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L-3 Communications Holdings, Inc. (NYSE:LLL)

Q4 2008 Earnings Call

January 29, 2009 11:00 AM ET

Executives

Karen C. Tripp - Vice President of Corporate Communications

Michael T. Strianese - Chairman, President and Chief Executive Officer

Ralph G. D'Ambrosio - Vice President and Chief Financial Officer

Analysts

Robert Spingarn - Credit Suisse

Cai von Rumohr - Cowen And Company

Joseph Campbell - Barclays Capital

Joseph Nadol - JPMorgan

Chris Donaghey - SunTrust Robinson Humphrey

Myles Walton - Oppenheimer & Co.

Operator

Good day, ladies and gentlemen, and welcome to the L-3 Communications Fourth Quarter 2008 Earnings Conference Call. My name is Jerry, and I will be your coordinator for today. At this time all participants are in a listen-only mode, and we will be facilitating a question-and-answer session towards the end of today's conference. (Operator Instructions). As a reminder this conference is being recorded for replay purposes.

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

Karen C. Tripp

Good morning and welcome to the L-3 fourth quarter conference call. With me 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 over the internet and I will now turn the call over to our Chairman, President and Chief Executive Officer Michael Strianese.

Michael T. Strianese

Thanks Karen and good morning everyone. Thanks for joining our fourth quarter conference call. We had a strong fourth quarter as I'm sure you have seen in our release and I just want to start by thanking the employees of L-3 for their hard work and dedication, program performance and our two Presidents for their leadership and excellent performance as well.

We finished 2008 with a very strong fourth quarter and continue to build our backlog with record fourth quarter funded orders of 4.3 billion. Orders totaled 16.5 billion for the full year and our December 2008 backlog closed at 11.6 billion, that's up 21% from our September 31, 2007 backlog.

Our book-to-bill for the fourth quarter was 1.07 times and 1.11 times for the full year 2008. We were very happy with the book-to-bill numbers. For the quarter they were particularly strong in C3ISR with the book-to-bill of 1.22 times as well as our AM&M segment with the book-to-bill of 1.18 times. Services and specialized products book-to-bill both approximated 1 for the quarter but all in all we were very happy with the results.

Fourth quarter sales were $4 billion with 5% growth and for the full year sales were just shy at 15 billion, at 14.9 which were up 7% over the prior year. Fourth quarter earnings per share grew at 36% to $2.21 a share, excluding the business divesture gain of $0.17 which we reported in the fourth quarter, earnings still grew at 25%.

For the full year earnings were $7.72, that's up 29% from the prior year. Earnings per share grew 17% if we exclude the second quarter items which included the gain on the appeal on the litigation as well as the fourth quarter divestitures. So from an operating standpoint we're viewing the operation as having a 17% growth in earnings per share before the special items this year 2008.

In the fourth quarter free cash flow was 287 million and that was after the additional 100 million of pension funding that we talked about back around the Investor Conference and during the third quarter call. For 2008 full year free cash flow was also very robust, it rounds ups to 1.2 billion. Again even after the additional 100 million that went through the pension plans.

We had some significant contract wins and orders in the quarter, including funding on project Liberty, the F-16 MTC which we have been talking about for most of 2008, that's the mission training center. It should be a long-term program for us and we are very happy to have secured that win. And, also having our data links put on the shadow system as well.

In addition, there were significant follow on orders on some very important legacy L-3 programs including Rivet Joint, Comp Systems for UAV's, our Rover product, logistics for Big Safari, work on P-3 aircraft the contract field teams, task orders, funding on the join operations group, additional finding for Afghan support, Bradley transmissions, the EO/IR Systems saw additional growth, the service side of our Homeland Security business that services the installed base of eXaminers received additional orders and funding.

Our family acquired generators known as GQGs where additional orders were received for deployment in Iraq and Afghanistan and GMT which our ground mobile terminal system. So really across the board we're very happy with the order flow in the fourth quarter.

In terms of looking out to 2009 some of the major bids that are outstanding which we're watching of course, the first one is JOG. As you know that's a re-complete our bid was submitted back on October 1st. We're expecting an award sometime in the first half I would speculate to say perhaps early second quarter or towards to the end to the first quarter. It's a kind of hard to call at this point.

And by the way JOG is the only remaining major re-complete that we have right now, so we'd like to get that behind us and of course remain incumbent. The Royal Australian Air Force Project AIR 7000, we are expecting some activity in the first half of '09. The C-12 contract logistics services program should be later in 2009 with the exception by the way of JOG which as you know is a $5 billion 10 year program. Most of the others are at least $0.5 billion type opportunities. The next three are about a quarter billion dollar size opportunities namely the Deepwater Fast Response Cutter, the B2 Aircrew Training System and C-20 Aircraft Logistics Services as well.

So we are busy with many more proposals because they are some of the more significant one's that we can watch.

In addition, in terms of significant new programs that we are either team on or are performing like Joint Cargo Aircraft our progress continues to be pretty strong. We made our deliveries on time and have now four deliveries to make in 2010. There are no actual aircraft deliveries in 2009 but we are continuing to work well on that program and are very confident that 2010 deliveries which will occur in the first half will also be on time.

Project Liberty is well, we should have some aircraft in place to our customer in just before mid-year. There is not much detail I want to go into at this point other than this is really been strong program for showcase L-3s fast response to this requirement and get a fielded product out in a very, very limited amount of time that is going be a real force multiply for folks on the ground.

EPX which is the power launch to current P3, of course and the Aerial Common Sensor program, we have team -- continue to be teamed with Northrop, we been reporting and we expect that there will be additional progress on these programs in 2009, although at this point I can't promise that there'll be awards in 2009, just don't have the visibility yet.

And finally in that space we had project HELIX that we had won some time ago, which was now referred to as Swing time. It is going to be in what's called Main Gate in the UK and we expect to hear the final... get the final go ahead in the Swing time which is... make sense and we're very confident about this program, every indication we have its funded and going forward.

So, even though... this is an award that we were happy with really in 2006, I believe that came through early 2007 and we've been working on to a study contract, the real heavy lifting as not yet started. So, that's some volume that we can look forward to as we get into 2009 and beyond, because it really hasn't ramped up yet.

In terms of operationally around the company, we've continued to tightened up operations where we can. We have consolidated our SPAR facility in Edmonton, Canada into MAS. The volume we had come down over the years with some programs that had that not been re-awarded. But, we believe that tightening that up and consolidating with the MAS facility will provide better overheads and better competitive edge to continue to win programs.

In addition, we're looking at other places around the company. We'll have more to say on consolidations as we get into the year. On capital deployment and acquisitions, as I mentioned, we generated 1.2 billion of free cash flow in 2008. As the cash deployment, we repurchased $794 million of stock in 2008, with 221 million acquired in the fourth quarter alone.

About 70 million of that purchase in the fourth quarter represents or you can look at it as representing an early start on our 2009 commitment of 400,000... 400 million, I am sorry, shares of stock to be repurchased included in our initial guidance and of course, we received a new authorization from our Board of Directors in November for $1 billion over two years.

As far as acquisitions go, in 2008 we acquired four companies for approximately $250 million. We believe they were at very reasonable prices and continue to evaluate several other companies that fit well with L-3.

We've been cautious, as I have been saying, on valuations due to declining multiples for defense assets in the space where we were looking to buy and of course that's driven by a whole series of things with the economy and interest rates and everything else. But there's still some very nice companies that we are pursuing and in all likelihood we'll continue to add to the portfolio in 2009.

We closed the year with 867 million of cash. Our 2009 guidance assumes we end 2009 with more than 1.5 billion of cash, after repurchasing an additional 330 million of stock. And of course it doesn't assume acquisitions but you can rest assure that there will be additional acquisitions that L-3 will make. And even in the event that it runs a little slower than we expect, we also have the option of increasing the share repurchase that we have in the plan.

We have been monitoring the credit markets pretty markets carefully. We have no immediate financial... financing requirements and we have a strong balance sheet. But we do recognize we have our senior credit facility that will mature in the first quarter of 2010.

I don't think today is the time in this environment to renew it yet. We would wait for conditions to become a little more clear and perhaps improve later on in 2009. That does include a $650 million term loan outstanding, but it's well within our ability to repay it in part or in full. We have to term it out if we wanted to. So we have plenty of options. It is something that we will continue to watch and be opportunistic about when it's the right time to make the right deal for L-3.

The divestures, we completed a transaction in October that we had talked about that, in fact in the fourth quarter, we sold our medical patients simulated device business, where we had an 85% interest and it generated about 60 million a year in annual sales. Proceeds from the divestiture before tax were about $53 million. It generated $0.17 per share gain in the fourth quarter that we talked about already. We don't expect the same level I guess in 2009, although we do have several operations that we are continuing to evaluate for divestiture.

We've been approaching this in a very disciplined manner. There are no much sales, but there are opportunities where we if we find the right buyer where there would be operations that we would sell. So nothing is on sale. I think we need to get the right price from the right buyer. But again we're being disciplined in our approach both on the buy and the sell side with operations.

2009 outlook we updated the guidance today as you've seen. We reflected additional pension cost of about $0.21 a share resulting from lower discount rates and lower asset returns and have been projected back at the time we put our guidance out. Ralph will give you a lot more detail on that. We expect sales in '09 right now to be about 15.6 billion that's up 5%. And, we have additional upside from the ISR surge as well as any future acquisitions that we would make.

So, all in all we are very satisfied with the fourth quarter and the year. We look forward to a strong 2009. And with that let me turn it over to Ralph, and Ralph will give you some more color on the numbers and then we'll be happy to take your questions. Go ahead Ralph.

Ralph G. D'Ambrosio

Thank you Michael. I will review key points about Q4 results and talk about the changes to our 2009 guidance. Concerning earnings per share, it looks for the fourth quarter if you exclude the business divestiture gain that Mike talked about, our EPS was $2.04, 25% better than it was in Q4 of 2007.

In Q4 this year, the tax rate was lower than we expected because of benefits related to completing certain income tax audits, and they added $0.15 to our earnings. Excluding that tax benefit EPS grew by 16%. We had similar tax benefits in 2007 which occurred in Q2 and Q3 and they added $0.10 to EPS for 2007.

On sales, we did $4 trillion in Q4, that's 5% growth. Sales were almost 200 million better than we expected with higher sales in C3ISR, government services and aircraft modernization and maintenance are spread across many different contracts.

We had sales growth in every segment expect for government services which declined because of linguist contract, and we had our toughest comparison quarter-over-quarter on linguist in Q4 with sales declining by about a $150 million. Excluding linguist, government services grew 11% in Q4 and consolidated growth in Q4 was 10%. We are going to have similar but smaller headwinds on linguist in Q1 and a little bit in Q2 of 2009 and that will be it for the negative comparisons. And lastly on sales, sales growth from acquisitions net of divestures was about 2% in Q4.

Moving on to the operating margins they were unchanged at 10.4% for Q4 versus Q4 of last year. The only unusual item on the margins was that we incurred an additional $15 million of cost growth on an International ISR aircraft contract in the C3ISR segment. And that costs growth reduced Q4 margins by 40 basis points on a consolidated basis. That contract is still profitable and we believe we have adequate provisions. But we haven't retired all the risk yet. Those risks will be retired middle to end 2009. And margins improved in every segment except for C3ISR.

Free cash flow for Q4 was $287 million. We had declines and receivables and inventories which generated $73 million of cash and that offset most of the additional pension funding that we made in Q4. And the receivable day sales outstanding declined to 69 days at the end of December from 72 days, at the end of 2007.

So, we are continuing to make progress on the working capital front. Total pension funding in the quarter was $116 million, and we made $74 million of income tax payments compared to $67 million in Q4 of 2007.

Moving onto the changes to our 2009 guidance, our earnings per share, we reduced our previous guidance range by $0.18 to $7.12 to $7.32. Higher pension expense reduced EPS by $0.21 and the IRG acquisition edged $0.03.

So, the total pension headwind for 2009 versus 2008 is now $0.40 compared to our initial guidance that we provided in November of $0.19. And at the November Investor Conference, we also provided a pension expense assumption sensitivity analysis and the two main assumptions that we had were a 23% decline in assets for 2008 and a 7.5% discount rate for 2009. And we said that we would update the guidance based upon the actual results which were determined on December 31 of 2008.

As it turns out, the actual pension return was minus 28%, 5 percentage points worse than we expected and because of the plunge in interest rates that began at the end of November and continued through December, the discount rate is now 6.5% instead of 7.5%.

Combined, those assumption changes increased pension expense to $163 million for '09 which is $41 million higher than the previous guidance and $76 million more than pension expense in 2008.

On the pensions, I also want to point that we do not smooth pension asset returns and therefore 100% of the negative return in '08 is impacting '09. The good news here could be that there will be no spillover into 2010 and later from the asset return that we had in '08. And so it's possible that pension expense could be a tailwind in 2010. We will see what happens with the asset returns from the interest rates in 2009.

Comparing our 2009 EPS guidance to the 2008 EPS, there are a lot of reconciling items. We included a chart on the website that makes that reconciliation and it shows that the underlying projected EPS growth is a healthy 13% at the mid-point of our 2009 EPS guidance range.

Our new sales guidance is $15.5 billion to $15.7 billion, which is 5% growth at the mid-point and that's after absorbing a $300 million sale reduction on two programs '09 versus '08. They are linguist and the contract field teams which we talked about in the Q3 call and the Investor Conference.

We increased the low end of our guidance range by $100 million, mostly for the IRG acquisition that we completed in December. For now, we are keeping the high end at $15.7 billion. We want to be conservative while we weigh the outcome of the JOG re-competition and we also want to for now protect against any potential downsides in our commercial businesses that could rise from the global recession and financial crisis.

Also the sales guidance for next year includes $100 million of growth from acquisitions net of divestitures. As Mike said, the most important or significant upside that will have to our 2009 sales is the ISR surge and the extent to which the new administration continues it. And we'll learn more about that I'm sure in the next few months.

Our operating margin guidance was lowered to 10.4% from 10.7% for 2009 and that's entirely because of the higher pension expense. If you remove the pension headwind, we're expecting margins to improve by 30 basis points in 2009 compared to 2008.

We kept the tax rate at 36% and the free cash flow guidance at $1.2 billion. For the first quarter, we are expecting sales to be about 3.6 billion with EPS of about $1.58 and cash flow should be at least $100 million.

And that concludes the comments I wanted to make. So I am going to turn it back to Mike and I guess we will open it up for questions.

Michael T. Strianese

So, operator we are ready to take the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). You have a question from the line Rob Spingarn with Credit Suisse. Please proceed.

Robert Spingarn - Credit Suisse

Good morning. I'm looking to see if its morning or afternoon, its still morning.

Michael Strianese

Good morning Rob.

Robert Spingarn - Credit Suisse

Hey guys. On the couple of things, on the F-16 win and you mentioned Mike that you've been talking about that for sometime, can you give us a sense of the size of that and the ramp?

Michael Strianese

Well, there is some customer sensitivity is there and again it's the initial press release talked about $68 million. But as you know it's a mission training center. So I don't want to talk specifically to that but those are typically long, wide programs that would typically involve the provision of -- the wide training devices, course curriculum material in some cases, like in Oklahoma or on the AUX we provided an entire turnkey training facility. So, we'll be able to talk more about that I think later this year. But I would do that as beyond the one year opportunity.

Robert Spingarn - Credit Suisse

Okay.

Ralph D'Ambrosio

It's also very strategic for us in the sense that we believe that getting our state-of-the-art HD World Simulator in that F-16 community will be very key to creating demand for other fast jets where we do not have our simulators also. It's very strategic for us.

Robert Spingarn - Credit Suisse

Okay. And sticking with aircraft going back over to JCA, you talked Mike about deliveries in 2010 and a hiatus in 2009. How should we think about the revenue flow associated from '08 to '09 to 2010 on JCA?

Michael Strianese

Ralph has that for you, so go ahead Ralph.

Ralph D'Ambrosio

Sure, on sales we did a $130 million for 2008. We are currently expecting about 170 million in sales for 2009 and that goes to about 230 million in 2010 and then close to 400 million in 2011.

Orders we booked a 144 million in '08. We expect to have orders of about 220 million in 2009, that's for 7 aircraft. In fact, I think we already booked those 7 aircrafts last week. For 2010 we're expecting orders of 11 aircraft for about 350 million and then the orders could go through 0.5 billion in 2011. So we will have nice increases in both orders and sales in the next few years on this program.

Robert Spingarn - Credit Suisse

So Ralph given all those numbers. And the fact that this is still early stage in the program, how should we think about the sales flow on these earlier aircraft relative to their delivery because clearly some of this is advance payment?

Ralph D'Ambrosio

Since we're in the low rate production, we are using a cost-to-cost model which we transition to full scale production in the 2011 timeframe will be use of delivery.

Robert Spingarn - Credit Suisse

Okay, that's very helpful.

Ralph D'Ambrosio

Does that answers your questions or not?

Robert Spingarn - Credit Suisse

Yes it does, it does. And then just Mike, from a more top level standpoint, my final question, can you just talk about maybe your top three programs from a growth standpoint over the next several years. And then at the other end of the spectrum, what we should be looking at as winding down, obviously we are through linguist side on that, but sort of the top and bottom of the group?

Michael Strianese

Well there is a whole corduroy of programs at the top which are in the ISR space. Some of that is going to be driven by what happens with some of the newer programs as I mentioned like the EPX or the Aerial Common Sensor program but I think it's easier to answer in terms of product areas or business areas for us so ...

Robert Spingarn - Credit Suisse

Okay.

Michael Strianese

So that driver I would say is clearly going to be our ISR programs and whether that's -- whether it's a Rivet Joint or equipment that we put on the conference call or a Project Liberty they kind of fit the same types of programs that are in that same space.

So I would look that at that as a number one. Number two, JCA as Ralph alluded to has a pretty good ramp and some visibility, some strong visibility as to where that's going to go. So we feel very confident about the ramp that's there. And on our services side, again we've continued to see growth there in areas that are direct support to the military and also in the nation buildings side. Now that may have some scroll from one side to the other but we still see reasonably good growth in that area.

And lastly if you look at the products portfolio or the top things that are growing in that group maybe I will mention three of them, the Bradley work that we are doing and there is a (inaudible) reset that's there whether it's transmission characterized et cetera. The EO/IR turrets, whether it's the MX-15 or is the HD version they are just really have been going at a very strong clip level and we've been happy with that.

And I guess finally there is our simulator businesses has also been growing pretty strongly. So, I can give you couple of pieces from each segment that we see growing. In terms of winding down, obviously there should be one would logically say that with a withdrawal in Iraq there should some pro rata draw down of our services to the extent that there its almost a one to one or a collateral with the military headcount.

On the other hand that would likely be offset by this growing to Afghanistan one and number two we're expecting to start to see some direct contracting for services from the government of Iraq with defense contractors in the U.S. and other places of the world.

So that's obviously the most visible. Other ... we are very as you know immune to platforms into big wind down so I really don't see much more across the business in any significant areas that would be, you will refer to something as winding down. So, we think we'll hold our own pretty well as we're able to quickly adapt and move things around and continue to grow in places that are growing.

Robert Spingarn - Credit Suisse

Appreciate the help guys, thank you.

Michael Strianese

Thanks Rob.

Operator

And you have a question from the line of Cai Rumohr of Cowen & Company. Please proceed.

Cai von Rumohr - Cowen And Company

Bob good quarter. Ralph you mentioned the 15 million write-off in the release it talks about a 400 basis point impact which would work out to 30 million, could you reconcile that, does that apply to year-over-year and can you give us some more specifics, I assume that's the P3?

Ralph D'Ambrosio

Well the 400 basis points is the impact on the C3ISR segment not the consolidated results and that factors in that the program or the contract was profitable in Q4 of '07 and we have $15 million loss in Q4 of '08. So that's best to your answer there Cai.

Cai von Rumohr - Cowen And Company

Alright, okay. And is that the P3 and kind of give us some specific percentile write-off we've had on this program I believe?

Ralph D'Ambrosio

And we did had some cost growth in Q3, which I talked about but the program is still profitable. It's about $300 million in contract value. We've about $45 million estimate to complete there. And the margins are not as high as the company composite, but it's pretty close to it, even after those cost adjustments.

And, what's happened is we're finding a lot more corrosion on the Program-3 aircraft that we're retrofitting and modernizing. And as a consequence, it's costing us more. We've also been experiencing some productivity reductions and some of that's related to the huge increase in sales volume that we have in the ISR business. In general, and we have lot of people on board. And we're not getting the same type of productivity at the new hands, compared to the experienced hands. So, like I said, we expect to retire most of those risks towards the middle and end of this year, and we'll keep you posted. We think we have our arms around it.

Cai von Rumohr - Cowen And Company

Okay. A follow-up, your sales were better than expected in that sector. You are up nicely, can you comment how much of that was Project Liberty and how big you are now assuming Project Liberty is going to be in your 2009 guidance?

Ralph D'Ambrosio

Sure. Our Project Liberty sales were about $35 million in Q4, $53 million for the year, and we expect those to grow to about $185 million in 2009. And of course there is upside to those numbers depending on what happens with the program, if it's augmented etcetera. But the key thing that you need to pay attention to or remember is that, we do a lot of ISR work, a lot of it's classified. Liberty is just one program of many. So... and we're seeing a lot of growth on the classified side as well right now.

Cai von Rumohr - Cowen And Company

Okay terrific. Thank you very much.

Michael Strianese

Thanks Cai.

Operator

You have a question from the line of Joseph Campbell of Barclays Capital. Please proceed.

Joseph Campbell - Barclays Capital

Good morning Mike and Ralph.

Michael Strianese

Hi Joe.

Joseph Campbell - Barclays Capital

Mike, you win over a lot of accomplishments since we saw you in your investor conference and Ralph outlines the difference in the financials. But I wondered, what if anything you see different in the outlook sort of more strategically or anything maybe in the financials that is not about, but about what's happening in your inside the Pentagon. Maybe if you have any insights from your Board members of all the generals that are part of the team about what you think is going on inside that transition team. And when you make up this delay of the budget to April. I mean, normally they don't need extra time to spend more money, if that's the easy part. It's choosing that's the hard part?

Michael Strianese

Sure. Sure, Joe. Well, yes, we've been having numerous discussions internally with our, the team in Washington. That has been actually doing a spectacular job of keeping us informed and as you alluded to a Board member, I guess everybody's aware that John White had, one of our Board members had served on the DoD transition, he actually led to DoD transitions. We'll actually be seeing John next week at our regular schedule Board meeting

But I think it was little amount he could tell us everything went very well and he was very professional and he was very pleased. So that's not giving you the color you're looking for. But there is couple of things to note here. One, I think that while the commitment to a strong United States international defense policy and recognition of the needs of the war fighters in Iraq and Afghanistan continues, there is obviously going to be a shifting in how are done.

I think that the delays to April is really related to not only dealing with the budget situation where there is many more demands than there are dollars, at the same time funding to wars and overly the economy on that I am not surprised with the delay. I quite can't believe I would rather get it right and get something out that's not well thought out.

I do think in the input I've gotten from the folks in Washington. has been that from our standpoint, from industry's standpoint, the full understanding of really the new administration's defense priorities will really emerge in the FY '11 budget/QDR process and that's what we are really focusing on. So we are not expecting significant changes necessarily in the short run.

In addition, I mean there is some new directives that are out, not only from the administration, but even example from the Head of Secretary, (inaudible) and Head of Homeland Security, with things like Critical Infrastructure Programs, Risk Analysis, State and Local Intelligence Sharing, Transportation Security, State-Local and Tribal Integration, etcetera. Until we get a better hand on what the funding is and what the programs will be, it's hard to really assess that what, how we can address them. But the good news is that they're being focused on and the direction is up.

And, then overlaid on everything Joe, as you know is the economy and whether there is a desire to go forward or not on any particular program in the Pentagon or at the administration level, everyone is going to tempered in my opinion by jobs, because that's effected the economy. So... it's a lot of impacts are going to be affecting what's gets done, but all-and-all I am very optimistic about where we are as a company and the industry really, the industry's health in general is going to be very strong from what everything we've seen.

Joseph Campbell - Barclays Capital

And Mike, you mentioned one thing that didn't change, and that was M&A prices sort of after crisis everything still has before crisis expectations. I mean, but all other companies are relatively fresh with cash and everybody is looking. Do you really think that we're going to see a strong loss in M&A prices or is it just a matter of kind of making sure that you don't get caught just before... some sort of shift in the way things are viewed?

Ralph D'Ambrosio

I'd say it this way. I mean that which is a very visible thing and everybody knows the last three any public company deals we saw in this space. I don't think you will see those multiples repeat.

Joseph Campbell - Barclays Capital

Great. Thanks very much. Thanks Ralph.

Ralph D'Ambrosio

I think it's difficult to get there. It's ... Joe, the cost the capital was high, so the hurdle rates for buyers are higher. And I really believe there is a lot of discipline in my colleagues in this industry as to be who is the first person to flinch in and pay more than they should for something. So I think that that's going to hold things back a little bit.

Joseph Campbell - Barclays Capital

Terrific, thanks again.

Operator

You have a question from the line of Joe Nadol of JPMorgan. Please proceed.

Joseph Nadol - JPMorgan

Thanks, good morning Mike and Ralph. Starting on the products business you had some... I think some probably some positive team adjustments in the quarter and you looking for little bit of margin decline next year. Just wondering I guess what went well in the quarter? And is it possible that that could continue to do well into 2009?

Ralph D'Ambrosio

Well, we really didn't have big tuned catch-up adjustments, in that segment in Q4, Joe. We just continued good performance and the margins are looking a lot better in several business areas. The reason we're expecting more it just to be flat in 2009, versus 2008, excluding impact of the higher pension expense.

As I talked about earlier, that we're being cautious on some of the commercial business areas. So, for example, in the commercial aviation business, where we do about $290 million a year in sales, we are expecting those sales to decline today by about 10% and those sales have higher margins than the rest of the segment does.

So I would just say we're being conservative until we have some more clarity on what happens in the commercial business areas. And we'll see what that... we'll know about that as we progress throughout 2009.

Joseph Nadol - JPMorgan

Okay, could you comment in like fashion on the commercial ship equipment business which I know have been doing well, subsequent to acquisition and then just overall Ralph, what's the percentage in, I guess updated percentages within products and then for the company of a whole of commercial?

Ralph D'Ambrosio

Okay. Well at the commercial ship building, it was about a little more than $500 million in sales in 2008. And we are expecting it to grow by about 10% before FX in 2009. And I talked about the foreign exchange headwind that we have '09, versus '08 at the Investor Conference which is going to cost us about $100 million in sales, but ex that, the business is growing.

The three mark store (ph) should have begun drop off in orders in Q4. We've pretty much new ship building orders almost came to a halt. Now we have very strong backlog in that business area that's going to carry us into 2010. And in some cases beyond there. So, we'll see what happens, but as of right now we are expecting the growth in that business area to slowdown, particularly after this year.

Joseph Nadol - JPMorgan

And then just overall for the company now, what's your percentage of commercial sales and then I guess, specifically within the products business?

Ralph D'Ambrosio

The commercial sales for '08 were 14% of consolidated 2008 sales. And I don't have the numbers with me, but in the specialized products area the commercial sales are probably about 35% or 40% in total.

Joseph Nadol - JPMorgan

Okay. And you gave some good color on Project Liberty, you said it is a big driver and you mentioned I know that there is other classified programs that are similar, that are also providing growth, because I am just wondering you have this JCA ramp up, that's very visible. The ISR seems, I mean it's a great ramp up also, but it doesn't seem maybe as visible, at least to us on the outside beyond 2009. Could you put some color on what do you think, what kind of visibility you have into '10, '11 on those types of projects?

Ralph D'Ambrosio

Well, on the ISR side, we've always believed that it's going to be an enduring growth area for the company. It's probably one of the best growth area across the businesses that we have.

It just so happens that there aren't many programs on record in the ISR space. A lot is always classified and we're confident that we're going to have good growth in that area, whether it's Liberty or something else in the next few years.

We think it's something that the war fighter needs and it is increasing demand for those types of capabilities and we think we're uniquely qualified to meet those demands. So we are very excited about ISR in general.

Joseph Nadol - JPMorgan

Okay.

Michael Strianese

I would like to add to that, Joe, couple of the drivers here, and Liberty again is a good example. It's a different type of procurement where this is a rapid delivery of the capability integrating some state of the art sensors, a commercial airplane, we are commissioning an airplane which we will do well. The drivers for the demand are either the war in Iraq or Afghanistan, as well as just overall security requirements to keep that unblinking eye. There are new platforms that I mentioned, like the EPX or the AC --the area of common sense that will come online some day, but that's a long way off and there is a lot of the legacy platforms that are in this space we're involved with, whether it's a Rivet Joint or P3 for example. Those undergo continuous upgrades. They've been used way more than has ever been projected -- ever been projected. And the demands to keep them maintained and operational including current on evolving threats is really unabated right now, and we see that pretty much not changing for a fairly long time. It's -- while it's growth, its steady stay for us. So that's some of the reasons for that core process.

Joseph Nadol - JPMorgan

Okay. Thanks guys.

Operator

You have a question from the line of Chris Donaghey of SunTrust Robinson Humphrey. Please proceed.

Chris Donaghey - SunTrust Robinson Humphrey

Hi, good morning guys. Mike, just kind of sticking with Project Liberty, as you look at the ISR surge, this is obviously a very nice project that venture there, are there opportunities of similar sized, I guess number one, and then just a point of clarification. I don't know if you said this or not, but did you say you expect to be the second provider on Project Liberty as well?

Michael Strianese

We -- yes, I don't really want to get into the details on the roles on that program, I just can't. But what I said is we are integrating the airplane, and there are certain L-3 components that are part of that integration. But that's kind of a close hold as to how that works. Are there -- there are other requirements, but at this time I really can't go through them individually other than the general requirement for persistent ISR, not only in the areas of engagement today but if you can pick up some of the other areas of concern, whether it's problem in North Korea or nuclear Iran, other regions of the Middle East, Africa etc. etc. There's just -- South America, there is just a continuing demand and not enough assets to meet that demand, and that's really the simple model that we look at.

Unidentified Analyst

Okay, great. And then just along the same lines of the secretary of defense is obviously talked pretty visibly about wanting to kind of shift some of the focus away from traditional modernization programs to more irregular warfare, intelligences, surveillance and reconnaissance types of technologies. Do you feel comfortable with your current portfolio of businesses in terms of being able to organically develop that capability, should there be a significant shift towards that, or do you see that as an area of additional acquisition opportunity?

Michael Strianese

Well both. I think, one, we are -- we're demonstrating more and more of our unique capability in that space, is that we are really the one stop shop in that space. Having said that, there are always great small companies that come up with the technology that can fit and we review them regularly, and when we come up with one that is a fit, we'll pursue it and acquire it. So its both, and really you're getting it to make process by decisions, when you get this -- given our capabilities here, there's a lot of things we can do on our own nickel in terms of developing product and this is not in concert -- very close concert with our customer requirements. However, if you can get to the market faster and get something that's already been developed and you are willing to pay up for it, you can certainly buy it as well. And that's the trade that we always go through should we do it on our own, or should we buy the capability. So we are looking at things in that space, both in black boxes that duce various types of signal processing all the way to the antenna side for example. I mean there's a lot of technology out there that we are looking at.

Unidentified Analyst

Okay, great, thanks a lot.

Michael Strianese

Thanks.

Operator

You have a question from the lines of Myles Walton of Oppenheimer & Company. Please proceed.

Myles Walton - Oppenheimer & Co.

Thanks good morning Mike and Ralph. Mike or Ralph may be in the stimulus bill looks like there is 600 million or so for ports and airport screening product, a 100 million for ports and 500 million for airport screening. Do you think that or can you quantify what kind of near-term opportunity that represents for L-3 given kind of your market share and maybe what exactly they are looking for as well as any time line if you have insight there?

Michael Strianese

I think that's going to be a topic Myles, so we can give you more color on probably at the first quarter call. We are aware that its there, we have our folks in Washington staying on top of exactly what these requirements are. Some of that money is going to filter through the States first before it gets programmed. So it's not going to go direct as you might think but we are I'd like to say all over it that we are aware that there are requirements both in the airports and in the ports.

As well as sensor for nuclear Myles, there is a whole laundry list of things of areas where we can play including interoperability has come back on board and we have a very strong position in interoperability in terms of our communication systems.

So unfortunately I can't give you a number but I can tell you that good news is there is another budget source for us for funding. We are going from budgets to supplemental to the homeland security account, and just add on the list now the stimulus package that's coming out. There definitely is some work to be done there, but there is not enough visibility now to what the really discreet things that are going be put on.

Myles Walton - Oppenheimer & Co.

Okay. Fair enough.

Michael Strianese

We're discussing building and putting in a system right, it's hard to tell.

Myles Walton - Oppenheimer & Co.

Okay so, they are kind of 500 million of products your guys in Washington are kind of telling you that that might take a while to flow through the systems, so don't kind of plan on it for '09 this year?

Michael Strianese

Yes, because even if you listen to the talking heads as they say on television at night, especially one particular channel saying yeah, but all this money won't creates jobs for year and half. This is not going to get, you can't spend it that fast. So that is the question how fast you can get to it's destination whether its a State Local government and then you are put on the contract which you do a competition and not go three to six months there as well. So I'd rather not bring it up, but I would tell you that it's another budget target for us to stay tuned to.

Myles Walton - Oppenheimer & Co.

Fair enough and one other Mike that the incoming D&I Blair has talked about, one of it's first duties or goals to transfer to Federal employees anything inherently governmental that's being done outside by contractors that falls in his preview, is their anything you think in your portfolio that might be susceptible to that kind of policy shift?

Ralph D'Ambrosio

I think very little, but that's subject to definitional interpretation there. Certainly, perhaps we see the type work that would be done which we don't do a lot of. Obviously, the interrogation is something that I know the secretary does not want the contract of communities to be a part of that has military function which we agree by the way.

So, where we are in that space is providing high end systems, analysis tools, the infrastructure that allows for collection of data, analysis archiving, dissemination. So it's managing the systems which I think is typical contract to work. So I am not very concerned at this point, that this is a impact to us here.

Myles Walton - Oppenheimer & Co.

Okay. Thanks.

Ralph D'Ambrosio

Thanks.

Operator

We have a question from the line of Rob Ron Axtin (ph) of Banc of America Securities/Merrill Lynch. Please proceed.

Unidentified Analyst

Hi, good afternoon, guys. Just wanted follow-up on the IFR team. What do you guys think about the market for cyber security and how do you think about it and how do you go to market in that space?

Ralph D'Ambrosio

This is an emerging area, Ron. And it's an area that the new administration has placed particular emphasis on both from an offensive and defensive strategy. I think that it has to be a very classified area as well. So there is not a lot that I can say, generally this is not a lot, but actually know, the... first of all, we have a lot of big players in the commercial space and a lot of these systems, whether it's e-mail or like have some commercial element in there.

So I think this is not going to be an area that's restricted only to the DoD and contracting community. I think it deals with a lot of good things in the commercial side. However, where we address this market and what areas we are looking for is our secured communications obviously. Our encryption where we have a very strong capability on encryption. It's also a focus area for us in terms of acquisitions and capabilities. We are looking to acquire to help us further address that market space. So that is another growth area that I think is going to evolve over the next 12 to 24 months in terms of what the missions enrolls for the contracting community, the types of systems that are desired. So it's again something we will be talking about over the next several quarters.

Unidentified Analyst

Okay. And just one another follow-on if I may, with the demise of the Reconnaissance Helicopters, do you expect some sort of maybe follow-on program or different program that maybe you guys could team up on with platform provider just like you did with JCA.

Michael Strianese

Yes, we are actively looking at that whether it's missionizing existing helicopters or teaming for replacement helicopter. We are active in that process right now.

Unidentified Analyst

Okay great, thank you.

Michael Strianese

Thank you.

Operator

Okay, thank you. Mr. Strianese, you will present the concluding remarks now.

Michael Strianese

So in summary I think 2008 was a very good year. And we have a good outlook for 2009. Again, we are able to showcase the capabilities of L-3 pretty well in 2008 with the on-time delivery of JCA which we are getting a lot of recognition for and actually if that questions on is that how did you do it? Because things don't tend to get delivered on time often enough. So which is good, and as well as again we talked a lot about Liberty, but that is a great example of some of the capability we have in L-3, that defines what L-3 is and why L-3 is different that we are able to do a quick reaction.

I think based on everything we know today, we think 2010, while we obviously won't be giving guidance out until the end of the year, but there is nothing that we see today that is causing us tremendous concern that our business growth cannot continue and that 2010 can't be at least as strong as 2009.

Particularly, when you look at some of the orders that we've taken that are really in the multi-year category, some of the programs that are just starting to ramp up now, as well as the fact that we will have this pension headwind. So, we're looking forward to a strong '09 and beyond. With that, we look forward to speaking with you over the quarters in 2009 and thanks for joining us.

Operator

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

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Source: L-3 Communications Holdings Q4 2008 Earnings Call Transcript
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