Orbital Sciences Corporation (ORB) Q3 2008 Earnings Call October 16, 2008 9:00 AM ET
I would like to welcome everyone to Orbital's third quarter 2008 financial results conference call. (Operator Instructions) Mr. Thompson, you may begin your conference.
I am Dave Thompson and with me on the phone today are J. R. Thompson and Garrett Pierce. Before we get under way, I would like to ask everyone to take special note of the safe harbor paragraph at the end of our earnings release. This paragraph emphasizes the major uncertainties and risks in the forwardlooking statements that we'll make this morning. Please keep these risks in mind as we discuss our future strategic and operational plans and our financial guidance during today's call.
We'll follow our customary outline for the call this morning. I will begin by discussing some highlights from the third quarter and then turn it over the Garrett, who will cover the company's financial results in greater detail, update you on our guidance for this year, and provide our first outlook and preliminary guidance for 2009.
After that, J. R. will recap recent space missions and major satellite and launch vehicle deliveries. He will also provide a preview of upcoming launches, system deliveries, and other significant operational events on the calendar for the remainder of this year.
Finally, I will address third quarter new orders and contract backlogs, discuss our new business outlook for the remainder of 2008 and the early part of 2009 and update you on several of our major strategic initiatives at the company. At that point, we will open up the call for your questions.
To set the stage for today's discussion, I would like to begin by highlighting three areas in which the company's third quarter was noteworthy. We will come back and cover each of these in more depth later in this morning's discussion.
First, there's our financial performance. Orbital's financial results in the third quarter were solid. Revenue increased to $278 million. Operating income declined to $21 million on about a threefold increase in research and development spending on the Taurus II launch vehicle. Adjusted earnings per share came in at $0.22 in the quarter. Our free cash flow was a very robust $37 million, which boosted the company's ending cash balance to a record $341 million.
Continuing the growth trend established early last year, the company's Advanced Space Programs segment again led the way this quarter with nearly a 30% revenue increase. This was followed by our Launch Vehicle Segment, which exhibited more than a 10% revenue gain in the quarter. Garrett will give you all the financial details for the third quarter in just a few minutes.
Second, let's look at the company's operational highlights. The third quarter saw two major space missions being carried out. These consisted of a communications satellite deployment in August and a longrange target rocket launch in September. We also completed two other communications satellites and one scientific spacecraft that are scheduled for launches in the coming months. Beyond that, we delivered three additional launch vehicles for future missions as well.
Looking ahead, we expect our nearterm operational activity to include eight or nine satellite and rocket launches that are planned over the next four months. J. R. will discuss these and other matters a little later in the call.
Finally, let's consider our new business activity. Orbital continued the year's first half new business momentum with approximately $475 million of contract awards and option exercises in the September quarter. This brought our yeartodate new business totals to just under $1.75 billion, setting a new ninemonth record for the company.
Orbital also continued to be active with new business pursuits in the third quarter. Submitted over $600 million worth of proposals on potential contracts in the July to September period. In addition, we are now preparing another $400 million or more of additional bids for delivery later this year. As a result, our outlook remains positive for new orders and contract backlog growth over the next six months.
Now, I would like to ask Garrett to take you through the financial results from the third quarter and to discuss our financial guidance for 2008 and our preliminary look at 2009. Garrett.
Before commenting on the financial results, I want to note that during this call we will provide certain nonGAAP financial measures, a reconciliation of these measures to comparable GAAP financial measures can be found in our earnings release or, to the extent not addressed there but discussed in this call, will be available as an appendix to the transcript of this call and will be posted under the Investor Relations heading on our website.
Revenues for the third quarter of 2008 were $278.6 million, compared to $275.6 million in the third quarter of 2007. Advanced Space Programs increased 29% over the prior year, reflecting the growth in intelligent defense programs. Our Launch Vehicles segment also increased with revenues up 11%, driven by the Interceptor and Space Launch product lines. Our Satellites and Space Systems segment revenues were down 19% due to the substantial completion of certain GEO and science and technology satellites since the third quarter of 2007. This decrease reflects the timing of orders execution between the comparable quarters. Our satellite backlog remains robust.
Our operating income was $21 million or 7.5% return on revenue in the third quarter of 2008, compared to $21.6 million or 7.8% operating margin in 2007. It should be noted that, during the third quarter 2008, operating income includes $3 million of research and development expenditures that are not recoverable under government contracts. As discussed in our Q1 and Q2 2008 earnings release conference calls, research and development expenditures not recovered under government contracts will reduce our fullyear 2008 operating income margin in earnings per share. Our current estimate for this impact is about a 125basispoint reduction to operating income margin and about $0.10 to $0.12 reduction in earnings per share in 2008.
We continue to believe that our investment in the Taurus II product line with significantly expand our Space Launch Vehicle market and provide substantial revenue growth in future periods. I will now highlight certain factors in each of our three operating segments.
The third quarter of 2008 revenues in our Launch Vehicle segment were up $11.5 million over last year's third quarter driven by the growth in the Interceptor and Space Launch product lines.
Launch Systems segment operating income decreased $2.1 million in the third quarter compared to last year, primarily due to the $3 million unrecoverable research and development costs driven by the Taurus II program. For the yeartodate period, the Launch Systems segments results include $7 million of unrecoverable research and development costs. Excluding these R&D expenses, this segment operating income was $11.4 million for the quarter and $36.4 million for the yeartodate period. The current quarter's operating margin for the Launch Systems segment, excluding the abovementioned R&D costs, was 10.2% compared to 10.5% last year. The margin in our Interceptor product line was 12.1% for the quarter and consistent with the third quarter of 2007.
The third quarter revenues in our Satellites and Space Systems segment were down $22.8 million yearoveryear, due to the decreases in the GEO satellite and science and technology product lines, which were down by $19 million and $6 million, respectively, reflecting the timing of completion our nearcompletion of certain satellite contracts since the third quarter 2007. Operating income was $8.1 million for the quarter. The operating margin in the Space Systems segment increased 8.1% in the third quarter of 2008 as compared to 6.4% in the comparable quarter of 2007.
Revenues in our Advanced Space Programs segment were up $15.5 million, driven by our intelligence and defense programs. Operating income was $4.5 million for the quarter, an increase of $900,000 or 26% over the prior year. The operating margin in the Advanced Space Programs segment was 6.6% in Q3 2008, compared to 6.7% in last year's third quarter.
During the third quarter, Orbital purchased 272,300 shares of outstanding common stock for $6.4 million. As of the end of the third quarter 2008, we have approximately $40 million remaining in our $50 million repurchase program authorized by the board in April of this year. Since the inception of our buyback program in 2004, we have purchased approximately 10 million shares at a total cost of $163 million at an average price of $16.30. The repurchase program, since the inception in 2004 through the end of the third quarter 2008, reduced outstanding shares by approximately 15%.
Free cash flow for the third quarter was strong at $37.1 million, primarily driven by cash flow within our Advanced Space Programs segment. Capital expenditures included in free cash flow totaled $7 million in the quarter. Yeartodate free cash flow was $68.2 million including $18.9 million of capital expenditures.
Our liquidity is very strong. At the end of the quarter, we had $341 million in cash balances and we also have a $100 million revolving credit facility in place through 2012.
As discussed in prior quarters, we hold investments in auction rate securities with a total par value of $34.5 million. During the third quarter, based on our ongoing monitoring and assessment of the value of these securities, Orbital recorded an additional $1 million noncash impairment charge to the P&L and an additional $1.7 million temporary impairment charge in equity. These securities are classified as noncurrent investments on our balance sheet. We have ample liquidity to hold these securities for an extended period of time. All the auction rate securities continue paying interest, currently at an average rate of approximately 5.2%.
Beginning in 2009, we will be required to adopt a new accounting standard related to convertible debt instruments including our convertible net share debt. This new rule must be applied retrospectively aimed at beginning in 2009. Our 2008 and prioryear financial statements will be changed to reflect the new accounting.
The new rule will require us to separately account for the liability and equity components of this convertible debt. This will result in an imputed debt discount there will be amortized as noncash interest expense. Although we have not completed our analysis, we believe the adoption of this rule will increase noncash interest expense by approximately $5 million for $0.05 per share in both 2008 and 2009.
Free cash flow and average shares to calculate EPS are unaffected by the new standards. I want to emphasize that this accounting change will not have any impact on the company's earnings power or fundamental economics. It is a noncash charge.
We are updating our guidance for 2008 from that provided in our July earnings release conference call. We estimate that fullyear revenues will be in the range of $1,155,000,000 to $1,135,000,000; operating income margin of approximately 7.5%; and adjusted diluted EPS from continuing operations in the range of $0.96 to $0.99 per share. This excludes the impact of the noncash auction rate securities impairment charge mentioned previously.
We are also reaffirming our free cash flow guidance in the range of $80 million to $85 million. We have not completed our review and approval process of our 2009 plan; however, on a preliminary basis, we are estimating the 2009 revenues in the range of $1,175,000,000 to $1,200,000,000; operating income margin in the 6% to 6.25% range; and diluted EPS in the range of $0.85 to $0.92 per share. The decrease in margin from 2008 reflects higher unrecoverable research and development expenditures in the range of $20 million to $25 million versus $10 million to $12 million in 2008.
As outlined earlier, this guidance excludes noncash interest expense of about $5 million or $0.05 per share expected to be recorded upon adoption of the new standard in the first quarter of 2009. The tax accounting provision for 2009 is estimated at 32%. I want to underline that is the tax accounting provision, not the cash provision, at approximately 32% and reflects the favorable impact of research and experimental tax credits related to the increase in new product research and development expenditures for Taurus II and COTS. Our tax accounting provision for prior years have been approximately 40%.
However, more importantly, the cash tax rate is expected to continue to be about 2% to 3% and the research and experimental tax credit and to our NOL tax shield dollarfordollar is a tax credit versus a tax deduction at 40%. Finally, free cash flow is targeted in the range of $75 million to $80 million. I want again to emphasize that the 2009 outlook is preliminary. Once we have competed and approved our 2009 operating plan, which will occur later this year, we will provide our 2009 guidance early next year in connection with our fourth quarter 2008 earnings call. Now back to Dave.
Now I would like to ask J. R. to update you on the company's major operational events from the third quarter and also to preview what's ahead in the fourth quarter of this year.
J. R. Thompson
The third quarter was extremely busy and productive with excellent operational results. Highlights for the quarter and since our last report include nine major system deliveries, three OBV interceptors, two GEO communications satellites, a NASA science spacecraft, a Pegasus rocket for the upcoming IBEX mission, one supersonic seaskimming target, and one mediumrange target.
These deliveries, combined with the successful execution of two missions (onorbit delivery of the AMC21 GEO communications satellite and a Minotaur II target launch for imaging operations with the Missile Defense Agency's NFIRE spacecraft) provided the basis for another solid quarter.
Orbital's OBV Interceptor outlook through 2013 remains strong. Both houses of Congress are supporting a very robust 2009 GMD Interceptor program. We have proposals in work with Boeing to definitize up to 24 more Interceptors, 10 twostage OBVs for European deployment, 12 Interceptors for flight test, and 2 spares. If all this happens as we expect, Orbital will be on contract to deliver 83 OBV GMB Interceptors through 2013. Thirtyeight Interceptors have been delivered to date, with 26 currently in silos.
The KEI Interceptor program is also being strongly supported in Congress. The first boost test flight is now scheduled for August 2009 with a second boost test flight recently added in 2010. Orbital manpower to execute this Interceptor work will be at a peak next year.
This has been a particularly busy time in our satellite manufacturing area, with the shipment launch and onorbit check out of the AMC21 GEO communications satellite, shipment of the MEASAT GEO satellite, and shipment of NASA's IBEX scientific satellite to be launched on a Pegasus rocket later this week. The NSS9 GEO communications satellite has been completed and placed in storage for an early 2009 launch. A total of 11 GEO communications satellites are in some phase of manufacturing, integration, and test in our facilities at Dulles, a peak period of activity for our GEO business unit.
This level of activity should remain high with two additional new orders received during the quarter Intelsat 18 and another to be announced later. Several more potential orders remain possible for award late this year.
I mentioned last quarter the significance to Orbital of the potential award of the commercial resupply services contract to the international space station. We have now been down selected for oral negotiations and will be responding to NASA questions early next week before submitted a best and final offer. We still expect an award of this contract by the end of the year and are optimistic this will become the Taurus II anchor customer. We continue to make good progress on the two basic elements of this resupply system, the Taurus II launch vehicle and the Cygnus space station rendezvous spacecraft it will carry to orbit.
For Taurus II launch vehicle over the next six months, all major systems critical design reviews will be completed and include Aerojet modified AJ26 engine, the Ukrainian supplied liquid first stage, the solid propellant second stage, the total integrated system, and the CER for the ground system and operations at the Wallops Island launch site.
The Cygnus spacecraft critical design review will be conducted in stages, but completed by midnext year. We are still on track to begin engine testing at Stennis in mid2009 with operations at Wallops beginning in mid2010 and our initial launch scheduled for the end of 2010.
Progress continues in the development of the launch support system for the Orion spacecraft with the successful firing of a fullscale jettison motor behind us, the abort motor test scheduled for November, and control motor test early in the first quarter of 2009. We are feeling confident about the abort system test occurring in April of next year at the White Sands missile range. This will be the first major high profile systems test in the Orion spacecraft development program.
This has been our most productive quarter this year in adding staff with a net increase of 126 employees. During this quarter, we will be occupying new office space at our southern California engineering center as well as both our Chandler and Dulles campuses.
Looking ahead to the fourth quarter, we plan 13 major systems deliveries. Two OBV Interceptors, five supersonic seaskimming targets, a mediumrange target, a Patriot target, a Minotaur I launch vehicle scheduled to carry the spacecraft to orbit, a Taurus launch vehicle for the OCO mission, delivery of the OCO spacecraft, and the recently competed NSS9 GEO communications satellite.
Nine missions scheduled include the Pegasus launch of NASA and Orbital IBEX scientific spacecraft, mediumrange target vehicle for planned intercept operations, two seaskimming target stream rate operations with the U.S. Navy involving four targets, the Minotaur I launch of Tac Sat3 spacecraft, and the very high profile [FT5] OBV interceptor flight test scheduled to be launched from the Reagan missile range. With that, I will return the discussion back to Dave.
I will now discuss in a little greater detail the company's new orders and contract backlog. I will also preview our overall market outlook for the next three to six months. Of Orbital's $475 million in total new business volume in the third quarter, about $190 million was in the form of new firm orders, $235 million was in new option orders, and $50 million was in option exercises under existing previously awarded contracts.
Our Satellites and Space Systems segment won approximately $330 million in new business, followed by Launch Vehicles with about $115 million, and Advanced Space Programs with $30 million in the quarter.
Major new orders in the third quarter included the award, as J. R. mentioned, of the Intelsat 18 geosynchronous communications satellite, as well as a contract for a GEO communications satellite not yet formally announced by its customer, a significant contract addition to our OBV Interceptor vehicle program with the Missile Defense Agency, an option exercise by the U.S. Air Force for another Minotaur space launch vehicle, a new contract for several mediumrange target vehicles for the Missile Defense Agency, and an option exercise for a scientific satellite from NASA.
As a result of this new business activity, the company's firm backlog at the end of September was about $2.1 billion and our total backlog stood at approximately $4.2 billion at the end of last month. This backlog gives the company almost 90% of our targeted 2009 revenue with one more quarter still to go before the new year begins.
Looking ahead to the next six months, our new business prospects continue to look strong. While we will not win all of our outstanding bids, the company currently has over $2.3 billion worth of active proposals that should be decided on by customers over the next three or four months.
As I noted when we talked three months ago, the company's most promising new pursuits and opportunities for existing contract addons are in human space systems, missile defense programs, commercial communications satellites, and military space systems. These four areas together account for about 90% of our potential new business between now and the early months of next year.
I would also like to update you on several strategic initiatives that are very important for Orbital's longerterm growth looking out over the next three to five years.
First, as J. R. noted, the company's Taurus II launch vehicle development program made generally good progress over the last three months. However, we did delay our final engineering reviews by several months, now planning to complete those in January and February instead of November and December, to make sure that the vehicle's technical configuration will be fully up to date by that event.
We also increased our estimates for Taurus II research and development spending in 2009 by $10 million to $15 million. This is partially offset by a $3 million to $4 million lower estimate for R&D expenses in the remainder of 2008. Overall, the Taurus II program remains on track for its first launches in the second half of 2010 and a ramp up to some four or five launches a year with around $300 million or so in annual revenue potential by 2012 or 2013.
Second, on a closely related program, our COTS space station cargo delivery spacecraft that we call Cygnus completed several major technical milestones together with NASA in the last three months. These included preliminary design reviews of both the Cygnus pressurized and unpressurized cargo modules as well as its ground processing and launch site operations and facilities. So far, progress by our team of the COTS program has been very good. This has allowed us to keep it on schedule for a demonstration flight to the space station about two years from now in the fourth quarter of 2010.
Finally, we are now in the early stage of assessing the business prospects for a new mediumclass geosynchronous communications satellite, including a look at the sales potential, the competitive landscape, and the product development options for such a new spacecraft. Earlier this year, several of our biggest commercial satellite customers asked Orbital to consider developing and offering a GEO communications satellite platform in the 6 to 10kilowatt power range which would extend the company's current product line well above the 2 to 5kilowatt power levels provided by our satellites that we build today.
Such a mediumclass satellite, if successfully developed and accepted by customers, could more than double our addressable market from the $600 million to $700 million a year smaller class GEO communications satellite demand that we address today to as much as $1.75 billion to $2 billion in annual spending for combined small and mediumclass GEO satellites in the future.
I want to caution that Orbital has not yet completed our assessment of the business outlook or the trade studies of technical alternatives for such a satellite, and we may well decide not to pursue it at all. In any case, though, we are taking a careful look at this and we should be in a position to make a go or nogo decision by sometime late this winter or early next spring on this new product program.
In conclusion, the company had a solid third quarter and is expecting a strong finish to 2008. Orbital expects that new records are likely to be set for revenue, earnings, and contract backlogs this year. Our preliminary look at 2009 calls for additional revenue growth, sustained solid cash flow, and important progress in strategic initiatives in the year ahead. Thank you for your attention. We are now ready to open up the call for your questions.
(Operator Instructions) Your first call comes from Howard Rubel – Jefferies & Company.
Howard Rubel Jefferies & Company
David, could you talk about where you are in terms of the order cycle for Taurus, and then I have one followup question.
As J. R. mentioned, our primary nearterm focus for the Taurus II program is the operational program that NASA calls commercial resupply services, or CRS, that will follow the COTS demonstration mission to supply the space station with cargo during the period from 2011 to at least 2015 and probably for a good bit longer than that.
We anticipate that NASA will make one or more contract awards under the CRS program sometime in December. If we are successful in our proposal on that opportunity, we would anticipate generating roughly two or three Taurus launches per year in support of space station cargo launches beginning in 2011.
Beyond that anchor customer potential for Taurus II, we are also in discussions with NASA for the future use of Taurus II in science and robotic exploration missions beyond earth as well as with various departments and agencies in the Defense Department concerning their use of this new mediumclass vehicle.
Putting all this together, we continue to view our addressable market over the first five years following Taurus II's introduction in late 2010 as being between seven and nine total launches per year. It's our objective to capture 50% to 60% of that market, working out to some four to five launches per year once we reach a steady state in the 2012 and beyond period.
Howard Rubel Jefferies & Company
To follow on a question to Garrett, could you help me a little bit understand some of the puts and takes in both your cash flow outlook and your guidance. My guess is that part of what you have done is you have factored in lower interest income for the balance of the year and into next year. Then, second, you're setting kind of a low hurdle for free cash flow in the fourth quarter around onethird of what you did in the third. Could you explain the difference there?
You're right, we have factored in a low rate of return on our cash balances reflecting the current interest rate environment that we're in. The fourth quarter, really, is just timing difference of progress payment, milestones that were received under some major contracts. We think we put together what we believe is a conservative, realistic estimate, but it has nothing to do with the cash flows per se, it's the timing of benchmark payments, milestone payments on some major contracts.
I would just add on that part of the question that the third quarter, relative to our plan, came in $10 million or $12 million hot due to the receipt, before they were scheduled to come in, of several milestone payments that had been programmed for the fourth quarter. So third quarter was better than planned; fourth quarter reflects $10 million or $12 million that was originally expected to be collected in the fourth quarter having actually come in in the third quarter.
Howard Rubel Jefferies & Company
If you get some of these satellite orders and a few other things to happen, there is some upside to the cash flow numbers? Is that a fair observation?
There could be some upside to it. But at this point, we think the $80 million to the $85 million is the right range to maintain our guidance in. The timing of the award of those contracts, and the short delay of 30 days or so following the actual signing of the contract or when the cash is received, makes it prudent to not count on anything beyond our current plan for the final quarter of the year.
Your next question comes from Patrick McCarthy – Friedman, Billings, Ramsey Group.
Patrick McCarthy Friedman, Billings, Ramsey Group
My first question is just on the NASA business and the impact of the continuing resolution might or might not have there. I am just curious. You sound like you have a lot of confidence that the COTS program comes through in December. Can you talk about technically how that occurs under a continuing resolution environment?
We don't see the continuing resolution that NASA is operating on now and that will probably persist into the spring of next year, really affecting the agency's ability to proceed with the CRS contract award or to continue meeting its commitments on the COTS program. From everything we have been able to determine from discussions with NASA, the continuing resolution should be not be a problem whatsoever in that regard.
NASA, just to talk a little more generally about the NASA situation, our business with NASA has increased steadily over the last three years. In fact, this year for the first time in many years, our NASArelated revenue will exceed revenue from every other customer group except commercial communications satellite operators. It will this year, 2008, exceed that from the Missile Defense Agency as well as from the various national security satellite customers that we work for. So NASA revenue has grown quite nicely and we expect that to continue on the strength of primarily of COTS and CRS over the next several years.
The budget that was submitted to Congress nine months ago covering fiscal year 2009 called for about a $500 million increase, which works out to be a 3% increase over NASA's 2008 budget. In both the House and the Senate, final budget plans were worked out, although never put into a final spending bill that further increased NASA's proposed appropriations for 2009 by about another $200 million.
The continuing resolution is expected to run through the early spring. At that point, hopefully, NASA will have a final budget approved by the new Congress, signed by the new President, and it will represent better than a 5% increase over the current spending levels.
At this stage, though, other than imposing a bit of a slowdown in the Orion project, we don't see the continuing resolution having any adverse effects on COTS or the follow on program, CRS.
Patrick McCarthy Friedman, Billings, Ramsey Group
Is that because it was already a line item in the FYOE?
Yes, that's right. It's not considered to be a new start program.
Patrick McCarthy Friedman, Billings, Ramsey Group
My second question is more on the commercial satellite side. When you think about the end market in a slowing global economy, can you talk about what the impact could be there, what the market looks like from a replacement perspective versus an endmarket growth perspective and whether you're concerned about any impact given what's happening globally.
That's a good question and I can bring you some very recent observations from many of the commercial satellite operators themselves because we are just today completing our annual commercial satellite customer conference here at Orbital that started on Tuesday and which is being attended by eight of the top ten global satellite operators as well as many of the smaller, regional operators as well.
Here's the report from the satellite operators themselves concerning the effect of the financial turmoil and the general economic slowdown on their businesses. The established operators, those that have been in the business and are now well beyond their first generation of satellites, seem to be relatively insulated from financial market factors and, in general, from broader economic ones as well. I will come back to one possible exception there in a minute.
As an example, the top ten global operators, including companies like SES Global, Intelsat, Eutelsat, Telesat, JSAT, and so on, who typically account for about 65% of new satellite orders and roughly 65% of existing inservice satellites, are likely to continue with fairly aggressive programs to order and put in place replacement satellite capacity driven by the fact that they have very large and longterm backlogs. The top ten operators, eight of who are here this week, together currently have approximately a $35 billion order backlog.
It seems clear that they are going to continue with programs to make sure they've got the capacity in place to deliver the services in support of that backlog. The possible exception on the margin could be capital expenditure cutbacks for brand new type of services, either in new geographic areas or in new categories of satellite delivered services. We haven't seen that yet, but that is something we are watching.
Offsetting that, from our standpoint, is to the extent that beyond the top operators, some of the regional operators pull back a little bit. We think that will tend to favor smaller and less capitalintensive satellites of the type that we specialize in. Within the established market, our outlook is pretty strong for the next two or three years. Startup operators, those that are just now financing and building out their fist generation of satellites, who depend on nearterm access to the financial markets or who may be trying to develop new types of services, could however run into problems in raising funds and be cause to delay or potentially abandon their projects.
That part of the market is not one that we've been involved with to any significant extent in the past. Nor, with maybe one exception, are operators of that type on our target list for nearterm orders. That part of the market that does depend on ready access to the capital markets may run into a little more trouble, but in our part of the business, the outlook continues to be pretty good.
Patrick McCarthy Friedman, Billings, Ramsey Group
One more quick question. I am assuming that you are staffing ahead of revenues with the net increase in employees this quarter, do you have a sense, if that's true, as to how much of the margin impact you are factoring into your guidance for next year?
The two areas where we are in a way staffing ahead of at least reported revenues are in Taurus II, which is in heavy research and development now, and also the COTS demonstration program.
You may recall from either the first or second quarter call when we first brought this up, that we're accounting for the work we're doing on the COTS demonstration program under a shared research and development agreement with NASA. Therefore, we're not recognizing revenue on the $170 million that NASA is contributing to Orbital to carry out the development and demonstration of the COTS space system or the first Taurus rocket that is included in that amount that will launch that system.
That invisible revenue, or phantom revenue, that nevertheless reflects real work and real activity amounts to almost $20 million of activity, not revenue, in 2008 that is expected to jump almost fourfold to $75 million to $80 million of invisible revenue, but real activity in 2009. So quite a bit of the new hiring, in one way or another, supports that ramp up.
The remaining new hiring is being driven, particularly in the second half of the year, by ramping up our work force in Arizona in support of expanding missile defense work that you will start to see coming through over the next couple of quarters. Mostly in the Interceptor areas, both the OBV Interceptor as well as the KEI Interceptor.
Your next question comes from Troy Lahr Stifel Nicolaus.
Troy Lahr Stifel Nicolaus
Can you briefly discuss the Satellites Space Systems margin in the quarter? Was there any favorable contract adjustments there? I think last time you guys did 8% if you had some.
There was not. It was business as usual. There are puts and takes on all the contracts, but there was nothing extraordinary in the third quarter.
In one area that contributed significantly to the margin improvement there is the biggest product line in our Satellite and Space Systems segment, namely the commercial or GEO communications satellites. We have seen over the last couple of years pretty steady improvement in margins in that product line.
In fact on a yeartodate basis, comparing the first nine months of 2008 to the first nine months of 2007, we have achieved over 100 basis points, about 120 basis point improvement in the margins on our GEO communications satellites. That's been the big driver. Science and Technology satellite work has been pretty steady during that time. But the GEO satellite margins have continued their improvement trend.
Troy Lahr Stifel Nicolaus
I guess if I look at the backlog you have higher margin work in the commercial satellite business, so you should be able to at least kind of stay in this range of 8%, is that the way I should think about that?
We won't have dramatic jumps in improvements from quarter to quarter basis, but over the next year or so, we would hope to be able to see those margins continue to increase potentially by another 40 or 50 basis points.
I would further say that as you look at the GEO product line, we're expecting those margins to increase in the ensuing quarters. The Science and Technology area has some volumes that have been down. That might impact the bottom line, the 8.1%. If you are looking at the GEO product line, the backlog and execution thereof, should continue with increased margins.
Troy Lahr Stifel Nicolaus
Just briefly on 2009. I know it's a preliminary look that you guys have out there. Can you maybe walk through the segments? I don't really expect any numbers out of you, maybe just what you expect from Launch Vehicles, Satellites, and Advanced Space Programs, just preliminary as you look into 2009.
Let me talk about the revenue side of it first. On the Launch Vehicle segment, we're looking for medium to high singledigit growth, 7% or 8% range, something like that, over 2008. We're looking for similar growth in the Advanced Space programs area again, 7% or 8%. In the Satellite and Space System segment, at this point, although it was expected to show growth in the Commercial Satellite area, the outlook on the Science Side is flatter, so that will be in the low to mid singledigit range, 2% to 4%, based on the current look.
That could change depending on our success over the next quarter or two in some of the new proposals that are under evaluation now. But at this point, that's what we see for revenue increases by segment.
On the margin side, we do expect to add another 30 or 40 basis points in overall operating margin in the Satellite and Space Systems area relative to 2008 levels. The pressure next year will be most significant in the Launch Vehicle segment due to the peak level of spending on the Taurus II launch vehicle development occurring in 2009.
That could easily put couple hundred basis points of headwind on Launch Vehicle margins compared to this year. Advanced Space Programs will probably be down a little bit on a mix shift, but probably not dramatically different than what we're seeing this year.
Troy Lahr Stifel Nicolaus
How does the COTS service impact the guidance at all? If you guys win that?
We have made an assumption in the guidance today that I think is fairly conservative about the revenue contribution next year from the COTS operational service phase. We will revisit that as we wrap up the year based on the outcome of the ongoing competition, and see whether any adjustment there might be called for if we get good news late this year on that program.
Your next question comes from Chris Donaghey – SunTrust Robinson Humphrey.
Chris Donaghey SunTrust Robinson Humphrey
Dave, can you go back over what you were talking about with the shadow revenue? I am a little confused by how that is showing up. Is it showing up in the income statement at all? That's number one on the Taurus II program. The second one is I was surprised to see the magnitude of the dilutive effect in 2009 of Taurus II. Were you expecting by this point that you would already have a second contract for maybe a satellite launch that would be offsetting some of the R&D expense for next year?
Let me hit the accounting side, and I will let Dave talk on the operating side. COTS is being handled as a funded research and development project. Therefore, as we receive payments from the government, it's offset against our expense. You don't see the full impact of COTS coming through research and development. It is disclosed in our footnotes in terms of what we incurred.
In fact yeartodate we've incurred cost of about $10 million and we've been funded to the tune of about $9 million. The residual of that, the $1 million, gets into our IR&D rates. It's recovered in that fashion. As you look at the financial statements and you look at research and development, conceptually it goes in, but it's netted out. When the statements are issued, the expense is offset by the funding from the Federal Government. However, we do disclose that. I think you had some questions on orders. I will let Dave handle that.
Before going on in the Taurus II order part of the question, let me add that what Garrett said. You may recall back in February or March, when NASA selected Orbital for the COTS demonstration program, we announced and they announced that they were investing about $170 million of NASA funds in Orbital as their contribution to carrying that out. Our contribution is on top of that. But we are not recognizing revenue on the $170 million of NASA's contribution.
If we were recognizing revenue, that's the invisible revenue that I referred to, the cost is being incurred, the activity is taking place, that for this year, if you added all that up would be about $20 million worth of invisible revenue jumping to $75 million or $80 million next year and roughly a comparable amount, another $75 million or so, in 2010. If you add those three up, you get the $170 million of NASA's total contribution. That doesn't show up as revenue at our level.
That fits the ratio I just gave you, the $10 million incurred and the $9 million funded by the government.
The second part of your question about the Taurus II matter. From a market standpoint, I think things are pretty much on track. The target for the first nonCOTS or CRS order is still the first part of next year. The potential for a 10 or potentially 12unit block order under the CRS program is better than we anticipated this time last year, and so we focused most of our business development attention on trying to put the company in the strongest possible position to win that to really put a foundation under the production program for Taurus II going out probably through most of the next decade.
We are spending some time now. And we will spend more time as we get into next year on some of the early potential opportunities for Taurus II in some other market areas. The increase in the 2009 R&D numbers represent on one hand partly a delay in some spending that we expected to occur this year, that will now take place next year. That's the smaller part of it. There has also been an increase in our estimates for the development of the system and virtually all of those cost increases come through during 2009.
We are going carry next year a little heavier load for the R&D investment in Taurus II. It will also be significant use of cash for us next year in the range of $60 million or so of net cash investment in 2009. Fortunately, most of the rest of the business continues to generate robust free cash flow, so we still have a quite positive outlook overall for free cash flow next year.
Chris Donaghey SunTrust Robinson Humphrey
Obviously preliminary, as you start thinking about a mediumclass satellite offering, is that another similar type of effort level as Taurus II. How should we be thinking about that as you get further along in that decisionmaking process?
It's not in the same league at all, although it would represent some level of investment of both research and development and capital. It's a small fraction of what we're talking about for Taurus II. It would not be in the same league at all as what's involved in the Taurus II program.
Your next question is from Gary Liebowitz – Wachovia Securities.
Gary Liebowitz Wachovia Securities
Most of my questions have been answered. Maybe, Dave, you can tell me what went into your decision to protest the MSST award? I think this is the first protest I recall the company ever filing with the GAO.
You're correct. It is the first time we protested a contract award. I probably shouldn't get into the concerns and the merits of our questions on this. I can tell you we do expect a decision to be reached by the GAO by about the end of the year. I will just ask you to wait and see how that comes out without commenting much more on it now.
Gary Liebowitz Wachovia Securities
That's fine. Also just one quick one. Given what's happened to your share price since the end of September, has your view of share buybacks changed in the last few weeks?
My view sure has. If the market continues to behave as it has over recent weeks, I would expect that we will be a good bit more aggressive than we have been recently. Like many companies, perhaps most companies, we have a policy of not doing active buybacks during the period just before the end of each quarter. If you go back and look at things where things were relatively calm in the early part of September and got fairly wild in the markets only in the second half of last month and the first couple weeks of this month.
We got a relatively modest [10D5] program that we put into effect around the middle of September during the period when we could not do active buybacks. Had that not been the case, we probably would have been a bit more aggressive than we have been to date. At these levels, we will probably be a lot more aggressive in the weeks ahead than we have been earlier in the year.
Your next question comes from Michael French.
Michael French Morgan Joseph & Company
Another question about how the macro environment might affect you guys. Particularly in your strategy on deploying cash. You discussed buybacks. Might this present some opportunities on the acquisition side? Or does this make you want to hold on to your cash for other things like Taurus II or maybe the mediumclass satellite? Have there been any changes at all to the way you've been thinking about deploying your cash?
I would say in general we really haven't changed our overall outlook from the one that we've maintained now for several years. Using excess cash in a balanced program of stock buybacks, new product development investments, and if suitable opportunities that look compelling from a strategic standpoint and sensible from a valuation standpoint can be identified in acquisitions. The situation today, though, is that I don't see in the near term, even though valuations have certainly dropped, I don't see compelling strategic options on the acquisition side.
That's not to say that won't change in six months or a year from now. There could well be something that we've explored in the past or something new that comes up that does make sense. In the short term, I think we will follow the path that we've been on now for the past year or so in the Taurus II and COTS area with investments in those important new products. And then as Garrett mentioned, over the last three or four years the path we followed in terms of buybacks that have reduced outstanding shares by significant amounts. I think we will be a little more active in that last area in the rest of this year at these levels of valuations. We will certainly keep our eyes open though for opportunities on the strategic acquisition side. Those are a little harder to control and to predict.
Michael French Morgan Joseph & Company
With respect to demand, you did discuss that. Is it safe to say that your outlook for the total number of satellites sold per year in the market has not changed or might there be some reductions there? Or particularly where your customer base is that would remain unchanged?
That's a good question and one that was discussed earlier this week as we had many of the more established satellite operators visiting us. I think the consensus view right now is that the high end of the prior projections that were potentially in the area of 25 or more new orders per year over the next couple of years, has probably been scaled back. We have been targeting in the 22 to 25 range for the industry as a whole as an average for the next three years. Others had high ends that went a little higher than that. We may see the range narrowed a bit to the low to mid 20s instead of the wider magnitude from the low 20s to the high 20s. From what we've seen so far, though, and from the pattern of behavior in the past to the industry, I think the smaller segment will be the one that is most insulated from any downturn that might occur.
At this point, we don't see any nearterm signs of a letup in demand for between seven and nine smaller GEO satellites over the next couple of years. In fact, for this year, there have already been eight small satellite orders. Fortunately, we won four of those. I expect one or two more, possibly even three more, across the industry will be contract for by the end of the year. So we could have as many as 10 or 11 in small class this year, and we would continue to forecast between seven and nine small class orders over the next couple of years.
Michael French Morgan Joseph & Company
Since the last call, have there been any developments with the plan to upgrade the OBV from a threestage to a twostage vehicle?
That work has proceeded quite well over the last several months. J. R. alluded to the schedule for next year, which calls for the first flight test of a twostage OBV next July or August. I think so far we're in very good shape to meet that schedule. That will be an important event because although from a engineering standpoint, that is not something we view as a particularly difficult, more risky test. It's very important for proceeding with the twostage deployments in Europe, that vehicle prove itself in flight beyond just what the engineers are saying about it. That's moving along quite well now.
We do anticipate, according to the current plans from Boeing and the Missile Defense Agency, that we will have our first order late this year for the production versions of the twostage Interceptor. So things are really moving there and hopefully we will have some more good news on that within the next two or three months.
I think at this point we will bring the discussion to a close. Thank you all again for joining us this morning. We look forward to talking with you again soon.
This concludes today's conference call.
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