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L-3 Communications Holdings (NYSE:LLL)

Q3 2013 Earnings Call

October 29, 2013 11:00 am ET

Executives

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

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

Robert W. RisCassi - Former Senior Vice President

Analysts

Myles A. Walton - Deutsche Bank AG, Research Division

Carter Copeland - Barclays Capital, Research Division

George Shapiro

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Robert Spingarn - Crédit Suisse AG, Research Division

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

Howard A. Rubel - Jefferies LLC, Research Division

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Robert Stallard - RBC Capital Markets, LLC, Research Division

Operator

Good morning, everyone, and welcome to the L-3 Communications Third Quarter 2013 Earnings Conference Call. [Operator Instructions] Please note today's event is also being recorded.

I would now like to turn the conference call over to Mr. Alex Hamilton of FTI. Please go ahead.

Unknown Executive

Good morning, and thank you for joining us for L-3 Communications' Third Quarter Earnings Conference Call. With me are Michael Strianese, Chairman, President and Chief Executive Officer; and Ralph D'Ambrosio, Senior Vice President and Chief Financial Officer. After their formal remarks, management will be available to take your questions.

Please note that during this call, management will reiterate forward-looking statements that were made in the press release issued this morning. Please refer to this press release, as well as the company's SEC filings, for a more detailed description of the factors that may cause actual results to differ materially from those anticipated. Please also note that this call is being simultaneously broadcast over the Internet.

I would like to turn the call over to Michael Strianese. Mike, please go ahead.

Michael T. Strianese

Thanks a lot. Good morning, and thanks for joining us. Our third quarter results, which were out this morning, reflect strong growth in earnings per share, net income and solid cash flow. Importantly, we remain focused on outstanding program execution, operational excellence and winning programs in what's become a very challenging industry environment, including the sequestration constraints, the Afghanistan drawdown and the lingering effects from the partial government shutdown we just went through. Our leadership team and employees have done an exceptional job, however, in executing in this environment.

Earnings per share and net income continued to grow, reflecting those efforts. We generated diluted earnings per share from continuing operations of $2.23, that's a 13% increase compared to last year's third quarter, which was $1.98. Across our businesses, net sales decreased to $3 billion, which is about 9% compared to last year's quarter. However, net sales to commercial and international customers increased by 2% over last year's third quarter and rose by 3% year-over-year, and it's now representing 28% of our total consolidated net sales. These steady increases demonstrate our commitment to winning new business that is less dependent on domestic defense and budget issues, and we'll continue to move in this direction as part of our overall business strategy.

We're also focused on operational efficiencies and improving productivity. This increased margins to 10.5% over the 2012 third quarter. Funded orders for the quarter were approximately 2.7 billion and our book-to-bill ratio was about 0.91 for the quarter and about 0.97 year-to-date. That's about where we think we'll come in for the year. Ralph will give you more color on that a little later.

Funded backlog decreased slightly to $10.6 billion compared with the third quarter of 2012. While the partial government shutdown has ended, our industry continues to feel the effects of sequestration and the declining budget environment. However, as you know, our portfolio at L-3 is diverse and we are positioned well. As you know, many of our businesses are either #1 or #2 in their respective markets, and are concentrated in DoD priority areas that we anticipate will be less impacted by some of the funding cuts. We're continuing to pursue and win new commercial and international programs to offset the declines in the DoD budget.

We're also leveraging our agility to develop affordable market-leading products that are disruptive in terms of price and functionality, and we're able to move quickly and collaborate both internally and with our strategic partners to take advantage of new and adjacent market opportunities as they emerge. Our strategy is working. We're executing well, improving operational efficiencies, delivering for our customers, growing market share and generating significant free cash flow.

Taking a look at our business segments. We continue to be well positioned and had several significant awards over to the third quarter. In each segment, decreases were partially offset by gains in customer priority areas, as well as new business captures. We also recorded key new business wins in our Electronic Systems and Platform & Logistics Solutions segments that exemplify our strategy of expanding our international and commercial sales and growing market share.

I'll give some comments on each of the 4 segments. The C3ISR net sales for the quarter decreased by 15% compared to last year's third quarter and that's primarily due to about -- half of it is roughly due to Afghanistan drawdown. We had a new ERP system at our Comm system's West operation that was about 5% of the decline and then other general declines across the business were about 3%.

But notwithstanding that overall decline, we had some bright spots in C3ISR. First, we received continued funding for a variety of international ISR integration programs, as well as aircraft sales to the United States government. We've also secured key U.S. government fleet management services and logistics support programs. We delivered our first Rivet Joint under the Air Seeker program months ahead of schedule to our U.K. customer.

There's a continued international interest in the SPYDR ISR platform, it's performing well, including 100% operational performance during a recent customer trial. We have a very high customer satisfaction rate for this multi-intelligence platform, which positions us well for international sales. We also recently introduced the multi-mission platform aimed at international maritime patrol markets, as well as domestic use.

In Electronic Systems, net sales for the quarter decreased by about 4% year-over-year. And about half of that decrease was the Afghan drawdown and the other half were delays or sequestration effects in the TSA-related business, so Security & Detection business.

As you know, Electronic Systems is our broadest business area. It's also very well-positioned for growth in this environment. We offer differentiated leading products that are favored by customers worldwide. And a few examples include, our Warrior Systems business area continues to break into new markets, including a major competitive win to provide ground laser target designators for the Republic of Korea. We also secured an award to supply night vision equipment to the United Arab Emirates. Those are 2 important and strategic international wins in that area.

We booked a broad range of orders for Security & Detection Systems, including cargo, baggage and personnel screening, notwithstanding the delays that we're experiencing with the TSA. We received strong orders for sensor, fusing and ordinate systems and U.S. Army transmission systems as well. We booked additional simulator contracts with civil airline customers. And on the military side, we received additional bookings for Flight School XXI. We were selected to provide contractor logistics services and training support services for the U.S. Air Force's Predator UAV program.

In terms of our Platform & Logistics Solutions business, also a 9% decline in net sales and that is all related to the Australian C-27 program and simply timing of our level of effort. The quarter saw some increases in Logistics Solutions that came from increased volume for field maintenance and sustainment services on Air Force training aircraft, as well as ongoing work for NASA and training work for the Iraqi Air Force.

On the Platform side, we booked key awards for the EC-130 Compass Call aircraft, as well as additional work on EP-3 upgrades and the P-3 SMIP program. We also continue our work on a variety of maintenance, head-of-state and upgrade programs from the Canadian Department of Defence and other domestic and international customers.

Finally, our National Security Solutions business had a 9% reduction in sales as well. About half of that was due again to sequestration, with the balance being a reduction in one particular program related to Better Buying Power where our single-award vehicle was changed to a multiple award program and we lost some market share.

In NSS, we recently captured a role on a new U.S. Army initiative for communications and transmission systems. In a significant collaborative effort with our C3ISR business, we won an ID/IQ contract that enables us to compete for $4.1 billion in task orders going forward. We also earned position on the EAGLE II and NETCENTS-2 programs, which are also multibillion-dollar ID/IQ awards. So the pipeline in NSS still remains robust. But again, we need to complete on each one of these task orders. We also secured extension and follow-on funding for several intelligence program.

So in terms of capital allocation and M&A, consistently delivering shareholder value remains a priority. And we do this through a combination of returning cash to shareholders and employing a disciplined approach to M&A.

During the third quarter, we repurchased 156 million of our common stock and also paid cash dividends of about $50 million. Year-to-date, we've returned $555 million to shareholders, over $0.5 billion, in dividends and share repurchase representing 116% of our free cash flow. This is an increase over last year's year-to-date measure.

We're also looking to organically expand our addressable opportunities and we do that by investing in R&D and technology development that align with customer and market priorities. And we find that to be very key in this space that we remain focused on areas that will harvest future sales because, as you know, things are moving quickly in terms of the budget and priorities.

We plan to continue our disciplined and balanced approach to managing our operations and to maximize cash return to shareholders. At the same time, we've been screening a number of companies as possible M&A candidates. There hasn't been much activity this year in terms of actual deals that we've closed, in fact, I don't think there are any this year as I think about it. But we have 2 or 3 smaller companies that would be pure technology tuck-ins that we're looking at, perhaps we'll be able to close one of them within the year. They're all under $100 million, so there's nothing very large yet. Perhaps once there's some clarity around the budget, this is an area that will pick up.

As you know, the -- for us, the effect of reduced funding and declining demand, both from the Afghan drawdown and sequestration is reflected in our results for this year, as well as our guidance. But we do continue to work with our customers to try to mitigate the impact on their programs. We're also engaged with government officials to find a solution to sequestration that will not further compromise our national security strategy.

As we announced earlier this morning, our guidance for the 2013 full year period has been updated in certain areas. We've also decided to move our Annual Investor Conference typically held in the beginning of December to the spring. We believe this shift will enable us to better provide shareholders and investors and analysts with clarity on the outlook of our business since the budget environment is still moving around. I think we'll have a lot more productive meeting if we wait and have it in the first quarter.

So overall, we remain confident about the future prospects for L-3's business and continue to operate from a solid financial and operational position. That said, Ralph, would you do a review on the financials and then we'll take questions?

Ralph G. D'Ambrosio

Sure. Thanks, Mike. I'll discuss some details about the third quarter and our 2013 guidance update and I'll also preview our 2014 outlook.

Our third quarter results were generally in line with our expectations. Sales came in at the low end of our range at $3 billion. And as we expected, orders translated into a book-to-bill ratio of 0.91 for the third quarter and 0.97 for the 9 months ended September. Encouragingly, operating margin increases plus lower taxes, interest expense and shares outstanding drove a 13% increase in EPS to $2.23 and that was very solid.

Consolidated sales declined 8.7% as a consequence of the U.S. government sequestration budget reductions impacting our businesses, the continuing Afghanistan drawdown, plus the low -- the slower second half international and commercial sales growth, which we expected and talked about on our 2Q earnings call in July. Additionally, delays and lower productivity associated with the new ERP system's implementation at a business unit in C3ISR lowered third quarter sales by about $45 million and we do not expect that. However, we continue to expand our commercial and international sales, which grew 2% and they offset some of the decline in our U.S. government sales.

Consolidated operating income was very strong and margin increased 40 basis point to 10.5%, and that was driven by higher margins for Electronic Systems and NSS, more than offsetting margin declines for C3ISR and Platform & Logistics Solutions.

The third quarter included a few abnormal cost and expense items, which lowered operating income by $12 million. They were comprised of $15 million associated to the ERP system's implementation that I just mentioned, $5 million for severance, and partially offset by an $8 million gain related to some acquisition earn-out accounting.

Electronic Systems' margin increased to 12.9%, and that was mostly due to better contract performance and a more favorable sales mix, as well as cost takeouts. Additionally, adjustments for acquisition earn-outs, which I just mentioned increased operating income by $8 million and margin by 50 basis points in the Electronic Systems segment.

C3ISR margin decreased to 8.4% versus 10.5% for the second quarter of 2012, but improved sequentially compared to the second quarter of 2013. And the margins there were negatively impacted by that ERP systems implementation which lowered productivity and raised labor and overhead costs, reducing margin in the segment by 140 basis points and operating income by $15 million, of which $5 million was attributable to the $45 million of lower sales caused by that implementation. We did not anticipate the ERP system's implementation to be the impact that it did have in the quarter.

That said, without that impact, margins would have been 9.8% in C3ISR trending close to the normalized 10% type margin that I discussed on the second quarter earnings call. Next year, we expect C3ISR margin to continue to improve and I'll have more to say about 2014 in a few moments.

Moving on to the 2013 guidance update. We increased our diluted earnings per share guidance at the midpoint by $0.20, making the new EPS range $8.25 to $8.35, and that increase was primarily due to lower taxes. For consolidated sales, our guidance remains $12.5 billion to $12.6 billion, which calculates to a decline of about 4.5% at the midpoint versus 2012.

During the third quarter, we continue to make progress on our remaining book and ship business and we only have to now book about $550 million of orders that convert to sales in the fourth quarter to achieve our sales guidance for the year.

At the segment level, we lowered C3ISR sales and margin, primarily due to the disruptions caused by the ERP systems implementation, and those reductions were offset by small improvements or increases in both Electronic Systems and Platform & Logistics Solutions.

Free cash flow guidance remains $1,010,000,000 and we also have revised our capital allocation assumptions for 2013. The major change is that we're now assuming that we buy back $300 million more of our common stock, bringing it to a total of $800 million and we're also assuming that we make no debt repayments. And if you recall, we had a debt replacement placeholder of $250 million, and the improvement in our unfunded pension obligation has allowed us to avoid having to make those repayments.

So, when you consider that we've purchased about $400 million of our stock through the first 9 months, we'll buying about the same amount in the fourth quarter to wrap up and to get to the $800 million for the year.

Finally, I want to share with you a preliminary outlook for 2014 compared to our 2013 guidance. This outlook is based upon everything that we know as of today. The major assumptions include that sequestration remains in effect and that the continuing resolution for FY '14 goes through January 15.

With respect to sales for next year, we expect sales to decline by about 4% to about $12 billion. Operating margin, we expect a net improvement of 30 basis points to 10.1%. That includes lower pension expense of about $54 million, which itself, translates into a 50 basis point improvement in operating margin. And the key assumption there is that the discount rate for the pension stays at 4.7% from now till the end of the year.

Partially offsetting the decline in pension expense next year will be slightly lower core margins of about 20 basis points, stemming from the lower sales and some mix changes and we're also factoring in about $20 million to $25 million of severance and resizing cost next year, which is similar to what we're incurring 2013.

Interest expense and other expense will be about flat versus 2013 and the tax rate is expected to increase to 32.5% due to the expiring federal R&D tax credit and the absence of some statute of limitation tax gains that we had in 2013. And if you recall, we had 2 years worth of R&E credit in 2013. All told, the tax rate headwind for next year is about $0.44 of EPS and if the R&E credit is reenacted for next year, which we're not assuming, it would add $0.17 to EPS.

What that all boils down to, with respect to diluted earnings per share for next year, is an EPS range in the low $8 range with $8 dollars even being at the bottom end of EPS range and that's how we presently see it. And finally, we expect to generate free cash flow next year of about $1 billion and that's going to translate into free cash flow per share approaching $12 per share.

To conclude my financial review, I'd like to say that while the environment continues to be challenging, while we believe that we're effectively managing that environment and making progress as we go through it, we have a number of uncertainties but those uncertainties are generally understood. And the key thing is that the company continues to be strong and healthy, we're continuing to generate very robust cash flow and we're using that cash flow and allocating it to increase shareholder value.

That concludes my comments and we'll go to the Q&A now.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Myles Walton from Deutsche Bank.

Myles A. Walton - Deutsche Bank AG, Research Division

The first one, I guess for Ralph, on the working capital and the fourth quarter performance working capital. Is there something specific in terms of timing related to that improvement sequentially? Obviously, you'd usually have a really good improvement in the fourth quarter but just looking for any other moving parts that are kind of -- that were deferred from this quarter?

Ralph G. D'Ambrosio

The only abnormal item pertains to the ERP system implementation I talked about in C3ISR. And that probably caused a delay in invoicing and collections of about $50 million, which we will recover in the fourth quarter.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. And maybe, Mike, on the mix of sales, you get 7% from kind of overseas ops in '13, obviously down from the prior year. If you look at your backlog, what do you think that looks like in kind of 2014 as a headwind?

Michael T. Strianese

I'm sorry, as a headwind?

Myles A. Walton - Deutsche Bank AG, Research Division

Well, what is the percent of sales that you thinking about for 2014 that's tied to Iraq, Afghanistan that obviously is coming down over time. Just curious what the placeholder is for '14 at this point?

Michael T. Strianese

The Iraq and Afghanistan sales have declined steadily. So we're looking at a number that's going to be in the $0.5 billion neighborhood, perhaps $600 million for next year. That's reflecting a 32% drop, roughly, from this year, from '13 to '14. But I mean, if you want to take a very, very top level view of the business next year, given our mix, commercial, international versus DoD, I would say that we're looking at DoD declining double-digit-ish, 10, 11-ish, 12% in that neighborhood, and commercial and international growing at approximately the same amount. So 12, 13, whatever -- 12%, say. When you factor the business mix in, we are looking like a consolidated decline of around 4%, which I think is consistent with what Ralph just told you, I hope he did.

Ralph G. D'Ambrosio

Yes.

Michael T. Strianese

And actually, the government DoD business is a little offset there, which is some of the agencies which would be up but that's a small number. So net-net, I think, again, low-double digits up in the commercial and international and down in DoD. So the impact is diminishing of the Iraq -- the Afghanistan drawdown because sales has now become a pretty small number and there will be some remaining contingency there that will continue on. So I think we're very close to the bottom on that shrink.

Myles A. Walton - Deutsche Bank AG, Research Division

Got it. And the last one, Mike, maybe on a high level. You're seeing cyber properties in the market earn pretty, pretty ripe valuations. Does it make you think about NSS as a potential value-unlocking move at this point?

Michael T. Strianese

We continuously evaluate our portfolio in light of current market conditions. So we've also taken note of some of the multiples and that's something that we always think about. So the overall game plan is to generate as much shareholder value as we can and we you can rest assured we haven't missed it.

Operator

Our next question comes from Carter Copeland from Barclays.

Carter Copeland - Barclays Capital, Research Division

Just a quick expansion and clarification on the 12% to 13% international growth that you're thinking about for 2014. Can you give us some color on what the big drivers of that growth will be?

Ralph G. D'Ambrosio

Sure. The biggest driver is the C-27J Australia contract that we won last year. That's going to itself increase by about $60 million to $75 million year-over-year next year. And then additionally, in Electronic Systems, we've had some recent success in the night vision. In Sensor Systems area that Mike just talked about, we won a contract in the UAE and we also won a contract for South Korea, which we'll book in the fourth quarter. But those won't translate into sales until next year. And together, they're going to be about $80 million to $90 million of sales for next year. So those are the biggest drivers in terms of single contracts. And then, we expect to have similar but smaller international gains in the other segments, including some Canada work that we won early this year and some additional growth in small ISR aircraft in C3ISR.

Carter Copeland - Barclays Capital, Research Division

Great. And I may have missed this, but did you say what you intend to contribute to the pension next year?

Ralph G. D'Ambrosio

I didn't say that. But since you asked, we expect that we're going to contribute somewhere between $150 million to $170 million. And that exceeds our required funding under ERISA probably by about a $40 million to a $50 million. So we have some flexibility there with respect to cash flow next year as well.

Carter Copeland - Barclays Capital, Research Division

Okay, great. And one final clarification, the ERP system implementation, that's complete at this point, correct?

Ralph G. D'Ambrosio

Well, it's complete in that we transitioned to the new systems. However, it's not complete in that we have not yet attained what I would call 100% productivity of the pre-implementation at the business unit. And we expect to get there sometime in the fourth quarter, and certainly by early next year in the first quarter. So we think the disruption is largely behind us.

Operator

Our next question comes from George Shapiro funds Shapiro Research.

George Shapiro

Since your revenues really are down more than others this quarter and yet you're saying you're better positioned than a lot of others, is it just due to the fact you have higher short cycle businesses? And if so, could you give us what the -- how you look and what percentage of your business is short cycle?

Michael T. Strianese

Yes, first, George, let me clarify, I said I think we're well-positioned and I'm not sure I said better than our competitors. But the answer is, yes, our business is more exposed to short cycle. But Ralph can go through the mix question that you have.

Ralph G. D'Ambrosio

Well, George, I would say that a substantial majority of the company is short cycle in nature in that you may recall that we typically generate about 50% to 60% of current year sales at a funded backlog, which means we have to book including compete for the remaining 50% to 40% of sales in any given year. And that said, most of our business turns over on an annual basis. The exceptions would be in Platform systems in the PL&S (sic) [P&LS] segment, where that business is longer cycle in nature with a lot of multiyear contracts. And some of the work that we do in comm systems is also multiyear in nature within the C3ISR segment. But aside from those instances, most of the business is booked incrementally on an annual basis. So we're very short cycle to summarize it.

George Shapiro

Okay. And Mike, just one clarification, did you say that the defense business next year, the DoD, would be down 10% to 12% or is that just the international being up?

Michael T. Strianese

No, it was the same, I said it would be down about 10 to -- between 10% and 12%.

George Shapiro

Because then with the international only 28% of the total, you would think that it would -- defense is down that much, how does that compute to only being down 4% overall or you think it would be greater?

Ralph G. D'Ambrosio

Well, the international was 28 -- international commercial were 28% of our sales in the third quarter of this year, George. Next year, they're going to grow to 30% to 31% of total sales.

Michael T. Strianese

Yes, if you want to be a little more precise on the math, George, lean a little lower in the defense, so I assume down 10% or 11%, and lean a little higher in international commercial so think 11%, 12% and increase the mix, as Ralph said. But it foots to -- you know we're not aggressive in our numbers, we foot to about 4%.

George Shapiro

And then Ralph, just one simple one. Did you say, what the share count would be for next year?

Ralph G. D'Ambrosio

No. But we're modeling about $0.5 billion of share repurchases for next year and that should translate to a share count reduction of about 5% versus 2013.

Operator

[Operator Instructions] Our next question comes from Cai Von Rumohr from Cowen and Company.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

So to get back to commercial and foreign, I mean all the opportunities you mentioned, Mike and Ralph, Australia, night vision, Canada, that's all international. So if the total is up 12% to 13%, is that all international or are they both international and commercial both up 12%, I was a little confused by that?

Ralph G. D'Ambrosio

We expect the international work or the foreign government work to be up around 15% and our commercial work to be up in the high-single digit range and that foots down to the over 10% growth in total that Mike talked about.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Got it. And then there have been stories in the press about one of the things DoD is considering would be basically just shutting down Liberty in its entirety. Refresh us about how big is that program today? And maybe give us any thoughts you have, is that really plausible that they would do that? What's the status of that?

Ralph G. D'Ambrosio

Well, Project Liberty in 2013 is just about $300 million in sales and we count that entirely in our Afghanistan OCO sales figure, which to remind everybody is approximately $900 million for 2013. And as Mike said, it goes down to about $600 million in 2014. So there has been some discussion about the U.S. Air Force essentially divesting the MC-12. But there's also been discussion among the other services, including the Army and USAF having interest in those aircraft. So we expect that those sales will, at the end of the day, not decline to zero. They will decline significantly though from $300 million in 2013.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Okay. And then, you mentioned $12 billion in sales, down close to 5%. Maybe you can give us a little bit of color in terms of the relative declines by your 4 sectors?

Ralph G. D'Ambrosio

Well, I don't want to get into too many specific details by segment because there's likely to be some changes between now and when we introduce our formal guidance for next year at the end of January and that's when we report our fourth quarter earnings. But generally, you got to see trends that are similar across the segments for 2014 to what they've been in 2013 directionally, if that give you some insights.

Operator

Our next question comes from Robert Spingarn from Credit Suisse.

Robert Spingarn - Crédit Suisse AG, Research Division

When you think about the 4% decline next year and the 10%, 11%, 12% defense, domestic defense, what are -- other than Liberty, so following on to Cai's questions, what are some of the other watch programs here? And then really second part of the question, Mike, maybe you could delve into how you think about fiscal '15 and the [indiscernible] dip, is that where we should expect to see most of the platform adjustments and program decisions made or you think that could come in a '14 budget or is it timed so closely together it's irrelevant?

Michael T. Strianese

Yes, Rob, I think you hit it on the latter. I think the timing is so close together, it's kind of doing -- it's irrelevant. The crystal ball on all those answers, we don't have and that's part of the problem with answering the first part of your question as to what programs are the watch programs. Given the diversity of our business, we are arriving at what we think the decrease looks like, if you will, on just kind of a pro rata basis. I mean, we're not immune to it, we'll get affected, by I mean it's and pretty smooth. There's no -- as you know, we have no single program that's more than 2%, 3% maybe of sales that happens to be probably Fort Rucker that -- one that we compete a year or 2 ago. So that -- take that out and then things fall off pretty quickly. So there's nothing was -- if it was completely canceled and went away that would be much to talk about, because there'd be something else offsetting it somewhere else. So when I say we're well-positioned, that's kind of what I mean being well positioned, is we have enough offsetting things going on, including a lot of work we've been doing on pushing the international marketplace, in getting products qualified for export and sold, as well as some of the things in development are being specifically developed to qualify for export sales. So that is also part of our strategy. But it's very difficult to say today where we're going. I would anticipate that we'll have much more fidelity when the '15 budget is released in February as to the question you had on programs.

Robert Spingarn - Crédit Suisse AG, Research Division

Mike, would you say your confidence in international demand has changed? You and I have talked about this over the last few years. And obviously, a lot of your peer companies had been very focused on this as an offset, at least partially, to what's going on domestically. Would you say you're more confident that international demand is sustainable and viable than you were before?

Michael T. Strianese

I could say I'm encouraged with what we've seen over the last few years. And I'm optimistic, cautiously optimistic, that the trend continues. But a couple of things regarding our proposition, the typical contract, the typical products that we're selling are different decision points than some of the other companies in our space is big systems. Their sales cycles are longer. Remember, we're a much shorter cycle. So again, we are probably out there with multiple, multiple opportunities and making assumptions that we are not going to win everyone of them. But we'll win a mix of them. So, is it sustainable? It looks sustainable now for the next couple of years, at least. And again, we have our SPYDR aircraft that has a lot of interest internationally that is in the final phases of productization, if you will. And we are hopeful that when those sales start to occur, they'll be again replacing other sales that will be falling away that we have today. So I -- given the backlog, things that we have in the pipeline and things that we have in development, I feel pretty confident about our positioning internationally.

Operator

Our next question comes from Bill Loomis from Stifel.

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

I guess if you can talk a little more about the sequestration impact. How exactly are you seeing it impact you? Is it just awards getting pushed to the right, so things you won aren't ramping up? Or are you having -- or customers actually coming to you and saying you need to reduce this program by 15% or what have you?

Michael T. Strianese

Yes. It's kind of all of the above, Bill. It depends, of course, on what the customers were seeing. Things ranging from low reductions, 3%, 4%, et cetera, on typically that what you'd see on a service program, quantity reductions on certain products, to the potential to have a total cancellation on others. So it's kind of all over the lot really depending on the customer.

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

One programs there's been some press out is the Fort Rucker contract with 20 -- potentially a 20% reduction in flight hours and then layoffs. Has that been decided, the press reports are talking about 250 to 300 layoffs, does that just depends on what happens with that program next year? Or is that if...

Michael T. Strianese

Ralph will answer that -- go ahead Ralph.

Ralph G. D'Ambrosio

Bill, so that's not been decided, that's one of the items that is being contemplated by the Army to achieve their sequester reductions. And that would be related to a reduction in the Army force structure. So when the force structure comes down in the Army, it's likely to have an impact on Fort Rucker because presumably, there will be less -- there will be fewer aviators going through flight training. So if anything, I think that's less of a 2014 issue even if it comes to pass.

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

So they wouldn't even make a decision on that until sometime next year and it probably won't impact you until the -- kind of the next year after that, is that what you're saying.

Ralph G. D'Ambrosio

Correct. It's going to force structure-driven ultimately.

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

Okay. And then just on the services side, in terms of margins, excluding one-time severance and things of that nature, can you talk a little bit about the trends you're seeing there as you've put on some of the recent wins you've had. Do expect margins on an apples-to-apples basis x any severance charges or anything. How are they trending over to next year on NSS and your other services-type businesses?

Robert W. RisCassi

Well, I would characterize the margins in our service business for next year versus this year as stable to slightly improving. So I don't want to get in too many and any specific details on the segments, but I will tell you that in addition to expecting the margins to improve in C3ISR, which I talked about already, we're expecting a modest improvement in the NSS segment as well in 2014.

Operator

And our next question comes from Howard Rubel from Jefferies.

Howard A. Rubel - Jefferies LLC, Research Division

I want to just touch for a moment, Mike, on this restructuring, say, it's $20 million, $25 million this year and the same next year. How do you think about the benefits, either in terms of cost going forward or in terms of improved competitiveness?

Michael T. Strianese

Well, I think everybody in the industry is getting ahead of -- out ahead of some of these reductions. So yes, I mean, our consolidation, if you will, or efficiency program is designed for all the above. It's designed to improve margins, thereby improving competitiveness and it -- one thing that we've done very well, I think, is to keep the business properly sized to what we see is the future volumes. So we believe we are sizing to the right volume going forward and we are expecting improved operating leverage, if you will, in terms of margin and competitiveness going forward. I mean, that's the plan.

Howard A. Rubel - Jefferies LLC, Research Division

What I don't -- what I struggle with a little bit is ordinary severance is typically a contract cost. How is it you're not able to include some of that in your contracts?

Michael T. Strianese

No, we would include it all in our contracts other than if it's in a commercial space, but go ahead Ralph, I'm not sure I understand the question but, yes.

Ralph G. D'Ambrosio

Well, to the extent that it pertains to the U.S. government business, it's in -- there will be an allowable contract cost. And we certainly would recover it on cost reimbursable business with the U.S. government and on a fixed price work, it depends on the overall pricing situation, particularly if it's on -- in supply related-type work.

Michael T. Strianese

The question is why are you seeing a number at all instead of zero, I see..

Ralph G. D'Ambrosio

And I would tell you that the number that I -- the numbers that we disclosed for severance for this year, which is $25 million, and I said, next year, will be $20 million to $25 million, that is after the cost reimbursement of a portion of those costs. So those are the net cost that we expect to actually hit the bottom line.

Howard A. Rubel - Jefferies LLC, Research Division

So they are not recoverable is what you're saying?

Ralph G. D'Ambrosio

Correct. It's after some of the recovery.

Michael T. Strianese

Right. That's the -- let me give you the mechanic on that. I understand the question now. Yes, that's the net number that after we consider reimbursement, Howard, and part of that mix, if you will, is you'd apply it after you account for what you recover on cost plus contracts. You don't necessarily cover on fixed price we already priced, that's as good as being commercial, which are already priced that's not in there. So some of that drops to the bottom line, as well as anything related to commercial or international business. So just based on our mix, there's always going to be a piece that's going to fall to the bottom line if it's across the company.

Howard A. Rubel - Jefferies LLC, Research Division

I got it. And I mean -- and then depending upon the competitive situation, is what you do in terms of being able to benefit in future periods. Just a couple of things, on -- you talked about commercial and international opportunities, if I'm not mistaken, the C-27 contract with Australia was, what, about $600 million and probably would peak volumes be in '14 for that?

Ralph G. D'Ambrosio

Yes. So it's a little more than $600 million in total over 5 years, which began in 2012. And 2012 and 2013 are each about $70 million in sales. And I said the sales next year would increase by $60 million, $80 million and probably be at a similar level in 2015 and then they taper off a little bit in 2016.

Howard A. Rubel - Jefferies LLC, Research Division

Are there -- when you look at other international opportunities, either SPYDR is going to fill it in and/or maybe there'll be another C-27, hard to call. Are there some other large opportunities, Mike, that you might be able to kind of point out in general?

Michael T. Strianese

Well, we're always in the marketplace with all of our products. But this head-of-state aircraft that it typically every couple of years that are large dollar items, there's airport security, equipment, there's simulator sales, we have a multi-mission aircraft that will be qualifying for export over the next couple of years that will also fill in, if you will, there's the international P-3 market where we have a large market share and there's international C-130s where we have a capability that maybe one other company has, 1 or 2, in terms of being able to do end-to-end center wing box, avionics, a 20 years life extension program. So we're in the marketplace with all of those. I mean, that's some of the bigger things we do, beyond this place in night vision things like that.

Howard A. Rubel - Jefferies LLC, Research Division

I would have guessed on the -- I mean, you obviously won some things with P-3 already and that's very important. And then, finally, Ralph, where did you end the quarter on shares outstanding? Because it sounds like we should be thinking about a fairly reasonable drop in the fourth quarter. You probably also bought some stock that pays -- that's paid for in Q4 that traded in Q3?

Ralph G. D'Ambrosio

Well, the -- I'd like to talk about it in terms of diluted shares outstanding because that's what factors into EPS. So in the third quarter, it was 91.3 million, which we reported today. And that's going to decline to about 88.6 million, 88.7 million for the fourth quarter.

Operator

Our next question comes from Joe Nadol with JPMorgan.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Ralph, I think you mentioned this, but just on the ERP, it sounds like you lost $15 million of EBIT on $45 million of sales. I think you broke it out into 2 pieces, but how do you explain or why was the income impact larger than one would have thought?

Ralph G. D'Ambrosio

Well, so first of all, you have the profit that would be associated with those sales, just -- which was the $45 million lower-than-expected sales and I quantified that at about $5 million. And then, the other $10 million is what I termed lost productivity and higher labor and overhead cost. So essentially, what we have or what we had was a diversion of a lot of our direct labor into indirect labor to either get those systems up to full productivity or you basically had a lot of idle time. And in some cases, we did some furloughs where it made sense. And then additionally, we also had some expenses with third-party consultants that are used in the implementation of those systems.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Okay, that makes sense. On the commercial outlook for next year, so I think you had maybe $1.6 billion of sales this year. Could you walk us -- maybe just high level, to the degree you're willing through the different major pieces of commercial and how you arrive at the high-single digit growth?

Ralph G. D'Ambrosio

Okay. So the high-single digit growth for next year is approximately $150 million to $160 million of incremental sales. And about 20% to 25% of it will come in the -- our aviation products. Probably going to have another 15% to 20% of it in our Security & Detection System products. Recall that most of the overseas sales go to privately owned airport entities, so we classify those as commercial. Then we're also expecting a rebound in our power device TWT, Traveling Wave Tube, business that is used in commercial satellites. So that business should probably grow $30 million to $40 million next year. And those are major elements of the growth, and we'll have some additional VIP head-of-state sales also. We expect offsetting that growth is going to be some more reduction in our commercial shipbuilding products business in Europe.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Okay. All right, that's helpful. And then on the international side that you guys ran through a whole -- a bunch of orders that you've either received or are about to receive that are going to help the growth. Are there any other -- just knowing that you're depending on international for next year and that international often does slip. Are there any other big or important pieces that you're expecting that you didn't list that you're expecting to get in the early part of next year that could be at risk?

Ralph G. D'Ambrosio

There's some small ISR aircraft sales to Middle East-type customers next year. And I'll put that in the $35 million to $50 million range of sales.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Okay. But most of it's in the backlog or will be in the backlog at the end of this year?

Ralph G. D'Ambrosio

The majority of it.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Okay. And then just one more, just on ES this quarter. The strong performance, the 80 bps that you mentioned across several of the businesses. Is that -- are those -- are there any performance adjustments on contracts or was that mostly just underlying stronger margins in those business areas?

Ralph G. D'Ambrosio

There was some favorable contract adjustments included in those results. I think we quantified it in the earnings release.

Joseph B. Nadol - JP Morgan Chase & Co, Research Division

Well, you quantified 80 bps of performance but you didn't say, I don't think you said...

Ralph G. D'Ambrosio

The majority of that is contracted catch-up or tune catch-up.

Operator

And ladies and gentlemen, our final question today comes from Robert Stallard from Royal Bank of Canada.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Mike, first question, on this SOCOM contract where it moved from single award to multiple award, as far as you can tell, are there any more of these in the pipeline or is this a one-off?

Michael T. Strianese

I'll hand it to Ralph, he was a little closer to that one, but I think we've been through most of that pain already. It wasn't a one-off, there were a number of those over the past couple of years. Go ahead, Ralph.

Ralph G. D'Ambrosio

Well, this transitioning from the single award contract that we had to 7 individual contract actually began in 2011. So once we get through 2013, all those negatives comparisons are over. And I'm glad to report we have nothing like that in front of us for next year or the year after where we have a big single award contract that's been targeted to be segment into smaller pieces. So that's -- I expect it to be a nonrecurring trend in our sales in NSS once we get into next year.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Okay. And then, Mike, a strategic one for you. You mentioned there haven't been any deals this year that sort of DoD budget environment has held things up. Perhaps you could comment on your non DoD acquisition pipeline, whether you're seeing anything outside of the defense world that might be of interest?

Michael T. Strianese

Unfortunately, not anything of at interest. Last year, as you know, we bought the Link simulation business in the U.K., that was virtually all commercial or substantially all commercial, then at the time, I said I wish we had a couple of these every year but there really isn't anything like that, where it's very adjacent for us. We're into the U.S. side and the military where it's kind of dual use technology. We can go either way with military or commercial sale. So there's nothing that I would consider of the scale or quality as at the price we'd be willing to pay at the moment. But we probably been through 50, 60 books already this year on things. Just a lot of very small properties for sale. I think the M&A activity at the low-end of the market is active. But things that are over $100 million is an arbitrary point. I think have been very few and far between, I haven't seen much that would be a good fit for us. And once you get into a business that's 100% or the majority of which is DoD dependent, you'd course this budget issue where it's very hard to get at a valuation that's going to make sense to a buyer and a seller because of the uncertainty. I expect and I think I've heard a number of bankers tell me that this is going to improve going into next year. I hope we get that clarity that allows it to improve. But M&A is still part of the plan. It's just, we are willing to be patient and wait for the right properties.

Okay. Well, our strategy pretty much remains unchanged. We've adjusted to this environment pretty well. The -- and sometimes you hear a view on the hill that the sequestration may not be that bad because defense stocks are trading well or earnings have been growing. And it's certainly not the measure of whether sequestration is bad as to look the price of defense stocks on a given day or a -- the fact that we've streamlined our operations. I think the real measure's have to be looked at in terms of the job affects and we are down several thousand employees this year and I think across industry it's a much -- I know it's a much healthier number, unfortunately. And the ultimate test is the military readiness -- the readiness of our war fighter, which are all being negatively impacted.

So with that, we are advocating -- we continue to advocate a way out of the sequestration, although it's looking pretty bleak. So again, we've done everything we could do internally to adjust for it. And the balance sheet is strong. We've been opportunistic on M&A. We continue to review the portfolio. We will be opportunistic in making acquisitions where they make sense. There are some smaller properties within L-3 that we've targeted for divestiture, but again, small. But again, it’s just the ongoing pruning and shaping, if you will, portfolio shaping that one would always do.

With that, our management team, our employees around the world, have agility and the expertise and innovative spirit to drive growth and position us well for the future. So we look forward to speaking with you again at year end towards the end of January 2014. Thanks.

Operator

And ladies and gentlemen, the conference has now concluded. We thank you for attending today's presentation. You may now disconnect your telephone lines.

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