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 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 the three and six months ended June 30, 2023, we generated approximately 85% and 86%, respectively, of total revenues from contracts with the U.S. government, as compared to 86% during both of the three and six months ended July 1, 2022. 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 is currently working on the 12 appropriations bills that will fund the federal government in government fiscal year ("GFY") 2024. The bills must presumably be within the agreed upon spending caps set by the debt ceiling bill that was signed by President Biden on June 3, 2023. For GFY 2024, the total federal discretionary spending request is $1.59 trillion with $886 billion for defense spending and $703 billion for non-defense discretionary spending programs. Failure to pass the appropriations bills or a continuing resolution by September 30, 2023, results in a partial or complete federal government shutdown. International Markets Sales to customers in international markets represented approximately 9% of total revenues for both the three and six months ended June 30, 2023, as compared to 8% of total revenues for both 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. 24 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 Six Months Ended June 30, 2023 July 1, 2022 Dollar change Percent change June 30, 2023 July 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 3,838 $ 3,597 $ 241 6.7 % $ 7,537 $ 7,091 $ 446 6.3 % Operating income 331 271 60 22.1 % 596 542 54 10.0 % Non-operating expense, net (57) (46) (11) 23.9 % (115) (95) (20) 21.1 % Income before income taxes 274 225 49 21.8 % 481 447 34 7.6 % Income tax expense (64) (53) (11) 20.8 % (107) (98) (9) 9.2 % Net income $ 210 $ 172 $ 38 22.1 % $ 374 $ 349 $ 25 7.2 % Net income attributable to Leidos common stockholders $ 207 $ 171 $ 36 21.1 % $ 369 $ 346 $ 23 6.6 % Operating margin 8.6 % 7.5 % 7.9 % 7.6 % Segment and Corporate Results Three Months Ended Six Months Ended Defense Solutions June 30, 2023 July 1, 2022 Dollar change Percent change June 30, 2023 July 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 2,187 $ 2,052 $ 135 6.6 % $ 4,299 $ 4,101 $ 198 4.8 % Operating income 175 139 36 25.9 % 322 272 50 18.4 % Operating margin 8.0 % 6.8 % 7.5 % 6.6 % The increase in revenues for the three months ended June 30, 2023, as compared to the three months ended July 1, 2022, was primarily attributable to programs wins, a net increase in volumes on certain programs and a $28 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 completion of certain contracts and a $11 million unfavorable impact from exchange rate movements. The increase in revenues for the six months ended June 30, 2023, as compared to the six months ended July 1, 2022, was primarily attributable to program wins, a net increase in volumes on certain programs, net write-ups and a $58 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 completion of certain contracts and a $33 million unfavorable impact from exchange rate movements. The increase in operating income for the three months ended June 30, 2023, as compared to the three months ended July 1, 2022, was primarily attributable to program wins and a net increase in volumes on certain programs, partially offset by the completion of certain contracts. The increase in operating income for the six months ended June 30, 2023, as compared to the six months ended July 1, 2022, was primarily attributable to program wins, net write-ups and a net increase in volumes on certain programs. The increase was partially offset by the completion of certain contracts. Three Months Ended Six Months Ended Civil June 30, 2023 July 1, 2022 Dollar change Percent change June 30, 2023 July 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 902 $ 857 $ 45 5.3 % $ 1,779 $ 1,652 $ 127 7.7 % Operating income 64 38 26 68.4 % 104 81 23 28.4 % Operating margin 7.1 % 4.4 % 5.8 % 4.9 % 25 Table of Contents LEIDOS HOLDINGS, INC. The increase in revenues for the three and six months ended June 30, 2023, as compared to the three and six months ended July 1, 2022, were primarily attributable to a net increase in program volumes on certain programs and programs wins, partially offset by the completion of certain contracts. The increase in operating income for the three and six months ended June 30, 2023, as compared to the three and six months ended July 1, 2022, were primarily driven by a net increase in program volumes on certain programs and $17 million and $19 million in legal reserves and fees, respectively, resulting from an adverse arbitration ruling related to the 2016 acquisition of the Information Systems & Global Solutions business from Lockheed Martin in the prior year periods. Three Months Ended Six Months Ended Health June 30, 2023 July 1, 2022 Dollar change Percent change June 30, 2023 July 1, 2022 Dollar change Percent change (dollars in millions) Revenues $ 749 $ 688 $ 61 8.9 % $ 1,459 $ 1,338 $ 121 9.0 % Operating income 122 126 (4) (3.2) % 229 244 (15) (6.1) % Operating margin 16.3 % 18.3 % 15.7 % 18.2 % The increase in revenues for the three months ended June 30, 2023, as compared to the three months ended July 1, 2022, was primarily attributable to a net increase in volumes on certain programs, program wins and net write-ups, partially offset by the completion of certain contracts. The three months ended July 1, 2022, included $28 million in recoveries related to stop work orders on certain programs as a result of COVID-19. The increase in revenues for the six months ended June 30, 2023, as compared to the six months ended July 1, 2022, was primarily attributable to a net increase in volumes on certain programs and program wins. The increase was partially offset by the completion of certain contracts, higher volume of net write-ups in the prior year and $28 million in recoveries in the prior year related to stop work orders on certain programs as a result of COVID-19. The decrease in operating income for the three months ended June 30, 2023, as compared to the three months ended July 1, 2022, was primarily attributable to $28 million in recoveries related to stop work orders on certain programs as a result of COVID-19 in the prior year quarter, partially offset by net write-ups on certain programs and program wins. The decrease in operating income for the six months ended June 30, 2023, as compared to the six months ended July 1, 2022, was primarily attributable to $28 million in recoveries related to stop work orders on certain programs as a result of COVID-19 in the prior year, higher volume of net write-ups in the prior year and increased labor costs, partially offset by programs wins. Three Months Ended Six Months Ended Corporate June 30, 2023 July 1, 2022 Dollar change Percent change June 30, 2023 July 1, 2022 Dollar change Percent change (dollars in millions) Operating loss $ (30) $ (32) $ 2 (6.3) % $ (59) $ (55) $ (4) 7.3 % The decrease in operating loss for the three months ended June 30, 2023, as compared to the three months ended July 1, 2022, was primarily attributable to reduced foreign payroll tax reserves in the current period. The increase in operating loss for the six months ended June 30, 2023, as compared to the six months ended July 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. The increase was partially offset by reduced foreign payroll tax reserves in the current year. 26 Table of Contents LEIDOS HOLDINGS, INC. Non-Operating Expense, net Non-operating expense, net for the three months ended June 30, 2023, was $57 million as compared to $46 million for the three months ended July 1, 2022. Non-operating expense, net for the six months ended June 30, 2023, was $115 million as compared to $95 million for the six months ended July 1, 2022. The increases in non-operating expense for both periods 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 June 30, 2023, our effective tax rate was 23.4% compared to 23.6% for the three months ended July 1, 2022. The decrease to the effective tax rate was primarily due to a decrease in underpayment penalties, offset by a decrease in excess tax benefits related to stock-based payment transactions and an increase in unrecognized tax benefits. For the six months ended June 30, 2023, our effective tax rate was 22.2% compared to 21.9% for the six months ended July 1, 2022. The increase to the effective tax rate was primarily due to a decrease in excess tax benefits related to stock-based payment transactions offset by a decrease in underpayment penalties. 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 $110 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. Bookings and Backlog We recorded net bookings worth an estimated $2.9 billion and $5.9 billion during the three and six months ended June 30, 2023, as compared to $2.2 billion and $7.6 billion for the three and six months ended July 1, 2022. The estimated value of our total backlog was as follows: June 30, 2023 July 1, 2022 Segment Funded Unfunded Total Funded Unfunded Total (in millions) Defense Solutions $ 4,904 $ 13,500 $ 18,404 $ 4,351 $ 13,668 $ 18,019 Civil 2,134 7,710 9,844 2,051 8,846 10,897 Health 1,233 4,671 5,904 1,139 4,667 5,806 Total $ 8,271 $ 25,881 $ 34,152 $ 7,541 $ 27,181 $ 34,722 Total backlog as of June 30, 2023, as compared to July 1, 2022, included $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. Backlog estimates are subject to change and may be affected by factors including modifications of contracts and foreign currency movements. 27 Table of Contents LEIDOS HOLDINGS, INC. Liquidity and Capital Resources Overview As of June 30, 2023, we had $329 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 June 30, 2023, there were no borrowings outstanding under the revolving credit facility. We had outstanding debt of $4.9 billion at both June 30, 2023, and December 30, 2022. 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 June 30, 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%. At June 30, 2023, the applicable margin for SOFR-denominated borrowings was 1.25%. We have a commercial paper program in which we may issue short-term unsecured commercial paper notes and have maturities of up to 397 days from the date of issuance. On May 26, 2023, we increased the size of the commercial paper program by $250 million, or not to exceed $1.0 billion. As of June 30, 2023, we had $200 million Commercial Paper Notes outstanding. We made principal payments on our debt of $325 million and $2,036 million during the three and six months ended June 30, 2023, respectively, and $407 million and $434 million during the three and six months ended July 1, 2022, respectively. This activity included a required principal repayment of $320 million to discharge the 364-day term loan credit agreement ("Term Loan Agreement") for the three months ended June 30, 2023, as compared to required principal payments on our term loans of $404 million for the three months ended July 1, 2022. The activity for the six months ended June 30, 2023, included a $1,210 million payment to discharge the existing Term Loan Facility, a $498 million payment to discharge the $500 million 2.95% notes, due May 2023, and a principal repayment of $320 million to discharge the Term Loan Agreement, as compared to $428 million required principal payments on our Term Loan Facility for the six months ended July 1, 2022. Our credit facilities, commercial paper notes, senior unsecured term loans and notes outstanding as of June 30, 2023, contain financial covenants and customary restrictive covenants. We were in compliance with all covenants as of June 30, 2023. During the three months ended June 30, 2023, we modified our interest rate swap agreements to reference SOFR prior to the discontinuation of LIBOR. Under the revised interest rate swap agreement, we will receive monthly variable interest payments based on the one-month SOFR rate and we will continue to pay interest at a fixed rate. Under the ASC 848 relief, we will continue to apply hedge accounting for the interest rate swap arrangement. We paid dividends of $50 million and $100 million during the three and six months ended June 30, 2023, respectively, and $49 million and $100 million during the three and six months ended July 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 six months ended June 30, 2023, we made open market repurchases of our common stock for aggregate purchase price of $25 million. No share repurchases were made during the three months ended June 30, 2023. 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 approximately $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. 28 Table of Contents LEIDOS HOLDINGS, INC. 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. Summary of Cash Flows The following table summarizes cash flow information for the periods presented: Three Months Ended Six Months Ended June 30, 2023 July 1, 2022 June 30, 2023 July 1, 2022 (in millions) Net cash provided by operating activities (1) $ 164 $ 45 $ 66 $ 138 Net cash used in investing activities (44) (8) (83) (29) Net cash (used in) provided by financing activities (164) 6 (221) (513) (1) Net cash provided by operating activities during the three and six months ended July 1, 2022, were recast to present the effect of foreign exchange rate changes on cash, cash equivalents and restricted cash as a separate line in the condensed consolidated statements of cash flows. Net cash provided by operating activities increased $119 million during the three months ended June 30, 2023, when compared to the prior year quarter. The changes were primarily due to strong collections on trade accounts receivable and favorable timing of customer advance payments, partially offset by higher tax payments. Net cash provided by operating activities decreased $72 million during the six months ended June 30, 2023, when compared to the prior year. The changes were primarily due to higher tax payments of $152 million mainly in connection to the TCJA provision and a $62 million payment for payroll taxes related to the CARES Act, partially offset by strong collections on trade accounts receivable and favorable timing of customer advance payments. Net cash used in investing activities increased $36 million and $54 million, respectively, for the three and six months ended June 30, 2023, when compared to the prior year periods, primarily due to higher capital expenditures of $19 million and $30 million, respectively, and proceeds received from the sale of Aviation & Missile Solutions LLC in the prior year periods. Net cash used in financing activities increased $170 million for the three months ended June 30, 2023, when compared to the prior year quarter primarily due to a decrease of $173 million in net proceeds received from debt activities. Net cash used in financing activities decreased $292 million for the six months ended June 30, 2023, when compared to the prior year primarily due to a net decrease of $485 million used in stock repurchases primarily attributable to the accelerated share repurchase activities from prior year, partially offset by a decrease of $189 million in net proceeds received from debt activities. 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. 29 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 June 30, 2023 December 30, 2022 (in millions) Total current assets $ 2,017 $ 2,115 Goodwill 5,811 5,810 Other long-term assets 1,283 1,188 Total assets $ 9,111 $ 9,113 Total current liabilities $ 1,992 $ 2,922 Long-term debt, net of current portion 4,669 3,925 Intercompany payables 2,037 1,695 Other long-term liabilities 624 699 Total liabilities $ 9,322 $ 9,241 30 Table of Contents LEIDOS HOLDINGS, INC. Statements of Income Information for the Guarantor and Issuer of Registered Notes Six Months Ended June 30, 2023 (in millions) Revenues, net $ 5,125 Operating income 382 Net income attributable to Leidos common stockholders 117 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. 31 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.