Greetings. Welcome to L3Harris Technologies Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mark Kratz, Vice President, Investor Relations. Thank you. You may now begin.

Thank you, Rob. Good morning and thank you everyone for joining us to discuss third quarter results. Joining me are Chris Kubasik, our CEO, and Michelle Turner, our CFO. Yesterday, we published our investor letter detailing our results, guidance and key company updates. So this morning's call will be focused on answering questions. As always, we may discuss certain matters that constitute forward-looking statements. These statements involve risks, assumptions and uncertainties that could cause results to differ materially. For more information, please reference our provision found in our investor letter and our SEC filings. We will also discuss non-GAAP financial measures, which are reconciled to comparable GAAP measures in the investor letter. I'd now like to turn it over to Chris for some brief remarks.

Okay. Thank you, Mark, and good morning, everyone. I know you've all had a busy week, and we appreciate you joining us this morning. The current events in the Middle East remind us that what we do at L3Harris matters. And the industry in which we operate is more critical than ever before. As a national security technology focused company, we remain committed to supporting the U.S. and its allies to deter aggression and foster stability around the world. As we embark on our fifth year since the merger of L3 and Harris, I'm proud of our achievements. We built a diverse and seasoned team that is integrating our company. L3Harris is viewed as a disruptive competitor that is reshaping the U.S. Defense industrial base. Meanwhile, underpinning our strategy is a focus on operational excellence, delivering quality products on time, driving costs out of our system, and focusing our portfolio as a national security company. This ultimately benefits our customers and creates long-term value for our shareholders. While the macro environment has been challenging, we are making considerable progress. The business is on solid footing, and we are building operational momentum. In the third quarter, we reported 16% top-line growth, the second consecutive quarter of sequential margin improvement and strong cash generation, resulting in more than 100% free cash flow conversion. This extends our trend of generating positive free cash flow in each of the quarters since the merger. The team and I look forward to providing more details on our strategy and our 2024 outlook at our Investor Day in December. And with that, Rob, let's open the line for questions.

Thank you. We'll now be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question is from Kristine Liwag with Morgan Stanley. Please proceed with your question.

You know Chris, Michelle, after owning Aerojet Rocketdyne now for a few months. Are there any surprises to the positive or negative that you've seen?

Okay, well, I expected an Aerojet question. So let me take this one and try to answer your question and maybe give a little more insight on Aerojet Rocketdyne. But just to refresh everyone's memory, we signed and announced the deal back in December. And we're able to close it in seven and a half months, which I think is pretty impressive in this environment. So either there was support or probably no objections, obviously from industry and in the Department of Defense to allow the acquisition to go through. So probably closed a little quicker than we expected. I think when we announced that we said it could take up to 12 months, but we did hit the ground running on day one. Deployed the L3Harris leadership team to run the business which I thought was critical to the success that we're going to realize. I'll say from an integration perspective, all was going well, we're clearly on track to get the 40 million to 50 million of cost savings that we talked about previously. We've shut down the Aerojet Rocketdyne headquarters in California. We're ready for January 1 to transition all the employees to L3Harris payroll system benefits and such. The IT team is already connected all the network. So the communication and such is working well. And we obviously have a little longer term IT strategy to optimize the business from that perspective. I will say the workforce, we actually did a survey of the workforce about a month ago, and the results were actually off the charts. I was more than pleased to see the enthusiasm of the workforce, the confidence that they have in being part of L3Harris, the alignment of being a part of a larger company that's focused on defense and national security…

Our next question is from the line of Gautam Khanna with TD Cowen.

I actually wanted to switch subjects and ask about Tactical RF. Maybe, if you could talk about book-to-bill in the quarter where backlog stands and give us some pipeline color, both domestically and internationally? And also if you can answer the supply chain questions, how that's evolved in that business line? Thanks.

Yes. So thanks for the question. From an overall comps perspective, we continue to be on track to deliver to our guidance, which was double-digit growth across the business, which includes to your point, gotten about the [bidding] [ph] supply chain challenges. which we continue to see along with the acquisition of our tactical data links business. Specific to radios and comms from an overall DoD budgetary perspective, we continue to see support. We're about 40% of the way through that modernization program. And we continue to see strong demand internationally as well. And so overall, I'd say we're feeling like we're in a good place from a comps perspective. And then just from looking at supply chain specifically, we continue to see hiccups like you're hearing across the industry, but significant complements to our supply chain, our tactical communication business, Sam Mehta, Chris Abley. The efforts that they've put in over the last 18 to 24 months in truly building a resilient supply chain that allows us to pivot when we continue to experience these hiccups is enabling us to continue to deliver for our customers and for our shareholders. And the other thing I would note for this quarter is that our overall deliveries are actually up from Q2. And so we continue to see the results of the efforts and the diligence that the team has put in over the last 18 to 24 months.

Our next question comes from the line of Noah Poponak with Goldman Sachs.

Chris, so you've alluded to the competing inputs for national security spending. I guess when you think about what's evolving geopolitically versus what's evolving with the deficit battle in the U.S., maybe some of the short-term items as well. I guess, what do you -- how are you thinking about what your medium-term end market growth rate is? And your latest thinking on the L3Harris spread versus that growth rate?

Yes. No, thanks. Noah, I appreciate the question. As I step back a moment, I think kind of implied in there is the budget and what's going to happen with the supplemental. So as we all know, we finally have the speaker of the house, so that's step 1. I do believe and I've been pretty outspoken on this. It feels like it's an even more dangerous world than it ever has been. You look at what's going on in the Mid East, Ukraine, South China seas, national security has to be a top priority. And I'm concerned that a government shutdown would clearly weaken our national security as does a continuing resolution. So I think I speak for the entire industry and probably our customers, we hope that we get a budget here in the next couple of weeks, so we can start having the money flow to the industrial base. There's been a lot of talk about the supplemental over $100 million, split between state and DoD and Ukraine and Israel and Taiwan and the south border. I think we feel confident there will be a supplemental, I don't know if it will be 1 or 2 or somehow be partitioned, but I look at the supplemental as kind of playing into the near term. And I think when I look at our portfolio of products, literally products, not necessarily systems or platforms, we've been well positioned, specifically in Ukraine with a quick turn on the radios, night vision goggle, sites, sensors, cameras. So I look at the supplemental to kind of help us in the near-term. The midterm, I think, is relying more on a continued budget growth, the need to invest in technologies, advanced technologies for a peer or near-peer threats. And we keep talking about…

Next question is from the line of Scott Deuschle with Deutsche Bank.

I have two quick questions, both for Michelle. The first is on what's driving the difference between the $56 million of M&A expense add-backs on the P&L and the $215 million of add-backs for M&A on adjusted free cash flow. So that's my first question. And then my second question is what would drive CS margins to the 26% range in the fourth quarter, which is I think what's implied in the guide. Thanks.

Thanks for that Scott. I'm going to start with the margin question and kind of take a step back and address it starting with the enterprise margins because we really think about this as managing our portfolio. So we're encouraged with the overall margin results within the quarter. This is our second consecutive quarter of sequential improving margins at 15% and this includes 2 months of Aerojet as part of our portfolio. And so, we're most pleased because we're starting to see the efforts of our actions related to our Performance First initiative, which you may remember is really grounded in meeting the commitments of our customers and shareholders, and it's starting to pay dividends now in terms of margin improvement. So I'll walk through each of the segments because I think there's a lot of good work that's happening across the organization, plus it gives you a little bit of flavor as to how you should think about your models go forward. So I'll start with our Space and Airborne Systems business. It delivered a record op profit in Q3 and 12.5% margins. And [indiscernible] and the SAS team have really been early adopters on our LHX NeXt initiative in terms of really leaning into maniacally managing cost and spend, but also looking at organizational construct to ensure that we are most effectively running our business. The SAS business also benefited from a couple of accretive contract mods that they were successful and being able to deliver on within the quarter. And so when you look at Q4, there is a step-down as a result of those onetime accretive actions that occurred within Q3. From an Integrated Mission Systems business perspective, this business and along with John Rambo's leadership and the IMS leadership team, saw sequential margin improvement of…

Our next question comes from the line of Jason Gursky with Citi.

I just wanted to go back to the Space business for a minute, if you don't mind. Little contracting things going on here in the industry this quarter, you guys had a positive EAC in one of your customers, one of your competitors out there in the world at a very large start this quarter in the aerospace business. So I wonder if you could just help us or maybe walk around the space portfolio and tell us a little bit about what you have in that portfolio from a fixed price versus cost plus kind of mix and help us understand what the risks are and what the opportunities are as it relates to both revenue in the future. But I think most importantly, given what we're seeing across the industry, kind of what the risks might be on execution in EACs and just kind of help us better understand the overall health of that business.

Okay. Well, let me take that one, Jason. Great question. And yes, I mean to give the answer on the cost plus fixed price, it's about 50-50 between the 2. And that's a big change over the last decade or so. I mean, people generally would have thought of space being predominantly cost plus if you go back 10 or 20 years. And as you know, that trend has changed, bringing more risk to everyone. I think a lot of this goes back, I don't know specifically who you're referring to. But I think a lot of the challenges that the industry is having stems from the supply chain, which I'm sure is getting hold hearing that. But if you go back a few years, we were talking about our portfolio, having a combination of short-cycle, quick-turn products that were reliant on microelectronic parts. So I felt like L3Harris was kind of at the pointy end of the spear and leading the industry and the supply chain adverse impacts given the fact we couldn't get those parts to deliver our core products and recognize the revenue and profit. And then I think the longer cycle business is, which I would kind of throw space in there. It's also having supply chain issues. But the challenge there, I believe, is more on inflation and then workmanship that everybody is dealing with those quality challenges. So while there's still supply chain challenges, I think they've shifted. And I think they're hitting the longer-cycle businesses now. So what we've done is really double down on our bidding discipline, some of the longer-cycle things going back 5 years, probably are making less margin than I would like. But on the new bids, we're clearly factoring in the appropriate risks, taking the most current estimates,…

I would just add to complement that along with the SDA and NDA work that Chris just referred to. We also have a very steady, stable business that we've been in for decades from a civil weather perspective. And so that -- there's also a growth cycle that's happening there, and we booked about $1.5 billion associated with that business. So it's a good complement to the other work that's really growing from a DoD perspective.

Our next question comes from the line of Richard Safran with Seaport Global Research.

Chris, I heard your remarks about 2024 in the Investor Day, but I thought you might be willing to discuss and maybe give a qualitative assessment of which segments have the most room to grow in '24? Any color you could provide there, I thought would be helpful.

Are you going to come visit us in December at our Investor Day, Rich?

I'm already signed up.

Well, there you go, there you go. I mean this is like the coming attraction here. This is after Taylor Swift, it's the second hottest ticket in Florida apparently. So we're in the process of going through our 2024 plan, actually next month. So I'm not going to actually give you an answer that will be satisfying. I will tell you, based on what I see right now, it looks like all 4 of our segments will be growing. So we'll reveal which ones are growing faster in December. But in all seriousness, we kind of want to get through the next month or two and see what's going to happen. We can't have a government shutdown for any period of time. We can't have a continuing resolution. We all know the impact that has on our business. We all say it really doesn't impact 2023 because the year is 3 quarters over. It's more or less true, but 2024, a 1-year CR, which I'm not at all suggesting will happen. But the one thing we can all agree on is we have no idea what's going to happen in D.C. And I kind of want to get through November and get some of those things behind us, including world events. But right now, it looks like we're going to experience top line growth in all segments. And on a consolidated basis, which we'll be talking about in December. I expect cash and OI and EPS notwithstanding pension headwinds and revenue to all grow. So that's encouraging, but details to come.

Our next question comes from the line of Ken Herbert with RBC Capital Markets.

Chris, maybe just following up for Michelle on that comment and some of the comments on AJRD in the opening remarks, beyond some of the Defense Production Act opportunities, can you just talk about how you're viewing CapEx across sort of legacy L3Harris and then more importantly, sort of AJRD as we think about 2024 and half of this year. And are you seeing a need to specifically sort of accelerate CapEx in AJRD to address some of the issues you outlined? And maybe how should we think about that as it relates to the growth in free cash next year?

Yes. I'll start it off and then ask Michelle to fill in. I mean we're going to continue to prioritize our R&D and our CapEx based on business cases and based on needs. I think Aerojet Rocketdyne always had $50 million, $60 million of CapEx in their plan so that I don't see any scenario where that would change or come down significantly. But we'll look at it compared to all the other investments that we have. I think I've all been said, it's a pretty high-growth market. and we're trying to accelerate. So between the DPA money, which is over 200, the $50 million to $60 million annual CapEx, any other supplemental sources of funding we get sometimes from states and local municipalities. I think it all fits within our overall CapEx target and to the extent we need more, it will be at the expense of something else in the legacy portfolio that we don't view is having the near-term need or the ROI. So that's kind of how I see it. There could be new markets down the road once we kind of catch up on this acceleration. And those will be case by case, but there's a lot of exciting new technologies within Aerojet Rocketdyne, but the team is really focused on the backlog and the core business for now.

Yes. So I would just add in terms of your question, Ken, around free cash flow for next year. So to Chris' comments, we do expect income to grow. So we think that, that will be a tailwind from an overall cash perspective. We expect some kind of nominal improvement in working capital. And then offsetting that, just as a reminder for everybody, our initial deal model on Aerojet assumed free cash flow accretion in year 2. So we expect there'll be some kind of marginal impact just in totality of where they're at in the program cycle. And then, on overall CapEx, we typically run around 2%. We're not expecting any fundamental change in that level of investment as we go into next year.

Our next question is from the line of Matt Akers with Wells Fargo.

I wanted to ask if you could touch on LHX NeXt a little bit. And specifically, just curious of the $500 million benefit that you called out, how much do you get to keep? Does any of that flow back to your customer or any other offsets we should think about?

Yes. Thanks for this question. I'm glad we're getting to talk about it a little bit more. And so this is the next phase of our L3 and Harris merger evolution, if you will. And so if you think about the initial integration savings that we did as a company, several hundred million along with some offsets. This is the next phase of this, kind of the harder parts, if you will. And it's really focused on leveraging our scale to drive efficiencies and also functional organization to ensure that we're optimized for value creation. And so to your point specifically around the overall bottom-line impact, we do anticipate that there's more investment that goes along with this phase of the journey, Matt. So you'll see in our investor letter, we laid out about $400 million of investment. And so you should think of this more as a nominal tailwind from a margin perspective and not flow it all to the bottom-line. But I do want to highlight a couple of tangible examples that the teams have already driven as we're in the early stages of this, just so you can start to characterize what are we talking about, when we're talking high level about LHX NeXt. And one of our recent wins, I'll complement our HR team in [indiscernible]. They've done a fantastic job in renegotiating our employee benefit package, again, leveraging the scale of the new L3Harris portfolio to not only increase our benefits and also save on costs, but we're also going to be holding our employee benefit cost flat to our employees. So this is really creating a win-win opportunity, both from a shareholder perspective, and our employees in terms of better benefits while maintaining the cost that they have to flow back to their families. And then, on the organizational side of the equation, our comms team led by Tania Hanna has redesigned how we serve the company from a comms perspective and really focusing on the things that matter, right? And so, when you think about comms and how we send out external communications or internal communications, what are the things that are really going to move the needle from a value creation perspective in terms of our shareholders. And so they focused on streamlining our overall workflows, and we've actually reduced double digits the number of communications that we're distributing as a result. So that gives you a little bit of color as to the things we're looking at. But the biggest buckets, I would highlight here are really around the material opportunities, both on the direct side and the indirect side of the equation. And so again, going back to -- we're in our fifth year as a company and truly leveraging the scale of L3Harris as a $35 billion market cap. And what we can bring to the table and negotiating with our suppliers has a real opportunity to drive value for our shareholders.

The next question comes from the line of Seth Seifman with JPMorgan.

Michelle, maybe another question for you. If you could talk about the path to the delevering and just kind of how much cash you need to have on the balance sheet. I think there's probably some more debt coming up, then the company will have an ability to repay. So how do you think about what to term out versus what to repay now?

Yes. Thanks for this question as we want every opportunity, we can to highlight that we are focused on debt repayment. And so what are we going to focus on first? We're going to focus on the commercial paper, the higher interest rates the variable rates, if you will. Where we sit today, post-acquisition, we're at $13.5 billion, and our target by the end of the year is to get to about $13 billion of debt. And so from a leverage ratio perspective, we're looking to be at 3.5 and our expectation is that we get below 3 over the next couple of years.

The next question comes from the line of Sheila Kahyaoglu with Jefferies.

Rob, this will be our last question this morning.

Just stepping back, big picture, your margins are 15% today. How do we think about expansion from here, is it possible? And then, to that extent maybe specifically on communication systems, can you talk about the puts and takes there? Can you shake off some of these supply chain issues? And how do you think about the improvement progress and just the core margin of that business and run away from here?

Okay. I think I'll take this one since it's our last question, Sheila, and I guess you snuck in right under the wire here. So good morning. Yes, thanks for acknowledging the 15%, which I think are industry-leading margins, which we are quite, quite proud of. And even though they are industry leading, we are committed to find ways to continue to grow those margins. So on the CS side, we do have the commercial business model, which has played well for us. And that goes beyond just the tactical radios, we also have it at West Cam with our turrets and some of our sensors. So I think that's just an area that we need to leverage. We've been increasing our prices to cover the dilutive effect of the cost increase. And I think that's something that this industry doesn't naturally do. I think we all see in our day-to-day lives, prices are going up all over the place. So we tend to try to want to hold pricing flat. But the new reality is, it's cost you more to buy components and labor. And Michelle mentioned, holding the employee benefit costs flat for 2 years in a row. Those are going to be priced into our products, plain and simple, and that's going to help keep the profitability where it is, if not maybe even increase it. And again, we'll try to leverage the supply chain and power the enterprise. We recently had some successful negotiations by working across all the segments and sectors, getting all the buy together and negotiating at a corporate-wide basis for actually direct material, and everybody does that for indirect, but direct is a lot harder, and we were able to pull that off. So I think that's a key part of it.…

So I think with that, I'll just thank everybody for joining the call this morning and another shout out to the employees who are really coming through and delivering a great third quarter. I know we're all working hard on Q4 and can't wait to see everybody in early December for our Investor Day down here in Florida. So with that, we will sign off, and thank you again.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.