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Executives

David W. Thompson - Co-Founder, Chairman, Chief Executive Officer and President

Garrett E. Pierce - Vice Chairman and Chief Financial Officer

Analysts

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

Chris Quilty - Raymond James & Associates, Inc., Research Division

Gary S. Liebowitz - Wells Fargo Securities, LLC, Research Division

Tyler Hojo - Sidoti & Company, LLC

Greg Konrad - Jefferies & Company, Inc., Research Division

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Orbital Sciences (ORB) Q4 2012 Earnings Call February 14, 2013 9:00 AM ET

Operator

Good morning. My name is Justin, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Fourth Quarter Year End 2012 Financial Results Conference Call. [Operator Instructions] Thank you. David Thompson, you may begin your conference.

David W. Thompson

Okay. Thank you, and good morning, everyone. Thanks for joining us to discuss Orbital's fourth quarter and full year financial results for 2012. I'm Dave Thompson, and with me on the phone today are Garrett Pierce and Barry Beneski.

Before we get underway, I'd like to ask everyone to take note of the Safe Harbor paragraph at the end of our earnings release. This paragraph emphasizes the major sources of uncertainties and risks in the forward-looking statements that we will make this morning. Please keep these factors in mind as we discuss our future operational outlook and our financial guidance during today's call.

We plan to follow our customary outline for the discussion this morning. I'll begin by covering several highlights from the fourth quarter and last year, and then Garrett will discuss our financial results in greater detail and update our preliminary guidance for 2013. After that, I'll recap recent space missions and Antares development program progress and also provide a preview of upcoming operational events over the next 3 months. Finally, I'll address new orders and contract backlog, as well as our new business outlook for the early part of the new year. And at that point, we'll open up the call for your questions.

So let me begin with some highlights in 3 areas that I think characterize the company's final quarter of 2012. Garrett and I will cover each of these in more depth a little later on this morning. First, let's look at our financial performance.

Orbital's revenue in the fourth quarter was $355 million, an increase of nearly $20 million or about 6% over the same period in 2011. Our launch vehicle segment generated most of our top line growth, as Antares' rocket production and target vehicle sales increased substantially over 2011 levels. Operating income in the quarter was $31.3 million, up about 41%, compared to last year's result. Operating profit margin of 8.8% reflected substantial margin improvements in 2 of our 3 business segments driven by positive adjustments on the closeout of several satellite contracts.

Net income and EPS were $13.9 million and $0.23 per share, respectively, after factoring in about $6.3 million or roughly $0.10 per share of after-tax non-recurring charges in connection with our long-term debt refinancing that we completed in December. Free cash flow in the quarter was $300,000, which resulted in a year-end cash balance of $232 million.

Second, let's turn to operational highlights. In the fourth quarter, the company carried out 3 major space missions and delivered 6 additional satellites and launch vehicles for future application. This brought our full year operational totals to 9 major missions, 19 smaller launches and 20 additional system deliveries. In our Antares rocket program, fine-tuning of the liquid propellant and pressurization systems at the Wallops Island launch complex was completed late last year, and cold flow fueling tests were carried out using the first Antares rocket during December and January. This paved the way to the vehicle's hot fire test this month and our first launch, which is now targeted for early April.

Finally, here's a summary of new business activity. New contract awards and option exercises totaled about $770 million in the fourth quarter. This total included $445 million in new firm and option orders, plus $325 million in option exercises under previously awarded contracts. Together with previous new business activity, in the first 9 months of last year, fourth quarter contract awards and option exercises boosted total new business activity to approximately $2.3 billion for 2012. Firm contract backlog was $2.2 billion and total backlog was $5.0 billion at the end of December. I'll provide more details on recent orders and new business pursuits later in the call.

Now I'd like to ask Garrett to take you through our financial results from the fourth quarter and the full year, and to update our preliminary guidance for 2013 that we provided last fall. Garrett?

Garrett E. Pierce

Thank you, Dave, and good morning. Before commenting on the financial results, I want to note that during this call, we'll provide certain non-GAAP financial measures.

A reconciliation of these measures to comparable GAAP financial measures can be found in our earnings release or to the extent not addressed there but discussed in this call will be available as an appendix to the transcript of this call and will be posted under the Investor Relations heading on our website.

As reported in the company's earnings release this morning, revenues for the fourth quarter of 2012 were $355 million, compared to $336 million in the fourth quarter of 2011, an increase of $19 million or 6%. The revenue increase was led by the CRS contract with an $18 million or 26% increase over 2011. The target product line revenues increased $8 million or 20%. The science and technology product line increased $7 million or 40%. And finally, interceptors increased by $4 million or 20%. These increases were offset by a $22 million decrease in the National Security Space Systems, NSS, revenues.

Consolidated operating income was $31 million in the fourth quarter of 2012, resulting in an 8.8 operating margin, as compared to $22 million operating income with a 6.6 operating margin in the fourth quarter of 2011. Operating income was up $9.1 million or 41% for comparable quarter-over-quarter. This performance reflects an $8.7 million increase in operating income for the satellite segment due largely to favorable contract adjustment for GEO satellite programs at or near completion.

Now I'd like to highlight certain factors in each of the 3 operating segments. Launch vehicles segment revenues were $134 million in the fourth quarter of 2012 versus $130 million in the fourth quarter of 2011, an increase of $4 million. This was primarily due to a $20 million increase in Antares revenues for the CRS contract, an increase of $8 million for target launch vehicles, an increase for other space launch vehicles of $7 million, and interceptor revenues were up $4 million. These revenue increases were largely offset by a $35 million reduction in Antares' intercompany revenues for the COTS R&D program. Since these revenues are eliminated in our consolidated statements, intercompany revenue eliminations were also $35 million lower in the fourth quarter of 2012, as compared to the same quarter of 2011. The significant reduction at Antares activity for the COTS program was largely offset by an increase of Antares production activity on the CRS program. Excluding the intercompany Antares revenues, which are recorded at cost, launch vehicle segment revenues increased from $89 million in 2011 to $129 million in 2012, an increase of nearly 45%. This was across all product line groups in the launch segment. Launch vehicles segment operating income was $9.9 million or 7.4% of revenues in the fourth quarter of 2012, an increase of $2.8 million or 39%, compared to the fourth quarter of 2011. The operating income improvement was principally due to increased activity on Antares rockets for the CRS contract and target launch vehicles and profit improvements on certain space launch vehicle contracts.

As previously discussed, we do not recognize any profit on the Antares rockets that are being built for the COTS R&D program that is led by the advanced space program segment. Accordingly, the $35 million reduction in Antares revenues for the COTS program that I discussed a couple of minutes ago contributed to the improvement in segment operating margins. Satellite and space systems segment revenues were $125 million in the fourth quarter of 2012, up $3 million compared to the fourth quarter of 2011, primarily as a result of the $7 million increase in science and remote-sensing satellite revenues, partially offset by a $4 million decrease in GEO satellite revenues. Satellites and space systems segment operating income for the fourth quarter of 2012 was $16.1 million or 12.8% of revenues, an increase of $8.7 million relative to the fourth quarter of 2011. This increase was principally due to operating income improvements of certain GEO satellites that were substantially complete during the fourth quarter of 2012 from a manufacturing and risk reduction standpoint. The profit improvement in part reflected scheduled improvements with cost reductions in the final integration and testing manufacturing processes.

Advanced space program segment revenues were $102 million in the fourth quarter of 2012, down $24 million or 19%, as compared to the fourth quarter of 2011, primarily due to a $22 million decrease in the national security space satellite revenues. Advanced space program segment operating income was $5.3 million or 5.2% of revenue for the quarter, a decrease of $2 million compared to the fourth quarter of 2011. This operating income reduction was primarily attributable to the revenue decrease in the NSS product line.

Research and development expenses decreased by $4 million principally due to a decrease at COTS' research and development expenditures. The GAAP tax rate in the fourth quarter of 2012 was 24%. This compares to a tax rate of 33% in the fourth quarter of 2011. The fourth quarter of 2012 benefited by a tax adjustment of $2.8 million or $0.05 per share. Our full year 2012 effective tax rate was 34% and our cash tax rate was 3%. Our GAAP diluted EPS for the fourth quarter of 2012 was $0.23 compared to $0.29 for the fourth quarter of 2011. However, as noted in our earnings press release, there are certain significant transactions that should be adjusted to arrive at a comparable adjusted EPS for 2012 and 2011. The fourth quarter of 2012 included a pretax debt extinguishment charge of $10.3 million or $0.11 after-tax EPS reduction, which was primarily noncash charge;, that is, $7 million was noncash and approximately $3 million was cash. Also, the quarter included a favorable tax adjustment for the extraterritorial income tax exclusion of $2.8 million or $0.05 EPS. Further, our fourth quarter 2011 results included an R&D tax benefit of $1.2 million or $0.02 EPS. We did not recognize any R&D tax benefits in 2012.

Adjusted EPS reflecting at the removal of these items resulted in a $0.29 adjusted EPS for the fourth quarter of 2012, as compared to adjusted EPS of $0.27 for the fourth quarter of 2011. This improvement in quarterly EPS reflects growth in consolidated revenues and operating results. Free cash flow for the fourth quarter of 2012 was essentially breakeven at $300,000. Capital expenditures totaled $11 million in the quarter. And at the end of the quarter, our cash balance stood at $232 million.

During the fourth quarter of 2012, the company opportunistically refinanced its long-term debt and extended its revolving credit agreement with a 5-year term loan priced at LIBOR plus 175 basis points. The $300 million existing revolving credit agreement was also extended to a new 5-year term with existing terms and conditions. The proceeds of the term loan were used to fund the tender of existing convertible bonds that were due in January of 2014.

Our updated guidance reflects greater uncertainty than usual at the beginning of the year due to both external events, specifically potential sequestration, as well as the timing of bookings and related program execution. Therefore, we are adjusting downwards by $25 million our revenues to a range of $1,425,000,000 to $1.5 billion. We're also lowering our operating margin by 25 basis points to a range of 7% to 7.5%. And we narrowed our EPS to be in the range of $1 to $1.10. We expect that our GAAP effective tax rate will be approximately 38% and our cash tax rate will be about 10%. We anticipate that our free cash flow will be breakeven to $20 million positive. Now I'll turn it back to Dave.

David W. Thompson

Okay. Thanks, Garrett. I'll now update you on the company's major operational events that took place in the fourth quarter and preview what's ahead in the early part of 2013. As I noted earlier, the company conducted 3 major space missions and also launched 3 smaller sounding rockets in the fourth quarter. These recent missions were highlighted by 3 commercial communication satellites that we deployed in the months of October, November and December. The company also completed and delivered 6 additional launch vehicles and satellites in the December quarter consisting of 3 commercial and government spacecraft and 3 missile defense interceptor and target vehicles.

For the full year, Orbital carried out 9 major space missions, launched 19 smaller scientific sounding rockets and delivered 20 additional systems for future applications for a total of 48 operational events. The major missions and deliveries included 5 satellite deployments and 4 additional satellite deliveries, two of which have been launched since the new year began. The major missions also included 4 rocket launches, while another 16 rockets were completed and delivered for future uses. One of these rockets was launched in January and 2 of them are scheduled for flights later this month.

Looking ahead now to 2013, the company has a busy calendar of operational activity planned for this year. Our current schedule shows between 20 and 22 major missions made up of 6 satellite deployments and between 14 and 16 rocket launches planned for 2013. We also expect to launch up to 20 smaller sounding rockets and to deliver between 18 and 20 additional systems for future launches during the year. Major rocket missions planned in 2013 include 3 Antares launches, 3 Minotaur and Pegasus flights and 2 or 3 Orbital Boost Vehicle interceptor launches, along with 6 or 7 target vehicle launches. Satellite deployment plans for the year include 3 commercial satellite missions and 3 government spacecraft deployments.

With respect to recent and near-term Antares events, cold flow propellant and pressured loading tests were conducted in December and January using the first Antares rocket with the operational launchpad infrastructure at Wallops Island. Just last night, our first attempt at the hot fire test of the vehicle's first stage was aborted by the onboard computer less than 2 seconds before engine ignition. Based on a preliminary assessment of the cause of the scrub, it looks like the turnaround work to prepare for another test will be fairly straightforward. I'm hopeful that we'll be ready for another try within a week. I would also observe that the countdown proceeded very smoothly with all vehicle and launch complex systems operating exactly as planned.

The successful outcome of the hot fire test will clear the way for the program's next big milestone, the long-awaited first flight, which will use the second Antares vehicle. Subject to completing pad refurbishment and vehicle checkout, we're planning to conduct the test flight in early April. If the flight is successful, the company will then complete assembly of the third Antares rocket, which together with the first Cygnus spacecraft that was completed in the fall of last year, will be used for our COTS demonstration mission to the International Space Station. This COTS mission is now expected to take place late in the second quarter or early in the third quarter of this year.

Our first operational cargo delivery mission under the CRS contract would follow in the fall, and our second CRS flight would take place sometime next winter.

I will now take you through the fourth quarter of new business results and discuss our outlook for the first half of this year. As I mentioned earlier, fourth quarter new business volume totaled $770 million. Our launch vehicles segment led the way with about $455 million in orders and option exercises, with about 75% of these being with defense customers and 25% being with nondefense customers. Our advanced program segment contributed approximately $275 million in volume, about equally divided between defense and non-defense customers. And our satellites and space systems segment rounded out the total with $40 million in new business activity, all of which was with non-defense customers.

Looking ahead to the first 2 quarters of 2013, Orbital currently has outstanding proposals for new contracts and option exercises worth over $1.25 billion that are expected to be decided by late this spring. However, with the situation in Washington with agencies operating under continuing resolutions for the first half of 2013 and with the possibility of the sequester taking effect sometime in the next month or 2, all of this means that new order opportunities this year are certainly less predictable and may well be lower than what we've seen in the last few years when Orbital averaged nearly $1.9 billion in annual new orders and over $500 million in yearly option exercises.

In summary, 2012 was a year of mixed results for the company with substantial successes in many areas tempered by disappointments in a few important ones. On the positive side, Orbital reported solid financial results for the year with revenue and operating profit setting new records for the company. We also achieved strong operational and financial performance in our established satellite and launch vehicle product lines with 48 launches and system deliveries being completed last year. On the negative side, the company experienced frustrating delays in completing the Antares launch site and in conducting main rocket engine testing, which combined to push back the first flights of our new launcher into 2013. We also feel somewhat short of our goals for new business wins in several major market areas including commercial and defense satellites due to delays and other changes in customer plans. With 2012 now behind us, we're looking forward to an eventful first quarter highlighted by major operational milestones in our Antares program. We also anticipate a busy year of satellite deliveries and rocket launches with up to 60 space missions and system deliveries expected in 2013. With good progress in these areas, we would hope that our shareholders will be rewarded with better stock price performance as the year proceeds. Thanks for your attention. We're now ready to open up the call for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first Western comes from the line of Bill Loomis from Stifel, Nicolaus.

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

Just looking at the -- in the first quarter, I know you don't give quarterly guidance, but the R&D tax credit, looks like you didn't take any in the fourth quarter. Is that all coming in the first quarter? And then also, in terms of the other programs, I know commercial had a strong quarter on with the true-ups and closeouts in the fourth quarter. Any unusual closeouts do you expect in the first half or first quarter as well?

David W. Thompson

Bill, this is Dave. I'll ask Garrett to field the first part of the question, and I'll comment on the second part.

Garrett E. Pierce

Yes. To make sure, you're talking about the first quarter of 2012?

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

No, the first quarter of '13?

Garrett E. Pierce

Yes, right. There -- our forecast on taxes are, as I said, the GAAP tax rate is 38%. There could be an adjustment as we true up our tax returns as most companies file the return in the ensuing years. So as we look at our final tax return, it could be a true up. And I don't expect anything significant in the first quarter.

David W. Thompson

And, Bill, with respect to the second part of your question, I don't anticipate that the profit margins on our commercial satellite work will stay at the levels that we saw in the fourth quarter and as we go into 2013. We had a particularly productive run in the second half of last year, and particularly in the fourth quarter. In the final 5 months of the year, we completed and launched 4 satellites. We also delivered a fifth one. It was launched last week. And virtually all of these satellites came in at lower cost than we expected. We had just terrific performance in our manufacturing and integration and test areas due to that volume. Usually, we expect that somewhere along the lines, something -- there will be some hiccups in manufacturing or test, but that didn't happen in the second half of last year. So those contracts were closed out without drawing down any of the management reserve that we had in them. So it'd be great if that happens again, but we're not counting on that as we plan 2013.

Operator

Our next question comes from the line of Chris Quilty from Raymond James.

Chris Quilty - Raymond James & Associates, Inc., Research Division

David, just a quick follow-up on the commercial SatCom part of the market. I think in your last conference call, you said you expect 2013 to look a lot like 2012. But can you give us your forecast for number of satellites and satellites in your class?

David W. Thompson

Yes, sure, Chris. To put it in context, by our count, there were 19 new commercial communication satellites ordered across the industry last year. 4 of those were what we refer to as small satellites and Orbital 1, 2 of those 4. The outlook for 2013 at this point is for somewhere between 17 and 20 new satellites to be purchased. So within 1 or 2 orders plus or minus of what we saw last year. At this point, we expect between 4 and 6 of those 17 to 20 satellites to be in the small category, and we're aiming to book orders for 3 of those addressable satellites, so sustaining roughly 50% share in our addressable market that we've had over the past 5 years or so.

Chris Quilty - Raymond James & Associates, Inc., Research Division

Okay. And excluding the positive benefit in the fourth quarter, what's a more sustainable operating margin for this segment when you're running 2 to 3 satellites through the factory?

David W. Thompson

Historically and prospectively, I think we've typically been in the neighborhood of 7%. We are spending a little bit more on research and development in the commercial satellite area than we did a few years ago to upgrade the product line, to allow us to compete for some medium-class satellites. And so, that's likely to hold margins in the short term at the 6% to 7% range.

Chris Quilty - Raymond James & Associates, Inc., Research Division

And the medium class is the -- goodness, I just blanked -- GEOStar-3?

David W. Thompson

It's what we refer to as our GEOStar-3 product, and although definitions vary a bit from a payload power standpoint, it picks up where the small category leaves off around 5 kilowatts and goes up to, say, 10, roughly 10 kilowatts. Our GEOStar-3 product will not address that full spectrum of 5 to 10, but will give us the ability to compete for satellites up to about 8, between 7.5 and 8 kilowatts of payload power.

Chris Quilty - Raymond James & Associates, Inc., Research Division

And when you look at this product category, you've got large players like Boeing coming downstream with electric propulsion satellites, maybe traditionally smaller satellite guys like Surrey moving up a bit. When you look at the portfolio on the satellite side, where do you think your best opportunities or challenges are going to be? And any thoughts on pushing the product category? You do some things, remote-sensing on the national space security side, but does it make sense to push Commercial business, which I don't think you've done since back in the ORB image days?

David W. Thompson

In specifically, Chris, in regards to imaging?

Chris Quilty - Raymond James & Associates, Inc., Research Division

Correct.

David W. Thompson

Yes. We follow that market and there are opportunities that develop from time to time. Most of those that are likely to be on the radar screen for the next couple of years are going to be with international operators. With the recent completion of the DigitalGlobe-GeoEye merger, we don't foresee near-term opportunities in the U.S. market, at least among the primary operator domestically. There are some international opportunities that we're tracking. Right now those do not factor into our bookings to revenue plan for this year. But looking out over a 3- to 4-year period, there may be some things that we could do there on the strength of work we've done in other market areas.

Chris Quilty - Raymond James & Associates, Inc., Research Division

And regarding competition in the GEO product line?

David W. Thompson

It has intensified a bit and it's shifted. I think you're correct in saying that Boeing is a bigger factor at least in the medium market, not really in the small market, but in the medium market, than was the case a couple of years ago. So I don't expect that it will be -- any of these areas will be ones where we'll find an open field without some challenging competition. But that's been the case all along, and I don't expect that to change looking ahead.

Operator

Our next question comes from the line of Gary Liebowitz from Wells Fargo Securities.

Gary S. Liebowitz - Wells Fargo Securities, LLC, Research Division

Garrett, could you give a little more color about the 2013 cash flow outlook? I thought maybe with CapEx coming down and milestone achievement on CRS that you might have returns at historical 7% or 8% of revenue type free cash flow. What am I missing?

Garrett E. Pierce

Well, firstly, the last thing you said is our goal, certainly to return -- that's our financial model, to get there. We have built up on the receivable -- on the balance sheet a significant amount of unbilled receivables in the form of CRS buildings that are not collectible at this point. And just to emphasize the fact that, that contract has payment terms such that the last 25% is not paid until essentially the mission is completed to the International Space Station. So that would be a drag. But as you pointed out, as we move forward the program, as we will this year, we're expecting cash flow to improve. Capital expenditures are going to be down, but they're still going to be in the range of $45 million. Last year, they were around $55 million. So that would be a drop of about $10 million. But I would say, the principal thing is on the CRS contract. Our other financial models for our GEO business works very well as it has to produce cash as our launch group, et cetera. So I would say the key focus point for us is the execution of CRS. And as we work through that during the year, we'd expect free cash flow to improve and then in the out-years, to return to the returns that we've had back in 2008 and earlier.

David W. Thompson

Yes. I would just add to what Garrett said regarding the CRS contract area that sometime in the late -- this first quarter or in the early part of the second quarter we expect to hit the point of maximum negative cash flow, cumulative cash flow on the CRS contract because of the billing holdbacks that Garrett referred to. In our operational plan for the year, we're assuming that only 1 of the 8 CRS missions is completed in time to affect the billing. If we do a little better than that, then we benefit on the positive side of cash flow for the year. We do expect that the profile of the cash flow will be back-end loaded, that the first half of the year will be negative and the second half will be positive, and the net will be a mild positive for the year.

Gary S. Liebowitz - Wells Fargo Securities, LLC, Research Division

Okay. Just one follow-up. Now that the Landsat program is done, can you talk about the utilization at the Gilbert facility and because I think Landsat was by far the biggest program there? And what the prospects are for more order intake there?

David W. Thompson

Yes, sure. You're right. As of a year or 2 ago, Landsat was the big ship in the harbor out of Gilbert. Today, we have 2 additional NASA science satellites. They're going through the engineering and manufacturing cycle at Gilbert. The first of those satellites is due for launch next year and the second is planned for launch in 2016. In addition, by the end of this year, the factory will start to get busy with the early work that will really ramp up in 2014 and 2015 as we carry out the -- both initially the low rate and then the high rate assembly integration and test of 80-plus Iridium next-generation satellites. All that work will be done at Gilbert. There's not much going on in our factory in the first half of this year other than preparing for the arrival of the first small batch of those satellites about this time next year or late in 2013 and early in 2014. We have some facility modifications that we're making and some test equipment and so on that we're either fabricating or buying. But by this time next year, we'll have the first few Iridium satellites in the factory. And by this time 2 years from now, things will really be humming in Gilbert with the Iridium assembly and test. And there's also some additional defense-related work that takes place there.

Operator

Our next question comes from the line of Tyler Hojo from Sidoti & Company.

Tyler Hojo - Sidoti & Company, LLC

Just firstly, you already provided kind of the segment guidance for satellite, but I was hoping you could perhaps fill us out on launch and advanced space programs?

David W. Thompson

Okay. Let me give you some preliminary indications of the way we see the components of 2013 adding up. On the launch vehicles segment, which is where we really expect the major growth to occur this year, we're looking at revenues probably in the range of $555 million to $565 million, up 5%, 6%, 7% over last year. Operating margins are probably going to be in the neighborhood of 8% plus or minus a few tens of basis points. Garrett -- or I guess both Garrett and I talked a bit about the satellites and space systems segment. That's likely to be -- it's going to be down a bit this year from a revenue standpoint. We're looking at probably somewhere between $470 million and $490 million in revenue for the year, down 2% or 3% from last year. Operating margins probably in the range of 7.5% to 8%. And finally, advanced space programs, also flat or maybe down a bit, likely revenue in the range of $440 million to $460 million, operating margins in the 6%, 6.5% range, something like that. And then the other -- the missing term in the equation that you need to round out a model would be the intercompany eliminations largely driven by the work, the Antares work in support of the COTS R&D program. That should be down quite a bit from last year from, I think, the eliminations last year were around $55 million. That should be down to around $15 million or $20 million this year.

Tyler Hojo - Sidoti & Company, LLC

Great. And then I also just wanted to move over to the CRS contract. I'm kind of curious if you could talk a little bit about reserves on that program. In the past, I believe you guys had talked about achieving kind of a high single, maybe 10%-type margin on those revenues. Is that still achievable with the most recent delays?

David W. Thompson

I don't think we'll get to 10% on this first CRS contract. We have been accruing profit at a 5% rate since the inception of that contract back about 3, almost 4 years ago now. We are roughly half -- we're roughly at the halfway point in terms of the percentage complete on the contract. We still need to get through the first flight or 2 of Antares and probably the first flight of Cygnus, and then assess where we stand from a cost standpoint before we would want to adjust the margins upward if there is a reason to do that. We still have pretty healthy reserves, but we've got to get through the next 6 months or so with the demonstration launch and the COTS mission to the space station before I think the time might be appropriate to reassess how much of the reserves might be released.

Tyler Hojo - Sidoti & Company, LLC

Okay, that's fair. And just one follow-on for me. You mentioned not getting to 10% this go-around. Assuming everything's successful from here, at what point would you start negotiating with your customer about a follow-on CRS contract?

David W. Thompson

I would guess that would take place next year, in 2014. The current CRS contracts will run through with launches continued through 2016. So if you back up a couple of years from that, given the lead times involved, I would expect that to take place sometime next year.

Operator

Our next question comes from the line of Greg Konrad from Jefferies.

Greg Konrad - Jefferies & Company, Inc., Research Division

Just quickly to follow up on Antares. I know there's a couple of IDIQs in place for additional customers. Can you talk a little bit about this activity and possible opportunities to add to the customer base for Antares?

David W. Thompson

Sure. Last year, we did receive 2 long-term IDIQ-style contracts, 1 from NASA in the middle of the year and another from the Air Force at the end of the year, the former covering just Antares for medium-class satellites and the latter covering both Antares for medium class, as well as our Minotaur family of vehicles for smaller class launches. In terms of how, of when we might first expect to see firm orders being issued under those contracts, I would say that's maybe late this year or next year. The main prerequisite to that taking place is we've got to get a couple of launches under our belt and demonstrate the performance and reliability of the rocket. Those conditions hopefully will be satisfied by this summer. And then it will depend, assuming we've done a good job, it will depend on the timing of satellite programs that need launches. Those launches probably are ones that would occur not before 2015, more likely in the '16, 2016 and beyond period. Although we -- with an order late this year, we could certainly support launches as early as midyear 2015. So that's the outlook right now and the main prerequisite is we got to get through the first couple of launches on Antares.

Greg Konrad - Jefferies & Company, Inc., Research Division

And then just in terms of national security stat or stats and knowing there's quite a decline in Q4 and that you talked a lot about the tough defense environment, which is understood. Is there anything else going on in that business in terms of maybe a strategy shift or market share changes?

David W. Thompson

Well, from our standpoint, no real strategy shift. We have historically focused on providing substantial capability at cost and on cycle times that are much lower than most of our competitors. That is to say that sometimes referred to as the 80% performance levels for the 40% or 50% price. I think that's a good strategy and will be an even better one in the future that it's been in the past as budgets tighten up across virtually the entire national security space market. We are not alone in pursuing that strategy, and we will have competition as we've had in the past in most opportunities that we see for the future. We've been early and vocal advocates of a new architectural approach to many of the national security space missions, in which this aggregation of multiple missions and payloads from very large platforms towards single or at most, dual payloads, small and medium-class platforms are adopted for reasons both of resiliency and economy. And we're seeing that this aggregation approach beginning to catch on. It sometimes doesn't move as rapidly as we would like it to, but it does seem like through many of the mission areas within the national security space market that this aggregation is now being adopted and at least the medium and long-term, if not the short-term planning, of most of the customers in that market.

Operator

Our next question comes from the line of Michael Ciarmoli from KeyBanc Capital Markets.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Garrett, if I may, just to look at the income statement a bit, can you give us what the expectation is for R&D spending? I think we've all looked at sort of your model and the financials. If we win, R&D starts to subside. Do you have an absolute dollar level or expectation that you'd be willing to share next year for us?

Garrett E. Pierce

Well, I certainly would tell you that it's going to be down from where it is this year. We came in at around $114 million in R&D for 2012, and I would expect it to drop significantly, potentially to $75 million.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Okay, okay. And then presumably, you can get back on to that trajectory? I mean, at one point, you were running, I think, $15 million to $20 million. Does it continue to trend lower in the coming periods as CRS rolls entirely off in the system?

Garrett E. Pierce

Well, I mean historically, we've run about what goes through the R&D line. There was a lot of research and development up in the cost of sales line historically, but that's been 1.5% to 2% of revenues. So as revenues go up, we would expect that to be maintained. As Dave pointed out, it's not an R&D program of any stretch of the imagination compared to COTS. But in SSG, we are spending from R&D money to enter in a more powerful satellite market to 78 kilowatts. So I would expect it to trend down though from the $75 million number I just added.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Okay, that's fair. And then just if I were to look at it, I mean that's $40 million of savings. What are we missing in sort of the -- what's causing a lot of that savings not to drop to the bottom line? I mean, is it just a different elevated cost on other programs, mix, gross margins? I mean, can you give us a sense of why we're not seeing all of that drop into earnings?

Garrett E. Pierce

I would say the main -- there are several factors there, Mike, but probably the big -- the dominant one, the biggest one for sure is we just right now can't count on replicating in 2013 the very strong satellite gross margins and operating margin performance that we saw particularly in the second half of 2012. I mean, there are other puts and takes. Launch vehicles should be a little stronger, advanced programs a little weaker. But most of that noise kind of cancels out and what we are left with is we had an extraordinary good run in 2012 in the commercial satellite business and a better-than-expected run in the science satellite business. And we'll work hard to replicate those, but I don't think we can assume that going into the year.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Okay, no, that's fair. And then, Dave, if we could just shift gears maybe. We've talked about Antares and other contracts and other potential uses. What about the Cygnus spacecraft? I mean, are there other potential uses for that capsule or is this going to be solely a CRS mission-dominated platform?

David W. Thompson

I think for the short-term, the next couple of years, it's probably going to mostly be used in just the cargo runs under the CRS contract. There are certainly mid- and long-term possibilities for other areas in which it could be employed, both in commercial and in government markets. Those are a bit speculative at this time. They, for instance, they include, in some modified configurations of Cygnus the ability to refuel or otherwise to carry out repair or servicing missions of commercial satellites, and they -- and it could do the same thing in some of the higher value government spacecraft. That's an area that I think sooner or later we'll see come to fruition, but I don't think it's in the real near-term -- it's in the category of being likely in the near-term. But those are things that we are exploring. And probably the best midterm avenue into that market would be through some sort of a government funded or at least cofunded demonstration program that might eventually open it up for broader commercial satellite use.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Okay, perfect. And then just a last one and I'll jump off here. On sequestration, does this outlook assume sort of sequestration or is there a potential downside if that goes into effect?

David W. Thompson

I would say at this point, we've tried to, at least at the low end of our range, we've tried to capture the, maybe not the absolute worst case, but a reasonable worse case from the standpoint of the federal budgets. From what we're hearing -- well, it's hard to make any sense on what we're hearing, but I think the NASA market, the NASA budget outlook is actually not bad. I think it's stronger with or without sequestration than the defense outlook. So I'm a little more concerned on the defense side than I am on the civil government side. And that's reflected, or at least we've tried to reflect it in our somewhat lower range of guidance than where we were last fall. Thank you, Mike, and thanks to everybody for joining us this morning. At this point, we'll wrap up the discussion and bring the call to a close. Thanks, again, for calling in today. Good morning.

Operator

This concludes today's conference call. You may now disconnect.

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