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Leidos Holdings Inc (LDOS) Q3 2022 Earnings Call Transcript

Leidos Holdings Inc (NYSE: LDOS) Q3 2022 earnings call dated Nov. 01, 2022

Corporate Participants:

Stuart DavisSenior Vice President, Investor Relations

Roger KroneChairman & Chief Executive Officer

Chris CageExecutive Vice President and Chief Financial Officer

Analysts:

Gavin ParsonsGoldman Sachs — Analyst

Robert SpingarnMelius Research — Analyst

Spencer BreitzkeCowen — Analyst

Eric YanWells Fargo — Analyst

Peter ArmentPeter Arment — Analyst

Colin CanfieldBarclays — Analyst

Bert SubinStifel — Analyst

Ellen PageJefferies — Analyst

Mariana Perez MoraBank of America Global Research — Analyst

Tobey SommerTruist Securities — Analyst

Ken HerbertRBC Capital Markets — Analyst

Presentation:

Operator

Greetings, and welcome to the Leidos Quarter Three 2022 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Stuart Davis, Senior Vice President of Investor Relations. Thank you, sir. You may begin.

Stuart DavisSenior Vice President, Investor Relations

Thank you, Maria, and good morning, everyone. I’d like to welcome you to our third quarter fiscal year 2022 earnings conference call. Joining me today are Roger Krone, our Chairman and CEO and Chris Cage, our Chief Financial Officer.

Today’s call is being webcast on the Investor Relations portion of our website where you will also find the earnings release and supplemental financial presentation slides that we’ll use during today’s call.

Turning to Slide 2 of the presentation. 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, as shown on Slide 3, during the call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is included in today’s press release and presentation slides.

With that, I’ll turn the call over to Roger Krone, who will begin on Slide 4.

Roger KroneChairman & Chief Executive Officer

Thank you, Stuart, and thank you all for joining us this morning. Our third quarter results demonstrate the momentum in our business as we continue to report revenue growth at the upper end of our guidance across our diversified portfolio. In addition, our dedicated team delivered earnings in excess of our forecast and generated the highest quarterly cash flow from operations in our history. These results position us well to deliver on our full year financial targets as we make the world safer, healthier and more efficient. As usual, I’ll touch on our financial performance, capital allocation, business development performance and people.

First, our financial performance for the quarter was strong and ahead of consensus at both the top and bottom-lines. Record revenue of $3.61 billion were up 4% year-over-year. Adjusted EBITDA margin of 10.3% was up 10 basis points sequentially and non-GAAP diluted EPS came in above our forecast and consensus. Our third quarter performance and improved visibility enables us to raise our revenue outlook and derisk our earnings for the full year. We also generated a record $748 million of cash flow from operations. This puts us on-track to meet our cash commitment for the year, strengthens our balance sheet and positions us for future capital deployments to benefit shareholders, which brings me to point number two, our approach to capital allocation.

Yesterday, we closed our acquisition of Cobham Aviation Services, Australia’s Aviation Special Mission unit. This business provides border force airborne surveillance and marine safety search-and-rescue and generates roughly $100 million in annual revenues. It is immediately accretive to both non-GAAP EPS and EBITDA margin. At this point in our strategic journey, the Cobham acquisition is a great example of what we’re looking for. It expands market access, provides us franchise programs with a customer of strategic importance and complements our existing business, all at a multiple below ours and a price that enable our shareholders to benefit from future revenue and cost synergies.

Our cash balance at the end of the quarter was $807 million as collections were especially strong in the back half of September, the close of the government fiscal year. Our plan is not to accumulate cash. We just paid for the Cobham acquisition, and we’ll be paying down some debt to move closer to our target leverage ratio of 3 times. Our balance sheet enables us to steadily deploy capital in productive ways. Given the strength of the company and evaluation that doesn’t reflect our long history of driving steady earnings growth and cash generation, we’ll lean towards share repurchase when we have deployable capital.

Number 3, our business development results demonstrate that our strong positioning in the government technology marketplace is enabling us to navigate a difficult environment. Procurement timelines continue to extend, and DoD outlays continue to lag budget authority. With net bookings of $4.1 billion in the quarter, we achieved a book-to-bill ratio of 1.1 and grew backlog to $35 billion or $35.4 billion on a constant currency basis. We also had nearly $1 billion of third quarter awards protested. Absence the protests, book-to-bill would have been 1.4.

Highlighting some important awards. We received a 5-year $1.5 billion dollar task order to support the DoD with rapid technology insertion to enhance C5ISR missions globally. We expect to receive the full award value over the life of the contract. But in accordance with our policy, we only booked $100 million in the quarter. This award noted as Sentinel is all about getting capabilities into theater and to the combatant commanders quickly. As a solution-agnostic integrator, part of our role is to find innovative technologies that can be rapidly matured, proven and integrated in support of multi-domain operations.

Sentinel fits within the Joint All-Domain Command & Control or JADC2) umbrella. Our positioning on JADC2 was also bolstered by the Air Force’s selection of the Advanced Battle Management System Digital Infrastructure Consortium. With four other consortium members, Leidos will work to deliver the Air Force’s vision for distributed battle Management and decision advantage by enabling speed, security and integration at-scale.

NAVSEA awarded Leidos a $358 million contract to design and build a medium-sized unmanned undersea vehicle to provide autonomous oceanographic sensing and data collection for operational intelligence as well as to support mine countermeasures. We also received our first task order on the $11.5 billion Defense Enclave Services contract. The $138 million task order will lay the framework and begin to consolidate integrate and optimize 5 agencies on a common network architecture through digital modernization and transformation. We successfully completed the transition period and have assumed operational responsibility for DoD net and DISA net.

And a key win for our space business within Dynetics, we received a subcontract with Northrop Grumman to develop hypersonic defense sensors for the Space Development Agency. We have more than 40 years of experience developing and flying space-based electro optical and infrared sensors and payloads for a variety of missions. Through this award, we’ll develop and build the sensor payload for a proliferated constellation of low earth orbit satellites for the Tranche 1 Tracking Layer. The tracking layer constellation will detect and track advanced hypersonic and ballistic missile threats as part of SDAs missile defense architecture.

On the predecessor contract, our Tranche 0 payload is on schedule to launch by the end of the year. The Tranche 1 design will increase coverage area while reducing payload size, weight and power. Eventually, these constellations of satellites will form the core of a new national defense space architecture providing global coverage and adding resiliency in the country’s initial warning arena. As a reminder, we’ll be hosting an Investor site visit at Dynetics in Huntsville, Alabama on December 1st. Please reach out to Stuart if you’re interested in attending.

And the final key win that I’ll touch on this morning is the re-award of our IT support to the Social Security Administration. As of the second quarter call, our award was protested by the previous incumbent, and after a resubmission of proposals, the SSA re-awarded all of the work to Leidos. The incumbent once again protested the award, and the new GAO review period expires on January 3rd.

And lastly point number four. Leidos is an attractive destination for great talent. In the third quarter, we hired just over 2,800 people and year-to-date, we have hired more than 9,000 people and increased headcount by more than 2,000. It’s still early, but voluntary attrition is trending in the right direction, and we don’t expect that staffing will significantly constrain our plans for next year. Our dedicated and capable people are a key differentiator for us and an important national asset.

Before turning it over to Chris, let me touch on the federal budget landscape. As expected, the federal government is operating under a continuing resolution at last year’s funding levels until December 16th. Congress is still working on the appropriations and authorization bills for government fiscal year 2023. Nothing will get voted on until after the November 8th elections, but we expect that robust budgets will get passed before the end of the calendar year. Outlays are beginning to improve, which bodes well for future growth.

Chris, over to you.

Chris CageExecutive Vice President and Chief Financial Officer

Thanks, Roger and thanks to everyone for joining us today. Third quarter results were positive and in-line with the picture that we gave on the second quarter call.

Turning to Slide 5. Revenues for the quarter were $3.61 billion, up 4% compared to the prior year quarter, despite a currency translation headwind of $32 million. Adjusted EBITDA was $372 million for the third quarter for an adjusted EBITDA margin of 10.3%, which was up 10 basis points sequentially. Non-GAAP net income was $221 million or $1.59 per share. Non-GAAP net income and diluted EPS were down 15% and 12% respectively compared to the third quarter of fiscal year 2021, which had the highest earnings in our history, driven primarily by the COVID catch-up in the business.

Let me touch on a few of the below the line drivers. Net interest expense increased to $50 million from $47 million in the third quarter of fiscal year 2021 with the rise in interest rates. The weighted average diluted share count for the quarter was 138 million compared to 143 million in the prior year quarter, driven by the ASR we executed in the first half of the year. Finally, the non-GAAP effective tax rate for the quarter was 25.8%, up 170 basis points sequentially which reflected the cumulative catch-up for changes to the mix of revenues across foreign and state jurisdictions. The higher-than-expected tax rate lowered non-GAAP diluted EPS in the quarter by $0.04.

Now, for an overview of our segment results and key drivers on Slide 6. Defense Solutions revenues increased by 3.3% compared to the prior year quarter. The largest growth drivers were the ramps on the NGEN and various force protection programs, which more than offset the end of our Afghanistan support contracts and the foreign exchange headwind. Defense Solutions non-GAAP operating margin for the quarter came in at 8.1%.

Civil revenues increased 10.4% compared to the prior year quarter. The NASA AEGIS program was the primary revenue driver, but we also saw good growth on our security products and commercial energy businesses. The mix shift helped drive non-GAAP operating income margin to 11%, up from 9.6% in the prior year quarter and the highest level in six quarters.

Health revenues decreased 3.4% over the prior year quarter. Revenue in the year-ago period benefited from the backlog of disability exams caused by COVID-19. And our share of certain exams has fallen with additional competitors added to one of our contracts. These factors outweigh another strong quarter on the DHMSM program. To this point, we have not seen much benefit from the PACTE Act that was passed in the last quarter, although disability exam volumes remain high. Non-GAAP operating income margin came in at 15% which is where we’ve been signaling all year.

Turning now to cash flow and the balance sheet on Slide 7. Operating cash flow for the quarter was $748 million and free cash flow was $721 million. These were record numbers for Leidos and I’m tremendously proud of the team’s focus and dedication. In addition, the government customers were looking to clear the decks at the end of their fiscal year, and in some cases paid invoices that would normally have been collected in Q4. DSOs in the quarter came down 3 days sequentially to 58, which is our target level. Great effort by the entire team.

During the third quarter, we returned $53 million to shareholders, primarily through our ongoing dividend program. At the end of the quarter, we had $807 million in cash and cash equivalents and $5 billion of debt. We closed the Cobham Aviation Special Mission acquisition earlier this week for $214 million, inclusive of the hedge that we had taken at the signing of the definitive agreement. In addition, we continue to focus on reducing our leverage ratio and we’ll use some of our cash balances to repay part of the $1 billion of debt that matures in the first half of 2023 and reposition our balance sheet for the future.

Onto 2022 guidance. Our new ranges are shown on Slide 8, and you can see the outlook has improved from last quarter based on strong performance across the company. The revised guidance includes 2 months of contribution from the Special Mission business acquisition as well. We now expect 2022 revenues between $14.2 billion and $14.4 billion. So, we’ve added $300 million to the bottom of the prior range and $100 million to the top-end, even after absorbing an adverse impact of foreign exchange rates of about $70 million.

We’re reaffirming our adjusted EBITDA margin guidance of 10.3% to 10.5%. We still have work to do to get back in the margin range for the year, but I’m proud of how the entire company has responded to the margin pressures that we spoke of on last call. For example, we decreased indirect spending and improved direct labor utilization across all three segments. We’re also taking a look at accelerating real-estate reductions to drive out additional costs, which will improve our competitiveness in our margins going forward. We’ll have more to report on that front on the Q4 call.

We’re now guiding non-GAAP diluted earnings per share between $6.20 and $6.40, so we’ve taken $0.10 off the top and bottom of the prior ranges. As I touched on earlier, our effective tax rate for the year is going to be a full point higher than we previously expected, which creates an $0.08 headwind to EPS. Compared to last quarter, our confidence around operating performance has improved.

Finally, we’re keeping cash flow from operations guidance at $1 billion or greater. Obviously, we had a tremendous performance in Q3, which puts us on-track for another strong cash year. We continue to monitor the potential for Congress to act on the tax research cost capitalization rules. With no change in law, the cost capitalization provision amounts to a negative impact to operating cash flow of about $150 million annually. We haven’t made any federal tax payments related to the amortization of research cost this year and do not plan to, although we will continue to reevaluate as conditions change. Barring a legislative fix, we expect to pay this $150 million in early January of 2023 and then make normal quarterly tax payments, inclusive of this impact thereafter.

With that, I’ll turn the call over to Rob so we can take some questions. I’m sorry, Maria, we’re ready to take some questions.

Questions and Answers:

Operator

Thank you. [Operator Instructions] Our first question is from Gavin Parsons with Goldman Sachs. Please proceed with your question.

Gavin ParsonsGoldman Sachs — Analyst

Hey, good morning.

Roger KroneChairman & Chief Executive Officer

Hey, good morning.

Chris CageExecutive Vice President and Chief Financial Officer

Good morning, Gavin.

Gavin ParsonsGoldman Sachs — Analyst

Roger, you mentioned you don’t expect staffing to significantly constrain your ’23 plan. Could you give us an early look at what that plan is in terms of revenue margins and maybe cash flow?

Roger KroneChairman & Chief Executive Officer

Yeah, you know Gavin, we don’t guide to ’23 until the end of the year and so we’re not kind of put out any numbers. What we will tell you though is that if you go back to our Investor Day, and we put some longer-term goals on Investor Day and we’re still confident with the numbers we provided you, gosh, I guess it was October, a year-ago so. But we’re still very excited about what’s going on in our space and we had a great quarter, and we expect ’23 to be strong.

Gavin ParsonsGoldman Sachs — Analyst

Okay. I appreciate. Thought I’d try. And then maybe in terms of Defense, you guys have talked a lot about investments you’re making there. I don’t know if you tell us a little bit more about that and the expected payback period, will be great?

Roger KroneChairman & Chief Executive Officer

Well, maybe I’ll start and then Chris can come back. And we, especially in our mission and operations area find customers who want to accelerate capability and look to the contractor base to make investments, to get them capability into the theater faster, and the Army has some airborne programs, in fact, I think our RFP just came out a week ago and we made some investments ahead of that program, and we hope till I get a decision, which will be next year, and actually start the program next year. So, some of these, when we make an investment like that, it’s usually on a pretty short string and it’s very consistent with the airborne work that we already do, and those margins tend to be above our corporate average.

Chris CageExecutive Vice President and Chief Financial Officer

Yeah, that’s right. And Gavin just to add to that, Roger talked about the great win our space team had on the Tranche 1 Tracking Layer, and that’s an example of where we’ve made some investments to ensure we could acquire the appropriate long-lead items, everybody’s talking about supply chain constraints, we’ve been monitoring that to make sure we got out ahead of the materials we needed to successfully win that contract, as one example. And then to continue to invest in our capability in clean rooms, engineering talent, etc. So, those are a few examples. The Dynetics, if you’re able to make it down to the trip that Roger talked about, that will give you a first-hand view of some of the areas where we’ve clearly made some investments in our facilities, team and capabilities.

Gavin ParsonsGoldman Sachs — Analyst

Okay. Thank you.

Roger KroneChairman & Chief Executive Officer

Great. Thank you.

Operator

Our next question comes from Rob Spingarn with Melius Research. Please proceed with your question.

Robert SpingarnMelius Research — Analyst

Hi, good morning.

Roger KroneChairman & Chief Executive Officer

Hi, good morning, Rob.

Robert SpingarnMelius Research — Analyst

Can you hear me.

Roger KroneChairman & Chief Executive Officer

Yes, we hear you. You sound great.

Robert SpingarnMelius Research — Analyst

Hi, there. So, Roger, when we talk to investors new to Leidos we often highlight your diverse segments and end-markets, and so on that vein I wanted to ask a longer-term question, as you head into next year and beyond where you see the sales momentum among the segments based on market interest in your products and services. So essentially what I mean is that, obviously, we are hopefully exiting a pandemic and rethinking how we handle a major medical crisis and you’re in the health business, we’re in the midst of a major infrastructure build here in the U.S. and you’re in the civil business, and of course, with the rising defense budget and a war in Europe. So how do you think long-term about relative growth for each of the sites?

Roger KroneChairman & Chief Executive Officer

Rob, thanks for the question, and of course, what we have been saying for years is we have been portfolio shaping and positioning the company both in Health, Civil and Defense to be in the swim lanes that are moving faster, and so just as I reflect on all three of those, of course, our Health business continues to have a really strong momentum, we’re almost through the COVID catch-up and back to normative levels, but we see continued growth in our Health business really driven by CMS, social security and what’s going on in DHA and it’s just been a great performer for us.

In Civil, we’ve talked now for quarters about the resurgence in air travel and we’re seeing strong resurgence certainly in the U.S. as I think all of us can attach to and we’re finally starting to see the revenue passenger kilometers pick up internationally. And our SCS team has had probably more meetings with customers in the last quarter than they did all of last year. So, we’re traveling again, and that bodes well for increased orders which will lead to increased sales in our global security business.

And then Defense, which we actually, if you think about a year-ago, thought was probably going to be our lower growth business, but as we’ve all come to learn, the world is a very complicated place, and it continues to be very, very complicated and I think those issues require that both the U.S. and our allies continue to invest maybe more than they would otherwise like to in the Defense of the nations. And so, our defense business has really held up well, and we don’t see anything on the horizon, it changes our view of that future and I think it really speaks to some of the decisions we made to shape the portfolio and emphasize on the parts of the business that we did.

I’ll highlight one other thing, it’s a smaller business for us and we don’t often talk about it, but within the Civil group, we have a commercial energy business. And that has just been going great. We do a lot of engineering for investor-owned utilities and energy savings programs for large production facilities, and that business has been growing in double-digits. And it’s interesting that utilities are connected to 5G, because you put 5G on towers and you need engineering for that, and that business has turned out to be a huge growth engine for us as well. I don’t know, Chris, you want to add?

Chris CageExecutive Vice President and Chief Financial Officer

Yeah. I mean, Rob, I think Roger covered the landscape pretty well. I would say that in the near-term again our Health business, very proud of that business and the team and we spoke about the SSA, this is a hard-fought battle to make sure that we ultimately prevail through the protest, feel confident that’ll be a growth catalyst for us in ’23 where we’re quite sure the RHRP program that we’ve been talking about for year, finally we’re up and running on that. So really feel like the Health business has room to grow in the near-term and then the Dynetics business is really ’24 and beyond, when you’ve got these force protection programs, you’ve got space, you’ve got things that can really ramp-up into significant program quantities, we’re very excited about that.

Robert SpingarnMelius Research — Analyst

So, Chris on that last part, you talked about up to ’24, but when I think about five years from now, for example, if Dynetics is growing fast than the rest of the company, do you see the overall portfolio of the three segments the same relative sizes in that long-term timeframe, 5 years out?

Chris CageExecutive Vice President and Chief Financial Officer

No. I would say that I would expect that.

Roger KroneChairman & Chief Executive Officer

Well, it depends on the biggest piece by double.

Chris CageExecutive Vice President and Chief Financial Officer

Yeah, if you start to get into the back half of the ’20s, I mean if things play-out the way we hope to, I think Dynetics has more opportunities with the defense hardware side to really grow those into substantial programs. But don’t forget, I mean, we’ve got the DES program too ramping-up on the digital modernization side, so that should be a big catalyst for us in Defense as well. So, probably back-half of the year I can see that Defense segment accelerating growth or beyond what we’re seeing in Health and Civil, but I wouldn’t count them out.

Roger KroneChairman & Chief Executive Officer

You know Rob, the point I would make, as you think about the company five years from now, the Health is primarily a kind of a people services-driven business, and I think it will continue to grow well and will provide health managed services to active military and veterans and others. But five years from now, some of the programs that we’ve been talking about, IFPC or SAS, they will be in significant production. And that will help to — it will change the complexion of the company a little bit so that we have 15% or 20% of month-over-month production programs generating higher-margin than our average, and what we’re going through now in ’23, ’22 and ’23 is the development of the programs in Enduring Fires and high energy laser, the Common-Hypersonic Glide Body which is just ramping-up and the stuff we’re doing on Tranche 1, by the way there is a Tranche 2 and a Tranche 3, so if you think about what we will look like five years from now, we will have the base business that we’ve always had and we will add to it kind of above that base some significant production program. So, we’re really excited about the company five years from now.

Robert SpingarnMelius Research — Analyst

Thanks so much.

Roger KroneChairman & Chief Executive Officer

Thanks, Rob.

Operator

Our next question comes from Cai von Rumohr with Cowen. Please proceed with your question.

Spencer BreitzkeCowen — Analyst

This is Spencer Breitzke on for Cai. Thanks for taking the question. Can you talk about if you’ve seen a pickup in award activity since the Pentagon occupancy limit was listed in September? Thank you.

Chris CageExecutive Vice President and Chief Financial Officer

I don’t know that — Spencer this, that we’ve seen a noticeable difference before or after quite honestly. That wasn’t really a constraint that we’ve seen. I think the Pentagon activity generally has been as expected, the bookings that Roger mentioned, we did see a number of RFPs dropped in our Defense business here over the course of October, so that’s been very active in our proposal pits very recently, so that’s exciting to see. But the Pentagon volume, I wouldn’t say we noticed a big impact, pre or post.

Roger KroneChairman & Chief Executive Officer

Yeah, a comment I would make is, Bill will plant, finally was confirmed by the Senate and putting as the acquisition exec in the Pentagon, and I would say since he has taken office, we’ve seen sort of upbeat in activity. Bill has been very accessible to industry, there have been a couple of drivers, tri-service meetings with Bill, and he’s trying to, I think accelerate the RFPs and to get outlays where they need to be, and I think that’s a real positive sign. I would look more towards that than I would the occupancy limit on the Pentagon. But I will confirm, when Fritz delivered on the Pentagon or not, I think we’ve probably been in the Pentagon more in the last quarter than we were in the first half of the year. So, I think it all bodes well that we’ll increase the activity, we’ll get some of these procurements under contract.

Spencer BreitzkeCowen — Analyst

Great. Thank you.

Roger KroneChairman & Chief Executive Officer

You’re welcome.

Operator

Our next question is from Matt Akers with Wells Fargo. Please proceed with your question.

Eric YanWells Fargo — Analyst

Hey, this is Eric Yan on for Matt. Thanks so much for the question. Just on CR, could you talk a little bit about the environment we’re in today compared to last year? Just what kind of impact have you seen from the CR so far? Also, if you think it will get extended again into next year?

Roger KroneChairman & Chief Executive Officer

Yeah, especially if we compare it to last year, this time last year, I guess, I was optimistic that we’d get a bill before the end of the year, and as we recount what happened last year, almost took the whole first quarter to finally get a bill, and that did have an impact. I mean, it just caused everything to slow because you’re capped at the prior year level. I’m more optimistic this year. I can’t predict the future, none of us can, but when we talk to members of Congress, the senior senator from the State of Alabama, they all seemed committed to get it done in lame-duck period after the election. And so, I have more confidence that we’ll get an omnibus before the end of the year, but no one can predict the future, lots of issues, I think we’re all reading the newspaper about the election and how things will go, but I feel better today than I did a year-ago that we’re going to get an omnibus and will avoid the extended CR that we had last year.

Eric YanWells Fargo — Analyst

Great. Thanks so much.

Roger KroneChairman & Chief Executive Officer

Sure. Thanks Eric.

Chris CageExecutive Vice President and Chief Financial Officer

Thanks Eric.

Operator

Our next question comes from Peter Arment with Baird. Please proceed with your question.

Peter ArmentPeter Arment — Analyst

Yeah, hi good morning, Roger and Chris.

Roger KroneChairman & Chief Executive Officer

Yes, hi good morning, Peter.

Chris CageExecutive Vice President and Chief Financial Officer

Good morning.

Peter ArmentPeter Arment — Analyst

Okay. Great. Maybe you could just update us on how you’re dealing with labor inflation, just regarding any salary adjustments and how that kind of flow-through and impacts the top-line? How should we be thinking about that?

Roger KroneChairman & Chief Executive Officer

Well, definitely, and thanks for the question, Peter. It’s certainly something we’ve spent a lot of time on throughout the year and even most recently as a leadership team. So, I think what we’ve been doing is obviously our merit budget pool has been increasing and we’ve seen that consistently over the course of the past 2 to 3 years and expect it will tick-up again as we’re looking ahead to 2023. So, in the past that was a sub 3% kind of annual pool, and then we have some one-off increases over the course of the year. I think what we’re seeing now is above, it’s mid 3s to 4 or higher in certain cases and so that will roll-through the topline as a tailwind on the cost reimbursable programs, which I’m sure you’re aware in the order of 50% of the portfolio.

So that’s goodness there on the topline contributor for growth and the balancing act is managing that on the fixed-price and T&M programs, and we’ve been successful there. I would say that managing margins this quarter at 10.3%, could have been better, well we’re looking ahead to a strong Q4, so we’re very thoughtful on building our pricing up and passing those inflationary cost pressures along to our customers where we can, certainly, it will be priced in as we put together next year’s forward pricing rates. But it’s absolutely something we’re spending a lot of time on as a management team and being thoughtful especially for the areas of talent that are in the highest demand.

Peter ArmentPeter Arment — Analyst

Thanks. That’s helpful and just as a follow-up. Roger can you maybe just update us on the aviation screening business. I know that you kind of put it out here that this was still going to be on ’24 but just any kind of green shoots you might be seeing there? Thanks.

Roger KroneChairman & Chief Executive Officer

Yeah, I’ll see if I can do this quickly. We’ve always described the U.S. business as sort of an RFP, get certified, compete for the business. And it’s funded really through authorizations and appropriations. That business continues to go well. There’s opportunities to insert new technology, what we call CT, or Computer Tomography at the checkpoint for carry-on, and we’re in the process of getting our equipment certified and we continue to see success domestically or in the U.S. along with our competitors so that business is great. But what will really drive growth in that business is the return of the international business, and the international business tends to be funded by ticket surcharges, so it’s more related to travel volume than it is in the U.S. where it’s essentially funded by the federal government, and it’s a lag.

So, the tickets, traffic has to come back, the ticket volume has to go up, the airport authorities, and every airport has a different governance structure, they have to be confident that the volume is there, and then they start to engage with the contractor base, they put out RFPs, we go and talk, we do demos, all right. And then it takes literally months or a year or two before there is an acquisition, you get certified, you get an award, you build the equipment, you deliver it. So unfortunately, there is a long timeline to this recovery, but the good news is at the front-end, the RFP activity, the demos, the requests that we have for specifications and the like is up significantly year-over-year. And I said our team is literally flying all over the world, talking to airport owners and operators about what’s available.

And I’ll make another point, we’ve done this before, during the period, kind of the COVID period, we kind of use that as an opportunity to up our investment in technology and our product as we wanted to make sure that we had state-of-the art detection equipment, there are a variety of new substances that airports want to detect, fentanyl being one of them, and that required us to tweak our algorithms, Eric, there’s some other reasons why we tweaked algorithms in the U.S. But we took the time, right, when maybe production wasn’t where we wanted it to be, but we took our team and used it to invest in technology to make sure that our products were worldwide competitive. And now we’re benefiting from that, is that we are at the leading-edge with the competition on what we have to offer, and the customers realize that and they’ve asked us to come and talk to them. So, we’re excited about it.

Chris CageExecutive Vice President and Chief Financial Officer

Especially, in the European market Peter, I’d say that’s probably the area we’re seeing the most receptiveness, we’ve had the most visits, there’s probably some things that we’re more optimistic on there. Hopefully, Asia will follow, but that’s probably further behind.

Roger KroneChairman & Chief Executive Officer

Yes. I think everyone knows that China is still essentially shutdown for COVID, and that does dampen travel in the Pacific region, but Chris is right, we’ve had a lot of trips there.

Peter ArmentPeter Arment — Analyst

Appreciate all the color. Thanks.

Roger KroneChairman & Chief Executive Officer

Yeah.

Operator

Our next question is from Colin Canfield with Barclays. Please proceed with your question.

Colin CanfieldBarclays — Analyst

Hey, good morning, guys. Circling back on the Defense production and airport recovery comments, can you just maybe talk us through the margin bridge from here to 2024 as Investor Day target of over 10.5%? And then maybe discuss which programs that you guys are developing under fixed-price and how you think about kind of that cash risk versus get into production?

Chris CageExecutive Vice President and Chief Financial Officer

Yeah, Colin I’ll start, and Roger can pile on. So certainly, the margin bridge and as Roger was asked earlier, we’re not going to paint a detailed ’23 picture at this point in time, but the good news is, when you look at how this quarter played out, I think that’s indicative of a great jumping-off point right, Health kind of came back to where we expected to be more on a normalized basis, we’ll have some up quarters and down quarters, but mid-teens was kind of the baseline and to give us a platform to potentially expand from there. Civil showed what it’s capable of with a modest increase in volumes in security products and good management, and I’d say the Defense side of the business is where we have some more opportunities to increase margins, right. So, balancing all that out, I’d say looking ahead to ’23 coupled with the inflationary discussion earlier, we’ll put together a plan that keeps us in the 10s and where that falls out more work to be done, but I mean I like the portfolio, but definitely when we get to ’24, and we’ve got more production-oriented outputs, a bounce-back in SCS, that’s when we feel more bullish on the 10.5% plus margin target longer-term. So, I think we’re in a good place to bridge that. I don’t know if it will be an up year or a flat year, but more to come on that when we give you the ’23 guidance.

Colin CanfieldBarclays — Analyst

Okay. Got it.

Roger KroneChairman & Chief Executive Officer

I’ll just add a sense or two. And we’re kind of foot stomp, what Chris discussed early, two-ways we drive margin, performance on existing contracts and then changing the mix so that we have programs on their face have higher revenue opportunity. We have always focused on performance, and that’s write-ups versus write-downs and control of indirect costs and overheads. And we are a very lean company, we have less than 100 senior executives in the company, we’re $15 billion, $14 billion company with that, and we continue to focus on that. And we’ve had success, but in our success, we’re not adding to corporate office, overhead and indirect costs.

And then on mix, and that’s been our story now for years is that we do have in our portfolio some businesses where we operate in Antarctica, we do large M&O, and those tend to be below the corporate average, and over time, and those are very important programs, important programs for the nation, but we want to complement those with programs that have higher margin potential. And we talked about production programs earlier even in some of our digital transformation programs, we can get a special project work if we can do enhancements, we can drive those two the higher margin and we do all of that the 10.5% is achievable. Yeah, Colin.

Colin CanfieldBarclays — Analyst

Yeah, okay. And then it looks like the DoD put out its strategic plan on Friday. I mean, it seems like the plan suggested that we get to a 100% MHS GENESIS rollout by 2024. So, if you could just maybe update us on the revenue cadence around that program and kind of how that multiyear stepdown interacts with your health margins? Thanks.

Chris CageExecutive Vice President and Chief Financial Officer

Yeah, Colin so again, I think the team has done an excellent job. GENESIS has been a growth driver for us this year, and we certainly are pivoting into a point where it’s going to taper down a bit and we’re approximately two-thirds deployed through the program at this point in time, right, so ’23, we’ll continue on that cadence. What I will say is, certainly the customer, and Roger can elaborate on this, there’s been a lot of discussion even getting the base deployments but then enhancing the capability of the software suite that we’ve got available to the customer and there has been a lot of discussion and opportunity and growth that we’ll see coming on the back of that to take full advantage of what the capabilities are. So, a little early to paint the picture on how much of a step-down we’ll see as the deployments moderate, but we’re very cognizant of that and the Health team has been working hard to find opportunities to offset that. Roger, you want to…

Roger KroneChairman & Chief Executive Officer

No, we continued our deployments through Hurricane Ian and are really on schedule to finish the program, frankly on cost or under cost and on-schedule. The DHMSM program is probably below the average in the Health group, so if you kind of understand the portfolio, it’s a very solid program, we’re excited about the performance, but there are just the way that portfolio shapes and the nature of the programs that as it tails down and we replace it with other work, frankly, there might even be some opportunities for margin improvement, but the volume is definitely going to come down and we’re trying to get to a position where we’re doing the operations and maintenance of the system at all the military treatment facilities. But as we’ve said, and I’m sure you follow the program from the beginning, you do get to the point where you’ve installed the GENESIS software in all the military treatment facilities and the program takes a different shape.

Colin CanfieldBarclays — Analyst

Got it. Thank you for the added color.

Chris CageExecutive Vice President and Chief Financial Officer

Thanks Colin.

Operator

Our next question is with Bert Subin with Stifel. Please proceed with your question.

Bert SubinStifel — Analyst

Hey good morning.

Roger KroneChairman & Chief Executive Officer

Hey Bert.

Chris CageExecutive Vice President and Chief Financial Officer

Good morning.

Bert SubinStifel — Analyst

Maybe staying on the Health side of things, the PACTE Act should result in an uptick in the VA backlog just as better and start applying for those benefits and compensation, but Chris you seem to note during your prepared remarks that you aren’t seeing that yet, how should we think about that Bill impacting both 4Q sales and then into ’23? And is this something that could get Health back to year-over-year growth?

Chris CageExecutive Vice President and Chief Financial Officer

Well, definitely. I mean, part of what we’re not seeing is that the VA didn’t necessarily set-up a way to track that explicitly just yet, so the team is working to make sure we understand what’s coming through as the PACTE Act case versus otherwise. But I think the main point is, this is ahead of us, right. So, and yes, it could be a contributor to the fourth quarter, that would be something if it were to happen could be one of the catalysts to push us up in the margin range as an example, right. So, that’s why there’s a range there, but certainly for ’23, we’re bullish on how that plays out and we’ve seen good overall referral volume, you know we are navigating throughout the year this recompete and reallocation of some of our other work to multiple competitors. But for the most part that’s settled out, maybe there’s a little bit more of that to go. But I certainly look at the PACTE Act case volume to be one of the areas that can drive growth for us in ’23.

Bert SubinStifel — Analyst

Okay. And then just on your comments there on sort of the margin and EPS range, the narrowed guidance that you guys have implies a pretty wide range of potential outcomes for 4Q. I think from anywhere from $1.44 to $1.64 in earnings, which would be at the midpoint below what you’ve seen sort of each quarter this year. Just curious what’s driving that expectation, and if you guys were to end up closer to that low-end, what do you think would have driven that?

Chris CageExecutive Vice President and Chief Financial Officer

Yeah, Bert, so I mean, a couple of things going on there, obviously, we’ll still see interest rates have been trending up, right. That’ll be a little bit of a headwind as you look at the fourth quarter on the below the line item. Bert, diluted share count were at 138 million, rounding down, I mean there is a scenario where it could pop to 139 million and round up, so that’s kind of in play there, and then we talked about the tax rate, right. So, taxes were a driver, the tax rate being higher than we expected at the end of the year, team is working hard as they always do to minimize the tax expense, but I’d say it’s more of the below the line items that are kind of in play there. I think operationally we feel solid about the trajectory of the business.

Bert SubinStifel — Analyst

And just a clarification question Roger for you, if I could quickly.

Roger KroneChairman & Chief Executive Officer

Sure.

Bert SubinStifel — Analyst

You noted some positive commentary on SD&A, are you sticking with sort of the 2024 full recovery timeline?

Roger KroneChairman & Chief Executive Officer

Yeah. Yeah.

Bert SubinStifel — Analyst

Okay.

Roger KroneChairman & Chief Executive Officer

We expect in ’24 to be at or above pre-COVID levels.

Bert SubinStifel — Analyst

Great. Thanks very much yeah.

Roger KroneChairman & Chief Executive Officer

Yeah.

Chris CageExecutive Vice President and Chief Financial Officer

Thank you.

Operator

Our next question is from Elan Page with Jefferies. Please proceed with your question.

Ellen PageJefferies — Analyst

Hi, two sort of question. I understand that you don’t want to give 2023 guidance but are there any major program drivers beyond the DES and RHRP to think about, and we always hear about your successes, but are there any losses to be aware of?

Chris CageExecutive Vice President and Chief Financial Officer

Sure, Ellen. So, I mean those are the bigger ones, obviously, the SSA, RHRP that we just talked a bit about the PACTE Act on the disability case volume and where that could play out. AEGIS will have a full year of volume, so that’s great. And you mentioned DES as well, right. So those are some of the ones that are kind of in the bag that will be growth catalysts. We’ll see, it’s not a recent loss, but the NGA ITEMS UFS contract, for example, we talked about that at the beginning of the year is a loss. We continue to execute on that for half the year through the third quarter, that will fall-out of the portfolio, so that’s one of the headwinds that we’ll have, but more recently our recompete win rate has been quite strong and so feel good about that, and so, I can’t think of another material down or that we have to overcome heading into ’23.

Roger KroneChairman & Chief Executive Officer

Yeah, Ellen, what’s been great about the journey at Leidos is losing $1 billion-dollar program when we were 5 or 10 years ago was really, really material for us. Now we’re bidding probably north of $50 billion worth of stuff in a year, and so, if we were to lose $1 billion program and clearly we don’t win everything, and so there are programs like that that we have not won, usually new business and takeaways not recompetes, it tends not to have a significant impact, all companies do this, sometimes we stretch to bid on something that’s maybe a little bit outside the strike zone, and we lose those, but it helps to build a relationship with the customer and then maybe when we bid the next program we win those. And like all companies there are, we do or lose programs not every week but often. But we win a lot more than we lose, which is what we’re trying to do, and as Chris said, we have a lot of work to do between now and the end of the year. It’s amazing how many RFPs have dropped, and how busy our team is frankly across all five of our business groups and three of our reporting segments and writing proposals over the two holidays which tends to be the way things work in our industry.

Ellen PageJefferies — Analyst

Great. That’s helpful. And then just on NGEN profitability was a little lower in the first half, how do we think about revenue and profitability on that program into Q4 and beyond?

Chris CageExecutive Vice President and Chief Financial Officer

Yeah Ellen, I think that’s one that I would say the best days are ahead of it as far as profitability goes, quite honestly. Revenue is settled into a nice range, team’s done a great job, staffing levels are robust and so our team, DJ, our program manager, Stifel, our Ops Manager have done an excellent job preparing that program for success. But I still would say our expectations are margins will continue to tick-up. I don’t think you should expect significant movements, but it should be a nice tailwind for us as we look ahead to ’23 and beyond.

Ellen PageJefferies — Analyst

Great. Thanks for that.

Chris CageExecutive Vice President and Chief Financial Officer

You’re welcome.

Operator

Our next question is from Mariana Perez with Bank of America. Please proceed with your question.

Mariana Perez MoraBank of America Global Research — Analyst

Good morning, gentlemen.

Roger KroneChairman & Chief Executive Officer

Morning.

Chris CageExecutive Vice President and Chief Financial Officer

Good morning.

Mariana Perez MoraBank of America Global Research — Analyst

So, with Cobham acquisition closed, what’s your appetite to increase international and/or NATO exposure?

Chris CageExecutive Vice President and Chief Financial Officer

International. Mariana, I would say, well, obviously Roger talked about Cobham extensively, very excited about that one. You know, we’ve got a large presence in Australia just like we do in the UK, so certainly those would be areas that we’re quite comfortable adding more capability on to. And then internationally, NATO has been a customer of ours, historically we’ve done some excellent work for them, some challenging programs and some very successful programs. But I don’t think you’ll see a scatter shot of other international beachheads. I think we’ll be very selective where we have kind of a major muscle movement, obviously, our SCS business does a lot of work internationally, so that’s one that if there’s areas to complement their capabilities from a service delivery perspective, we’ll look to do that. But right now, I mean, it’s probably playing to our strengths, and I would say our strengths are our business in Australia and the UK is the top priorities.

Roger KroneChairman & Chief Executive Officer

Yeah, Mariana, we tend to go where the U.S. goes. The Five Eyes countries, the NATO Alliance countries and we tend to go where the world is complicated. And right now, Europe and the Pacific Rim are places that we see growth, and so we’re excited about that. And Chris mentioned, I think we sell equipment through the SCS business maybe to 125 different countries, that all that is direct, some of those through manufacturers’ reps, but we have people, probably in 40, maybe 45 different countries supporting some of the SCS products at commercial airports so.

Mariana Perez MoraBank of America Global Research — Analyst

Great. And then could you mind reminding us from an M&A point of view, what do you look at in terms of like capabilities, customers, contracts that you would like to add to your portfolio?

Roger KroneChairman & Chief Executive Officer

Yeah, we’ve been talking about M&A for quite some time. And first the foot-stomp, we don’t feel compelled to do a big M&A. We like the portfolio. We like the size the scope and scale of the business. It’s really opportunistic in places where we can either add a new capability that complements an existing line of business, or we get access to a new customer. The Cobham acquisition is really an example of a capability that we’re very comfortable with, we actually fly the same type of aircraft, Challenger 650s and Dash 8s, so really familiar with the hardware, but it allowed us to extend to a new customer in Australia. That’s really, really important to the country, Australia has literally thousands of miles of coastline and really important that those are surveyed, and if they provide search-and-rescue services, and so we saw that in combination with our existing footprint in Australia to extend our business and to access a new customer base that we hadn’t access before. So, it’s a perfect example of what we would look for, but I will just foot-stomp again, we’re not in an aggressive posture on M&A. I think we’re going to be opportunistic as we go forward and execute on our book of business and deploy our cash in a way that creates value for our shareholders.

Mariana Perez MoraBank of America Global Research — Analyst

Thank you very much.

Chris CageExecutive Vice President and Chief Financial Officer

Well, thank you.

Operator

Our next question is from Tobey Sommer with Truist Securities. Please proceed with your question.

Tobey SommerTruist Securities — Analyst

Thanks. From a product standpoint and solutions standpoint sort of the higher margin areas of the business, where are you from a mix-shift perspective, sort of where the current portfolio is versus maybe what you aspire to over time? And do you have any visibility to that improving or increasing into next year? You mentioned the LEO satellite, which is why I asked?

Roger KroneChairman & Chief Executive Officer

Yeah, Tobey, we don’t put out hard numbers. I would tell you from a solutions standpoint, we’re pretty comfortable with where we have moved and the value-added work that we do, the special project work we do on some of our contracts and to provide a solution to a customer we’ve really worked hard to position the business in that way. From the actual hardware component, and by the way, we love to make hardware that’s part of the bigger solution where those things go hand-in-glove, but we’ve been working through program wins and through M&A to add a slight bit more hardware component to our offering. by the way it tends to have very sticky IP, if you’ve got a manufacturing facility, it tend to hold on to the program. It tend to be longer lived as programs go, you 5-year production runs, you have 10-year production runs. And although, we have some things that are in production, our hope is to add four or five products to our production portfolio, and as we said, at the beginning, 5 years from now to have a more significant part of our portfolio is actually connected to some hardware.

Tobey SommerTruist Securities — Analyst

And it’s a follow-up on the prior question about sort of M&A. I know you’ve, for instance, but from a market perspective with higher rates, and PE maybe not being able to pay the same kind of multiples they otherwise would, the low leverage and interest. Does that over the next, I don’t know so many quarters provide a better opportunity for strategic buyers such as your Health sales with the financial flexibility to maybe compete even more successfully on a go-forward basis for acquisitions than you might have been able to in recent years with low interest rates?

Roger KroneChairman & Chief Executive Officer

Yeah. I mean, Tobey it’s a good theory, and I think there’s a strong basis in the points that you make. First, I’d point out is PE is still very strong in our markets, and without going through some of the specific firms, one just did a $10 billion capital raise, and so there seems to be a lot of money available to private equity, so we see them leaving the market. Interest rates drive-up cost of capital for everybody, it does change the business case, and also would change the business case for us. Do I think strategics kind of come back with a little bit more balance sheet power and employee in the market, it could happen. What we try to do is not get tied-up in the kind of, it’s a good interest rate, it’s a bad interest rate, we really try to look at the fundamental strategic fit of the business and then see if we can get it at a price which closes on our business case. And we’ve used that approach in everything that we bought and that’s really how we do M&A going forward and interest rates come and go, PE can come and go, and we just need to stay close to our strategy and our knitting and buy those things that makes sense for us.

Tobey SommerTruist Securities — Analyst

Thank you.

Roger KroneChairman & Chief Executive Officer

Yeah.

Stuart DavisSenior Vice President, Investor Relations

Hey, Maria, it looks like we’re just at the top of the hour, so I think we have time for just one more question.

Operator

Okay. Our last question is Ken Herbert from RBC Capital Markets. Please proceed with your question.

Ken HerbertRBC Capital Markets — Analyst

Great. Thanks for squeezing me in. Hey, Roger, I just wanted to ask you, you’ve got obviously a number of opportunities on the hardware side. And as I think about your Defense portfolio, and you’ve alluded to an anticipated step-up in ’24 in this business. What should we focus on, what are the key milestones in ’23 as you look at that portfolio either in terms of contract milestones down selects, how should we think about tracking this through ’23 and what could you highlight as sort of the key watch items?

Roger KroneChairman & Chief Executive Officer

Yeah, Ken, great kind of provocative question, by the way the good news is lots, so no single program, no single down select drives the business. We’ve got to get Wide Field of View Tranche 0 up into space, we’re going to get Tranche 1 up into space, we’ve got to transition our Enduring Fires, both the enduring, which is the missile and high-energy laser, we need to get those into test. We have some things on the weapons side, those needed to get into test. On the airborne, we need to win the next airborne competitive program with the Army for their enhanced ISR program, which is Bombardier 6500 class aircraft, and so if we just go around the portfolio and it’s a lot of, I won’t call it singles and doubles, but it is World Series season. So, they really are kind of singles and doubles. There is no big homerun out there that we need to execute the strategy, and so you just kind of look at the press releases and we winning the programs, winning up hardware content, are we successful in getting these things feel they’re getting things in more a bit. Our MUUV program that I talked about, so we’re going to get, we now are in development, so that needs to go PDR, CDR, into production when you start building your UUVs and it just continue in that vein.

Chris CageExecutive Vice President and Chief Financial Officer

Ken, I would, again, not to, I feel like we shell for the Dynetics business, but the team will certainly talk in more detail at the end of November-December first on what some of those milestones look like, and so Roger just hit on it, we’re excited that we have more than a handful to focus on, but we’ve got the right team executing against that and there are some things where hopefully will be some additional contractual orders, you’ll see out of SES, and maybe a low-rate production order out of Dynetics. But again, that site visit will give you an opportunity to dig deeper there.

Ken HerbertRBC Capital Markets — Analyst

That’s great. And if I could just one quick follow-up, you’re obviously well-positioned in a lot of growing markets relatively early stage in some of these, how much is technology maturation risk around just the government’s ability to move forward on some of these to the scale in which we’d like to see?

Roger KroneChairman & Chief Executive Officer

Let’s — so, by the way, come to Huntsville, so and we’ll talk about technology, we’ll talk about the technologies and the different products. First of all, we want to have programs across the lifecycle of technology, we’re going to be doing work with DARPA, low-level TRL kind of programs, and then we want to have when we are starting to talk about production then those are higher TRL programs, and if I think about say the EF, the Enduring Fires programs, the technology risk is essentially behind us, okay. So, we need to apply the technology, we need to make it work, we need to connect it to the fire control system, we need to take it out on the ranges and shoot it and demonstrate it, but from invention standpoint, we do that kind of work under we call 62, 63, kind of early-stage programs with customers like the Office of Naval Research and AFRL and DARPA. And then those are, take risk, invest, fail fast, kind of programs and we love having those, our people love working on those, but the ones that are significant in our financials going-forward we’ve gotten through CDR, PDR, we bought down the technical risk and I think you’ll be impressed with the level of technology we have in those programs and how mature that technology is, if you can make it tangible.

Ken HerbertRBC Capital Markets — Analyst

Great. Thank you very much.

Roger KroneChairman & Chief Executive Officer

You’re welcome.

Operator

Hey, there are no further questions at this time. I would now like to turn the floor back over to Mr. Davis for closing comments.

Stuart DavisSenior Vice President, Investor Relations

Maria, I want to thank you for your assistance on this morning’s call. And thank you everyone for joining us this morning and your interest in Leidos. We look-forward to updating you again soon. Have a great day.

Operator

[Operator Closing Remarks]

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