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Executives

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

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

Eric Boyriven - Investor Relations

Unidentified Analyst -

Analysts

George Shapiro - Citi

L-3 Communications Holdings (LLL) Q3 2010 Earnings Call October 28, 2010 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the L-3 Communications Third Quarter 2010 Earnings Conference Call. My name is Madge, and I will be your coordinator for today. [Operator Instructions] I would now like to turn the presentation over to your host for today's call, Mr. Eric Boyriven of FD [Financial Dynamics]. Please proceed.

Eric Boyriven

Good morning, and thanks for joining us for L-3 Communications Third Quarter Earnings Conference Call. With me here are Mike Strianese, Chairman, President and CEO; 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 will now turn the call over to Mike Strianese. Mike, please go ahead.

Michael Strianese

Okay, thanks, Eric, and good morning, everyone. Thanks for joining us for our third quarter earnings call. We'll start by, of course, thanking our employees for their continued hard work and commitment to the program performance in satisfying our customers, and our Group Presidents for their continued leadership efforts.

Overall, it was a solid third quarter. Earnings were up about 11% to $2.07 a share if you adjust for the debt refinance charge of about $0.03 that we had in this year's third quarter, and also adjust the $0.22 tax gain that was in the 2009 third quarter. Operating margins and cash flow continue to be strong. Sales were a little weaker than we expected. They were $3.8 billion. However, our C3ISR businesses continue to do very well with 8% growth, which had offset declines in A&M and Electronic Systems. Our Government Services segment grew at about 1%, but that reversed the trend of declining sales that we saw in the first half.

Orders grew at about 4% to $3.5 billion in the quarter versus 2009 third quarter, resulting in a book-to-bill of 0.92. Year-to-date, however, the book-to-bill is a 0.98, a little lower than the 1 that we would have liked to have seen, but still encouraging. Our funded backlog was $10.8 billion at the end of the quarter.

In terms of significant awards, there were several. First of all, the U.S. Army C-12 logistics support contract. Also with the Army, the Enhanced Night Vision Goggle or ENVG contract. That's getting a slower start than was expected, however, because of a protest, which has now been resolved. Intelligence Support Services in Afghanistan, our Special Operating Forces Deployable Node-Lite or SDN-Lite contract. A recent win known as the Battlefield Anti-Intrusion System, or BAIS, for the U.S. Army and the Advanced Checkpoint Carry-on X-ray Screening Systems for TSA. On top of those wins, there was significant follow-on order activity as well, and it's a long list, but just to name a few, Project Liberty, our EO/IR turrets, Rover ManPacks, CF-18, Law Enforcement Professional Program, Rivet Joint work, more eXaminer work, Flight School XXI and C-12 Logistics Services, just to name a

few.

In terms of the larger programs for JCA, total orders received to date are 21 aircraft. We're expecting another eight in fiscal '11. The total Air Force buys continue to be expected to be 38 aircraft, with the final mind coming in fiscal '12. We plan to deliver four in 2010, three are already delivered. That brings the total for the program will be six. The National Guard is still projecting the need for additional aircraft, and there is a potential for a plus up in fiscal '12 and beyond. And there are also still several foreign military sale opportunities, mostly those we see slipping to 2013 and 2014 due to government fiscal pressures and the fact that most of our production is dedicated to the U.S. delivery schedule as well.

For Project Liberty, we completed delivery of all 37 aircraft to the Air Force in August, and that was on budget and ahead of the contractual schedule. We look forward to continuing to apply L-3's expertise to other small aircraft ISR applications, both within the U.S. DoD and with foreign customers. For example, we currently expect the Air Force to expand the Liberty fleet by five aircraft sometime later this year. That has slipped out from where we had expected it and probably part of the OCO request for fiscal '10. We also are currently competing as a prime, as I'm sure you know, for the U.S. Army's EMARSS program.

A few words about EMARSS, that is the Enhanced Medium Altitude Reconnaissance Surveillance System. It's an aircraft that focus on the regular warfare mission, SIGINT, COMINT, EO/IR, and communications. It is the replacement for the canceled ACS program and a possible replacement for the aging Guardrail fleet, expected to be of $1.5 billion program of record. Configuration is a small aircraft similar to the Liberty MC-12 platform. The initial buy is now anticipated to be 6 EMD aircraft, with a six aricraft LRIP option plus logistic services and is expected to further grow to at least 30 aircraft.

We expect the award decision before year end. Now that was expected at the end of September and then the end of October. So that's moved out, as I'm sure you've all read, that's a heavily-competed program of between major primes and ourselves. We think we have a good shot at it, but again, it's a heavily-competed program, and we look forward to hearing the results at the end of year.

U.K. Air Seeker, formerly known as Springtime, formerly known as HELIX and sometimes known as U.K. Rivet Joint, just all on the same page, that program has survived Britain's Strategic Defense and Security Review, and is expected to proceed. It's a significant program for L-3 worth over $800 million over seven years. It consists of three U.S. Air Force RC-135 aircraft to replace the U.K. Nimrod ISR aircraft. The first aircraft delivery to the MOD is anticipated in April 2014, and we expect to receive the first aircraft to induct it in our Greenville facility in January. We're already beginning preliminary work on long lead items and planning. But I think what's important to note here is, this is really a good example that shows, one, the importance of ISR; two, the confidence in L-3's reputation and our ability to deliver on time and on budget even during the significant budget cuts we saw in the U.K. So we are very happy that this is proceeding as scheduled. And we're currently negotiating with the MOD presently, and expect the conversion kit contract by early next year. The program will be incrementally funded over the seven-year period.

In the Whole Body Imaging airport checkpoint scanner program, there were only two qualified suppliers as you know. Back in April, we received the TSA order to deliver 202 systems. This was the first order placed on our five-year ID/IQ from the TSA, which was valued at up to $167 million. All 202 systems will be delivered by the end of this year. We delivered 135 of those systems during the third quarter and plan to ship the remaining 67 units in the fourth quarter. We expect the next TSA order in the first quarter of 2011. Future orders are dependent on the testing and acceptance of the auto-detect software, which is planned to be deployed in the first half of next year.

In terms of our capital deployment, we repurchased $215 million of stock in the third quarter, bringing year-to-date repurchases to $469 million. Our remaining authorization was about $957 million at the end of the quarter, and we now expect to repurchase about $800 million of our stock for 2010, up from our previous estimate of $500 million. We continue to believe our stock represents a good value.

With respect to acquisitions, we acquired Airborne Technologies in August and 3DI Technologies in September for an aggregate price of $93 million. Both of those companies augment our existing capabilities. They were bought at attractive prices. They're already contributing to our operations.

We continue to evaluate several other companies. However, as you know, the valuation multiples for publicly-traded defense companies and those that are not are kind of out of balance, and we're being cautious in terms of valuations that are excessive compared to where the company trades in most cases.

Three acquisitions that were made to date that's worth noting, were all negotiated non-auction transactions, again, where we paid reasonable prices. In terms of our 2010 guidance, we provided an update today, maintaining our EPS range at $8.05 to $8.25 per share. At the midpoint, that represents about 7% growth from 2009. We lowered sales to $15.6 billion to $15.7 billion compared to our prior guidance, and that decrease is due to the continued procurement and funding delays we've experienced since the beginning of the year. However, margins are doing better and a little bit better in taxes, a little bit better on the share count, we've been able to maintain our earnings guidance.

I want to spend a couple minutes on the DoD budget and spending priorities before I get into the 2011 numbers. They've received a lot of press lately. Of course, overall, the budget's remain healthy and robust with modest base budget growth plus supplementals. However, be addressable DoD budget per industry, which include the investment account and the O&M account is essentially flat when you include the base of supplementals, and that is pressuring sales growth. If you look at the base budget, the O&M account is growing at about 8%. The 11 requests compared to fiscal '10 and the investment account or the hardware account is growing at about 2%, combined at about a 5% level. When you overlay, however, the decline in the supplemental, what it's doing is it's actually causing a 1% drop in the combined base plus supplemental addressable market. On balance, however, about 50% of our sales are coming out of the O&M account and on a base level. That does account for 8% growth and we will continue to do well with the way the company is positioned even in these flattening budget times.

Of course, Iraq and Afghanistan continue to determine the near-term resource decisions. We think that accounts, in some cases, to some of the slippage and reprioritization of funding, as well as lower new starts and the reprogramming. The tighter budget has been confronting the DoD and underscored repeatedly since May by Secretary Gates and Under Secretary Carter and Deputy Secretary Lynn. In May, it his Eisenhower Library Speech, Secretary Gates said that given America's difficult economic situations circumstances and fiscal conditions, military spending should expect closer, harsher scrutiny. And Secretary Gates wants to reduce DoD overhead costs and transfer those savings to pay for force structure and modernization in the DoD budget. What I'd like to underscore there is the requirement of force structure and modernization hasn't gone away, it's getting more and more difficult to fund, and it's certainly going to be stretched out over a longer period of time than we would of course like to see.

Following, we have Secretary Carter's acquisition memorandum that was issued last month, focusing on eliminating unproductive, low performing programs, redundant programs, low value overhead. And the objectives include delivering the needed war fighter capability within the budget, restoring affordability and doing more without more. The implication for industry of course is the need to be responsible partner and outperform negotiated costs and schedule. Notwithstanding that, the geopolitical scene confronting the U.S. and its allies remains complex and challenging and will likely continue to require a healthy DoD budget. Therefore, I think, on balance, industry should be okay. In general, I think L-3 will be better than okay as well.

To give you some sense for what we're seeing next year, I know you've seen our guidance in the release, but as you know, we will have an Investor Day that will be in December. We will provide a lot more granularity on guidance, but from a segment basis, we continue to see C3ISR leading the growth in the company. There continues to be strong demand for small aircraft via ISR and network communications, as well as the demand for international airborne ISR continues to grow.

With regard to AM&M, of course, we have a headwind in that segment with the loss of the SOFSA contract and a bit of price competition in the logistics work. However, the aging aircraft fleet that the U.S. has continues to present significant opportunities here at home. Internationally, there's been a bit of a slow down, of course, by physical fiscal constraints. Services, we're looking at an overall flat 2011 right now and a little bit of downside risk actually due to the competitive nature. However, I would stress in the Services segment that it has more opportunities for winning large programs than most other segments of our business areas right now. So acknowledging that reality, we are focusing some investment next year in cyber, indigent proposals and also the move of CECOM down to Aberdeen where we have a contract with a lot of content.

Electronic Systems, we expect to see modest growth in the diverse product portfolio we have. Of course, the reprogramming and cuts have affected several of our business areas. But what's growing would include EO/IR, Microwave, Aviation, Displays, Precision Engagement, Security and detection; with Marine & Power Systems, Simulation and Training, Propulsion systems and Telemetry declining.

As for the commercial markets, our commercial and international sales are about 16% to 17% of our consolidated sales and our commercial markets, currently, they have been declining both the avionics, as well as the equipment that we put on ships, both commercial and military. We're starting to see a rebound in avionics beginning in the latter part of this year and extending into 2011.

On the Shipbuilding side, we expect to see a rebound in 2012. So that'll continue to be slow next year. The homeland security market continues to advance as we introduced new products. And in terms of foreign military, it's an uneven environment. There's a lot of growth in the Middle East and Asia, but much lower growth in Europe, U.K., Canada and Australia.

When you look of course the company, let me to summarize what we're seeing. Again, the ISR segment to be growing next year. Services flat, AM&M will be down because of JOG [Joint Operations Group], but if you remove that effect, it is growing, and if you look at the Electronic Systems segment between the advancers and decliners, again, EO/IR, Microwave, Avionics, Displays, Precision Engagement, Security and Detection collectively are growing at about 8%, but they're being offset by Marine & Power Systems, Simulation and Training, Propulsion and Telemetry and Advanced Technologies, which are declining by about 5%. And in terms of the reasons for the declines, I can hit them very quickly. But again, Marine & Power Systems is just the slowdown in the, primarily, the commercial shipbuilding area. And we see that recovering at the end of 2011. So we don't believe that's permanent or long term. Simulation and Training, it's really a function of reprogramming of funds in the U.S. and program slipping out of the year in the international marketplace. Propulsion systems is one program, it's funding for the Bradley that has been redeployed elsewhere since that is not a priority for Iraq and Afghanistan. It doesn't mean the requirements gone away, there are still a load of Bradley fighting vehicles that we are transmissions and reset work, so I believe that will recover in 2012, and the Telemetry Advanced Technology area again is one program there, a U.K. program that is going to experience of funding decline next year. So that's a broad summary of what we see for 2011.

In terms of the guidance, we were looking at the consolidated sales of between $15.7 billion and $15.9 billion, which is about 1% above what we saw in 2010. To remove the effects of JOG, the growth is about 3% to 4% that's going to be a big headwind next year. The earnings estimate for next year is in the range of about $8.40 to $8.60 before the pension charge or the increased pension expense, if you will, which will be up 4% at the midpoint compared to 2010. But we're expecting, if everything stays equal as we see it today that, that pension will run about $0.20 a share. So that's where we see 2011 from an early view. Again, there's an Investor Conference that we'll have as we always do in December. In fact, I'll give you the date. It should be on December 7, if you want to mark your calendars, starting at 8 a.m. at the Essex House here in New York. Sure you will receive an invitation.

To wrap up, we believe that L-3 will continue to thrive and grow in this new emerging greater efficiency environment with flattening budgets. I think that what will differentiate L-3 will be our culture and dedication to outstanding program performance, meeting budgets and exceeding delivery schedules plus our quick-reaction capabilities. Strong product areas in EO/IR, ISR, Intelligence Support will continue to lead growth, albeit probably at a slower pace. But again, we expect to see those areas all growing, and the broad product portfolio will continue to provide products to upgrade and enhance existing platforms. We continue to see that as a positive. In terms of our cash flow yield for 2010, it's going to approach about $11 a share representing a 15% yield compared to the market price of L-3 stock. The balance sheet and cash flow will continue to be strong, and we'll use them to and deploy the cash to continue to grow the company and increase shareholder value.

So with that, Ralph will give you some more color on the financials, and the we'll be happy to take your questions.

Ralph D'Ambrosio

Thank you, Mike. I'll highlight some trends about the third quarter, review the changes to our 2010 guidance and finish with some comments on our capital structure.

As Mike said, we had a solid third quarter despite flat sales driven by strong margin performance that drove operating income growth to 5%, as well as strong cash flow. Our diluted EPS was $2.07, and that included a $0.03 debt retirement charge. For our third quarter 2010 income tax rate was also lower than we planned, and that added about $0.05 or $0.06 to EPS in the quarter. With respect to sales, our third quarter sales were $3,835,000,000 or essentially flat versus the third quarter of last year. And at the segment level, growth in C3ISR was offset by declines in Aircraft Modernization and Maintenance and Electronic Systems. Our Government Services was up about 1%. In C3ISR, the growth was driven by ISR, Logistics Support and ISR Manpacks. Sales in Government Services increased 1%, driven by growth from a large competitively one classified IT contract that we began working on in April. And that offset lower subcontractor pass-throughs on the Army, SSES [systems and software engineering and sustainment] task orders.

In Aircraft Modernization and Maintenance, sales declined 5%. That was mostly due to the timing on that Joint Cargo Aircraft, which decreased $17 million, and we had some additional declines in contract field services and on the SOFSA contract. In the Electronics Systems segment, sales decreased 3%. What happened there was growth in EO/IR, Security & Detection systems and Microwave Communications was offset by declines in Marine & Power Systems driven by lower commercial shipbuilding sales, Combat Propulsion Systems due to less funding on the Bradley Fighting Vehicle, as well as funding cuts and delays on Middle-Eastern engine programs and in Training and Simulation due to lower sales on AVCATT and the F/A-18 program where we saw reduced ECP-type funding, and also when Precision Engagement and in Marine services, due to a handful of contracts nearing completion. And finally, we also had some delays on some new starts, which affected sales in this segment. For example, the Enhanced Night Vision Goggle protest delay and our recent win of the SOCOM SDN-Lite program, which happened later than we thought it was going to happen.

Moving on to operating margin. Consolidated margin was very strong at 11.4% in the third quarter, up 50 basis points over 3Q of last year, and that was driven by strength in the Electronic Systems segment. We had a continued favorable higher profit margin sales mix, which overcame lower sales in the segment. And we also had a $5 million pick up on the restructuring of a contract, which itself increased segment margins in ES by 15 basis points. Also within Government Services, we received an annual award fee in Q3 that we're anticipating in Q4 and that helped the margins in government services.

Our cash flow for the quarter was very strong. Our free cash flow was $367 million. Year-to-date, nine months, free cash flow was almost $900 million, up 5% versus the first nine months of last year. And we're on track with our full year estimated of $1,260,000,000 of free cash flow.

With respect to the changes to our 2010 guidance, as Mike said, we maintained our EPS range, which is $8.05 to $8.25. And while the range remains the same, we had a few changes in the components of EPS, primarily comprised of three items: One, lower sales volumes are going to reduce EPS by about $0.24, and that's being offset by higher operating margin, again mostly in Electronic Systems, which is adding $0.15 and the lower tax rate, which is increasing EPS by about $0.14.

We lowered our 2010 sales guidance by $400 million to the new range of $15.6 billion to $15.7 billion. The lower sales are mostly due to continued procurement and funding delays on several programs, about which we also commented during the first and second quarter earnings conference calls. During the third quarter, those funding delays continued and in some cases, spreads in new programs and more business areas. We also experienced some funding cuts and some reprogramming actions. In any event, those funding delays are manifesting themselves in lower book-to-bill ratios, slower sales growth rates and lower sales levels. And we currently do not foresee a quick uptick in the order flow that would make up for the year-to-date delays that we've experienced. And we've updated these changes in our 2010 sales guidance.

At the segment level, with respect to sales. In C3ISR, we're now at the lower end of our range, and that's due to lower funding on Rivet Joint and the negative impacts of a few undefinitized contract actions. In Electronic Systems, we reduced the sales guidance by $200 million. That's due to the program delays and funding cuts that I talked about, and it's impacting the Training and simulation business area, Precision Engagement, Propulsion Systems, Undersea Warfare and Advanced Technologies.

And finally, in the Government Services segment, we reduced our sales by $100 million in previous guidance. That's due to the loss of a training contract in Afghanistan and more-than-expected subcontract that are pass-through reductions on the SSES task orders. We've also seen some procurement delays on Afghanistan new business competitions, as well as some Intelligence work and reductions on certain Iraq and Afghanistan contracts.

Moving on to the consolidated operating margin guidance, we raised it by 20 basis points to 11.1%, primarily due to Electronic Systems, and that's offsetting reduced expectations for C3ISR, Government Services and the Aircraft Mod and Maintenance segment. The lower tax rate, which is now 35% is due to true ups from filing last year's tax return, as well as lower taxes from foreign locations. Our tax guidance continues to assume that the federal R&E credit is retroactively enacted. Back to January 1, sometime in the fourth quarter, that is reducing our 2010 estimated tax rate by 110 basis points, and it adds $0.40 in EPS, which is in our guidance. So if the R&E credit is not extended, we'll be at the lower end of our EPS range.

A couple of comments on the fourth quarter. We expect sales to be between $4.2 billion and $4.3 billion, with EPS of about $2.27 at the midpoint of our full year EPS guidance range. If you look at the margins, the year-to-date margins consolidated were 11.3%, and our updated guidance implies fourth quarter margin of approximately 10.7%. We expect margins to be lower in the fourth quarter because of a less favorable sales mix in Electronic Systems, and some lower prof rates on some new follow-on contracts in Government Services and on the Aircraft Logistics Support side.

We are intend to take somewhere between $10 million and $15 million of severance and restructuring charges in the fourth quarter to rightsize certain businesses for lower volumes in 2011. Those reductions in the fourth quarter margins are being offset by a technology license fee that's going to add $9 million.

Moving onto the balance sheet. We expect to end the year with about $650 million. That's after the increase and the share repurchases to $800 million and paying our dividend and the three acquisitions that we made. Regarding our debt, we have about $700 million of convertible notes that can be put to us on February 1 of next year. If that put occurs, we expect to refinance those convertible notes with new investment-grade senior notes. And we'll continue to be opportunistic in the debt capital markets. We believe we have a strong balance sheet and liquidity, and we'll continue to use our strong cash flow to increase shareholder value and grow the company.

That includes my comments. Thank you. And we'll go to Q&A now.

Michael Strianese

Operator, we're ready to take questions. Thank you.

Operator

[Operator Instructions] And your first question comes from the line of Cai Von Rumohr from Cowen and Company.

Cai Von Rumohr

Your quarter ended before the last week of September, so I know you expected some awards towards that would fall into the fourth quarter. What are you looking for, for a book-to-bill quarter and maybe give us a little bit color by the sectors?

Michael Strianese

The fourth quarter, Cai, is looking at about 0.96, but, again, the environment has gotten very fluid in terms of things moving around and is certainly a lot less predictable than what we're used to seeing. So I mean, the number could be slightly better or worse. What's different here? What's different is that normally, you've had puts and takes at the end of the day, but net-net, you'd be even or net positive. And you're seeing that trend become a little bit of a net negative now because there's more things declining and advancing, and I think it's more sign of the times. I think that what we see now on a segment level is the ISR segment should well exceed one in the fourth quarter, probably closer to 1.15. With services at about 1, AM&M at about 0.88 and Electronic Systems at about the same place. So that would bring the year to the 0.98 that I had mentioned.

Cai Von Rumohr

And then the one surprise I guess in your 2011 guidance is that if you back out the pension, you're looking for your margins to be down 50 bips. You've been pretty consistent on being able to hold stable margins. You're doing some severance here. So maybe tell us a little bit about, and give us some more color on why those margins are down? And is that conservative or is this a risk that could get worse?

Michael Strianese

I think it's our best estimate today, Cai, and as I said, we're going to update our guidance or probably reiterate our guidance as the case may be, of course, in December when we do our Investor Day. It's virtually all in the Services segment. And Ralph will go through the details. I'll tell you, it's a combination of three things: One, as we've been saying almost every quarter that the competition in Services was increasing and we are seeing margin pressure. So a piece of it are margins in Services. In addition, we are going to invest in the cyber center, which we've started to spend money on but that'll cost us a couple of points of margin. As well, we're going to deploy some more resources in the bids and proposal area, because this is a space that is really dominated by a lot of large-dollar contracts that I'd like to put more resources on because just a little more penetration in that area will help us a lot. And I don't know, Ralph, what did I leave out? Why don't you fill in the blanks?

Ralph D'Ambrosio

Sure. We'll give the segment guidance for next year including the margins at the Investor Conference on December 7, but what we're currently seeing today is lower margins in the Government Services segment, which Mike talked about. We're also seeing lower margins in C3ISR and in Electronic Systems. And what's happening in C3ISR, we have a changing sales mix where we're doing less equipment modification-type work and more logistics support work. I commented earlier about the undefinitized contract actions in the segment, and that's also putting some pressure on margins. And in Electronic Systems, it's also a changing mix situation within the EO/IR space. We talked about the Bradley fighting vehicle and in our training and simulation, this is an area we're doing more logistics works as opposed to equipment modification. So it's mostly a mix issue, and this year, we had a couple of pick ups, I talked about one in the third quarter, and one we had in the first quarter. But most of the margin pressure continues to be in the Government Services area that Mike talked about.

Cai Von Rumohr

You've mentioned this investment in the cyber center, taking a couple points, that's 20 bps on total margins. That's a very big number, maybe tell us a little bit more about that.

Michael Strianese

Well, Cai, I don't want to put the exact number out, that's interesting of a number, but as refining, this is an important growth area. As you know, we have a large footprint in the beltway area. And it's becoming more and more important to build out our facility to include a capability demo area to bring customers in, in a classified community, which requires it to be in a secure area, which we have, but it needs some work. This is one of the bright lights that we see in our future. And given where funding is going, it's a place where I believe it's in our best growth interest to invest a little bit of money and be able to provide our customers a little more face time with us and to work on capabilities.

Operator

And your next question comes from the line of Robert Spingarn from Credit Suisse.

Robert Spingarn

I want a comment to Cai's question from a slightly different angle and just note that the trend for us this year has been for better-than-expected margins against lower-than-expected sales, and might that be a risk for next year? In other words, you're recognizing the margin pressure, but what if we continue on the weaker sales?

Michael Strianese

Well, I mean that's always a possibility, Rob. I think we have our best estimates today out there. But, yes, if sales slip next year, would there be a commensurate reduction in margins? Well, let me just think about it. It would have to depend on the mix, and I would tell you that the area that would be most prone to slippage right now, we would see in probably Services. So Services earns a lower margin than our composites, so I can't tell you would be that our composite rate. But we do everything we can to try to maximize our performance, but yes, there would be a risk to the margins as well of course.

Robert Spingarn

I think, Mike, it's clear, you guys are trying to focus on the growth plans. I think a lot of people are and it's the right thing to do. But what I worry about is that the expectation for sales growth is really turning out to be somewhat unrealistic. And with that in mind, from a portfolio-shaping perspective, my other question would be given you've got great cash flow, we all know that. But is now the time to be selling properties as opposed to buying them?

Michael Strianese

Well, again, our purchases this year had been, with the exception of Insight, which was a larger purchase, they've been really tuck-in in multiples that were consistent with our own multiples. We regularly go through the portfolio. I commented on our areas that we're declining next year, we're trying give the audience a view towards how we look at those declines, whether they were long term or shorter term in nature. And finally, yes, of course, we think of that. But again, there's nothing that stands out in our portfolio as something that we would divest at this time. I think, also, that there might be a bit of a difference in opinion between what one would think could be achieved in terms of the sell price today versus what I think would actually happened. I'll point out that in terms of auction transactions in the quarter, I can pick up at least three of them that busted. I'm not going to name them. You guys got through, you guys know them. But because prices were not achieved. So I would not be as exuberant as others might be about really what you can get in the market at this point in time. Having said that, we always have the radar on and we're always looking to maximize shareholder value.

Operator

And your next question comes from the line of George Shapiro from Access 342.

George Shapiro - Citi

If I look at C3ISR, a couple of things. One, you had a big margin drop from the second quarter, and is that mix or repricing? If comment on that. And on the other side, you're expecting -- even to meet your low end of your guidance, you've got to get 14% sales growth in the fourth quarter? And with the last Project Liberty occurring this quarter, what causes that growth?

Ralph D'Ambrosio

Okay so first of all, your question on the margin in C3ISR, it is the -- we've been changing on Liberty and some other classified programs from doing equipment mods to logistic support. And that carries lower margin, and I also talked about the impact of some undefinitized contract actions in that segment that pressured both sales and margins. So those are the two items. With respect to the sales pickup in the fourth quarter in C3ISR, it's coming from additional logistic support work. We expect to have some additional Liberty aircrafts that are currently in the second FY '10 supplemental, five additional aircraft, and we're also expecting to have significant deliveries of our Rover ManPacks Systems in the fourth quarter, as well as data links on a variety of unmanned aerial vehicles. So that's what's causing the uptick in sales that we anticipate in that segment, George.

George Shapiro - Citi

And one other, Ralph, if you can just update us on you usually give us kind of the expectations on where we are in terms of sales to Iraq and Afghanistan.

Ralph D'Ambrosio

For 2010, our current guidance assumes a little more than $1.2 billion in sales coming out of Iraq and Afghanistan. And we see that declining next year by about $300 million, and the declines are coming in SOFSA because we lost the contract. Less Contract Field Teams support work because of the drawdown in Iraq, slightly less Linguist work in Iraq and fewer shipments on the equipment side, namely of some EO/IR equipment in Afghanistan and some ManPacks. So we think next year's sales there are going to be about $1 billion as we've seen Iraq and Afghanistan.

Operator

And your next question comes from the line of Carter Copeland from Barclays Capital.

Unidentified Analyst

Just a quick question to follow up on George's question. With respect to the sales that are related to the war to the off tempo. Are any of these declines really surprises, if you look at SOFSA and Lindquist and EO/IR, is it the ManPacks and the lower CFT work that is a surprise? Are you seeing anything I guess just because you guys have been more sort of forthcoming and honest about the sales in the region and what you're seeing? Is there any surprises that you're finding that's influencing the revenue guidance, or is most of the Delta in the revenue guidance related to funding delays and things of that nature?

Michael Strianese

There is more funding delay level area, but like I give you as an example of what we're finding with certain customers is that their funding is limited. So while we may be upticking in a certain area, it's coming out of another area where we're doing work, and it's causing a delay that we previously hadn't seen. A good example of that would be some of the slippage that we've seen on Rivet Joint, for example. Yet we're seeing increased demand from communication systems and EO/IR equipment and the like. And if you look at the budget and you try to make sense of all this, you could see the numbers are staying constant and there's more demand in one area. There are some gains, it's reducing something else is what's going on here. So that is what's changed.

Unidentified Analyst

And one quick one for Ralph. You mentioned a couple times, undefinitized contract items. You providing color about what that pertains to, what sort of product area?

Ralph D'Ambrosio

It's in the airborne ISR area.

Operator

And your next question comes from the line of Noah Poponak from Goldman Sachs.

Noah Poponak

Just a follow up on that portfolio reshaping divestiture question. We've seen -- it's interesting you made that comment that maybe multiples aren't quite where you'd want them to divest something. We've seen I think a pretty decent multiples for some OCI or SEDAR related businesses. I believe you guys have a SEDAR business acquired earlier in the decade? Is that the case, and what have you seen with whether or not you need to sell that or have you tried to and what was the pricing like.

Michael Strianese

Well, no, we haven't gone out the pricing on it, because we haven't seen the need to sell it. But really, it's part of the tightened acquisition. It was five years ago now. There was a business unit there that is almost in a proxy structure, similar structure that you see where there's a foreign ownership and a special security agreement, which under current thinking qualifies as a valid mitigation tool for OCI. Given that we've moved contracts that have OCI potential into that vehicle. However, sales in that vehicle are between $100 million to $200 million. Not anywhere near the kind of the level of what you saw being sold earlier this year. As we look across the company and I guess we're alluding to services, again, our Services segment is I'd like to say, it's really two I guess your flavors, one of them is the direct support to the war fighter, that's primarily being delivered by experienced former military officers and physicist like MPRI. It's a unique business that provides a service that continues to earn good margins. And our Intelligence/Engineering Support business is mostly here in the states. Again, those are decent margins and is unique in terms of our workforce and clearances that we have. So our view is that they are non-commodity type businesses and given the pipeline that we see out there, notwithstanding OCI and not withstanding in-sourcing, we still see it as an area that can have continued growth. So from a capital deployment standpoint, we view the best value right now, candidly, is our own stock, which is where we've been directing most of our cash flow with the 15% yield, cash yield on our stock, we're returning almost 12% of that through our buyback and dividend. So I think right now, and of course, you're seeing that across the industry, that's kind of where I see it for now. It terms out. We got an offer, we decided to sell something at a very compelling multiple, would we evaluate it? Yes, it didn't hurt the long-term growth aspects of L-3 and was the best thing for shareholders, of course, we'd evaluate it.

Noah Poponak

And just on the in-sourcing topic that you just mentioned, it seems like some of your peers that have reported in the past week or so have maybe suggested that, that discussion is coming back up as the rules have been more clearly definitized. Is that what you're seeing? And is that a renewed concern for you or not?

Michael Strianese

No, actually, I would say the opposite. I would see it as less of a concern. There's a memorandum out there, if you call us offline, we can provide it you. It's a public domain that Secretary Gates had put out that basically put the brakes on the in-sourcing because it is inconsistent with the cost savings objectives that's being realize in DoD. Now that doesn't mean it's reduced to zero. But I think that the wholesale in-sourcing trend that was once viewed as being, I don't know 30,000, 40,000 feet is not going to happen. And I don't even think it's a number that we would quote you as to how in-sourcing may have affected our sales. It de minimis. There's really nothing to talk about.

Ralph D'Ambrosio

We had lost a few small contracts in the beginning of last years to in-sourcing, but since then, we really haven't had any meaningful reductions to in-sourcing.

Noah Poponak

Ralph, did you mention the share buyback number that's embedded in the '11 guidance?

Ralph D'Ambrosio

No, I did not. But it's $0.5 billion.

Operator

And your next question comes from the line of Joseph Nadol from JPMorgan.

Joseph Nadol

Mike, on the delays and the tough conditions that everyone is seeing including you guys, you have a little bit of a different perspective because you're more of a supplier than some of the others. I was wondering if you could maybe compare and contrast to the degree possible the operating conditions you're seeing as a supplier versus those as a prime contractor? Is it tougher being a supplier than a prime, or the other way around right now?

Michael Strianese

You know, Joe, I would tell you that, that part of it, I think, is pretty level. But what we are seeing that's unique to us, I'd say, maybe it affects us more than some of the companies that are more weighted into platforms, is that we're a shorter cycle. So I think you're seeing more sensitivity in our numbers to movement in budgets and reprioritization that you are with some of our colleague companies that have longer-term platform programs, that are harder to move. I mean, it will turn on a dime like a product buy like whether it's Rovers or EO/IR. I mean, these things slip on and off pretty rapidly. So that's really the distinction I would draw and I hope it works both ways, both up and down, which it has. Some of the stretch outs I think, we're experiencing the same things, the funding for the additional Liberties didn't show up this year. We expected five more Liberties in the middle of the year. It still hasn't come. I think the JCA order, which we expected mid year was late a quarter or two. I'm sure, Ralph, you can name more than I can. But there are a bunch of those. I think everybody is seeing that. But again, I think we're more exposed to the short-cycle dilemma here that things find their way to our numbers faster.

Joseph Nadol

Well, that would suggest that you'll have a leading-edge, hopefully as you point out, that on things sort of when things start improving or bottoming out on the pricing pressure side in particular and obviously, the budget stuff we can track. I think it's the margins and the pricing that a little more -- it's obviously tougher to get your arms around. So as we stand here today and looking forward, you're looking sort of down off the top of the mountain. Do you have any sense on how bad it gets? How much longer it goes or you just kind of in the same boat all the rest of us are, wondering where margins in the industry go?

Michael Strianese

Well, Joe, I'll give you my thoughts on it and again in my thoughts because this environment is something that came up in the second quarter of this year. If you look at where -- and I'd say that because the equity prices of defense companies. We're in pretty good shape in the first quarter and kind of deteriorated in the second and third, and I guess that's all the concern here about budget and margins and the like. Now having been in numerous meetings with Secretary Carter, Secretary Lynn and even Secretary Gates, the mantra has been we need a healthy defense industry. And they're really looking for efficiency versus margins. And I'm sure you've seen the September 14 memorandum of Secretary Carter, which kind of reiterates that. Now as well-intentioned supportive as we all are as an industry, to his objectives, and everybody is working hard to them, you can't help but be concerned that there will be a hit in margins in some way, shape or form. Companies are going to be able to respond differently to those requests. I think in our case, we are already a lean company. We are not sitting on a lot of excess or any excess capacity as far as I know actually. Maybe a little bit where we make Bradley transmissions right now because of the slowdown, but nothing that I would say is looming out there for us. And I would hope that this environment of increased competition could work in our favor. There'd be less tendency than for vertical integration, if they, DoD, will insist on more competitions for subsystems and a lot more milestone reviews, which is what they are saying. And I'll give you a negative. On the other hand, to the extent that the platform companies really get ratcheted down because the cost growth and cost concerns, they very well will turn around to their supplier community and put pressure as well. So that will be downside. The dependency there is, I mean, how much we're able to maintain our pricing. I think we do a pretty good job across the company in our -- but the more proprietary we are, the stronger our pricing is as you would expect. So when you put it all together what does it mean? It means it's not perfectly clear yet, but that's kind of our sense of some of the things that we're likely to be faced with going forward.

Joseph Nadol

On that last point in particular, the negotiations with the primes, Wes commented the other day that their North is still in negotiations on the F-18, with Boeing on the multi-year and then with Lockheed on the LRIP 4 for the F-35, and they're obviously the largest by far in both of those programs. And so the pricing pressure is just, their negotiations now, really hasn't filtered down. Would you say that you've already seen some of these tough negotiations with the primes? Or is this something more that you're anticipating? Just any comments around that.

Michael Strianese

Actually, we haven't seen it to that extent, to tell you, we're not in the same category that Wes alluded to yesterday or the day before, but I expect -- it's not like we're not ready for it, but again, I think that our cost structure is lean. And many of the areas where we are on the platforms have been competitively won. In many cases. I mean some of them have been directed, like Datalinks and the like. So is it cautious note? Yes, a little bit. But there could be margin pressure off the road. I don't see anything now that's worrying us, and I feel good about next year's guidance. But again, weren't in an environment now that has got uncertainty in it, and I think we're talking about at least another year, year and a half's worth of work before it really shakes out in terms of priorities, programs, funding levels and the impact of the cost, the affordability initiatives, because they're only in their infancy right now. So how they get applied is going to be -- remain to be seen.

Operator

And your next question comes from the line of Troy Lahr from Stifel Nicolaus.

Troy Lahr

I wanted to drill down on Government Services a little bit. Should we now think about that as kind of a mid-8% margin business given the current competitive environment? Or do you think compensation continues to pressure margins even lower and we might see kind of low-8% or even 7% down line?

Ralph D'Ambrosio

Well, its mid-8% for this year and for next year, we see it around 8%. As we said earlier, we think we're going to have more margin reduction in Government Services. And the whole topic of price competition which we just talked about, I would say that we've been seeing a lot of competition on price and Government Services and also in the aircraft maintenance CLS part of our Aircraft segment for about two years now and you've seen the impact of that roll through our margins as our contracts come up for re-competition and we bid for new work. And the last question asked about, we're beginning to see some price competition in product areas as well. So in some cases the customers are changing selection criteria to using what they call low-priced technically sensible where there, I guess, there's a deliberate attempt to reduce price and we're seeing that emerge in some of our products business areas. So that's something we're watching now and as we get into next year, as well.

Troy Lahr

And then at C3ISR, can you maybe just say how much is that logistics support work? And longer term, should some of that business start rolling off? Or that the nature of that business is now that it will be carrying much more of this lower margin-type work?

Michael Strianese

Well, first of all, we've always done a lot of logistics support work on C3ISR on the Airborne ISR systems. And our logistic work is probably 35% to 40% of segment sales now. But it's on the proprietary variety, but still carries lower margins than it does, than equipment work does.

Cai Von Rumohr

But you said that 30% or 40%, what has it been in the past though? Because you still said you were carrying a lot more...

Ralph D'Ambrosio

If I compared to last year, it's probably increased by a little more than $200 million, this year versus last year sales in that segment. And we see a continued increase into next year.

Cai Von Rumohr

The logistics support grows further next year?

Ralph D'Ambrosio

Correct.

Operator

And your next question comes from Brian Ruttenbur from Morgan Keegan.

Brian Ruttenbur

First part of my question is dealing with margins in 2012 and beyond. What do you think the sustainable margins are out there? I know that this has been a topic that you addressed for 2011, but 2012, 2013, is it sustainable at 10.5% operating margin level or do you think that you'll dip into the 10s or below?

Michael Strianese

Well, in this environment, I think somebody had -- probably Joe Nadol, I think, I read a report data, history of margins over the past decade by company, and that kind of bounce where things have been in good times, and not as good times. But for us, I think we've been able to maintain a north of double-digit-type range and of course that is our goal, and our goal has been to, with the exception of next year, to increase our margins each year.

Brian Ruttenbur

So your goal in 2012 would be to increase over 2011 operating margins?

Michael Strianese

Given market conditions, of course. Our goal would be to increase our margins. Now, we'll be updating you next year as to our ability to achieve that goal of course. But whether that involves cost reductions or more consolidation where we can, it's something we look at all the time. So, yes.

Brian Ruttenbur

And then my one follow-up question, on the international side, can you, in domestic, just name the major programs that you're going after in 2011 that we should be monitoring?

Michael Strianese

On the domestic side, the big competitions are EMARSS, which we talked about and C3ISR, it's probably largest one for that -- definitely the largest one for that segment. In fact it's one of the few new starts that's happening in that whole space. Within Government Services, at some point, they're going to re-compete the worldwide Linguist contract that's slipped from the earlier part of this year. Expectations, now that we would have an RFP for that before the end of the year, and that there will be an award made sometime early next year, and that's going to be going from single award to multiple award ID/IQ, where you have more suppliers and they compete on each of the task orders. There's also a large Afghan training contract in-source selection right now, which was the old CNTPO that reincarnated itself is a new full and open competition. That's in-source selection, and there's supposed to be an award before year end. So those are the bigger ones in Government Services. In the Aircraft Modification and Maintenance segment, we're going to be re-competing our P3 Sustainment Modification contract into next year. It's currently in-source selection, but they're making some amendments to it. And we expect that there'll be an award on that early to mid-2011. So that's the largest one there, and there really isn't any single large re-competition going on in Electronic Systems due to the adversity of that segment in terms of the number of businesses, the supplier versus prime situation, et cetera.

Operator

And your next question comes from the line of Howard Rubel from Jefferies.

Howard Rubel

First, just a comment Mike, I noticed you won the Dixon Award and I recognize how important that is and represents the whole company. So I just wanted to offer you a kudos on that. What I don't understand about all this disruption that sort of taken place is a lot of these funds have already been appropriated and why all of a sudden is it just so broad-based and so pervasive that, I mean almost insidious, that you're just finding these difficult challenges?

Michael Strianese

When you say disruptions, do you mean across the industry or for ourselves?

Howard Rubel

Yes, across the industry, and you specifically. It's as if somebody has flipped the switch all of a sudden and said make it more difficult for you to operate when in many cases, you should still be able to perform. I mean it's not as if you're missing contracts or you're overrunning anywhere?

Michael Strianese

No, we're not. But the performance is excellent. I can tell you. Really, in terms of red programs, we're not know for them. So we operate very well. I got to tell you, we spent a lot of time on your question on that topic, because I asked the same question. Why are we seeing this? And we went through every single business unit, and we see little disruptions everywhere. And that, again, to give everyone -- to let you see what we're seeing, I mean that's why I'm sharing this with you, is that it is pervasive and I think some of it is just backlog of paper. Competitions are taking longer. Protests always slow things down, although I don't think that's a major driver here. I think this is a reprioritization that's going on continuously now, because -- Howard, you know the numbers as well as anyone. If you look at the supplemental, if you go just a couple of years, it went from a high of around $163 billion in '08 to the '11 request of $100 billion, that's $63 billion that's moved around, and we're still engaged albeit spending less in Iraq, spending more in Afghanistan. That money is getting pulled from somewhere. So our sense of it, and again, it's very hard to pin it down discretely, is that there is a broad reprioritization of funding going on and that is affecting numerous programs.

Howard Rubel

And then just on Iraq, some of what you're doing there is very important to help maintain pace in operations and stability of that business. Do you see that, that market has more or less stabilized?

Michael Strianese

Well, yes. And yes it has. And what has been slow to materialize though has been direct contracts with the government of Iraq for some of the training and leadership development and putting in an acquisition capability and equipment maintenance, et cetera. I mean this is only starting now and it'll be hard for me to quantify to any one what it's worth. But an example is, there's a procurement that was floating around to the Iraqis to get a hold of some Russian helicopters for them to start to build out their own capabilities. And that's just starting. Once you start moving going that path, there's all kinds of requirements, basing, training, logistics, maintenance and support and the like. So we still think that that's an area where they'll be offset to the decline on the U.S. side, but it's been slow to take off.

Operator

And your last question comes from the line of Myles Walton from Deutsche Bank.

Myles Walton

I wanted to touch on the longer-term cash outlook. Obviously, cash performance is generally the distinguisher for you guys versus others in terms of the cash flow conversion. Part of the initiatives, kind of the efficiency initiatives, are for the customer to be a smarter buyer and it's also delving into the area of smarter on cash terms as well looking at progress payments, milestone payments and not necessarily making it more difficult for your contractors, but using it more as a carrot on a stick. I'm wondering if you see that playing out now or is this still too early in the game and we might see that more into the longer-term horizon?

Michael Strianese

No. Miles, I think that's something to be played out. I know that it's a topic that, as you alluded to, in Secretary Carter's memorandum, to use cash flow to incentivize margin, leading in contractors taking more cash flow, carry more cash flow risk that are in higher margins or not. I don't see that as being a major impact at this point. But again, just implementing, those principles have not been tested yet, and my sense is it's not going to be a significant driver to our cash flow in the future.

Myles Walton

And then on the 2011 cash flow, Ralph, what are you looking at cash taxes and also working capital?

Ralph D'Ambrosio

So for this year, we're expecting our cash tax payments to be about $380 million, and we see that increasing to about $465 million next year. On the working capital, and here is just taking every working capital as well as action liability count and aggregating them together, it's going to be about use of cash of $100 million this year. A lot of it is that we've been deliberately making advanced procurement buys on some inventories on some of these quick-churn items, and then We'll be shipping in the fourth quarter and into next year. So next year, we see less of a working capital to use for next year. It's probably going to be $10 million to $20 million of working capital, use of cash for 2011.

Myles Walton

Okay, so the two roughly switching places?

Ralph D'Ambrosio

Yes.

Michael Strianese

Okay. Well, I think that brings us to a conclusion. Just a couple of parting thoughts. The two constants here that we're dealing with as an industry and of course as L-3 are the: One, the budget situation here in the U.S. is tight, it's going to have effects. It's not going to change in the short term. And number two, the geopolitical situation, which is complex, it's a longer list than before. And that's not changing either. And therein lies the tension. I don't think that it's our belief that national security becomes an option. And given the condition of our equipment and the need for modernization and upgrades and reset, which is not factored anywhere in the budgets, I think, there's, I would like to believe, limited downside in where we can go as the budget. In terms of L-3, I think that we continue to be well-positioned, portfolio-wise, I think the clarity issue will take a little time in terms of budget priorities, in terms of programs and funding levels, as well as the future impact of Secretary Carter's initiatives, which again, industry is embracing, but it's going to be some pain in shaking out some of the redundancies and cost that they're alluding to. But on balance, again, I think that we're well positioned, not only in our business areas, but also in our performance history, in our ability to continue to deliver on time, on budget, listening to our customers and outperforming their expectations. It does give us an edge on our area. And with that, thanks for joining us and again, I hope to be able to see you all at the Investor Day on December 7. And thank you. Bye, bye.

Operator

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

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