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. In some cases, forward-looking statements can be identified by words such as “will,” “expect,” “estimate,” “plan,” “potential,” “continue” or similar expressions. 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 and six months ended July 1, 2022, the COVID-19 pandemic did not have a material impact to revenues and operating income, other than the receipt of $28 million in recoveries for the three months ended July 1, 2022, within our Health segment related to stop work orders on certain programs. 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. 22 Table of Contents LEIDOS HOLDINGS, INC. Business Environment and Trends U.S. Government Markets During both of the three and six months ended July 1, 2022, we generated approximately 86%, 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. 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. Congress is currently working on the 12 appropriations bills that will fund the federal government in GFY 2023. Failure to pass the appropriations bills before October 1, 2022, will require a continuing resolution to avoid a federal government shut down. The length of any continuing resolution will be determined at a later date. International Markets Sales to customers in international markets represented approximately 8% of total revenues for both of the three and six months ended July 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 Six Months Ended July 1, 2022 July 2, 2021 Dollar change Percent change July 1, 2022 July 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 3,597 $ 3,448 $ 149 4.3 % $ 7,091 $ 6,763 $ 328 4.8 % Operating income 271 269 2 0.7 % 542 577 (35) (6.1) % Non-operating expense, net (46) (46) — — % (95) (92) (3) 3.3 % Income before income taxes 225 223 2 0.9 % 447 485 (38) (7.8) % Income tax expense (53) (53) — — % (98) (110) 12 (10.9) % Net income $ 172 $ 170 $ 2 1.2 % $ 349 $ 375 $ (26) (6.9) % Net income attributable to Leidos common stockholders $ 171 $ 169 $ 2 1.2 % $ 346 $ 374 $ (28) (7.5) % Operating margin 7.5 % 7.8 % 7.6 % 8.5 % Segment and Corporate Results Three Months Ended Six Months Ended Defense Solutions July 1, 2022 July 2, 2021 Dollar change Percent change July 1, 2022 July 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 2,052 $ 2,004 $ 48 2.4 % $ 4,101 $ 3,962 $ 139 3.5 % Operating income 139 137 2 1.5 % 272 289 (17) (5.9) % Operating margin 6.8 % 6.8 % 6.6 % 7.3 % The increase in revenues for the three months ended July 1, 2022, as compared to the three months ended July 2, 2021, was primarily attributable to program wins, a net increase in volumes on certain programs and a $14 million net increase in revenue related to our acquisitions made in the second and third quarter of the prior year. The increase was partially offset by the completion of certain contracts, $24 million related to unfavorable exchange rate movements and contracts that were reassigned from Defense Solutions reportable segment to the Civil reportable segment during the third quarter of fiscal 2021. 23 Table of Contents LEIDOS HOLDINGS, INC. The increase in revenues for the six months ended July 1, 2022, as compared to the six months ended July 2, 2021, was primarily attributable to a net increase in volumes on certain programs, program wins and a $47 million net increase in revenue related to our acquisitions made in the second and third quarter of the prior year. The increase was partially offset by the completion of certain contracts, $34 million related to unfavorable exchange rate movements and contracts that were reassigned from Defense Solutions reportable segment to the Civil reportable segment during the third quarter of fiscal 2021. The increase in operating income for the three months ended July 1, 2022, as compared to the three months ended July 2, 2021, was primarily attributable to program wins and a net increase in volumes on certain programs, partially offset by the completion of certain contracts and unfavorable exchange rate movements. The decrease in operating income for the six months ended July 1, 2022, as compared to the six months ended July 2, 2021, was primarily attributable to the completion of certain contracts and increased amortization expense, partially offset by program wins and a net increase in volumes on certain programs. Three Months Ended Six Months Ended Civil July 1, 2022 July 2, 2021 Dollar change Percent change July 1, 2022 July 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 857 $ 799 $ 58 7.3 % $ 1,652 $ 1,565 $ 87 5.6 % Operating income 38 55 (17) (30.9) % 81 129 (48) (37.2) % Operating margin 4.4 % 6.9 % 4.9 % 8.2 % The increase in revenues for the three and six months ended July 1, 2022, as compared to the three and six months ended July 2, 2021, was primarily attributable to a net increase in program volumes, program wins and contracts that were reassigned from Defense Solutions reportable segment to the Civil reportable segment during the third quarter of fiscal 2021. The increase was partially offset by the completion of certain contracts. The decrease in operating income for the three and six months ended July 1, 2022, as compared to the three and six months ended July 2, 2021, was primarily due to a $17 million and $19 million increase in legal reserves and fees, respectively, resulting from an adverse arbitration ruling related to the 2016 acquisition of the Information Systems & Global Solutions business (“IS&GS Business”) from Lockheed Martin, during the current year periods. Operating income for the six months ended July 2, 2021 included a $26 million benefit from a legal reserve adjustment related to the Mission Support Alliance joint venture. Three Months Ended Six Months Ended Health July 1, 2022 July 2, 2021 Dollar change Percent change July 1, 2022 July 2, 2021 Dollar change Percent change (dollars in millions) Revenues $ 688 $ 645 $ 43 6.7 % $ 1,338 $ 1,236 $ 102 8.3 % Operating income 126 107 19 17.8 % 244 209 35 16.7 % Operating margin 18.3 % 16.6 % 18.2 % 16.9 % The increase in revenues for the three and six months ended July 1, 2022, as compared to the three and six months ended July 2, 2021, was primarily attributable to a net increase in program volumes and $28 million in recoveries related to stop work orders on certain programs as a result of COVID-19. The increase was partially offset by the completion of certain contracts. The increase in operating income for the three months ended July 1, 2022, as compared to the three months ended July 2, 2021, was primarily due to $28 million in recoveries related to stop work orders on certain programs as a result of COVID-19. The increase was partially offset by the completion of certain contracts. The increase in operating income for the six months ended July 1, 2022, as compared to the six months ended July 2, 2021, was primarily due to $28 million in recoveries related to stop work orders on certain programs as a result of COVID-19 and an increase in net profit write-ups on certain programs. The increase was partially offset by the completion of certain contracts. 24 Table of Contents LEIDOS HOLDINGS, INC. Three Months Ended Six Months Ended Corporate July 1, 2022 July 2, 2021 Dollar change Percent change July 1, 2022 July 2, 2021 Dollar change Percent change (dollars in millions) Operating loss $ (32) $ (30) $ (2) 6.7 % $ (55) $ (50) $ (5) 10.0 % The increase in operating loss for the three and six months ended July 1, 2022, as compared to the three and six months ended July 2, 2021, was primarily attributable to an increase in legal costs, offset by lower acquisition and integration costs. Non-Operating Expense, net Non-operating expense, net for the three months ended July 1, 2022, was $46 million, and remained unchanged as compared to the three months ended July 2, 2021. Non-operating expense, net for the six months ended July 1, 2022, was $95 million as compared to $92 million for the six months ended July 2, 2021. The increase was primarily due to higher interest expenses driven by changes in interest rates, partially offset by exchange rate movements. Provision for Income Taxes For the three months ended July 1, 2022, our effective tax rate was 23.6% compared to 23.8% for the three months ended July 2, 2021. The decrease to the effective tax rate was primarily due to lower state taxes in current quarter offset by an increase in unrecognized tax benefits. For the six months ended July 1, 2022, the effective tax rate was 21.9% compared to 22.7% for the six months ended July 2, 2021. The decrease in the effective tax rate was primarily due to an increase in benefits related to employee stock-based compensation and an increase in research tax credits. Beginning in 2022, the Tax Cuts and Jobs Act of 2017 (“TCJA”) eliminated the option to currently deduct certain 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 income taxes payable and net deferred tax assets will each increase by approximately $150 million in fiscal 2022, and the related impact to cash from operations will be realized in fiscal 2023. The actual impact on cash from operations will depend on the amount of research and development costs the Company will incur, whether Congress modifies or repeals this provision and whether new guidance and interpretive rules are issued by the U.S. Treasury, among other factors. For the six months ended July 1, 2022, unrecognized tax benefits increased $55 million with a corresponding increase to net deferred tax assets as a result of uncertain tax positions arising from certain provisions of the TCJA becoming effective. 25 Table of Contents LEIDOS HOLDINGS, INC. Bookings and Backlog We recorded net bookings worth an estimated $2.2 billion and $7.6 billion during the three and six months ended July 1, 2022, as compared to $3.8 billion and $7.6 billion for the three and six months ended July 2, 2021. The estimated value of our total backlog was as follows: July 1, 2022 July 2, 2021 Segment Funded Unfunded Total Funded Unfunded Total (in millions) Defense Solutions $ 4,351 $ 13,668 $ 18,019 $ 4,293 $ 14,154 $ 18,447 Civil 2,051 8,846 10,897 1,608 7,493 9,101 Health 1,139 4,667 5,806 1,255 4,720 5,975 Total $ 7,541 $ 27,181 $ 34,722 $ 7,156 $ 26,367 $ 33,523 The increase in backlog includes $49 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 July 1, 2022, included a negative impact of $268 million when compared to total backlog at July 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 July 1, 2022, we had $339 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 July 1, 2022, there were no borrowings outstanding under the revolving credit facility. We had outstanding debt of $5.2 billion and $5.1 billion at July 1, 2022, and December 31, 2021, respectively. On May 6, 2022, we entered into a Term Loan Agreement which provided for a senior unsecured term loan facility in an aggregate principal amount of $380 million. 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 July 1, 2022, we had $150 million of commercial paper notes outstanding. We made principal payments on our long-term debt of $407 million and $434 million during the three and six months ended July 1, 2022, respectively, and $27 million and $53 million during the three and six months ended July 2, 2021, respectively. This activity included required principal payments on our term loans of $404 million and $428 million during the three and six months ended July 1, 2022, respectively, and $24 million and $48 million during the three and six months ended July 2, 2021, respectively. Our credit facilities, term loan agreement, commercial paper notes, senior unsecured term loans and notes outstanding as of July 1, 2022, contain financial covenants and customary restrictive covenants. We were in compliance with all covenants as of July 1, 2022. 26 Table of Contents LEIDOS HOLDINGS, INC. 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. We paid dividends of $49 million and $100 million during the three and six months ended July 1, 2022, respectively, and $48 million and $98 million during the three and six months ended July 2, 2021, respectively. During the six months ended July 1, 2022, we sold $209 million of accounts receivable under accounts receivable purchase agreements and received proceeds of $209 million. We did not sell any accounts receivable during the three months ended July 1, 2022. During the three and six months ended July 2, 2021, we sold $228 million and $693 million, respectively, of accounts receivable under accounts receivable purchase agreements and received proceeds of $229 million and $693 million, respectively (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. During the quarter ended April 1, 2022, we paid $500 million to the financial institution and received an initial delivery of 4.5 million shares. In May 2022, the financial institution elected to partially settle $125 million of the original $500 million prepayment under the ASR agreement based on the volume-weighted-average-price of $104.32 per share for the period February 17, 2022, to April 29, 2022, which resulted in an additional delivery of 0.1 million shares. Subsequently, the financial Institution elected to fully settle the remaining $375 million of the original payment under the ASR agreement based upon a volume-weighted-average-price of $104.23 per share for the period February 17, 2022, to May 5, 2022, and delivered an additional 0.2 million shares. During the third quarter of fiscal 2022, we anticipate making a $25 million payment in connection with the adverse arbitration ruling related to the 2016 acquisition of the IS&GS Business from Lockheed Martin, which occurred during the current quarter. 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 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. 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. 27 Table of Contents LEIDOS HOLDINGS, INC. Summary of Cash Flows The following table summarizes cash flow information for the periods presented: Three Months Ended Six Months Ended July 1, 2022 July 2, 2021 Dollar Change July 1, 2022 July 2, 2021 Dollar Change (in millions) Net cash provided by operating activities $ 40 $ 17 $ 23 $ 133 $ 256 $ (123) Net cash used in investing activities (8) (396) 388 (29) (640) 611 Net cash provided by (used in) financing activities 6 313 (307) (513) 165 (678) Net increase (decrease) in cash, cash equivalents and restricted cash $ 38 $ (66) $ 104 $ (409) $ (219) $ (190) Net cash provided by operating activities increased during the three months ended July 1, 2022, when compared to the prior year quarter. The change was primarily due to favorable timing of customer payments partially offset by less favorable timing of working capital changes. Net cash provided by operating activities decreased for the six months ended July 1, 2022, when compared to the prior year primarily due to unfavorable timing of customer payments, higher tax and interest payments of $22 million and less favorable timing of working capital changes in the current year. Net cash used in investing activities decreased for the three months ended July 1, 2022, when compared to the prior year quarter, primarily due to $375 million of net cash paid related to the acquisition of Gibbs & Cox from the prior year quarter. Net cash used in investing activities decreased for the six months ended July 1, 2022, when compared to the prior year primarily due to $593 million of net cash paid related to our business acquisitions in the prior year and $15 million of proceeds received from the sale of Aviation & Missile Solutions LLC in the current year. Net cash provided by financing activities decreased for the three months ended July 1, 2022, when compared to the prior year quarter primarily due to a $380 million decrease in net cash inflows related to our short-term senior unsecured term loans, partially offset by $75 million net proceeds received from our commercial paper program in the current quarter. Net cash used in financing activities increased for the six months ended July 1, 2022, when compared to the prior year. The change was primarily due to an increase of $402 million in stock repurchases primarily attributable to the Accelerated Share Repurchase agreement, a $380 million decrease in net cash inflows related to our short-term senior unsecured term loans and a $42 million decrease in net capital contributions received from our non-controlling interest, partially offset by $150 million in net proceeds received from our commercial paper program. 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 12–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 expenditures or capital resources, operations or financial condition. 28 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 July 1, 2022, was as follows (in millions): Balance Sheet Total current assets $ 2,021 Goodwill 5,811 Investments in consolidated subsidiaries 3,276 Other long-term assets 1,283 Total assets $ 12,391 Total current liabilities $ 3,075 Long-term debt, net of current portion 4,021 Intercompany payables 1,621 Other long-term liabilities 670 Total liabilities 9,387 Total stockholders' equity 3,004 Total liabilities and stockholders' equity $ 12,391 The summarized statements of income for Leidos Holdings, Inc. and Leidos, Inc., net of eliminations, for the three and six months ended July 1, 2022, were as follows (in millions): Statements of Income Three Months Ended Six Months Ended Revenues, net $ 2,402 $ 4,776 Operating income 138 306 Net income attributable to Leidos common stockholders 34 108 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 12–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 December 31, 2021. 29 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 December 31, 2021.