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L-3 Communications Holdings (NYSE:LLL)

Q2 2011 Earnings Call

July 28, 2011 8:00 am ET

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

Analysts

Cai Von Rumohr - Cowen and Company, LLC

Howard Rubel - Jefferies & Company, Inc.

George Shapiro - Citi

Joseph Nadol - JP Morgan Chase & Co

Joseph Campbell - Barclays Capital

Myles Walton - Deutsche Bank AG

Peter Skibitski - SunTrust Robinson Humphrey, Inc.

Operator

Good day, ladies and gentlemen, and welcome to the L-3 Communications Second Quarter 2011 Earnings Call. My name is Modesta, and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Eric Boyriven of FD. Please proceed, sir.

Eric Boyriven

Good morning, and thanks for joining us. 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.

Also please note that this call is being simultaneously broadcast over the internet. I will now turn the call over to Michael Strianese. Mike, please go ahead.

Michael Strianese

Thanks, Eric, and good morning, everyone. Thanks for joining our call. I know it's early. Let me begin by saying overall, we performed well in the second quarter. We won new awards and received key follow-on contracts, and our business continued to perform well.

We did have a decline in sales. It was primarily driven by the loss of the Special Operation Forces Support Activity and Afghan Ministry of Defense support contracts last year in 2010 and continued lower pass-through volume related to the Army's systems and software engineering and sustainment services contract due to a change in the contract vehicle that have occurred in 2009. And we had a delay in the 2011 order for Joint Cargo Aircraft.

Notwithstanding, we have achieved a book-to-bill ratio for the quarter of 1, and this a result of our strong sales mix which continues to be driven by our C3ISR business. In keeping with our strategy, we continue to take the actions necessary to enhance our ability to anticipate and effectively address our customer priorities and promote growth while also optimizing the efficiency of our business.

With this in mind, we've completed our strategic review across our business units, which as you know, has been going on for about the last year. In our Electronics Systems segment, as I mentioned back in April, we consolidated our Sensors and Simulation and Products Group businesses into a single unit named Electronic Systems Group.

We also consolidated administrative operations within our Marine and Power Systems Group in the second quarter within our Warrior Systems business. We completed a consolidation of production facilities, including EOS and EOTech, with the newly acquired Insight, and that was done to streamline manufacturing processes and reduce redundancies and overhead. We also sold to smaller operations in that business area.

And recently, we also consolidated our Unmanned Systems business including the ATI unit, which we acquired last summer. So now, all of our Unmanned locations are operating under the Unmanned Systems name, and we have a wide ranging scope of platforms and capabilities to offer.

And finally, as we announced this morning, we intend to execute a tax-free spin-off of businesses in our Government Services segment to create an independent, publicly traded company. This decision has been unanimously approved by L-3's board. The newly formed company will be called Engility, and it will be a leader in SETA and training and operational support.

The name Engility is a combination of engineering and agility, and you might recognize it because it's been used by one of our wholly owned subsidiaries in the past. It's recognized in the industry.

L-3 we'll retain our Cyber, Intel and Security businesses that currently are part of Services, and we'll change the segment name to national security solutions upon completion of the spin-off transaction. There's a presentation posted on the website that I'll cover in a few minutes. Let me just finish up some comments on the quarter first.

On top of those actions, there are a number of additional internal consolidations and divestitures that we're working on, but they are much smaller and they have more fine tuning in particularly the electronics area.

These initiatives enable us to build on our core strengths of agility and innovation, sharpen our focus and increase our efficiency to drive performance and drive shareholder value. L-3 develops next-generation solutions by fusing our current capabilities across all of our businesses.

Overall, we remain confident in L-3's business mix and capabilities, and we believe we are well-positioned across the company for the future.

We were, once again, recognized by the DOD's Defense Security Service for our outstanding security program when we received 3 2011 James S. Cogswell Awards for Outstanding Industrial Security Achievement, and this really shows that we set the benchmark for outstanding security practices and excellence in handling classified information.

Our program performance was also very strong in the quarter. Our Intel and Cyber business achieved significant milestones on the U.K.'s Integrated Broadcasts System Program when we delivered an extremely complex secure communications infrastructure and data dissemination systems on budget and actually ahead of schedule.

Additionally, we recently participated in the successful return to flight test, target flight for the Missile Defense Agency and Space and Missile Command.

Across our company, there are many other positive examples of L-3's performance in innovation, and of course, I'd like to thank all of L-3's employees and group presidents for their continuing efforts to move our company forward.

I'm not going to say a lot on the budget. I'm sure you've heard it in some of the previous conference calls. It's challenging. But within fiscal '11, the budget is set at over $500 billion, about $513 billion.

Congress is reviewing the Omnibus reprogramming for fiscal '11, which taken together with the reprogramming of military intel and the ISR task force, is about $6 billion. Of that, L-3 might benefit for about $100 million in additional funding for legacy programs, including Project Liberty, Rivet Joint, Constant Look, night vision equipment and WIN-T and SATCOM communications.

DoD priority areas include ISR, sensors and night vision equipment, SATCOM and Comms-On-the-Move, Cyber and Intel and equipment reset or refurbishment and upgrades. These are all very strong areas for L-3. We're well diversified, and we think we have sufficient content in all the areas and all priorities.

That said, we don't expect much action on fiscal '12 until after Labor Day and expect a continuing resolution or omnibus until it's worked out. This could affect our outlook if there's a delay, of course, but we went through that this year once already.

On the financials, I'll give you a very brief summary. Ralph will give you a little more color later on. Earnings per share for the quarter were $2.26, that's up 16% compared to 2010 second quarter. Sales were $3.8 billion, orders also $3.8 billion, which gave us our 1 book-to-bill ratio. Funded backlog, just about $11 billion at the quarter end, and our operating margins came in at 10.7%.

On significant programs, there's a couple I'll share with you. Project Liberty and Spider, first of all. We continue to receive funding for upgrade and retrofit work on existing Liberty aircraft. Liberty is a perfect example of the broad participation across our business segments to provide turnkey solutions.

So our C3ISR and Electronic Systems businesses provided and integrated the sensors and comm systems and other equipment, while the AM&M business handles the youth service support and continues revenue stream on that program post-delivery.

In addition, at last week's REAC [ph] show in the U.K., we introduced a new product which is a small manned ISR aircraft called Spider, currently on a King Air 350. However, it is a platform-agnostic system that offers complete processing, exploitation and dissemination. Specifically designed for military and civilian customers who want flexible, multiple intelligent solutions at what I believe is a disruptive price point based on comparable systems in this space.

So rather than show a PowerPoint presentation to customers, we have an operating system that we can bring into a customer and let them operate it, customize it, define the platform they want. I think it's going to be a very successful product over time.

We're marketing Spider internationally of course as a turnkey system, and we're planning to fly our demonstrator aircraft at the Dubai Show this fall.

U.K. Air Seeker, that's the 3 Rivet Joints that we're under contract for, for the MoD. A few weeks ago, MoD signed a $1 billion support and upgrade deal with the U.S. government regarding 3 Rivet Joint intelligence aircraft. It's worth about $800 million to us over the next 7 years.

We continued our modifications of these Rivet Joint aircraft at our Greenville facility. Program is going extremely well. I'm expecting more on-time, on-budget performance for our customer that we're becoming very well known for. Our training efforts with U.K. air crews continue to proceed well with some joint operations underway right now.

There was some significant second quarter orders. I'll just go through a small handful of significant ones. First of all, on the P-3 SMIP program, it was competitively awarded to us. It's a sustainment, modification and installation contract valued at approximately $104 million to perform aircraft sustainment on the U.S. Navy's suite of P-3, EP-3 and NP-3 aircraft.

Also, an award on the Airborne Sensor program for HALO and DC-10 aircraft. The C-17 training program, which was a competitive win for the work transition to L-3 on June 1 and we're proceeding smoothly with that transition.

Also, Criminal Justice Support System was one. Contract VLC in depot level vehicle maintenance for the Marine Corps, which you'll start to see that ramping up as some of these resets starts kicking in, and an ID/IQ to provide Linguist to INSCOM under the DLITE program, which is a follow-on version of old linguist.

In terms of capital allocation and acquisitions, we continue to focus on improving shareholder returns through a very disciplined approach to cash deployment. In April, we announced a $1.5 billion share repurchase plan. Share repurchases are a essential element of our capital deployment strategy and reflects our ongoing commitment to deliver value to our shareholders.

With that, as I said, there's a short, maybe a 10- to 12-page presentation posted on the website. I'll go through it, dealing with what we call "project saber." It's a spin-off transaction, and I'll name the slide as I go. But I'm going to move pretty quickly, and you certainly can ask questions when we're ready to have the Q&A.

So let me go right to Slide 3 with the title Addressing Changing Industry Dynamics.

Right. As you know, the defense industry continues to evolve. Geopolitical challenges include emerging threats, which create rapid procurement requirements and shifting budget priorities, including the DoD efficiency and affordability initiatives.

Over the past year, we conducted a thorough and disciplined review across our business units. Overall, we have a strong strategic position and attractive prospects with no major platform exposures.

We continue to build on our well-diversified contract and program base, and there are significant pull-through opportunities across our segments. This pull-through has allowed us to successfully develop integrated solutions on high-profile programs.

As I mentioned earlier, we use capabilities and products from C3DISR, AM&M, and Electronic System segments to work together to deliver the Project Liberty, a mission-critical solution that rapidly responded to an urgent battlefield requirement.

We've also successfully combined our systems integration capabilities with our state-of-the-art technologies and products to provide complete solutions for major programs such as the Rivet Joint and the Expeditionary Unmanned Aircraft System.

Essentially, those capabilities allow us to serve as a prime on very high-profile programs, where we are regarded as a national asset, a one of a kind company that can deliver these types of capabilities in very rapid time frames.

Just to give you an order of magnitude, Liberty was conceived a prototype and delivered in less time than it took to do the EMARSS competition, just through the procurement competition. So we have a very special capability.

But as a result of our review, we have proactively addressed the challenges that we face to position the company for the future. By consolidating business units as we did by merging products and sensors, we've reduced and eliminated overhead and rightsized certain operations.

The Government Services segment has some unique challenges however. Services has some competitive differentiated businesses based on deep intellectual property and technical capabilities which align well with L-3.

There are other areas, however, such as manpower management related that offer limited synergy with the rest of L-3. Also, cost competition is increasing as government shifts to cost plus past order type contracts, which enable Tier 2 and Tier 3 players to come in and take market share from larger companies, the Tier 1 companies. In addition, OCI has created limitations that continue to be a factor, and the OpTempo wind down has produced an additional burden, given margins within that business area.

We have concluded that some of the businesses within our Government Services segment are limited in opportunities as part of L-3, both due to OCI and other constraints. With the drawdown in Iraq and Afghanistan, there's been a decline in OpTempo-related business and a shift in budget priorities towards Cyber and Intel.

There's also been a division among government services companies, with some becoming low-cost service providers while others focus on the technology-based services. Our solution enables us to build on our core strengths of agility and innovation and sharpen our focus and increase our efficiency to drive performance.

We have the ability to develop next-generation solutions by fusing our current capabilities across our segments. To achieve this, we're focusing on our technology-driven versus cost-driven businesses.

Going over to Slide 4, the transaction overview. Following the unanimous approval by our board, we announced today that we intend to execute a tax-free spin-off to create an independent, publicly traded company. The newly formed company named Engility will focus on SETA, training and operational support for the DoD and other government agencies, as well as civil and international customers.

Engility will be structured to more effectively address its customer priorities with competitive and innovative solution and enhanced operational efficiency. Engility will create value in a number of ways. It will expand its opportunities in the marketplace by leveraging its existing capabilities and operating as a low-cost provider of high-quality services.

It will also benefit from expanded opportunities for growth, as it will not be subject to potential OCI issues as part of L-3 and will be able to pursue businesses that are outside of L-3's area of strategic focus. This transaction is anticipated to be structured to be tax-free to the company and its shareholders. This, of course, is conditioned upon a private letter ruling from the IRS, as well as the other customary approvals common to spin-off transactions.

We expect to complete this in the first half of 2012, and this transaction does not require a shareholder vote.

Moving on to Slide 5, the Engility investment highlights. Engility will have an attractive and well-balanced business mix. It will start out as a leader in government services with the ability to accelerate growth in its core areas. Engility's margins will be above average relative to its peers, and its large employee base with specialized skills and expertise will help the company be competitive and deliver value to its customers.

Engility will be leveraged to an appropriate level, reflecting its healthy cash flow and debt capacity. We anticipate somewhere between $500 million and $650 million of leverage, which is between 3x and 4x the estimated EBITDA at the time of the spin. That number may move around a bit, but we think it's pretty accurate as to where it will end up.

We have selected Tony Smeraglinolo as Engility's CEO. We brought Tony back to L-3 at the end of 2010 to help us address the challenges at LSG. He has a wealth of industry experience, and we are confident that he has the vision and strategy that will successfully lead Engility going forward.

Slide 6. I'm not going to read the whole table, but it's a good slicing up or parsing of the key business areas of Engility and what their core capabilities are. So I encourage you to read it, but they will be a formidable player in its field.

Moving on to Slide #7. Engility has an attractive and well-balanced business mix. We have some pie charts there that give you the traditional splits by sales area and customer contract type and business type that will give you a sense for what the company is going to look like.

I think Engility is expected to have, yes, $2 billion in sales, $179 million of operating income and $14 million of D&A. Based on the business breakdowns that we showed you, it will have a balance in its business areas and contract vehicles as well and has a very broad customer base.

Moving on to 8. Let's talk about the business that will stay with L-3 for a minute. Our National or new National Security Solutions segment. Following the spin, L-3 will retain Cyber, Intel and the Security business. This segment will be named National Security Solutions as I said. It will be led by Steve Kantor, one of our most seasoned senior vice presidents who currently runs the entire Services segment. He took that over last year on June 1.

This business has attractive prospects and fits our long-term strategy of delivering innovative solutions to our customers. It is also well aligned with our other businesses, which will allow us to leverage synergies across our segments to deliver integrated Cyber, Intel and global security solutions for our customers.

If you think about it, just pause a second here on the page, it gives us, if you look at the intel chain, everything from sensor to data processing to the transmission of data over a data link, to the processing on the ground, to the archiving, to the analysis. We will own every piece of that intelligence chain from sensor all the way down to the archiving and dissemination, based on our capability across our segments which is a pretty powerful discriminator in this business.

It also provides critical touch points with our DoD and Intel customers. These are competitively differentiated businesses based on deep IP and technical capabilities that enhance our opportunities in established adjacent markets.

Both companies will have critical mass that compete in their respective marketplaces and be agile enough to deliver unique solutions for customers. When you look at the breakdown, in case you were wondering, the total Services group, Services segment for 2011 is expected in total to be $3.6 billion. $2 billion of it is going to be Engility post-spin, $1.6 million will remain as our NSS segment.

So that's -- they're both going to be very formidable competitors in their respective markets. The spin-off will also enable us to enhance our overall growth rate and margins, as well as reduce our OpTempo exposure.

Moving to Slide 9. Creating and unlocking value. As I mentioned earlier, this transaction is expected to be tax-free to the company and shareholders. It will also improve our pro forma 2011 estimated growth rate and margin. We expect a sales growth rate increase of approximately 170 basis points, operating margin increase of approximately 30 basis points initially and an EPS growth rate to improve by over 400 basis points.

We have no plans to change our capital allocation strategy, which has been focused on share repurchases, increasing dividends, disciplined M&A. There will be no change to the dividend program which we up already earlier this year for the share repurchase plan, and we are committed to preserving our investment grade credit rating.

We'll continue to aggressively pursue value creation using our existing strategy of addressing customer priorities, managing costs to enhance competitiveness, excellent program execution and grow earnings and balance capital deployment.

And in summary, on Slide 10, we are confident that the spin-off of Engility is the best strategy to address the current environment and create value for our shareholders. This transaction not only improves L-3's pro forma growth rate and margin, but enables concerted management focus on L-3's core capabilities.

Engility, on the other hand, will enhance its competitive position by providing more cost-effective and innovative solutions for its customers. It also creates new and exciting prospects for Engility's employees. As the environment continues to evolve, both companies will be better aligned with DoD, government and customer priorities.

So that concludes my comments on the spin-off. Let me hand it to Ralph now, who will give a very summarized overview of the second quarter numbers, and then we'll turn it over to Q&A.

Ralph D'Ambrosio

Thank you, Mike. Good morning. The major trends in our second quarter results are covered in the earnings release. So I'll add a few comments about the results and review the changes to our 2011 guidance.

On the second quarter results, as Mike said, EPS was $2.26, up 16% versus last year's second quarter. And if you analyze the results, you'll see that lower taxes, interest expense and shares outstanding, plus no debt retirement charge this quarter compared to last year, offset the small declines we had in sales and margin.

The results also demonstrate that the capital allocation actions that we have taken with respect to share repurchases and debt refinancings are bolstering and increasing our EPS growth. Generally, the second quarter results were in line with the expectations that we provided on April 21. Sales were $35 million lower than the $3.8 billion we expected, and that was due to the Joint Cargo Aircraft order delay.

EPS was $0.16 higher than we expected, primarily due to a lower tax rate, including an $0.11 gain on the resolution of some prior year tax's contingencies. And free cash flow was about $50 million better due to better receivable collections than we had planned.

Regarding the full year 2011 guidance update, we increased our diluted earnings per share guidance by $0.15 for a lower estimated tax rate, which increases or raises the EPS range by $0.15, making it $8.65 to $8.75. We made no other changes to the guidance from the prior updates, both on a consolidated and a segment basis.

With respect to the sales guidance, while it's unchanged, we have some downside risks that will be sorted out in the second quarter -- rather, the second half. The largest risk concerns JCA. As I just said, we have not yet received the order which is supposed to be 8 aircraft. And if the order continues to slip, our segment sales in the Aircraft Modernization and Maintenance segment could be up to $80 million lower, depending on when we receive the order.

The rest of the second half sales risk pertain to funding delays on a few programs in Electronic Systems segment and small aircraft ISR and the C3DISR segment.

Finally, looking at the third quarter, we currently expect sales to be between $3.8 billion and $3.9 billion, earnings per share between $2.10 and $2.15, with free cash flow of about $300 million. Our operating margins should be about 10.7%. And we expect the book-to-bill ratio in the third quarter to be about 1.0, and the full year to be close to 1.0. That concludes my brief comments. We will go to the Q&A now.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question today comes from the line of George Shapiro with Access 342.

George Shapiro - Citi

Ralph, I just wanted to know, could you provide a little more specifics about the framework and thinking about the size of the capital contribution you'll get from the spin? How much do you think the SETA business has been held back by being part of L-3? And could you maybe just quantify the OCI exposure Engility might have?

Ralph D'Ambrosio

Okay, so you asked a few questions there. The first one concerns the capitalization of the spin co-entity, or Engility. And we'll finalize. What we'll do next year as the spin is completed -- our current thinking is that the company's going to be well-capitalized and efficiently use debt in their capital structure. Given its strong earnings and cash flow conversion, we're thinking it has a good amount of debt capacity, and we're presently targeting it to be a BB type credit, and which Mike said earlier, that means we expect the leverage it will have to be somewhere between 3x and 4x its EBITDA. And as Mike said, that translates into dividends back to L-3 of somewhere between $500 million and $650 million. Your second question concerns to what extent Engility's business prospects have been constrained by OCI issues that pertain to the rest of L-3. We definitely think that that's been a factor in their growth rate. Certainly, there are OCI or potential OCI issues between their SETA work and the hardware and systems work that we do at L-3. So that prevented them from pursuing certain opportunities. And if I take a swag at it, it's probably worth a few hundred million dollars of sales that they essentially have been not allowed to go after, given the overall situation as far as L-3. Did I answer all your questions, George?

Operator

Your next question today comes from the line of Joseph Campbell with Barclays Capital.

Joseph Campbell - Barclays Capital

I wanted to ask about -- this is a little bigger than I was thinking. You might spin out, I think, at the off-site. You said, "well, maybe it would be $1 billion." And I wondered if you could talk a little bit about how you came to the boundaries of Engility? And then just an update, a quick one on what this will do to the total OCI or OpTempo that you've talked about for the whole company, just sort of how much of this is in Engility and how much did you keep? And maybe a reminder of how much commercial will now be of L-3?

Michael Strianese

Yes, Joe. I think the last time I commented, I said about $1 billion. We have been in the process of a comprehensive year-long review across the entire company, and we've been evaluating all transactions, alternatives. As we progressed in the review, we looked at structuring the business competitively and got to a point that -- a couple of things happened. One, what became very apparent is there was a bifurcation in services between services that are being more competed on price only, which is the more manpower-related type work, and it's characterized by a dozen or so competitors showing up, most of which were not traditional L-3 competitors. You're dealing with Tier 2 and Tier 3 competitors that are operating at lower cost structures. One thing. Number two, the government has changed contract vehicles that have driven the margins -- they're pressuring the margins down every time things roll over. From a macro view, the way I've looked at it, if you look at 3 or 4 companies that traded in the last year, they all traded to private equity, and they're all highly levered. And I'd interpret that as being: if you're going to earn margins as low as 4%, 5%, you need that level of leverage to get a return on investment. So it became apparent once we did that, that the businesses that we would be parting with was a bigger population, number one. Number two, since we've decided to go with a spin since our tax rate is very low, we wanted to create a company that will be a formidable player and create value. And if you look at the competition where it's going to operate, this is going to be a big player in that space. So that's what's changed since we have gone through this exercise. Now you had a follow-on to that about OCI? Could you just repeat what your follow-up was?

Joseph Campbell - Barclays Capital

No, it was just a question of -- it looked like a good bit of the war-related, OpTempo-related, OCI-related stuff will find a home in Engility. And I wondered what the remaining L-3 exposure, sort of this direct exposure to the theater of operations, was going to be?

Michael Strianese

Yes. Well, based on the numbers we've been reporting, there's roughly $400 million that we would characterize as OCI-related revenue that is going as part of Engility.

Operator

Your next question comes from the line of Cai Von Rumohr with Cowen & Company.

Cai Von Rumohr - Cowen and Company, LLC

NSS. Actually, as I looked at the split between the 2, I guess I'm a little bit surprised that Engility's margins are as high as they are, and that NSS's margins are as low as they are. What's the opportunity to improve profitability at NSS? And secondly, as a separate spin, should we be concerned that Engility's margins may be difficult to sustain?

Michael Strianese

Look at it this way, Cai. On the NSS piece, our Cyber business is in a period, I would say, of investment. Not only in that we are building a Cyber Center, but we've been bidding very competitively to secure a growing base of business. So the plan is to get those margins to grow. And I guess the follow-on question was, how much can you get them to grow? And I would say, but not -- I can't marry the numbers today because we have a bit a road the whole year. It would probably get up around the 8%. Now I'd also say that our view on creating value is not just improving margins, but it's growing our operating income. So even though those margins may be lower than what our product would get, the growth rates should be higher. And that's the way we're looking at the Cyber and the Intel business. With regards to the Engility margins being high, yes, I think there'll be a period of time where those margins will normalize based on contracts rolling off. There's a lot of legacy OpTempo-related programs in there that where T&M-type programs, where there was an opportunity for additional profit growth based on as you got more experience into a program. As you know, you have margin opportunity. As these programs rollover -- Linguist is a great example by the way. If you look into where Linguist used to be versus where it is in the new world, in the days that we had Linguist as a pun, the margins were around 8%, 9%, 10%. We estimate that under this new DLITE program, those margins will be as low as 3% or 4% because of the change in contract vehicle. So yes, there is a downside, pressure is going to be on the new co-margins that were on Engility margins. But again, we look at it this way. One, those OpTempo contracts or the backlog will be a vehicle for Engility to rapidly delever. They'll manage the cash out of that, and that will help them delever. And they'll have to make up for the margin with volume into a low-cost structure. And that is the reason for separating these businesses. They're going to have very distinctive business capture strategies. So you kind of right on, on the subtleties of the margin situation on both businesses.

Cai Von Rumohr - Cowen and Company, LLC

And last one, you mentioned you're not looking at anything as big. Can you say anything more about what you're looking at in terms of additional initiatives?

Michael Strianese

Within the company?

Cai Von Rumohr - Cowen and Company, LLC

Yes.

Michael Strianese

We're always looking. We have 75 and 100 business units, given the current environment, of gaining more efficiency through consolidating, creating centers of excellence, sharing facilities. I mean, that's a process that I would tell you will go on almost indefinitely. Much smaller, whether we put together business units or have a small divestiture. But there's nothing of the magnitude that we just concluded. This decision followed an already very long review over the entire business. We are trying to be proactive here in actively managing the portfolio to deliver value to customers, as well as generating shareholder value. We still continue, we look at acquisition, acquisitions to strengthen the business areas that we think are going to grow. But we believe the other businesses are well positioned. There's always an occasion to get better. I don't think any company can ever say we're done, there's nothing else we can ever do to increase and enhance efficiency, and that's something that we'll always do.

Cai Von Rumohr - Cowen and Company, LLC

Okay, and last one, you mentioned your bidding to win business in NSS. Could you give us any color on some of the things you might be pursuing?

Michael Strianese

Go ahead, Ralph.

Ralph D'Ambrosio

Sure, Cai. There are a handful of intelligence-related programs that we are pursuing this year and next year. And they're both within the intelligence community and within the intelligence arms of the armed services, Army, Navy and Air Force. And those awards are going to be happening over the next 12 months or so. And like I said, there's more than a handful of opportunities.

Cai Von Rumohr - Cowen and Company, LLC

Okay, based on what you're not saying, I assume this is pretty much all black business?

Michael Strianese

Yes, that's pretty much the space, Cai. I mean, what you can look to is one, we have a unique situation for structured solutions from the emerging problems there. But two, it was just -- it was this week or last week, that Secretary Pineda and the White House came out with a national cyber strategy. Now while I don't think there was a lot of meat on the bones there to get the financial community and the analyst community comfortable with what it really means, what we see is a ramp-up of activity on existing contract vehicles. So kind of the secrecy around all this is this a real classified world. And while there are new competitions, you don't hear about them. And a lot of the funding is getting put down the pipelines of existing contracts. So it is a bit of an area where it's hard to point the specific competitions out in the daylight.

Operator

Your next question today comes from the line of Howard Rubel with Jefferies.

Howard Rubel - Jefferies & Company, Inc.

Just an implementation question and then a bigger picture one. How do you propose to sort of solve the overhead problems that you have when you complete this split? Some of it will have to come out of the existing L-3 I would suspect? And also, the newer companies are going to be located outside of New York. Or how are you going to think about that?

Michael Strianese

That's right, Howard. Ralph will talk to the overheads a little, and then maybe I'll chime in. But go ahead, Ralph.

Ralph D'Ambrosio

Obviously, there's a portion of our existing corporate overhead that Engility absorbs like the rest of our businesses do. I'll tell you that we have a very low corporate overhead to begin with, and I expect that we're going to be able to find reductions in the overhead spend that are going to offset the loss of that absorption. So I don't view it as an issue at all for L-3.

Michael Strianese

Well, one of the things, Howard, that we're trying to accomplish here is that we don't have to recreate the wheel with Engility in terms of systems, practices, ethics programs, training and everything. We can share what we've already developed with L-3 with the company. We also plan to offer corporate positions in the new company. And since we do have people that are in the Washington area already that are L-3 corporate people, we think through the staffing-up of Engility with existing people at L-3, as well as normal attrition that happens over the next year. And this really doesn't become an issue for about a year, as well as managing a little tide, already a very lean organization to begin with. If I would say we're about one deep at everything, that would not be an exaggeration. But we don't view this as a major event for us. We'll manage a soft landing on the overheads, and we'll end up exactly where we should be.

Howard Rubel - Jefferies & Company, Inc.

No, I realize the office hasn't changed in forever. So despite this -- despite the growth and the size of the enterprise. So I get it. That is, not too many people are as lean as you are. And the other one is on Spider. Clearly, you're not going ahead with this because it's neat. You're going ahead because there's opportunities, and there's customers that are probably near in. Could you characterize the response and what you might see in terms of being able to go to work on this in a reasonable period of time, Mike?

Michael Strianese

Well, again, with any new product introduction, it's hard to give you a lot of clarity around that. But I'll say the following, and what we've noticed in the marketplace internationally that, one, is a desire for an airborne ISR capability that includes everything from ER to electronics sensors to synthetic aperture radar, to a way to transmit the data to a ground station, et cetera. However, many of the customers in the space we're looking at do not have to spec or anything as to what they want. And I think you spend a lot of time in writing their proposal for them, where we finally said, for a very modest investment, we develop what I would call an export-qualified Project Liberty airplane that has a nice blend of sensors that can handle a number of tasks whether its maritime patrol, border patrol, critical infrastructure, civil matters and the like. It operates. We can bring it into a country. We can operate it, show the potential customer what they see on the ground, how the data can be used, and offer them any number of options such as hosting it on different airplane, to swapping out sensors and the like. So we think it makes it much closer to a sales point by having something that operates than starting with paper. And with that, I'd say customers everywhere from the Middle East to Asia, we think will have a strong interest here in this airplane. And not only that, but I also said, I think, the price point that we're at on this is disruptive compared to what else is available. I think where we are going to be on this is going to be a very attractive system for many countries to pick up that capability that don't have it.

Operator

Our next question today comes from the line of Joe Nadol with JPMorgan.

Joseph Nadol - JP Morgan Chase & Co

First question is just on the -- as you thought about how you were going to separate the business, Mike and Ralph, it seems to me like the tax basis in this business probably wasn't that depressed, given a chunk of this was tightened, I think? And so as you evaluated a sale versus a spin, can you maybe share a little bit of the detail as to how you came to the spin? Because if you look at some of the SETA businesses out there that have been separating with defense companies, they've gone to private equity at some pretty high EBITDA multiples.

Ralph D'Ambrosio

Well, Joe, regarding your question about the tax basis, the tax basis is actually very low in Engility. And that relates to the fact that we've made a number or several acquisitions in Government Services over the past decade, really since the beginning of L-3, and we had consolidated and integrated most of them into single entities. So when you break it apart, the tax basis is very low.

Joseph Nadol - JP Morgan Chase & Co

Okay, that makes sense.

Michael Strianese

So yes, let me pipe in a little bit. Again, we undertook a comprehensive year-long look at this and really got into a lot of detail on it. And what you found is like -- you have a great observation what happened to -- but remember, MPRI was in there. It was one of the first companies we bought that originally did about $45 million in volume and ended up well over $1 billion. That's more than half of Engility. So there's a very low basis in it.

Joseph Nadol - JP Morgan Chase & Co

Okay, that helps a lot. On the margin mix within Engility, the op support must be low. So are there midteens margins in the SETA part?

Ralph D'Ambrosio

We have some high margins like that on a few select contracts. Generally, not that high, of course, of different business areas.

Joseph Nadol - JP Morgan Chase & Co

Okay, okay. I guess we'll get more details on this later obviously. Then finally, just when you look at NSS and at this business, Government Services overall sales peaked in '07, had been down a little bit every year since then. If you were to look at the profile of these 2 businesses going back 4 or 5 years, would NSS have grown over that period of time, and all of the decline be within Engility? Or how does it fall out?

Ralph D'Ambrosio

You mean, from the '07 timeframe to wherever you are today, correct?

Joseph Nadol - JP Morgan Chase & Co

Yes, that's right.

Ralph D'Ambrosio

Right. So if you look at our Government Services, segment trends over that period, you'll notice that we've had some meaningful declines in sales and operating margins continuing into this year. Now if you -- or to separated it between Engility and NSS, you can have a very different profile. Most of the sales declines and margin declines have occurred in Engility, and that pertains largely to the Iraq drawdown exposure, including the Linguist program. And over the same period, the sales and NSS have actually grown at a very modest pace. And where we stand today, to the extent that those 2 entities both remain in L-3, we see those divergent trends continuing into the future. So one of the rationales for separating the businesses the way we did it is we believe that if Engility is on its own, it's going to be able to pursue certain opportunities that we're not willing to pursue, and that they'll be able to effect and improve that trend line that they have going forward.

Operator

Your next question today comes from the line of Pete Skibitski with SunTrust.

Peter Skibitski - SunTrust Robinson Humphrey, Inc.

Actually, I have a couple more Engility questions, but figured I'd take the opportunity to ask something non-Engility wise. Ralph, can you tell us what's going to put pressure on AM&M margins in the second half and maybe what's going to drive the uptick to a GS margins in the second half from your guidance?

Ralph D'Ambrosio

Well, what's happening in the AM&M segment is that, if you recall in the first quarter, we had some, what I would call, non-recurring gains or improvements that I said we're not going to recur. And if you strip that away and look at the first half margins, they're very consistent with what we expect to achieve in the second half. So that's what's happening in the Aircraft Modernization and Maintenance segment. In Government Services, what we expect to drive the increase in the operating margin is that there are more than a handful of award fees on different programs that are scheduled to be awarded in the second half. And accounting-wise, we recognize award fees when they're awarded. And that's what's going to drive the improvement in the operating margin in Government Services.

Peter Skibitski - SunTrust Robinson Humphrey, Inc.

Got you, okay. And then just one Engility question. Aside from MPRI, can you tell what other -- which are

the other sub-units that are going to Engility?

Ralph D'Ambrosio

Sure. Well, I'll talk about it in terms of prior acquisitions. Because there's been a lot of consolidation, but it's ILEX. It's part of EAR, DMA, SyColeman, MTI systems, IRG, and then some large divisions that were part of Titan, including the aviation and maritime division and the technical management support division plus the Linguist operation. That's the bulk of what is comprised in Engility. And in addition to that, we had some program movements back and forth to make -- that made sense with each of the 2 entities. So that's what it substantially is comprised of. I looked at MPRI. Actually, Mike talked about. That's also the largest part individually in Engility.

Operator

Your next question today comes from the line of Myles Walton with Deutsche Bank.

Myles Walton - Deutsche Bank AG

I was wondering if you could give us the pro forma free cash flow contribution from Engility for 2011? And also, obviously a big part of the value unlock is leverage you're able to put on Engility and put the proceeds back to remain co. Was there a consideration, or was there consideration to essentially just do the leverage portion? Or do additional leverage on remain co in addition to what you doing with Engility?

Ralph D'Ambrosio

Miles, I'll take the first question which concerns the cash flow characteristics of Engility. And what's its impact to L-3 is -- I said earlier, that has very strong cash conversion characteristics, which are actually very similar to the consolidated L-3. So if you look at their operating income, which we provided the estimates for in the Engility investor presentation, imply a similar conversion rate. That's a good way to estimate what the cash flow is. The only difference being that Engility is going to have a higher effective tax rate than L-3. So its effective tax rate is likely to be in the 38% to 39% range, which is similar to its peer companies. And that's simply because it's not going to have the kind of deductions that we have elsewhere in L-3 relating to R&D activities and manufacturing activities as part of the international business.

Myles Walton - Deutsche Bank AG

Okay, that's fair. And then another question on the leverage, the standalone?

Michael Strianese

What's your question? Whether the...

Myles Walton - Deutsche Bank AG

Yes. I guess, Mike, I mean, the key piece of the value unlocking story of yours, yes, you're spinning off a piece of business that has been a drag on the corporation, but really though, the value -- the kind of the accretion offset is based on a leverage that you're taking out on Engility. I'm curious if Engility -- the comfort level there is clearly to put additional leverage on it. Why not do the same, why not step-up the leverage on the remain co?

Michael Strianese

Well, we've been very aggressive on our share repurchases in the past. We've just up-bit -- put another $1.5 billion in the plan. As I said last quarter, if you took 2010, '11's and '12's plan on share repurchases, that would account for about 25% of our outstanding equity. So I think that's pretty aggressive on its own. Our credit ratings, our investment grade rating, is important to us, given who we compete with, which is the large defense primes. So while the BBB maybe acceptable in the Engility world and their competitors, I think it would not be helpful to us, nor do I think we need it. I think we're appropriately capitalized. We're also going to close the year with $1 billion of cash on the balance sheet, so we have options to enhance the share repurchase guidance that we already have outstanding. So that's the long and the short of it.

Myles Walton - Deutsche Bank AG

Okay, fair enough. And the proceeds, the preference at this point, is it for acquisitions over share repurchase? Or is it...

Michael Strianese

Well, you can't plan on acquisition. And right now, we consider where our equity is trading at, and we do give guidance on an annual basis as to what we think we're going to repurchase these proceeds, wouldn't show up until next year anyways. So we will consider that as part of our plan. But the priority has been to, what, the dividend, to the share repurchase and then to acquisitions. And again, acquisitions are as they come. And we haven't been chasing prices up. But the 3 we did last year, or 4, were all non-auctions. And all had multiples that were very attractive, all accretive. This year, there haven't been any of any substance, and we're not going to go create one for the sake of creating one. So with that, it's something, Myles, that we monitor every quarter. So I'll turn it over to Eric.

Eric Boyriven

We've reached the allotted time for the call, so I'll turn it back to management for any concluding remarks.

Michael Strianese

Yes. Well, let me make a comment or two. One, I think the company is well-positioned. We continue to perform well in the current environment. We have businesses that are viewed as national assets in key markets and significant synergy across our business. And we are leaders in the business areas and provide our customers with cutting edge technologies and outstanding performance. I think Engility will be also well-positioned to pursue growth opportunities and succeed as an independent company. L-3 will capitalize on our leading market positions to develop innovative national security solutions and continue our performance, customer focus and commitment to shareholder value. We're pleased to have completed this process, the strategic review. We're excited about the opportunities we expect to come from today's events, and we look forward to this new chapter in L-3's history and updating you again when we talk at the October call. So thanks for joining us on this early call today.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation, you may now disconnect. Have a great day.

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