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

Q1 2010 Earnings Call

April 22, 2010 11:00 AM ET

Executives

Eric Boyriven - IR

Mike Strianese - Chairman, President and CEO

Ralph D'Ambrosio - VP and CFO

Analysts

Cai von Rumohr – Cowen and Company

Robert Spingarn – Credit Suisse

George Shapiro – Access 342

Joseph Campbell – Barclays Capital

Rob Epstein – Merrill Lynch Bank of America

Noah Poponak – Goldman Sachs

Joseph Nadol – JPMorgan

Troy Lahr – Stifel Nicolaus

Howard Rubel – Jeffries

Michael Lewis – BB&T Capital Markets

Operator

Good day ladies and gentlemen and welcome to the L-3 Communications first quarter 2010 earnings conference call. My name is Michelle and I will be your operator for today. At this time all participants are in listen only mode. We will be conducting a question-and-answer session towards the end of today's conference. (Operator Instructions)

As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's conference, Mr. Eric Boyriven of FD. Please proceed.

Eric Boyriven

Good morning and thanks for joining us for L-3 Communications first quarter earnings conference call. We have Michael Strianese, Chairman, President and Chief Executive Officer and Ralph D'Ambrosio, 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 will now turn the call over to Mike Strianese. Mike, please go ahead.

Mike Strianese

Thanks, Eric and good morning everyone, thanks for joining us. I hope everyone has had a chance to read the earnings release. We had a good start to 2010 with a solid first quarter. Our earnings were up -- earnings per share were up 13% to $1.87 per share and that's even after a $0.04 per share charge related to that Medicare Part D prescription drug coverage compared to 2009’s first quarter.

Overall though sales were essentially flat at $3.6 billion, our ISR business continued to do very well with significant growth offsetting declines in the other segments, ISR grew at approximately 11%. The flatness in sales we attributed to orders and sales that have moved from the first quarter out into probably the second quarter; most notably are order for the additional JCA, the Joint Cargo Aircraft expected in March has moved out of the quarter, probably will come in the second quarter.

So at the end of the quarter March 31, our backlog was at $10.8 billion; first quarter orders were $3.6 billion, which gave us a book to bill of one but that's even without this $233 million JCA order. So we are happy with the book to bill at one.

We had some significant wins in the quarter, several which were competitive including a NAVAIR systems engineering support contract and a US Air Force Cyber Security Operations contract as well as linguist services for classified customer.

We also had significant follow-on orders on several important legacy programs including our UAV Communications Systems, EO/IR Charts, our rover product, Phoenix Communications Systems, our compass call aircraft, the Canadian F18 program, the Law Enforcement Professionals Program, our Contract Field Services, maintenance work at Fort Rutger, the small ISR Aircraft such as Project Liberty, River Joint work US Navy P3s, (ABCAPS) and to the C-12 CLS just to name a few.

In terms of recompetitions, the only major outstanding recompete for us continues to be the special operations for support activity contract or job. Where that stands today is that SOCOM is currently taking corrective action in response to our protest. They said they expect to release a new RFP in April and they can award by next January.

As of now we still haven't received the RFP but in the meantime the period of performance on our contract, the incumbent contract has been extended to January 31, 2011 and our contract value has been increased by $400 million.

We expect to see a new contract in this competition being worth up to $5 billion over 10 years and this is obviously a very important program to us and we await this competition and look forward to continuing on as the incumbent force.

In terms of our significant programs I'll name a few in terms of the larger ones and give you some color. First of all on JCA, the Joint Cargo Aircraft, we expect orders for eight aircraft, they're in the fiscal ‘10 budget, which will bring our orders to date to 21 aircrafts; now that's the order that mentioned slipped out of the first quarter but we still expect it, it's in the budget so we expect to see the money, I think it's a paperwork issue. We also expect eight more in fiscal ’11. So the total US Air Force buy is expected to be 38 aircrafts with the final nine coming in fiscal ‘12.

This year we expect to deliver four JCAs bringing total deliveries inception to date to six. We've already delivered in the first quarter, two of those four, so we're in good shape to make those deliveries this year. In addition, the National Guard is still projecting a need for additional aircraft and there's also a potential for a plus up in fiscal ’12. So we remain optimistic on this program and obviously there are still several foreign military sales opportunities. I would not characterize them as being in the short term just because the sales cycle is longer internationally but as this aircraft begins to get deployed we expect to see more interest in it.

In terms of project liberty, we are modifying as you know a total of 37 MC12W aircraft for the US Air Force. So far we've delivered 23 aircraft on time on budget and our deliveries are surpassing our contractual schedule. We expect to finish delivering all 37 aircraft this November.

Not only was Liberty the fastest delivery of defense contractor, by a defense contractor for a weapons system to the US military since World War II but also the aircrafts performance to date has been truly exceptional; we're very proud of the performance here. The fleet has flown more than 2100 sorties over 7000 hours with a mission availability rate exceeding 96%.

We look forward to continuing to apply L-3’s expertise to other small aircraft ISR applications both with the DOD as well as international customers. For example we currently expect the air force to expand the Liberty fleet by six airplanes hopefully later this year or in fiscal ‘11 and several international customers are expressing strong interest. So there's a lot of activity in this space.

As you know, the army is also proceeding with a competitive procurement for what's known as the Enhanced Medium Altitude Reconnaissance Surveillance System or EMARS and that's an aircraft to focus on a regular warfare missions, communications intelligence, Electro-Optical Infrared Missions and Communications. The EMARS configuration will be a small aircraft similar to the Liberty MC-12 platform, draft RFP was already released and the final RFP is expected next month with a contract award likely by the end of September.

The initial buy is expected to be about six probably four aircraft I'd say and could go to 36 aircrafts for the full program, the initial contract. L3 is competing for EMARS as a prime.

The UK Springtime Project, as you remember that was once known as Helix now Springtime. The good news with Springtime is that the UK Ministry of Defense and the US Air Force are going forward with the program. A letter of authorization for this foreign military sale was signed by the MOD and the US Air Force last month in March and as you know, we were selected to be the prime.

There'll be a significant program for L-3 with over $700 million over the next seven years. It consists of three US Air Force RC-135 aircraft to replace the UK Nimrod, ISR Intelligence surveillance and Reconnaissance aircraft. Although the program is going forward, which is the good news it has been delayed per the LOA that was signed with the first delivery slipping 12 months to April 2014. We expect to begin negotiating our contract with the MOD soon with the award happening, we expect no later than the first quarter of 2011 and quite possibly later this year and we could receive a long lead materials contract by the second quarter of this year, which we are in.

So we expect to provide three River Joint UK versions plus ground training and training equipment. The logistics and sustainment part of that program will be provided under a separate agreement. So our scope today is the aircraft integration including the ISR and mission data systems installation, logistic services and sustainment.

Finally, the whole body imaging product for airport checkpoint is finally getting a little bit of wind behind it. As we previously said in December of 2009 we received a five-year IDIQ contract from the TSA, valued it up to $167 million depending on quantities ordered. In the first quarter we also booked about 17 million of orders from international customers. The TSA is expected to deploy 300 of these systems soon. Today there are only two qualified suppliers, it's L-3 and another company. Our system relies on millimeter wave and it's not an X-ray.

This morning, I'm pleased to tell you we received the TSA order for the first 202 systems valued at $31.7 million, so they're drawing down on that IDIQ. The whole body imagining situation is unfolding and we continue to keep you posted as it does evolve. So I would be very hopeful that once they're deployed and used in airports and hopefully we'll take advantage of the automated screening and there is no actual imaging or privacy concern. The travellers will become more comfortable. It will speed lines at airports and it'll pick up the demand I expect there to be at least a market for 2000 of these systems if not more, and you can define that market as every lane and every terminal in every airport. So it's a big market and we're optimistic that this will start to pick up speed as we go forward.

There's been a bunch of buzz in the press about the tanker opportunity with EADS. As you know L-3 is always interested in expanding our program base when our capabilities are a good match and we're also very eager to forge strategic partnerships to advance our business. This sounded like a potentially interesting opportunity for us and we were considering a subcontract to position. We did evaluate carefully the opportunity and decided not to proceed. Being part of the team the scope of work was not something that typically we would do in our mission integration business and it really didn't fit anywhere else for us, but the door is not closed forever, there's always an opportunity to start talks again some day. And of course we still work with EADS on a number of other opportunities and we wish them well in the competition.

In terms of other new business opportunities for 2010, what we're seeing generally is just a slippage of things by month not by years but the paperwork process competitions funding is delayed somewhat. So the EMARS and Springtime Programs I just talked about, you could see they moved a little bit to the right.

The counter narcotics Afghan police training program competition is also being delayed because of competitors’ successful pre-award protest. It appears the army may have to conduct a full and open competition pushing the award into the second half of 2010. Linguist, we're still waiting for INSCOM to issue the RFP for the worldwide linguist re-competition. The RFP had been expected to be released in February. The new contract is expected to be a multiple award IDIQ and it’s now expected to be awarded in the fourth quarter of this year. So again you'd see things moving to the right in several places.

Other areas would be the Department of State Civilian Police Training Program, C-17 training system sustainment contract, the US army C-12, contract logistic services competition and the army CECOM S3-2G competition, that one is slipping till next year and will likely be broken into three to five elements, so not only is it going to slip but it's going to be broken into smaller pieces.

The actual timing of these awards will be impacted by protests and other procurement delays potentially but we will keep you posted on our quarterly calls and, you know, our press releases, of course.

In terms of capital deployment and acquisitions, this quarter we repurchased a $123 million of our stock in the first quarter. Our authorization that remains is about $300 million and we expect to complete it this year before the end of the year.

With respect to acquisitions, we continue to evaluate several companies; currently have some very good opportunities and expect to invest more dollars in 2010. As you know we announced the acquisition of Insight Technology and closed it last week. We think it's a great fit. As you know we've been very selective in what we acquire and it's been slow the last couple of years because of the lack of qualified candidates in the general business environment but I'm happy to say that Insight is the perfect type of acquisition that we look for.

It broadens significantly our capability and EO/IR and warrior systems and in fact we are creating a new segment in our electronic systems area called L-3 Warrior Systems. It'll be a $700 million operation that'll include Insight as well as our EOS or Electro-Optical Systems business, our infrared products business and our (Reotech) business and it accomplishes many of the things I talk about regularly such as synergy among our pieces getting better value to our customers, consolidating and developing best of three products. We're delighted that Ken Solinsky who is the founder and President of Insight is staying with L-3 and will lead our new sector known as Warrior Systems.

The types of products and technology include laser aiming lights, target pointers, tactical illuminators, laser range finders, night vision devices, thermal imaging system, sensor fusion and a host of others and it's – again we're very, very pleased to have completed this transaction in the first quarter and slightly after the first quarter and we hope that we'll be able to announce a few more this year as well.

Overall in terms of our liquidity and capital resources, our balance sheet continues to be very strong as well as our liquidity position. As you know last year, we were upgraded to investment grade if we need to access the capital markets particularly that market for a larger transaction, not much larger but a larger transaction we certainly could.

As you know, in our release this morning we updated our 2010 guidance increasing our earnings per share range to $8.13 to $8.33; that's up 8% at the midpoint. We expect to see sales between $16.2 billion and $16.3 billion; that's up 4% at the midpoint. The major increases to the guidance relates to the extension of the (sourcer) contract and for the full year now and the Insight technology acquisition as well.

We also have some upside from winning some of the new business opportunities I discussed earlier and from deploying more of our cash in strategic ways that will also increase our earnings.

The only other item I talk about is since the last call, the DoD budget was finalized as well as the QDR and our view is the budget remains healthy and robust, modest space budget growth plus a large overseas contingency operation supplemental. As you know, the Iraq and Afghanistan will continue to determine the near-term resource decisions.

As for the QDR, the Quadrennial Defense Review, it emphasizes the key objective centered in the fiscal ‘10 proposed budget by secretary Gates and I view it as a balancing document if you start with the premise that our current force structure is more geared towards conventional or mere peer type warfare. You would look at this QDR as being a document that would balance that structure to one that's more towards today's engagements meaning asymmetrical, regional, warfare willing to take a little bit of conventional risk and prepared to fight the fight we're going to.

You see that in the programs that we're working on notably things like Liberty, the EMARS Competition, the training programs in Afghanistan, I mean that has become obviously the major focus and looking to tomorrows potential conflicts, that's the way things are being structured.

We think that works very well for the way L-3 has put together in terms of our business areas notably ISR, electronic systems, both of them address these areas very well in terms of the things we do and our services with the nation building military training services among others that we provide in the intelligence area and the AM&M taking today's platforms and making them more relevant for tomorrow’s threats or taking small aircraft and converting them to ISR platforms quickly, rapidly, rapid deployment, these are all things that will be important as we go forward. So we're very confident of the L-3 business model going forward.

The budget, as you know contains few new starts and we expect to see some rationing and reprogramming to continue but again we think reprogramming the areas we are a strong player.

So overall, I think the portfolio of businesses at L-3 and our capabilities as well as the quick reaction culture that we demonstrated in the Project Liberty and other programs are very well positioned for the new evolving DoD QDR priorities.

With that let me turn it over to Ralph to give you some of the financial details and then we'd be happy to take your questions.

Ralph D’Ambrosio

I highlight some of the trends about the first quarter results, review the changes to our 2010 guidance and finish with some comments about our March balance sheet.

As Mike said, overall we had a very solid strong first quarter, which was underscored with our diluted earnings per share of $1.87, which was up 13% or $0.21 over last years first quarter and the main driver of that EPS growth was higher margins.

With respect to sales in the first quarter, consolidated sales declined $12 million or about 0.3% to $3.624 billion. C-Cubed ISR, that segment grew 11% and that growth was offset by declines in our other three segments. And those three segments’ sales for the first quarter were about $70 million less than we expected due to a variety of delays on several programs and products including Joint Cargo Aircraft, WIN-T, EP3, examiner and whole body imaging detection systems, C cell terminals and also a large classified IT services contract that we competitively won at the end of last year for which the start date moved to April because of a protest by an incumbent.

Another factor, which also unfavorably impacted the first quarter sales growth rate is that we look at all of our negative sales comparisons for 2010 versus 2009, they are more pronounced in the first half and those include Linguist, the army CECOM task orders and the Bradley Fighting Vehicle.

Getting back to the segments, sales in government services declined 6% or $64 million and that was driven by two items; lower subcontract pass throughs on the army CECOM SSES task orders reduced sales by $45 million and the Linguist Iraq subcontract sales declined $22 million.

In aircraft modernization and maintenance, sales were down about 2%. JCA was one of the main drivers there, which declined $6 million and JCA sales were actually $25 million less than we expected for the first quarter because of the slip in the FY10 aircraft order that Mike talked about.

In electronic systems, sales declined 1% and what happened there was that growth and EO/IR microwave communications, simulation and training in undersea warfare was offset by declines in combat repulsion systems due primarily to the Bradley Fighting Vehicle and also declines in our marine and para systems business areas driven by the lower commercial ship building product sales and also lower US Navy sales on the Virginia class submarine.

Also sales of security and detection systems declined $12 million and that was due mostly to lower international examiner sales and what happened there was shipments that we planned for the first quarter slipped into the second quarter because the customers were simply not ready to receive the equipment. And lastly Mike talked about the WBI order or Whole Body Imaging systems, that was also delayed from the first quarter and we're happy to have booked that order today.

Moving on to operating margin, consolidated margin was very strong reaching 11.3%, up a 100 basis points over the first quarter of 2009. Margins expanded significantly both in C-cubed ISR and electronic systems. We had improvement in contract performance meaning direct labor and material cost and continued to discipline on reducing overheads plus better higher profit margins in the sales mix.

Additionally we had some favorable items which occurred early including a contract modification adjustment and a supply agreement volume price adjustment; those two improved the margins in the first quarter.

So the first quarter margins were unseasonably high for Q1 and we don't expect to repeat those 13% plus margins in those segments C-cubed ISR and electronic systems for the balance of this year.

Margin was weaker than expected in government services on a couple of timing items concerning an award fee and a contract award and we also had an unplanned charge on a security systems contract, which reduced the margins there by 40 basis points. But overall we continue to make very good significant progress on our operating margins.

Free cash flow for the quarter was also very strong by $245 million, up $133 million compared to the first quarter of last year.

Moving on to the changes to our 2010 full year guidance, we raised EPS by $0.13 on both the high end and the low end of our range making the new EPS range $8.13 to $8.33. Three items primarily caused the increase; first, the acquisition of Insight Technology, which was completed on April 14th, that'll add $0.12; the contract extension on SOFSA taking it beyond May in our guidance for the full year adds $0.05 and those were offset by the $0.04 charge on the new healthcare law that was enacted last month.

We increased our sales guidance by $400 million to $16.2 billion at low end and by $300 million to $16.3 billion at the high end. At the segment level we increased sales by $200 million in electronic systems for Insight and $200 million for SOFSA extension in the aircraft modernization and maintenance segment.

We tightened the consolidated sales guides range by $100 million because of the slower start we had in the first quarter and we also want to guard against any continued order and funding delays.

Consolidated operating margin was increased by 10 basis points to 10.8% due to the strength in C-cubed ISR and electronic systems and that strength is more than offsetting reduced margin expectations in the other two segments. Aircraft modernization and maintenance is down a bit because we now will have SOFSA for the full year and then government services. The pricing environment continues to be very challenging.

The tax rate was increased to 30 basis points also related to that healthcare law and our free cash flow guidance was raised slightly by $10 million to $1.26 billion.

Finally, looking to the second quarter, we expect sales to be about $4 billion with EPS of about $1.90 and free cash flow of about $200 million. Similar to the first quarter, we expect to have a challenging top line growth situation in the second quarter and that's due again mostly to those negative sales comparisons for the full year compared to 2009, which are more pronounced in the first half.

A couple of comments on the balance sheet. We ended March with $1.1 billion of cash and we expect that to be about the same when we get to the end of the year after we pay for Insight due a half a billion dollars of share purchases and pay our dividend. Now that will leave us with ample cash for more share purchases and/or more business acquisitions.

Overall, we think our balance sheet is very strong and that we have ample liquidity and cash to pursue growth opportunities. That concludes my comments and we'll now go to the Q&A.

Question-and-Answer Session

Operator

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

Cai von Rumohr – Cowen and Company

In light of the awards delays that we're seeing, what do you look for for book-to-bill in the second quarter and what's your guess as to where it might be for the year?

Mike Strianese

Well, Cai, we're looking at a book-to-bill of one for the year, that's in our guidance. Although it probably wouldn't be aligned drive through the next three quarters, if everything that slipped in the first quarter obviously catches up in the second, we'll see it higher. Any additional wins that have been factored that would cause especially ones that are backloaded towards the end of the year where there's no immediate deliveries would cause the number to go up as well. So, we're comfortable where we are right now projecting at least the one for the year and obviously we're working hard to try to beat that.

Cai von Rumohr – Cowen and Company

Your second quarter guidance really assumes a big dip in margins given that you had some abnormal factors in the first quarter, could you give us just some color in terms of the pattern of margins as we go through the year?

Ralph D'Ambrosio

Well, as I said, yes, margins that we had in the first quarter we're unseasonably high for L-3. Typically we have our weakest operating margins in the first quarter and then they improve sequentially throughout the balance of the year. But like I said, the combination of those funding delays and lot of it was on lower margin type work including JCA plus the early favorable items that we had planned for later in the year, which happened in Q1, those drove the margins up in the first quarter.

That said, the margins are still a little better than we expected and for that reason we took the margins up 10 bps for the full year to 10.8 and as we always do, we're going to try to do better. We just don't want to commit to it yet. But when you get to the second quarter, I think our quarterly margin trends are going to resume what you've seen in the past, Cai.

Cai von Rumohr – Cowen and Company

So we should expect the second to be the weakest and the third to be better and the fourth to be better just in terms of the general pattern for the year?

Ralph D'Ambrosio

Correct.

Operator

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

Robert Spingarn – Credit Suisse

Just a couple of quick things; Mike, you mentioned the scope on the tanker really wasn't the right fit, could you elaborate a little?

Mike Strianese

Well, we evaluate -- first of all, Rob, we love the team, we love to be with the two teams we love to be on both teams in the competition and we certainly are happy to do work with E3 supply equipment on the A300 series of airplanes in terms of (inaudible) and flight recorders. In this particular instance though where it would have involved our mission integration division, which is where we're cranking out Liberty's bidding on EMARS have the Springtime programs ramping up and have a limited amount of hanger space and capacity, but it's really not space, it's more resources personnel wise.

We did a business evaluation and so that's the scope that we would have liked to have seen would have been bigger for us to commit to that program. Now I'm not to say that it doesn't end up there somebody but where it was during the time when we were looking at it, it was just something we typically wouldn't do in terms of committing our mission integration division’s resources.

Robert Spingarn – Credit Suisse

That makes sense. Also on aircraft JCA, is there any risk to this order, this fiscal ‘10 funded slug that we've been talking about here?

Mike Strianese

Well, Rob, I wish I could say absolutely not. I believe it's absolutely not, it's in the budget and the planes are in production if I'm not mistaken. I mean you can't wait for the (inaudible) and start screwing things together. So again I don't have a good explanation nor do I think any of my colleagues across the industry of why some of these orders are slipping from where they should have landed but I'm not expecting to see it slip much longer, I mean we're planning this in the second quarter.

And as I said, for the four deliveries this year two of them are already made. So as you know, we like to manage these programs types stay ahead of everything and we did do a big in advance on Liberty as well where we went advance of contract and provide materials and things to make sure that we were able to meet the rapid delivery that the customer is looking for and we're on the same page here. So the answer is no, there's been no indication that there's anything that would cause me to think it's in jeopardy but there's unforeseen things. I’m not a 100% positive but I have no reason to believe it's not coming in the second quarter.

Robert Spingarn – Credit Suisse

Well, the only reason I asked Mike and it maybe too far long for it to matter, it's just the dichotomy here with Air Force versus Army and the real appetite that the Air Force has for these planes to begin with, no fault at all to you guys, it's just – this idea that the C-130 is there and available and this program has shrunk and you see what I'm getting at.

Mike Strianese

Yes, of course, I do. I mean we had a firm commitment for 37 airplanes, the money was in the budget, is in the budget and we fully expect it to be funded. I guess you always run the risk of a contract program termination but we haven't heard anything like that. That's nothing that we're planning on and that scenario we'd be reimbursed for most of the things we spent money on. So I hear you but we haven't got (wind) to that all.

Robert Spingarn – Credit Suisse

And then the last thing I would just ask you to comment on Generally McCrystal has been out there saying there's too many contractors in theater, you've got some there. But do you make anything in that, is there going to be an effort here to try and pressure that number down?

Mike Strianese

Well, the way these contracts are getting broken up into smaller pieces actually they can expect more.

Ralph D'Ambrosio

Now I don't know what more means, more means the total number of heads or more means total number of companies, but the way things are getting broken up, you are going to have more companies running around the theater of operations because with everything going to task order in smaller pieces.

Robert Spingarn – Credit Suisse

And he's talking individually, so too many individual contractors in terms of the number of people.

Mike Strianese

Okay, the ratio up to the –

Robert Spingarn – Credit Suisse

Yes, so he’s – if the ratio of contractors to soldiers has gotten very high.

Mike Strianese

Well, I think some of them are probably in there in advance of the surge, I think the surge is halfway through on those additional 30,000 troops, there is about 15 there now. I don't have a response to that Rob because I don't know that people sitting down doing nothing, it’s a very demanding environment. There's contract field teams, they ought to keep the equipment running whether its helicopters or land vehicles or UAVs or ground electronics and the likes, so I gather -- they're okay there.

The training is something that is our exit strategy, so training both the Afghan National Army as well as the Police Force is something that is a precursor to the US withdrawal. So I think that those services are necessary and those are the areas that are of interest to us if there are other places where there are too many people running bases and (inaudible) and things like that. I'm certainly sure they don't want to waste the money and they'll withdraw them. We have no indication of that, (I don't think they are) doing them.

Operator

Your next question comes from the line of George Shapiro of Access 342 please proceed.

George Shapiro – Access 342

I guess Ralph I was just looking at electronics, the margin that you did in the quarter and your guidance at 12 plus a little bit, it would seem Insight for the whole year as a higher margin, that would help it a little bit. You don't think there's some opportunity at the margin in electronics, so it’s a little bit better given that usually the first quarter is one of the weaker quarters as well.

Ralph D’Ambrosio

There is some opportunity and I think I just said that we're going to try to do better. We had some very good mix in that quarter, the first quarter in electronic systems and if that continues, the margins are going continue to be strong in that segment.

George Shapiro – Access 342

What was the size of the competitive loss that you had at AM&M?

Ralph D’Ambrosio

That was a program doing P3 work for the customs and border patrol. The annual sales on that program used to run about $50 million to 60 million.

George Shapiro – Access 342

Okay and then finally for Mike, can you give a feel of how you look at ‘11 in the C-cubed area given that project Liberty is ending and EMARS is a big – it would potentially big contribute on it, can you kind of size how you look at that business with and without a win for EMARS next year?

Mike Strianese

Sure, George. Well, the EMARS would be a great win for us and as I said it could be actually the next aerial common sense for all we know. So that would certainly be incremental or additive. But even without EMARS our core business is extremely solid in this area. The other (inaudible) demand for 24x7 full motion video is not going away even in drawdown situations. That is a force multiplier that allows the remaining troops in place to stay safe and know what's going on. So I don’t see that impacting us dramatically in terms of drawdown. The Rover products, for example is still in production, we're going up to version 6 of Rover and I see no slowdown there as well.

When you take a look at Liberty, we think that even though we'll be delivering the 37th aircraft in November that there's the opportunity for several more orders, another six or so, and there's additional capability that's being looked at based on the current fleet that's operating that again is a new airplane doing special missions and the operators coming back with their experience with it and saying, “Gee, could we have this or change so much in the classified space.”

There's a potential to refit the existing 37 with advanced mission systems whether we drop things in in theater or they come back. So I view this as a long tail in this business area. It's consistent with what's in the budget, it's consistent with the strategy set forth in the QDR that the C-cubed ISR area will continue to be a major focal area

And finally, the technology, George, in this space is moving quickly whether it’s smaller, faster, lighter, different wave forms, wider bands, you can imagine the networks that are in place now, the demands on bandwidth are incredible. So, you know, it's driven by a bunch of things, the environment, the engagements obviously, the technology changes in the threat environment. So we feel very solid about the ISR business going forward.

George Shapiro – Access 342

You care to want to bound it in terms of the low end side to a high end side depending on how say Liberty and EMARS shake out?

Mike Strianese

Growth rates?

George Shapiro – Access 342

Yes.

Mike Strianese

I'll give you a wide range, I'll go out on the (ledge) here and then Ralph will push me off it. I would say eight on the low end, maybe 12 to 15 on the high end. I'm happy at around 10, let's call it 8 to 12. I think I'm comfortable in that bandwidth.

Operator

Your next question comes from the line of Joseph Campbell of Barclays Capital please proceed.

Joseph Campbell – Barclays Capital

Good morning Mike and Ralph. Just to be on that same question, I mean looking at Spring at, the little program that's ending in November, the small aircraft, is there a big change when you stop delivering aircraft or does the sort of retrofit and change out as you've done for so many years on a larger aircraft kind of carried this thing without a big drop off, I mean I think people might have thought that because you were delivering the last aircraft, there was some sort of valley that needed to be filled. Is that the case or not?

Ralph D’Ambrosio

Joe, you're talking about Liberty, correct?

Joseph Campbell – Barclays Capital

Yes on Liberty.

Ralph D’Ambrosio

So what happens when we get into next year while we complete the deliveries in 2010 this year and into next year, we're going to be ramping up our COS work, logistic support.

Joseph Campbell – Barclays Capital

Right.

Ralph D’Ambrosio

So, for that reason the revenue is going to remain pretty steady, it might be down a little bit but if we get those six additional –

Joseph Campbell – Barclays Capital

If we get the six airplanes then it'll be up either.

Ralph D’Ambrosio

Could be marginally up. So like Mike said, we see it as a program that'll have some very long legs.

Joseph Campbell – Barclays Capital

No, I just -- I'm sure that people will have the impression that because it ended there was some valley that I understand that what you're saying now is that the field support of it, the contractor support of it whether back home or in the field will step up with the full fleet and there won't be any big valley and if you get the other airplanes, it'll be flat to up.

I'm just changing subject, you talked a little bit about the business of the TSA machines, the whole body imaging, can you just, Ralph, go back and summarize how the whole of the commercial businesses are looking so it looks like that portion is up. You had the marine business that was pretty weak and then the commercial aerospace stuff, which presumably might be starting to see some signs of pickup even if it hasn't happened yet.

Ralph D’Ambrosio

If you recall, what our 2010 guidance assumed and continues to assume that our commercial businesses in total will be down about a $100 million in sales versus 2009 and those assumptions are continuing to hold. On the aviation side, which we expect to be flat for the year, the growth is going to come in the second half. So, those sales were down a little bit in the first quarter and we expect sales to pick up there in the second half and Q3 and Q4.

The ship building, maritime products are going to be the main driver of the lower sales, $75 million or so and those sales were down about 10% in the first quarter and trending to what we expected.

The whole body imaging which is going to be about $50 million for the year in sales, I’m sure there could be some upside there, the combination of what we booked in the first quarter on the international orders plus this $32 million that we received today from TSA is going to get us there. So we could have some upside there in the back end of the year, the TSA does more procurement.

Joseph Campbell – Barclays Capital

Terrific thanks Ralph.

Ralph D’Ambrosio

It's holding to what we expected on the commercial side.

Operator

Your next question comes from the line of Rob Epstein of Merrill Lynch Bank of America. Please proceed.

Rob Epstein – Merrill Lynch Bank of America

Mike, I was wondering if you could maybe give us some color on what you're seeing in cyber security markets if there's really anything there, is there any M&A to do in that space, just kind of broadly some color on cyber security.

Mike Strianese

Sure. It's a space where the most you're going to read is the word cyber security because of (inaudible) there is an intrusion because many of the things that are done in this space are certainly done in the agency world in a very classified space. But what we see and we have visited with the customers that operate in this space regularly is that the funds are getting programmed through existing contract vehicles that are addressing their current systems and changing threat environment. You're not seeing any -- it's like after 9/11 there was a big stampede to Homeland Security place and everybody stood up the Homeland Security Organization.

Well, this is kind of a similar thing, I don't think it comes in a big bang, it's been a gradual ramping up in that space of capability. I know that there is an insatiable demand, to use the phrase again, for qualified network analysts that -- young people coming out of colleges and in fact that could be a business just being able to bring these people and train them and then send them over to work for the NSA or CIA or typically this is an NSA function. So there's plenty of activity but it's not the big bang everybody thought they were going to see.

The good news is we have several contract vehicles that are in the right place and we have several both products and services that we provide that are in that space. As Ralph mentioned it was a large classified program that we just got turned on for, it's about a billion dollar program.

In terms of M&A in that space, well, you got to be careful, there's a lot of companies now, they got the buzz word cyber and cyber shows up on everybody's dossier as something that they do (inaudible) as you call it. And when you take a closer look, sometimes it’s there and sometimes it’s not but it's fair to assume that companies that have real cyber capability in this space will command a premium valuation for companies that do not and that is absolutely true. So that's kind of the way we look at it.

Operator

Your next question comes from the line of Noah Poponak from Goldman Sachs. Please proceed.

Noah Poponak – Goldman Sachs

When I look at the 11.3% operating margin you printed in the quarter, is that as high as the margin can go for L-3, you're obviously saying it goes lower for the rest of the year a little bit but longer term can you get the margin higher than that?

Ralph D’Ambrosio

What we've been saying for several years right now is that one of our financial growth objectives is to have modest expansion in our margins each year and we said it should be around 10 or 20 basis points per year. With most of the increase coming in the two products, hardware type segments, electronic systems and C-cubed ISR.

So we're trending to where the margins are going to hopefully get to 11% and higher, just it's going to take some time at least to do it consistently each quarter. But once we get to the lower leverage, then we should revisit the conversation but we still have some room to go.

Noah Poponak – Goldman Sachs

Fair enough. You mentioned a few programs slipping to the right. The Linguist Program in particular we're now coming up on almost I think nine months since there was a panel that said a recompete was already underway. What's going on there? Is it that the small business that has the Afghanistan piece is performing or is it just that INSCOM is notoriously slow, what's going on there?

Mike Strianese

This is conjecture more than anything. The question should really go to the government as to what they are – but I would tell you knowing from other areas of the business and how things are going, I think it's just a priority basis that there's just so much going on, there's new people that's coming into DoD to do acquisition work; that is just slipping on their own time schedule of things they have to get done.

I'm not reading anything into it as -- I certainly don't believe it's a case where somebody is doing good or bad and we're going to move the procurement around, I don't believe it's that at all. I just believe it’s internal prioritization within the agency, and no, I don't think INSCOM is notoriously slow either, I just think they are amidst the army's intelligence demand if you think about all the things that they have to do in theater, this probably will be a long list of things they have to get done. And again, I guess the observation is while you have an incumbent there and it’s marching along, so things are jumping in front of it on their desk where there are new requirements that are there.

Noah Poponak – Goldman Sachs

That makes sense.

Mike Strianese

So I don't – yes, I don't read anything into it other than -- of course, it's not just INSCOM, I mean it's in multiple places we're seeing it and I can't say everybody is slow. I mean if that's -- I know the secretary has been pounding desks at the DoD about getting things done that are relevant to the war fighter today and I think that's what everybody is doing so that's why you're seeing priorities changing.

Noah Poponak – Goldman Sachs

If I could slip in one more, you guys had few quarters ago first started to talk about price only competitions and the government IT services were all in pricing pressure, at your Investor Day you sort of said the customer was regretting that and backing off a little bit. What's the latest that's going on there?

Mike Strianese

Well, in cases they are backing off a bit but we still see plenty of competitions that come up that are price only. Certainly the IDIQs are structured that way where they'll qualify multiple bidders and to be able to compete on work under the IDIQ contract, whichever particular contract it is, but then when it's task orders come through, it's price period because they've already qualified you

So we're still seeing a mix. The good news is we've seen a few come through as best value, which does not necessarily mean low price it means price as well as the ability to deliver in low risk and task performance with technical capability. And given the areas where we compete, we think we have an edge that helps us more than when its simply on price only because of our strong positions at task performance. So it's a mixed bag right now and it depends on, has swung all the way back for being best value, it's still a mix.

Operator

Your next question comes from the line of Joseph Nadol of JP Morgan. Please proceed.

Joseph Nadol – JPMorgan

Hi guys good morning. Just want to get back to C-cubed and Mike, you already answered a whole bunch of questions or a couple of questions on this, but I guess mine is specifically just on the book to bill. When do we see that start to come back up to 1.1 or 1.2 to support the sort of 10% growth you see coming there next year? Is that Q2 or do these awards really come more like towards in the back half of the year?

Mike Strianese

It's more back loaded Joe in the back half of the year. The book-to-bill is certainly an important measure for us but it doesn't get affected by the timing of obviously when these awards are made and it gets affected by the duration. So you can keep doing things like incremental funding, small pieces that they keep adding, you'll lose the benefit of having the big backlog. So it doesn't necessarily indicate your sales are going to be off. People are watching that very carefully. In other words, if you keep getting the funding in January and delivering by December, your book-to-bill could be one and your backlog is zero.

Joseph Nadol – JPMorgan

Yes, of course. So you would say then that we shouldn't necessarily – if you don't get a 1.05 or 1.1 book-to-bill this year in C-cubed that doesn't necessarily mean given the backlog you already have and sort of the very close relationship between booking and shipping but that doesn't mean you're not going to get to 10% next year in that business.

Mike Strianese

Joe, that's absolutely correct and (we) add true sense to it. And therefore what we would be telling you then is obviously we'll be giving you our sales guidance but inherent therefore would be an amount that would be considered book and ship, that would give -- I would say that that would definitely give a slightly riskier profile of hitting the sales plan.

Joseph Nadol – JPMorgan

Right.

Mike Strianese

That is the way we look at it. But again we're pretty diligent when we look at our sales guidance and we look at what is that mix of book and ship and how secure it is before we put a number up but yes, that's absolutely the way we would be looking at it.

Joseph Nadol – JPMorgan

Okay and just one other for you. On Iraq, we have this pretty significant drawdown that's happening kind of as we speak and I'm wondering if, you know, as you look at your sale sort of quarter to quarter sequentially Q4 to Q1 and as you think about Q2, if you're seeing that based on your whole mix of sales there or if you're seeing things kind of steadier, how do you characterize it?

Mike Strianese

Ralph's going to give you some numbers but what's happening, Joe, is that the drawdown, the quasi of the drawdown is exceeding the ramp up in Afghanistan, so it's obviously not one for one. So there's a negative delta between what we're ramping up in Afghanistan and what's getting cut but go ahead Ralph, you have something?

Ralph D’Ambrosio

So if you recall, our guidance for 2010 includes about $800 million of sales for Iraq related work and that's coming down from about $1.1 billion in 2009 and I talked earlier about the headwind on Linguist being more pronounced in the first half. So we're seeing a bigger drop off in those Iraq sales happening in the first half and the biggest driver is our Linguist. So once we get into the second half, the negative comparison should reduce a bit.

Joseph Nadol – JPMorgan

Okay but if you were to -- we had the debate or there was always the question a year ago or two years ago when the tempo comes down, when the drawdown finally comes in Iraq what's going to be the relationship of your sales and we talked about training and maybe that goes up and it's -- I'm just wondering now that you're seeing it if you try to strip out the impact of changes in contracts and maybe Linguist is one of those, if you just look at your sort of regular way of sales, are they coming down with the troops faster or slower? If you can answer that maybe you can't.

Ralph D’Ambrosio

I would say slower. The last time we discussed this what we said was that once the troop drawdown aided to the 50,000 or so support groups that were outlined by the administration and which is supposed to happen toward the end of this year into next year and they would still be doing ISR type work and training type activities. So I think what that means for our revenue base, the $800 million probably goes down to about half a billion. So that's the additional downside that we see in the Iraq related sales and we also said that that could be offset by direct contracts with the Iraqi government but none of that has happened yet and that won't happen until drawdown is completed. So that's how we see those Iraq revenues trending right now.

Operator

Your next question comes from the line of Troy Lahr of Stifel Nicolaus. Please proceed.

Troy Lahr – Stifel Nicolaus

Thanks, just to clarify the last point, do you think that it needs to go below 50,000 troops before you start going to the Iraqi government or kind of what is the drawdown number that you're looking for? Do you have any indications from the Iraqi government on timing on, “Okay, yes, you know, we think it's going to be 2011”? Are discussions even open and can you also talk about Iraq, your expectations for -- I'm sorry, for Afghanistan revenues in 2010 and 2011?

Mike Strianese

Troy, first of all, I think some of those discussions have to happen between the US government and the government of Iraq because there's going to come a point in time where I wouldn't put the trigger at a number of troops although that will be -- that's not a magic number because it'll be 50, 40 whatever it is, there'll come a point in time where the US will say, “All right, well, do you want to pick up the bill for the training now or not”, which will be withdraw our trainers, and certainly there'll be an interest in maintaining the law and order and security that has been worked on over the last eight years, 10 years, which was our expectation to have that discussion.

So again, I think that's a government to government conversation that'll happen naturally as these bills have to continue to be paid. I would also say that there is – offsetting any drawdown (inaudible) as this equipment comes out, this is like millions of pieces of equipment that needs to get sorted out, so there's a big logistics problem right now that's mounting on sorting through what goes to Afghanistan and what comes home (because) it's not serviceable in need, so that reset that way is kind of out there too.

So, you know, we'll wait and see. It was almost two years ago I believe that there was supposed to be a contracting conference in Iraq that was postponed to this very topic that you're asking about. It's a two year slip. We had the invites and people were ready to go, so we're sure it's going to come back, we don't know whether it's going to be later this year but that activity will have necessity have to start soon.

Troy Lahr – Stifel Nicolaus

Okay and the Afghan revenue for 2010 and 2011?

Ralph D’Ambrosio

The last time we talked about this on 4Q09 call, we said that we expected it to be approximately greater than $50 million, it's now about $400 million and that's due entirely to the SOFSA contract extension, mostly due to -- so about $400 million included in the current guidance for the year, Troy.

Troy Lahr – Stifel Nicolaus

Okay, thanks. And then you probably addressed it a little bit but could you help me understand that aircraft modernization, the increase in guidance but the decrease in the margins.

Ralph D’Ambrosio

Again I hate to keep saying SOFSA but it’s SOFSA. We had $200 million of sales for the SOFSA contract and the margins on that cost plus award fee contract are substantially less than what they are for the company average and for the segment average there, that's why it's a mathematical calculation, Troy.

Troy Lahr – Stifel Nicolaus

Do you care to tell us what the margins are?

Ralph D’Ambrosio

No, we're in a competition right now. I think I gave you the key takeaway, it’s less than the –

Mike Strianese

Composite.

Ralph D’Ambrosio

The composite.

Operator

Your next question comes from the line of Howard Rubel of Jeffries. Please proceed.

Howard Rubel – Jeffries

Thank you. Mike, you kind of alluded a couple of times to more difficult competitions, what are you doing on the cost side, I mean to make yourselves even leaner than you already are. It looks like you've won a couple of opportunities where you've picked up some market share as a result of that. And then, just as a follow-on, are you finding that there is some OCI opportunities that you see yourself uniquely equipped to take advantage of because others have conflicts of interest.

Mike Strianese

Sure, Howard. On the cost competitiveness question, as you know first of all, the areas that we feel that are the most cost competitive are in the services such as our government services segment and AM&M, the contract field teams in particular where you're always at risk of what I call a re-badging situation if you lose the kind of workforce stays in place and they change contractors as happened in linguist.

So we have been consolidating operations as you know in our services segment. We have brought our intelligent solutions together with our IT business, which really is also -- it's not a seat management business it's government, you know, high end IT business, (inaudible) unit now is referred to as Stratis. It's a combination of those two business units that took out a complete layer of overhead from depriving a separate business unit infrastructure there.

We are also going to work -- this is kind of an integrated answer I'm going to give you. The OCI rules came out today, I believe they're being published today in the federal register. I wish I could talk to you more about them but I haven't had a chance to read them yet this morning but depending on where they – I doubt we're going to have any divestiture from them, it could be something small but nothing of. So assuming that there's no action there what would happen would be the next step in services will be to combine all the back office operations for the entire $4 billion segment. We don't need to have multiple back office operations.

So there is low hanging fruit for us to go ahead and harvest to make it more competitive. As you know, Ralph has been saying there's margin pressure here because we have to keep bidding low and that's certainly the case.

Similarly in AM&M, we have been working the same overhead issues there. They are not the same consolidation opportunities there for facilities because again these are field teams, so they're out in the field and they have to be where the customers are. So that becomes more a question of well how much more can you take out at the group level or the corporate level there and we've been trying to get some economies of scale between the Greenville operation and the Madison Mississippi operation, which runs these contract field teams that kind of the (inaudible) business, that's the hub there.

OCI, I'm dying to hear what came out this morning, honestly I am because in other words whether – so, let me give you what the twist is. If there's mitigation plans that most companies can meet to avoid OCI problems, you will see less divestitures. If it’s anything less than that and it’s going to call into question or companies will be forced to choose whether to sell hardware or provide SETA services, you Systems Engineering and Technical Assistance or other type procurement related services, well, then you're going to see divestitures and is that an opportunity for us?

I'll give you a cautious yes because obviously we don't want to stub our toe and have a problem with our product business, which obviously is something we guard very carefully, it's very proprietary. We don't have the same competitive issues in terms of price because we know we make the best data link in the world and we do the best job at integrating aircraft and the likes. So we don't want to stub our toe and have those businesses disqualified because of OCI issues. So this is something we're going to be more prepared to talk about at the next quarter call and again, I'm interested in seeing what the rules say today.

Operator

Your last question comes from the line of Michael Lewis of BB&T Capital Markets. Please proceed.

Michael Lewis – BB&T Capital Markets

Thanks very much for taking this final question. Mike, export controller, Secretary Gates recently was in the press talking about possibly revising the walls on export controls and I really want to ask you about what do you think the likelihood of this occurring, does it really have legs. And if so, where are the future opportunities that you think L-3 could really materially change its operations internationally?

Mike Strianese

Well, the biggest opportunity – first of all, let me say, yes, I agree I've heard the Secretary say that it was the industry has been complaining and the background is that certain systems that we're not allowed to export are available commercially in the international marketplace. So what that means for us is that in the past we may not have been able to compete for subsystems on an international platform with some of our sensors because they were export controlled and if those controls are relaxed in a sense then we would be able to compete with them.

So the space where it makes the most sense for us would be on international ISR platforms, unmanned and manned. Having said that, you can only go so for in this space before you're going to hit the export wall again because we have very high end systems that I could tell you no matter what kind of reform they do, they're not going outside the country and why should they.

So, we are happy to participate and by the way, the bigger issue here is not so much we can sell systems to our allies or other friendly countries but the bigger issue is how do you control the resale of that technology and that's something that I have to be sympathetic to the folks in the state department and in the DoD that have to deal with this everyday is that that is the real issue.

I'm sure there's no problem with many of the countries involved where that are (inaudible) technology, but the ability to control the resale is another story that many countries aren't willing to sign up to. So in other words if a country is building a UAV system and we throw data links and sensors on it with their own domestic national security uses, that's probably not a problem. Now if they want to market that system on the international market, which many of them do because they're smaller countries that would like to defray their cost, that becomes a problem. So I wouldn't see it as a windfall but it would provide a modest upside for us.

Michael Lewis – BB&T Capital Markets

Okay, got it, thank you.

Mike Strianese

Actually, I'm sorry. Okay, well, thank you for joining us on the call. Again, it was a strong quarter and I don't want to end the call without thanking the men and women of L-3 who just did a superb job getting us through the first quarter and focusing on great program performance. So thank you to everyone. And we hope to talk to you soon at the second quarter call. Thanks for joining us, bye-bye.

Operator

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

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Source: L-3 Communications Holdings Inc. Q1 2010 Earnings Conference Call

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