L-3 Communications Holdings Inc. Q3 2008 Earnings Call Transcript

L-3 Communications Holdings Inc. (LLL)

Q3 2008 Earnings Call

October 23, 2008 11:00 am ET

Executives

Karen Tripp - VP of Corporate Communications

Michael Strianese - Chairman, President and CEO

Ralph D'Ambrosio - VP and CFO

Analysts

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the L-3 Communications third quarter 2008 conference call. My name is Dan, and I will be your coordinator for today. (Operator instructions).

I would now like to turn the call over to your host for today's call, Ms. Karen Tripp, Vice President of Corporate Communications. Please proceed.

Karen Tripp

Good morning, everyone, and welcome to the L-3 third quarter conference call. With us today are Michael Strianese, Chairman, President and Chief Executive Officer; and Ralph D'Ambrosio, Vice President and Chief Financial Officer. As always, after our formal presentation, we will be available to take your questions.

During this call, management will reiterate forward-looking statements that were made in the press release we issued this morning. Please refer to this press release as well as our SEC filings for a more detailed description of the factors that may cause actual results to differ materially from those anticipated.

Please note that this call will be simultaneously broadcast live over the internet.

I will now turn the call over to our Chairman, President and Chief Executive Officer, Mr. Michael Strianese.

Michael Strianese

Good morning, everyone. Thanks for joining us for our third quarter call. Let me hit the highlights of some of our results. I am sure you've all seen them. Overall, we had another strong quarter in Q3.

Funded orders for the third consecutive quarter this year topped $4 billion, and we're very happy with that performance. Our book-to-bill for the quarter was 1.08, again, orders outrunning sales by about 8%. Funded backlog increased to $11.3 billion. That's an 18% increase from December 31, '07. It's giving us some nice visibility into 2009.

Sales for the quarter were about $3.7 billion, which is approximately 6% growth. Our earnings per share grew at 11% to $1.73. Margins were up by 10 basis points to 10.9%, and our free cash flow was $340 million. That's a 17% increase from the third quarter of 2007.

These results are the result of the efforts of a lot of people, so let us thank our employees for their hard work and the Group presidents for their leadership for the great performance this quarter.

We had a number of new wins during the quarter as well as follow-on business. But just to touch quickly on some of the segment results: for the ISR Group, the book-to-bill ratio for the quarter was 1.17, with total sales growth of over 20%. And that just demonstrates the continued strength in the ISR segment with the requirements for consistent surveillance that has just been going on unabated in terms of network security, network sensors and streaming video. We're seeing continued demand in that area.

Our government services had a book-to-bill of 1.09 for the quarter and sales decline of 6%. Of course, that's driven by the Linguist program that was lost and had transitioned to a subcontract earlier this spring. If you strip out the effect of that decline from Linguist, the rest of the government services segment grew at 5.4%.

Aircraft Maintenance and Modernization had a book-to-bill of just under 0.9. It was a little bit softer there than we would have liked. Nevertheless, the sales growth was about 1.6%. We had very low sales in the quarter related to the JCA program due to its completion for the first two deliveries. But again, there is additional funding for seven more Army aircraft in the budget. So, that will pick up next year, and in addition, when you consider that the services applying the oldest fleet of airplanes in the U.S. history, we're optimistic of future growth prospects in that segment.

Specialized Products grew. First of all, the book-to-bill is 1.12 for the quarter, and the overall sales growth was 13.8%. There were a couple of acquisitions in the result. Organically, it was up about 8.3%. And if you look at the total, again all adjusted for Linguist, just because it was such a significant item, the overall sales growth number was 6.2. Linguist was about just under a 4% headwind on that number. So, the overall growth of the rest of the business, but for Linguist, was slightly north of 10% actually.

In terms of follow-on orders, it was really pretty strong across the board, but especially in the ISR segment, in the areas such as the Rivet Joint program, Systems for QAVs, our Rover product, logistics work for Big Safari, our classified work in the ISR space, C3 program. In addition, in services, you have support in Afghanistan. In the products side, additional funding on Bradley transmissions, EO/IR turrets, even an uptick from the TSA for examiner service work.

Our ship marine business has been benefiting from a strong commercial shipbuilding market so far. So, their orders have been increased also over the quarter, particularly driven by our SAM Electronics business in Germany; and just overall strong performance in orders.

In terms of recompetes, we had two major ones we were tracking with you. One of them was the Contract Field Teams, and as you know, we were selected as a winner in that competition. However, there is competition for each of the task orders, and we last week notified that we did win the task order for Southwest Asia, which is the largest task of the task orders under that program. It runs about $250 million for the year in sales force. So, we're happy to have that one behind us.

Last of the recompetes for this year is JOG, and that's a sole source contract with SOCOM. Our bid was submitted on October 1st. The current contract ceiling was about $2.1 billion with annual sales for L-3 approaching $400 million. The new contract that we have bid on, the recompete, is worth about $5 billion over 10 years. So that's a big one. It should be awarded by the end of the year or early in the first quarter.

On the Joint Cargo Aircraft program, as we've been saying, we planned to deliver on time and indeed we did on September 25th. And we have a very happy customer and just a great job by the entire team, especially the folks at Alenia who worked 24/7 for most of the summer on getting these airplanes ready. JCA Number 2 is in the facility Waco. We were there last week, and that will be delivered on time in November as well.

As I mentioned, the fiscal '09 DoD budget includes funding for seven additional Army JCAs. Some of the Air Force funding for the program was in and out of the budget. You may have seen that. But at the end of the day, R&D was included and the Air Force is continuing to work the hill as far as we know.

You're heard about a program called Project Liberty. It's some ISR assets. And there is a limited amount I can tell you about it because of customer sensitivities and the like. But L-3 along with a number of other contractors is participating in efforts to augment the airborne ISR Surge capability of the Air Force to the forward-role fighter.

The primary capability is to provide more coverage for streaming video to U.S. ground forces in Afghanistan and Iraq. Several Beechcraft King Air 350s are being modified to provide that capability. In addition to the aircraft modifications, L-3 is working through multiple vendors to provide contract field support for maintenance, repairs, and logistics in both the U.S. and overseas locations. The order flow on that program is approximately $200 million this year, and we're looking at $300 million next year.

In terms of new program starts, there are several of them. Some of them have been slowed down like the tanker program. But the point I'd like to make is the whether it's BAM, Aerial Common Sensor, the EPX, JLTV or the tanker, the KCX, L-3 has positions on all teams, in some cases, multiple teams for our products and/or integration work. And I think we're well positioned on all those programs.

We continue to work with our business units to get more synergies through more collaborative work on programs as well as more consolidation of operations, and that continues to drive forward. You can see some of the increase in margin over the year in the government services segment for one.

In terms of capital deployment, as I mentioned earlier, we generated almost $900 million of free cash flow through the third quarter. As for the deployment of that cash, to date we've repurchased $688 million of our stock, 73 of that was acquired during the third quarter.

We expect to complete the current authorization, which was $750 million this year, which is again ahead of schedule, it was a two year authorization. And again we'll ask our Board to approve a new authorization.

As far as acquisitions, year-to-date we acquired four companies for just under $200 million. We continue to evaluate several other companies. We are being cautious however, on valuations due to the declining multiples for different assets. We closed the quarter with over 850 million of cash in an unused revolver of 950 million approximately, and expect to complete the year with over $1 billion of cash.

We might make a few more acquisitions by the end of the year, but they are likely to be small ones. I think in terms of balance sheet and liquidity, we believe we are in good shape, and that maintaining our good performance and giving us financial flexibility going forward will pay off through attractive acquisition opportunities.

During the quarter, we also completed a divestiture that we will report in Q4. It happened at the beginning of October, and that was the medical patients' simulator business that we had an 85% interest in. It had about $60 million of annual sales, it was consolidated. Proceeds from the sale before taxes were 53 million and generated a $29 million pre-tax gain, which we will report in the fourth quarter.

We don't expect any further divestiture this year, although we are working with several other business units and potential buyers; so possibly more in the first or second quarter of next year.

In terms of our outlook, we updated our 2008 guidance today, increasing our EPS. We are expecting 14.7 billion in sales for 2008, with earnings per share reaching $6.75 excluding the unusual items, and free cash flow remains at $1.2 billion.

Sales growth for the year; if we take the Linguist program out, it should be about 8%. Ralph's going to give you more details on the 2008 guidance in about a minute or two.

Geopolitically, it's a situation that, while Iraq seems to be improving due to the surge, we are hearing good news; Afghanistan we hear is deteriorating daily, when you take into account other areas such as Iran, Pakistan, which seems to be moving backwards or sideways. North Korea, while manageable, is a bit unstable.

The most important thing, I guess, that happened over the past several months is some of the issues with Russia, which seems to be reasserting its relevance and the question there is the end game. It was the military exercises that have really been unprecedented in the last couple of weeks, including the firings of Kruse missiles, which hasn’t been done for 25 years. And we do not have to talk too much about Venezuela. We know there are some Russian ships down in the Caribbean. And China is always a challenge whether it's in the area of space or cyber.

Point is that, with the election coming, we don't hear either candidate really talking about substantial or actually any reductions in defense spending. In fact both are talking about a strong National Security policy. And for those reasons we think that the budget should remain pretty stable going forward.

I think that everybody has seen the numbers. But the '09 budget was approved at $488 billion, supplemental funding so far of 66 billion has been approved with an additional expected. I think all of L-3's will continue to grow that we've been growing at.

Iraq drawdown won't be an issue until post-election. One candidate wants to do it a little faster than another. But at the end of the day there will be offset I think with Afghanistan, and again as I've been saying consistently, it's unclear as to the impact on the business model, because we're not assuming there's a pro rata drawdown with the people we have in countries. So that's kind of a wildcard I think for everybody, but I don't think anything is going to happen very quickly in any event.

As you know, we will have an investor conference here in New York in a couple of weeks, just about two week on November 13th. We intend to provide comprehensive guidance to 2009, and we'll have our Group Presidents available for your questions, as we always have.

As you also know there are some non-operating headwinds, as everybody calls it, for next year and notably pensions. So we know there'll be an increase next year. But I could tell you that in terms of the 2009 EPS growth, we are expecting to continue to achieve our objective of double-digit growth; that is at least 10% over 2008 guidance of 675 excluding the unusual items.

To be sure, depending on how the year looks like it's going to close, Ralph's going to give you more details on pension. In all likelihood, we will pre-fund the contributions in the fourth quarter, so it will probably give a lift to 2009 cash flow.

In addition, we're working with our actuaries and tax folks to determine the optimum amount of fund. We may fund a little more in December. That will offset some of that headwind. So, fortunately, a good cash performance gives us some options on how we will deal with the pension issue.

So, with that, I think I'd like to turn it over to Ralph to give you some more financial details, and then we'll take your questions. Go ahead, Ralph.

Ralph D'Ambrosio

Okay. Thank you, Mike. I'll comment on some key points about the Q3 results, the balance sheet, the changes to our 2008 guidance, and then a quick look at how the next year looks.

As Mike said, EPS grew 11% to $1.73. That growth was driven by an 8% increase in operating income and a 3% reduction in diluted shares. Lower net interest expense offset a higher tax rate in the quarter. And the operating income increase was driven by both sales growth, which was 6%, and 10 basis points of improvement in operating margin.

On the sales, as Mike said, we had the highest organic growth in the C3ISR segment, which was 20%. That was driven by continued strong demand for network, communications systems, airborne ISR systems and classified work. We expect that growth rate in C3ISR to slow down in Q4. We will have a very tough comparison in Q4.

If you recall, in Q4 of 2007, we had unusually high special aircraft deliveries, with about $80 million happening in December of '07 that we had anticipated to happen in January of '08. So, that's going to impact the Q4 '08 growth rate in that segment.

Specialized products grew 14%. Organic growth was 9%. It was led by simulation and training, EO/IR, power and control systems, precision engagement and propulsion systems. M&A growth in that segment was 5%. The Aircraft Modernization and Maintenance segment grew 2% organically. And what's happening there is that the lower aircraft mod sales continue to reduce the growth rate. We're expecting growth to increase in Q4 because of higher sales on JCA, and they support services.

And Mike talked about the impact on Linguist in the Government Services segment. Linguist was down $130 million compared to last year. And we'll have a similar sales headwind in Government Services in Q4 because of Linguist. It could be down by about $150 million.

On operating margins, they improved 10 basis points on a consolidated basis. C3ISR improved 20 basis points to 9.2%. The improvement there came from higher sales and lower development costs for secure comm products. And together, those improvements offset $9 million of cost growth on international airborne ISR systems, which we were not expecting to incur.

In Aircraft Modernization and Maintenance, the margin was up significantly. We had some early delivery incentive fees in Q3 and we also had a $3 million favorable litigation accrual reversal for a settlement of a claim.

In specialized products, we had a negative for a litigation cost settlement increase of $4 million which offset operational improvements. And in Government Services, margins declined 40 basis points to 9.5%. We're seeing some more price competition in that segment on certain contracts.

Moving on to cash flow, we had a very good Q3 with free cash flow of $340 million. That represented 1.6 times of net income. Increases in receivables and inventories were pretty much fully offset by a $59 million increase in advances, and we expect to liquidate most of those Q3 advances next year.

Cash tax payments were $71 million Q3 of this year versus $49 million in Q3 of 2007. CapEx increased by $29 million to $63 million, and we also expect to have slightly higher CapEx in Q4. We're making some investments for the ISR Surge.

On pension funding, we funded $23 million in Q3. Our guidance assumes $65 million for the full year. But as Mike commented, we will likely increase pension funding in Q4 by at least $100 million, possibly $200 million. And if we do that, we'll end up reducing the '08 free cash flow guidance by about $100 million or a little bit more.

On the balance sheet, our debt was unchanged at $4.5 billion. And our leverage, at least as far as calculated for the banks, was 2.2 times at the end of September. As Mike said, we believe we have a strong liquidity position with our cash balance and our unused revolver of nearly $1 billion. And we're happy to report that at this time, we have no near-term needs for external capital.

If you want to take a look at our debt maturities; the first one occurs in March of 2010, when our senior credit facilities, including the 600 million of term loans and revolver matures. We expect to refinance them in the first quarter of 2010.

The second possible debt maturity will occur on February 1, 2011. And that's with our 700 million of convertible debt. On that day, holders of those notes can exercise a put option, requiring L-3 to repurchase the notes for 100% at par. And beyond that, our subordinated notes will begin maturing not until June of 2012.

So generally, we expect credit market conditions to continue to improve, and certainly by the time those maturities begin happening a few years out.

In terms of the 2008 financial guidance, we kept sales unchanged at, at least $14.7 billion. We're expecting a little more sales on Linguist for about $20 million, but that's going to be largely offset by lower sales from the business that we divested earlier this month.

On EPS we dropped a low-end of our previous range and kept the high-end at 675. That excludes the unusual items that Mike talked about. If you look at what's happening with EPS; number one, a lower share count is going to add about $0.02. We had some operational improvements offsetting the 9 million of cost growth in C3ISR, and that's adding about $0.02. And then the divestiture of that medical business subtracts about a penny.

Operating margin remains at 10.7%. The full year tax rate is now at 36.4%. It includes the federal R&E tax credit, which was reenacted on October 3rd. And if you recall, we had been assuming that it would be reenacted all along in our 2008 guidance. So what will happen is that our tax rate is going to drop in Q4 to about a 35.5%.

The free cash flow guidance is 1.2 billion, but that of course, assumes that we make no additional pension pre-funding or contributions and we likely will.

On Q4 of this year, we didn't provide any guidance in the earnings release. But if you look at our full year guidance, you can back into the fact that we're expecting sales to be at least 3.8 billion, with EPS of about $1.80 and free cash flow before the additional pension funding should be around $300 million.

Moving on to the outlook for 2009; we will formally provide our initial 2009 guidance at the November 13th investor conference. That said, I'll give you a quick look at 2009 sales and EPS growth.

On sales, we expect that our '09 guidance range will be in the 5% to 7% growth area. And that's after absorbing a $300 million or 2% sales decline on the Linguist contract and the CST contract '09 versus '08. Also as of right now, we expect that acquisition growth will be offset almost 100% by sales from this year's divestitures. So the '09 growth is all organic, that I'm talking about.

On earnings per share, as of today, as Mike said, we expect that our initial guidance range for next year will include 10% nominal EPS growth. And if you remove or exclude a 2009 pension expense increase that we will have as well as the impact of some accounting rule changes, the 10% nominal growth rate in EPS translates to about 15% underlying EPS growth.

On pension expense, to give you a little more detail, we do not smooth asset returns, and therefore the negative 2008 pension returns will immediately affect 2009. And depending on how the asset pension returns finally end for this year; and we won't know until December 31st, we are confident that we have a strong cash position available to us and the ability to deploy excess cash to offset the pension headwind.

There are two accounting rule changes that are going to impact next year. And they've both become effective on January 1st, 2009. While they are both non-cash items, they'll reduce 2009 EPS by $0.15. One of the changes effects on convertible debt and it will require us to record about 20 million of non-cash interest expense, which lowers EPS by $0.10. And the second accounting rule change affects the way companies account for restricted stock that pays dividends during divesting periods.

And what happens there is that we'll have to treat them as fully outstanding shares on a day of grant and that's going to reduce our EPS next year by about $0.05. Both accounting rules will be applied retroactively, so the back to years will be restated beginning in Q1, 2009.

And overall, we believe next year will be another good year of growth of L-3 and I look forward to giving you more details on 2009 at the Investor Conference.

That concludes my comments, and I'll turn it back to you, Mike. Thank you.

Karen Tripp

We're ready to proceed with questions now.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Cai von Rumohr with Cowen and Company. Please proceed.

Cai von Rumohr - Cowen and Company

Great quarter. You mentioned $200 million this year and $300 million next year from Project Liberty. Could you tell us how much you booked on Project Liberty in the third quarter? How do those numbers split between your divisions?

Ralph D'Ambrosio

On Project Liberty and the other ISR Surge activity, we booked about $150 million in Q3. Most of it was in integrated systems and some of it was some of the product companies.

Cai von Rumohr - Cowen and Company

If you look at next year, you mentioned that the $60 million is coming out. Are you going to restate to exclude the $60 million or you're just going to drop it out? So --.

Ralph D'Ambrosio

You mean for the divestiture?

Cai von Rumohr - Cowen and Company

Yes.

Ralph D'Ambrosio

No, we're not going to do a restatement. It's really not large enough to treat it as a discontinued operation.

Cai von Rumohr - Cowen and Company

Where preliminarily do you look for the tax rate next year?

Ralph D'Ambrosio

The tax rate is going to be about 36%.

Cai von Rumohr - Cowen and Company

Great. Thanks a lot.

Michael Strianese

Thanks, Cai.

Operator

Your next question comes from the line of Richard Safran from Goldman Sachs. Please proceed.

Richard Safran - Goldman Sachs

Good morning.

Michael Strianese

Hi, Rich.

Ralph D'Ambrosio

Hi.

Richard Safran - Goldman Sachs

You talked about your acquisitions and what you're doing for end of the year. You've been making relatively small ones. Could you comment on the M&A landscape now? Is the situation such that you would actually consider making a larger acquisition? Or do you think that going forward, you're going to keep the acquisitions in the $200 million to $300 million range?

Michael Strianese

No, Rich, There is no targeted range we're trying to keep them in, but it's been tempered by properties that have been for sale. And I think you probably know as much as we do on this year's activity. We haven't seen a lot of large transactions.

But having said that, the current environment is tempered: one, obviously by the liquidity situation, not that we have that situation, but it certainly has put a bit of a chill on willingness until things loosen up a little bit. We're trying to be a little bit defensive while things are unstable. That's A.

B, there seems to be a disconnect between the public company valuations in the market for the aerospace and defense companies versus where sellers of private companies are. I would anticipate that that gap has got to close. Hopefully, there will be movement up on one end and down on the other. But right now, it becomes a very academic exercise to say, 'would we want to pay a much higher multiple and then acquisition when we can buy ourselves at rather low multiple today?'

Notwithstanding that, we do continue to see companies that fit the model well and that will provide good returns. So, it's buying good companies and we're buying at the right price. That's how we see it.

Richard Safran - Goldman Sachs

Okay. At C3ISR, can you put a little more color on what platforms were driving the growth in the comm systems? If you would rather not name the systems, please tell me if they are new platforms or upgrades to existing systems.

Ralph D'Ambrosio

Well, on the network communication systems, it's every major unmanned system on the high end that you can think of. And on airborne ISR systems, it's a lot of classified work with the Air Force, as well as work that we're continuing to do on Rivet Joint.

Richard Safran - Goldman Sachs

Thanks a lot.

Operator

Your next question comes from the line of Rob Spingarn from Credit Suisse. Please proceed.

Rob Spingarn - Credit Suisse

Good afternoon.

Michael Strianese

Hi, Rob.

Rob Spingarn - Credit Suisse

Mike, I don't know if this question is for you or for Ralph, but concerning the 5% to 7% growth for next year, could you give us some sense of how that flows out through the segments and what kind of assumptions are in there? Is there a spring supplemental or is there something on top of that?

Ralph D'Ambrosio

We're not expecting any increase in supplementals. And I'd like to get into details on the segments at the investor conference. That said, we're expecting to have higher growth in C3ISR and specialized products, which is really a continuation of what you're seeing in 2008.

Rob Spingarn - Credit Suisse

About the margin in C3ISR this quarter, could you tell me what's going on there?

Ralph D'Ambrosio

We're still working on that development and certification. So, we're not finished yet. But the good news is that unlike Q3 of last year, we're not experiencing any contract cost growth. And the burn rate on the R&D has also declined. So, for example, quarter-over-quarter, we probably spent $4 million or $5 million less on that contract, including Iraq. Then you get into the cost mix issue, but it's about 4 million or 5 million less. So we are making progress there.

Michael Strianese

In terms of the product, the light is visible at the end of the tunnel. Orders are being taken now for the product, and we would expect and would hope to have delivery start sometime in the first half of next year.

Certification with our customer on the inscription is being finalized. We know that there is a demand out there for the product, because there is a competing product available now, but there are operating differences, and we are confident that our solution is one that is being, people are anticipating. They're actually waiting for ours to come out since they are placing orders with deliveries that aren’t next year.

So we feel good about the progress, but it will be a slow ramp up process. It took a couple of years for us to get ramped up to meaningful volumes. But again, the order book was opened this year and we started taking orders, and hopefully sales will start flowing through next year.

Rob Spingarn - Credit Suisse

One last thing Mike, is there an update on U.K. interest in Rivet Joint?

Michael Strianese

There is what is called main gate approval, as I understand it from the UK, which is to acquire two or three US Rivet Joints.

Rob Spingarn - Credit Suisse

Okay.

Michael Strianese

As I understand it, the aircraft had even been identified. Having said that; there's pressure globally right now at all MODs, due to the bailouts that have been going on. The program has been renamed springtime if you see that term, that's what it means. It sounds like the decision is coming in the springtime. But we're optimistic that that will go forward as a solution for the UK ISR platform.

Rob Spingarn - Credit Suisse

Great, thanks very much.

Operator

Your next question comes from the line of Joe Nadol JPMorgan. Please proceed.

Joe Nadol - JPMorgan

Thanks, good morning. First question Mike on Iraq. You mentioned a couple of things in your prepared remarks. Wondering, if you are hearing anything in the context of what’s going on government to government in terms of the security deal? Are you are getting any sense for contractors on the ground, and what time line might be there? Any color?

Michael Strianese

Not a lot more, than you're able to read right now. I believe an agreement will be reached shortly.

Looking at it from a contractor's point of view, there is about $10 billion plus of equipment being acquired by the government of Iraq. I would expect contracting activities for logistics, maintenance, training and services to follow that thing.

So what we're anticipating is that there will be some transition of contracts or contract activities directly to the end user now, which would be the Government of Iraq and the Iraqi military.

Joe Nadol - JPMorgan

Okay. A couple of questions on the segments. In Q3 you brought down your margin guidance a little bit, and you talked about some higher costs on international airborne ISR. Any color there? Is that what drove down the guidance? And is that UK or any guidance there?

Ralph D'Ambrosio

Joe that is what causes us to reduce our margin guidance is C3ISR for the year. And like I said earlier, it was unexpected. It's unrelated to the UK, and what's happening is we got a couple of programs that are entering the integration and test phase. And we had some software bugs, more than we expected, and as a result, we're experiencing cost growth.

And additionally, with the big increase in ISR work at state side, it's causing pressure in the work force in terms of where we have our experienced hands. That could probably cause some lower productivity. That's also contributed to the cost growth.

Joe Nadol - JPMorgan

But you indicated that you are still looking for nice growth next year. Do you feel like you have your arms around work force issues and managing that growth?

Ralph D'Ambrosio

Yes. And right now we think most of the growth in C3ISR is going to come from US based DoD work next year. The couple of international programs that we have are both nearing completion and their sales are going to drop off in 2009.

Joe Nadol - JPMorgan

Okay. And then over in services, your margins were a little lower. You mentioned in your press release some headwind from new contracts. What kind of contracts are those and why are they lower margined? You got a little bit of boost from lower linguist. But the margins were a little bit lower than expected there.

Ralph D'Ambrosio

Right. Well the boost from lower linguist was itself less than we expected, and that's because of the new fee structure. Our award fee is essentially contingent upon the award fee that the prime earns. On the pricing side, more and more we're seeing price competition on even new start programs or re-competitions of incumbent contracts that we have. It's the nature of businesses in services that it's just more susceptible to price competition than in product and systems areas.

Joe Nadol - JPMorgan

Is the mix changing in terms of contract type and services?

Ralph D'Ambrosio

We don't see much of a mixed change, although there seems to be a conservative effort in OSD to use less award fee contracts. But aside from that, we're not seeing any big shift between cost reimbursable or fixed priced work.

Joe Nadol - JPMorgan

Finally, a clarification on pensions. Can you just give the numbers again? I am sure you gave them, but I missed it. What exactly is in your cash flow guidance for this year in terms of contributions and what's in earnings for next year, because it sounded like there is more than what your guidance is giving and might that be in your earnings guidance?

Ralph D'Ambrosio

On the cash flow side, the $1.2 billion of free cash flow guidance for this year includes about $65 million of pension contributions. And Mike and I have both said that we will likely increase that by at least $100 million, possibly $200 million. So, if there was $200 million, for example, when you factor in the tax benefits that come along with it, that would reduce our free cash flow in '08 by about $150 million.

Joe Nadol - JPMorgan

Okay.

Ralph D'Ambrosio

And if things go good in cash flow in Q4, we might offset it operationally. In terms of EPS, I'll give you a scenario. If, for example, our pension asset returns for 2008 are down by 25% and also if we're able to increase our discount rate on the pensions to 7.5% and based upon prevailing interest rates, it would be 7.5%, the pension expense headwind on a pre-tax basis '09 versus '08 is $50 million. That's 30 bips of margin improvement, everything else being equal, and about $0.25 of EPS headwind.

So, we'll see where the pension returns actually wind up by the end of the year. But like I said earlier, we're confident that we can deploy our very strong cash position and excess cash flow to mitigate a good part of that headwind.

Joe Nadol - JPMorgan

So, something less than $50 million of headwind is baked into 10% earnings growth?

Ralph D'Ambrosio

Yes. What we call 10% nominal earnings growth, yes, a little less than that.

Joe Nadol - JPMorgan

Okay. Thank you.

Operator

Your next question comes from the line of Myles Walton from Oppenheimer. Please proceed.

Myles Walton - Oppenheimer

Thanks. Mike, maybe you can talk a little bit about Project Liberty, but the broader ISR Surge as well. And are there other programs like it that you're pursuing or have in hand? And also, do you consider Project Liberty to be kind of a one-off, a couple of year event, or is there a longer tail to this than we might at first see?

Michael Strianese

Well, I believe that there will be a longer tail to it. And if you look at what Secretary Gates had said during the summer that we need to do things, his words, DoD, that are more relevant to today's threat environment to folks on the ground. And reprogram the several billion dollars to this space is clear recognition in our view that ISR is a force multiplier and a game changer for our troops.

They're looking at a battlefield that is a 360-degree battlefield. We have persisting surveillance. And this streaming video is proving to be a critical determinant in success. Now, having said that, if you pan over to Afghanistan and look at the issues there, given that the terrain and the vast ground to be covered, it becomes obvious that, again, ISR comes out on top in that scenario as well.

When we look across L-3 in the portfolio, not only do we have products, whether it's data links, rovers, sensors that play well in this space, but we also have an unparalleled systems integration capability to get the products on the platforms and provide a turnkey system, if you will.

So, to say it simply, we are able to take today's platforms and yesterday's platforms, if you will, and make them relevant to today's threats and adjust them rather rapidly. If you look at the timeframe on the delivery side on Liberty, it's very, very rapid. And we're very pleased to have been the contractor chosen to provide this capability, and it's a good recognition that what we do in this space we do very, very, very well.

So, I am confident that there will be further recognition and growth in this space.

Myles Walton - Oppenheimer

Can you characterize how much more is up for compete that you're bidding on with respect to the ISR Surge?

Michael Strianese

I cannot, because none of these are programs of record. And if I knew, I probably couldn't tell you. But these are coming up as threats and operational requirements become defined. In terms of a book of business out there to bid on, there isn't one.

Myles Walton - Oppenheimer

Okay. And then Ralph may be if you can comment on your profit booking rates on JCA, as you make these deliveries last month and then in November? Are those going to meaningfully allow you to increase the booking rates, and also if you can characterize where they are, relative to the segment?

Ralph D'Ambrosio

Well, to answer your last part of the question. First, we've said all along that the prop rates JCA are lower than they are for the aircraft mod and maintenance segment. As you know that was a very fiercely competitive contract, and a consequence there's lower margins there.

In terms of our ability to increase the operating margins on JCA, we don't see it happening in Q4. And until we get to the point where we have a significant ramp in volume, we're not going to see much marginal improvement on that contract.

Myles Walton - Oppenheimer

Okay, thanks.

Operator

Your next question comes from the line of Robert Stallard from Macquarie Capital. Please proceed.

Robert Stallard - Macquarie Capital

Good morning.

Ralph D'Ambrosio

Hi.

Robert Stallard - Macquarie Capital

Mike, you commented that a tricky thing to predict would be Afghanistan and Iraq. I was wondering if you could size your current activities in both those campaigns, and what product you think would be most vulnerable to go up or down.

Michael Strianese

Ralph's going to size it for you. So as he turns the book, let me tell you how we see it. Obviously, we're going to assume that what would cause a change in our volume would be services that are direct to war fighter that would be reduced pro rata with a redeployment.

And in other sense, services that are augmentation services to the war fighter, which also would include training and logistics with respect to the Government of Iraq and their newly formed armed forces, would not be susceptible to a force reduction. So it's in two buckets, and whether they offset each other is the tricky part to guess. But Ralph has some numbers. I want to look at some of the numbers. Go ahead, Ralph.

Ralph D'Ambrosio

Sure. First of all on Afghanistan, our current annual revenues are probably about $250 million. Most of it is services work, supporting those emerging Ministries of Defense and Interior, as well as some work on CFT, and Mike talked about the fact we won the [re-competition] on the Southwest Asia task order. That includes some work in Afghanistan and the balance in Iraq.

For Iraq related sales, and there's nothing new here. We've been talking about the fact that we have about 1.4 billion in 2008 that we broadly define as coming from Iraq. That 1.4 billion includes almost 400 million for Linguist, and as I said that's going to decline heading into next year by a little more than $200 million because of the diminished work on the subcontract on Linguist.

So take Linguist away, it's about $1 billion between CFT and JOG. The Iraq work is $350 million. Training work right now is about $150 million, and that includes law enforcement work as well.

Big Safari and other ISR, CCOM related support is probably around $100 million, and then some intelligence work that we do there is about $150 million. The balance is related to a variety of different products at about $300 million.

So what we see happening is that, we think the demand for the work that we're doing to support ISR, training, law enforcement, and special operation forces, is really in the worst case going to stay flat. In fact it possibly could increase, depending on what happens in Iraq and Afghanistan.

So, although it's $1.4 billion in a '08, we don't believe that we have a lot of exposure on our sales for next year, with the exception of Linguist which we know is going to decline by a little more than $200 million.

Michael Strianese

Which let me add Rob that, Linguist is one of those categories that I would say would be a direct correlation or almost, it would draw down pro rata with any drawdown of U.S. Forces. And just as an overarching requirement that's not in any of these numbers is the reset of course.

And as you've heard, there is a large reset obligation to get the equipment that's in use back to a state of readiness some day, and that would be offsetting in our opinion as well.

Robert Stallard - Macquarie Capital

Okay. That's very helpful. Thank you.

Operator

Your next question is a follow-up from the line of Cai von Rumohr from Cowen & Company. Please proceed.

Cai von Rumohr - Cowen and Company

Yes. Ralph, you mentioned - if its 25% that you'd have a headwind of 50 million. If you put 200 million, that would only offset by my math about $17 million of that. So, how do we get to kind of flattish pension next year?

Ralph D'Ambrosio

Well, I didn't say pension was going to be flat. It's definitely going up.

Cai von Rumohr - Cowen and Company

Okay.

Ralph D'Ambrosio

And certainly if we did pre-fund by $200 million this year, it reduces the headwind by a little less than $17 million, because you're using that cash, which is currently earning lousy returns in the money markets. So, it's a little less than $15 million.

Cai von Rumohr - Cowen and Company

Okay. And let's see. Where are you in your investment performance as of today?

Ralph D'Ambrosio

As of today, it's probably somewhere down 25% or 30%, which I understand is what it is for most companies that have defined benefit pension plans.

Cai von Rumohr - Cowen and Company

Okay. If we think about how it spreads across your operations, are there any operations where we have more of it? Is it concentrated --?

Ralph D'Ambrosio

It's mostly concentrated within C3ISR and then I would say a little bit in the Specialized Products and the Aircraft Mod and Maintenance segment and very little to virtually no impact on Government Services.

Cai von Rumohr - Cowen and Company

Thanks so much. Thank you very much.

Operator

At this time, there are no further questions in queue. I would now like to turn the call back over to Karen Tripp, Vice President of Corporate Communications.

Karen Tripp

Thank you. Mr. Strianese will now present his concluding remarks.

Michael Strianese

Well, for all of you on the phone, it's been kind of a dicey environment since October, the beginning of the fourth quarter. And in terms of the effects on L-3 and the industry in general, we've been asked this question when we were down in Washington last year. I mean access to the capital markets obviously is not where it has been for us historically. Fortunately as Ralph said earlier, we don't have any urgent requirement in terms of our vendor base.

We are being rather cautious with some of the smaller companies, if they indeed are being affected by their access to credit. And if they're in spaces where other customers of theirs, for example, if you can envision a supplier that provides - I'm making this up as an example, machine parts to both us and the automotive or other industries that are slowing down, we are very cognizant of keeping tabs on their financial health because we do have some critical components that we're buying from that part of the marketplace.

Other than that, we don't see much else of an impact, putting aside pension, which I think everybody's got the pension too right now. But that's a long term horizon, and we've been very cautious there as well in trying to tie down the numbers because it's going to base on where things land at December 31st.

And a little movement in interest rates and a little bounce and every market changes the number rather dramatically. And I think the numbers that Ralph was discussing, I'd like to think are worst case. But what do I know at this point about what worst case really is?

Having said that, we have every reason to be optimistic in terms of our business prospects for future for 2009 and beyond. The model continues to work very well, and we talked about liberty. But just to drive a point home to you, that's an example of a program where we have virtually every segment L-3 engaged at some level, and it really drives home the point that our business model works and it works well.

And we're very optimistic for 2009. We look forward to seeing you in a couple of weeks at the Investor Conference and we can go through things in detail. We'll even have pictures. So with that, thank you.

Karen Tripp

Thank you very much. That concludes today's call.

Operator

Thank you for your participation in today's conference. This concludes the presentation, you may now disconnect.

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