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Executives

Eric Boyriven - Managing Director

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 - Access 3:42, LLC

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

Myles A. Walton - Deutsche Bank AG, Research Division

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Joseph Nadol - JP Morgan Chase & Co, Research Division

Robert Spingarn - Crédit Suisse AG, Research Division

Carter Copeland - Barclays Capital, Research Division

Noah Poponak - Goldman Sachs Group Inc., Research Division

Brian W. Ruttenbur - Morgan Keegan & Company, Inc., Research Division

Robert Stallard - RBC Capital Markets, LLC, Research Division

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

L-3 Communications Holdings (LLL) Q4 2011 Earnings Call January 31, 2012 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2011 L-3 Communications Holdings Inc. Earnings Conference Call. My name is Genaida and I will be your operator 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. Please proceed.

Eric Boyriven

Good morning, and thanks for joining us for the L-3 Communications Holdings Inc. 2011 Fourth Quarter 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 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 would now like to turn the call over to Michael Strianese. Mike, please go ahead.

Michael T. Strianese

Thanks, Eric, and good morning, everyone. Thank you for joining us this morning for our year-end earnings call. I'd like to start by thanking our employees again delivering L-3 solid performance. Strong program execution under the leadership of our group Presidents continues to be a performance driver for us and remains a differentiator for the company.

Our GAAP earnings in the fourth quarter were $2.72 per share on a diluted basis, despite the persistent challenging economic environment. Excluding some unusual items, EPS was $2.54, which is 7% up versus the 2010 fourth quarter. Our free cash flow is also strong, generating just shy of $0.5 billion. The exact number was $498 million for the quarter. Sales for the quarter were $4 billion, led by 8% growth in C^3ISR, which partially offset headwinds in our other segments. We ended the year with sales of $15.2 billion, which is a 3% decrease when compared to 2010.

Orders were $3.2 billion for the quarter and $14.8 billion for 2011, which resulted in a book-to-bill ratio of 0.97 for the year. Our funded backlog was $10.7 billion at year end.

Overall, we returned over $1.1 billion of cash to our shareholders in 2011 through share repurchases and dividends, representing an increase overall of 13% in cash returned versus 2010. And I'll note that since inception of our share repurchase plan, we have repurchased about 45 million shares or roughly 1/3 of our outstanding stock with about 13 million of those shares coming in 2011 alone.

Our commitment to value and responsible deployment of cash extends to our investment in technology and innovation despite the budget downturn, I-red does remain a priority for us. We will continue to invest our cash in R&D and other activities to expand our business space.

Looking at the business segments. ISR had strong performance, showing solid growth on healthy customer demand. Our AM&M contract logistics support business performed well with recent competitive wins, a steadily increasing backlog and a growing market share. A difficult budget environment and lower JCA volume for AM&M were partially offset by CLS services work particularly for the army's C12 aerial surveillance aircraft. Our Electro-Optical infrared integrated sensors business experienced increased volume within the Electronic Systems segment. The troop withdrawal from Iraq and the drawdown in Afghanistan resulted in program declines that continue to impact our services business. As I said at the onset of the call, L-3's been able to demonstrate consistently strong program performance defined in part by operating more efficiently and anticipating our customer needs with innovative products and services.

That performance was recognized by the customer when our army fleet support unit received the 2011 Materiel Readiness Award from the Army Aviation Association of America. This prestigious honor is awarded to a defense contractor that has made an outstanding contributions to the material readiness of army aviation. And given the upcoming recompete, that has us very happy going into 2012.

We continue to look closely at our operations to ensure that they align well with our production requirements and help us achieve maximum efficiencies. This involves making sure that our businesses are sized appropriately and are focused upon delivering for our customers. We continue to integrate and consolidate our businesses with that goal in mind.

We're also concentrating on adding new capabilities that expand our product lines and broaden our customer base. In 2011, our acquired businesses contributed about $160 million to our net sales. A good example of our strategy to add capability and broaden our base is the recently announced acquisition of Kollmorgen Electro-Optical, which develops and manufactures specialized equipment such as submarine photonic systems and periscopes, ship fire control systems, visual landing aids and ground EO and sensor queuing systems. KEO also expands our base in the EO/IR market and strengthens our position as a mission-critical sensor systems provider.

KEO is a market leader and positioned in very high priority areas in the DoD budget, including the Virginia class submarine. It also creates a variety of technical synergies and pull through opportunities for us that enhance our offerings and situational awareness for our customers. And KEO demonstrates how we successfully execute our acquisition strategy of thoughtfully and selectively considering opportunities that offer excellent value and provide a good fit with our current mix of businesses.

Now as you know, we've announced the acquisition in December. We expect it to close over the next couple of weeks. And again, KEO is a market leader in its space and when that's combined with our existing EO/IR business, you can imagine some of the synergies we're going to see from the technology standpoint and the broadening of our portfolio products and customers. So it really is a nice fit, and we are excited about getting that closed in the next couple of weeks.

With regards to M&A in general, we're going to continue the strategy of being vigilant and disciplined in seeking out opportunities that contribute to our growth and help us drive customer advances and expand our market positions. We've been very sensitive to pricing on acquisitions. We want to be absolutely sure that we're going to be delivering shareholder value when we go forward.

Internationally, there are opportunities for L-3, including foreign military sales. We're already doing very well in certain regions. We have a wide range of products, both commercial and military, that are procured by international customers. This includes airborne ISR and sensors, Aviation Security equipment, commercial shipbuilding, aviation products, sonar systems and unmanned and optionally piloted aircraft. We'll continue to look to expand internationally in areas that play to our strengths.

Regarding an update on the Engility spinoff, we're proceeding on schedule. The management team and board are being assembled, and we anticipate IRS approval soon for the tax-free status of the spin. We expect the transaction to be completed by midyear around June 30. We believe in Engility's prospects going forward, independent of OCI constraints and with a streamlined operating structure to enhance its competitiveness.

The remaining service businesses -- business which we're calling NSS or National Security Solutions have opportunities in areas where we have effective distribution channels in place.

This allows us to offer customers end-to-end capabilities, from sensors and products that securely move the data, to processing systems that allow the war fighter or government agencies to use the data more effectively. The action we're taking with Engility and NSS demonstrate our strategy of focusing on our core strengths in areas that align well with our customer priorities. Regarding the budget, as we're all aware, the President will submit his budget on February 13.

Last week, Secretary Pineda provided some guidance on the budgeting process. He emphasized that the military will be smaller and leaner while remaining agile flexible and technologically advanced. He also outlined a focus on operations in the Asia Pacific and Middle East regions. He stressed protecting and prioritizing investments in key technologies including cyber capabilities, special operations forces, missile defense and countering weapons of mass destruction. The new defense budget will produce about $260 billion in savings over the next 5 years. And the Pentagon feels that a further round of cuts would inflict severe damage to our National Security for generations to come. Pineda continues to support a scenario that does not sacrifice military readiness and the administration affirms a commitment to maintaining military superiority with a leaner core structure.

The administration, as well as senior leaders in both the House and Senate are working hard to avoid sequestration in favor of a reasonably robust DoD budget.

The important message here is that we will continue to see the savings achieved by DoD's initiatives invested in many of our core strengths, such as C^3ISR, EO/IR systems, special operations and intelligence support and counterterrorism. And will benefit such programs as the Virginia class submarine, littoral combat ship and amphibious ships, as well as upgrades and reset maintenance on aircraft, helicopters and aircraft carriers. We believe L-3's size and agility are assets in this environment in responding to customer needs, particularly in light of the DoD's new direction of focusing on more quick strike force global actions and less on protracted ground wars.

We'll continue to monitor the situation closely as it unfolds over the coming months, and we'll provide you updates on our quarterly calls as we normally would. In terms of some of the significant milestones and awards during the quarter, let me just share with you a few of them. In C^3ISR, we continue to see follow-on orders for ROVER 6, which provides real-time battlefield communications between ground forces, ships, aircraft and UASs. We received contracts in support of sustainment programs for both Global Hawk and Predator. We received follow-on order for additional ship set equipment for the Virginia class sub, a program mentioned by Secretary Panetta as a DoD priority.

We received additional funding for upgrades and logistics work on existing Project Liberty aircraft, demonstrating our cross-business segment capability, with sensors and Communication Systems from Electronic Systems and C^3ISR businesses and in-service platform systems support provided by AM&M.

We'll receive funding for capability enhancements to our SPDR, small manned ISR aircraft for government and international military and civilian use. That's a new product that was introduced in 2011, about midyear. It's gotten a lot of attention on the international stage as an affordable, ready off-the-shelf platform that customers can try before they fly. And we are expected to get some traction on orders in 2012.

For AM&M, we continue to see good performance on our army fleet support contract logistics service and SFS contracts. And we received orders for work on missionization and integration projects from OEMs such as Bombardier. With respect to C-27J, or the Joint Cargo Aircraft as you know it, we're not anticipating any additional orders from the Air Force.

Internationally, Australia is currently considering an FMS purchase of 10 aircraft. But consistent with our prior guidance, we think we have it pegged correctly and we're not anticipating any additional orders from the Air Force.

With regard to Electronic Systems. Our Link Simulation and Training division want to recompete for the U.S. Air Force's F-16 Training System. We continue to receive strong orders for WestCam sensors, including systems for the army's aerostat initiative or PTDS, EMARSS and helicopter programs as well, Warrior Systems Products received an order from the Army under the Storm PI program. On airport security, the ProVision ATD system has strong international interest, including an order from Ireland recently. Our upgrade of existing systems in the field to the image-free automated threat detection configuration is proceeding well. And we received an order from CAFSA, that's in Canada, for checked baggage systems.

We had orders for SATCOM equipment including the NFMS sale of VSAT systems to the Iraqi MoD and a competitive win to provide the satellite control system for the Iridium NEXT satellite constellation. In partnership with Lufthansa and airport operator Freight Port we have successfully demonstrated back in December our green taxiing technology, which does not require the use of aircraft engines while taxiing, thus reducing fuel usage and resulting emissions. Now, not only does it not require the engines, but you might imagine, it doesn't require any of the pushback equipment either. So these are using hub-mounted Magnet Motors that L-3 has developed to move an entire airplane around the airport including pushback from the runway. While it's in its early stages, I would tell you that this a good example of transitioning some of our technology to "green energy" in commercial applications. Now, it's a long way to get to production, but we had a very good start with this successful demo because it was quite a technological feat to move an airplane given the weight with a small hub-mounted Magnet Motor.

We also received orders for submarine equipment from the Turkish Navy and we're selected as a sonar supplier to Indonesia. In addition, we received a number of international orders for our HELRAS sonars. In Services, we received a competitive win to continue our work providing C4I integration operational work for SPAWAR. We continued to make good progress on classified programs, including receiving customer accolades for excellence in operations and engineering support. We also continue to receive contracts in support of the DLITE program, which was formerly known as Linguist.

With regard to capital allocation and acquisitions, our commitment to shareholder value has been consistent in terms of our focus on being disciplined in how we deploy our cash. During the quarter, we used the cash flow to repurchase 158 million of common stock and paid dividends of $45 million for the quarter, resulting in about $1.15 of cash returned to shareholders in 2011, 13% over the comparable amount in the comparable mix in 2010 of buybacks and dividends.

Our commitment to capital allocation also focuses on M&A. And at the same time, we remain committed to preserving our investment grade credit ratings. We'll continue to aggressively pursue value creation using our existing strategy of addressing customer priorities, managing costs to enhance competitiveness and grow earnings and balance capital deployment.

I'm going to turn it over to Ralph to go through some of the numbers in the fourth quarter and his 2012 guidance, and then we'd be happy to take your questions. So Ralph, take it away.

Ralph G. D'Ambrosio

Okay. Thank you, Mike. Good morning. As Mike said, I'll add some comments about the fourth quarter results and talk about our 2012 guidance update. On the fourth quarter, our GAAP earnings per share were $2.72. We had 2 unusual items affecting the quarterly results. First, we had a gain of $78 million or $0.77 of EPS related to the resolution of prior-year tax contingencies. And secondly, we had recorded a non-cash impairment charge of $57 million or $0.49. Now most of that charge was for the -- a goodwill impairment at our Marine Services business, a small business in Electronic Systems segment that was due to a decline in its projected operations and cash flows. Except for these unusual items, the 2011 fourth quarter results were generally in line with our outlook.

EPS was about $0.10 higher than we expected. And what happened there was higher segment operating margin, lower taxes, lower interest expense and shares outstanding combined to offset declining sales and drive the growth in EPS.

Fourth quarter sales were $4 billion and $15 million, down 5.6% versus the 2010 fourth quarter. Those sales were lower than we expected by about $140 million, with most of the actual versus guidance difference in the Electronic Systems segment.

I characterized the lower sales as endemic of the slowing and now declining U.S. defense budget, coupled with the shorter cycle nature of a lot of our businesses.

Segment operating margin improved 20 basis points to 11% versus the fourth quarter of last year. And that was 50 basis points higher than we expected. And what happened there was we had an improvement in our sales mix while with higher products versus services sales plus a more favorable product sales mix. The individual segment results are covered in the earnings release.

Free cash flow was very robust at $438 million, up 10% versus the fourth quarter of last year, bringing free cash flow for the full year to a very healthy $1.3 billion.

Before I move on to the 2011 -- or sorry, 2012 guidance update, I want to add one point about the fourth quarter goodwill impairment charge. As you know, L-3 has a large goodwill asset balance. And depending on how events unfold the next 12 to 24 months around the U.S. Defense budget, especially the outcome of the BCA sequester, it's conceivable that we could have additional goodwill impairments. And we'll monitor the situation as events unfold over the next year or 2.

Moving on to the guidance update for 2012. It's unchanged, both on a consolidated and segment basis, from our initial guidance that we provided at our Investor Conference on December 6. Consolidated 2012 sales guidance is $14.4 billion to $14.6 billion, which is a decline of 4% to 5% versus 2011. At the midpoint, we expect a sales decline of about $670 million, with about $0.5 billion of that relating to the U.S. Military drawdowns in Iraq and Afghanistan.

At the 2012 segment guidance midpoints, we expect a 19% decline in Government Services. Sales for the other 3 segments net to about flat, with growth of 2% for C^3ISR, flat sales at aircraft modernization maintenance and 2% decline for Electronic Systems.

The guidance does not include the Kollmorgen Electro-Optical business acquisition that we announced on December 13. We expect to complete that acquisition sometime next month as Mike indicated, and that's when we'll include it in our guidance.

For the year ending December 31, 2012, we expect the KEO business to generate sales of about $165 million, with EBITDA of about $27 million. And that's before expected synergies, transaction expenses and purchase accounting adjustments. And we believe that's an excellent acquisition and we look forward to adding it to L-3.

The consolidated operating margin guidance for next year is 10.1%, declining 70 basis points versus 2011. Higher pension expense is causing a 30 basis point reduction. The rest of the margin decline is a combination of lower sales, product sales mix changes, pricing pressure and OSD [ph] initiatives with the largest impacts affecting the Government Services segment.

We'll continue to aggressively manage our cost structures and our businesses and try to deliver better margin for 2012.

Free cash flow is expected to be about $1,170,000,000, declining versus 2011 due to lower operating income and higher income tax payments. And finally, taking a look at the first quarter, we expect sales to be somewhere between $3.4 billion and $3.5 billion, with EPS of $1.85 to $1.90 per share and free cash flow of about $100 million. The operating margin in the first quarter should be in the mid-9% range.

The book-to-bill for the first quarter should be close to 0.95, and we expect the full year book-to-bill to be slightly less than 1.0. That concludes my comments. And we'll go to the Q&A now.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of George Shapiro with Access 3:42.

George D. Shapiro - Access 3:42, LLC

A couple of questions. Just overall, how much is your exposure to the canceled Global Hawk? And maybe a benefit that you get from the U-2 based on what the Defense Secretary said last week?

Michael T. Strianese

Well, George, there's a couple of offsetting things. One is and that -- we're not down to the decimal points yet on how they're going to offset. But it's not only the extension with U-2, it's also the broad area of maritime Surveillance platform as well that’s going to -- will be a pickup versus the reduction in the Global Hawk. So I think net-net, it's going to be a wash to a net, maybe a net positive because you have a new platform coming on. So we're never happy to see platforms go away or deduct the Block 30 upgrade but it's not a material event for either the segment or for L-3.

George D. Shapiro - Access 3:42, LLC

Okay and then another one on that score, Mike. The retiring C-5s and C-130s, that were talked about. What kind of impact might you get, if any, in the AM&M segment?

Michael T. Strianese

C-5s haven't been a -- it's been very minor as you not lodged -- I would say material event in AM&M. We do, do C-130 work, although a good chunk of it is international. The global fleet of 130s is very, very large with a lot of old planes out there. So I'm not expecting to see anything to speak of in terms of reduction of what we're doing on 130s, which would typically be the work that's done in Waco. That facility is full now and it's pretty much booked up for the next year or 2, so I think we'll be okay.

George D. Shapiro - Access 3:42, LLC

And then just maybe one general one. With the fiscal '12 budget passed, you're seeing any evidence services awards are being delayed? And what the contracting officers are doing in light of concerns about sequestration?

Michael T. Strianese

No, actually I think it's a little early in the year to see that. But if I had to guess, the action that you actually might see will be an acceleration of putting money on contract, as we wind our way through the summer and get down on September 30. The part that concerns me, if you want to know what concerns me, is the ability of the customers to get the money obligated by the run out of the fiscal year, because remember, if there’s unexpended funds they can be swap [ph]. So I think the real challenge for our customers is to be getting the money put on contract this year, so I would expect that to be a big focus item as we get through the third quarter.

Operator

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

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

So you'd mentioned there was a slip in Electronics in the fourth quarter. What were the items that slipped? And is there any chance -- you didn't change your guidance for 2012, pretty big slip given you gave the guidance in December. So are any of those items that, because they slipped actually make 2012 look a little bit easier to do?

Ralph G. D'Ambrosio

The answer is possibly, Cai. The sales that slipped out of the fourth quarter in the Electronic Systems segment, there really wasn't any single item causing most of that slip. It was spread across several different business areas in, for example, Training and Simulation, we saw some delays on some upgrades that we're anticipating on the F-16 Mission Training Center, some man packs for our Video Scout product delivery slipped out into the first quarter. We saw some reduced funding on WIN-T, and the common to move products and our Marine power systems business areas we saw some slips on some tow to rate [ph] work for the U.S. Navy going into 2012. So -- but as I said, I think, this is what happens and what we've been experiencing in a lot of our short cycle businesses with the defense budget slowing and now declining. So I don't think it's unusual to see these types of slips occurring and something that we've been seeing for the better part of a year now, Cai.

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

Okay, terrific. And maybe -- and I was sort of cut off but update us on the new business prospects and kind of the key competitions coming up and whether they've slipped.

Ralph G. D'Ambrosio

Most of the major competitions, both on new business and recompetes are generally on schedule when we talked about it at the Investor Conference, Cai.

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

Okay, terrific. And then a last one. In terms of cash deployment priorities, I think you have a normal dividend meeting coming up. Mike, I think you said you look for a significant increase, something -- some verbiage like that in the dividend. Maybe talk to us a little bit about kind of how you're looking at this dividend. And whether its priority in your overall cash deployment thinking has changed.

Michael T. Strianese

Sure. We do have our regular board meeting coming up at the beginning of February. And as has been our practice, we address the annual dividend. I take exception to significant -- in terms of increase. I said, we're looking at the dividend in with regards to its -- our positioning with the rest of our industry in terms of its yield, but we are kind of in fairly in line other than there’s one outlier that's way up there maybe yielding close to 5%. I said there's a possibility that the increase could be larger than it's been in the past. But I think over the last several years, we've increased the annual run rate by about $0.20 a share. But that's a discussion that we'll have with our board. The general sentiment though is that our deployment is fairly balanced between repurchases, which leave us the flexibility to be opportunistic in acquisitions when they come up. And of course, continue the dividend and the recent purchase plan was very -- we were very aggressive this year because of the weakness in the stock price and the great cash flow that we've been enjoying. And I expect more of the same. The Engility spinoff is going to obviously have an impact on our recurring cash flow. There'll be a drop because the cash is going to go with Engility. And there'll be a dividend that we expect to receive that we anticipate to use to bring some of the leverage down and maintain the investment grade rating. So again all those items will factor into the deliberations that'll go on in the next couple of weeks.

Operator

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

Myles A. Walton - Deutsche Bank AG, Research Division

Ralph, I guess on CFT Southwest Asia, that's probably the nearest term one, I may have missed it, but can you give us an update on the timing for that one?

Ralph G. D'Ambrosio

Sure. That's currently in source selection. We expect an award to be made early in March with the new task order starting on May 1.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay, great. And AM&M in the quarter tracked above playing on the margin side, and again, apologies if I missed it, it was I think about 30 basis points above the top end of what you were looking for. Could you give us any color? I think you were anticipating what happened on the JCA, what was the upper to it?

Ralph G. D'Ambrosio

The upper was we had some better than we -- better than expected performance on some other aircraft modification jobs. That pushed the margin a little higher.

Myles A. Walton - Deutsche Bank AG, Research Division

But more one-time in nature, which is why it didn't flow through to '12?

Ralph G. D'Ambrosio

I wouldn't call it one-time in nature, but I'm currently not expecting the same for 2012. Let's see what happens.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay, fair enough. And I guess just to go more into the M&A path, Mike, Kollmorgen looks like a good transaction and there was a period of time where assets were being spun out of parents as opposed to just stand-alone transactions being taken out. And you'd commented, I think back at the Analyst Day, about some of the failed auctions that had gone on in the market in the prior 12 months. What is the current activity in the market in terms of bid-ask spreads and deals coming to close and realistic assessments of buyers and sellers?

Michael T. Strianese

I think that the pricing has moderated the expectation. First of all, Kollmorgen is a good example of that. It's at a price that's certainly lower than it would have been a year ago and reflects market conditions. I think that the pullbacks or the failed auctions, as we've said of the prior year, meaning 2010, didn't recur to the same extent in 2011, which indicate to me anyway that there's a -- some more realism in the expectations of sellers. Typically, January is a slow month going into the year, but there's an acceleration of deals that happen as companies complete their year-end exercises. And we see a steady supply of descriptive memorandum. I guess we’d call them offering memorandum if they come out on companies. I can tell you last year, there was no shortage. I know that we went through about 100 deals. We probably went to indications of interest on about half of them. But as you know, we closed maybe 2, with Kollmorgen being obviously the larger one and something that was very small. So being selective is kind of key here and it's not only getting companies at the right price. But there's a lot less room for error, given where the budget is and the growth prospects right now. So you need to be very cognizant of your environment and what the prospects are, so which we think we do well. And again, we're going to continue to be diligent in what we see and we're certainly interested in adding to our market-leading businesses. Where, like in the Kollmorgen case, we have a technology that is complementary to what we do in our EO/IR business, but it brings a different product set, a different platform set and a different customer set to us and we can really lever the technology in creating more and better products. And that's what we're going to continue to do. So there's going to be more to come.

Myles A. Walton - Deutsche Bank AG, Research Division

Just one follow-up on Kollmorgen. What has been the -- in the last couple of years growth and what is it expected to be in terms of tracking relative to your business?

Michael T. Strianese

I'll give that one to Ralph. He's the guru of the numbers, but it's comparable, but get it, Ralph.

Ralph G. D'Ambrosio

Our sales growth in the last year or 2 has been kind of flattish, because they've been -- it's completed some work on ram [ph] vehicles. But perspectively, we expect them to actually have a better sales profile than the composite L-3, given their position on the Virginia Class Submarine and the Service Navy fire control work that they do. So they seem to be very well positioned in the current budget environment and budget priorities.

Operator

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

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Couple of things. Ralph, it seemed to me that there was probably about $17 million of kind of one-off operating items that reduced the results in the quarter. Could you address those? And how have you sort of factored restructuring into your outlook for next year?

Ralph G. D'Ambrosio

When you say one-off items, you mean some of the severance charges that we incurred?

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Yes, the severance charge you had, the aircraft charge for the 27...

Ralph G. D'Ambrosio

Okay, so through the -- on the JCA charge, that's something we had talked about on the third quarter call, and that we were expecting that there potentially could be no additional aircraft ordered. And so that's what seems to be occurring based upon all the current statements coming out of the DoD, including those from Secretary Panetta last week. So that's a one-off item that we don't expect to recur obviously. The severance charges, I wouldn't characterize them as unusual because we're continually analyzing and right-sizing our business structures as we see fit given what's happening to their volumes. And I expect that we'll be doing more of the same in 2012. And it wouldn't be an item that would cause a hiccup with respect to our guidance. So it's something that we do as a matter of normal course in L-3. That's not an [indiscernible]

Howard A. Rubel - Jefferies & Company, Inc., Research Division

And where -- on the revenues on C-27, they split -- they're -- they run off after '13. Is that correct?

Ralph G. D'Ambrosio

Correct. We did -- our sales, we're about $150 million in 2011. It's going to decline to about $110 million in 2012 and then about $50 million in 2013. And that's when the sales will run out for the 21 aircraft that have been ordered.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

And then just 2 more questions. One is, how much cash did you repatriate in the quarter?

Ralph G. D'Ambrosio

It was about $275 million.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

And then also if we look at the run rate on the business at Engility, and it looked like it decelerated -- or it was on -- in the fourth quarter, do you still see some further deceleration as you go into the first quarter and then it levels off? Or is it just sequentially down for the quarters for the balance of the year?

Ralph G. D'Ambrosio

Well, based upon the estimates that we've provided for Engility and NSS, we're expecting both of those businesses to decline again in 2012, so there's some timing aspects to the quarters in any given year. But we expect that they're going to decline again. That's what's causing the 19% reduction in sales guidance for the Government Services segment.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Well maybe let me just ask it one more way and then I'm done. Is -- you've got -- we should be largely out of Iraq at this point, and a big chunk of the Iraqi business would be behind you. So we probably would see a run rate in the first quarter that might very well be representative of NSS for the year?

Ralph G. D'Ambrosio

Yes. And clearly, once we get beyond 2012, there's going to be less downside risk pertaining to the drawdowns in Iraq and Afghanistan. We're taking a pretty sizable reduction in that regard in 2012.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Right. And most of it's in the first quarter would be my thinking, right?

Ralph G. D'Ambrosio

Right. Yes.

Operator

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

Joseph Nadol - JP Morgan Chase & Co, Research Division

Ralph, I just want to get back to the sales outlook that Cai was asking about earlier. You note that the Electronics segment came up a little light and there was really kind of little stuff across the board. We got a lot of information last week. I'm sure some of which was not new to you but some of which was probably was new. And just when you think about the $14.4 billion to $14.6 billion, can you offer maybe some color? I mean, your growth rate is better now on Electronic Systems because the sales came in light in 2011. And so, are we looking at the lower end of the range? Or do you feel okay about it? And any other color maybe you could offer.

Ralph G. D'Ambrosio

Well, at this point in time, I would say we're in the middle of the range for Electronic Systems. If we go back to how we determined and set the guidance for 2012, we deliberately made some adjustments for what we've experienced the past couple of years. And that is if, as you know, we missed our sales guidance for each of the last couple of years. And we took that into account when we determined the initial guidance for 2012. So my view is that we've adequately factored it based upon the information that we have available to us. So that's why we're still comfortable with that range despite the shortfall that we had in Electronic Systems in the fourth quarter.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Okay. And then just on the margins, the inverse has happened and you've been able to find opportunities. And you're guiding for down 70 bps and 30 of it is pretty mechanical with the pension. And you talk about pricing pressure and volume declining, which are of course pressures. But are there opportunities there if sales come in light again to beat margins again? Or could you characterize that a little?

Ralph G. D'Ambrosio

The answer to -- short answer to your question is yes. If you look at our performance in the last couple of years, we've exceeded our initial operating margin guidance in both of the years. And I said earlier, we're going to continue to manage the cost structures aggressively and take, if you want to call them countermeasures to what's going on in the competitive and pricing environment. And that should enable us to do a little better than we're expecting in operating margin, especially if we see some softness in sales. So like I said, we're going to try to do better than our guidance in 2012. I just don't want to commit to it yet.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Okay. And then just finally on KEO, you hit a couple of the operating metrics. I actually missed the full, all the numbers. But if you could just repeat those. And then the question is, you know that there's going to be a lot of synergies here. And I imagine that's the case given the overlap with your existing business from a manufacturing standpoint. Could you quantify those synergies and whether they're included in your numbers or not?

Ralph G. D'Ambrosio

Well I said that we expect the Kollmorgen business to generate sales of about $165 million for the full year 2012, EBITDA of about $27 million and that was before synergies. We think we're going to realize some cost synergies there in the next year or 2. I'd put it in the $3 million to $5 million category, but it's going to take time for us to realize it. There really isn't a lot of overlap in terms of the products that they serve. So it's really an adjacency or expanding our EO/IR sensor business to enable market right now. So most of the synergies that we're going to have are going to come on the cost side with respect to the business and it just opens up a bigger market to us where we should be able to sell some of our existing products to new naval-type customers.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Yet they slipped up Virginia class a little bit as they indicated maybe last week that, presumably, it wouldn't be enough to impact your business case here.

Ralph G. D'Ambrosio

No, if anything I think they wanted to slip the schedule a bit to allow them to be able to implement some upgrades before they go forward, so that's probably a positive for the Kollmorgen.

Operator

Your next question comes from the line of Robert Spingarn with Crédit Suisse.

Robert Spingarn - Crédit Suisse AG, Research Division

Mike, you and I have talked in the past about international and trying to gauge what -- what are the real pipelines are, what's real, what isn't. You've mentioned that sometimes, it's a lot of RFP activity with no delivery on the actual contract. So could you contrast the areas of international that are likely to happen with those that aren't?

Michael T. Strianese

Sure. One area where we continue to see more realism than hype is in the sensor and airborne ISR area, both customers in the Middle East and in Asia have expressed a strong interest in the SPDR product, while other variants of some of the products that L-3 makes, including some of the unmanned systems. With respect to customers in Korea, the sonar products -- and in Europe for that matter, the sonar products seem to have a strong foothold where the sales become more real and predictable. In fact, we've booked several things, the airport security equipment activity, is -- while competitive, it's all real. I mean those, they go forward with. Some of the longer-term areas where we're working, I believe are real, but I think that's a longer sales cycle than the ones I just mentioned, would be tank upgrades in Saudi Arabia and in Bahrain and potentially Oman, as well as some of the AM&M work regarding head of state airplanes that typically are coming out of the Middle East, where we expect to induct the first 747-800 in Waco to do a conversion, and we being the first on that platform will widen that market. It's going to be a popular plane to be upgrading given its size. So that's kind of the flavor of it. We try to avoid being the stalking horse in some of these competitions where we feel it's just not real. If we're going to spend resources, I'd like to spend them on things where I see we have a strategic advantage either because we're the only ones who have that type of product, or with regards to for example, the airborne ISR where we have a product that is disruptive in terms of price versus capability, price versus performance and no one has that. So we're mindful of not getting too bogged down in areas were we're not going to get any traction.

Robert Spingarn - Crédit Suisse AG, Research Division

Okay. And then just on the bookings, you talked about -- I think you had said you'd come in just shy of 1.0 for the year. I think you're 0.97. So --

Michael T. Strianese

Right.

Robert Spingarn - Crédit Suisse AG, Research Division

Was it within your level of expectations? And if not, did some of it slip into Q1? And therefore, why would Q1 just be 0.95?

Michael T. Strianese

Well, first quarter always gets off to a slower start. 0.95 in the first quarter is actually a good number.

Robert Spingarn - Crédit Suisse AG, Research Division

I'm just putting it into context of a little -- of a light Q4.

Michael T. Strianese

Yes. No, Q4 was at, just about at expectation. We would not expect it to reach a 1.

Robert Spingarn - Crédit Suisse AG, Research Division

I don't mean 1 for the year. So Q4 was 0.8, right? That's pretty low.

Michael T. Strianese

Yes, for the year. Well, it's reflecting the environment we're in. We had a surging third quarter with a book-to-bill of 1.17. So I think we were pretty upfront in saying we expected this to not recur and to be significantly lower in the fourth quarter. I don't really get that concerned about the book-to-bill in any one particular quarter. Obviously, I like to look at the trailing 12-month trend on it. And being that close to a 1 is not upsetting me that -- I'd like to not see it get any lower. And obviously, I'd like to see it north of 1.05 going forward. But right now, we are seeing slippage just because of the budget environment and particularly driven by services.

Robert Spingarn - Crédit Suisse AG, Research Division

Okay. And then just -- do you expect with the fiscal '13 cuts there would be any blowback, for example, into the fiscal '12 funding? So where things are getting moved around and cut they might come back and say let's not throw good money after bad, let's cut these things early?

Michael T. Strianese

No, I think those areas are already identified. But you raise an interesting point where, if it becomes known sooner than later, that sequestration were to occur and more cuts on platforms would happen in '13. So your question is, would they change '12 because they know it's going to end? And the answer's yes, but I can't think of anything in that league that would affect us.

Operator

Your next question comes from the line of Carter Copeland with Barclays Capital.

Carter Copeland - Barclays Capital, Research Division

Just a few quick ones. Ralph, you said that the margin in Q1, you were looking for sort of mid-9s versus the kind of low-10s for the full year. Can you give us some color on what the kind of segment level drivers are behind that?

Ralph G. D'Ambrosio

Well, the -- generally the margins tend to be a little softer in the first quarter. And if you take a look where I think the first quarter margins will be, on a segment basis, compared to the full year margin guidance, we're a little below the mark full year guidance in Electronic Systems. And that's typically -- the reason is that we have a very large seasonally higher fourth quarter in that segment each year, so that's what the trend is in that segment. And then, the rest of the segments tend to be towards the low end of the margin guidance range for the full year, so I consider that to be relatively normal.

Carter Copeland - Barclays Capital, Research Division

And on the -- you called out the cash taxes being a headwind for '12. Can you quantify roughly what that amount is? And speak to if we have incremental headwind in the following year in '13?

Ralph G. D'Ambrosio

The tax headwind is going to be about $130 million versus 2011. And the reason for the increase in taxes is one, we had some unusual tax gains that reduced the effective rate during 2011. Those are not going to recur for next year. At this point in time, we don't have an R&E credit. And our expected tax rate for 2012, and that's worth roughly about $15 million or so in extra cash taxes. And then, we had some bonus depreciation that we enjoyed in 2010 and 2011, that's not repeating in 2012 unless new stimulation -- stimulative efforts undertaking in the tax law. And that's disclosing that trend. Additionally, we're expecting a small recapture on some debt repayment that we will do this year, assuming that we repay some of the contingent convertible debt and that's in the -- that's approximately $20 million to $30 million. So...

Carter Copeland - Barclays Capital, Research Division

Great. And lastly, just a follow-up on Howard's question, a point of clarification. You said that the Engility plus NSS guidance for '12 envisioned a decline in both spaces. But relative to the sort of trajectory you outlined for Engility 2 quarters ago, has that changed and decelerated relative to what you initially thought? Or is it still roughly the same?

Ralph G. D'Ambrosio

Well, our current expectations for Engility are lower than what we initially thought back in July, but they're consistent with the update that we provided in the guidance.

Carter Copeland - Barclays Capital, Research Division

In December?

Ralph G. D'Ambrosio

So, it's in line with that. Most of the downturn -- or most of the reduction already happened in our fourth quarter. In the fourth quarter of 2011, the Government Services segment, sales were down 19%. So that's kind of resetting to the -- a level that we expect to be at for most of 2012.

Operator

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

Noah Poponak - Goldman Sachs Group Inc., Research Division

I wanted to go back to the previous question on the degree of conservatism in the 2012 top line guidance. Because just from a high level, it looks like you're sort of forecasting a similar total rate of revenue decline, and you're exiting '11 with a lower average of the last 12-month book-to-bill, and you have $700 million of recompete that's in, I guess, your more competitive segment in the current environment. And the budget environment isn't really any different. So can you maybe just elaborate on what specifically -- what programs you've haircut or what win potentials are out there that you're not really factoring? Or maybe just get a little more granular on how it's more conservative in '12 than it was in '11?

Ralph G. D'Ambrosio

Sure. So let me just first state that I think our sales guidance is appropriate for 2012. I don't want to suggest that it's conservative. I said it's conservative in the context of what we've experienced the last couple of years. So I think it's the correct appropriate sales guidance. If you look at 2012 compared to 2011, we had some headwinds in 2011 that we're not going to have in 2012, SOFSA's the biggest example of that. Plus the decline in JCA revenue is greater in '11 than it is in '12. So that's going to help to offset some of the other declining trends that we're experiencing in 2012. With respect to the major recompetitions and the Aircraft Modernization and Maintenance segment, and that's really the only segment in 2012 that has any major recompetes and I define a major recompete as one that does and has sales in excess of $100 million per year. And I -- we explained at the Investor Conference that we think we adequately factored what could happen on those 2 recompetitions and to our sales guidance. And it's also mitigated by the fact that when those new contracts would begin, with the larger one being Fort Rucker, it doesn't happen until October 1.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Right. So specifically on those, I mean have you factored that it's fairly likely you lose them just because you've got an environment where it’s -- you're going to have 1 or 2 guys in there bidding very low margins in all likelihood? Or not?

Ralph G. D'Ambrosio

I'll just say that we factored appropriately for what could happen in the competitive environment there.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay. And then one more higher-level question, I guess. In this environment where revenue is declining and margins are compressing, the earnings, the bottom line earnings of the company have stayed fairly flattish. And obviously, the share repurchase program is the reason for that and paramount to that is your ability to keep generating free cash the way you have. And you've surprised us positively with how strong the free cash has remained and where you've guided it to in '12, given a tougher environment. So, Mike, I just wondered if you could speak longer term to the sustainability of that cash flow generation for the company going forward.

Michael T. Strianese

Yes. No, first of all, I think that the strength of our cash flow has been pretty much consistent throughout most of the company's history. We have always been a strong generator of cash. What's driving the earnings, of course, is how we're deploying that cash, not only with the repurchase program, but also with accretive acquisitions and the fact that we've refinanced a good portion of our debt and lowered our interest charges consistently over the past 2 or 3 years or so. So in my experience, in history in this industry is that as volume declines, the working capital that we have invested in a particular program will liquidate and will keep the cash flow strong. And I go back to managing through the declines that went on in the early-to-mid '90s, and that was the effect that you saw, as working capital was liquidated, more cash gets generated. Candidly, I'd rather be in a place where our cash flow was lower because we're investing it in new facilities and technologies because the top line's growing, and I think we would all agree we'd be happier. But it does give us a natural cushion in this environment, that where there are these declines that we're confident that as long as we manage our programs, and don't take on unbounded risks, which we don't plan on, that we will be able to maintain the consistent cash flow generation that we have and be able to use the deployment of that cash to buttress that bottom line and keep it modestly growing. That's our goal.

Noah Poponak - Goldman Sachs Group Inc., Research Division

So if we have a 5-year budget downturn that translates into revenue declines and margin compression for that period of time, you guys think this sort of 135%-ish free cash to net income conversion is sustainable through that rough order of magnitude?

Ralph G. D'Ambrosio

Well, the conversion rate from net income to free cash flow is sustainable because of the -- the structural reasons why it happens and those are going to remain intact even as we go through the cyclical downturn. And in addition to that, what happens to our operating income is going to be a good indicator of what happens to free cash flow in total. But we're going to continue to have very strong conversion where we convert substantially more of our net income to cash flow. And as you said, it's been about 135% or so and that type of ratio is going to -- should be sustainable.

Operator

Your next question comes from the line of Brian Ruttenbur with Morgan Keegan.

Brian W. Ruttenbur - Morgan Keegan & Company, Inc., Research Division

Can we talk about acquisitions, possibly outside the defense sector? What your plans are? Areas that you'd like to acquire to maybe diversify, if that is in fact your plans? And multiples you'd be looking at paying, traditional multiples or something higher to diversify?

Michael T. Strianese

Yes, the answer, Brian is no, I can't talk about that because we have no plans to get outside of our bidding. The other lesson learned in the '90s was where defense companies got off the reservation and went into things like space communications and whatnot, it was not a happy story. So I -- instead of saying out of the defense space, I would rather focus you on what things can we do in L-3 to move our portfolio that's more in those segments of defense that are growing, or in areas of adjacency. I referenced the green taxi earlier in this conversation or things that if it's IT and healthcare for example, which by way, I don't mean that to mean I'm planning anything in that space. I'm just using it as an example. Or things where -- we can take the technology that we are comfortable with and bring it to a broader marketplace and that could be other customers within the DoD or intel intercommunity, within the federal government or in the commercial space, in certain areas of commercial space, generally the more industrial areas and not the consumer products areas because we're not built for those kind of distribution channels. And those are the areas that we focus on and I’ve asked all our group presidents to come in with ideas for expanding their market applications. And some of it could be using EO/IR or sensor technology for things like agriculture or domestic security means like guarding critical infrastructure pipelines, et cetera. So I mean we are committed to staying very close to home in terms of our core areas and not wandering too far outside our areas of expertise. But we have a treasure trove of technology here. And I think with a little bit of innovation and imagination, they are applicable outside into a broader marketplace.

Brian W. Ruttenbur - Morgan Keegan & Company, Inc., Research Division

Okay, so is -- can I interpret that, that you don't plan to make acquisitions in the commercial space? You're going to try to use your existing technology to get into there? Or would you -- if you have an existing technology and you find a company out there, you would also be opportunistic in that commercial space?

Michael T. Strianese

Yes, you can interpret it that way. That's fair. No, we're not going to go into a completely unrelated commercial space. There are no plans for that, and we are opportunistic. If we see something in commercial -- a commercial company where we could take existing technology, buy it at a reasonable price, and insert it -- as technology insertion into some of our systems that make our products better and more desirable from our customers, we will do that, and we've done that in the past.

Operator

Your next question comes from the line of Robert Stallard with Royal Bank of Canada.

Robert Stallard - RBC Capital Markets, LLC, Research Division

I was wondering if you can just talk on the services side, about how your win rate on recompetes has tracked this quarter? And also, Mike, if the margin issues you talked about in December have continued. I think you said that some of the margins on these recompetes were getting halved or something like that.

Michael T. Strianese

Okay, let me talk to the margins and Ralph can look up some of the win rate statistics. But, yes, I mean the margins vary directly with the level of type -- commodity type services you're bidding. It's directly a function of we see a competition where you have 12 to 15 companies show up, you have one where there's 3, depending on what the work to be done is. So there is clearly more margin compression in areas where you have more competitors. If you wanted my perspective on that phenomenon as a cycle, what we've seen over the past cycles is that when that happens, you get companies that invariably will win on price that are not qualified to do the work, or just really don't have the experience. And I -- so, I call it the pendulum effect and we're all the way at the price trumps technical capability right now. That I would expect to transition back to something more normal over years, unfortunately once a customer has a couple of bad experiences with contractors that aren't capable of doing the work, where they're just qualifying them on price only. We've already experienced a pretty good drop in the composite margins in services to date. So the question is how much more is there to go. Well I think after the Engility spinoff, they'll be more stable. Engility has experienced the drop more or has been leading in terms of the volume of drop more than the rest of our services business. In terms of L-3's guidance, just for example, our 2012 guidance is about 10.1% of the midpoint on margins post Engility, but you've taken up 40 basis points. You can see where the bulk of that weakness has been happening. In terms of win rate, Ralph, what could you add on the win rates?

Ralph G. D'Ambrosio

The win rates in the fourth quarter on recompetitions was probably near 75%. That said, we didn't have a lot of recompetition decisions that occurred in the fourth quarter, Rob.

Robert Stallard - RBC Capital Markets, LLC, Research Division

And then just finally, on Engility, you mentioned that there was going to be a dividend which you’d use to reduce leverage. Have you sized how big that dividend could be?

Michael T. Strianese

We gave a range. I think we said in the $400 million to $500 million neighborhood. But that's a number we're not signing up to at this point because it's going to be based on market conditions at the time. The targeted credit rating for the business, what our board wants to approve based on the input from some of the experts in the area, notably the bankers, and the overall credit environment. But based on what we've seen in similar transactions then -- and by the way, we're in a discussion with the DoD who's routinely will -- we're fully expecting an inquiry as to the amount of leverage we’re going to put on the company, I mean that's not new. So there's a number of hurdles to get over, but we think that, that's a reasonable expectation. If it came in a little lower or a little higher, we'll manage it.

Operator

Your last question comes from the line of Michael Lewis with Lazard Capital Markets.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Ralph, you had commented on shorter cycles in the ES business. I was wondering if you could talk a little bit more about that, and whether that is having any significant impact in your near-term visibility on that business.

Ralph G. D'Ambrosio

Well, I talked about the short versus long cycle nature of L-3's business at the investor conference. And you may recall I said that we expect about half of our sales for 2012 to come out of funded backlog. Another 41% to come out of follow-on business and then the rest will be recompetes and new business. So if you look at Electronic Systems, there's probably about 55% coming out of funded backlog. So a little more than the company average, but it tells you that there's a large amount of follow-on work to be booked to make the full year sales, and that's typically where it's been. And that introduces the risks around short cycle. So in the past, when the budget was growing year-after-year, the short cycle nature of the business tended to help us because funds just seem to be more -- they just seem to pop up when you wouldn't expect them and that used to cause upside on the follow-on business. Now in the declining budget situation, you have the inverse happening, where there's more risk with respect to the follow-on work and that could be just due to some of the things that we talked about earlier today, some hesitation on the part of procurement officials concerning future budget levels. There's been some reprogramming that's happened the past few years as the budgets have gotten tighter. That's likely to continue, and that's what creates the short cycle risk on the follow-on orders that we're seeing in Electronic Systems and frankly, in our other segments as well. So sooner or later, the cycle catches up to all businesses, short and long. I'll just leave you with that thought.

Operator

This is all the time we have for Q&A today. I would now like to turn the call back over to management for any closing remarks.

Michael T. Strianese

Okay, well I'm happy that we had a robust Q&A period. I don’t mind running a little bit over. We feel confident given where the DoD came out over the last couple of weeks on their priorities and choices that L-3 is positioned well. While not immune from declines in the budget, there's no major structural issues I see within the company where we're just in business areas that are not going to be positioned to continue to be leading players in the new world order of defense spending. And finally, I think the thing to watch this year is going to be the disconnect between the budget that's been passed and the fact that sequestration has been triggered and how Congress and the DoD get that reconciled and corrected. We'll keep our eye on it, of course, because that's going to affect planning for 2013 and beyond. Given the statements that have been made though by both the Office of the President as well as the Pentagon and leading members of Congress, there seems to be some unison -- and the military leadership by the way, that the structure for the U.S. Armed Forces needs to be not hollowed out and have the technology edge that it enjoys today. And those comments give me comfort that we're positioned in good areas within L-3. So we'll speak with you again at the end of the first quarter in April, and thanks for joining us. Bye-bye.

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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