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. Business Environment and Trends U.S. Government Markets During both of the three months ended March 31, 2023 and April 1, 2022, we generated approximately 87% of 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. President Biden released the annual President’s budget request for GFY 2024 on March 9, 2023. The President’s $6.9 trillion budget request includes $886.4 billion in defense spending and $809.1 billion in non-defense spending. The appropriations subcommittees in both chambers of Congress began holding budget hearings on the President’s Budget Request after its release. In addition to working on the GFY 2024 appropriations bills, the Congress is also working towards an agreement to raise or suspend the debt limit to prevent the U.S. from defaulting on its debt. International Markets Sales to customers in international markets represented approximately 8% of total revenues for both the three months ended March 31, 2023, and 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. 21 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 March 31, 2023 April 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 3,699 $ 3,494 $ 205 5.9 % Operating income 265 271 (6) (2.2) % Non-operating expense, net (58) (49) (9) 18.4 % Income before income taxes 207 222 (15) (6.8) % Income tax expense (43) (45) 2 (4.4) % Net income $ 164 $ 177 $ (13) (7.3) % Net income attributable to Leidos common stockholders $ 162 $ 175 $ (13) (7.4) % Operating margin 7.2 % 7.8 % Segment and Corporate Results Three Months Ended Defense Solutions March 31, 2023 April 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 2,112 $ 2,049 $ 63 3.1 % Operating income 147 133 14 10.5 % Operating margin 7.0 % 6.5 % The increase in revenues for the three months ended March 31, 2023, as compared to the three months ended April 1, 2022, was primarily attributable to program wins, a net increase in volumes on certain programs and a $30 million increase in revenues related to our Cobham Special Mission acquisition made in the last quarter of fiscal 2022. The increase was partially offset by the completion of certain contracts and $22 million related to unfavorable exchange rate movements. The increase in operating income for the three months ended March 31, 2023, as compared to the three months ended April 1, 2022, was primarily attributable to program wins and operating income related to our Cobham Special Mission acquisition made in the last quarter of fiscal 2022. The increase was partially offset by the completion of certain contracts. Three Months Ended Civil March 31, 2023 April 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 877 $ 795 $ 82 10.3 % Operating income 40 43 (3) (7.0) % Operating margin 4.6 % 5.4 % The increase in revenues for the three months ended March 31, 2023, as compared to the three months ended April 1, 2022, was primarily attributable to program wins and a net increase in program volumes. The decrease in operating income for the three months ended March 31, 2023, as compared to the three months ended April 1, 2022, was primarily driven by reduced volume on higher margin contracts, temporary supply chain disruptions and investment in research and development in our security products business. 22 Table of Contents LEIDOS HOLDINGS, INC. Three Months Ended Health March 31, 2023 April 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 710 $ 650 $ 60 9.2 % Operating income 107 118 (11) (9.3) % Operating margin 15.1 % 18.2 % The increase in revenues for the three months ended March 31, 2023, as compared to the three months ended April 1, 2022, was primarily attributable to program wins, a net increase in volumes on certain programs, partially offset by completion of certain contracts. The decrease in operating income for the three months ended March 31, 2023, as compared to the three months ended April 1, 2022, was primarily attributable to increased labor resulting from the ramp-up on new programs and certain disability examinations. The decrease was also attributable to non-recurring net profit write-ups on certain programs during the first quarter of fiscal 2022, partially offset with program wins. Three Months Ended Corporate March 31, 2023 April 1, 2022 Dollar change Percent change (dollars in millions) Operating loss $ (29) $ (23) $ (6) 26.1 % The increase in operating loss for the three months ended March 31, 2023, as compared to the three months ended April 1, 2022, was primarily attributable to increased administrative costs and transaction fees in connection with the issuance of the senior unsecured notes and Credit Agreement entered into during the first quarter of fiscal 2023, see "Note 6–Debt" for further information. Non-Operating Expense, net Non-operating expense, net for the three months ended March 31, 2023, was $58 million as compared to $49 million for the three months ended April 1, 2022. The increase was primarily due to higher net interest expense driven by increased interest rates and refinancing activities, and unfavorable exchange rate movements. Provision for Income Taxes For the three months ended March 31, 2023, our effective tax rate was 20.8% compared to 20.3% for the three months ended April 1, 2022. The increase to the effective tax rate was primarily due to a decrease in excess tax benefits related to employee stock-based payment transactions, partially offset by a decrease in unrecognized tax benefits and taxes related to foreign operations. 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. Based upon our interpretation of the law as currently enacted, we estimate that the fiscal 2023 impact will result in increases of $112 million to both our income taxes payable and net deferred tax assets. We also estimate an increase to our unrecognized tax benefits of $75 million with a corresponding increase to net deferred tax assets. The actual impact 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. 23 Table of Contents LEIDOS HOLDINGS, INC. Bookings and Backlog We recorded net bookings worth an estimated $3.0 billion during the three months ended March 31, 2023, as compared to $5.4 billion for the three months ended April 1, 2022. The estimated value of our total backlog was as follows: March 31, 2023 April 1, 2022 Segment Funded Unfunded Total Funded Unfunded Total (in millions) Defense Solutions $ 4,811 $ 13,936 $ 18,747 $ 3,919 $ 15,068 $ 18,987 Civil 1,944 8,330 10,274 1,812 9,516 11,328 Health 1,548 4,517 6,065 1,360 4,670 6,030 Total $ 8,303 $ 26,783 $ 35,086 $ 7,091 $ 29,254 $ 36,345 Total backlog as of March 31, 2023, as compared to April 1, 2022, includes $610 million of backlog acquired through a business combination 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 March 31, 2023, included a positive impact of $30 million when compared to total backlog at April 1, 2022, 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 March 31, 2023, we had $379 million in cash and cash equivalents. In March 2023, we entered into a senior unsecured revolving credit facility which can provide up to $1 billion in additional borrowing, if required. This new credit facility replaced the previous senior unsecured revolving credit facility. As of March 31, 2023, there were no borrowings outstanding under the revolving credit facility. We had outstanding debt of $5.0 billion and $4.9 billion at March 31, 2023, and December 30, 2022, respectively. In February 2023, we entered into $750 million 5.75% fixed-rate senior notes. The annual interest rate is payable on a semi-annual basis. In March 2023, we entered into a Credit Agreement with certain financial institutions, which provided for a senior unsecured term loan facility in an aggregate principal amount of $1.0 billion (the “Term Loan Facility”). The proceeds of the Term Loan Facility and cash on hand were used to repay in full all indebtedness, terminate all commitments and discharge all existing guarantees related to the $1.9 billion senior unsecured term loan facility and $750 million senior unsecured revolving facility, due January 2025. As of March 31, 2023, borrowings under our Credit Agreement were based on a Term Secured Overnight Financing Rate (“SOFR”) with a 0.10% Term SOFR adjustment and an applicable margin range from 1.00% to 1.50%. Borrowings under our terminated $1.9 billion senior unsecured term loan facility had an applicable London Interbank Offered Rate (“LIBOR”)-denominated margin range from 1.13% to 1.75%. At March 31, 2023, the applicable margin for SOFR-denominated borrowings was 1.25% based on our recent upgrade by Moody's credit rating, as compared to our LIBOR-denominated borrowings which had a 1.38% applicable margin at December 30, 2022. 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 March 31, 2023, we did not have any commercial paper notes outstanding. 24 Table of Contents LEIDOS HOLDINGS, INC. We made principal payments on our debt of $1,711 million and $27 million during the three months ended March 31, 2023, and April 1, 2022, respectively. Current quarter's activities include a $1,210 million payment to discharge the existing Term Loan Facility and a $498 million payment to discharge the $500 million 2.95% notes, due May 2023, as compared to $24 million required principal payments on our Term Loan Facility in the prior year quarter. Our credit facilities, term loan agreement, commercial paper notes, senior unsecured term loans and notes outstanding as of March 31, 2023, contain financial covenants and customary restrictive covenants. We were in compliance with all covenants as of March 31, 2023. 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. In December 2022, the FASB issued guidance which provides relief for entities with such LIBOR denominated credit instruments so that entities may continue to account for contract modifications as a continuation of the existing contract and the continuation of the hedge accounting arrangement through December 31, 2024. The interest rate swap agreements, which currently reference LIBOR, are expected to be modified to reference SOFR during fiscal 2023. We paid dividends of $50 million and $51 million during the three months ended March 31, 2023, and April 1, 2022, 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 months ended March 31, 2023, we made open market repurchases of our common stock for an aggregate purchase price of $25 million. Beginning in 2022, a provision in the TCJA which eliminated the option to currently deduct research and development costs for tax purposes and requires taxpayers to capitalize and amortize the costs over five years became effective. We anticipate our tax cash payments to increase by $300 million in 2023, primarily to cover both the 2022 and 2023 tax obligations related to this provision. The actual impact will depend on the amount of research and development costs the Company incurs, 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 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, borrowings from our commercial paper program and, if needed, sales of accounts receivable and borrowings from our revolving credit facility. 25 Table of Contents LEIDOS HOLDINGS, INC. Summary of Cash Flows The following table summarizes cash flow information for the periods presented: Three Months Ended March 31, 2023 April 1, 2022 (in millions) Net cash (used in) provided by operating activities $ (98) $ 93 Net cash used in investing activities (39) (21) Net cash used in financing activities (57) (519) Net cash used in operating activities increased $191 million during the three months ended March 31, 2023, respectively, when compared to the prior year quarter. The changes were primarily due to higher tax payments of $127 million mainly in connection to the TCJA provision and a $62 million payment for payroll taxes related to the CARES Act. Net cash used in investing activities increased $18 million for the three months ended March 31, 2023, when compared to the prior year quarter, primarily due to higher capital expenditures in the current year and proceeds received from the sale of Aviation & Missile Solutions LLC in the prior year quarter. Net cash used in financing activities decreased $462 million for the three months ended March 31, 2023, when compared to the prior year quarter primarily due to a net decrease of $483 million used in stock repurchases primarily attributable to the accelerated share repurchase activities from prior year quarter, partially offset by a net decrease of $23 million in cash inflows from proceeds received from the issuance of debt, payments for borrowings and payments for debt issuance costs. 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 expenditures or capital resources, operations or financial condition. 26 Table of Contents LEIDOS HOLDINGS, INC. Guarantor and Issuer of Guaranteed Securities Leidos Holdings, Inc. ( “ Guarantor ” ) has fully and unconditionally guaranteed the debt securities of its subsidiary, Leidos, Inc. ( “ Issuer ” ), that were issued pursuant to transactions that were registered under the Securities Act of 1933, as amended (collectively, the “Registered Notes”). The following is a list of the Registered Notes guaranteed by Leidos Holdings, Inc. Senior unsecured Registered Notes: $500 million 3.625% notes, due May 2025 $750 million 4.375% notes, due May 2030 $1,000 million 2.300% notes, due February 2031 $750 million 5.750% notes, due May 2033 Leidos Holdings, Inc. has also fully and unconditionally guaranteed debt securities of Leidos, Inc. that were issued pursuant to transactions that were not registered under the Securities Act of 1933, as amended. The following is a list of unregistered debt securities guaranteed by Leidos Holdings, Inc. Senior unsecured unregistered debt securities issued by Leidos, Inc.: $250 million 7.125% notes, due July 2032 $300 million 5.500% notes, due July 2033 Additionally, Leidos, Inc. has fully and unconditionally guaranteed debt securities of Leidos Holding, Inc. that were issued pursuant to transactions that were not registered under the Securities Act of 1933, as amended. The following is a list of unregistered debt securities guaranteed by Leidos, Inc. Senior unsecured unregistered debt securities issued by Leidos Holdings, Inc.: $300 million 5.950% notes, due December 2040 The following summarized financial information includes the assets, liabilities and results of operations for the Guarantor and Issuer of the Registered Notes described above. Intercompany balances and transactions between the Issuer and Guarantor have been eliminated from the financial information below. Investments in the consolidated subsidiaries of the Issuer and Guarantor that do not guarantee the senior unsecured notes have been excluded from the financial information. Intercompany payables represent amounts due to non-guarantor subsidiaries of the Issuer. Balance Sheet Information for the Guarantor and Issuer of Registered Notes March 31, 2023 December 30, 2022 Total current assets $ 2,068 $ 2,115 Goodwill 5,811 5,810 Other long-term assets 1,260 1,188 Total assets $ 9,139 $ 9,113 Total current liabilities $ 2,278 $ 2,922 Long-term debt, net of current portion 4,672 3,925 Intercompany payables 1,714 1,695 Other long-term liabilities 597 699 Total liabilities $ 9,261 $ 9,241 Statements of Income Information for the Guarantor and Issuer of Registered Notes Three Months Ended March 31, 2023 Revenues, net $ 2,549 Operating income 172 Net income attributable to Leidos common stockholders 47 27 Table of Contents LEIDOS HOLDINGS, INC. 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. 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 30, 2022. 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. 28 Table of Contents LEIDOS HOLDINGS, INC. 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 30, 2022.