Leonardo DRS(DRS) - 2022 Q4 - Annual Report

PART I Business Leonardo DRS provides advanced defense technology to the U.S. government and allies, operating through two segments and heavily reliant on U.S. government contracts under FOCI regulations - The company is organized into two primary operating segments: Advanced Sensing and Computing (ASC) and Integrated Mission Systems (IMS)[21] - The Advanced Sensing and Computing (ASC) segment focuses on technologies for situational awareness, including advanced sensors (EO/IR, SIGINT, EW, radar) and rugged network computing for battle management and command and control[22][23][24] - The Integrated Mission Systems (IMS) segment specializes in power conversion, ship propulsion systems (notably for the Columbia Class submarine), force protection systems (like C-UAS), and transportation/logistics systems[25][26][29] Revenue by Customer (2022) | Customer Group | Percentage of Total Revenue (2022) | | :--- | :--- | | U.S. Government (Total) | 84% | | - U.S. Army | 37% | | - U.S. Navy | 32% | | - U.S. Air Force | 5% | | - Other DoD Agencies | 10% | | Foreign Governments & Commercial | 16% | Revenue by Contract Type | Contract Type | 2022 ($M) | 2021 ($M) | 2020 ($M) | | :--- | :--- | :--- | :--- | | Firm fixed price | $2,347 | $2,498 | $2,408 | | Flexibly priced | $346 | $381 | $370 | Backlog Summary | Backlog Type | 2022 ($M) | 2021 ($M) | 2020 ($M) | | :--- | :--- | :--- | :--- | | Funded | $2,783 | $2,510 | $2,847 | | Unfunded | $1,486 | $351 | $444 | | Total Backlog | $4,269 | $2,861 | $3,291 | Company-Funded R&D Expenses | Year | Amount ($M) | | :--- | :--- | | 2022 | $58 | | 2021 | $48 | | 2020 | $41 | - Key strategic activities in 2022 include the merger with RADA Electronic Industries Ltd., the sale of the Global Enterprise Solutions (GES) business, and the divestiture of its interest in Advanced Acoustic Concepts LLC[58][59][60] - Due to its majority ownership by Leonardo S.p.A., the company operates under a proxy agreement with the DoD to mitigate Foreign Ownership, Control, or Influence (FOCI) and maintain security clearances for classified programs[68] Risk Factors The company faces significant risks from U.S. defense spending dependence, fixed-price contract exposure, stringent government regulations including FOCI, supply chain disruptions, and potential conflicts of interest with its majority stockholder - The company is heavily dependent on U.S. government contracts, which accounted for approximately 84%, 86%, and 84% of total revenues in 2022, 2021, and 2020, respectively, where reductions in defense spending could materially impact the business[104][105] - A significant portion of revenue (approximately 87% for 2020-2022) comes from fixed-price contracts, which carry the risk of cost overruns and reduced profitability if costs are not accurately estimated or controlled[108] - As a company deemed to be under Foreign Ownership, Control, or Influence (FOCI) due to its ownership by Italy's Leonardo S.p.A., DRS must operate under a proxy agreement with the DoD to maintain security clearances for classified contracts, where failure to comply could result in contract termination[111][112][222] - U.S. government contracts are often only partially funded and can be terminated for convenience, meaning the full value of backlog and bookings may not be realized[115][132] - The business is susceptible to security breaches, including cyber-attacks and insider threats, which could disrupt operations, compromise sensitive government information, and result in significant financial and reputational damage[158][159] - The ultimate majority stockholder, Leonardo S.p.A., may have interests that conflict with those of other stockholders, and this relationship may discourage change of control transactions and requires US Holding's approval for certain major corporate actions like material M&A or incurring significant debt[231][233][237] - As a 'foreign person' under CFIUS regulations, future acquisitions or investments by DRS in U.S. businesses may be subject to review, which could block, delay, or impose conditions on such transactions[228][229] Unresolved Staff Comments The company reports no unresolved staff comments from the SEC - None[242] Properties Leonardo DRS is headquartered in a leased facility in Arlington, Virginia, operating a mix of owned and leased properties across 16 U.S. states, Canada, and Israel, considered adequate for current operational needs - The company's principal executive offices are leased in Arlington, Virginia[244] Significant Facilities | Location | Operating Segment | Approx. Sq. Footage | Owned/Leased | | :--- | :--- | :--- | :--- | | Milwaukee, WI | Integrated Mission Systems | 610,800 | Leased | | West Plains, MO | Integrated Mission Systems | 447,067 | Owned | | Menomonee Falls, WI | Integrated Mission Systems | 372,856 | Leased | | Melbourne, FL | Advanced Sensing and Computing | 336,287 | Leased | Legal Proceedings The company is involved in ordinary course legal proceedings, including a notable CERCLA matter where a subsidiary is a potentially responsible party for radioactive material at a national park site - A subsidiary received a Request for Information from the National Park Service under CERCLA regarding radioactive material at a site operated by an alleged predecessor over 50 years ago, where the NPS may seek reimbursement for investigative and remedial efforts[252][253] Mine Safety Disclosures This item is not applicable to the company - Not applicable[254] Information about our Executive Officers This section provides biographical information for the company's key executive officers as of December 31, 2022, including the CEO, COO, CFO, General Counsel, and EVP of Business Operations Executive Officers (as of Dec 31, 2022) | Name | Age | Position | | :--- | :--- | :--- | | William J. Lynn III | 68 | Chief Executive Officer and Chairman | | John A. Baylouny | 61 | Executive Vice President, Chief Operating Officer | | Michael D. Dippold | 42 | Executive Vice President, Chief Financial Officer | | Mark A. Dorfman | 48 | Executive Vice President, General Counsel & Secretary | | Sally A. Wallace | 56 | Executive Vice President, Business Operations | PART II Market for the Company's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The company's common stock is listed on the Nasdaq and the Tel Aviv Stock Exchange under the ticker symbol "DRS", and it does not currently pay cash dividends or have a share repurchase program - The company's stock is listed on the Nasdaq and the Tel Aviv Stock Exchange under the symbol "DRS"[270] - The company does not currently pay cash dividends and does not expect to in the future[271] - The company does not currently have a common stock share repurchase program[273] Reserved This item is reserved Management's Discussion and Analysis of Financial Condition and Results of Operations In 2022, revenue decreased due to divestitures, but operating and net earnings surged from asset sales, while backlog grew significantly, and free cash flow declined due to supply chain investments Results of Operations In 2022, total revenues decreased due to divestitures and supply chain issues, while gross profit and margins improved, and operating and net earnings significantly increased due to gains on business disposals Consolidated Results of Operations Summary | (In millions, except per share amounts) | 2022 | 2021 | 2020 | % Change (22 vs 21) | | :--- | :--- | :--- | :--- | :--- | | Total revenues | $2,693 | $2,879 | $2,778 | (6.5)% | | Gross profit | $575 | $547 | $494 | 5.1% | | Gross margin | 21.4% | 19.0% | 17.8% | +2.4 p.p. | | Operating earnings | $561 | $236 | $181 | 137.7% | | Net earnings | $405 | $154 | $85 | 163.0% | | Diluted EPS | $1.88 | $0.73 | $0.40 | 157.5% | | Backlog | $4,269 | $2,861 | $3,291 | 49.2% | | Bookings | $3,156 | $2,595 | $3,055 | 21.6% | - The 6.5% revenue decline in 2022 was primarily due to the disposal of the GES business ($109 million impact) and supply chain component availability issues in the ASC segment (over $100 million impact)[318] - Operating and net earnings growth was largely attributed to the pre-tax gain of $354 million realized on the GES and AAC disposals[314][327] - General and administrative expenses increased by $64 million (21.8%) in 2022, driven by $38 million in transaction costs for the GES/AAC dispositions and RADA merger, and a $10 million increase in IR&D investment[325] - Backlog increased by $1.4 billion (49.2%) to $4.3 billion, primarily driven by a multi-submarine contract for the Columbia Class program which added $1.083 billion in unfunded backlog[348] Key Non-GAAP Operating Measures In 2022, Adjusted EBITDA and margin improved, Adjusted Diluted EPS remained flat, and free cash flow decreased due to increased investments in inventory and contract assets from supply chain delays Key Non-GAAP Operating Measures | (In millions, except per share amounts) | 2022 | 2021 | 2020 | | :--- | :--- | :--- | :--- | | Adjusted EBITDA | $318 | $310 | $268 | | Adjusted EBITDA Margin | 11.8% | 10.8% | 9.6% | | Adjusted diluted EPS | $0.83 | $0.83 | $0.58 | | Free cash flow | $74 | $122 | $82 | Adjusted EBITDA Reconciliation | (In millions) | 2022 | 2021 | 2020 | | :--- | :--- | :--- | :--- | | Net earnings | $405 | $154 | $85 | | Income tax provision | $120 | $46 | $27 | | Amortization of intangibles | $10 | $9 | $9 | | Depreciation | $55 | $49 | $44 | | Restructuring costs | $3 | $5 | $12 | | Interest expense | $34 | $35 | $64 | | Deal related transaction costs | $43 | $5 | $9 | | Other non-operating expense | $2 | $7 | $18 | | Gain on sale of dispositions | ($354) | — | — | | Adjusted EBITDA | $318 | $310 | $268 | - Free cash flow decreased by $48 million in 2022, attributed to supply chain delays that resulted in increased investment in inventory and contract assets[373] Review of Operating Segments In 2022, ASC revenue declined due to divestitures and supply chain issues, while IMS revenue and Adjusted EBITDA significantly grew, driven by key programs and strong execution, leading to a substantial increase in IMS backlog Segment Performance Summary (2022 vs 2021) | (In millions) | ASC | IMS | | :--- | :--- | :--- | | Revenue | | | | 2022 | $1,733 | $983 | | 2021 | $1,940 | $959 | | % Change | (10.7)% | 2.5% | | Adjusted EBITDA | | | | 2022 | $199 | $119 | | 2021 | $220 | $90 | | % Change | (9.5)% | 32.2% | | Adj. EBITDA Margin | | | | 2022 | 11.5% | 12.1% | | 2021 | 11.3% | 9.4% | | Backlog | | | | 2022 | $1,868 | $2,401 | | 2021 | $1,762 | $1,099 | | % Change | 6.0% | 118.5% | - ASC segment revenue decreased by $207 million, primarily due to the net negative impact of the GES divestiture and RADA acquisition ($108 million) and supply chain delays[407] - IMS segment revenue increased by $24 million, driven by growth in Counter UAS/Short range air defense ($26 million) and Columbia Class submarine propulsion ($70 million)[418] - IMS Adjusted EBITDA increased by $29 million (32.2%), with margin expanding to 12.1%, attributed to improved performance on the Columbia Class program, including a $15 million positive impact from a contract modification[420] Liquidity and Capital Resources As of December 31, 2022, cash decreased due to lower operating cash flow impacted by tax payments and increased working capital, offset by proceeds from divestitures, while financing activities included a significant dividend payment Cash Flow Summary | (In millions) | 2022 | 2021 | 2020 | | :--- | :--- | :--- | :--- | | Net cash provided by operating activities | $33 | $178 | $125 | | Net cash provided by (used in) investing activities | $436 | $39 | ($70) | | Net cash used in financing activities | ($403) | ($38) | ($80) | | Net increase (decrease) in cash | $66 | $179 | ($24) | - The decrease in operating cash flow was attributed to tax payments from the GES and AAC dispositions ($79 million) and transaction-related outlays ($29 million)[432] - Financing activities included a $396 million dividend paid to US Holding following the asset divestitures[398][437] Critical Accounting Policies and Estimates The company's critical accounting policies involve significant management judgment and estimates in revenue recognition, goodwill impairment, pension assumptions, business combinations, and income taxes - Key critical accounting policies involve significant judgments and estimates in the areas of Revenue Recognition, Goodwill Impairment, Pension Assumptions, Business Combinations, and Income Taxes[448][449] - Revenue on the majority of contracts is recognized over time using the cost-to-cost percentage of completion method, which requires significant estimation of total contract costs and is subject to cumulative catch-up adjustments[450][451] Quantitative and Qualitative Disclosure of Market Risks The company's market risks include interest rate fluctuations on variable-rate debt, limited foreign currency exposure, and inflationary pressures on supply chain costs impacting fixed-price contracts - The company is exposed to interest rate risk on its variable-rate borrowings, where a 0.5% increase or decrease in the weighted average interest rate would change annual interest expense by approximately $1 million[468] - Foreign currency risk is limited, with primary exposure to the Canadian dollar on receivables of $46 million as of year-end 2022[469] - The company has experienced inflationary pressures on supply chain costs, which could negatively impact profitability, particularly on longer-term firm fixed-price contracts[470][471] Financial Statements and Supplementary Data This section presents the company's audited consolidated financial statements for 2020-2022, including the auditor's report and detailed notes - The financial statements were audited by Ernst & Young LLP for the year ended December 31, 2022, and by KPMG LLP for the two-year period ended December 31, 2021[475][489] - Critical Audit Matters identified by the auditor for 2022 were: 1) Revenue recognition based on the percentage of completion method, due to the judgment involved in estimating costs at completion for long-term contracts, and 2) Valuation of acquired intangible assets from the RADA merger, due to significant estimation in determining fair value[481][486] Changes in and Disagreements with Accountants on Accounting and Financial Disclosure The company reports no changes in or disagreements with its accountants on accounting and financial disclosure - None[788] Controls and Procedures Management concluded that the company's disclosure controls and procedures and internal control over financial reporting were effective as of December 31, 2022, excluding the recently acquired RADA business from the latter assessment - Management concluded that disclosure controls and procedures were effective as of December 31, 2022[789] - Management concluded that internal control over financial reporting was effective as of December 31, 2022[790] - The assessment of internal control over financial reporting excluded the operations of RADA, which was acquired on November 28, 2022[792] Other Information The company reports no other information for this item - None[795] Disclosure Regarding Foreign Jurisdictions and Prevents Inspections This item is not applicable to the company - Not applicable[796] PART III Directors, Executive Officers and Corporate Governance Information regarding directors, executive officers, and corporate governance is incorporated by reference from the company's 2023 definitive proxy statement - The information required by this item is incorporated by reference from the company's 2023 definitive proxy statement[797] Executive Compensation Information regarding executive compensation is incorporated by reference from the company's 2023 definitive proxy statement - The information required by this item is incorporated by reference from the company's 2023 definitive proxy statement[801] Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Information regarding security ownership is incorporated by reference from the company's 2023 definitive proxy statement - The information required by this item is incorporated by reference from the company's 2023 definitive proxy statement[803] Certain Relationships and Related Party Transactions and Director Independence Information regarding related party transactions and director independence is incorporated by reference from the company's 2023 definitive proxy statement - The information required by this item is incorporated by reference from the company's 2023 definitive proxy statement[804] Principal Accountant Fees and Services Information regarding principal accountant fees and services is incorporated by reference from the company's 2023 definitive proxy statement - The information required by this item is incorporated by reference from the company's 2023 definitive proxy statement[804] PART IV Exhibits and Financial Statement Schedule This section lists the consolidated financial statements and provides an index of all exhibits filed with the Form 10-K, including key agreements - This item lists the financial statements and schedules filed as part of the annual report[805] - An index of exhibits is provided, incorporating by reference key agreements such as the RADA merger agreement, the new Credit Agreement, and the Tax Allocation Agreement[807][809]