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L-3 Communications Holdings (NYSE:LLL)

Q2 2014 Earnings Call

July 31, 2014 8:30 am ET

Executives

Jed Repko -

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

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

Analysts

George D. Shapiro - Shapiro Research

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

Noah Poponak - Goldman Sachs Group Inc., Research Division

Howard A. Rubel - Jefferies LLC, Research Division

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

Jose Caiado De Sousa - Crédit Suisse AG, Research Division

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Robert Stallard - RBC Capital Markets, LLC, Research Division

Operator

Good morning, and welcome to the L-3 Second Quarter 2014 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Jed Repko, Please go ahead.

Jed Repko

Thank you. Good morning, and thanks for joining us for L-3's Second Quarter Earnings Conference Call. With me are Michael Strianese, Chairman, President and Chief Executive Officer; and Ralph D'Ambrosio, Senior Vice President and Chief Financial Officer.

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

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

Michael T. Strianese

Thank you, and good morning. Thanks for joining us. Earlier this morning, we announced the preliminary results for the second quarter of 2014. The financial results are preliminary because we are currently conducting an internal review that primarily relates to accounting matters on a fixed-price logistic support contract in our Aerospace Systems segment. The conclusion of that review could result in changes to the amounts we report today. While the review remains ongoing, I want to share what we know at this time, the actions we're taking and our plan for moving forward. We take this matter seriously and are dedicating the appropriate time and resources to resolving it promptly and thoroughly. Ralph will discuss the accounting adjustments we're making in more detail, but first, let me give you an overview.

Through our internal processes, we became aware of the misconduct. We initiated a review and identified overstatements of net sales and contract cost overruns that were inappropriately deferred. The misconduct included concealment from L-3's corporate staff and external auditors. As part of our review, we are examining the financial records of the entire Aerospace Systems segment. The adjustments arising from the review include a charge of $34 million related to the first half of 2014, of which $30 million relates to the second quarter. We are extremely disappointed by this matter. While the review remains ongoing, we have taken remedial actions, including the termination of 4 employees, a fifth employee has resigned. Based on the ongoing review and the findings, we'll take additional remedial actions as necessary. Although the matter is regrettable, it should, in no way, detract from the good work that has been and will continue to be performed by our 48,000 hardworking and dedicated employees. It's worth reiterating that, based on what we know at this time, these accounting issues are primarily limited to 1 business unit in the Aerospace Systems segment. We have no reason to believe that this issue occurred at any other segments of the company. Our goal is to complete the review expeditiously, so as to file our 10-Q as soon as possible. I need to make absolutely clear that this issue does not represent the way L-3 does business. We have self-reported it and have taken decisive action to underscore the importance of adhering to our policies and procedures. I can assure you that we will fully resolve this matter, and we'll take all prudent steps to ensure it never happens again.

Now I'd like to talk about our second quarter results. Overall, we had a strong second quarter, marked by consistent excellent program execution and increased international and commercial sales. Recently, we exhibited at the Farnborough International Airshow, which provided a great opportunity to meet with current and prospective customers, showcase our business and, introduce new platforms. It was a productive environment that reinforced the strong interest in L-3's products and technologies within the international community.

As you've seen, we had net sales for the quarter of $3 billion, which is a 6% decrease compared to the 2013 second quarter. Sales to the U.S. Government, including DoD, declined 8%, which was partially offset by a $21 million increase in net sales from acquired businesses in both Electronic Systems and National Security Solutions segments.

Our strategy of expansion in overseas and non-DoD markets yielded a 2% increase in sales year-over-year to both international and commercial customers, and our international and commercial net sales as a percentage of consolidated net sales increased to 28% compared with 26% in last year's second quarter. Diluted earnings per share for the quarter were down 12% to $1.75 from $1.99 in the second quarter of 2013. Funded orders for the quarter were 3.3 billion, down 6% from 2013. However, the book-to-bill ratio was 1.08 compared with 1.01 in the first quarter of 2014. Funded backlog increased 3% to 10.7 billion at the end of the quarter compared to 10.3 billion at the end of 2013. Our strong backlog underscores some solid growth prospects, and our increased net cash flow in the quarter demonstrates that we are operationally focused and executing efficiently.

Our agility and adaptability will continue to be key differentiators in meeting the needs of a dynamic and demanding marketplace. The global events that we are seeing and the uncertainties inherent in the geopolitical environment in the still uncertain budgeting picture present, not only challenges, but opportunities for us.

Our business strategy, combined with our responsiveness and fast to-market ability, provides real advantages in capturing new business and winning key recompetitions. Across our business, we won some strategic recompetes and also received new contract awards that expanded our market share, enhanced our role on legacy programs and demonstrated our customer's confidence in L-3.

Now I'd like to briefly review our results and key contract awards by segment. So starting with our Aerospace Systems. Net sales were $1 billion for the quarter, which was an 8% decrease of $85 million compared with the 2013 second quarter. We see continued strong performance in our special mission integration work at our VIP head-of-state business where we secured our first 787-8 customer. We have received continued funding for many legacy programs, including Compass Call, Project Liberty, Dragon Spear and others, including -- our SPYDR product continues to perform well, and we have recently introduced SPYDR II, a modular variant that allows mission-to-mission reconfiguration to accommodate current and future sensors for different missions. And if you think about it in the customer world, the affordability of having a unique different platform for every mission is becoming unaffordable. So we believe developing a reconfigurable platform that can, for example, handle a SIGINT mission or a search-and-rescue mission or a video-type surveillance scenario is a good model and customers are very interested in that capability.

We recently delivered 5 days early, our Rivet Joint, that is the first aircraft of a new baseline. The new configuration is the first to use in L-3 developed concept informal array antenna. Our work on the U.K. Airseeker program, which is the U.K. variant of the Rivet Joint, continues to be outstanding. The first aircraft has officially gone into deployment in the U.K. and aircrafts 2 and 3 are on schedule. In addition, the first Airseeker has just been refueled in-flight for the first time ever. We've been selected to supply contract to logistic support for the U.S. Navy's T-45 aircraft. We will be providing maintenance and logistics services in support of approximately 200 T-45 aircraft for the Navy. This is an important recompete for L-3, and we have a full year of funding as part of a 7-year program.

At Farnborough, we announced that we are investing in a modified version of the Bombardier Q400 multi-mission aircraft to address the need in the U.K. for up to 12 aircraft and beyond that, a growing global market for maritime patrol. And we're using the same reconfigurable concept in the way this aircraft is being developed. So it can handle maritime patrol, it can handle Signals Intelligence and other missions.

In addition to providing an affordable solution for this specific market need, the Q400 is an excellent example of a program that draws on L-3's cross segment collaboration and opens up new opportunities in adjacent markets.

On top of that, as you know, we're bringing to our customers an operational system, not PowerPoint. They can fly it before they buy it, they can ask for modifications. It's really proving to be a discriminator and how we are approaching the marketplace.

For Electronic Systems, second quarter sales declined by $22 million or 2% compared to the 2013 second quarter. We're gaining market share in Aviation Products and have received a strategic contract to supply our T-cubed CAS [ph], and aviation recorders to Asia's fast-growing Lion Air. This order provides equipment for more than 230 A320 aircraft. We have received ongoing funding for maintenance services to the TSA for our scanning equipment, including a 1-year maintenance contract with the TSA for the eXaminer systems, and we're generating increased sales of our mobile security equipment in the Middle East and Asia. We've been selected by the Libya customs program for our advanced cargo screening systems. Also, this region has a strong demand for pilot training as the aviation market there expands.

In our maritime business, we received the Service Life Extension Program for the LCAC, both on the East and West Coasts here at home. We have also been selected to provide automation and navigation systems for 2 new-build ships for Star Cruises. And in a strategic win, we were chosen to provide electrical propulsion drives for Silversea Cruises. This is a significant market share gain for larger electrical propulsion drives in the cruise ship segment.

We have received the new option award for fuses for the U.S. Army, our diverse training business is expanding on both the military and civil sides. We have received continued funding for Flight School XXI, and with the prime contract to Sikorsky, we are developing course ware and curricula for maintenance training in support of the new presidential helicopter.

We also received a strategic international FMS order to build 3 UH-60L operational flight trainers for the Royal Saudi Land Forces Aviation Command. Delivery of these high fidelity trainers marks the first time our Link Reality Seven Full Flight Simulator technology solution will be used in support of the military training program.

And as you recall, we acquired the Link U.K. business a couple of years ago now. But it was our goal to use that business as a platform for international sales and to integrate both the U.S. and the U.K. technologies to bring more advanced solution to customers, and this is the first evidence of that success.

Also, the recent efforts by the U.S. Department of State and DoD to relax export requirements are enabling us to expand our night vision products into the global market. We see international demand for these items and also our Scarab product, which we sold to South Korea last year, if you recall, and are currently pursuing several follow-on opportunities.

In Communications Systems, our net sales for the second quarter decreased by $79 million or 13% year-over-year. Funding for our legacy work continues, and we received ongoing funding for data links in support of our programs like Predator, Reaper and Global Hawk. We received additional funding, which expands our scope of work on the Riptide [ph] Program.

In Australia, we were selected to provide the Communication Systems for the Collins class submarine modernization program. We continue to see strong demand for SATCOM, both domestically and in international markets, including in Iraq.

The National Security Solutions net sales for the second quarter increased by 3%. We're just under $23 [ph] million -- I'm sorry, or just about 1% compared to the 2013 second quarter. It's gratifying to see what we hope is the bottom on the declines we've had over the past years in National Security Solutions. So this is the first quarter where we're seeing some growth, and excess [ph] has done a great job growing its ID/IQ contract base. We've earned spots on contract vehicles for a variety of customers, including SOCOM, GSA, Department of Homeland Security, as well as the Air Force, Navy, FAA and FDIC. We've received a variety of task orders for program under the XYTEX vehicle, Oasis, DIA SIA II, SPAWAR IPS, eFAST and the EAGLE 2 programs.

In the quarter, we recently won the U.S. Air Force's in Europe vehicle for broad technical and analytical services. We are also focusing on strengthening our solid relationships with our customers and continuing to receive ongoing funding for NASA's contract and Okaloosa's County School District. The contract includes broad scope, seat management services, network management, cloud and server virtualization and mobile device support.

The recent Data Tactics acquisition completed earlier this year continues to expand opportunities. We have demonstrated our big data engine to several existing customers who have been very receptive and enthusiastic about this new capability. Additionally, Data Tactics received a DARPA Nexus 7 program contract award for the development of a new cloud infrastructure to support ongoing and future cyber analytic efforts.

With respect to capital allocation and M&A, we returned $252 million to shareholders during the quarter, that's a 44% increase compared to the $175 million returned in the second quarter of 2013. Our percent of free cash flow returned to shareholders was 105% compared to 89% on a year-over-year basis.

The other key component of our balanced approach to employing our capital is maintaining a disciplined M&A strategy. Core segment synergies are what we look for in evaluating prospective fits with our businesses, along with companies that expand our market share and bring technological innovation to us.

We continue our disciplined portfolio review to look for new firms that add capability in customers to L-3's existing base. We are currently evaluating several candidates that meet our criteria. At the same time, we are also focused on divesting noncore operations. And in the second quarter, we sold our AIM product line of standby instrumentation for the general aviation marketplace.

Before I turn it over to Ralph, I just want to reiterate that the company is committed to the integrity of its financial statements and internal controls. We are dedicated to resolving this matter as promptly as possible. With that, Ralph will provide a review of the quarter. Ralph?

Ralph G. D'Ambrosio

Thanks, Mike. Before I discuss our preliminary second quarter results, I want to provide some additional details regarding the ongoing internal review, and the impact of the charges we announced this morning on our results in our guidance.

As Mike mentioned earlier, we're conducting an internal review related to misconduct and related accounting matters at the Aerospace Systems segment. They primarily related to 1 contract in the segments, Logistics Solutions sector, for which sales and profit were overstated and cost overruns were inappropriately deferred. We're taking the matter very seriously, and we are working closely and diligently with our outside accounting and legal advisors. We've made significant progress to date and our goal is to complete the internal review, so that we can file our June Form 10-Q as soon as possible.

Based on the findings and the results of the internal review to date, we recorded preliminary pretax charges against operating income totaling $84 million. Those charges pertain to periods from 2011 through the first half of 2014. Specifically, $30 million is for the second quarter of 2014, and $34 million is for the first half of 2014. For 2013, the charge is $34 million, $13 million for 2012 and $3 million for 2011. Additionally, with respect to 2013, $5 million of charges affected the second quarter, and $11 million affected the first half. We also recorded preliminary adjustments to reduce sales by $43 million in the aggregate with $15 million for the second quarter of '14, $17 million for the first half of 2014, $25 million for 2013 and $1 million for 2011. We are reporting these financial statement adjustments that pertain to periods before the second quarter of 2014 by revising our previously issued financial statements for those periods.

Our 2014 second quarter preliminary earnings release includes tables that provides additional details for these financial statement revisions.

As I said a few moments ago, the adjustments primarily pertain to 1 fixed-price maintenance and logistic support contracts for the U.S. Department of Defense. We began working on that contract on December 1, 2010, and our period of performance ends on January 31, 2015. That contract has averaged annual sales of approximately $150 million. It has been a lower margin contract and with these adjustments, it is now in a loss position. Given that the review is ongoing, I cannot get into more details about the specific accounting entries or personnel at this time. What I can tell you is that we are working around the clock to resolve this matter and have dedicated significant internal and external resources to resolving it quickly. Assuming there are no further developments in the review, our prior financial statements are being revised, but they're not being restated.

With that, I'd like to highlight some items from our preliminary second quarter results. Excluding the adjustments from the initial review -- the internal review rather, for the Aerospace Systems segment, our second quarter was generally in line with our plans. Orders and book-to-bill ratio were higher than we expected, while margin was slightly lower and below the operating income lines improvements resulted in EPS in line with our second quarter outlook.

Diluted earnings per share for the second quarter was $1.75 and $1.96, if you exclude the Aerospace Systems segment internal review charges. Orders were 3.3 billion, yielding a book-to-bill ratio of 1.08.

With respect to sales for the second quarter, they were just above $3 billion, and they declined almost 6% compared to the 2013 second quarter. Our DoD and other U.S. Government sales declined about 8% with the Afghanistan drawdown causing 20% of that decline. International and commercial sales grew 2%.

At the segment level, sales for NSS and Communication Systems were slightly better than we expected and Aerospace Systems sales was slightly lowered. Aerospace Systems sales continued to be impacted in the second quarter, as they were in the first quarter by their international growth that we're expecting for 2014 being second-half loaded. Consolidated operating margin was 8.9%, and excluding the Aerospace Systems review charges, margin would've been 9.8%.

Within the segments, we increased core operating margin at Electronic Systems and Communications Systems. And as we recently discussed this year, those are the 2 segments where we expect to have the most prospective margin expansion, and that has not changed. Margin was slightly lower than the other 2 segments, Aerospace Systems and NSS, and that was primarily due to sales mix changes. Free cash flow for the second quarter was $241 million and at the high end of our second quarter outlook.

I'll now review our preliminary guidance update for 2014. I'll begin by explaining how the preliminary results of the internal review Aerospace Systems segment have reduced our 2014 financial guidance.

We made 4 adjustments for that internal review. First, in addition to the first half charge against operating income of $34 million, we also lowered operating income for the Aerospace Systems segment by $30 million for the second half of 2014. This reduction is comprised of 2 elements. We're going to continue to incur losses on that fixed-price contract of approximately $20 million, and we have expenses associated with the internal review. Second, consolidated operating margin for 2014 was reduced by 60 basis points and Aerospace Systems margin by 160 basis points. Third, free cash flow will be $75 million lower than we previously estimated. And fourth, 2014 EPS will now be reduced by $0.48 for items pertaining to the internal review at Aerospace Systems segment.

We also made some other changes to our guidance for 2014. We increased our sales at the midpoint by $75 million with $50 million of it pertaining to NSS and $25 million for Communications Systems. Excluding the Aerospace Systems internal review adjustments, consolidated operating margin would have remained at 10.5% for the full year.

We made some changes to the segment operating margins in the guidance update as well. We increased the margin for Electronic Systems and it's offsetting some decreases at NSS and Communications Systems. If we take a look at our EPS, for which we reduced the midpoint guidance range by $0.30 compared to our prior guidance, if were not for these internal review charges, Aerospace Systems segment, we would have been increasing our midpoint EPS range by $0.15. And free cash flow would have remained at $1 billion.

With respect to our capital allocation, we increased our share repurchases estimate by $125 million to $700 million for this year. After those share repurchases and paying our dividend, we expect to end 2014 with a cash balance of about $650 million. So we will have additional cash to deploy this year up to probably $400 million after you exclude cash overseas, and we'll use that either for M&A or additional share repurchases.

I have a few comments about the third quarter outlook. We expect sales to be about $3 billion. Margins are going to be about 9.5%, and they would have been about 10% if we didn't have any of those internal review adjustments at Aerospace Systems segment. EPS we're expecting $1.80 to $1.90 for the third quarter. And free cash flow in the range of $150 million to $200 million.

With respect to the book-to-bill ratio, we expect it to be approximately 0.84 for the third quarter and our full year estimate remains 0.98 to 0.99. Admittedly, we've had very strong quarters in the first half of this year and if that trend continues, we should do better on our full year book-to-bill ratio.

The preliminary 2014 financial guidance, as well as the third quarter outlook that I just reviewed, are subject in all material respects to the completion of the internal review. And depending on the outcome of the final findings, there could be additional reductions to our guidance for 2014.

I also want to spend a few minutes updating all of you on our expectations for 2015 because we've discussed them on the first quarter earnings call and I also commented on them at 2 recent aerospace and defense conferences. So the key thing is that assuming we don't have any adverse findings from finalizing the internal review of Aerospace Systems segment, our outlook for 2015 remains intact. We expect consolidated sales to decline next year by 1% or 2% versus 2014. And we continue to expect to have 30 basis points of core margin expansion in 2015 versus 2014, and that is before lowering 2014 margin for the Aerospace Systems segment internal review findings. We also expect to generate about $1 billion of free cash flow next year.

So to conclude my financial review, while I didn't talk about it, the U.S. Defense environment remains challenging, but the DoD base budgets have troughed and they're set to resume growing in FY '16 even with a full sequestration scenario.

Getting back to this internal review at Aerospace Systems segment, I must tell you that we are terribly disappointed by the misconduct at that segment, and I am outraged by it. There's nothing more important to me than the integrity of our financial statements. They are the absolute bedrock, and we are taking all the necessary remedial actions. Notwithstanding the internal review Aerospace Systems, we continue to effectively manage the company, and we're continuing to make progress. L-3 is healthy, is generating robust orders and very strong cash flow.

Thank you, and we'll now begin the Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from George Shapiro of Shapiro Research.

George D. Shapiro - Shapiro Research

So I guess my question really gets along to kind of management controls. I mean, if this contract has been ongoing since, I think, you said December 2010, I mean, what took so long to find out what's going on? And how do we get confidence that this is not -- we're not going to find stuff elsewhere?

Michael T. Strianese

George, we have -- we still have no indication that there's anything elsewhere. And in terms of what took so long, well, the -- it's -- you presume the issue began -- when the contract began, which I don't believe is the case, but I'm really restricted into get into details given the ongoing nature of the matter. What I can tell you that our systems did work in terms of detecting it, and we were on top of it virtually immediately, and the numbers -- don't want minimize it. They're not huge, but we won't -- no matter how small or big, we're not going to tolerate this kind of behavior. And the people are being just dealt with including terminations. I'm confident that we have a very strong ethical culture at L-3 and that buck stops here. And that we have no reason to believe that this exist anywhere else in the company.

George D. Shapiro - Shapiro Research

And maybe just for Ralph. What's the percentage of other sa -- of sales if you have similar kinds of fixed price development contract?

Ralph G. D'Ambrosio

You mean fixed-priced maintenance and support, logistics side contract?

George D. Shapiro - Shapiro Research

Yes.

Ralph G. D'Ambrosio

Yes. It's a very small percentage of our sales. A lot of those contracts are structured as, of course, reimbursable arrangements and some with PNM [ph] arrangements.

George D. Shapiro - Shapiro Research

Okay. And then one just -- one quick one for you on the ongoing operations, Ralph. So the margins went down a little bit in Communications and NSS in addition to Aerospace. I mean, what's actually happening there? I mean, you talked a little bit about it on the call, but maybe a little bit more color? I mean, NSS sales were better, so does that mean I conclude that you're getting more sales at much weaker margins? Or how do I look at that?

Ralph G. D'Ambrosio

Let me explain each of those items to you. So at NSS, sales are better than we previously expected. And for that reason, we've raised the full year guidance there by $50 million. Now a lot of that additional $50 million in sales pertains to pass-through items that don't carry any fee. So that is diluting the margin in the segment. Additionally, Mike talked about some very good success that we had recently in terms of competitive new business wins, and we're investing some more dollars in new business pursuits. And that's why the margins are being reduced at NSS for the full year. Within Communications Systems segment, if you recall in the first quarter, we lowered the operating margin there by about 20 basis points, and that was primarily due to the fact that we were realizing lower-than-expected productivity improvements from the ERP systems that we had implemented at Comm Systems West, or Broadband Communication Systems as is now referred to, in the middle of 2013. Well, we're still having some lower productivity from those ERP systems. But the good news is that we're continuing to make improvement with respect to reconfiguring the production and scheduling parameters within those MRP systems. So the 30 basis points of lower margin for 2014 is due to more leakage, if you will, from those ERP systems. But everything else that I said recently about the improvements that we're expecting to realize in that segment, including those pertaining to the ERP systems and those pertaining to the consolidation and combination of our 2 legacy Microwave Products and Communications Systems groups that we did in March. We still expect to get all those improvements in 2014 -- in 2015, I'm sorry. And then lastly, within Aerospace Systems, I commented at the impact to margins, excluding the items that pertain to the internal review for the segment as being attributable to sales mix changes, and the fact that our international sales in that segment are second-half loaded this year and that's what it is.

Operator

Our next question is from Cai Von Rumohr of Cowen and Company.

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

So to get back to the contract, you said it's $150 million a year. What is the volume of the division in class gen [ph]? And approximately how many contracts does it have?

Ralph G. D'Ambrosio

That was an annual average. So appreciate that there's some variability from year to year, particularly with respect to the judgments that we announced. And I outlined those when I made my comments. That contract is part of a business unit or division that generates about $900 million a year in sales. And how many contracts we had there? We probably have about 12 to 15 contracts with a few large ones. In fact, our largest contract, the Fort Rucker maintenance support contract, which is cost reimbursable, is in that segment. And if you recall, that generates approximately -- it's in that business unit rather, not that segment, I'm sorry. And the Fort Rucker maintenance support contract, generates about $450 million a year in sales.

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

Okay. And just, I guess, if there, clearly, were 4 to 5 people involved, how can it be that -- are they totally siloed on that 1 program contract, which is why they were able to kind of get away with this for this extended period? Or how did it happen that this one was infected and that all the others are okay?

Ralph G. D'Ambrosio

Well, Cai, as we said in our comments, because the review is ongoing, we really can't add a lot more detail. But you understand how each of our segments are structurally organized and that we have 3 levels. The divisions or the business units, on top of that we have sectors, and then you had the segment staff or the group staff. In the preliminary press release on the first page, we talked about these matters being concealed from the corporate staff. Well, that concealment occurred at all 3 levels.

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

Okay. And quick question on pension on -- so next year, how are you thinking about roughly the joint account played is down? And maybe some comment on the potential impact of mortality and MAP-21 as the House proposes it.

Ralph G. D'Ambrosio

Okay. So I'll take the last part of the question, first, Cai. So with respect to updating mortality, tables and assumptions and another relief coming from the MAP-21 or similar type legislation, not litigation, we don't expect to have a lot of impact. If anything if there's more MAP-21 relief, it'll give us more ability to stretch out our pension contributions. With respect to the discount rate, and interest rates, as we all know, have declined since the end of last year. The sensitivity of our expense, the pension expense, to discount rate is approximately $10 million of pretax expense for every 25 basis points of discount rate change. So since interest rates are down approximately about 50 basis points, that's a $20 million increase in pension expense next year. But we have been anticipating before any of these other changes, that our pension expense would decline by about $20 million for 2015 versus 2014 and that's something we covered in detail at our Investor Conference on March 25. So based upon everything that we know as of today with respect to the pension assumptions and appreciate that we won't also set those assumptions for next year until December 31, our pension expense looks like it will be neutral, '15 versus 2014.

Operator

Our next question is from Noah Poponak of Goldman Sachs.

Noah Poponak - Goldman Sachs Group Inc., Research Division

I wanted to ask about the non-U.S. government businesses. Is either the international or the commercial piece coming along slower than you thought it would for the year because, Ralph, I have written down in my notes that you thought of that combined piece would become more than 30% of revenue for the year? And I think the release said 29% in the first half. And then can you just update us in discussing that on what's embedded in the back half versus the first?

Ralph G. D'Ambrosio

Sure. So the last time we talked about our international and commercial business for 2014, we explained that we expected to grow in the mid single-digit range, the middle of which is 5%. So if you look at the first half results, we have 4% growth in our international commercial business. So it's trailing a full year estimate by about 100 basis points. Most of it is in the international side, and it's due to the timing of some awards that we're pursuing and more importantly, the timing of some shipments on existing contracts. So we expect that our international sales growth will increase in the second half of the year, and that will allow us to achieve the mid single-digit growth that we're anticipating in our international and commercial sales for this year.

Noah Poponak - Goldman Sachs Group Inc., Research Division

So you had some slide in some international that you're assuming lands pretty soon?

Ralph G. D'Ambrosio

Yes. Some slides, it's not meaningful.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Of -- can you breakout the 4 in terms of what international and commercial grew to get to that 4?

Ralph G. D'Ambrosio

Sure. For the first half, it's coincidental but they each grew 4%.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay. And in the 2015 color, is there any change to your thought process on the U.S. Government versus international versus commercial split of that consolidated sales outlook?

Ralph G. D'Ambrosio

Compared to what I previously commented on, no.

Noah Poponak - Goldman Sachs Group Inc., Research Division

And can you just remind us what were you looking for there?

Ralph G. D'Ambrosio

Sure. So that basically entails that we're going to continue to have a mid single-digit type growth in our international commercial business and that instead of our DoD business declining 10% like it is this year, next year it's going to decline in the mid single-digit range. And that's what will get us to the 1% or 2% growth in consolidated sales for next year versus 2014.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay. And then I just wanted to ask about NSS. Mike, in your prepared remarks you sort of alluded to it maybe sort of finally finding a bottom, and I guess that's kind of a new comment from you all. I mean, I think it was still down a little bit organically, if you take out acquired revenue. But I mean is that something where you're feeling like that can actually flirt with being flat next year? Or is it just going to be a slower pace of decline for a while?

Ralph G. D'Ambrosio

Well, I would tell you that our business units believe it's going to be flat next year, but we are applying some conservatism to those estimates. So in the outlook that I talked about for 2015, that presumes that we're going to have low single-digit sales declines at NSS. Low to mid single-digit sales declines. So to the extent that we can continue doing what we did in the second quarter, that's going to help the sales for that segment and the consolidated sales for next year.

Michael T. Strianese

Let me add to that though that one thing that's not in the numbers was there are a number of wins towards the end of the quarter that would had been protested that are not in our orders number, so their book-to-bill would've been better. And those have been worked through the protest process. But we have been, and I have, particularly, been encouraged by their win rate performance over the last quarter. There's a marked difference between what we're seeing there recently versus what we have seen over the past couple of years. And I'm sure we will be able to give more color in the next quarterly call when these protests are resolved as to really what's been awarded and you'll start kind of get the flavor. For the most part, what we're seeing, of course, is these are ID/IQ's, but they're big, very big, in terms of potential. I mean, obviously, you still have to win the past quarters. But it's been a very positive story as of recent, so I am encouraged.

Operator

Our next questions is from Howard Rubel of Jefferies.

Howard A. Rubel - Jefferies LLC, Research Division

I only want to ask one question on this incident. Is there any potential for a recovery either from employees or insurance?

Michael T. Strianese

Yes. Howard, actually, yes, there's a potential. Individuals are individuals, and there is a model there that about how much it would cost. More important to me is that the fact that this overrun existed suggest that they're, potentially, just a claim. Of course, as you know, there is an option called or a technique available called REA, or request for equitable adjustment, as well as the filing of a formal claim. And that is in process in terms of whether there are amounts in there that should be -- should have been recovered, or should be in process of recovery on the program. And that we're looking at very carefully. So the answer is yes.

Howard A. Rubel - Jefferies LLC, Research Division

And just to follow on that, I'm sorry to do this, is that your position on this particular business has probably been long-standing, and you probably have a good relationship with the customer. This isn't likely to harm your ability to win future business, is it?

Michael T. Strianese

No. And again, I -- we'll take direct responsibility for our customer relations on all matters, including this one. And I spoke directly to customers last night on this matter, and they were very appreciative of being briefed and that this is a self-reporting situation, and that we gave them the heads up. But of course, there are people being changed there that they'll notice any way. But again, this is -- goes to L-3's culture and integrity on the things like this. We are going to get in front of it and talk to our customers about it, and I assured them that we are doing a very thorough review, and we'll completely resolve it in short order.

Howard A. Rubel - Jefferies LLC, Research Division

I appreciate the candor. To just turn to new products, as I look through the trade magazines, there's a whole host of things you're doing in UAS and in other systems, communications products. Could you talk a little bit about what sort of traction you're getting there, Mike?

Michael T. Strianese

Well, first, anything that we're investing has been done in consultation with customers, so that we are in this dollar-constrained world were in both on our side and the customer side that money is being spent efficiently to develop products, systems, upgrades that are needed. So there -- a lot of the UAS side, things are becoming more and more classified due to a variety of reasons. But if you look at the changing threat environment globally and the different missions that one could imagine, there is a lot of interest in various capabilities across the board, whether it's Comms, whether it's UAS capabilities, whether it's covert communications, encryption, you name it. So there is traction, the point that I'm hoping to see some activity going on in the latter part of this year in terms of orders.

Howard A. Rubel - Jefferies LLC, Research Division

And then, Ralph, you talked about, I think you said you increased the share repurchase, was it $250 million?

Ralph G. D'Ambrosio

Well, no. We increased the -- increased it by $125 million. It was previously $575 million, and we're now expecting that we're going to buy back at least $700 million for this year.

Howard A. Rubel - Jefferies LLC, Research Division

All right. And is that really an indication that while you're looking at strategic drop-ins or complementary items, there's nothing of any size on the table at the moment?

Ralph G. D'Ambrosio

I would say that's correct.

Operator

Our next question is from Joe Nadol of JPMorgan.

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

I'd like to just go back, just to make sure I understand exactly the level at which this happened. So you have 3 sectors in Aerospace Systems and this was in Logistics Solutions?

Michael T. Strianese

Correct.

Jose Caiado De Sousa - Crédit Suisse AG, Research Division

Okay. In that so -- according to your slides beginning of the year, that was 30% of $4.5 billion, which is $1.35 billion. So what, there's 2 business units in that sector? And this was one of the 2, is that...

Michael T. Strianese

Correct.

Jose Caiado De Sousa - Crédit Suisse AG, Research Division

Okay and none of the employees that you're talking about were outside of that business unit?

Ralph G. D'Ambrosio

You mean in terms of the terminations?

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

Yes.

Ralph G. D'Ambrosio

They were in the segment at all levels that I talked about.

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

They were at all levels of the segments?

Ralph G. D'Ambrosio

Sector and segment of group level.

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

Okay, okay. So the natural question is how far along are you in your -- I mean, how long has this been going on? How long have you known about this? And how much conviction do you have that -- yes, I know you said this is isolated to the one contract but...

Ralph G. D'Ambrosio

What we said was it was primarily isolated to 1 contract.

Michael T. Strianese

Joe, finish your question. What was your thought that you want to...

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

Well, yes, I mean how do we know -- the big question everyone is going to be wondering is whether this 1 contract is $84 million or $120 million isn't the issue, it's how -- is it possibly pervasive elsewhere in other fixed-price contracts within this segment?

Michael T. Strianese

Again, as you know, it's -- I think we have to repeat it. It's ongoing. But as to what we know as of this morning, there has been nothing identified that suggest that this is beyond the borders that we have found. And we're involving employees beyond those that have already been terminated. So we don't have that absolute assurance because we're not complete yet. But with every day that goes by, we get more confident when nothing else comes up. But again, we want to run this to completion, and we've -- and as you know, we will.

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

And then on the free cash flow front. In Q1, we talked about on the call that it was the first time in 15 years that you'd had a negative free cash flow result for the company and, Ralph, I think you mentioned that Aerospace was where the greatest source of weakness was. In retrospect, was this a red flag? And if the answer is yes in retrospect, why didn't your systems pick it up at that time?

Ralph G. D'Ambrosio

I would say, it wasn't a red flag.

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

Okay. And can you say why?

Ralph G. D'Ambrosio

Well, I'm saying that based upon the trending in our working capital levels that we look at each of our divisions and sectors at, as well as the segment level, we look at multiyear trends. So...

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

Okay. What I'm getting at was this contract responsible in significant part for the lower-than-usual cash flow in the first quarter?

Ralph G. D'Ambrosio

No. There was an element of it, but it was a small portion of it.

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

Okay. So just a final point on this is since you have had low cash flow from Aerospace, and since we're not 100% sure that this is isolated to 1 contract, you see where I'm getting -- what I'm getting at, I mean, that's, I guess, that's my area of concern, is that maybe this might be a little bit more pervasive. Can you give anymore, if you feel any better, about that potential issue?

Ralph G. D'Ambrosio

Well -- so all I can tell you is that we share your concern, which is why we're giving this matter the proper expedient diligence. And that's why we're looking at the entire Aerospace Systems segment.

Michael T. Strianese

But again, as of today and this, as you know, we have -- a lot of people that have been working around the clock, Joe, for a while, nothing that's come to our attention to indicate is beyond -- primarily related to 1 contract at 1 business unit, and those involved have been dealt with.

Operator

Our next question is from Ron Epstein of Bank of America Merrill Lynch.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Not to beat a dead horse, but I'm going to a little bit here. My apologies for that in advance. Can you give us more color around just to kind of -- the point of failure? In your prepared remarks, you mentioned that your internal system did work because you found it and I guess maybe, Joe is driving at this a little bit, but it happened in the first place. And I guess you'll see it in the market today. I mean, the worry, it will be just -- and I know you said you haven't seen any place else. But how can you just make investors feel comfortable that it really is contained? I mean, can you tell us what the point of failure was? And how you can assure us it's not going to happen again?

Michael T. Strianese

Well, again, Ron, the investment -- the inquiry is ongoing. The corporate review is ongoing, and we have outside experts engaged, including some very high-power resources in the field. But the people involved have been fired. They are gone. So that gives me a lot of confidence that, that was the failure point because we had some bad actors, and they are no longer part of L-3. And that's my answer.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

I don't want to bring back bad memories, but completely unrelated. But there was an issue a couple of years ago when the JOG contract was suspended. And again, those were some bad actors in the different business unit, doing a different thing.

Michael T. Strianese

Well, I just want to...

Ronald J. Epstein - BofA Merrill Lynch, Research Division

Do you see them diving at that, that's the worry, do you know what I mean?

Michael T. Strianese

Well, Ron, let me correct you on that and I would like you to go look up, it's public record, the administrative agreement with the Air Force. In that agreement on the first page is a statement that says, while the investigation is ongoing, to date, there has been no indication that anybody at L-3 did anything wrong. So I have to take objection to your comment that we have bad actors. It actually proved we did not have any bad actors, so it's the exact opposite. And I personally handled that. My signature is on that agreement. And I was very insistent that unless somebody could march out bad actors and show them to me, there weren't any and, in fact, they were not. So I have to object to that.

Ronald J. Epstein - BofA Merrill Lynch, Research Division

All right, perfect, great. And then, let me just -- one last comment. I mean, with the exception of this accounting thing, otherwise the quarter was pretty darn outstanding. So anyway, I sympathize at the situation and I hope you guys can resolve it really quick.

Michael T. Strianese

Thank you. And we will. We are, to coin a phrase, all over it.

Operator

And we have time for one additional question. Our last will come from Robert Stallard of RBC Capital Markets.

Robert Stallard - RBC Capital Markets, LLC, Research Division

First of all, Mike, finally, on this topic, do you expect any of your processes to be changed as a result of this investigation either just simple accounting, but also a bid and proposal?

Michael T. Strianese

That will be a product of the final report at the end of this exercise. We have, as I believe, very strong controls on this. It's unusual for us to have a loss contract, nevertheless, have the accounting for it wrong. But both are unusual. But listen, we are open to always improving our controls and improving the quality of everything we do. So we will absolutely look at everything and make any adjustments that are necessary.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Okay. And then just secondly, you mentioned in the release about competitive pricing pressure NSS. Has this actually got worse? You commented about this in the past, but is this just ongoing situation?

Ralph G. D'Ambrosio

Well, it's Ralph. You're correct. We have commented on that competitive pricing in the past, and it is not new that competitive pressure really began almost 4 years ago now when the DoD embarked upon its better buying power or efficiency initiatives. So it's more of the same.

Michael T. Strianese

Okay. Well, I want to thank everyone for joining us and adjusting to the new time. To wrap up, we are staying focused on the outstanding program execution and working on delivering consistent shareholder value.

While we're currently dealing with this matter outside the scope of our normal business, we -- please be assured, we have allocated the proper resources to resolving it. This past quarter, we continued our trend of increasing our international and commercial sales and meeting the challenges of the current environment by staying focused on performance, operational efficiency and responsiveness to our customers' priorities.

In Electronic Systems, we're well-positioned for future opportunities across a variety of business areas and in the near term, are driving margin expansion. We see considerable growth potential in the aviation marketplace, which creates opportunities for our avionics and support businesses in terms of new products, retrofits and upgrades. Along with our solid outlook, we are making excellent project -- progress on process improvements and cost reductions, which we expect will continue to drive margin expansion. On the NSS segment, it's experienced growth and is well regarded in this very specialized marketplace with many long-term contract positions and solid customer relationships. We're advancing and combining our capabilities in our enterprise and mission IT businesses where we see an addressable market for our new big data capabilities. Across the company, we are developing cost-competitive solutions in building long-term customer relationships by anticipating their needs and helping them achieve their goals.

Overall, we remain confident about the future prospects of L-3's business, and we continue to operate from a solid financial and operational position. We look forward to speaking with you again on our third quarter call in October. Again, thanks for joining us.

Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

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Source: L-3 Communications Holdings' (LLL) CEO Michael Strianese on Q2 2014 Results - Earnings Call Transcript
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