VAGO MURADIAN: Welcome to the Defense and Aerospace Report. I’m Vago Muradian. I’m here in northern Virginia at the Washington headquarters of L3 Technologies, one of our sponsors, to talk to Chris Kubasik, the new chairman, president and CEO of the company. Chris, congratulations.
CHRIS KUBASIK: Well thank you very much. Good to see you, Vago.
VM: Great seeing you.
VM: You’ve been with the company since 2015. You were chief operating officer. Last year, you became CEO. Just last week, you became chairman, succeeding Mike Strianese, who led the company for 12 years after the tragic passing of one of the company’s founders, Frank Lanza, in 2006. And when Lanza, [Robert] LaPenta and Lehman [Brothers Holdings, Inc.] founded the company in 1997, the model was sort of the Sears catalog for defense and aerospace, and, over the last 21 years, you guys have built a $10 billion company, and your goal now is to take this technology-packed company that people have had a little bit of difficulty understanding fully all of the things you do and to try to rationalize it and to restructure it.
One of the other things you’ve told investors is that you want the company to become the sixth prime contractor, especially when it comes to undersea systems. But you also want to prime in air systems and in other areas where you feel that you guys have the mass and the capability to try to do that. How are you going to transform L3, and what do you want this company to look like when you get done with this transformation?
CK: Okay, well, first of all, it’s a great honor to be able to lead a company like this. Having known Frank and known Mike Strianese for over 30 years. They both built a great corporation, and my job is to take it, as we call it, to L3 3.0, the next level. So we have a very engaged workforce. One thing I’m very proud of, we just conducted our first ever employee survey — 80 percent response rate and better than industry average relative to employee engagement, so the employees love their jobs, they want to work hard and they get a sense of purpose, which gives me a great feeling. They care about the country and they care about the company, so that makes my job a little easier, in my opinion.
So what we’re trying to do at L3 is to take all these great capabilities and find a way to bundle ’em together to better serve our customer needs and also to move up the food chain at the same time, and I’ve talked about being a non-traditional sixth prime. The nontraditional piece is we’re more agile, we’re more affordable and we’re more innovative. And I think we backed that up with some of our actions over the past year or two.
The second part is the sixth prime. We wanna deal directly with our customers and end users. The UUV strategy was one we executed on where we’re gonna be obviously in a position to sell our platforms to the US Navy and other navies. Historically, our ISR [intelligence, surveillance and reconnaissance] work has been directly with the end user and we have other products, like our Wescam balls or night-vision goggles. So we’re trying to grow and move up the food chain and give our customers alternatives to the traditional contractors that are out there.
VM: Let me ask you, before we go further, for sort of a baseline understanding of what the budgetary environment looks like because that’s shaping … not only your investment plan, but your business plan.
There is — you know, everybody wants more defense spending, but there is an expectation that after a strong 2018, 2019 is gonna be a peak in 2020, is gonna be flat, if not declining. Talk to us about what your expectations are for defense spending and how they’re shaping how you’re approaching the structure of your business.
CK: Yeah. I think we’re a little unique in that we not only focus on the investment accounts. A fair amount of our contracts and revenues come from the O&M account, so it’s a little more diversified than a lot of companies that are focused primarily on the procurement and investment accounts. So, you know, we anticipate mid-single digit growth for the foreseeable future.
In my discussions in the Pentagon, even on the top line may be flat in the out years, what they’re talking about is what we’re doing and most companies are doing is looking for more internal efficiencies. So, the savings that they get within the Pentagon, [US Defense Department Deputy] Secretary [Pat] Shanahan working this first and foremost, take those savings and redeploy them to the investment or the addressable account. So I think, within the total budget, the addressable accounts — mainly Investment and O&M — could have growth as a result of these internal studies and efficiencies that they’re working on.
VM: I’m gonna ask you a little bit about business-process change at the Pentagon, but I’m going to stick a little bit to stay on L3. What do you think the company does well, what do you think it does less well and how does that shape where you think you should be directing investment or directing less investment or divest?
CK: Yeah, well I think our heritage and what we do well is focused on defense electronics, products, subsystems and then, ultimately, systems, which is why we made the decision to divest Vertex [Aerospace] in 2016.
We thought there was a change in the landscape. Mike and myself decided we’re gonna give it a year. We’re going to try to fix this business, we’re gonna win more business and we were unsuccessful for a variety of reasons.
VM: 0 for 3.
CK: 0 for 3. And we, therefore, decided — and successfully and quickly, I might add, divested, in fact, signed a contract just last week and that should close in the middle of the summer. So the services piece, when you go back over our history, whether it was the Engility spin, the NSS sale or the most recent Vertex sale, we’re out of services. What we do well and what our core is our defense electronics and those types of systems, so that’s ultimately where we’re focused. We changed our name to L3 Technologies to focus on the technologies and the breadth of our portfolio, and that’s where we’re focused for growth.
VM: You just mentioned L3 3.0, but you also have L365, which is another initiative in this sort of two-year process that you’ve set for yourself to refocus the company, restructure it, you know, change its internal processes, as well. L3, since its founding, has operated a bit like a mall with a whole bunch of boutiques that have been, you know, in that mall. Talk to us a little bit about what’s the right structure to have to have the company operate in a more integrated fashion. I know Mike worked on that a little bit to try to rationalize some of those elements, and I know that, internally in the company, the debate was always, you know, “well, these companies are really, really good at what they do” and sort of let ‘em flourish — a little bit like an SAIC model almost.
VM: Talk to us a little bit about how you think it’s gotta be reorganized, how it’s restructured, what are the process changes and how much savings can you reap in this process because nobody said headcount reduction without, you know, wanting to significantly look at whether or not you’ve got, you know, the right kind of headcount.
CK: No, I think that’s that’s a great question, and the culture at L3 is something special. And what I’m trying to do and work with my team on is how do we maintain that entrepreneurial spirit that we have in these various entities and take advantage of being a $10 billion dollar corporation, as you said, with the scale and the economies of scale, and that’s the fine line we’re working.
So ultimately I want the individual entities to innovate, sell, build and deliver products — top-quality, on time, on budget — to our customers. But there’s a lot of other aspects to a business, as you know, and I think those are the types of things we’re looking at centralizing — the procurement, the IT systems, the e-mail systems and the financial transactions. So it’s really that balance of having the entrepreneurial spirit out there to be innovative and creative and agile, and then reduce the cost of the overall enterprise by having more common systems. In fact, just in this year alone, we’ve been very aggressive and we’re quite proud of two things I mentioned recently. Microsoft and we signed a deal where we were the first contract to be in the Gov cloud.
VM: The [Microsoft] Azure Gov [Cloud] initiative.
CK: Azure Gov Cloud. Exactly. So they came to us, probably because of our reputation for being able to make quick decisions and, based on some prior relationships I had with Microsoft, and we’re pretty proud to be the first one in there. I would expect others to follow, but it’s more secure, more affordable and is really a little bit of a game-changer. We’ve been investing internally on a project that we name “Project Sumo” for wrestling with data, and kind of have a little sense of humor, and SAP has recognized us as a 2018 Innovation Award. So those are the types of things that we’re investing in, where we get more visibility to data, wanna make decisions based on timely, accurate data, and I think that’s ultimately gonna make us a better company. The L365 initiative is just a focus on continuous improvement, lean manufacturing, Tizen, whatever terminology you want. So our overall umbrella for every employee, every day — that’s where the 365 comes from — to think how they can do their job better, how we can make this a great company.
VM: Do you, because … so many folks are developing so much technology across the company, do you have as much visibility as you want about who’s doing what and how you can apply that technology that’s even within your own walls to solve problems that that other divisions have?
CK: We’re doing a much better job in that regard. I recently hired [former US Navy Assistant Secretary for Research, Development and Acquisition] Sean Stackley, and Sean is our vice president of strategy and advanced programs, so he’s been spending a lot of time on the road looking at our different capabilities. Of course, the group presidents and I spend a lot of time together, and we’re doing a much better job bundling these capabilities.
I’ve talked publicly about what we’re doing with the Canadian surface combatant, where we brought eight entities together for a single proposal to Lockheed Martin. We recently won a program in Australia, the Sea 1180 program, where we, again, had multiple divisions. So people want to work together, and we’ve incentivized them financially to do so, and we’re investing in the tools so that they know what the different capabilities are. We just put in our first CRM system, customer relation management system, so we’re were able to track the different opportunities. People are able to see what’s out there and work in a collaborative manner.
VM: And I should say, Sean Stackley, the former assistant secretary of the Navy for research, development and acquisition, who held that job for a very, very long time, handling some of the Navy’s most important programs. While you guys have had successes, you’ve also had a few stinging failures on some … key competitions you guys wanted to win, and some of those were obviously from the Vertex side of things, but there was the [US Army] C-12 [transport-plane] award… on aircraft maintenance, there was the [Boeing] P-8[A Poseidon], the Fort Rucker helicopter competition, and then the SOF aviation one. And then there was the F-35 [Lightning II fighter] displays contract, and I know you’ve told investors that you don’t really see a common causal theme here, but, at the same time, you’ve gotta be, as the CEO, sort of looking at this and saying, “okay, look: what are the lessons here to be derived, and how do we do business differently in order to increase our probability of winning?”
VM: What are some of the lessons you’ve learned? What are the things that you guys have to do differently to increase that win quotient at a time when all these contracts are a lot more competitive than they used to be?
M2: Yes that’s a great question, and I think the overall lesson we’ve learned and what we’re now doing differently is taking advantage of all the great capabilities and knowledge and experiences that everybody has within the corporation. So, in the old days, you know, a lot of these bids were done at the division or the entity level. Now we’re having strategic reviews. We have some major recompetitions coming up for F-16 training, as an example, and instead of reviewing it the week before the proposal was done, we’re having monthly meetings, we’re including people with great experiences both from the military, the government and industry, and we’re spending time together coming up with ideas and innovative innovative solutions. So, I would expect the win rate to increase. And, again when you have 31,000 employees, you have great talent, great expertise, and you’ve gotta be able to reach up and take advantage of that. And people are more than willing to help, and people are more than willing to raise their hand and ask for help, and I think that’s the big difference. So it’s transitioning probably more from a holding company to an operating company, and trying to add value from a top-down perspective. And I’m looking for better results.
VM: And you were always a good student at the University of Maryland, and … you’ve brought that to the company.
VM: It’s a hot time. Merger and acquisition activity is on the rise … so are valuations, for that matter, but you are looking to grow the company. As we’ve discussed, it’s $10 billion company now and you wanna to turn it into a prime, right, an innovative and nontraditional prime contractor, but some of the guys that you’re competing with are twice your size, you know, on an effective basis. You’ve said you wanna strike deals $300-500 million, but you’re willing to consider things that are higher up on that food chain — perhaps a billion dollars — if it, if you really view it to be truly strategic. As you look at this competitive landscape and where you stand in it, do you have the scale to be as competitive as you need to be against companies that are twice your size? Do you do you need to be bigger? And, if so, how much bigger and where bigger to more effectively compete?
CK: Yeah. I think, you know, I try to balance all of our stakeholders, spend a lot of time thinking about our customers, our employees and our shareholders, and I believe that’s my responsibility and try to balance those. Our shareholder base and what we’ve communicated is we’re a growth company, so we’re gonna focus on organic growth and we’re gonna focus on inorganic growth. So we have an alignment with what we’re saying and what our shareholder base wants us to do. I think, absolutely, we’re gonna be acquisitive. We made eight acquisitions last year. We didn’t make anything this year relative to being able to compete with larger companies.
I think our key is affordability and agility, and we’re moving quickly. We have, I think, most times, more affordable offerings and products. And I gotta clarify, the top pick 6 prime, because the first five are important clients, and we have great relationships and teaming on a variety of important missions for the country. And, while we probably will never build a bomb or a fighter jet or a destroyer or a major submarine, there are smaller systems and platforms that we think complement what those companies are doing and allow us to better help our customers. And then, ultimately, the key, and I think what’s unique to us is the communications — a low probability of intercept, low probability of detection — is what’s going to be critical to connect these systems, small large and cross-services. And I think we have some unique capabilities there, and I think that’s a vulnerability that needs to be focused on, and we have the capabilities to solve some of those challenges.
VM: What are the market areas where you’re going to be putting … most of your investment at this point?
CK: I like to remind people that L3 is a diverse company. Only 70 percent of what we have is US DoD, so, you know, we’re in two other growth markets: the airport security and detection — we’ve made a few acquisitions there, so as you go through your travels, whether it’s passenger screening or baggage screening, you normally see the L-3 logo. I want you to think of me as you’re going through those. We have —
VM: But in a good way.
CK: In a very good way. Hopefully, if you talk to your congressman or woman, you’ll encourage them to buy our new machines that allow you to keep your laptop and your liquids on your checked bags. So, it is a serious challenge for the airports and the airlines to get passengers through the airport quickly and onto the planes. So, I think, in our lifetime security, at airports will continue. And we’ve made some innovative investments and acquisitions to grow, so I think that’s an important part of our business. And in certain parts of the world where I’ve been traveling a fair amount, those capabilities are also from a national-security perspective, just beyond the airport security, and commercial pilot training. We have a nice military-pilot training program, but we also have a commercial pilot. We think we’re No. 2 in the world. When you look at that and when you look at the pilot shortages and the challenges, I think we’re in a unique position.
In the first quarter of this year, we were awarded more simulators than we did all of last year. We’ve made acquisitions. We’re investing. So those two parts of the business are growing, and I plan to continue to have a commercial-aviation part of L3, and, hopefully, that grows over time. So, you know, we talk about getting bigger and larger. In this industry, you know, there is some benefit to scale relative to overhead and competitiveness, so we’ve been able to maintain a relatively lean corporate headquarters throughout our 21- year history, and I think we can grow without adding people, and make us even more affordable. So I’m optimistic about the future.
VM: You know, when you went off in the commercial aviation side of things, I was going to mention that, in December, you hired John Feren of Aviation Capital Group to head, to become the vice president for business development and marketing for your commercial … division, and pilot training has been going gangbusters.
You know, a friend of mine said that… it’s an eight-cylinder business running on all nine cylinders at this point, and avionics has also been something that’s been a very strong area for you. From an M&A investment standpoint, is — it’s a two-part question. Does commercial get more attractive, looking at some of the defense multiples, from an acquisition standpoint? I mean, is [sic] commercial acquisition actually start to become a little bit more attractive?
CK: Yeah. What we try to do and from our processes, think about everything, first and foremost, strategically. So, every acquisition we’ve made, we look at it through a strategic lens, irregardless of the price, so does it makes sense for us? Is it filling a gap? Is it giving us new capabilities for existing customers? Is it giving us access to new customers for existing products?
CM: There’s a whole strategic filter, you know, aligning with the budget and macro trends that, if it passes that, we go into an operational check: what are we going to do? Integrate it or keep it standalone? Systems, culture, ethics, is there a fit? And, then, last is the financial check. And, if you make it through the first two, then it’s just a matter of what’s the right price to pay. And I think we’ve done a reasonably good job in that regard. I mean, we look at our own valuation and we look — generally, we like to pay less than what we’re trading at as a simple rule in this industry.
VM: It’s a good rule.
CM: Sometimes you trade at eight or nine times even though sometimes you’re at 15, and the market adjusts. You know, it’s like when you buy a house and sell a house. You know, you’re proud ‘cause you sold it high, but then you’re taking the money and buying it higher. Right. So it’s all relative. We don’t look at it necessarily in that regard. Last couple of years, we’ve made acquisitions in security detection, commercial pilot training, defense, Australia, Portugal, UK, US. So it’s somewhat opportunistic based on what’s available, and then, you know, we’ve been pretty aggressive in making opportunities for us. I tell my team, if we’re receiving a book from a banker, we’re probably a little too late to the game. So we like to do exclusive deals and we like to build relationships over years, and, when people are ready to sell, they like to come to L3 for the reasons I’ve mentioned, because they can still maintain their company, their entrepreneurial spirit, and be part of a larger enterprise, and a lot of the men and women that we’ve acquired are still with the company, you know, which is something we’re quite proud of.
VM: Do you need to expand into commercial aerospace or aviation to give you some countercyclicality if the defense budget doesn’t pan out and starts to trend downward that you have a bigger anchor there to be a countercyclical counterweight?
CK: You know, I look at it more from a capabilities perspective. The capabilities are somewhat aligned. You know, when I joined, it was already there. We’ve been growing it. You know, when I had a couple of years between my Lockheed and L3 experiences, you know, I worked for a company that gave me great exposure to the commercial aviation and the airline, so I was able to meet a lot of executives, which, actually, you know, was fortuitous, and it now gives me a broader exposure to both markets. There is the benefit of diversity and countercyclical, so, you know, I think it makes it makes sense, and they are very successful companies, as you know, that have [a] nice balance between commercial and defense, and I think that’s one of the benefits and one of the things that differentiates us. We talk a lot about, “how do we make this company great and how do we differentiate ourselves from everybody else?” And that’s where we go back to the agility, the innovation, the speed. And, you know, even the portfolio and the mix of business.
VM: I was going to ask this question a little bit later, but I’ll move it up.
VM: You mentioned, you know, you started your career and Ernst and Young where you work with Mike Strianese —
VM: — a while ago, so you said that it was a many-decades relationship —
CK: 34 years ago
VM: 34 years ago. And you were at Lockheed, where you … were chief operating officer after you left you went to Seabury Capital…well, Seabury Advisory Group, part of the Seabury Group, and Accenture bought the advisory part of it. What did those experiences all teach you, each one of them in a unique way? You mentioned Seabury to an extent, right, where that gave you a lot of like private-equity experience as well. But, how do all of these experiences come together to shape how you’re going to be leading L-3 now?
CK: Yeah, it’s a great question. You know, as you go through life, you have lots of different experiences, and you try to learn from each and every one of them. I think a lot of the changes that I was instrumental in making at a company like Lockheed, I’m now making here at L3, so, if you’ve done it once, it’s easier to do it the second time. It’s all about speed. We’re not getting any younger, right? So, I think I tend to move pretty quick. I always have had this sense of urgency. I think it’s kind of contagious.
People are going at a fast pace at L3. We’re making decisions. I’m a big believer in making decisions. The worst thing you can do is not make one. So, we get the data, we put in the systems, we get the data, may not be 100 percent accurate, but it’s good enough and then we move forward. I believe in getting my team’s input. We all sit around. We talk about things. We make a decision. We go off. No passive-aggressive behavior. No meetings after the meetings. We’re too busy. We move on to the next challenge, and the pace of change that we’ve had is pretty impressive.
We just had our annual shareholder meeting. Two of our board members elected not to stand for re-election. And, just yesterday, we announced a new board member, Rita Lane. She’s a graduate of the Air Force Academy. She worked at Motorola, IBM, and retired recently from Apple as the V.P. of operations, so we have an interesting addition. Everybody loves her. She’s got great experiences and brings some diverse thoughts and idea, and a little more technology and West Coast thinking to L3, which I’m excited about.
VM: When you were CEO at Lockheed, there were those who looked at you as a little too sharp-elbowed, maybe, in that job. Has there been a transition of mellowing from your standpoint, in terms of the approach you’re bringing now as CEO?
CK: People thought I had sharp elbows? Wow, I didn’t think of that.
Now, you know, it’s all about making change, and I’ve always had a sense of urgency, and, depending on the size of the company and the structure, I guess, I’d say I’m more mellow. But with this relatively small headquarters and empowered team, we talk about things. We recently froze our pension, and it was three one-hour meetings over a three-week period, and everybody got on board. We thought it was the best thing for all involved, and we made the decision and we’re executing upon it. M&A, same thing.
Every week, there are bankers in bringing us ideas, outside advisers, we’re meeting amongst ourselves, whether it’s our CFO, Ralph D’Ambrosio, myself, [Vice President and Chief Analytics Officer] Heidi Wood, would know it’s a very collaborative effort, the group president.
So, you know, you’d have to ask the people I work with. I’ve always thought I’ve been mellow, but apparently not.
VM: You mentioned this a little bit higher up in the conversation, about balancing all of … your investor needs, right, and the company’s needs.
CK: Yeah, stakeholder needs.
VM: All the stakeholder needs, and a couple of years ago, you were sort of a leading proponent of, you know, dividends, buybacks in order to attract shareholders, and almost everybody in the business has done that on a fairly aggressive way. Now, it seems like you’re leaning toward more of an M&A approach.
How do you work that with investors who get used to almost being bought by a company? You know, they’re looking forward to those buybacks, they’re looking forward to those explosive share-price increases, they’re looking forward to those dividends, and then they … get very, very terrified sometimes when a company is investing money and look at it as a negative.
How are you doing this, and how are you doing that hand-holding and sales part of this with the investor community to sort of keep ‘em aboard that you know, “hey look, stick with us man. We’re spending money in order to make more money downstream.”
CK: Right. Well, if you go back on the buybacks, the original purpose of those buybacks was ultimately to absorb share creep, and, you know, the defense industry was in decline, and everybody was historically compensated through stock options, and if you look at any of the large companies, there were literally tens of millions of options that were about to be exercised and, ultimately, significantly dilutive to the shareholders. So, if you go back into the 2000 time period and you look at the hundreds of millions or billions of dollars that were spent on share repurchase in the industry, you really didn’t see any reduction in share count because as the options were being exercised, you were barely keeping up with them.
CK: So that was the motive and the origin. And once that stopped, and all the options had been exercised, and people went to RSUs, a lot of companies — in fact, just about all of them — kept doing the share repurchase. What we’ve told our shareholders — and we’ve been very clear — is, you know, we generate $900 million of free cash, hopefully, in subsequent years, more free cash. We will fulfill our dividend commitment, which is about $250 million. We’ve had 13 straight years of, you know, minor increases and see no reason why we wouldn’t continue to do that.
CK: Also, taking that same philosophy of we don’t want to have the share creep. So we’ve talked about $300 million of repos to offset the share creep, 401k match, all the employees get stock through the 401k, and then we have our usual equity for the leadership team, so we get that back to 80 million shares outstanding. And then the question is, what do you do with the rest? And what I’ve said is we wake up every morning trying to grow L3 organically and inorganically, and our preferred choice of cash usage is to make acquisitions.
We’ve made over 120 in our 21-year history, and that’s kind of in our DNA. We have expertise. We have a great team that knows how to execute upon these, and that’s how we would like to spend it. So I’ve been clear. People understand it. I think the shareholder base is adjusted to that. They’re generally growth-oriented. And, you know, here it is, early May, and we haven’t made an acquisition this year, so we’ll do what makes sense.
If, at the end of the year, we don’t have an acquisition, you know, personally, I’ll be a little disappointed, but knowing we had a good process and there was nothing there that made sense, I’ll feel good about it. Will I take some of the extra cash and maybe buy a few more shares? Sure. But, first and foremost, we try to grow. I’d be disappointed if we didn’t do a couple this year only if they make sense.
VM: Do I wanna bet you a quarter on whether or not you’re gonna end the year with with a deal or not?
CK: I think I’ll end the year with a deal.
VM: Okay. I won’t take that bet.
VM: You said that you spent, you’ve been traveling the world, going and meeting with all your customers, meeting with all your suppliers, listening to them. What are you hearing from them and what are you telling them as you go around the world, whether it’s through Asia, the Middle East, Europe or elsewhere?
CK: Yeah, well, there’s a couple of things going on. I have had relationships so I’m leveraging those. I’m bringing my executive team with me, and I’m basically introducing myself and L3 to these countries and laying out some of our capabilities. And what you find everywhere, not only here in the U.S., but everywhere,you know, the the money is tight, right, so they’re looking for creative, innovative, affordable solutions. And a lot of what we do, you know, are relatively inexpensive compared to some of these other systems that are hundreds of millions or, you know even larger for a single platform.
VM: Billions of billions.
CK: Billions of dollars, right. So, a lot of it’s about situational awareness. We’re probably world-class, in my mind, and C4ISR, which is really C6ISR — as we add in cyber and things there — and these countries want to have situational awareness as to what’s going on in their various countries, so we’re seeing a lot of interest in the ISR platforms, secured comms, you know, we can have proprietary waveforms for certain countries, of course with the unmanned undersea vehicles, which we’re still progressing. That gives you a lot of these countries I visit or around water or islands is quite appealing. So you’re hearing, you want companies and [to] get your products on time, on budget quickly and affordably, and it’s playing quite well.
CK: Now a lot of these, we work with partners, as I mentioned earlier, but a lot of things we have, whether it’s night-vision goggles, Wescam EOIR balls, you know, are sold directly to the end user, either FMS or DCS, and, you know, I think we’re pretty good at doing that. So you know, they like competition and they like moral alternatives, and I think that’s what we provide them.
VM: This team is also beginning to look and ask some very fundamental questions about what capability looks like in a great power competition and so that can involve some very, very large trade-offs.
As the CEO of a company that is a technology developer on a lot of very, very sensitive systems, you know, not just on the C6ISR side of it, you know, but you’ve also talked about a whole bunch of technologies to secure networks and that being kind of a key part of it.
At such a disruptive time, how how do you map where you need to be in this changing ecosystem of changing threats, potentially changing needs, folks questioning even the need for certain very big systems in which we’ve invested billions as a nation, do we need that, is that relevant for the kind of conflict we’re going into?
How do you look at this dynamic space and make decisions, given that anything you’re investing now is really not gonna pay fruit until two, three, five years from now?
CK: Yeah … this is something we spend a lot of time talking about internally. We have some great expertise that’s on board. We meet with our customers. We look at the published documents. We have access to the Defense Science Board. We have the appropriate clearances and access to know where we think we need to go as a nation.
You know, not being a large-platform provider, you know, we’re on most every system to some degree. You know, it’s probably an interesting aspect of L3. We don’t have a single point of failure, but then, equally, we probably don’t have a single contract or program that moves the needle. So it’s that diverse portfolio from a business base that I think gives us the ability to sustain the ups and downs in the cycle.
As far as three to five years, though, I’m not sure I buy in on that because we’ve been adopting these innovation sprints, and these are one-week projects. We’ve done a couple. We started in January. Some include customers, and, you know, if you give people money and time, they’re going to spend the money in time. If you give ‘em a week, you’d be shocked with some of the things we’ve been able to do in a one-week period, and it’s either fail fast or succeed. So we’re kind of changing the paradigm. I don’t think we need three to five years on a lot of things, and we’re doing things in weeks that move the needle that then give us confidence and opportunities to go forward.
So, the innovation sprints are something unique and, again, different than what other people do. But the end of the day, you’re right, it’s going to be C6ISR and it’s going to be about comms, and those are our sweet spots, so I think we can be agile and adjust and, you know, with all these investments you’ve got to have the off ramp. So we take our best shot at the beginning of the year. Some of these programs, maybe they are three to five years, but after six months or 12 months, you gotta have the discipline to say, “the customer doesn’t want it — it’s not working.” And I think we do that better than most. You make the decision, you give yourself the off ramps, and you either get on or off.
Well, I’ll mention, you know, a lot of the acquisitions we’ve made are technology plays. This year, we’ve made two minority investments in a company called Peak Nano and GRIN (the company’s gradient refractive index), so, again, it’s a different model.
A lot of people want to own 100 percent of everything. These companies have commercial and defense capabilities. We make an investment. We get board representation and we get the exclusive rights for the defense piece. They get the exclusive rights with a commercial market. We share in the profit and their synergies. So, we’re trying to be as creative, innovative and flexible on the business models and how we’re investing our money, and I think we can adapt quickly and change as the world changes. And that’s what’s unique about L3.
VM: You also have been working, as you said, acquisitions around the world. Talk to us about the international business space and how you’re growing L3’s international footprint, which has been something that was a focus that was set a couple of years ago, and you guys have been methodically sort of working to expand that each year.
CK: Yeah. That’s a great question. We’ve really tried not to boil the ocean here. We’ve picked about 10 countries that we’re focused on, based on our capabilities, our relationships, their budgets, their needs, their relationship with the US, and we’ve invested by putting offices in those regions. It tend [sic] to align somewhat with the co-coms, and earlier this year, I set up boards in Australia, Canada and the UK, with both inside L3 executives and outside executives to give us a perspective, to have country-wide presence, strategies and oversight. And, ultimately, these boards are more focused on our strategy and growth. And, again a country like the UK, where we have over 1,000 employees, various divisions and entities, is a branding. One L3, go to universities to recruit and deal with our customers at that level. So, we’re excited about the upcoming air show in Farnborough. I’m sure you’ll be there, and we’ll reconnect with the customers I’ve been meeting with, and we’re going to meet more customers. So, you know, the door’s been opened. Just earlier today, I had a few hours in the Pentagon, and, you know, things are going well.
M3: Let me ask you about … the Pentagon, but also, how you guys are picking in internal investments on R&D and on innovation. You know, in the last administration, when the Pentagon asked contractors, “hey, we want you guys to invest and bring technology to us,” you were at Lockheed at the time and were one of the prominent voices that said, “well, hang on a second, you know, we’re not going to willy-nilly start investing money.”
First, we don’t know whether or not you’re actually going to buy what it is we invest to develop for you, and, second, the budgetary outlook was very cloudy, so, you know, if you guys want to pay for it, we’re willing to invest and develop the technology for you.
You’re now in … it’s a different company. What are the metrics, the thinking you use to invest your own money to develop technology? How are you, especially in a company where almost every part of it is competitive in its own right, in its own little ways, with their own, again, entrepreneurial spirit, I would suspect that that makes this an even harder process when you’re trying to sort of shoot multiple smaller arrows at each one of these areas?
CK: No, I think that’s a great question. Historically, it’s been more bottoms-up, as you suggested, over the last couple of years. We started doing corporate-wide R&D reviews, and taken, really, a focus as to where we want to spend our money. In years past, we might have 200, 250 different IRAD projects.
We’ve cut that in half and doubled the money so we can get things to market quicker, and we’re starting to see that pay off. I mean, just last year, I mentioned how we were gonna increase our spending on sensor systems, we tell Wall Street, our shareholders, by 30 million dollars because we see some opportunities. And it’s no coincidence that we grew 16 percent in the first quarter by spending that money.
CK: So, I’ve said from day one, you know, we’ll get smaller if it makes us better, which is why we sold Vertex, and I will take a short-term charge, whether it’s severance or closing a facility or additional R&D, if it’s in the best long-term interests of the company. So we focus long term. I know there’s this desire for quarter-to-quarter, but I balance those two. We’ve increased R&D over the last several years in actual dollars and as a percent of our revenue. And it was one of the discussions I had today in the Pentagon. So … there is… as you know, a national security policy that’s been published and briefed. Industry was called in with [Defense] Secretary [James] Mattis and others to get the classified version, so it’s nice to actually know what the strategy is and what the concerns are. It’s been well-documented — at least, the unclassified — and we can align our capabilities with what our customers need, not only in defense, but I already talked about the commercial investments. And, you know, we’re starting to see it pay off. So it’s another element of growth.
When you’re a growth company, you’re looking, how do you grow, right? You’re hiring great people. You’re investing in R&D. You’re spending capital. You’re making acquisitions, and, while we’ve talked about reducing headcount and being more efficient, it’s not in the strategy department, it’s not in the business development department. It’s possibly in the support functions and the underlying systems, like I.T. and finance. And that’s what we’re doing, and we’re starting to see results.
VM: You mentioned being in the Pentagon. The deputy defense secretary is Pat Shanahan, who is from Boeing. The acquisition chief, Ellen Lord, is from Textron Systems. Richard Spencer is the Navy secretary who’s got a very deep Wall Street and experience across the board, was chairman of the Defense Business Board, so, you know, former Marine aviator, so somebody who knows the enterprise really well. [Army Secretary] Mark Esper, West Point graduate, lots of industry experience, also as Army Secretary, and that’s not even talking about Mike Griffin and some of the other folks who are engaged in the process.
Talk to us a little bit about how this administration is different, how the dialogue with industry, and what are some of the things you know, you like that you’re seeing, and what some of the advice you and your counterparts, you know, I know that that the cohort and through AIA and NDIA, some of this is happening, that you’re passing along to the department to sort of improve the relationship between industry and government.
CK: Well, from my perspective, well, first of all, you have to admire these men and women for taking the time and changing their careers and lives to give back to the nation. I think it’s something that is pretty admirable on their part. You know, the outreach to the industry seems to be much more. I mentioned Secretary Mattis and Shanahan had meetings with the top execs from industry to review the defense strategy and the national strategies, which I don’t think had been done previously, and maybe we didn’t have a national defense strategy for the last 20 years, to quote Secretary Mattis, you know. Secretary Lord has been approachable through AIA and met with the industry, so I think the industry outreach is great. I mean, I think they’re meeting with us as groups, they’re meeting with us one-on-one and individuals.
You know, I think having Secretary Mattis, having worked with and having been in the military with so many of the leaders, there’s probably an immediate synergy and bonding. And everybody understands the mission, the threat, and things seem to be going at at a relatively quick pace, so, you know, the budget’s increasing. That’s good. I think the acquisition process is as efficient as it can be, all things considered. So generally I think it’s a positive environment. There have been changes to some of the export and licensing process. Is it perfect? Probably not. Is it better? Absolutely. So it seems like everybody’s aligned, and things are moving quickly. So, I’m very happy with how things are moving.
VM: Do you see that speed? I mean one of the things that Secretary Mattis, Secretary Shanahan, everybody has been talking about is increase that agility, increase the speed, bring a more business-like focus in terms of the department and how it’s run. Do you notice that extra speed? Do you notice that change?
CK: Yeah. Again, it’s not a big part of our portfolio because we work so much through other companies and support them in a variety of models, whether it’s the merchant-supplier model or the supplier model or the teammate, but, in those cases, we work directly with the end user. I would say absolutely. You know, a lot of our work historically has come through big safari, SOCOM, right. Secretary [Hondo] Geurts [assistant Navy secretary for research, development and acquisition] was first with SOCOM, and now with Navy, so you know all these things are headed [in] the right direction, and that’s one of the reasons we’re looking at becoming a sixth prime. I think we can get to these men and women some interesting capabilities in a timely manner. We hope to have a couple new orders announced in the weeks or months ahead that I think we’re quite proud of that will, in fact, confirm that things are changing and moving at a fast pace.
VM: You’re the chairman, CEO, president of a company. You were CFO. So, obviously taxes are very, very important to you. Big tax law change. Talk to us about how that tax law change has affected your guys’ profits, investment and the follow-up question to that is, if you were going to tweak that tax law, would you change the R&D clause that some folks look at as punitive toward R&D investment?
CK: Yeah, well, the tax law changes, obviously, lower the tax rate for corporations. In our case, it’s about a $50 million cash benefit each and every year, based on our current size and profitability, and we’ve opted to take that $50 million and treat it like every other dollar we have. I know other companies have tried to carve it out and do something special, but we put it into our free cash flow. We have a strategy. We know how we’re going to allocate capital. It’s beneficial, and it’s gonna go to dividends, repo, M&A, R&D, capital. We are looking at some enhancements to certain things for our employees.
I think I mentioned we had a great employee survey, and some great feedback and ideas that we’ll be implementing. I just hired a new head of human resources, which I think is a critical position that’s gonna position us for the future, someone who’s pretty innovative and creative. As far as the R&D tax credit, I’ve got to be honest: I’m not overly familiar with the aspect that makes it punitive. I think we’ve always thought it was fair and had some benefit. If it was larger or more beneficial, we’d be fine with it, but, again in this industry, a lot of the R&D is, in fact, reimbursed by the government.
So, while people like to call an investment, we’ve gotta be honest; most of it goes through the overhead and is, in fact, reimbursed by the customer, depending on the contract type. So, you know, we’ve benefited from the R&D tax credit. I think it works, and if it’s gonna be larger, would take it, but it’s not high on our hit parade.
VM: As I was getting ready for this, there were a couple of folks that I talked to who said, “well, you know, when’s Chris gonna sell, and what would that look like?” I mean, is there anything that you would be entertaining —
CK: Sell what?
VM: Well, sell the company, right?
CK: Of course not. Not at all. In fact, we just had a board meeting this week, and you know, my desire is to keep the momentum that Frank Lanza and Mike Strianese had. We call it L3 3.0.
We talk a lot about the next 20 years, how to position this company for the long term. So, absolutely, we are not for sale and we’re going to grow, and we’re going to be a force to be dealt with, and we’re gonna serve our customers, and we’re gonna get them products on time and that are affordable and on-budget and we’re gonna be a great place to work.
Again, the workforce is excited and you look at the caliber of people that have come to L3, and they could go anywhere they want, and they’ve chosen L3 because we’re trying to build something special. A lot of energy. A lot of excitement. And we’re having a lot of fun. So, I don’t think I’ll be here running the company in 20 years, but I plan to have a great run and hand it off to even a better leader when I decide to retire.
VM: And in five years, where do you think you’re going to be size-wise? So we’re gonna be looking at a $15 billion company, a $20 billion company?
CK: Hopefully larger, sure. I mean, I guess if we’re at $10 [billion], $15 [billion] would be the next milestone. But again it’s not only just the top line — it’s more cash, more e-bit, which converts to cash, and it fuels growth. So, as they say on Wall Street, it’s a compounding, free-cash flow story. We generate the cash, we reinvest and we get more. So it’s exciting times.
VM: Chris Kubasik: chairman, president, CEO of L3 Technologies. Sir, thanks very much for the time and best of luck.
CK: Well, thank you. It’s great to see you, and I appreciate you inviting me down today. Hope we can do it again.