Leidos Holdings, Inc.
Q2 2015 Earnings Call Transcript

Published: 5 Aug 2015

[Operator:]

Good day, ladies and gentlemen, and welcome to Leidos Second Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question-and-answer session and instructions will be given at that time. As a reminder, this conference is being recorded. I would now like to hand the conference over to Kelly Hernandez, Vice President of Investor Relations. Please go ahead.

[Kelly P. Hernandez:]

Thank you, Karen, and good morning, everyone. I'd like to welcome you to our second quarter calendar year 2015 earnings conference call. Joining me today are Roger Krone, our Chairman and CEO; and Jim Reagan, our Chief Financial Officer, and other members of the Leidos management team. Today, we will discuss our results for the quarter ending July 3, 2015. Roger Krone will lead off the call with comments on the market environment and our company's strategies. Jim will follow with a discussion of our financial performance for the second quarter and our expectations for the future. After these remarks from Roger and Jim, we'll open the call for your questions. During this call, we will make references to year-over-year comparisons. Due to the previously announced change in our fiscal year, we will be comparing our just released Q2 calendar 2015 results for the quarter ended July 3, 2015 with our previously reported Q2 fiscal 2015 results, which represent the three months ending August 1, 2014. During the call, we will also make forward-looking statements to assist you in understanding the company and our expectations about future financial and operating performance. These statements are subject to a number of risks that could cause actual events to differ materially, and I refer you to our SEC filings for a discussion of these risks. In addition, statements represent our views as of today. Subsequent events and developments could cause our view to change. We may elect to update the forward-looking statements at some point in the future, but we specifically disclaim any obligation to do so. Finally, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in the press release that we issued this morning and is also available in the supplemental information on our Investor Relations website. With that, I'll turn the call over to Roger Krone.

[Roger A. Krone:]

Thank you, Kelly. And thank you all for joining us this morning for our second quarter calendar year 2015 earnings conference call. Let me first start by formally introducing you to Jim Reagan, Leidos' new Chief Financial Officer. Jim joined just a few weeks ago and comes to us with a breadth of experience having served as a CFO of both public and private entities. Jim's diverse background and proven leadership will be a great asset for Leidos. During the quarter, we also hired Jon Scholl, our new President for the Health and Engineering sector. We are excited by the energy and impressive background he brings to Leidos. Jon spent 15 years with The Boston Consulting Group, and served as head of their North American Healthcare Provider Practice. Jon most recently spent five years as the Chief Strategy Officer for Texas Health Resources, one of the largest healthcare delivery systems in the country. I'd also like to take this moment to thank Mike Pasqua for his service as our acting President of Health and Engineering sector during this search. Mike will return to his prior role as Chief Operating Officer of the sector. Jim and Jon's arrival comes almost to the day of my one-year anniversary with the company. And I'd like to take a moment to summarize the journey so far. We have complemented our executive leadership team with the additions of Jim, Jon and Mike Leiter. We've also filled several other leadership positions throughout the organization including most recently, the appointment of our CIO, who was promoted from within. We have returned nearly $200 million to our shareholders through the combination of our regular dividend and our recently completed $100 million accelerated share repurchase program. We have retired close to $200 million of our debt at below par levels, bringing close to a $6 million gain and reduction in our ongoing interest expense. We have focused our operations by culling, underperforming and ill-fitting businesses through four transactions over the past year, including our just closed sale of the Plainfield Renewable Energy facility. We have strengthened our balance sheet through the generation of nearly $400 million of cash flow from operations and reduced the risk in our goodwill and intangible asset values. We have made improvements internally to benefit our employees and our culture and we're pleased to be named as one of America's Best Employers for 2015 by Forbes magazine. We have driven efficiencies in our cost structure through several initiatives including the recently completed enterprise-wide outsourcing arrangement for our IT operations and increased optimization of our real estate portfolio. We have done all this through the hard work of our talented employees and I want to thank them all for their part in enabling these successes. On to the quarter, this morning we announced our financial results for the second quarter of calendar year 2015. Revenues, earnings per share and cash flow from operations all came in better than expected. We grew our non-GAAP earnings per share nearly 20% from the prior year and generated more than a $150 million in cash flow from operations. Our bookings during the quarter were very strong and totaled $4 billion, representing a book-to-bill ratio 3.2. This strong outcome is driven by two factors, both of which are encouraging and worth highlighting. First, as we previewed last quarter, we did book approximately $2.8 billion into backlog for the United Kingdom Ministry of Defense, LCST contract win. Just as importantly, we're now beginning to see an impact from the improvements in our business development process. We've indicated before that these improvements take time to bear fruit. And during the quarter, we did see a modest improvement in the book-to-bill of both our Health and Engineering sector, and our national security sector even without the LCST contract. Now, there is still a lot of hard work ahead on this front, as we focus on continuing improvements and staffing in our BD organization, while one quarter does not make a trend, we are pleased with these early indicators. One highlight of our business development activity was the recent decision by the Department of Defense to award the Defense Healthcare Management Systems Modernization contract to the team led by Leidos. This award is a recognition of the world-class health IT capabilities of the company. The DHMSM program is the DoDs leading effort designed to deploy a modern electronic health record system across the United States and around the globe. Leidos has a 27-year history of supporting the military health system and a proven track record of integrating systems and serving as a trusted Department of Defense partner. The selection of Leidos for the DHMSM is recognition of that success and the tremendous efforts of everyone at team Leidos, who contributed to the capture and proposal effort, especially our teammates of Cerner, Accenture and Henry Schein. This award is an important milestone for our company, and our team is already actively engaged with the customer. I look forward to communicating more on the potential impact of this win once the protest period has concluded. Now, to provide you with an update on portfolio's shaping. As I mentioned briefly in my earlier remarks, we did close our transaction for the sale of Plainfield to Greenleaf Power in late July. This process was lengthier and more complex than one can imagine, but we remained committed to extracting the best possible value for our shareholders from this situation, and I believe in the end we have done so. There is more to go on portfolio shaping as we continue to evaluate our various businesses. However, we have nothing further to report for now, and we will update you at the appropriate time. Driven by strong cash flow generation through the quarter, we exited the second quarter with a cash balance of $365 million. This ending balance is net of the $100 million return to shareholders through the previously announced ASR and leaves us again comfortably above the $200 million minimum threshold we target to run our business. We recognize the importance of deploying our excess cash. Our first priority for capital deployment remains paying our dividend. Beyond that our options for uses of cash remain as they always have, investing for future growth, managing our financial leverage consistent with being considered investment grade and returning value to our shareholders. All of these options are evaluated every quarter with our board. As a company, in the year that I had been here and certainly preceding me, we have returned cash to shareholders in all of these ways. As for investing for future growth, over the past three years, we have focused our investments internally. That said, we routinely evaluate both organic and inorganic growth options while remaining focused on the markets we currently serve. We are not, at this time, interested in evaluating any properties that are outside of our wheelhouse. Through thorough and disciplined analysis of all options by the executive team and our board, we remain committed to maximizing the value of Leidos for our shareholders. In summary, I am pleased with the quarter. The early signs of growth, the progress we were making in addressing our served markets, improving our business development results, and focusing the company on our core competencies. Our priorities remain on our people, our innovation and our cost. And I firmly believe we are on the right track in all of these areas. Not just in the quarter we reported but in what lies ahead. With that, let me hand the call over to Jim Reagan.

[James C. Reagan:]

Thank you, Roger, and thanks, everyone for joining us on the call today. I'm happy to be with you here all this morning. I thank Roger and the board for welcoming me into the Leidos family. Leidos is a great company with a long tradition of delivering unparalleled technically innovative solutions to its customers. I've known and admired this company for many years, and I'm thrilled to now be a part of it. And I look forward to meeting many of you in the weeks and months ahead. At the midpoint of our fiscal year, we're pleased with how the year is progressing and our results to-date. Consolidated revenues were $1.26 billion for the second quarter, down 4% from prior-year levels, representing a continued moderation in the pace of declines. Non-GAAP operating income in the second quarter was $93 million, representing a margin of 7.4%. Non-GAAP operating income excludes the impairment charges taken on the book value of the Plainfield plant. The 30 basis point decline from prior year's level was due predominately to lower overall revenue level and the expected margin declines in the Health and Engineering sector. These were offset by strong margins in our national security sector and lower net expenses in the Corporate segment, which we'll discuss later. Non-GAAP diluted EPS from continuing operations was $0.73 per share, up from $0.61 in the prior year as detailed on slide 17 and 18 of the investor presentation on our website. Beyond the operational drivers highlighted earlier, earnings per share benefited by $0.06 due to a lower effective tax rate and a lower share count from buybacks executed during the quarter. The $100 million accelerated share repurchase, which we announced on May 20, was completed in early July and resulted in a reduction of 2.4 million shares outstanding. Fully diluted weighted average shares outstanding at the end of the second quarter was 74 million shares, reflecting the partial impact of this transaction. Operating cash flow generated by continuing operations was $151 million, better than expected, driven by strong collections and some timing items. DSOs ended the quarter at 67 days, down nine days from the year ago period and down four days sequentially. This significant improvement is the result of a focused processing improvement effort by a cross functional team, and they've achieved great results thus far. Shifting to our business development results, as Roger indicated, we had a very strong bookings quarter driven largely by the LCST contract. We ended the quarter with $10.2 billion in total backlog, including $2.8 billion, which was funded, giving us well over six months of forward revenue coverage. The value of bids outstanding at the end of the second quarter was $13.1 billion, up 9% from the prior year period. There was a sequential decline in bids outstanding of 19%, but this was expected and resulted from moving the LCST contract into backlog. Now, let me turn to our sector results for the second quarter. First, in our NSS or National Security Solutions sector, revenues decreased year-over-year by $46 million or 5%. This decline is solely attributed to the continued reduction in U.S. overseas war related or OCO funded business. This pace of the OCO decline is progressing as expected, and we continue to believe that our OCO revenues will come in at near $200 million for the calendar year. When adjusting for the OCO decline, our NSS revenues grew year-on-year. And although slight this growth is notable and that this represents the first time in more than five quarters that we have seen our non-OCO revenues growing within NSS, and we're optimistic that we've turned the corner. On to profitability. Our team's solid execution enabled us to earn 8.4% operating margins during the quarter, flat year-on-year despite the 5% revenue decline. This reflects a solid level of award fees earned during the quarter as our team continues to deliver strong program performance across the sector. Now let me give you a quick update on the UK LCST contract before I move on to Health and Engineering. As we indicated last quarter, we had signed the contract with the UK Ministry of Defense in April, but still had some conditions that needed to be satisfied before the contract became effective. Now those conditions have since been met, and the contract as I mentioned earlier has been booked into backlog. Since June 2, we've been working on the transition phase of the contract and on August 1, we assumed responsibility for operation of the UK MOD's Logistics Commodities Services organization. This begins a three-year transformation phase of the contract, and we're progressing well. We provided you with high-level details relative to our expected revenue and margin performance from this landmark contract last quarter, and those estimates continue to reflect our best estimates at this time. That said, however, from this point forward, we will treat this contract as we do all of our contracts in that we will not provide specific revenue, margin or cash flow impacts by contract, unless it is of material importance to the overall business. National security bookings for the quarter were $3.5 billion for a book-to-bill of 4.0. Excluding the LCST contract, book-to-bill would have been 0.8X, an improvement over the prior quarter's 0.7X level, as well as over the prior year's 0.6X level. We are happy with the directional improvement here and certainly with the total bookings in the quarter. We do, however, recognize that there continues to be work ahead to improve and optimize our business development engine, and we're focused on refining our processes and adding talent where necessary in order to accomplish this objective. Now on to Health and Engineering or HES. HES revenues for the second quarter were $379 million. These results reflect a decrease of $2 million over last year. Q2 operating margins for the sector as reflected on slide six of our earnings presentation on our website, include the impact of a $29 million impairment on the Plainfield power plant, as well as $5 million of operating losses from the plant during the quarter. The impairment was driven by final adjustments to their purchase price enabling the removal of all seller contingencies, as we drove to closure for this transaction as we did on July 24. When adjusting for these elements, Q2 operating margin for the sector was 7.1%, as expected and down 260 basis points from the prior year period. This decline was driven by a lower level of security product shipments during the quarter. As indicated previously, we continue to expect our security product shipments to increase in the second half. Our Corporate segment had a net cost of $3 million during the second quarter. This is lower than our normal rate driven by timing of some expenses and a $2 million favorable benefit during the quarter, due to the settlement of a legal matter. Now, moving on to guidance. With the first-half having coming in better than we expected, we're updating our full-year guidance for revenue, non-GAAP diluted earnings per share, and cash flow from operations. We now see revenue in the range of $4.8 billion to $5.0 billion for the year, up from our prior range of $4.6 billion to $5.0 billion. We expect non-GAAP diluted EPS in the range of $2.40 to $2.60, up from our prior range of $2.20 to $2.45. We're also raising our guidance for cash flow from operations to be at or above $250 million from our prior estimate of at or above $200 million. Our updated cash flow guidance assumes a slight increase in DSOs in the balance of the year and there could be upside to our forecast if we can hold DSOs at current levels. We expect our tax rate to be at or around 37% in the remaining two quarters of the year. We expect the Corporate segment expenses for the year to be approximately $35 million, down from our prior estimate of roughly $45 million due to the favorable resolution of litigation that I mentioned earlier, which resulted in a $10 million payment to Leidos, recognized over Q2 and Q3 of this year. In conclusion, we're pleased with how the year is shaping up. We're encouraged by the improved climate in our end markets, and most significantly by the contributions of our employees to position Leidos and our customers for future success. With that operator, let's now open it up so that we can take some questions.

[Operator:]

Our first question comes from the line of Cai von Rumohr from Cowen & Company.

[Cai von Rumohr:]

Yes. Thank you and terrific quarter, and welcome Jim. Can you give us a little bit of an update on DHMSM, your win? If it moves ahead without a protest, what sort of a ramp should we get to? And even if it's protested, how should we think about, how this is going to contribute to your revenue and earnings over the next couple of years?

[Roger A. Krone:]

Hey, Cai. Thanks for the question. It was a great quarter and capped off by the DHMSM win. As you might guess, we're in that weird period between the award and the expiration of the protest period. So we're not going to give a lot of guidance on what's going on. We probably have another five days or so until we think we're safely on the other side of the protest period. The government put out a press release. It has some numbers in it. We're going to leave those stand. And then if we either move forward without a protest or we have a protest and we survived to the other end of 99-day process, then I think we'll get back together and talk about the contract. So, I'm sorry, I wish I could give you more detail, but for right now, I think it's better from a legal standpoint for us to just defer all questions to the customer.

[Cai von Rumohr:]

Okay. And then Jim for you, Plainfield, could you give us, how much did you get in terms of cash, how much additional consideration could we look forward to? And then you mentioned this legal settlement $10 million over Q2 and Q3, should we therefore assume that the corporate expenses are going to be (23

[James C. Reagan:]

Yeah. Thanks for the question Cai. To date we've received $28 million in cash and you'll see that show up in our numbers for Q3. And in terms of your question regarding corporate expenses, we are expecting a lower level of corporate expense in Q3 that will reflect another $8 million of receipt on the legal matter that we talked about. So these are the things that are already reflected in our cash guidance for the full year.

[Roger A. Krone:]

Hey, Cai. If I could, this is Roger. Just back on Plainfield. In getting the deal done, we traded instant cash and evaluated the note for a bigger earn out. It just had to do with some complications in the operation at the last minute. And so – and again you'll see it all on our Q, but we took a note back of about, Jim, 70-plus and then we have a earn out which is capped at $30 million, but it's over the life of power purchase agreement and for the purposes of determining the impairment if you're trying back that out, we valued the earn out at zero.

[James C. Reagan:]

So when you think about the additional charge, Cai, that we took in the quarter, roughly $10 million is really something to think about in terms of cash, the rest of it was a non-cash impact driven largely by movement in our deferred tax accounts, so.

[Cai von Rumohr:]

Terrific. And the last one, maybe if you could give us some sense of the bookings momentum in your businesses particularly the commercial health IT? Thank you.

[James C. Reagan:]

Sure. Cai, on the commercial – the commercial health business, we're still seeing that as being a relatively flat business and while we're – we know we continue to be optimistic about that. We're still not seeing that kind of turning the corner. The bookings momentum though as we've said earlier, we're encouraged by the fact that we're seeing an uptick in the book-to-bill. The things that we've done in business development in terms of retooling processes, adding people where they're going to add some immediate value. And everything from – just changing people, but changing tools that we use and the rigor we put in the capture process. We're starting to see some of those bear fruit as we're pushing toward a one-to-one book-to-bill excluding of course the big bookings that we've talked about.

[Cai von Rumohr:]

Terrific. Thank you very much.

[James C. Reagan:]

Thank you, Cai.

[Operator:]

Thank you. Our next question comes from the line of Jon Raviv from Citi.

[Jonathan Raviv:]

Hi. Good morning, everyone. Thanks for taking the questions. I was wondering if you could, Roger or Jim go into a little bit more on the EPS guidance because it still looks like you probably got maybe a nickel from ASR, tax or corporate. Are we missing some kind of upside on the underlying?

[James C. Reagan:]

Jon, this is Jim. And Roger can maybe amplify on anything that I might have missed on this. But I think that where we have come out on issuing guidance is there is a couple of things that we wanted to make sure we reflected in how we're thinking and talking about the second half of the business. First, in the first half, particularly the second quarter we had some pick-ups on favorable adjustments for our estimate to complete for some larger programs and that was a nice pick-up we had in Q2. And we're not modeling quite the same level of that in the second half. It does mean it couldn't happen, but we're not including that. The second thing is we have to provide for some level of uncertainty on product shipments in second-half. And that's an important factor that we can't – we don't want to fully bake in all the upside there. And then the last thing is we're starting a couple of big programs up. And the program in the UK, we've moved into the transition phase of that contract on August 1, and – but we still have to get some more clear signs on how quickly that's going to ramp-up and what our longer term expectations can be on that. And, I would say that the last thing is, there's always something and we've provided a normal level of regulatory costs and they were a little bit lower than normal in the first-half, but we want to provide in guidance for those to be at a more normal level. So, I hope that gives you a little bit more color on how we're guiding.

[Jonathan Raviv:]

Yeah. That's very helpful. And then similar question on cash. Is the offset in cash just sort of a synergy you just outlined or are any of the 2015 headwinds that were flagged on the March call, like the advanced payments or the LCST ramp cost? Or do you have those perhaps slipping into 2016, which then provides some upsides to 2015?

[James C. Reagan:]

Well, the number that we're showing at the end of the second quarter is a very strong DSO number of 67 days, and even assuming that that ticks up two or three days in the second half, those were baked into what our guidance estimate was for the full-year cash flow of at or above $250 million. We talked about advanced payments. Turning around, those advanced payments are assumed to have turned around in our estimate. But if we're able to hold on to those that could represent some upside, but right now, I think, that it's safe to assume that the advanced payments from the customers are going to get burned off in the second half. So, I think that, if we continue to manage our working capital needs for the business as we have for the first half of the year, we're very comfortable that we're going to meet or exceed the $250 million, we've talked about.

[Roger A. Krone:]

Jon, just to add some additional color, we talked at the first quarter call about working capital in LCST, actually we've been doing better than we anticipated, which is a nice thing. And we work across the board relative to cash flow performance, and we just have a lot more confidence and decided to pick the range up by $50 million. And as Jon mentioned there are some opportunity maybe to go above that, which is why we said $250 million is the floor, but, I was over in the UK last month and that program is going really, really well. And we're pleased with the relationship we had with the UK customer and we're actually being paid quite promptly. And so that's given us more confidence in our cash estimate.

[Jonathan Raviv:]

Great. Thanks. I'll hop back in the queue.

[Operator:]

Thank you. And our next question comes from the line of Edward Caso from Wells Fargo Securities.

[Tyler J. Scott:]

Good morning. This is actually Tyler Scott on for Ed. Thank you very much for taking my question. Just to come back to the DHMSM contract quickly, I know details are going to be limited until we kind of work through the process period, but is there any color you can give in terms of the direct labor component, maybe compared to the current contract that you're on, and also if you've had any indication from the DoD or anyone else about a potential protest coming in? Thank you.

[Roger A. Krone:]

Let me talk about our conversations with the customer, and then we'll see if Jim can sort out the DL component. Think we can talk about how we've structured our team, we certainly can address that.

[Tyler J. Scott:]

Sure.

[Roger A. Krone:]

The way this works is we don't have any conversations with the customer about potential protest. It's really kind of a wall between their acquisition process and our team. The conversations we've had with the customer – we actually were called, I think on Tuesday, and we started work on Wednesday, and the teams have been out implementing the contract. And we've clearly separated the implementation team from what might eventually be a legal support team relative to the protest. So I'd love to give you some insight, but we actually have none, and that would be discussion between the other bidders and the customer. So all I can do is sort of recount the way the timing works which is in the far end. If a protest is filed in a timely manner there, potentially JO could issue a stay. If a stay is issued, we get a stop work order. We would stop work at that point and then we would wait to see the outcome of the protest. I don't know, Jim, whether you want to talk about the team and sort of how we're split.

[James C. Reagan:]

Sure. As you know we're teamed with Accenture and Cerner and several other contractors that represent a strong component of smaller businesses as part of our teammates, and we're all excited about the win. We're currently on the sustainment contract, and that's going to run for at least a couple more years as we ramp up the DHMSM contract. And so this is going to represent some significant pickup of direct labor and direct contract base for the business. So I wouldn't think of this as being kind of one thing ramping down and being replaced with DL from our – that is from the Leidos side of the business. This is going to be a pickup for everyone, and it obviously represents something that we've been pursuing. We've invested millions of dollars in this, and we're very excited about it.

[Tyler J. Scott:]

Okay, great. Just looking at 2015 guidance, is there any way to provide some details in terms of what UK – how much of the UK Ministry of Defense contract revenue is in there, and then I'm assuming just based on those comments, there is no DHMSM included in the revenue outlook?

[James C. Reagan:]

Yeah. We haven't baked anything material in for DHMSM, and I would have you think about there being a very modest amount of LCST revenue and margin baked into these forecasts.

[Tyler J. Scott:]

Okay, great. Thank you very much.

[James C. Reagan:]

Thank you.

[Operator:]

Thank you. And our next question comes from the line of Robert Spingarn from Credit Suisse. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Good morning. Welcome Jim. Congrats, Roger and Jim on these big wins.

[James C. Reagan:]

Thank you, Rob. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) If you could talk a little bit more perhaps specifically about the segments in the second half, what you're thinking for growth rates within the guidance of the two ranges maybe what some of the puts and takes are and how that revenue guidance shakes out in the second half?

[Roger A. Krone:]

Yeah. I would think of there to be a relatively flat year-over-year in the Health and Engineering segment of the business, with a little bit of upside in the NSS part of the business. As we've said we believe that we're at some level of inflection relative to where budget stand and where orders will look in the second half of the year. We're pushing a 1.0 book-to-bill, and we're still pushing for that. We've started to see closing on that 1.1 number, excluding the impact of the large wins. And as we continue to refine those BD processes where we think that there is probably some reasonable amount of upside possible in the NSS business. But I think it's too early for us to bake anything more than we've given you into the top line right now. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Okay. And then just getting a little bit more detailed on NSS and the OCO, I think you said it's around $200 million per annum at this stage?

[James C. Reagan:]

It's close to that, but not quite there. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Okay. Is that – so what do you think the bottom is?

[Roger A. Krone:]

Hey, Rob. It's Roger. We've actually said for some time we see it at about $200 million. If you're following what's going on with the budget, it looks like they're going to use OCO or OCO-like accounts to deal with sequestration. We're probably going to be in a CR again, and they're – I suspect, they're going to use OCO and maybe a broader definition of OCO to deal with some of the operational issues. So, we're pretty comfortable at the $200 million or $200 million plus going forward. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Well. Maybe Roger, given that there is a different way to look at it. What – how would your natural OCO, whatever is in theatre and so on. I mean is there downward pressure there still, or is that about bottom?

[Roger A. Krone:]

Yeah. It's a great question and I'm just thinking about all the activities we've got going. And I would tell you that, no, I don't see a lot of downward pressure from where we are. And I don't want to get too much enthusiasm going the other way, but we've got people actually as we speak today talking about OCO type assets that might actually see some expansion. The requirement for ISR in multiple theaters is actually, we see that on the rise, as we all know, it continues to be a very turbulent world, especially in certain AORs, and because we have surge capability, and we have offered some ISR, if you will, as a service. And so, some of our best customers have asked if we could do a little bit more. And because of the way those assets come online, we could see maybe a little bit of an uptick even this year. Now, don't expect it to double, I'm just talking about the confidence that we have there, it won't go down. And maybe the opportunity to see a little bit of growth in OCO. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) And then just a couple more. One more, Roger, for you, high level on cyber. A lot of – a lot going on out there with your competitors both big contractors and small getting in and out of cyber particularly on the commercial side. If you could just give us an update of where Leidos is and what your plans are and then, Jim, I've got a couple for you.

[Roger A. Krone:]

Yeah. We've always I think been very thoughtful on the commercial cyber side. First of all, I think we've used a number around $400 million, if you were to tag our NSS businesses, cyber, not cyber, so, we believe we've got a lot of expertise in the various aspects of what we'll all call cyber. And we have started and entered the commercial cyber market; we have a security operation center, which has actually been growing. We've actually added some more customers. Jon Scholl, in the health arena has added our security bundle to our offering to our healthcare clients. But I think we have also been if you will, more moderated in what commercial cyber is and the uptake, the commercial firms have relative to spending our dollars on cyber. We get a lot of calls the day after and that's been a nice revenue increase for us. I think, most of the folks in this market are trying to understand, how we can get cyber revenue prior to an event and do more network penetration testing and network sensors and security monitoring. And so, we're still optimistic about commercial cyber, but I think we've been very transparent with you all about, though we see moderate growth in commercial cyber. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Okay. And then just on the numbers, just quickly, the margin – the 7.1% adjusted margin in the healthcare and engineering business is a pretty good number. How should we think about that trending forward? And then on the cash flow side to some extent the higher, the better DSOs reflect an awakening of the customer, they are paying more readily. I think you said it goes back the other way a little bit, perhaps after this quarter. So is there any behavioral change there or a thawing if you will?

[Roger A. Krone:]

Rob, let me give you two quick answers and then I'll turn it over to Jim. As we mentioned, whether you were able to follow it or not, it was still a low quarter for security product deliveries in HES and we expect that to pick up certainly in the third quarter and the fourth quarter. And you've been following us for a while and so you sort of know that that would – that tends to be associated with an increase in margin. And so, we are optimistic. We have to get those – the VACIS systems actually delivered and out of the door. So, I think that's important. And I'll let Jim handle the rest.

[James C. Reagan:]

Sure. And you had asked, Rob, about the HES margins with the caveat Roger mentioned. Yeah, your – I think it's fair to say that the margins in the low 7%s are probably what you should continue to think about in the back half of the year. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Thanks.

[James C. Reagan:]

And then, just to amplify a little bit on cash. One thing that I've seen over a couple of decades in this business is that, there is a pretty strong correlation between really good DSO and strong award fees and our award fee performance on program has been very, very strong this year. And when customers are happy giving you strong award fees, you – they're amazingly cooperative in turning invoices around faster. So, it's not just the fact that we've been working on optimizing the billing process and the collections process, but also it means that customers are pleased with the work that we're doing. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) And any big advances in there given the wins?

[James C. Reagan:]

Nothing new in terms of advances. We've talked about the run-off of some advanced payments that – we talked about them last quarter and those are still on the books. We're assuming that they're going to run-off in the guidance that we've given you, but if they don't, then they – we might have a little bit of upside there. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Okay. Thank you both.

[James C. Reagan:]

Thank you, Rob.

[Operator:]

Thank you. Our next question comes from the line of Bill Loomis from Stifel.

[Bill R. Loomis:]

Hi. Thanks. Good morning and good results. Jim, on the – just on the guidance increase, I'm trying to understand the drivers there, what was included in the prior guidance. So it looks like the $0.06 benefit from the lower tax rate and the repurchase in the quarter and then with the second quarter $10 million and then in the second half $8 million, roughly $0.15 benefit from the legal. Were they in the prior guidance or is that part of the increase?

[James C. Reagan:]

That's part of the increase, Bill. The guidance that – especially the tax thing that you talked about, that's a situation where – that's a real cash benefit to the business, as we've been able to unlock some previously blocked tax laws carry forwards as a result of some of the transactions that are happening this year. They're helping our full year effective rate. Does that answer your question on the tax?

[Bill R. Loomis:]

Yeah. So, I mean, both of those benefits are legal, and the tax that was...

[James C. Reagan:]

That's right.

[Bill R. Loomis:]

Part of that was the reason, bulk of the reason for the EPS increase in that.

[James C. Reagan:]

That's correct.

[Bill R. Loomis:]

Okay.

[Roger A. Krone:]

Well, okay. Hey, let me just add this. So we also narrowed the range by a nickel. And I think it really speaks to a lot of increased confidence in our operations and our ability to perform. Here we talked about another $5 million or so of write-ups, EAC improvements in the quarter, and we think the engine is running well and by the way there are always these little non-recurrings that kind of go up and down, VirnetX was favorable. But relative to – I like to view it as quality of earnings, I would tell you that, I have much higher confidence in the quality of earnings we have going forward than maybe I did when I started the year. But, and then I would also remind you that we did an ASR in the period, so if you're looking at it from an EPS standpoint, you need to calculate in the reduction in shares outstanding.

[Bill R. Loomis:]

Okay. And then on the – you mentioned the commercial healthcare, it's running about flat, you mean, flat year-over-year, is the sequential trend flat and then also what does the profitability look like on that commercial healthcare business now, versus say a year ago or earlier in the first quarter?

[James C. Reagan:]

In the past, Bill, we've kind of backed off of giving subsector guidance in details, but as we've said before, that business has been running flat, I think it would be fair to say that the profitability is up marginally, but the commercial health piece continues to have some growth challenges.

[Bill R. Loomis:]

And do you see that as being a long-term trend. What do you see when you talk to you folks and customers and so forth? What are you looking at over the next 12 months, 18 months? It is a business that you want to stay in because it's temporary slowdown?

[James C. Reagan:]

Well, we've brought Jon Scholl in, who's got a long history of leadership in health both commercial and we're looking to him to help guide our overall health strategy. And so, I think that that speaks to our view that there is still a plenty of potential market that we can attack there. Roger, you have anything to add there?

[Roger A. Krone:]

Well, no, we're – we have been bullish on the healthcare market and clearly it goes hand-in-glove with the win that we have on DHMSM. We're going to be up against the ICD-10 implementation, and that could give us a modest lift in the back-half of the year, but Jon has been here about a month and he's getting a good view of our business and understanding what we've got and we expect great things out of Jon.

[Bill R. Loomis:]

Okay, great. And then just finally on NSS, a few years ago we saw a lot of big increase in pricing pressure, move to LPTA and so forth. So now those contracts are becoming a bigger part the mix, your margins are still doing good. So what is the outlook on – margins on NSS and we kind of turned the corner on the most aggressive pricing pressure. And we're probably not going to see downside from here and what's the environment right now on pricing?

[Roger A. Krone:]

We're always going to see – well, I wouldn't say always. I mean I think for the foreseeable future, we're going to continue to see pricing pressure in most of our end markets. This has been an emphasis of Frank Kendall for a while. And I think that all of our peers are seeing the same thing that we are. I think the one thing though that we have not seen as some of our peers have is as much pressure in the LPTA area. The kind of things that we're doing have more than some of our peers been awarded on a best value basis. And I don't mean best value that really is LPTA. I mean best value where you – when you look at it at the end of the day, we aren't always the lowest priced competitor and we're awarded because of our solution more than our price. So I think that some agencies are saying that the pendulum swinging some of them are still not seeing that. But from our standpoint, we're kind of in the sweet spot, where we can be competitive. We're working to continue to streamline our cost structure to be more competitive, because there will be those pressures. But I think that we're definitely not finding ourselves competing just on price.

[Bill R. Loomis:]

Okay, great. Thank you.

[Operator:]

Thank you. And our next question comes from the line of Michael French from Drexel Hamilton.

[Michael Kendrick French:]

Good morning, everyone.

[James C. Reagan:]

Good morning.

[Roger A. Krone:]

Good morning, Michael.

[Michael Kendrick French:]

Thanks for taking my question. I had a quick one on SG&A. I understand that some of the costs were shifted up into cost of revenues. However at least in my model, it looks like if you combine the two, it's still lower than what I was looking for. So I really have two things; one is, what costs moved up? And, two, were there any reductions in overall expenses or cuts that are likely to continue?

[James C. Reagan:]

Yeah, so I would refer you to the queue for some more details on the nature of the things they have shifted. Some things have shifted because of some changes in cost accounting practices that we agreed on with our government customer. But I think that putting that aside we are operating at a lower cost on overhead and G&A than we were a year ago and we're going to continue – and you're – we're all going to see continuing improvement in that area. And so, I think what you're seeing, when you look the numbers is the impact of some cost reduction actions that we've been taking and we're going to continue to take them.

[Michael Kendrick French:]

Okay, great. Thank you. And the next one, you're already pretty cleared that, you don't have anything else to discuss. At the moment on portfolio shaping, but just looking out, in terms of timing, what should we be thinking when we're likely to hear something from you on that?

[Roger A. Krone:]

Well, I think I've been saying all along – this is Roger, is I wanted to get through, if you will, a business evaluation and move relatively quickly to if you will, cull the portfolio, and I would say we are close to the end of that process. Probably another quarter or so, and again, I don't want to draw a red line because then you will hold me to it. And I think it's important frankly from an internal standpoint that people understand we're no longer looking at the portfolio, and really I see sort of this period as a time where we shift from thinking about analysis of our current portfolio to the portfolio that we want to have going forward for the long haul. Staying within our sweet spot within our core capabilities in the markets in which we have domain knowledge and just a lot of options and a lot of things to look at. I think we've talked before on prior calls, we filled a pipeline of external opportunities and we just kind of look at everything that comes along, and frankly a lot of things that aren't actively on the market, but would be of interest to us.

[Michael Kendrick French:]

Great. Okay, thank you. I appreciate it.

[Operator:]

Thank you. And our next question comes from the line of Brian Ruttenbur from BB&T.

[Brian W. Ruttenbur:]

Yes. Thank you. Just a couple of follow-up questions. First of all, share count on the year that you're basing your EPS off of, is it 72 million, is it a different number, just trying to get a calculation?

[James C. Reagan:]

For the full – excuse me, for the full year, it's about 74 million.

[Brian W. Ruttenbur:]

74 million. Thank you. And then ...

[James C. Reagan:]

Hey, Brian, that's an ending number, not on average for the year. So we were creeping up, we did a $100 million that was about what 2.5, 2.4 that we retired. And so, if you were to pinpoint on how you want to do your calculation, but if you do the weighted average for the year, it might be a little bit higher than that. I think we said it's a $0.01 in the quarter maybe $0.02 in the quarter, $0.04 for the remainder of the year.

[Brian W. Ruttenbur:]

Okay. So, on the calendar year, what is the weighted average share count that you're using to calculate your EPS guidance?

[James C. Reagan:]

Hey, let's get back to you on the exact number.

[Brian W. Ruttenbur:]

Okay.

[James C. Reagan:]

I don't have that on a ready piece of paper, and we'll take you through the numbers.

[Brian W. Ruttenbur:]

Okay. Great. Then the next question, just a follow-up on Bill's question earlier. It was about EPS, but just in terms of the cash from ops, is the majority of that increase in cash from ops due to tax and the settlement? It appears that the majority is, is there something else operational that I'm missing that would increase that cash from ops number?

[James C. Reagan:]

I would think of it as largely operational. There is a piece of it that's tax, but it's really better working capital efficiency. That's the biggest driver of the improvement, as well as the improved earnings outlook.

[Brian W. Ruttenbur:]

Great. Thank you very much.

[James C. Reagan:]

Thank you.

[Operator:]

Thank you. And our next question is a follow-up from the line of Jon Raviv from Citi.

[Jonathan Raviv:]

Hey, thanks for taking my follow-up. I was wondering if you could talk a little bit about free cash flow, and maybe a multi-year long-term target for this type of business. This year looks like 4.5%, last year was about 7%. We know last year outperformed. Can we expect something over a multi-year period to be somewhere between there, or how do you think about that?

[James C. Reagan:]

I'm sorry. Could you repeat the question, Jon? I'm not sure I understood it.

[Jonathan Raviv:]

I'm just asking multi-year outlook on what your free cash flow margins or free cash flow as a percentage of sales might be? Just trying to get an idea of, if there is some sort of expectation you have out of this type of business on free cash flow?

[James C. Reagan:]

Yeah. I would think of it as continuing to be kind of a light CapEx business. So if you think of the EBITDA less CapEx, model your EBITDA, take a fairly low percentage of revenue on CapEx where – I think, that that's a good way to look at the business, but we're not going to get specific on cash flow guidance for future years.

[Jonathan Raviv:]

Okay. Fair enough. And then can you also talk about some of the risks around security product deliveries? Some of that shifted to 4Q, or is 3Q still expected to be the big one?

[Roger A. Krone:]

We think of those as being kind of late 3Q, but it's – when we think about the risk, it's not the amount, it's just the timing because things – while things might be on the ship on their way to the Middle East, they could be delayed in documentation and customs and acceptances, those kinds of of thing. So, I wouldn't think of that as being an issue of amount, it could be just timing from quarter-to-quarter.

[Jonathan Raviv:]

And then, longer-term on security products, is this a structural growth market, or can we expect some lumpiness going forward? Perhaps are we setting ourselves up with a tough comp this year, which is most certainty next year?

[Roger A. Krone:]

I don't think that we're setting ourselves up for a tough comp. I mean, we're seeing a lot of interest not just from customers in the Middle East, but customers in the Western Hemisphere as well South America and markets where security is an increasing concern. We think about border security for the continental United States. And markets like that is being areas where that business could grow.

[Jonathan Raviv:]

Great. Thanks very much.

[Roger A. Krone:]

Thank you.

[Operator:]

Thank you. And our next question is a follow-up from the line of Cai von Rumohr from Cowen & Company.

[Cai von Rumohr:]

Thank you very much for taking the question. So just to follow up to Bill Loomis' thought. I guess, Roger, you mentioned share count is a plus $0.04 to $0.05 for the year. Tax rate looks like it's $0.06, settlement is $0.09, $0.02 from the debt retirement gain, and it is really like $0.22, and you've increased the range by $0.15 to $0.20. So that would really imply, you are looking for lower operating profit. Is that just more conservatism, because your tone seems to be that things are getting better?

[Roger A. Krone:]

Well, see Cai, it's great to have you run your numbers so quickly. As – it really is reducing uncertainty and building confidence, but first of all, let me equivocally say, it's not because we think our operating income is going to be down, right. So – but you know how we do an estimate. We take all the risks and opportunities. You've mentioned our opportunities, they're always some risks, right. I'll tell you one of the things that gives me confidence is that Plainfield will be out of our numbers in the third quarter and fourth quarter, we won't have an operating loss from Plainfield. And we run an internal set of numbers, we carry a band, as we see that band narrow for all reasons and by the way, we want you to grade us on operating income, how we manage the balance sheet, how we deal with share count, how we return value to shareholders through cash distributions. All of that we believe ought to be in our report card. It starts with a great operation and strong operational performance and we think we've got that, we've seen continued write-ups and estimates are complete both in the first quarter and second quarter and the team has been doing a great job.

[Cai von Rumohr:]

Thank you.

[Operator:]

Thank you. And that concludes our question-and-answer session for today. I would like to turn the conference back over to management for any closing comments.

[Roger A. Krone:]

Karen, thank you. Thanks everybody for tuning in. We actually had a large set of folks listening and we appreciate the questions that we've got from the Street. Yeah, as I said I've been here about a year. It has been a lot of fun. It's certainly been an exciting and eventful year for me and for the company. And I would just really, really feel good about where we are right now. Strong balance sheet, good operational performance really added to the team. We have also promoted a lot of people within. We don't talk about that perhaps as much. We've got a robust succession plan where we look internally for talent, and I'm very pleased with the depth of the talent that we've got here at Leidos. And I'm excited about the next six months and the years ahead. And Jim, I don't know whether you have a one-month or two-month retrospective, but I'll give you a minute to make a comment.

[James C. Reagan:]

Sure. I think it's – Roger, I think it's working day 24 something like that. And so, it's been a fast moving train, I've jumped on here. But as I have spent just a month here, it's been a very exciting time for me to ramp up my deeper understanding of the business. And tell you that this is a good time to be here and it's good time to be at Leidos for all the reasons that you've heard about on the call. So, I look forward to hearing more from you all on the phone and meeting and spending more time with some of the employees that are listening in this call too. And I'll be talking to you all next quarter. Thanks very much.

[Operator:]

Thank you. Ladies and gentlemen, thank you for participation in today's conference. This does conclude the program, and you may now disconnect. Everyone have a good day.