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

Q3 2009 Earnings Call

October 27, 2009 11:00 AM ET

Executives:

Karen Tripp - VP of Corporate Communications

Michael Strianese - Chairman, President & CEO

Ralph D’Ambrosio - VP & CFO

Analysts:

Robert Spingarn - Credit Suisse

Cai von Rumohr - Cowen and Company

Brian Ruttenbur - Morgan Keegan

Troy Lahr - Stifel Nicolaus

Joe Nadol - J.P. Morgan

George Shapiro - Access 342

Joe Campbell - Barclays Capital.

Michael Lewis - BBC Capital

Presentation:

Operator

Thank you patience. Good day ladies and gentlemen and welcome to L-3 Communications Third Quarter 2009 Earnings Conference call. My name s Francine and I will be your coordinator for today. (Operator Instructions). I would now like to turn the presentation over to your host for today’s call Ms. Karen Tripp, Vice President, Corporate Communications. Please proceed ma’am.

Karen Tripp

Good morning and thanks for joining us at the L3 Third Quarter Earnings conference call. With me 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. I will now turn the call over to Mike Strianese.

Michael Strianese

Thanks Karen, and good morning everyone. Thanks for joining us for our Third Quarter Earnings call. I want to begin by thanking our employees for their continued hard work and dedication to our program performance and our group presidents for their leadership and excellent performance in a tough environment.

Overall we had a good, strong third quarter. We saw some of the same business trends in the third quarter that we saw in the first half. Notably our ISR businesses including Integrated Systems, Greenville, Com Systems West, our EOIR products and our microwave business continue to do very well growing more than planned and offsetting weakness in government services and in our commercial businesses.

Aircraft Modernization and Maintenance grew significantly due primarily to JCA program. Additionally some of our specialized products business areas did very well notably EOIR and microwave both benefiting from ISR surge undersea warfare, which included the Chesapeake acquisition earlier this year in our Marine Services business.

Declining in the third quarter however were Combat Propulsion Systems and Stimulation and Training. What changed there was, in our propulsion systems business sales had turned down do to Bradley funding cuts and with simulation and training there was a slow down of DoD and foreign military sales orders.

Our backlog declined about $400 million in the third quarter because of more timing items affecting orders and because of reduced order flow in general. September 2009 backlog was $10.8 billion down 6% from December 2008.

Our third quarter orders were $3.4 billion and our book-to-bill was 0.88. That's a little lower than we had hoped for, nevertheless we believe they were timing items that affected the book-to-bill and we still think we are going to have a very strong year.

For the nine months, the book-to-bill was 0.92 and we expect it to be above one for the fourth quarter, slightly below one for the full year, somewhere in the mid-to-high 90s range.

Our third quarter sales were $3.8 billion with 5% growth. Our earnings per share grew 25% to $2.12 per share. If you excluded the higher pension expense and a $0.22 tax gain our earnings grew at 18%.

So however you measure it, earnings growth was strong in the quarter. Also very strong was our free cash flow, which was $405 million for the quarter up 19% over the third quarter of 2008.

We had a very strategic new business win during the third quarter. We won the SOCOM Expeditionary Unmanned Aircraft System or EUAS program as a prime representing our first significant UAV platform win with our Viking 400 system.

The EUAS program is worth about $250 million and it's under a five-year IDIQ contract. We were chosen over EUAS industry incumbents. Our Viking 400 is a tactical class UAS that is slightly larger more capable and less expensive than the competing systems.

Our Viking 400 discriminators are payload, endurance, smaller footprint and improved survivability. By way of background about two years ago we established a UAS working group within L3, which reached across the entire company. We have over 25 business units participating in this internally funded effort.

The EUAS was our first targeted opportunity. We have significant product pull through opportunities as well, notably our Vortex data links and our MX10 Electro-Optical and Infrared Turret.

As a result of this win and our internal efforts we've launched a new operating unit that is called L-3 Unmanned Systems and it's developing two other unmanned systems for future deployment. One is larger than the Viking 400 and one is a smaller system.

In terms of significant other activity in the orders area we had a lot of follow on business on several important legacy programs, notably our com systems for UAVs, Rover, our Phoenix System, Compass Call aircraft, law enforcement training, Fort Rucker, Project Liberty, special proprietary programs notably classified work at Greenville, AVCATT systems and our EOIR turrets.

As for major recompetes, the major outstanding recompete continues to be the Special Operations Force Support contract known as JOG. We lost that competition in March and filed a few protests because we determined and believed that some serious flaws remained in the selection process.

SOCOM is currently taking corrective action, which we believe validates that our protest had merit. They will amend the RFP and obtain new proposals, so we might hear something in the fourth quarter or first quarter. We can't rule out further protest if they are warranted.

In August, the ceiling of our current contract was increased again by $250 million and our period of performance extended through February 28, 2010. The new contract is up to $5 billion over 10 years. It’s a very important program to us and will likely grow because of its Special Operations Forces work.

As we discussed with you last quarter, L3 has very little exposure to the big-ticket programs that Secretary Gates has slated to be canceled or cut except for our JCA Program. It appears that most of all what Secretary Gates proposed for fiscal '10 will be passed by Congress.

With regards to our significant platforms and our programs, with respect to JCA, the proposal was to reduce the buy the 38 aircraft from the existing palm of 78 aircraft and to transfer the program to the Air Force from the Joint Program Office.

Significant support for JCA remains in the both the House and Senate. The army and the National Guard want more aircraft and recently the Air Force also said that 38 aircraft will be the minimum buy. JCA is a long-term program for our partner, Alenia, and us and we ultimately expect more than 38 aircrafts for the U.S military. However, there will not be funding for more than 38 until fiscal '11 or later.

Internationally, there has been interest in the foreign military sales aspects of this program with request from Ghana and Taiwan. So, we do still see a good future for the JCA program.

With respect to Project Liberty, as you recall, we will modify a total of 37 MC-12W Aircraft for the U.S Air Force. They are fully funded now. We delivered the first 8 aircrafts to the Air Force on time.

Our aircraft deliveries are complying and meeting our contractual schedule and Phase II aircraft deliveries, which are aircraft 8 through 31, are being accelerated at the customers' request. We look forward to continuing to apply L-3's expertise to other small aircraft ISR platforms.

Another program you may have heard about that would be a new program coming out as Aerial Common Sensor, which is expected to replace the U.S Army’s Guardrail and the air-borne reconnaissance low ISR fleets.

The ACS procurement strategy continues to change and slip. The army is significantly restructuring its reconnaissance surveillance and target acquisition approach to focus on today's fight with some mission redefinition towards a regular warfare and to use a layered system consisting of multiple platforms.

It will include the enhanced medium altitude reconnaissance surveillance system or EMARSS. The A160 Vertical Take Off and Landing Unmanned Aerial System and a Long-Endurance Multi-Intelligence Vehicle Airship.

The army is expected to proceed with a near-term procurement of EMARSS to focus on the regular warfare mission. The configuration will be similar to the Phase II Liberty MC-12 platform. We expect competitive rapid acquisition process with a draft RFP by year-end.

We are executing related IRAD, internal research and development activities in anticipation of that competition now. Medium-sized platforms similar in concept to the original ACS remains a possibility in the longer term, which by that I mean beyond 2012.

With regards to EPX, that is the program to re-capitalize the current EP-3 aircraft beginning about 2018, but it is likely that EPX will be delayed. L-3 is the incumbent on the current EP-3.

The Navy is conducting an analysis of alternatives from three teams and is expected to be completed in 2010. Then the Navy will transition to a technology development phase and likely down select two teams in 2011 with a further down select to one team in 2014 and 15.

L-3 is teamed with Northrop. Northrop is the prime our scope which is approximately an anticipated 40% of the value is in the sensor systems, data links and aircraft integration and possibly training logistic services and data storage equipment.

We believe that the EPX will be funded but likely with reduced capability and a smaller fleet size than originally envisioned. In the meantime, L-3 is the EP-3 incumbent today. We’ll continue to support and upgrade the EP-3 ensuring it remains revellent to the U.S Navy’s marathon ISR missions.

You might have recalled our program in the U.K know as Springtime which started out as the missions systems upgrade for the Helix aircraft, where that stands today is, the Ministry of Defense in the U.K. has requested now U.S Air force will join the aircraft as a foreign military sales replacement for the Nimrod ISR aircraft

The FMS program will provide three U.K. River Joint aircraft plus ground and training equipment. The aircraft will likely come from the U.S Air Force’s KC-135 tanker inventory. Logistics and sustainment will be provided under a separate Air Force MoD agreement.

Our scope for us at L-3 is ISR and mission data systems installation, logistic services and sustainment with an estimated sales value of $700 million over seven years. We have included U.K. industry partners (inaudible) on our team.

Where we stand today is, we still approval by the end of this year in a contract award in the first quarter of 2010, first aircraft delivery in 2013, and last aircraft delivery by 2016.

While we view this as a high probability of recurring on the time schedule, it’s not a done deal yet because of upcoming UK political elections where we could always end up with further slippage or they could have a negative impact on the program. Now withstanding that, we feel pretty food that this is going forward.

I'm sure you're aware during the fourth quarter we had several refinancing, which went very much according to plan. First of all, we issued a $1 billion of 5.2% senior notes back on September 29th. It represents L-3's first investment grade debt offering and we’re very happy to have brought our credit statistics up to investment grade.

We also made a redemption call for the outstanding $750 million of 7⅝ subordinated notes. We entered into a new $1 billion 3-year revolving credit facility on October 23rd. And we repaid $650 million of an outstanding term loan. Net, our long-term debt has been reduced $400 million and our leverage ratios of course are improved.

During the quarter, we repurchased $95 million of our stock, $396 million year-to-date. Our target for 2009 was $450 million and still included in our guidance and we believe we will complete at least $450 million.

At that level, our remaining authorization is about $535 million by the end of September, so we have plenty of room if wanted to acquire more stock.

Terms of acquisitions, we've been pretty quite this year, however we do continue to evaluate several companies, we’ve been cautious on valuations as I've been telling you, due to lower multiples for a public defense companies as well as slowing budgets and concentrations of business, sales in many of M&A candidates.

However, we're starting to see price expectations moderate and we are seeing several opportunities out there today. So we are engaged and actively looking at several companies.

We ended the quarter with about $1.2 billion in cash. Our 2009 guidance assumes we end the year with at least a billion of cash after repurchasing the $450 million of stock and the debt reduction that mentioned of $400 million.

So overall, we have a strong balance sheet and liquidity position and we, I think we are in a great position to be opportunistic should M&A opportunities arise.

We updated our 2009 guidance today increasing the low end of EPS $7.45 and the high end of $7.50 a share. We expect to see sales at about $15.5 to $15.6 billion, which will be up 4% at the midpoint.

We also provided our initial 2010 guidance in today's earnings release, we are expecting modest sales and EPS growth for 2010 by taking conservative position with respect to the SOFSA contract only assuming it in our guidance through February 10, which is the contractual period that we're covered under.

As in the past we scheduled an investor day for December 10th and we will have our Senior Management team including all of our group Presidents available to discuss in detail, the plans for 2010 and provide much more color on that guidance so, we hope you can attend.

That concludes my comments and Ralph is going to give you some financial details on the third quarter and then we will go to the Q&A. Thanks

Ralph D’Ambrosio – Vice President & Chief Finical Officer

Thank you, Mike. Starting with the third quarter, as Mike said, the diluted earnings per share grew 25% to $2.12 that growth was driven by growth in sales and lower share count and a significant tax gain.

The tax gain was $26 million or $0.22 per diluted share and it related to a favorable outcome on an income tax position, which is not recurring in nature. Including the tax gain, EPS grew 12%.

In terms of sales, consolidated 3Q sales grew $180 million or 4.9%. Growth from acquisitions and their divestitures were $27 million or just under 1%.

Again, 3Q buys in our segment had the highest growth, growing 21% or $132 million with ISR systems generating $108 of that growth.

Our third quarter sales in the Aircraft Modernization and Maintenance segment grew 17% or $108 million and that was of normally high and what happened there is all the growth on the JCA program that we are going to have this year versus 2008 happened in the third quarter and that amounted to $48 million.

Additionally, similar to the first half, we continue to have growth on the Helicopter Training, Flight Support work, SOFSA and the U.S Navy, P-3 modifications and together they offset the lower contract field services sales.

Sales in government services were down 3% in the third quarter, mostly due to reduced sub-contract and pass through sales and about $35 million on a large army contract. I've mentioned this item on the last conference call and said that that would negatively impact the second half of 2009.

It's happening there, so we have task orders that are migrating to a new contract vehicle away from our prime contract vehicle, because it's that feeling and on the new vehicle because they are not allowing second tier sub-contractors were losing pass through sales.

This change in contract vehicle will also have a negative impact on sales for next year. Additionally linguist contract sales declined $80 million in the third quarter.

Specialized products sales declined 2% or $25 million the biggest negative there was the continued weakness in the commercial aviation products and ship building products, which together declined $44 million.

Mike also talked about the declines in propulsion systems and simulation devices due to the Bradley fighting vehicle funding cuts and some other order delays. We expect Bradley sales to be down again next year.

Moving on to the operating margins, consolidated margin was unchanged at 10.9% versus 3Q of last year, even though we had higher pension expense, which reduced operating income by $21 million or margin by 50 basis points.

Overall margins were better than we expected, mostly due to timing items in every segment except C3ISR. Essentially all the growth and operating income in third quarter was in C3ISR but the margin there as you noticed was lower in Q3 than it was for the first half.

The main reason for those lower sequential C3ISR margins are that we were required to revise our overhead billing rates due to the large, rapid sales volume increase that we have experienced in the first half of 2009.

Those revised rates respectively give those volume cost savings to our customers. All told, it's a good trade because we have excellent customers there and also because we are required to revise those overhead rates under the cost and pricing regulations with the U.S. Government.

In Government Services our margins improved by 60 basis points. We earned some award fees earlier than we planned and we also had some favorable contract completion improvements and together they lifted the segment margins by $6 million or that 60 basis points.

From the aircraft modernization and maintenance and specialized product segments in Q3 margins also benefited from some favorable contract performance adjustments both related to cost side and the contract value side.

Free cash flow was up $65 million. That's due to better working capital performance.

And moving onto the full year 2009 guidance update, as Mike said we increased EPS by $0.20 rather on the low end and $0.15 on the high end. The new range is $7.45 to $7.50. Pre-guidance caused the EPS guidance increase. First we had that $0.22 tax gain in the third quarter that also lowered our 2009 estimated tax rate to 33.9%.

Secondly, we raised the low-ended guidance by $0.05 due to the better performance we had in Q3. And thirdly and finally, the refinancing that we recently completed which Mike talked about will reduce the fourth quarter EPS by $0.07 per share.

That includes a $0.05 debt retirement charge for an early redemption premium and $0.02 of additional interest expense related to the overlapping debt issues prior to the repayment of the debt in the fourth quarter.

However, beginning next year the debt refinancing will reduce our annual pre-tax interest expense, net of interest income by about $5 million or $0.03 per share. For the 2009 sales guidance we tightened the sales range from $15.5 billion to $15.6 billion.

On the Q2 call I said that we are closer to the low-end of the guidance and with the third quarter now behind us it may change to lower the high end of the sales range by $100 million.

We removed that $100 million out of the government services segment but that was a rounding mechanic more than anything else among the four segments. Also in government services, we've not incurred any new incremental sales losses due to the Department of Defense support services and sourcing initiative.

We made no other changes to the 2009 guidance. And finally looking at the fourth quarter, which you come back into from the 2009 guidance update and the September year-to-date actuals, we expect sales to be about $4.1 billion with lower margins than the third quarter and EPS of about $1.83 per share. That includes the $0.05 debt retirement charge and $0.02 of additional interest expense. Q4 free cash flow will be close to $300 million.

Today, we also provided our initial 2010 financial guidance. EPS, the initial guidance range is $7.85 to $8.05, which is an increase of about 6% at the midpoint compared to our 2009 guidance. Among other things, it assumes that pension expense is essentially unchanged in 2010 versus 2009. It also assumes a higher tax rate and about $500 million of share repurchases next year.

The sales guidance is $15.7 billion to $15.9 billion. Again we expect C3ISR to be our fastest growing segment. As Mike said, the 2010 sales estimates only include the SOFSA contract through February 28th, 2010.

So to the extend that we are able to retain that contract beyond February is going to represent a significant upside to next year's sales. If we are able to retain it for the whole year, it could add $400 million to next year’s sales guidance.

That’s also the reason why the sales in the Aircraft Modernization and Maintenance segment are expected to decline, SOFSA is in that segment.

In government services, we expect sales to be down slightly. That’s mainly because of $120 million headwind on that Army changing contract vehicle that I talked about a little while ago and we're also expecting some declining Iraq related sales.

Specialized products growth is slowing because of the decline that we are going to have on the Bradley Fighting Vehicle and we're also expecting commercial sales to be down another $100 million next year versus 2009.

And finally on the sales guidance. To achieve the high end we are going to need to avoid a few downsized risks, the most significant being continued weakness in government services and the possibility of more order delays in the stimulation device business area as well as more than planned softness in commercial.

Operating margin for next year we expect to improve by 20 basis points to 10.7%. Most of that increase is coming in the aircraft modernization maintenance segment, some of it from having fewer stock to sales, which are lower margined than the company composite.

We also expect to have some vast improvements in the two hardware segments C3ISR specialized products. Now the tax rate is going to be higher as I just mentioned. The higher tax rate next year versus 2009 is about $0.24 of EPS headwind.

And finally the free cash flow guidance is $1.25 billion. A major assumption there is that we expect to have higher pension funding $75 million more than 2009 to about $140 million for 2010.

That concludes my comments. Thank you and I’ll turn it back to Karen now for the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes Robert Spingarn - Credit Suisse.

Robert Spingarn - Credit Suisse

Mike, could you talk a little bit about the adjustment to profit that Ralph mentioned in the C³ISR area? We saw the operating income jump up in the second quarter, and I guess it looks you had to give back right back to the first quarter level. Could we get a little more detail on what’s happening here? Is there a trend? And it looks like the forward margin is somewhere between the two?

Ralph D’Ambrosio

Rob, let me take this question because it's more financial in nature. What’s happening there is, in C³ISR we have a lot of fixed price sole source business with the U.S Government. And under the cost and pricing regulations, whenever you have fixed price sole source business as well as cost-reimbursable business, and you have significant changes in overhead rates either way, you're required to revise those overhead billing rates.

And in our case where we had big volume increases, it had been 20% in the first half, that drove down the overhead and the G&A cost dramatically. And when that happens with the U.S Government, you give back savings back to the customer. And that’s what happened there. So I wouldn't call it a trend, it's basically requirement.

Robert Spingarn - Credit Suisse

Here's where I'm a little confused. If you saw most of the benefit from this in Q2, you had the big growth in Q1 as well, margins stayed kind at the same. So, what's the timing on this and which particular contract are we talking about.

Ralph D’Ambrosio

It happens across the companies and it began in Q3.

Robert Spingarn - Credit Suisse

I'm asking about the up tick, right. So the up tick, you had big growth in sales in Q1 and in Q2 but only the big margin expansion, well really in second quarter now that’s all reversing.

Ralph D’Ambrosio

Well, it's largely because of the rate in the changes in overhead billing rates which I just talked about.

Robert Spingarn - Credit Suisse

Second question is in the area of Iraq and Afghanistan Mike. What are you thinking your opportunities and head wins would be in south west Asia as the administration wrestles with the redeployment?

Michael Strianese

Well, we have two things going, we have war down that’s happening in Iraq and the question there is, can the up tick that we are starting to see in Afghanistan fully offset them and right now we are not planning that they are fully offset but we think there are upside opportunities.

In Afghanistan, first of all whether additional troops are sent or not, we believe that there is a strong focus and you would have probably heard it on most of news structures over the weekend in training the Afghan national Army.

A lot of focus on getting that army to standup a little bit straighter and you better train. We currently have just over 700 employees working there now under several contracts to the Ministry of Defense and the Ministry of Interior.

In both training and capacity building programs there is a lot of emphasis going on in the area of smart power building infrastructure. Earlier this year we were awarded a clean energy contract for about $80 million, a 4 year program to work with the interior department to develop alternative energy sources such as wind and solar.

We have also got a similar contract like that in Pakistan and while your question just focused on Afghanistan and Iraq, I don’t think you can neglect to include Pakistan as well because as you know the regional linkage of Afghanistan and Pakistan is vitally important.

And a great deal of State Department funding is going now to support smart power initiatives in both of these countries. So in addition to the Afghan initiatives that I had mentioned such as the smart power there are other initiatives going on in the area of public health, emergency management planning, law enforcement capacity building between our State Department and those governments.

So we’re optimistic about the opportunities associated with all these areas. They are all in one stage or another stage of development and there is yet to be contract formulation but we are pretty confident that they will go forward.

The bottom line however is the large smart power opportunities that are evolving in this region. It will probably not fully offset the draw down in Iraq for us but we think we are very well positioned to take advantage of whatever is available for us to bid on in both regions.

Robert Spingarn - Credit Suisse

So Mike, to conclude, should we think about government services as kind of a flattish business long term?

Michael Strianese

Well, in the short term, I would say it’s flattish until this money starts to get programmed.

A couple of things are going in line if you want to talk about a macro about the whole space. One of them is was becoming a little clear now is that this insourcing trend which everybody was worried about is a head win is not being equally or evenly applied across the customer base, some customer doing more, other are doing less.

It's certainly lumpy depending on where you are and what your services are. We think we are starting to see that some of, many of our services are not that susceptible to insourcing.

So one, we are feeling a little bit better on the insourcing. The second head win in this space has been OCI or conflict of interest which is also a concern and again the rule making isn't reality in place or has been tested yet, so we don't know that how much, what extent that have on our ability to bid service programs that would potentially conflict with our hardware programs.

Nevertheless we don't think that is big to us as it is to other players in this space. Thirdly you have the emerging areas and whether it's smart power, energy or nation building and training. I think you can't take one, that will be a driver, but I think if we can do well across the board in all of them we could probably see low-single digit growth in that space.

So I'd say flat to leaning up Rob, it's a long answer, but there is a lot of dynamics in that space right now.

Operator

Your next question comes from Cai von Rumohr - Cowen and Company.

Cai von Rumohr - Cowen and Company

Yes, thanks a lot. Mike, could you comment a little bit on what you might have in terms of initial consolidation opportunities and secondly maybe on government services, why the margins are flat next year what seems to lower margin linguist and pass through business moving down?

Michael Strianese

Let's take the first one and maybe Ralph will talk a little bit about the margins, cover the margin detail. In terms of the outlook and services -- I'm sorry. Ralph why don’t you do the margins first and let me get to my other topic.

Ralph D’Ambrosio

On the government services margins next year versus this year, your observations are correct. Based upon the declining pass through sub-contract sales and from lower linguist sales, everything else being equal, we should be seeing an increase in margins there.

However, as we talked about on the 2Q call, we explained that our uncertain re-competitions and another new pursuits, we are having to bid more aggressively on price given the competitive situation. For now, we are holding those margins constant.

You can be sure that we've passed our groups and divisions to improve those margins. I'm just not comfortable committing to it yet, given what's been happening in government services all year long.

Cai von Rumohr - Cowen and Company

Okay, and then Mike on the consolidations.

Michael Strianese

I'm sorry, but I wanted to just check my notes once again, consolidations are kind of sensitive internally and I wanted to make sure what I tell you it was announced already. First of all, on services we are looking at driving our cost down further, so we are consolidating our intelligence solutions division with our IT services business unit and putting them under one common management structure.

That will bring together approximately two $700 million units under one overhead structure and will drive our rates down

In addition, as I said we had put together a new operating unit that will be known as L-3 unmanned systems. And as you can appreciate over the ESO, a number of smaller, whether it was Geneva Aerospace or BAI or ASD etcetera, small players in this space, we've now brought them under a common management structure and they will start to share common overhead functions as well as some facility moves.

We have done a lot of the heavier lifting on consolidations but every year we try to push to get a few more done. So those are the two bigger ones we are looking at now.

Cai von Rumohr - Cowen and Company

Terrific. Last one, Ralph on pension, you said it's about flat. Could you remind us what your assumptions are regarding the discount rate and your investment performance this year and tell us where your performance is year-to-date in terms of your investments?

Ralph D’Ambrosio

Sure. The flat pension expense 2010 versus 2009 contemplates the following two major assumptions. On the discount rate, which was 6.5% for 2008, we are assuming that it tightens and declines to about 5.8% and that negative is being offset by better than planned pension asset return.

Year-to-date we're up about 16% compared to the plan assumption of about 8.75%. So obviously we will be updating what happens to the pension expense next year when we get to yearend and we set the assumptions on December 31st as you know.

And if rates continue trending the way they have for the past week or so which is upward

We could end up having a small tailwind next year. And additionally on the asset side, what you are seeing in 2010, is a benefit of us not using a smoothing method and using a same value mark-to-market method.

It was a big negative for 2009 whereas you know, we experienced the full brunt of the negative asset returns in 2008 and the good thing about that when you don’t do smoothing, is you get behind you immediately. So, depending on what happens in the financial markets, we could have a tailwind next year on pension.

Operator

Your next question comes from Brian Ruttenbur - Morgan Keegan.

Brian Ruttenbur - Morgan Keegan

The first question I have is the biggest contracts and awards and re-awards in 2010 that you are looking at. We obviously know about the JOG, on hopefully, the re-award side, but what are the other big contracts that you are pursuing that we should be looking for in the size of this?

Michael Strianese

In terms of major recompetitions, JOG is by far the largest one. We have a few others. There are three programs. Collectively, they will generate about $200 million of our 2010 sales guidance. One is in source election right now as the multinational forces. Intel support services, army contract in Iraq, that’s about $100 million.

We expect to recompete one of our Afghan support contracts and a CLS contract with custom and borders patrol. So, those three again account for about $200 million in next year's sales. The good news is that once we get pass JOG and we have been saying this for a while, we don’t have any significant multi 100 million dollar re-competition in terms of annual sales until 2011, 12 or 13, so.

Ralph D’Ambrosio

In terms of the major new business pursuits there is a lot going on the ISR side, some of it classified in nature. We're pursuing a lot of new business in government services and in the aircraft modernization maintenance side, on the CLS work, but frankly we factored that significantly down.

So the last thing we want to do is start factoring significant competitive winds in our sales base. I’ll like to wait till we win the programs to put them in the guidance and the plan.

So nothing really huge out there in terms of new business pursuits that more on talking about individually right now.

Brian Ruttenbur - Morgan Keegan

Very good. The other question I had was growth by division. You already addressed government services, but C3ISR, do you anticipate over the next kind of three years fee, is that going to still remain double-digit growth or is that going to slow to high single digit and maybe you can talk about each division other than government services that you addressed.

Ralph D’Ambrosio

Well on ISR from everything we know now, we would expect to continue to see double digit growth or high single digits, you know whether it’s 8 to 12 in that trademark remains to be seen. A lot of this is driven by the current efforts in Afghanistan and in Iraq.

So as they go solo-ISR, it is becoming increasingly apparent though that when your operating in those types of regions in Afghanistan especially given the challenging terrain and you’re fighting an enemy that mixes in with the general population, that’s very hard to locate that ISR is the hands-down winner in what’s needed.

A good way to think about it is, well if you're worried about it being saturated at some point the (inaudible) view that you're typically getting on these platforms is only scratching the surface in terms of what can be done, in terms of overhead surveillance using the platforms. So we consider to see this a growth area for many years to come.

AM&M is going to be driven by the fact that newer platforms just aren't going forward in the U.S or globally, and you have an ageing fleet of airplanes with ageing mission systems, as well as structures. And while it has been slower than we would like have like to have seen, I don’t know we can ignore the fact that without new platforms the old ones have to be maintained and upgraded both again from a flight worthiness to a mission systems standpoint if it's being used in any type of electronic surveillance applications.

Applications need to be upgraded just to keep them relevant to the threat environment, so we think all the dynamics in that space are positive for us to continue to grow.

Products, you've to take them one at a time. There’s things that are going to be growing, there’s things that are going to be flat, there’s things that are going to be shrinking. Net-net, we think that the diversity in our products portfolio it's over $5.5 billion in sales, the target should be around 5% gross growth over the long term.

Now that’s not every year because we have our budget headwinds this year in the commercial space both in the avionics and in the equipment, we supply to the ship building industry.

When you think about ISRs, it's not just the ISR segment, it permeates the products as well in terms of ground station equipment, EOIR, sensors, as well as other black box type of equipment.

Those areas continue to grow, training and stimulation, it should continue grow, flattening out would be more like the telemetry area. Some of our, we think that the heavy bleeding and combat propulsion is over, so that should stabilize but be barely flat for while.

And we have, based on what we are seeing in terms of how commercial aerospace companies are trading, it looks like the recoveries already priced in, we've yet to see that in our business book in that space but that should be an up tick in the future as well.

So that’s, without going into extreme details we will give a lot of detail on there area at our investor day because it will take long time to go through each and every one of them on balance we think about 5%.

Operator

Our next question comes from Troy Lahr - Stifel Nicolaus.

Troy Lahr - Stifel Nicolaus

Can you talk a little bit about the head wins that you are facing at the commercial aviation and the ship building and specialized products. Dose that start to recover in the back half of the year or is that more of a 2011 recovery, how long will these be soft do you think?

Michael Strianese

Well what we see is more of a 2011 event. But, the one that has a little clearer path right now is the avionic side. Again, as I said, given the stock performance of the companies that are - to replace in commercial, aviation, you would think its right around the corner.

For our business we see it as a little bit further out and we've had declines in the north of 20% area in both our Aviation reporters and our TCAS businesses. Displays has been better because we have a significant military component in the displays are and as you know that’s one of our high margin businesses.

On the ship building side, there has not only been a very steep drop off in new buildings, but of course you have a lot of ships parked outside places like Singapore and Malaysia. So we think before that order book gets healthy again, not only does the economy have to pick up but the ships that are idle right now would have to start to get back to work.

So that is going to be a little longer with the exception of two areas. One is in cruise ships, building still continues and we are providing bridge to propeller solutions on several operators fleets and the commercial offshore business that serves generally, the oil services.

A specialized platform is being built for drilling and servicing that are continuing to provide a base for that business area for us. So again, I would not say I expect to see that and it is certainly not planned to pick up in 2010. We are looking more towards 2011 and beyond for both those areas.

Troy Lahr - Stifel Nicolaus

I think in the past you talked about possibly there’s going to be a re-compete for linguist. Any update on that?

Michael Strianese

We are expecting that there should be an RFP later in the fourth quarter if not early next year to deal with the requirements in Afghanistan and we will certainly be a bidder on it.

Troy Lahr - Stifel Nicolaus

And any timing on the expected award for that if it’s the RFP’s fourth quarter?

Michael Strianese

I would put my estimation about a 90-day process, it will put it in the second quarter.

Operator

Our next question comes from Joe Nadol - J.P. Morgan.

Joe Nadol - J.P. Morgan

Thanks, good morning Mike and Ralph. First question is just on the bookings. You noted Mike, I think that there were some timing items, where those two, three timing items or those 2009 timing items and could you quantify them?

Michael Strianese

Yeah, that's a difficult question Joe, because putting a number on it is not going to be very easy. But let me tell you what we see and I think you are probably hearing this around the industry, is that due to probably a number of factors and I can't give you one in particular, whether it's changing personal on the government side in contracting or delays in funding or different policies or whatever.

But money that should be programmed is not getting programmed, but put on the contract as rapidly as it has in the past so displacing things do not get booked on a timely basis.

Now if you start to split well how much of it is things that have gone away versus how much is things that are relative to the fourth quarter versus how much of it is things that will run into the first quarter, I mean it would be a crap shoot investment guess from our standpoint.

I think the proof, the better answer will be when we see how strong the fourth quarter is, we said we are predicting a book-to-bill of over one and I think that's going out. I would say it's going out on wimble, we are very confident it'll be there, just a question of how far or when it gets just to bring us all.

Remember we were hoping to see one for the year and right now based on the slippage we are seeing, we are seeing in the high - 9.9 7.9 6 something like that. I would tell you mathematically if you took that delta what the one is partly now and what that calculates to, that's how we are calculating slippage to be, because we don't think it's things that have moved out

Joe Nadol - J.P. Morgan

When you look at the product business specifically here about $500 million below one to one year to date are the slippage is there or is that to commercial part of the business that you are getting impacted by or all the above.

Michael Strianese

It's well it's all the above Ralph have probably has color on that, tell you on the, the order book has been down substantially on the ship side, but can you Ralph give us some numbers.

Ralph D’Ambrosio

Well, most of the commercial business that we have is in specialized products so the down turn that we experienced in aviation in ship building products is impacting the book to build negatively for certain.

We had a timely item we were expecting $100 million fuse order that slipped out of Q2 and we thought we are going to book in Q3. We just booked it two weeks ago. So $100 million on this timing happened in Q4 for example.

We talked about the Bradley fighting vehicle funding-cuts that's about $70 million impacting that segment. We still see delays on the securing detection system side coming out of the TSA.

And that's odd because the TSA is going to receive economic stimulus funding, but that stimulus funding hasn't translated into orders yet. And then also in specialized products I've talked about this on the Q2 call, we've experienced significant delays in the stimulation device business both on foreign military sales and on the DOD side.

And those are instances where we sell source in many cases its only competition we just waiting for the orders to drop. And that continued into Q3 and we see lot of orders slipping out of '09 right now. So that's a big factor in excess of $100 itself. So that's the sampling of what's going on in specialized products Joe.

Joe Nadol - J.P. Morgan

On C3, Mike you noted that, I think you said I don't want put words in your month that beyond next year you still think that kind of a 10% type growth business but you also said as Iraq and Afghanistan so goes the growth rate.

So could you help in that and I know this is getting a bit a round of speculative since we are so far off. But conceptually how do you think about that?

Michael Strianese

I'll give you great example, if you look at Project Liberty it's being delivered to meet specific requirement in theater Now I would have to assume that without an Afghanistan or Iraq we would not have had Liberty.

So therefore it's the driver as well as the Rovers that we are selling as well as the ground mobile terminals that we're selling and data links and the life. So let's look at this and its kind of interesting question Joe because you can really roll over the place with this.

But you say that all right we're going to pullback the troops whichever strategy the U.S follows, we're going to increase troops, we're going to pullback troop. There's still going to be indication to have more overhead and more ISR.

If we completely walk away, I mean I think of that some, I still think you are going have ISR because you are not going to want to take your eye of the threat regions. So it's hard for me to consider a scenario where it’s not going to be required.

The equipment and this equipment is evolving and new threats were identified that things change and better ways to do it. So, it's kind of very iterative. The only thing I could tell you would be negative, if everything stopped in those regions and we weren’t going to engage with our ISR assets and we are not going to be building up the inventory either. Well, then I can see a heavy negative.

But I don’t see any of those factors. I think that whether we send troops; don’t send troops and scale back to a quarantine type of a strategy, abandon the project. You are still going to have the ISR. So that’s why I'm comfortable that we are going to see continued growth in that space.

Joe Nadol - J.P. Morgan

And then just one more quick one. Ralph, your collections have been very good. It looks like you are expecting that to continue into next year. Are you seeing any pressure though, it seems to me that some companies have been seeing a little bit more working capital build. What are you seeing on your end?

Ralph D’Ambrosio

Definitely the government orders are ordering more diligently, I will tell you that. But the reason why we are still over anticipating some modest growth in free cash flow for 2010 versus this year, we are not anticipating any meaningful improvement in working capital.

We had a couple of anomalies in 2009, which we talked about at least for a couple times earlier today. One was we do a lot of our payroll on a biweekly basis. When we do that, you are going to end up having a year where extra payroll payment drops. That dropped in 2009 and that is costing us about $110 million of free cash flow in '09. I don’t have that next year.

Additionally in 2009, we worked off about $40 million or $50 million of previously collected customer advances and we don’t have that phenomenon next year. So those two benefits are being offset by the higher pension funding of about $75 million. It nets down to about $50 million improvement or so and free cash flow for next year.

Joe Nadol - J.P. Morgan

Now in working capital in your plan is it what?

Ralph D’Ambrosio

Excuse me Joe.

Joe Nadol - J.P. Morgan

Working capital in your plan next year is a zero or is it a small use of cash or?

Ralph D’Ambrosio

Right now we have it as use of cash of about $50 million. And we’ll keep you updated.

Operator

Your next question comes from George Shapiro - Access 342.

George Shapiro - Access 342

Mike can you just update us on your thinking as far as how much sales from Iraq currently and how that is still going to trend?

Michael Strianese

The Iraq number for next year, we’ve taken it down, it’s approximately for 2000, just to give you a point of reference towards with. We are just north of $1 billion in '09, we are at about $1.1 billion. In the 2010 plan, we’ve modeled it to $800 million.

So it's down about 300 million. There is a modest offset for Afghanistan going from 2009 of about $275 million up to about $350 million in 2010.

And one of the previous questions I kind of went through a list of other opportunities in Afghanistan such as the soft power, smart power areas, as well as services that could be performed for Pakistan as well, which are not in the plan and provides some modest upside. But we don't want to count on them since these are new contract vehicles as well.

I will tell you the IRG acquisition made at the beginning of the year kind of put us in a good place because those energy programs that we won, one in Pakistan and in Afghanistan, the alternative or clean energy contracts were solely due to IRG.

So we think we got the right mix of offerings for both regions. It's kind of getting the money on contract.

George Shapiro - Access 342

I mean really you're still seeing pretty decent growth next year when you look at the fact that between Iraq and Afghanistan revenues are down $200 million or is it a lot of that is double accounting with not having a JOG program?

Michael Strianese

A $125 million of that roughly is JOG. So yes I mean it is a bit of double account. Yes, the balance is everything else it's off a little bit. A little bit less law enforcement, a little bit police training, a little bit less equipment maintenance and it all adds up a little less on the Bradleys etc.

George Shapiro - Access 342

And Mike for your fourth quarter book-to-bill, what’s been your assumption as far as when the budget gets passed because we may wind up with a continuing resolution till sometime into December the way I'm hearing it now?

Michael Strianese

Right, now I don’t know that we have a lot of trigger items that are going to hang on the budget. I guess as soon as it gets done in the end of November, early December, we should be fine. If it goes much later, given the pace of things in Washington, you're going to see slippage out of the year. It's just going to happen. It will show up in the first quarter then but we were assuming by the end of November, early December the latest.

George Shapiro - Access 342

And Ralph just back to the C3I margins guidance. I guess the question I had on it, is why was the adjustment in the third quarter versus the second quarter?

I mean obviously you've been anticipating it all here because you haven’t changed your overall segment guidance margin in that area. But just from a timing perspective?

Ralph D’Ambrosio

That’s when the customer and the government did it. I mean what happens is, we give our customers, the ACRO update in a monthly basis. They have to get around to negotiating in a new overhead billing rates.

And when they get, when they become negotiated, or when they executed or finalized they become effective from that point on respectively. That happened at about the beginning of third quarter and what's happened is that our overhead rates have about 200 basis points.

That was dropping into operating income, now the customer gets the benefit of it. That’s the way it is, that’s the function of being fixed price contract with U.S. government and we like that tradeoff overall because like I said, we have some excellent customers particularly in that segment.

Michael Strianese

Having grown up with this, George what happens is you are using a look back for the historical switch, your forward pricing rates. It just has been -- typically happen in periods after the actuals, right.

So its kind of - this is not really a, it’s a little more dramatic because if you look at the volume that went up this year because of things like Liberty and the like in that segment but its really not something that’s unusual for our business at all.

George Shapiro - Access 342

Ralph, just for clarity, the fixed price contracts would be fixed price incentive contract you have as opposed to firm fixed price contracts?

Ralph D’Ambrosio

Well, it is really all types of fixed price contracts and what changes is, you still collect your fixed price fee, it doesn’t change, but you are only able to build lower overhead cost and that ends up reducing the profit margin, the way it works mechanically.

The other item that is also impacted in 3Q buys, I didn’t talk about it earlier. On why the small aircraft ISR worked out, we do with Liberty and others. We have been transitioning to a little more logistic support work from modification work and you earn lower margins on logistics work.

So, that is also effecting the margins in Q3, it is not a big as a driver as the revised lower overhead rates.

George Shapiro - Access 342

Very good, that clarifies it, thanks a lot.

Operator

Your next question comes from Joe Campbell - Barclays Capital.

Joe Campbell - Barclays Capital.

Can you say a little more about what is happening with Bradley? There was always a lot of talk about if they were drawdowns in Iraq. Some of the Bradley's would come home and the demand would go down, but then there was always this commentary about reset and people talked a lot about the huge reset bill that there was going to be. Is this just a gap as people come home and we haven’t begun the reset or is there a story that goes with this?

Ralph D’Ambrosio

I think it is, it is what’s inside that Bradley's aren’t going to be used in Afghanistan. So, two things happened, that is one. So, there is no emergency to continue to upgrade. And two, there has been redefinition of what reset money can be used for, I don’t know if you have seen this go through, but they congress has made a very narrow definition of reset meaning you cannot put any improvement, use reset money to a platform.

So it's kind of closing problems, now we upgraded, so should be putting in a new transmission on upgraded piece of hardware to an existing platform does not qualifying as reset anymore.

So, we are sure the reset bubble is there, but getting the money on the problem is not there yet. So and the emergency to or the urgent requirement to get these transmissions upgraded as they pull out of one theatre and roll them into the other (inaudible) not using them.

So the compliment to those, I'll be honest with you, our customers are even surprised that this funding was cut. So this one caught everybody by surprise that that money was taken away and reprogrammed somewhere else.

Joe Campbell - Barclays Capital.

Okay, secondly on Liberty, it's been going up a lot. Is there any risk that you do so well on it, that you thought of in some sense completed and it starts to go back down or there are so many follow-on and if somebody Ralph eluded to change some modification to logistics support and so on that it might be, that it plateaus a bit, but it doesn't have any kind of bubble work goes up and goes down?

Ralph D’Ambrosio

I don't know that's a possibility. I don't see, we are just fixing the follow-on doesn't necessarily offset completely the hardware sales aspect. But, I think that there is enough building requirement from the operational experience they have.

Listen after first seven they went to the second configuration already, eight through 37 and I'm sure as we speak that there is a list somewhere of things that they'd like to change already to adjust the operating dynamics of the platform including putting some additional equipment and that's rather significant that I'm aware, but not liberty to talk about.

So I'm fairly confident that they'll see a pretty good tale in terms of modification to the existing fleet and possibly additional platforms that will go out here.

So some modest modification upgrade work along with logistics and tail work that you'd see should give us modest growth maybe not as deep as today, but I believe it will continue to grow.

Ralph D’Ambrosio

And then lastly you've got these two new UAVs, some of the UAVs have been out there and it's hard to tell exactly how often and how much they're being utilized, others are a bit more in the press like predator.

One of yours is I guess that size, is there going to be some attacks on the incursions and what has been sort of very Predator soul source business for the Predator guys?

Ralph D’Ambrosio

It doesn't replace the mission of the Predator at all.

Joe Campbell - Barclays Capital.

It's a collection platform.

Ralph D’Ambrosio

Yeah, it's a different platform although, let's talk about it, because it’s been at the show. It was at AUSA and it was the Air Force Association Show. It's a platform that's known as a Mobius.

Whereas the Viking is our platform, we make the Mobius as the platform that we are purchasing but [missonising] and what makes Mobius very different than Predator or anything out there first of all is that it comes in at a very disruptive price and it has the ability to operate manned or unmanned, it's what we call optionally manned for a single pilot.

So as you probably know you cannot operate any of these UAVs in civilian airspace because of the (inaudible) VOIT requirement.

This would allow you can use your imagination this plane to be flown into an area especially with some of the agency work that we do, flown into an area where it needs to be used piloted and then the canopy comes off you can put additional fuel or sensor packages in there and it operates on an unmanned basis.

It has more compared to predator, it's going to operate around 24,000 feet but it can operate in about, in terms of maximum rate of 25. Operationally predators at 15,000 this can operate from 6 to 24, endurance for both of them is about 24 hours.

Speed, we have a big advantage a crew is on a predator 70 to 99 knots, ours is a 150. Maximum speed for us is 215 knots predator is about 117. So time to station, time on station is much quicker.

So we're trying to find an niche area that's un-served and if you look at, if you put the programs of record in terms of UAVs on a piece of paper and look at their operating characteristics, we end in a wide space we were coming in here with the Mobius.

Now there is not a program or record here, so this is a little different usually we go to a program requirement or an RFP this is getting outside the box with the R&D but we view this as a very same place to put money rather than if you think about what some of the UAV company sold for in the recent years, billion dollar plus price tag.

I mean we've done this inside a $20 million so far. And we have got a program, a record. I am very, very proud of my guys, our guys here at L-3 for what they've done.

And we're getting a lot of interest in the Mobius. So the hope is that this gets on contract in the next year or so and becomes a program. The smaller one is more of an expandable that can be weaponized or not and get down real, real close and look at a target.

And it can be launched from our existing family, all two of them of our UAVs. But we are making this interoperable, open-architecture that can run anybody's sensors, they can run on anybody's ground stations as well. So we think we've got it. We think we've got a pretty good selection of products here.

Operator

Your next question comes from Michael Lewis - BBC Capital.

Michael Lewis - BBC Capital

Actually a follow up on Mobius and Viking. Mike I was wondering, do you have a 100% content on Viking right now since you provide the flight control and EO/IR sensors and all those components.

Michael Strianese

I would say we have substantially all, I can't guarantee it’s a 100% but flight controls, ground station controls, data links, telemetry, reporters, comps. I'm sure there is pieces on that we don’t make, that we are buying.

The logic behind doing this internally by the way, is we have so many pieces of things that went off to UAVs that an obvious question is (inaudible) we put it real together what do we get?

Do we get a state-of-the-art system that we can go to market with? So I would tell you all the critical components such as the sensors, the comps, flight controls, are L-3 systems.

Michael Lewis - BB&T Capital Markets

And I think that where I was going, the specific sensor portion is a high content L-3. And then just on Mobius. Would you consider this as a larger tactical or do you think this is a strategic type UAS and also do you have the capability to weaponize this system?

Michael Strianese

I would consider this more in the tactical space, because of its size. I really don’t have any comment on being able to weaponize at this point. We have got to find a customer first.

Michael Lewis - BBC Capital

With regard to the question on the bookings, you talked about the order flow impacting Q3, I just want to make sure I understood this correctly, you did not experience any contract cancellation to this, it is just really in relation a timing slip into Q4 maybe as late as Q1.

Ralph D’Ambrosio

That’s correct.

Michael Strianese

On the tail of that question, let me say. I mean particularly as an example, the transmissions at Combat Propulsion for the Bradley.

Michael Lewis - BBC Capital

That was cut in two-twos.

Michael Strianese

Now as we also said, there is a reset bubble that has to get spent anyway. So, you can view that as a [couture] in delay, eventually these transmissions have to get replaced. It is just that they don’t need them tomorrow. So, something else has stepped up and taken that money as a priority.

So, it’s not like a new system that’s going to wait forever. There is a requirement here, it has got to get funded eventually, it's just I can't tell you it's next year anymore or I can't say anything, because we don’t know.

So, mostly just walk away and leave broken Bradley’s all over the place. I have to believe these will get fixed someday, but in any event, I guess that wraps up our Q&A.

Thanks for a rather engaged call and I look forward to seeing everybody at the Investor Day where we can go through, in a bigger time footprint much more details on what we see going forward next year. We’ll have all experts in the room and we hope to see you there. So thank you.

Operator

Ladies and gentlemen we thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a good day.

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