KBR, Inc. (KBR) Q2 2020 Earnings Report, Transcript and Summary

Good day, and welcome to KBR Incorporated Second Quarter 2020 Earnings Conference Call. This call is being recorded. [Operator Instructions] For opening remarks and introductions, I'd like to turn the call over to Alison Vasquez, VP of Investor Relations. Please go ahead.

Thank you, Brian. Good morning, and thank you for attending KBR's Second Quarter 2020 Earnings Call. Joining us today are Stuart Bradie, President and Chief Executive Officer; and Mark Sopp, Executive Vice President and Chief Financial Officer. Stuart and Mark will provide an organizational update, discuss highlights from the quarter and present our updated guidance. After these remarks, we will open the call for questions. Today's earnings presentation is available on the Investors section of our website at kbr.com. I would like to remind the audience that this discussion may include forward-looking statements reflecting KBR's views about future events and their potential impact on performance as outlined on Slide 2. These matters involve risks and uncertainties that could impact operations and financial results and cause our actual results to differ significantly from our forward-looking statements. These risks are discussed in our most recent Form 10-K available on our website. I will now turn the call over to Stuart.

Thank you, Alison. Good morning, and thank you very much for joining us today. We've got a few topics to discuss, but I did want to start with a sustainability moment as we always do. So if you turn to Slide 4, this is our sustainability platform. You've all seen this before. And under our Zero Harm Courage-to-Care philosophy, you can see the environmental and social pillars that make up that platform. So if you turn to Slide 5, you've heard me say many times, I've said more than once that the secret sauce at KBR is our high performing culture. And a very important element of that culture focuses on social mobility. Social mobility brings three of our sustainability pillars together, as you can see on the slide. As a company that operates in many, many different countries and employs a very, very diverse workforce, I feel it is essential that we ensure there is equal opportunity and that we create an environment that encourages and facilitates individuals to succeed. We are also committed to working and giving back in the communities where we operate. In our sustainability report, we highlight a number of these, and we've shown a couple here to give you a bit of a flavor of the great work our people do. And I would like to take this opportunity to thank our people publicly. These are the people who give up their time and they lend their experience, et cetera. And it's a fantastic piece of our culture and one we at KBR can all be very proud of. So on to Slide 6, some key takeaways for the quarter. So another quarter of solid operational performance, with adjusted EPS in line with expectation and a notch above consensus. All of our businesses performed at or above expectation, but the real highlight of the quarter was, of course, the very, very strong cash performance. And this has led us to raise our cash guidance, and Mark will cover that later. Our business continues to prove extremely resilient, and our strong bookings in the quarter underpin future resilience. As promised, we have also concluded our portfolio review and in line with our strategy to move further up market. Our future structure will consist of two segments, Government Solutions and Technology Solutions. This shift really simplifies our business and kind of move us away from more commoditized, cyclical and volatile services and markets. Obviously, more on this later. As outlined in our press release, we are pleased to advise that the DoJ has closed its Unaoil investigations with regard to KBR. And the SFO has notified us that it is no longer focused on KBR with regard to Unaoil. And we've just also heard the SEC is closing its investigation into KBR as it relates to Unaoil, so real positive outcome and one that reaffirms that KBR as a company of integrity, and it has a world-class compliance program. As you're all aware, we set out a number of years ago to resolve – we had a number of legacy issues that the team inherited, and they resolved many of these, and this is another milestone. So let's move on to Slide 7. Mark will give you more detail on the segment performance, but at a group level, our overall results were very much in line or above our expectations. In terms of year-over-year comparisons, revenue was a little off last year – sorry, compared to last year. This reflected reduced contingency logistics in Government, primarily relating to Tyndall that you're well aware of, lower volume but higher margin mix in tech. And offset by increases on lower margin energy projects. Overall, the effect from COVID was not significant. And we've got to give a lot of credit to our employees and, of course, to our customers for that. Margins were very strong in Government and in Tech in the absolute and year-over-year. Energy was modestly profitable, consistent with our messaging outlined last quarter with margins a step down from last year's result, which was boosted by favorable project closeouts. And this difference pretty much drove the year-over-year reduction in EBITDA on a consolidated level. The segment results that Mark will present clearly show this impact. Adjusted EPS was $0.39, similar to last quarter, really further demonstrating the resilience and stability of the business even in these disruptive times. Operating cash flow was absolutely terrific at well over $100 million for the quarter, bringing year-to-date to $178 million and above – actually above our full year guidance range. I mean this really reflects a very strong cash conversion and underpins the increase in guidance, which Mark will cover shortly. Bookings were healthy in Government at 1.0 times. And remember, this does not include the large award announced at NASA's Marshall Space Flight Center. That remains in protest, and thus, we exclude it from our backlog until that protest is resolved. Bookings in Tech were very, very strong also at 1.5 times, very pleasing. Overall, backlog, however, came down about $1.2 billion, all due to debookings we have made in energy tied to our portfolio realignment. These debookings primarily relate to pass-through revenue associated with very low-margin reimbursable EC projects, that have either been canceled or indefinitely delayed. There is no impact to profitability as a consequence of these debookings. The good bookings in Government and Tech and the reductions in energy are all consistent with what was expected coming out of Q1 and support our stable forecast and unchanged P&L guidance for the rest of the year. On to Slide 8, and a bit more on the significant portfolio realignment. And you'll recall, this review was driven by the disruption in the energy markets globally, and we'll come to that in a second. But going forward, we will operate a two-segment model, as you see on the chart. You are well up to speed with our Government Solutions segment, which post realignment will represent approximately 80%, eight zero, percent of KBR. It is focused on mission-critical activities as we strategically move up market to higher-end and digitally enabled solutions. We have presented a number of times the attractive profile of the contract tenures, the margin profiles and the associated cash-generative qualities of this business. Given our recent Government Solutions in Focus Day, you are all hopefully well informed on this business and its attractive qualities. So moving on to Energy, we have or we are in the process of exiting commoditized services, including construction and lump sum EPC, including LNG. I have already mentioned the significant debookings associated with our exit for these high volume, low-margin activities, and Mark will present later the associated mainly noncash impairment and restructuring charges as we reduce our footprint and remove costs. Looking at our legacy Technology Solutions business, it is clear that although this – this business has and continues to perform it would benefit from an advisory consulting capability focused on emerging technologies and energy transition and sustainability. Plus, it would also benefit from greater OpEx exposure and to some extent, scale. To this end, as part of future TS, we will invest in and augment our current advisory and consulting business and our technology-led Industrial Services business. The latter leveraging off our proprietary digitally enabled remote monitoring solution linked intrinsically to our technology. This enhanced Technology Solutions segment will arguably reduce its current low risk profile, retain attractive cash conversion metrics and will, of course, be even more resilient. Let's move on to Slide 9. Given we've just been talking about Tech, it might actually be best, we start on the box on the right. It is worth noting at the bottom that the book-to-bill, as I said earlier, in the heritage TS segment was a pleasing 1.5 times in the quarter, and this was across ammonia, olefins and refining in the sustainability area, a brilliant result. We see good demand in the fertilizer market and closed a sizable deal in Q2 that would back this statement up. The olefins market is very active again. And in Q2, we closed a number of deals in Asia, including China. As you would expect, there is increasing demand for technologies that are more sustainable. And I think a good example of that in Q2 was the ROSE unit we sold to a refiner in Latin America. You will recall that our ROSE technology significantly reduces sulfur content and thus SOx and NOx in fuel oil. We continue to build our energy transition portfolio via our advisory business, ammonia being a preferred transportation option for hydrogen and with our technology position in ammonia and work at NASA on hydrogen storage being key differentiators for KBR. So our pipeline remains strong. Our activity levels remain high even in these times. And that's going to help with, I guess, with our limited exposure to the refining market, with the exception, of course, the greener technologies I mentioned earlier. Clearly, 2020 will be a transition year for new tech as we shape the portfolio. And thus, I would direct you to the following: our overall adjusted EPS guidance for all of KBR remains valid for 2020, and we're reaffirming that guidance today. The legacy ES, our legacy Energy business will be marginally profitable as we stated previously, and that, again, happened in Q2, and we stand behind those statements. So the key metrics we think for new TS are in 2021. We are forecasting revenues close to $1 billion, with margins in the mid-teens. This will result in strong earnings growth from what would be a combined TS and ES legacy businesses in 2020. As we continue to remove costs and build out the advisory and technology-led industrial services businesses, we do expect margins to grow 1% to 2% per annum, up to high teens by 2024. We've had a look at our peers, and this is very much in line with those who have a balanced OpEx and CapEx facing technology business. Now on to Government in the left box, in our recent In Focus Day, we highlighted our strategic growth vectors, and I hope, articulated the rationale for strong bipartisan support in the areas where we're actively involved. I will touch on LOGCAP V, as I'm sure it would be a question later. We have transitioned on Northcom and that's the piece in the U.S. and activity levels are actually higher than we expected, and these are actually likely to increase as the year progresses. In EUcom, where we are the incumbent, activity levels are also increasing a bit with announced increases in Poland, et cetera. In the Middle East, transition has been delayed due to COVID and our current task orders have been extended through to mid-2021. With increasing activity levels in the U.S. and Europe, and now with more clarity through to mid-2021, we think our original reasonably conservative forecast, which included reduced troop levels in Afghanistan, holds up well. Also, it was pleasing to note that our Space Admitted Solutions business had very strong organic growth year-on-year. And with the MOSSI win likely to start this year, this growth is set to continue into 2021. You will also have seen a number of announcements related to our engineering business. We've talked about the attractive contract vehicles we have that improve speed to market, et cetera. And they delivered over $150 million of new IDIQ wins in this quarter alone, so terrific. The last point here is the low levels of recompetes. Just a reminder, recompete activity and risk is low this year and next year. I will now hand over to Mark.

Great, thank you, Stuart. And I will pick up on Slide 11. Stuart already hit some of this upfront. As you've heard, Q2 came in as expected on the P&L front. And higher on the operating cash flow front. So we're really pleased with that. EBITDA margins for Government and Tech were strong at 11% and 26%, respectively, so we're really pleased to see ongoing strength and continuity there also. Overall gross margin was lower, which we expected with considerable volume coming through on the cost reimbursable EPCs on the Energy side, which are at very low margin. As we said, those types of projects will phase out over the course of this year under KBR Reimagined. This effect was offset by significantly lower SG&A across KBR, a result of deliberate cost reduction actions we have taken. Netting together all of that Q2 operating income before the special charges was pretty much a push year-over-year. We will see some of the low-margin EPC work carry forward into the second half. But as the year winds down, we expect this to ramp down and gross margins ramping up accordingly. Tying into what Stuart said about what we are targeting for 2021. I'll add that we expect SG&A to continue to trend in the $70 million to $80 million per quarter for the rest of this year. Interest expense continues to trend down, reflecting the lower rates we negotiated earlier this year and the associated debt reduction action taken then as well. Adjusted earnings per share was $0.39 with taxes and other nonoperating items coming in as expected. Cash generation was outstanding across all of KBR, including energy, this is attributable to ongoing focus of effectively managing working capital, which pretty much comes down to the team's [board] of prompt billing and collection. And the team has done that really well. Operating cash flow to net income conversion has exceeded 150% so far this year, underpinning the increase in guidance, which I'll cover in a moment. Let me briefly cover the nonrecurring impairment and restructuring charges in Q2. As Stuart outlined, we made the decision this quarter to no longer pursue commoditized construction services and lump sum EPC projects, including LNG. As a result, we've reduced our long-term forecast to exclude those projects, we also committed to a plan to rightsize our cost base across our business to remove excess capacity. These steps are an important component in reimagining KBR giving us greater agility and boosting profitability in the years ahead. These charges tallied up to just under $100 million pretax, mostly noncash. Now over to Slide 12. For both Government and Tech, you can see the step down in top line revenue, as Stuart said earlier, primarily tied to the episodic Tyndall revenues last year on the Government side and mix on the Tech side. The 9% growth in Space was a real highlight with the new Marshall Space Flight Center win, hopefully providing further boost later after that protest clears. It's important to highlight the significant EBITDA margin expansion achieved by each of these businesses this quarter, up a percentage point for Government and 6 percentage points for Technology, reflecting favorable revenue mix, strong execution and proactive cost control. The technology profitability level underscores the resiliency of providing innovative intellectual property to the industrial sector. We sold solutions in the three main sub verticals of this business in Q2. Ammonia, tied to fertilizer for food production, olefins tied broadly to the industrial production sector, and even in refining, where despite industry challenges, our solutions support our clients' important sustainability initiatives. Margins in Energy were low, but in line with our guidance last quarter at breakeven or marginally profitable for the year as we phase out the lower margin work and reduce the cost structure associated with those areas. I'll move over to Slide 13, Capital Matters. We finished Q2 with a gross debt-to-EBITDA leverage ratio at 2.5 times, with net of cash coming in at 1.1 times. That's all in line with what we expected. Our capital deployment priorities have remained steady, and there's no change on this today, but there are a couple of other developments to share. With this latest step in our transformation, we have further reduced our risk profile, increased our stability and predictability, set a path to improve our margin profile and remain attractively cash generative. This is on top of the significant growth in our earnings base, excellent cash flow production and several derisking accomplishments since we set our original gross leverage target of 2.75 times a couple of years back. These advances have improved our credit rating and lowered our cost of borrowing significantly. But all of this is appropriate to increase our targeted debt-to-EBITDA leverage ratio to 3.0 times going forward, which is right in line with our federal IT services peers. This increase enables greater deployment of capital towards strategic and accretive M&A and/or buybacks as opportunities present themselves. The decision to no longer pursue lump sum EPC business also presented another opportunity, which we took advantage of in Q2. No lump sum EPC means we consequently have very little need for performance letters of credit, which are commonly required for these projects, as you know. At the same time, we want to be positioned to deploy more capital, as just discussed. In June, we were able to convert all of our performance LC capacity to committed revolving line of credit capacity, dollar for dollar. As a result, our revolver capacity increased from $500 million to $1 billion, with no changes in its pricing grid or its tenor. This move bolsters overall liquidity and flexes strategic options as we move forward. I'll finish up on Slide 14 with our updated guidance. As stated earlier, Q2 was on or above expectations across the board, so we are reaffirming our adjusted EPS guidance of $1.50 to $1.80 for this year. And on the strength of the first half, we are raising our adjusted operating cash flow guidance to $210 million to $250 million. Now back to Stuart to wrap it up.

Thanks, Mark. Great job as ever. So final slide. So in conclusion, another resilient quarter with operations performing and delivering an EPS result a notch above consensus. And as Mark said, we're reaffirming our adjusted EPS guidance for the year. Book-to-bill was strong in GS and especially in Tech, but the standout for the quarter was our cash performance, which allows us to increase the op cash guidance you've just heard. Our portfolio review was concluded, actions taken and the resulting Technology Solutions business is very exciting. We are forward-facing and more resilient. And importantly, we are retaining the sizable tax shield pertaining to this business. With the update on the Unaoil matter, we are now very much focused on the future. At our recent investor event, we laid out the tremendous progress we've made in transforming and diversifying our portfolio to drive meaningful long-term growth and profitability. We have effectively transformed KBR through some significant portfolio changes, substantially derisking our business, investing in our technology segment and transitioning approximately 80% of our business to focus on government solutions, quite different from a few years ago. While we've made important progress, we are not resting on our laurels. As we move forward, we remain focused on reshaping KBR and moving further up market with higher margin, sustainable and resilient businesses. As we said in June, we continue to see opportunities to drive growth, both externally and organically. There's more to come in this journey to transform KBR. Thank you. And I will now hand back to the operator, who will open the call up for questions.

Thanks Stuart. [Operator Instructions] We'll take our first question from Jerry Revich from Goldman Sachs. Please go ahead your line is open.

Yes, hi good morning everyone.

Good morning Jerry.

Good morning Jerry.

Yes. I'm wondering if you could talk about the organic revenue performance of the engineering business in the quarter? You mentioned there were some momentum in terms of wins. Did that translated to revenue burn? And can you talk about the cadence of revenue burn for science and space and engineering over the balance of the year?

Jerry, I mean, I assume you're relating to the comments around the burn on the – what was the Energy Solutions business.

No. No, thank you for asking. No, I'm talking about within Government Solutions.

Within Government Solutions, I mean, what we have seen in the revenue burn for the Engineering business, it's all pretty well in line with expectations. They've been very successful at bringing backlog and they've grown nicely, and they continue to perform to deliver good margins. I don't see anything out of the ordinary there at all, Jerry.

Okay. So the year-over-year revenue performance in Government Solutions was entirely driven by logistics? So part of that is the Tyndall Air Force base, but anything else that's driving the revenue performance?

Yes, we had nice year-on-year growth in the Space business, just under double-digit growth there. The Engineering business performed as expected. And as I think Mark alluded to, we are – as he stated, we saw a downtick in the logistics side, primarily because of Tyndall and a bit less activity in the logistics business in the Middle East.

And I'll just add to all of the reduction was in the logistics for the reason Stuart mentioned. Engineering was pretty flat year-over-year. They had a sort of an episodic goody last year. So a tough comp there. But as you've seen, their IDIQ ones have been great. For most quarters we've had in the last two years, they've been growing. We're very bullish on that continuing going forward. And again, the highlight was space, of course, but we've shown that, that does swap from time to time with engineering and even logistics, given the type of agility we have in our contract vehicle base.

Okay. And then you folks continue to look at delivering Government Solutions margins. Can you talk about what went right in the quarter with a bit more context and what – why we should not think that, that continues into the back half of the year?

I mean, I think we're seeing absolutely stellar performance, and particularly, across our whole portfolio, but interesting enough, particularly in our logistics business, delivering margins are quite exciting. In terms of our guide going forward, we are conservative. We've guided the high single digits. And we get asked this question, I guess, every call because every quarter, we seem to do double-digit returns. And obviously, the margins are at that margin. It's probably a good way to describe it. But I mean, I think as we look into our planning for next year and we'll come back and either reaffirm that or change that guidance as we get closer to the year. It's difficult to give the longer-term guide there right now. I think, Jerry, just given where we're at and with the shift with cohort and things like that, although we're performing really, really well to say that's going to continue beyond the end of this year, and we need to have a good look at that.

Thank you. I appreciate for this session.

Thanks Jerry.

We will now take our next question from Tobey Sommer from SunTrust. Please go ahead, your line is open.

Thank you. Just to clarify something, are there aspects of the Energy business that will be retained in technology or are you simply shutting down aspects or parts for sale? If you could just speak to that, that would be helpful.

Yes. All right, Tobey, I think, the way to think about this is that our advisory consulting business or practice was sitting within Energy, and we're moving that across into Technology. And the reason we're doing that is that has with the differentiation we have with our ammonia technology and our knowledge of hydrogen storage and things like that from the work we do with NASA. We feel that our technology business would benefit with having a tip-of-the-spear advisory consulting business looking not only at hydrogen, but also at things like energy efficiency and recycling and electrolysis and things like that. So very much feel that, that's a very strong fit. We also looked at the technology business, very sort of seriously around its exposure to the OpEx market, which – sorry, the CapEx market, which it predominantly is at the end of the day, it's all about building projects and those projects basically acquiring our technology. And we felt that although the business has performed really well in difficult cycles in the past and continues to perform today even with a reduced disruption in the energy market. We felt it would do well to have a greater exposure in the OpEx side. And we've also got a proprietary remote monitoring capability. So effectively, we can run the facility sitting in the office in Houston or elsewhere regardless of where the facility is and our technical experts who understand the technologies can tweak the operations or advise the operators what to do to get enhanced capacity and throughput and reliability and things. So we felt that there was a fantastic opportunity to really look at how we build out a greater OpEx business, including Catalyst, for that matter, with the Tech business. So we asked the Tech business effectively, are there any bits of the Energy Solutions business that you feel would be synergistic and add value to that endeavor? Which they did, and they've taken in bits of that, that allow them to broaden their capability and their, I guess, their customer reach in the OpEx side. And that's kind of – and the reason for that is to get that balanced with CapEx and OpEx that we think will prove very resilient into the future. And so I think all that bringing together, we've exited all the bits of that we want to in the old Energy Solutions segment that are commoditized and low-margin and pass-through and all the things that we've talked about before and the new technology solutions or the enhanced Technology Solutions segment, as I said in my statements, in 2021, we'll deliver – it's about $1 billion business, and we think margins will be in the mid-teens, but will go up 1% to 2% a year as we continue to take cost out and we see the growth in this technology-led, OpEx-facing industrial services business, but also an advisory consulting business continues to grow, which has very, very strong margins, indeed. So we feel that, that really sort of puts and positions the new Tech Solutions business, it will have arguably a lower risk profile because you've got CapEx and OpEx than it does today. I mean its risk profile today is very low. Its cash conversions is low – I mean, it runs on negative working capital, and we expect that to be similar. And obviously, it's – it will prove to be far more resilient. So that's a long answer to your question, but I wanted to make sure people understood that this was a substantial realignment and a substantial change.

Could you let us know what the acquisition market looks like in the – to bolster your industrial services as well as the consulting advisory piece and also refresh us on the tax item that you said would be retained?

Yes. So I mean, one of the positive outcomes of the – by taking the bits of energy across the added value to the OpEx piece of Tech, as I explained, was that the historical or the legacy Energy Solutions business had a tax shield of – quite a substantial tax shield. I don't think we've actually ever disclosed the size of that number in the event of something happening into the future with that business, and we're able to move that tax shield across into the new Technology Solutions segment. So that's that piece. And in terms of the acquisitive landscape, I think, in terms of the advisory piece, I think it's all about people. So we're looking to acquire capability rather than go and buy companies there in truth. And in the Industrial Solutions piece, we're actually sticking out more white space than – because it's really our IP and our technology that we're leveraging often and our proprietary sort of solution around remote monitoring. So I do think that the investments that we're going to make there is really about actually just developing further that capability, but actually getting in and around the product development piece of it and making sure we're out talking to our customers about the value-add and the enhanced commercial outcomes they can have as a consequence. But in terms of the broader M&A market, good question. We've seen trading multiples come down. And with our government peers a couple of tons during this last little while. The heat that was in the market historically, well, certainly in 2019 and early 2020 on government services company multiples has probably come off a bit, and we've got a very strong balance sheet today. So as we've talked about before, we kissed a lot of frogs and as long as things hold up to our acquisition thesis, we're keen to look at strategic M&A into the future, particularly with the cost of capital at the point it is today.

Last question for me, within the Government Solutions space, which area of your business do you at this stage, expect to see the fastest growth?

I think, I mean, it seems to – the nice thing about that business is it ebbs and flows, depending on timing of awards and things. I think we said this before. I think over the last three or four quarters, we've seen logistics grow the quickest and then the next quarter it was engineering. And the next quarter, it was space. So I mean, I do think it ebbs and flows. I did say in the remarks that our growth in Space and Mission Solutions is terrific year-on-year. And of course, we won the large MOSSI win, which will – post protest, will obviously be a kicker to the revenue and returns associated with that business. So that we expect that business to continue to grow. But our pipeline remains really robust across all the aspects of what we're doing in government. And I think you'll see them passing the baton quarter-on-quarter. I don't see that what I'm seeing in the pipeline anyway, that it's going to be one that dominates the other.

Thank you.

Moving on to our next question, we will take it from Jamie Cook from Crédit Suisse.

Hey can you hear me okay? I guess my – congratulations on the nice quarter. I guess my first question, as we're exiting the fixed price portion of the Energy business, and you guys have taken some restructuring, understanding you guided to sort of $70 million to $80 million in corporate G&A for the rest of the year. But as we look to 2021 and beyond, are there opportunities to further streamline your cost structure because of that or just because of lessons learned from COVID? And then my second question, I think Jerry sort of answered it, but – or asked the question, but on your – when you had your Government Solutions Analyst Day, there was a slide in there that talked to the Government Solutions EBITDA over the next several years as well as your implied margins, which I think were your implied margins that you target. I'm getting a lot of questions from investors on whether or not that was sort of viewed as a literal guide for 2021? Or just sort of what you know today? So if you could just help us from that perspective.

Okay. So maybe, Jamie – and thank you for your comments on the quarter. So I think maybe answer the second question first. I mean, we get a lot of questions about the margins associated with GS just because we continue to outperform what we've said. We haven't given a guide for 2021. We gave long range targets, I think, way back in 2019 in May at high single digits. And I think we can – in terms of – it's not a literal guide in terms of the margin specifically for 2021, we will only do that when we actually guide 2021. But I do think that the performance of the business has been terrific. And if it continues to perform, and I mean there's no guarantee we'll get the margins we got this quarter. But if it continues to perform, we can see a path to – obviously, those continue in the high single digits and specific quarters coming into low double digits. That's probably all I really want to say there because you'll hang me here to dry if I say too much more, and we don't deliver against it. I think that we are delivering really well. The operations are performing really strongly and the cash-generative qualities of that business are terrific. So I think all in, it's more than just margins. It's cash conversions as well, and we're very pleased with that. And in terms of your first question, which having said all that, I've actually forgotten what it was. So you have to tell me, [indiscernible].

Yes. Now the first question was just opportunities on the corporate G&A side just as you exit the energy business and/or [indiscernible] COVID, is that an opportunity in 2021.

Yes. So I think the way we've tried to encapsulate that is that we've got margin increased targets that we talked about associated with what is in Technology Solutions going forward. I mean we do have – it does take time, I guess, to – we've got many, many entities and things that were associated with the old Energy Solutions business that we're trying to close down and we'll take cost out as we progressively go forward. And I think that flows into the 1% to 2% margin increase as we look to grow that business beyond 2021. So I think you'll see it coming through there. We haven't really guided beyond that, but I think that is – that gives you – I think those margin improvement opportunities are pretty significant actually.

Great, thank you.

We will now take our next question from Gautam Khanna from Cowen. Please go ahead, your line is open.

Yes, two questions. Mark, perhaps you can answer this. Just if you could speak to the GS margins that was asked about in the last question for next year, maybe just can you quantify what the known headwinds are because you guys have benefited in the past from some nonrecurring items. I just want to make sure we have a calibration on what the known headwinds are moving in to 2021. And as a follow-up, if you could just maybe rebaseline revenue on us on what will be the base of energy revenue that you will keep on an ongoing basis. So what is – maybe quantify on a 2020 basis or a 2019 basis, the type of business you are no longer pursuing. How large was that so that as we move out in time, we have a rebaseline to what is recurring?

Okay. Stuart, I'll get started. If you want to chime in, of course, you will. I think we were quite clear in our Government Solutions Investor Focus Day back in June on the GS margin outlook. And we were very clear that the current period and also into 2021, does benefit from the wind down of the Aspire Capital Works program, which is performing extremely well. And that does come to a natural conclusion towards the end of 2021. And so that mix, the mix that comes from that beneficial margin today will start to go away at some point in the latter half of 2021. And all other things being equal, would have the impact of taking the margins down by as much as a percentage point, if you'll recall that in that Investor Day. And so that's the most specific item that is known. There can be other things that come across that change that, but we're very proud of that program. It's delivered marvelously well. It is a cornerstone of our international business collectively, which has margins above the U.S. side, and it's actually growing very well in certain pockets as well. So what we know today is the Aspire wind down represents the answer to your question there. Just the capital works portion, the other two portions continue, which is the services component and the equity and earnings component. So as Stuart said, there are opportunities to go the other direction, and we'll work those through over the rest of this year, and then we will provide a formal guide relative to that target once we start 2021. Relative to the second question on the Energy side, Stuart mentioned earlier that the notional target size for 2021 of the new Technology Solutions business is circa $1 billion. And you already know the run rate of the Heritage Tech solutions business at $350 million, $400 million. And there's no change to that, obviously, given its stellar performance. So therefore, the difference, roughly $600-ish million is the piece of Energy coming over. And that is roughly $1 billion less than what you would see in an aggregate run rate this year. Stuart?

Yes. I mean, I think on the margin questions or – what Mark said, there are no specific headwinds that we see, Gautam, and I would argue that the performance of – particularly our logistics business at the moment is stellar in terms of its operating performance and the margins it's returning. So I think there's opportunity to continue to do very well in that arena regardless of ADC, that capital works, Aspire Defense Capital Works program coming off, as Mark said, but that doesn't really come off till the end of 2021. So again, 2021 should be quite positive. And Mark's quite right, the Technology Solutions business, I say this, I mean, I would kind of almost not ignore 2020, but it is – don't do the comparator of 2020 because I think it is a transition year in terms of that portfolio realignment. I think in terms of your model, I'd be looking at a business that is, as Mark said, $1 billion and mid-teen type margins and growing those margins and growing the revenue base we think double digits beyond that. We haven't guided to exact numbers. But we have guided Tech historically, and we don't foresee that changing too much given what we just said and the book-to-bill, how they're performing. So I think that's probably a good way to think about it, Gautam.

Excellent thank you.

We'll now take our next question from Steven Fisher from UBS. Please go ahead.

Thanks. Good morning. It's good to see the cash flow performance giving you some flexibility, but curious for a little more color on why you're raising the leverage target. Is it just to really kind of be in line with peers, as you mentioned? Or is it – because you see an opportunity to be a little more aggressive on the buybacks? I know you touched a bit on the M&A opportunities. And if you're going to be generating consistent solid cash flow, it would seem like with a higher leverage target and solid cash flow, that would imply more deployment of capital. So just kind of curious, a little more color on that.

No. I mean, I mean you're right in all three, Steve, but I'll let Mark answer it more specifically. But obviously, yes, I mean, you are correct in all three in terms of peers, in terms of deployable cash opportunity and what it means. So maybe if you can go, be a bit more specific, Mark?

I thought I was fairly specific earlier. But Steve, we set the 2.75 back in 2017, there was a very different risk profile in the business then. But conceptually, we felt we needed to be more conservative given the volatility we had in our energy business at the time. It was still in [sight]. Our Government business was not nearly the scale it is today. And so it is – I think just – as I said earlier, appropriate to set our capital structure in line with our business profile and the risk embodied in it. And we firmly believe, and even conservatively so, that a 3.0 leverage ratio with the type of business we have, sets the right tone and has the effect of lowering our cost of capital versus a lower target and that's where we should be in terms of level setting the debt and to deploy capital with what leverage that gives us. And so nothing really more to add. I think it's a natural and positive evolution of KBR and it's also very much aligned with the federal peers. As I said earlier, sometimes they have excursions above that to do M&A. And that's natural. And generally speaking, this sector has deleveraged down very nicely after making those excursions given the cash flow properties that we see in this business and those equally apply to us.

Yes, I was just trying to get a sense of how motivated you are to really start deploying capital. And it sounds like there will be opportunities to do that. Okay. The second – go ahead.

I'll just say that in 2016, we made a couple of acquisitions. We integrated them well. This benefited us tremendously. We did the same in 2018. We've integrated them well. Stuart made mention of valuations improving a little bit in that space and cost of capital is very attractive right now in general. And so that does add up to favorable conditions to deploy capital, certainly.

Got it. And I just wanted to ask about the profits from the legacy Technology business, obviously, ticked down a little bit. This quarter from the first quarter, but that was to be expected given, I think, what was going on in China earlier in the year in bookings. And I know you gave us the 2021 revenue and margin metrics for the new combined entity, but just kind of curious how you see the trajectory of the legacy Technology profits ramping over the next few quarters. How long of a dip do you see here? You did have a nice win in the quarter as you pointed out, how quickly will this legacy business start ramping up again on its profits?

I mean I think the Tech business, Steve, this quarter did exceptional. And its margins, it was 27%, I think is the number Mark gave – is the – and so I think we guide to mid-20s for that business and some quarters, it's down just depending on the cycle, if you're selling the license piece of that, the margins are up, if you're selling associated proprietary equipment is down and if there's a mix of Catalyst that's somewhere in the middle, et cetera. So it does ebb and flow, but I think that we're not seeing any reduction in the margin profile of what was the legacy Tech business, it's still going to be in or around the mid-20s.

I was just talking about the dollars. So the EBITDA dollars.

The EBITDA dollars, yes, I mean, that's right. We did expect the volume to come down. We've guided the year at around $75 million or so EBITDA, around that ZIP code, it could be a tad above or right around that number, and we expect to do that or a little bit better. I think is really – and that will be spread out over the quarters going forward from what we've achieved today.

Okay, fair enough. Thanks.

Thanks.

We'll now take our next question from Michael Dudas from Vertical Research. Please go ahead. Your line is open.

Yes thank you operator. Good morning Alison and Mark, and Stuart.

Hi, Mike.

Hi, Mike.

With the energy transition, remind us, I assume, at times you did with your technology market, selling in the marketplace, do some EPC work for the customers or advise them on that. How are you going to handle those types of opportunities going forward since you're exiting that side? And are there any – with these master service agreements, the agreements you've had with your energy customers, is that a way to kind of transfer some of the technology into that customer base, given the OpEx kind of industrial technology focus that could leverage going forward?

I mean, yes is the answer to the second question. And in terms of the – and it's quite an exciting opportunity for us, given the strength of our IP. In terms of the first question, we don't do EPC projects, Mike, in our technology business. We sell equipment, proprietary equipment, and as part of our license package, but others take the EPC risk. And we expect, in an energy transition world, where there's ammonia being used as a transportation fuel for hydrogen or et cetera, that we would stay true to our statements that we would not be taking EPC risk in that segment or any segment for that matter.

No. That makes perfect sense. And I guess the follow-up from me on the Government Services side. I know you covered much of this in the June deep dive, but as you – where we move forward towards September and elections, et cetera, just some observations that you've seen from the customer base or anything that gives you some pause or some excitement or just things steady as she goes, given where you're positioning is relative to appropriations that we could anticipate in the changes that are going to occur with the Congress administration.

Yes, you are right. We did try and give quite a bit of color around that in the In Focus Day. We do feel and I think I said a bit of this in my remarks as well that where we're positioned today, there's a – particularly in a number of areas, we've got very strong bipartisan support, the budget for next year is very robust and is robust in the areas where we're playing. I think we've got very strong domain expertise in those areas. And we've got very, very long contract tenures as well that underpin the future growth of the business. And I don't think that should be underestimated is how valuable those contract tenures are. And the stability and the, I guess, the visibility they provide as we guide into the future. So we're feeling pretty good about that, and we feel pretty good of where we are positioned today. And I have to say that customers are behaving immensely well globally in the face of quite interesting time. So I think all up, it’s – the business is not only proving resilient. As I said earlier, the pipeline of opportunities is tremendous, and we're very, very excited about the opportunity to grow across our various, I guess, sub-segments.

Yes. I put that slide amongst many of the helpful slides in the presentation in June of your long-term aspect of what you guys have is, I think, was certainly very helpful and visible for the street. Appreciate that, thank you Stuart.

Thanks Mike.

Moving on to our next question. It's from Sean Eastman from KeyBanc Capital Markets. Please go ahead.

Goo morning. I just wanted to start on going back to the corporate G&A side. I mean it's really helpful to get some guidance on the go-forward sort of new technology segment margin profile next year. But just in light of almost $1 billion in revenue coming out of the system from legacy Energy solutions. I just wanted to understand the potential to rationalize the corporate G&A around that. I mean maybe relative to that revenue coming out, how much corporate G&A structure was in place or has been in place to support that revenue, in particular, any kind of thoughts around that, just even from a high level, would be really helpful as we think about next year.

So I'm going to – yes I mean, Mark can talk a bit more about the corporate SG&A in a second but I would like to just reaffirm what I said in my remarks that the removal of the debookings of the mainly pass-through work and low-margin reimbursable EPC projects that have been stopped or stalled or canceled, this does not affect our profitability whatsoever. I just wanted to make sure that was clear. And I'll hand over to Mark to talk about SG&A and the opportunities we have there.

Yes, Sean, and I'll go back to what we said actually last quarter that we were confident that we could take cost out at pace with the revenue changes and retaining the margins of the surviving segments, if you will. We're very focused on the bottom line, and I think have shown good constraint of cost over the years. As we've grown to deliver what we said we would deliver. And next year, it won't be any different than that as we approach the budgeting season. I will say that the Energy business did have a fair share of complexity. When you think about multibillion-dollar EPC projects, there are systems and tools and legal entities and all kinds of stuff that goes with that. And so some of the restructuring takes that – some of the restructuring charges takes that out. But there will be a journey to rationalize some of that out of the system over the next one or two years and to be laser-focused on the two going forward. And so we're comfortable in our profit targets. There are opportunities, both short and long-term to rationalize cost. Some of that will happen faster than others because it does take some time to unwind things. And in other cases, we may invest in certain things to make our tools better for the longer haul. And so we'll guide on that going forward. 70 to 80 is our guide for the rest of this year. I certainly don't expect that to go north as we think forward, obviously. And we'll give you more precision come January, February as we get through the year, and we evaluate what we win between now and then.

Got it. I really appreciate that. And the other thing people are focused on is just as it's come up a few times is Aspire Capital Works ramp down next year. I think you guys touched on the margin side of it. But from a revenue perspective, I'm just trying to understand, just considering the very low re-compete risk this year and next year, there's still a lot of opportunity to backfill that wind down between now and sort of when you guys come out with that formal Government Services outlook for 2021. Is that kind of fair way to think about things?

Yes. No, we've got massive opportunities, as I said before, so we're really looking at that. Our pipeline quite – is terrific at the moment. And we continue to announce a number of awards as each month passes. Our ability to fill in that gap is certainly in front of us. And I think our current performance shows that we can perform, if we get it right, above guided margins. And so I think with both of those in mind, you're absolutely correct.

Thank. Okay I appreciate the color thanks for the time.

Moving on to our next question, is from Andy Kaplowitz from Citi. Please go ahead. Your line is open

Good morning guys.

Good morning Andy.

Good morning Andy.

Stuart, you mentioned the 9% growth in Space as a real highlight. We know you highlighted Space prominently at your Investor Day. So maybe you could talk about your visibility into continuing strong growth in that subsegment. Could you talk about your opportunities to take share moving forward, especially with the understanding that there could be a regime change in Washington?

Yes. So remember, our Space and Mission Solutions business is – we've got our NASA franchise. And obviously, that continues to grow and has the basis to do so with the MOSSI win. We also have our human health performance piece in there, and we're seeing a number of opportunities coming down the pipeline building on not only what we do for the astronauts and I remind the audience we are the only company in the world that's actually licensed to train astronauts for commercial space. We're seeing opportunities also building on the work we're doing for the special forces and in the other branches of military. So we see that as a continued growth vector in that arena. And I guess the third piece, which is also related to our Engineering business somewhat just because of the work we do with the Air Force there, is really military space. We have a fantastic pipeline of opportunities in that area. And it's not somewhere where we do a lot today. So anything we do there, and there's very strong bipartisan support, of course, in that arena given near peer threats. So we do think that's a significant opportunity for us. And we've got, as I said, it's not just a subjective in that sense, there's quality opportunities that we're bidding today.

Thanks for that Stuart. And then sometimes when you get out of the E&C, like, business, there can be outstanding liabilities. So you took the $1.2 billion out of backlog. Can any of the customers that you send contracts with come back to you and require you to work on their project? Or make you pay some sort of cancellation fee? Or you're kind of just done once you sort of take it out of backlog?

Yes. I think – well, I don't think there's any exposure in terms of companies coming back and asking us for any money back. In the main, these projects have been canceled or put on hold and definitely by them. So it's very – be kind of unusual for them to come back at that point. And as we – I don't think – so I don't think there's any risk in that sense. Our discussions with those customers on specific projects have all been done in a very amicable way, and I'm saying is exiting those. And if there's one or two that we have to just work out, we'll tell you and we'll set it aside in some sort of sense and nonstrategic or something like that. But we don't expect that to be the case. And certainly, the risk of anything going bad in terms of commercially is just not there. So we're feeling pretty good about that.

Thanks Stuart.

Thank you.

Moving on to our next question, we will take Michael Feniger from Bank of America. Please go ahead.

Yes thank you guys for thanking question and squeezing me in. I know we're running a little late. Just, Stuart, with your comment on M&A and how service multiples have come off, I appreciate that. But right now, your multiple is off as well. I mean, based on your Investor Day, it's hard to see why KBR should have such a valuation discount to some of these government services peers. And if there is a reason for that discount, please let me know. So is the best use of your capital that you guys are now able to deploy even more capital, how do you balance that with going out into the market for acquisitions with really the value of your shares that are at a discount to that peer group today? Any help and color on that would be helpful.

Yes. I'm glad we squeezed you in. I mean, that was a terrific question to start with. We don't know the reason why we trade where we trade. This is the 14th quarter in a row of meeting or exceeding expectations. Our cash performance has been absolutely stellar. We've driven down the – our debt levels to well within below industry norms and our cost of capital is as good as anyone's out there. Mark and his team have done a terrific job in that regard. And we – our performance in terms of operations has been really good, and we've retired risks as we've gone along. And now the Unaoil matter is effectively dealt with the DOJ, and you've had comments on what's happened with the SEC and the SFO. So we have retired such a lot of the legacy issues that would have a negative impact, we think, to stock or people not understanding the story. And then we had – there was a lot of concern around our appetite to take lump sum EPC in the LNG market. And when it became quite clear that. That is getting more and more commoditized as time progresses. Our exit from that and our realignment to what we talked about today is a significant shift away from that type of business and the associated low-margin piece of even the more attractive low-risk piece, but it's very low-margin and commoditized moved away completely from that. We don't understand why we're trading where we are. So that is a very, very good point to raise and one we're keen to address, and we work very hard to do so with the outreach to a broader investment base who understand this part of the market really, really well. And with 80% of our business in the government arena and given the sort of work we do there and our move-up market to higher-end through time is clear, I think, and we presented that in the in focus day. So I think that's probably enough said about that. And in terms of the M&A piece. Yes, I mean, exactly right. Our acquisition thesis has been one where we don't buy on cost synergy, you always get some, of course, but our whole focus is on looking for businesses that take us into new areas with very little overlap, but strong adjacencies so that we can maximize revenue synergy. And I mean they have to be good businesses in their own right with a good strong cultural fit, but it's a very fragmented market out there, particularly in the U.S. and the GS side. So there are – we do think there will be opportunities. So with cost of capital, where it is and our position in the market and our strong balance sheet, we – there may be highly accretive opportunities out there to take us faster into our strategic growth factors than you can do organically. But it's not easy to find those and – but they do exist, and we're working hard to do exactly that.

We're going to be taking our final question, it’s from Brent Thielman. Please go ahead your line is open.

Great. Thanks, so I'll keep it to one. Stuart, this transitional decision to me doesn't seem to be just about being a sort of a majority government services contractor, but more about changing the risk profile and focusing on higher value services. And I understand those two things are aligned. But when you look at this 80-20 mix, Government and Technology, is that something you'll want to deliberately maintain beyond 2021? Is there a desire and a build off this technology platform as a portion of the company and diversify the customer base?

Yes. I mean you're quite right, we have moved away in that sense and to these lower risk, higher end solutions. And I think the realignment of our portfolio is exactly that. And so there is the strong alignment there in terms of what we're doing digitally in the government side as well and moving higher up market from a service perspective also. So I think there's strong alignment there. In terms of the mix, I don't think we've really set out a desired mix. I think we've tried to help The Street by giving them what we think this business will look like when it shakes out as we go into 2021 and the sort of the margins and the cash conversions that we'll achieve on that $1 billion revenue base. So in terms of the mix, I don't think that we've really gone and figured all that out yet. We've given growth targets for our GS business that we're standing behind through to 2022. We've given indications of double-digit growth in our new Tech Solutions business and the attended margins. And hopefully, that will be a – from a modeling perspective, that's pretty clear. But yes, we don't have any predefined mix pieces there. But we do expect the opportunities to be there, particularly on the higher end Industrial Solutions piece, and in fact, in the energy transition side as well as our ongoing and sort of increasing disruptive technologies that come to market. So I think all those vectors are strong, but so is Space and what we're doing in Mission Solutions, and so is the opportunity to grow our Engineering IDIQ business and what we're doing in Australia is terrific as well. So we're kind of firing in all cylinders, it would be silly to put a false constraint on growing one faster than the other.

Okay, thank you Stuart.

At this time, there are no more further questions. I would like to turn the conference back to you, Mr. Bradie, for any additional or closing remarks.

Thank you for your questions. We have run over time, but I think it's important to allow those questions to be asked. Obviously, we'll be having more one-on-one sessions after this. But thank you for your time. Thank you for your attention, and thank you for the quality of the questions. And now we're really excited about the future and what does this transform KBR. So thank you.

And this concludes today's call. Thank you for your participation. You may now disconnect.