notes outstanding as of April 1, 2022, contain financial covenants and customary restrictive covenants. We were in compliance with all covenants as of April 1, 2022. Interest on our Credit Facilities is calculated based on the London Interbank Offered Rate (“LIBOR”). On July 27, 2017, the U.K.’s Financial Conduct Authority announced that LIBOR would be discontinued or become unavailable as a reference rate by the end of 2021 and LIBOR will be fully discontinued or become unavailable as a benchmark rate by June 2023. Although our Credit Facilities include mechanics to facilitate the adoption by us and our lenders of an alternative benchmark rate for use in place of LIBOR, no assurance can be made that such alternative benchmark rate will perform in a manner similar to LIBOR or result in interest rates that are at least as favorable to us as those that would have resulted had LIBOR remained in effect, which could result in an increase in our interest expense and other debt service obligations. In addition, the overall credit market may be disrupted as a result of the replacement of LIBOR or in the anticipation thereof, which could have an adverse impact on our ability to refinance, reprice, or amend our existing indebtedness or incur additional indebtedness on favorable terms. 24 Table of Contents LEIDOS HOLDINGS, INC. We paid dividends of $51 million and $50 million during the three months ended April 1, 2022, and April 2, 2021, respectively. During the three months ended April 1, 2022, we sold $209 million of accounts receivable under accounts receivable purchase agreements and received proceeds of $209 million. During the three months ended April 2, 2021, we sold $465 million of accounts receivable under accounts receivable purchase agreements and received proceeds of $464 million (see "Note 9–Sale of Accounts Receivable"). 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. On February 16, 2022, we entered into an Accelerated Share Repurchase ("ASR") agreement with a financial institution to repurchase shares of our outstanding common stock. We paid $500 million to the financial institution and received an initial delivery of 4.5 million shares at an average price of $88.72 per share. The specific number of shares that we will ultimately receive under the ASR agreement will be based on the volume-weighted-average-price during the period February 17, 2022, to May 16, 2022. Beginning in 2022, a provision in the Tax Cuts and Jobs Act of 2017 (“TCJA”) which eliminated the option to deduct research and development costs for tax purposes and requires taxpayers to capitalize and amortize the costs over five years became effective. Congress may defer, modify or repeal the provision, but the ultimate outcome is uncertain. The uncertainty surrounding the TCJA provision and the potential for COVID-19 to continue to affect the financial markets may impact our liquidity. If the 2022 effective date of the TCJA research cost capitalization provision remains in place, our initial assessment indicates we will have a negative impact to cash of approximately $150 million in fiscal 2022 and our net deferred tax assets will increase by a similar amount. We will continue to assess our liquidity needs as the tax legislation 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 from our revolving credit facility and commercial paper program. Summary of Cash Flows The following table summarizes cash flow information for the periods presented: Three Months Ended April 1, 2022 April 2, 2021 (in millions) Net cash provided by operating activities $ 93 $ 239 Net cash used in investing activities (21) (244) Net cash used in financing activities (519) (148) Net decrease in cash, cash equivalents and restricted cash $ (447) $ (153) Net cash provided by operating activities decreased $146 million for the three months ended April 1, 2022, when compared to the prior year quarter. The decrease was primarily due to lower sale of accounts receivable and timing of customer and vendor payments in the current quarter as compared to the prior year quarter. Net cash used in investing activities decreased $223 million for the three months ended April 1, 2022, when compared to the prior year quarter, primarily due to $214 million of net cash paid related to the acquisition of 1901 Group during the prior year quarter and proceeds received from the sale of Aviation & Missile Solutions LLC in the current quarter (see "Note 3–Acquisitions, Divestitures, Goodwill and Intangible Assets"). Net cash used in financing activities increased $371 million for the three months ended April 1, 2022, when compared to the prior year quarter. The change was primarily due to the Accelerated Share Repurchase agreement entered into by the Company on February 16, 2022, which resulted in an increase of $403 million in stock repurchases during the current quarter and $38 million in capital contributions received from our non-controlling interest in the prior year quarter, partially offset by $75 million of net proceeds from our commercial paper program in the current quarter. 25 Table of Contents LEIDOS HOLDINGS, INC. 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 11–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. 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 April 1, 2022, was as follows (in millions): Balance Sheet Total current assets $ 2,002 Goodwill 4,171 Investments in consolidated subsidiaries 4,916 Other long-term assets 1,317 Total assets $ 12,406 Total current liabilities $ 2,665 Long-term debt, net of current portion 4,568 Intercompany payables 1,487 Other long-term liabilities 720 Total liabilities 9,440 Total stockholders' equity 2,966 Total liabilities and stockholders' equity $ 12,406 The summarized statements of income for Leidos Holdings, Inc. and Leidos, Inc., net of eliminations, for the three months ended April 1, 2022, were as follows (in millions): Statements of Income Revenues, net $ 2,374 Operating income 168 Net income attributable to Leidos common stockholders 74 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 11–Commitments and Contingencies" of the notes to the condensed consolidated financial statements contained within this Quarterly Report on Form 10-Q. 26 Table of Contents LEIDOS HOLDINGS, INC. 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 December 31, 2021. 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 December 31, 2021.