Leonardo DRS, Inc.

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 3/5

Leonardo DRS, Inc. is a defense technology company specializing in advanced sensing, network computing, and integrated mission systems for the U.S. military and allied forces.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview and Analysis

Leonardo DRS, Inc. operates within the defense industry, a sector known for its high barriers to entry, long contract cycles, and significant government oversight. The company has carved a niche for itself by providing advanced technologies to U.S. military and related defense customers.

Revenue Distribution:

  • The company operates in three main segments:
    • Advanced Sensing and Computing (ASC): Designs and manufactures cutting-edge sensing, networking, and computing technologies.
    • Integrated Mission Systems (IMS): Focuses on power conversion, control, distribution, and propulsion systems for military and defense uses.
    • Other: Largely consists of small operations and corporate overhead.
  • Revenue is primarily derived from U.S. government contracts, which often involve long-term, fixed-price, cost-reimbursement, and time-and-materials agreements.
  • While international sales exist, they are not a significant portion of DRS’ revenue.
  • For the three months ended September 30, 2024, 75% of DRS’ revenue was directly derived from US government prime contracts and subcontracts, while 25% were received from commercial customers. However, for the nine months ended September 30, 2024, approximately 85% were derived from US government contracts.

Industry Trends:

  • The defense industry is undergoing a significant transformation with increased emphasis on technological innovation and data security.
  • There is a clear trend towards network-centric warfare, where advanced sensor technology, integrated systems, and cyber-resilience are crucial.

  • Government funding for defense technologies is generally stable with budgets that fluctuate on geopolitical factors.

    • With ongoing geopolitical conflicts and heightened security threats, the demand for defense technology, including advanced sensor, network computing, and integrated systems is expected to continue to rise.

Competitive Landscape:

  • DRS competes with a diverse array of companies, including large defense contractors, smaller specialty manufacturers, and technology providers.
  • Key competitors include Raytheon Technologies, Lockheed Martin, L3Harris Technologies, and several other major aerospace and defense companies.
  • Competition is fierce and driven by factors such as technological innovation, pricing, and ability to secure government contracts.

  • Government contracts often require specific certifications and clearances, effectively creating significant barriers to entry.

    • Given the nature of governmental contracting, the procurement of business often depends on established relationships with the government, making it difficult for newcomers to compete.

What Makes Leonardo DRS Different:

  • The company’s focus on specific niches such as advanced sensing, network computing, integrated mission systems and power solutions.
  • Company positions itself as more nimble and flexible compared to large aerospace and defense companies and as a reliable supplier to the US military.
  • DRS has a high degree of innovation in technology.
  • Has a close, long-term relationships with government customers.
  • Is a “trusted supplier” with the U.S. Government, often involved early in programs and projects.

Financials Deep Dive

Leonardo DRS, being primarily a government contractor, operates with a different financial profile than typical commercial businesses. Contracts with the U.S. government often involve progress payments and other types of reimbursements that affect cash flow. Furthermore, the business is capital-intensive due to substantial investments in research and development, which influences margins.

  • Profitability: DRS’ profit margins are under pressure and are not very high as they incur costs in development and manufacturing and are also sometimes subject to fixed price agreements.

  • For the three months ended September 30, 2024, the Gross Profit Margin was 23.0% which slightly declined to 22.9% in the nine months.
  • DRS is investing heavily in R&D and is trying to streamline and make its operations more efficient. As mentioned by management: “we are intensely focused on driving higher operational execution and program performance, while leveraging our engineering and operational expertise to drive efficiencies in our business”.

  • Adjusted EBITDA and Adjusted EBITDA margin were 12% and 11.2% respectively, for the three and six months ended September 30, 2023.

  • Cash Flow:
  • Free cash flow generation is limited by investments into growth.
  • FCF for the nine-month period ended September 30, 2024, was -$79 million.

  • Capital expenditures of around $80-$100 million each year reduce free cash flow, but are required to build out R&D activities and for growth.

  • Debt & Leverage: DRS had a net debt of $375 million at September 30, 2024 which is not too high as compared to its market cap of $1.66 billion.
    • The company is in compliance with its debt covenants with no issues regarding borrowing.
  • However, the debt level may make the balance sheet slightly riskier as the company relies on debt to finance investments and growth.
  • The company’s long term debt is also significantly higher than their shareholder’s equity.
  • Growth:

    • A key driver of revenue growth for DRS is increased government spending on defense technologies.

    • The company has a strong backlog of contracts, which is intended to be delivered over next several years, thus providing good visibility into future revenue.

    • Recent acquisitions are expected to enhance revenue growth by expanding the scope of products and capabilities.
    • Organic growth is limited to specific areas and new markets and the company’s focus is primarily on its existing business lines and contracts.

Recent Concerns/Controversies & Management’s Response:

  • In the earnings call the company mentioned that its revenue growth is affected by the timing of new program starts and contract completions and that it takes 6-9 months before a new program converts into revenue. Furthermore, delays from customers, particularly with new programs may further impact revenue.
  • Management expects to see a boost in growth from next year onward as new programs and contracts are set to start producing revenue in a higher volume.
  • DRS mentioned that they are focused on securing new business in the areas of electronic warfare, radars, power systems and sensors. The management team believes their new contracts will increase long term profitability of the business.
  • The company has been experiencing supply chain disruptions and longer lead times due to the global macroeconomic conditions, but the management has been implementing multiple initiatives to reduce costs and inefficiencies. They are making investments into digitalization to help streamline the supply chain.
  • The company noted that their operating margins had declined as a result of supply chain issues and that their gross profit margins were also pressured due to the timing of new program starts. The management hopes that operational efficiency improvements, pricing initiatives, and greater cost controls would boost margins in the coming future.
  • The management also noted that the U.S. defense budget has increased by 3%, and they expect this will lead to growth in their bookings and revenue in the next several years.
  • The company acknowledged that their debt increased significantly. However, that debt was raised to acquire RADA Electronic Industries and will improve the Company’s long-term profitability.

Moat Analysis

While DRS operates in a sector with inherent barriers to entry, we believe that it has a Narrow Moat.

Here’s the breakdown:

  • Intangible assets (3/5): DRS benefits from some technology patents, regulatory clearances, long-term contracts, and customer loyalty. However, the longevity of those patents is limited, new contracts must be actively sought after, and its customers may also be tied to other companies for particular components, so those advantages are limited.
* The brand name of DRS itself may not be a huge moat driver, as its customer base primarily consists of US government agencies and defense contractors, who are not particularly affected by brands.

  • Switching costs (2/5): The switching costs are lower for most customers. While the government may continue business with them for long periods of time, they can switch at any time for various reasons, including budgetary limitations. Some projects are also highly specialized to the supplier. However, DRS does have higher levels of switching costs in more customized production programs.

    • Customers have a large choice of other vendors and can be swayed by pricing and innovative technologies.

    • However, the switching costs for those in long-term service contracts are reasonably high.

  • Network Effects (1/5): There are minimal or no network effects. There is no reason for new customers to buy DRS over other providers because of previous customers’ usage.

    • Furthermore, the business is project driven as it provides specialized products and is dependent on each individual customer needs to win contracts.

  • Cost Advantage (3/5): The company has a certain cost advantage through its size and experience and having long-term contracts with its suppliers which can lead to efficient production.

    • However, there aren’t substantial barriers that will prevent other companies from developing similar expertise and processes.
    • DRS may be affected by input cost, which are primarily dependent on market conditions.

  • Overall, these factors combine to grant DRS a competitive advantage, but the limited barriers make it a Narrow Moat

Understandability Rating: 2 / 5

The company operates within defense and government contracts, making it more complex to analyze. Furthermore, the nature of contracts requires one to analyze data related to defense spending, technological trends, and government budgets, which can prove to be challenging to most average investors.

  • The mix of projects and product lines across various segments makes it hard to track individual product success.
  • The financials are impacted by different types of accounting methodologies used in government contracts, including long-term, fixed-price, and cost-reimbursement types. This makes a like for like comparison extremely challenging and requires one to closely analyze different segments.
  • Moreover, the Company’s earnings are affected by numerous adjustments for one-time items and accounting write-offs, making it very hard to analyze the results over time.

Balance Sheet Health Rating: 3 / 5

Leonardo DRS’ balance sheet is rated as Average due to a few key factors.

  • While the company’s debt has decreased in recent years as they’ve prioritized reducing debt, they have a significant debt-to-equity ratio which makes them more vulnerable to interest rate changes and other financial uncertainties.
  • The company’s cash position is limited. However, the company’s management is trying to increase cash-flows as seen by the negative FCF in the first nine months of 2024.
  • The company is dependent on the US government to make payments and on the approval of their budgets for their projects. This is why even if a contract is signed, the company’s revenue may be delayed or impacted.
  • The company has substantial investment in R&D which, although important for growth, limits its current cash generation. They need to find the right balance to drive free cash flows in the future to improve their balance sheet strength.
    • The company needs to ensure that it can continue its operations and grow its business at a reasonable risk profile.

Conclusion

Leonardo DRS provides critical technologies for defense and governmental contracts, with specific focus on networking, sensing, and power solutions. The company’s narrow moat is primarily built on its expertise, regulatory clearances, long-term contracts, and its existing business, but the moat is not particularly hard to overcome by competitors, as seen by the decline in operating profit margins, putting a cap on its long-term profitability. However, they also operate in an industry which has a strong secular trend and good growth prospects. Though the company has a strong backlog, it’s dependent on the US government for most of its revenue, which can cause uncertainty. The company’s financials, while overall decent and the management has taken actions to improve them, are affected by the nature of its business and need further improvements. As such, for a truly well-managed portfolio, a better understanding of the company, its industry, and its moat would be required to ensure sustainable returns over the longer term.