Leidos Holdings Inc (LDOS) 2020 Q2 法說會逐字稿

Greetings.

Welcome to the Leidos Second Quarter 2020 Earnings Call.

(Operator Instructions) Please note that this conference is being recorded.

At this time, I will now turn the conference over to Peter Berl of Investor Relations.

Please go ahead.

Thank you, Rob, and good morning, everyone.

I'd like to welcome you to our second quarter 2020 earnings conference call.

Joining me today are Roger Krone, our Chairman and CEO; 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, 2020.

Roger will lead off all with notable highlights from the quarter as well as comments on the market environment and our company strategy.

Jim will follow with a discussion of our financial performance and our guidance expectations.

After these remarks from Roger and Jim, we'll open the call for your questions.

Today's discussion contains forward-looking statements based on the environment as we currently see it and as such, does include risks and uncertainties.

Please refer to our press release for more information on the specific risk factors that could cause actual results to differ materially.

Finally, during the call, 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 presentation slides.

The press release and presentation as well as a supplementary financial information file are provided on the Investor Relations section of our website at ir.leidos.com.

With that, I'll turn the call over to Roger Krone.

Thank you, Peter, and thank you all for joining us this morning for our second quarter 2020 earnings conference call.

As we continue to navigate through these difficult times as a country and as a global community, I hope each of you are well and your families are safe.

Leidos' second quarter results demonstrate the resiliency of our business model, the value of our market diversity and the strength of our team as we delivered on commitments through the most challenging quarter I have seen in my career.

We exited 2Q with a strong business capture win rate, record-setting backlog, resilient cash position and improved capital structure.

These factors galvanize our optimism for the future despite the extended effects of the current pandemic.

In the quarter, the business delivered revenue of $2.91 billion, reflecting 6.8% growth from the prior year.

Adjusting for acquisition and divestiture activity, and effectively taking into account a full quarter's worth of COVID-19 impacts in specific areas within the business, organic revenue contracted by 3% over the same period.

We recorded our non-GAAP diluted earnings per share of $1.55, up 34% from the prior year.

In addition, we generated $422 million of cash from operations, ending the quarter with a solid cash balance of $588 million.

Net bookings of $4.6 billion yielded a book-to-bill of 1.6 for the quarter as well as a 1.6 on a trailing 12-month basis.

These impressive business capture measurements do not yet reflect material contributions from several notable single-award IDIQs that were competitively won over the past several months.

Upon receipt, those task orders will be captured in our bookings metrics in subsequent quarters.

Adjusted EBITDA margin of 11.8% was greater than the prior year.

The primary factor was the net gain resulting from the VirnetX legal settlement for patent infringement, which was largely offset by a full quarter of the anticipated COVID-19 impacts we discussed during last quarter's earnings call.

The impact of COVID-19 in the second quarter was approximately $222 million in revenue and $78 million in non-GAAP operating income.

While some of the Q2 impacts will be recovered in the second half of 2020, we expect more of the recovery to push into 2021 as the pace of reopenings began both later and slower in the second quarter than previously estimated.

Additionally, the security clearance processing timeline for new employees continues to lengthen, and some programs, such as Navy NextGen, remain affected by ongoing protest activity.

In the meantime, due to the critical nature of our work, all of our Leidos facilities have remained open, and each has implemented safe workforce plans to protect the health of our returning colleagues.

Per our guidelines, occupancy remains below 25% at this time, while more than half of our employee base continues to productively telework.

Other than a small percentage that remain home in a ready-state capacity, the remainder of our workforce reports to customer sites or other performance locations.

From a subcontractor and supplier perspective, our business partner network remains resilient and in good health.

We engage and monitor this important ecosystem daily.

Lead times have improved during the course of the quarter, and our teammates continue to perform across all of our programs.

Equally important, during the second quarter, recruiting and talent acquisition remained strong as evidenced by a nearly 8% growth in new hires compared to Q1.

This metric excludes additions from M&A.

Our ability to attract top talent in this manner is important as we staff up to successfully execute the new programs in our growing backlog, which now stands at a record $30.7 billion.

This core competency will also prove critical as we prepare the business for continued growth given the ongoing high pace of business capture activities across the diverse markets we serve.

When we compare mid-March through June of 2019 versus the same period in 2020, we found that we submitted more proposals during the pandemic with an aggregate approximate value of $8 billion.

Now turning to several notable awards.

Leidos was awarded the traveler processing and vetting software contract by the U.S. Customs and Border Protection.

Under this new blanket purchase agreement, we will provide a full range of software development life cycle services to support CBP's mission to safeguard America's borders and enhance the nation's global economic competitiveness.

This single-award BPA has a 1-year base period of performance followed by 4 1-year option periods and a total estimated value of $960 million.

The company was also awarded the Enterprise Standard Architecture V, also referred to as ESA V, task order to provide managed IT services for the Department of Justice, Bureau of Alcohol, Tobacco, Firearms and Explosives.

The single-award hybrid task order has a 1 10-month and 2 1-year base periods of performance, followed by 6 1-year option periods.

It includes a ceiling value not to exceed $850 million if all options are exercised.

Finally, our Dynetics subsidiary was awarded a sole-source contract for the production and sustainment of foreign radar simulators, known as the Laboratory Intelligence Validated Emulator, or LIVE, family of products.

The contract has a total estimated value of $356 million for production and sustainment for the next 10 years.

On the M&A front, we remain focused on the successful integration of both Dynetics and the former L3Harris' Security Detection & Automation businesses.

Both are progressing on schedule.

Since the Dynetics deal closed in late January, our integration has focused on combining our legacy Leidos Innovation Center, we call it the LInC, with our new Huntsville-based business.

The LInC has a great track record of executing early-stage R&D for DARPA and the Air Force Research Lab, and through the combination with Dynetics, we see opportunities for rapid prototyping and producing a higher conversion rate of research projects to programs of record.

Other early collaborations led to important wins such as NASA's human lander systems contract under the agency's Artemis program.

If down-selected, the follow-on contract to place the first woman on the lunar surface and return man could exceed $4 billion.

With Security Detection & Automation, key business systems integration decisions have been made, that further our confidence that the annual cost synergies of at least $20 million can be captured by 2022.

Additionally, we are pleased with the expansion of our checkpoint solutions that will promote the safety and health of the traveling public and those entrusted to provide security services.

To that end, in the quarter, we received an award at Edinburgh Airport in Scotland to upgrade the airport's security tray return systems with antimicrobial tray technology.

Also, the business was recently shortlisted for a 5-year opportunity at Munich Airport for the manufacturing, installation and service of explosive detection systems for cabin baggage.

This work would represent an important step in our strategy to grow in the airport security solutions market.

Turning now to the macro environment.

Despite a likely continuing resolution in the fall, we expect minimal overall impacts to our business sector as the fiscal year 2021 budget levels are already set under the bipartisan budget agreement.

Additionally, DoD has almost $125 billion in unobligated balances as of fiscal year 2019.

Therefore, if budget authorities are flat, these balances can allow higher rates of outlay to address our customers' ongoing critical mission requirements.

Looking through the Leidos lens, we are encouraged by our continued alignment with DoD's top 10 technology priorities.

The ongoing execution of our long-term business strategy further mitigates potential future headwinds for our business as does our portfolio diversity as approximately half of our business is aligned with the federal civil and health customers.

With regard to our health business, I'd like to reiterate that yesterday, we announced the appointment of Liz Porter as the new Health Group President.

Liz has held that position in an acting capacity since early March.

Prior to this role, she served as the Operation Manager for the Civil Group's federal energy and environmental business.

Liz has demonstrated leadership experience in program management, engineering and business development, will continue to position Leidos for growth in the expanding health markets.

Before I hand the call over to Jim, I want to acknowledge the pain over the continued injustice and violence suffered by the African-American community.

Over the past few months, we have seen this pain and more tragedy.

We all saw the killing of George Floyd in May and the tragedy in June as Rayshard Brooks in Atlanta was unnecessarily killed.

I said this to our employees on our website and our social media platforms, and I want to say this again to you: Racism and social injustice have no place in our society or at Leidos nor does any form of discrimination.

Equality and justice must be a universal experience, and we must take action.

And at Leidos, we are working to find new ways to engage on these critical topics in order for us to move forward together in unity.

To start, we are partnering with the Equal Justice Initiative, who fights against racial injustice and poverty and promotes equal treatment in our criminal justice system for the most vulnerable.

We have made a large donation in support of their important work, and I am moved by their focus on progress, education and equal justice under law.

Also, we are implementing inclusion training across our company and working to launch a Leidos' diversity and inclusion council and we are hosting listening sessions with management for our employees across the enterprise.

As CEO, I strongly embrace this responsibility and I want to share that with you today.

I will now turn the call over to Jim Reagan, our Chief Financial Officer, for more details on our second quarter results and guidance.

Thanks, Roger, and thanks to everyone for joining us on the call today.

As expected, Q2 has been a challenging quarter.

However, our quarterly results reflect our team's agility to respond to the fluid environment.

Let me start by sharing our quarterly results, an update on our recent financing activity, followed by an update to remaining year guidance, including COVID-19 impacts and assumptions.

Second quarter revenues grew 6.8% over the prior year period and contracted 3% organically.

The increase in top line revenue was driven by the recent acquisition of Dynetics and the L3Harris' Security Detection & Automation businesses.

These increases were offset by approximately $132 million of COVID-19-related impacts.

In addition, expected growth on existing programs was reduced by $91 million due to COVID-19.

Without these pandemic-driven headwinds, our second quarter organic growth would have been about 5% over the prior year period.

Adjusted EBITDA margins of 11.8% increased 180 basis points from the prior year quarter, driven by the following items: The first was the $81 million net gain related to the VirnetX legal matter.

The second was volume reductions on existing and new programs directly attributable to the COVID-19 pandemic of approximately $78 million.

And after adjusting for these discrete items and the related revenue impact of $222 million, adjusted EBITDA margins would have been 10.9%, reflecting strong program performance and reduced indirect costs for our business.

Non-GAAP diluted EPS for the quarter increased $0.39 over the prior year to $1.55, driven by increased volume, strong program performance and lower share count.

The net gain from the VirnetX legal matter and COVID-19 impacts largely offset one another.

Operating cash flows of $422 million reflects a onetime VirnetX litigation payment of $85 million, the incremental accounts receivable monetization of $74 million and lower tax payments.

As mentioned during our last earnings call, we remain committed to our long-term balanced capital deployment strategy.

In the quarter, we completed 2 actions toward our path to an adjusted net leverage target of 3.0x.

At the end of the quarter, the metrics stood at 3.4.

First, we've refinanced $1.75 billion of loans associated with the acquisition of Dynetics and the L3Harris' Security Detection & Automation businesses.

The deal marked our strong return to the investment-grade bond market, as evidenced by an oversubscription of approximately 12x, which facilitated lower rates compared to the initial price indications and simplified our debt covenant structure.

The transaction extended our debt maturities, resulting in 3 tranches of senior unsecured notes, including a 3-year, a 5-year and a 10-year, with a blended coupon rate of 3.75%.

Second, we used the VirnetX proceeds of $81 million, coupled with strong cash generation from operations during the quarter, to pay down approximately $226 million of our debt.

We had another solid quarter in business development, resulting in bookings of over $4.6 billion, bringing our book-to-bill for the quarter to 1.6x and an overall backlog position of $30.7 billion.

Large new business wins in the Defense Solutions segment and the Human Lander System program contributed to the record backlog number.

Let me now take a moment to recognize the outstanding work by our business development and capture teams in submitting a world-class winning proposal for the $7.7 billion Navy NextGen competitive procurement.

As you are aware, the award was protested, and in June, the U.S. government accountability office decisively denied 2 separate protests, including 1 from the incumbent.

These decisions reaffirm the outstanding rating assigned to Leidos by the customer across the most critical technical and management evaluation factors and also recognized our substantially lower price.

We remain confident that we will prevail in the U.S. Court of Federal Claims, and we look forward to ramping up the important work for our customer later this year.

Until then, the award will be excluded from our reported backlog.

I'll speak more to the ongoing protest later when we discuss our updated FY '20 guidance.

Before turning to our segment results, I'd like to provide an update on our hiring, given its importance to the growth of the company.

I'm pleased to report that we welcomed approximately 1,000 employees from the Security Detection & Automation businesses that we just acquired and we also onboarded nearly 2,000 additional new hires in the quarter.

Second quarter average weekly hiring has exceeded pre-pandemic levels, demonstrating our ability to attract top talent during a tight labor market.

The year-to-date annualized voluntary attrition rate has declined by approximately 230 basis points compared to the prior year, and we continue to invest in our people to drive retention and attract new employees.

Now for an overview of our segment results.

Defense Solutions revenue grew 12.6% on a year-over-year basis.

The primary driver for the growth was the acquisition of Dynetics.

From an organic perspective, the segment contracted 0.6% due to $18 million of contract volume reductions directly related to COVID-19.

In addition, expected on-contract growth was reduced by about $19 million due to COVID-19.

Non-GAAP operating margins of 8.1% declined 20 basis points from the prior year quarter, primarily attributable to COVID-19 impacts, which were partially offset by program wins.

Defense Solutions booked over $3.5 billion of net awards, including 2 large new business wins with our intelligence customers, resulting in a book-to-bill of 2.0x in the quarter and 1.5x on a trailing 12-month basis.

In our Civil segment, revenue grew 13.6% from the prior year quarter.

This growth was primarily driven by the $80 million contribution from the acquisition of the L3Harris' Security Detection & Automation businesses and increased contribution from new programs, partially offset by $18 million of reduced volumes on programs impacted by COVID-19.

Furthermore, the pandemic caused a reduction of $34 million in expected growth on existing contracts and delays to the ramp-up of new programs.

On an organic basis, the segment grew 1.6% from the prior year.

Non-GAAP operating margins in the Civil segment were strong at 12.9%, reflecting a 180 basis point increase over the prior year period.

This increase was driven by the acquisition of the SD&A business, program write-ups and performance on new programs.

Civil generated nearly $1 billion in net bookings in the quarter, reflecting the successful resolution of a protest on a new business award and the ESA V recompete award mentioned earlier.

The result was a book-to-bill of 1.3x for the quarter and 2.1x on a trailing 12-month basis.

And finally, turning to our Health segment.

Revenues were uncharacteristically low, declining 20.4% from the prior year period due to $96 million of COVID-19 impacts and the sale of the health staff augmentation business in the third quarter of 2019.

In addition, expected program growth reflected in our previous guidance was lower by $38 million due to COVID-19.

These negative impacts were partially offset by contributions from new programs and the acquisition of IMX in the third quarter of 2019.

After adjusting for the COVID-19 impacts and the acquisition and divestiture activity, revenues would have increased 11% year-over-year.

Non-GAAP operating margins for the Health segment were 5.3% for the quarter.

This lower-than-normal margin was the result of COVID-19-driven volume reductions on certain managed service contracts with fixed cost infrastructures.

Our Health segment saw approximately $150 million of bookings in the quarter, driving a book-to-bill of 0.4x with a trailing 12-month book-to-bill of 0.9x.

Moving now to the remainder of the year.

We are updating our guidance across all metrics to account for our second quarter results, additional COVID-19 impacts and increased visibility for the second half of the year.

We're adjusting our revenue guidance to a range of $12.2 billion to $12.6 billion, which is a reduction of $300 million or 2.4% from the prior range midpoint and represents a 12% increase over 2019 results.

This $300 million reduction includes additional COVID-19 impacts, which reflect the slower-than-anticipated customer reopenings, the delayed ramp-up of the Navy NextGen contract and various other program delays and volume changes.

As the NGEN protest has moved from the GAO, where it was fully decided, to the Court of Federal Claims, we remain confident that this protest will be resolved in our favor.

However, this does delay the full transition until late in the fourth quarter continuing into 2021.

Note that in our previous guidance, we expected our COVID-impacted programs to begin to ramp up back to normalized run rates during the second quarter.

However, with slower customer openings, we now expect programs to return to their normalized run rates in the fourth quarter and then continue unimpacted into 2021.

We anticipate that the majority of the 2020 impacts will be recovered in 2021, reinforcing our confidence in the ability to grow more than 10% organically next year, with margins at or above our 10% adjusted EBITDA margin target.

In terms of margins, we expect adjusted EBITDA margins of 10.0% to 10.2% for the year.

This 20% -- excuse me, this 20 basis point increase at the midpoint from the prior range reflects the net gain from the VirnetX litigation and the reduced indirect rates, partially offset by the impact of lower margins within the year in our Health segment.

As a result of these new ranges for revenue and margins, we are updating our non-GAAP diluted EPS guidance range to $5.25 to $5.55.

This increase of $0.25 at the midpoint from the prior guide reflects the net gain received from the VirnetX litigation, a slightly lower tax rate and reduced interest expense for the year, offset by the COVID-19 impacts discussed earlier.

Finally, we expect cash from operations to be at least $1.2 billion for the year, up from the prior guide of $1.0 billion, reflecting the proceeds from the VirnetX litigation and an anticipated $100 million increase in the net receipts from the accounts receivable monetization facility.

And 2 additional items to note to help you with modeling.

We expect lower net interest expense for the full year of $176 million, a decrease that reflects lower interest rates to our debt restructuring and a slightly lower non-GAAP tax rate in the range of 21% to 22%.

With all that, I'll turn it over to Rob so we can take some questions.

(Operator Instructions) And our first question comes from the line of Robert Spingarn with Crédit Suisse.

Just on the back of what Jim just went through, and Roger, you talked about this, too.

I just want to be clear on the pressure, particularly in the Health segment.

Are you saying that's mostly timing driven and that you're going to recover a lot of that next year?

Yes.

It has to do with some of the medical exam work that we do, think about it as fixed infrastructure, and because of COVID, a lot of facilities are shut down, and we have moved some of that to telehealth and some of that through review of existing medical records.

But the vast majority of the work that we do requires a medical exam.

And those are medical exams that have to be done, whether it be workmen's comp or a disability benefit.

And those have rolled, if you will, into backlog.

So think of it as a simple inventory.

Those need to get done, and they're not getting done.

And the individuals who need that benefit need a medical exam.

And so if they didn't get it in second quarter, then they're in the backlog now for third quarter and fourth quarter, but it's just going to take time to work through the backlog.

So it is literally a timing.

And what we have seen in the past, Rob, when we have seen the backlog, we will surge, right, and conduct more exams than normal to catch up.

So this is not a permanent timing difference.

It literally is just a delay and then we'll surge.

And then some time, probably late in '21, we'll come back to normal.

I see.

And it's not that they can get the exam elsewhere or that it's somehow lost share or anything like that, it's -- they come back to you.

Yes.

And all of the offers of these exams, whether it be workmen's comp or disability are in the same boat.

We've all been shut down, and the backlog has unfortunately grown.

And we are now 85% open, something like that as of earlier this week.

And so it's just going to take time now to work through the backlog, and we're committed to go do that.

Okay.

And then the other thing I wanted to talk about, I think it's very interesting, but your role on Skyborg as the system design agent.

I wanted to see if you could talk about the scope perhaps of that contract.

And if the work scope there is kind of a one-and-done or if you have any kind of recurring revenue stream from Skyborg long term?

Well, we're the -- essentially, the systems engineering contractor for the customer.

And as you know, I think you may have written, is that there are a handful of other companies that are working on the concept in the vehicle.

And our job on that program is to assist the customer in doing technical assessments and systems engineering at the content level.

And it's a nice program for us.

We're obviously very, very pleased with it.

It is not our largest program and probably won't grow to be because of our systems engineering role.

We stand more along with the customer and the user than we do with companies who may be designing and building the vehicle.

But that makes you somewhat agnostic on how this plays out.

Your role there...

Yes.

Absolutely.

And does this help you with autonomy efforts down the line?

Well, I think it helps us in many areas with autonomy, with systems engineering.

It advances, if you will, our past performance and our qualifications in the area.

And when we assessed it, we viewed -- we didn't really have an airborne offering and a better position for us was to be in the systems engineering role with the customer.

So it's a great qualification for us.

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

Roger, Jim, Peter.

I guess related to Rob's question to a degree, there's an element of Leidos with the thesis changing as the organic leader in the growth space given your recent wins like NGEN.

However, obviously, during COVID, I thought you gave a great explanation in May about the impacts of COVID, whether it was [dim sum] and Antarctica.

But clearly, that -- the scope of the COVID impact extended beyond those programs.

So I guess, why do you think those businesses were impacted?

And you touched upon it a little bit just now, but -- and how do you think that normalizes?

And how do we think about -- I guess, my follow-on is, how do we think about 2021?

Because you say in the slides, you normalize in Q4, whether it's revenue growth and margin mix.

Yes.

I'll get started and I'll let Jim finish.

By the way, the defense health program, the electronic records program for DHA is only impacted to a very, very slight.

In fact, we would -- we would reiterate that the completion schedule is still on track in the '23 time frame.

So most of our digital transformation work in the health care business is pretty close on schedule.

So we haven't seen huge numbers there.

Really, the impact this quarter has been in the exam business that we have, and it really caused us to take a couple of months where we just couldn't get the exams done.

And maybe I'll let Jim expand on that a little bit, sort of our fixed cost, variable cost view of our examination business.

Yes, I think, Roger, you just said it well.

But to just emphasize the point on what's changed from when we talked about the expected impacts a quarter ago, the real change has been that the impact of the pandemic in a number of geographies has been more prolonged and perhaps more severe than we had visibility to 90 days ago.

And that has caused some of our customer sites and some of our examination sites to be closed longer than expected and they return to work.

And some of our customer sites, whether it's our intelligence customers within the Defense Solutions segment or the places where we serve patients for these medical exam services, all of those have had a longer and more prolonged return to opening than we expected just 3 months ago.

But Sheila, your comment about '21, I think, was right on.

We expect to come back to a normative level in the fourth quarter.

And then, therefore, exceed that level in the exam business in 2021.

So obviously optimistic about what '21 will look like.

The next question comes from the line of Cai von Rumohr with Cowen.

Yes.

Could you please give us a little insight into recovery under the CARES Act.

For example, the areas in which you expect recovery.

Is that medical exam?

And do you have any hope?

And is it in your bookings that you would get recovery of these?

Yes.

Cai, I'll start, and if Roger has more to say, he'll pile on.

The CARES Act impact is actually helping us keep a number of employees in the Defense Solutions segment, primarily in the intelligence agency customer set in a ready state.

And so we're able to recover full cost, but not fee, for those people.

And it's no more than 5% of our employee base.

The CARES Act does not cover the recovery of ready-state employees or facilities for the contracts that we have in our Health Solutions business for 2 reasons.

One, a number -- a certain amount of that revenue is from commercial customers.

So think about insurance companies for whom we're doing disability exams and so forth, but also our government customers, because these are done on a fixed unit price basis where we do have some significant fixed infrastructure, think about lease costs and the cost of staff to process these exams.

Those costs are not normally covered by the provisions of the CARES Act.

So that's the primary impact that you're hearing us talk about in the Health business.

Our next question is from the line of Seth Seifman with JPMorgan Chase.

I was just curious with regard to the $300 million of incremental impact, should we think of that as being the vast majority of that in the Health business?

And I guess on the -- in the defense side, kind of thought of the main challenge for COVID-19 for federal service providers as being facilities that aren't open.

And so how should we think about the incremental impact that divided between those 2 areas?

Seth, think about roughly half of the $300 million is being incremental impact from COVID-19, with a little under half of it being the delay of the NGEN ramp-up because of the ongoing protest activity there.

And then the balance of it would be COVID-19 impacts in other parts of the business, such as the Civil business and other parts of the Defense Solutions segment.

Okay.

It sounds like then you don't really see that on the intelligence side, the impact of the pandemic unsecured facilities.

It sounds like that you don't see very much incremental impact there.

And not that much incremental.

The bulk of the incremental impact is being seen.

The largest single piece of it is being seen in the Health business.

Our next question is from the line of Jon Raviv with Citigroup.

Just Jim, some of those cash moving pieces heading from this year into next year, I think you got some sort of almost onetime transient items helping you get to the 1.2 or greater this year.

Can you just help us think about what the moving pieces are going forward, some of those tax items perhaps that go back, how sustainable the AR factoring is, et cetera, et cetera?

Sure.

Well, first of all, we expect to leave the AR monetization program in place, and that can -- there is some more possibility there to the extent that we need additional funding from it.

It's a very low-cost mechanism for us to use, and it's ready for us anytime.

And the other moving parts in getting us from the $1 billion to the $1.2 billion number on the change in guidance, there's, as we mentioned earlier, the VirnetX impact, that's cash in the bank today.

And then there are also some positive impacts from the CARES Act on how we pay taxes.

So we've been able to defer the payment of both income and payroll taxes, primarily payroll taxes into next year.

A portion of the deferral of our income taxes is simply moving it into Q3, Q4.

So think of the tax benefits into next year as being over $100 million.

And then the balance of the changes are primarily driven by COVID-19 impact being an offset to the tailwinds that we're seeing on cash flow.

Understood.

So should we be prepared for operating cash flow to fall year-on-year in 2021?

Or if, to the extent that the CARES Act items are offset by COVID, we can actually grow off that $1.2 billion in '21?

Well, some of the tax benefits will be offset next year and into 2022.

But the only other headwind that I think we can anticipate from a cash flow perspective is that we expect the business to grow nicely into 2021.

In the past, we've said high single digits, but now that we've got some significant backlog from the Health business and other parts of the Defense Solutions business for work that's going to carry into 2021, that's how we get to some confidence around 10% or better in terms of our top line next year.

The next question comes from the line of Peter Arment with Baird.

Roger, Jim, Peter.

Roger, just -- maybe just without getting into maybe specific dollar numbers, but when we think about the Security Detection & Automation kind of revenue profile, now that you've kind of been deeper into this business and seen the impacts of COVID or had conversations with customers, how do we think about this business as we go into '21?

Is it a business that's growing?

Or maybe just give us some color around the health of the business.

Right.

I'd love to.

By the way, they are ahead of our plan.

So we had an internal plan that we put together for the combined business, which included the Tewksbury business and the business in the U.K. that makes the tray return systems.

And they had a quarter that exceeded our expectations, and we expect that to continue.

And I know in the last call, we talked about what's going on at airports and is this going to have sort of a quieting effect on that business.

And our speculation was that airports are going to use this period of time to do capital improvements.

And we've certainly seen that.

We've also seen airports wanting to add social distancing and health and safety to the screening and the checkpoint.

If you have to stand 6 feet apart, you've got to redesign the checkpoint, which means you might need more lanes.

You're certainly going to need places for people to stand.

The antimicrobial trays, putting ultraviolet light in the return path for trays, doing touchless screening and looking at people's IDs.

There's just a lot of opportunity to grow the business beyond what we had anticipated when we built our original business case last year to acquire the business.

So then the team there led by Maria Hedden has been doing a great job of reaching out globally to customers and we are in 150 or more countries now.

And really, across the board, we've seen a lot of interest in capital improvements.

We would tell you that rebound has probably started a little stronger outside the United States.

We're sort of dealing with this kind of resurgence this summer, but in many of our foreign markets, they have had stricter lockdown on the pandemic and, therefore, their numbers are smaller, and they are implementing biometric concepts at their airport.

So we're very, very pleased, and the integration is going well.

And it is, like I said, ahead of our business case.

The next question is from the line of Edward Caso with Wells Fargo.

Can you talk a little bit about your recompete exposure for the rest of this year as well as 2021, please?

Yes.

Thanks, Ed.

There are kind of 3 that we talk about.

We've got our -- or what we call our NASA NEST program, which has been submitted.

And then we've got 2 more that have not been submitted.

We've got 1 at NGA, we call our user-facing and data services contract.

It's probably the largest.

It's up for recompete.

It's about $4.4 billion.

We should submit that towards the end of the summer.

And then we have the IT services work that we do for the Army Corps, we refer to as ACE-IT, that's a proposal that ought to submit also at the end of the summer, and it's going to be at $1 billion plus.

But the only one that's actually been submitted is our FAA NISC, which is the National Aerospace Systems Integration Support Contract, where we are the incumbent.

We're actually the incumbent on all 3 of those.

And is 2021 a normal 20%, 25% year?

Or is there anything unusual there?

Yes, very normal.

No, there's not a hanford out there.

Okay.

And you mentioned you were seeing issues in clearances.

We hadn't really been hearing that from some of your competitors.

Is there anything unique about the mix of your business that's challenging you more?

I think what may be unique for us, by the way, it's primarily in our intel business.

So it's the very high-end clearances, often requiring a polygraph.

I think the background investigations seem to be going okay.

I think the problem is -- I don't want to get into too much detail, but if you've ever been through a polygraph, it is a very COVID unfriendly process.

And how that's conducted and the throughput that the agencies have on getting polygraphs done has slowed down.

So it's uniquely in our intel business.

And I think why it affects us maybe more than others is because of the win and the growth that we've had.

So we -- we're not trying to maintain staff.

We're actually trying to significantly increase the staff in our intel business because of our wins.

And that means we have to get new people through the clearance process and able to support our growth.

And not reflecting on some of the others that have reported.

Our clearance process is not about our current workforce or really predominantly in what we call our collateral clearance, which you might see in our defense group, like a secret or a top secret, it really is in that high-end group.

Next question comes from the line of Joseph DeNardi with Stifel.

Jim, just in terms of 2021, is the thinking maybe that half of the growth is NGEN and half is all else, just in the context of you're sitting on a trailing 12-month book-to-bill of 1.6x ex NGEN, which would speak to really strong, maybe double-digit growth by itself?

So why can't growth be better than 10%?

Or do you see kind of a multiyear period beyond 2021 with really strong growth given the backlog?

And can you just update us on the pipeline of bids that you're expecting?

Sure.

Well, first of all, Joe, thanks for the question.

The -- speaking first of the pipeline.

The pipeline of new business opportunities continues to grow.

And interestingly, it is growing with a lot of programs where the -- first of all, we still have plenty of billion-dollar-sized programs in the pipeline, but there's also continuing growth in the size programs that are in the hundreds of millions of dollars.

So it gives us greater diversity and greater opportunity.

To your question about where the -- is half of the growth coming from NGEN?

Answer is really no.

Because the NGEN program will take some time during 2021 to ramp up.

And so the growth of the business, your point is well taken that it could be better than 10%, but it's our habit to be pretty careful and conservative in putting out those kind of targets this early in the cycle.

Last point that I would make is that we -- as we get to the back end of COVID, then our customers are more comfortable with the protocols that we're putting in place to protect patients and people undergoing these exams.

We expect that we'll be back on the path to the Health group's prior stature as being the part of our business that has the highest margins and the highest growth rates.

And while the Defense Solutions segment is going to enjoy nice growth from the NGEN program, we're looking forward to seeing the Health group get back to healthy margins and healthy growth rates in 2021.

Yes.

That's helpful.

And then just along those lines, in terms of the expectation that the business kind of gets back to normal by 4Q, do you have visibility into that?

Or is that more kind of hopeful in nature at this point?

I understand things are fluid.

Are you having customer conversations that give you confidence around that?

Or are you able to kind of change certain processes that lessens your exposure to kind of what you've been facing the past few months?

Yes, it's more the latter.

We already sit today in a better position where both the commercial and the government customers have allowed us to reopen clinics.

We have put social distancing, noncontact in place.

People are coming back to the clinics.

We're seeing the volume increasing.

It just did an increase in the second quarter.

And because we're now using PPE, we're having people wait in the parking lot before they come in for an exam, we're not at the same number of exams per day as we were pre-COVID, and so that's going to take another quarter or so to ramp back to where our capacity is, where it was pre-COVID on a clinic by clinic basis.

We're -- as I said, I think we're about 85% on the clinics that are open.

We expect it to be fully open in this quarter.

And then we've got to get our capacity up.

And you would only work so much overtime to get the number of exams done per day.

And we're all learning how to be more efficient in this COVID-19 environment.

And clearly, post-vaccine, we'll be either back or better than we were pre because we're learning how to be more efficient and had to do some exams by telehealth, which we -- was not a big part of our business prior.

And that allows us to do -- to have more capacity through a given site.

So -- and the customers across the board, corporations, government agencies are all very eager to work with us because the backlog is not good.

It's not good for them.

We want to go ahead and get these exams done so we can get the claims adjudicated and we can get reimbursements to the individuals.

Joe, one other point.

Aside from the Health business, in the Defense Solutions segment, and in particular, our intelligence agency customers, they've seen very real mission impacts because of the need to partially close their work locations and they're eager to work with us to get people back in those work locations.

And that is a process that's currently under way.

Last point that I would make, and one of the things that we've learned from how we've had to operate, we've reduced our cost structure.

And when you take the VirnetX settlement and when you take out the COVID-19 impacts to the business that are arguably temporary, the business had a 10.9% EBITDA margin in the quarter.

And while EBITDA margins go up and down from quarter-to-quarter, we do feel confident that, on an ongoing basis, what this has done is we've leaned out the business even further than we have, which gives us strong visibility into good margins into 2021 and beyond.

Our next question is coming from the line of Matt Akers with Barclays.

I wonder if you could comment just on what you're seeing kind of early Q3 is typically the big order quarter for the year.

I mean, are there any signs that this will be any slower than prior years?

Or are things sort of -- customer demand sort of holding up?

There's really no reason why it should be different than any other prior year.

I would simply point out, frankly, because of our success and the wins, we are also very successful in attracting protests and adjudication in the court of federal claims, and that has somewhat spread our 3Q.

We've got a couple of programs that have been in protest, they come out of protest, they get corrective action.

We have to resubmit.

And I think it -- where we might have seen a lot more concentration exactly in 3Q, we've seen some of that spread a bit.

We think NextGen, probably oral arguments are in October, that won't get resolved probably for a month.

After that, we have a program we call the Reserve Health Readiness program, which is a large program to provide services to the military reserve, and that is in corrective action.

So we have to go through a resubmit, which we have done, and then they have to adjudicate and make an award.

Again, that could be third quarter, but it's always hard to predict what happens in the protest world.

But -- but there is nothing unusual about this year that says third quarter should be any different than prior year quarters.

Got it.

That's helpful.

And then I guess one more just on tax with, I guess, R&D going from expensing to amortizing over multiple years, I think, in 2022.

Can you give kind of what the impact of that could be on Leidos?

Yes.

We're actually looking at ways that even with the change in the law, we're going to be able to recognize more of the work we do as eligible for the R&D tax credit.

I don't have a precise number for you, but we're not viewing it as something that can have a big impact or a material impact on our effective tax rate.

This year, we've done a really good job of identifying things that are eligible for not just the R&E tax credit, but even more importantly, in connection with the acquisitions that we've done, being able to take part of the ascribed value of the business and make them tangible personal property that is eligible under the accelerated depreciation rules that came with the recent Tax Reform Act.

So we think that there's some opportunity there to improve the cash tax position, not just from how we can optimize R&E, but even more importantly, get more benefit from the acquired companies.

We've reached the end of the question-and-answer session.

And I will now turn the call back to Peter Berl for closing remarks.

Great.

Thank you, Rob.

Thank you all for your time this morning and for your interest in Leidos.

We look forward to updating you again soon.

Have a great day.

This concludes today's conference.

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Thank you for your participation.