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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

Unknown Analyst

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

Yair Reiner - Oppenheimer & Co. Inc., Research Division

Robert Stallard - RBC Capital Markets, LLC, Research Division

George D. Shapiro - Access 3:42, LLC

L-3 Communications Holdings (LLL) Q1 2012 Earnings Call April 26, 2012 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q1 2012 L-3 Communications Holdings, Inc. Earnings Conference Call. My name is Grant, and I'll be your event manager. [Operator Instructions] I would also like to advise all parties, today's conference is being recorded for replay purposes. And now I would like to hand the call over to Eric Boyriven of FTI Consulting. Please go ahead.

Eric Boyriven

Good morning, and thanks for joining us for the L-3 Communications Holdings, Inc. 2012 First 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. Thanks for joining us. We started the year with a strong first quarter, overall. And as always I wanted to thank the 60,000 men and women of L-3 for just a tremendous job in the first quarter and their focus and excellent program execution.

We saw very strong orders combined with new awards, recompetes and follow-on business that drove the results this quarter. Internal funded orders were $4.1 billion, which generated a book-to-bill ratio of 1.14 and resulting in a backlog at March 31 of $11.4 billion.

Net sales were $3.6 billion, which were up -- essentially flat with the 2011 first quarter with our diluted earnings per share of $2.01, up from $1.85 in last year's first quarter, that's about a 9% increase.

The C3ISR business continued to lead with very strong performance, an increase in sales of about 16% compared to last year's first quarter. Driving the growth there were increased volumes for airborne ISR, logistics support and fleet management services for our DoD customers, as well as new business for international airborne ISR platforms.

Recent competitive wins helped us deliver solid sales in the AM&M segments, in the Contractor Logistics Support business area and an acquisition resulted in modest growth for Electronic Systems. Offsetting the sales performance were headwinds from the continued challenging defense environment where the largest impact was felt in the Government Services area. We continue to focus on growing and integrating our businesses, generating maximum efficiencies from operations that are aligned with both customer and production requirements.

As always the key aspect -- a key aspect of our strategy is our disciplined approach to acquisitions, where we continue to enhance our core business extending our addressable markets and strengthening our technology capabilities.

In February, we completed the acquisition of Kollmorgen Electro-Optical, KEO. It's a great addition to L-3's integrated Sensor Systems business with technologies that provide situational awareness and enhance our existing products including infrared images, targeting systems and ISR sensors and laser range finders. Also we recently announced an agreement to acquire Thales' civil aircraft training and simulation business. With an installed base of over 540 simulators and a global customer base, this business complements the linked simulation business and will extend our addressable markets with a full range of total training systems solutions for both military and, now, commercial customers globally. We expect the Thales transaction to be completed this summer.

We also completed an acquisition of a small company in the shipboard electronic control systems area called MAPCO. It folds in well with our [indiscernible] business unit, which designs customized high-end systems for the cruise ship industry and mega yachts. Each of these acquisitions is a great example of our disciplined strategy of pursuing acquisition candidates that expand our markets, product offerings, technologies, and our customer base and there were compelling valuations.

The Engility spinoff, I just wanted to give you a brief update. In February 9, we received the private letter ruling from the IRS that supports the tax-free spinoff for L-3 and its shareholders. On March 29, we filed our Form 10 registration statement with the SEC and are in the review process now. We're currently expected to complete the transaction on schedule by the end of June. Of course, the ultimate timing is subject to certain conditions and approvals, including completion of the SEC review. We are all looking forward to launching Engility and the opportunities for our National Security Solutions business that will bring L-3 as we sharpen our focus on building our value-added products and solutions business.

In terms of the budget, the final DoD budget continues to be unclear at this point. And as of today, Congress has no consensus plan to prevent the sequestration from becoming effective in early 2013. We're looking at just about a perfect storm later this year given the election, the probability that there'll have to be another increase to the debt ceiling and, of course, the sequestration trigger. There's a lot of things moving around and that does disrupt the visibility that we're used to having in this business, notwithstanding our backlog and our outlook is pretty stable, and we feel good about the year.

Secretary Panetta and others in government and industry have been very vocal about the devastating effects this would have on national security and military readiness. We heard many times on the hill and also at the Pentagon that the sequestration will not likely happen. However, there's no indication of any bill that will force it to not happen at this point, so we remain guarded on our view.

The uncertainty, of course, creates risk for the industrial base, including development and workforce issues. We understand that Secretary Panetta and others are committed to working with the lawmakers on both sides of the aisle to avoid the sequestration without compromising U.S. Military superiority.

The DoD is focused on communicating new priorities for the future with the focus on nimble, quick strike global military capability. Attention would begin to shift away from the Middle East and towards the Asia-Pacific region. This will require ISR assets, a strong naval presence and upgraded maritime systems and additional special operations forces and unmanned systems. And so we remain optimistic in our outlook in the DoD's emphasis on areas where L-3 has a strong base.

Our focus on these and other key priority areas where we have world-class expertise and leadership positions is going to be key.

In terms of the orders, significant orders and milestones, for the quarter, let me just share some of them. In C3ISR, we continue to receive orders related to Project Liberty for ISR integration work. We also received additional orders for our Battlefield Anti-Intrusion Systems for use by U.S. Army Infantry Platoons and military police units.

In our Electronic Systems, we continue to receive strong orders from the DoD and law enforcement for WESCAM's MX-Series of sensor systems. We captured 2 contracts for Service Life Extension programs for the U.S. Navy's Landing Craft Air Cushion. This will support both East and West Coast projects.

Our new KEO business unit was awarded a modification for 2 photonics mast systems for installation on SSN 788 and 789 submarines. We received an additional order for binocular night vision devices for use by the U.S. Special Operations Command. We received an order for checked baggage systems in Thailand. We continue to receive orders for our Cheetah SATCOM systems. So really across-the-board, we're seeing pretty robust activity in many of our key areas.

In AM&M, we received 2 new VIP/Head of State aircraft design and MOD contracts for international customers, and we're also manufacturing and assembling cabins on the CH-47 helicopter. In services, including National Security Solutions, we received additional task orders under the SITEC program. We're also partnering with the advanced research laboratories at MIT and the University of Maryland for technology research in complex computing. And that's a terrific way for us to leverage our R&D investments and develop the next generation technologies that we hope will further drive our business growth in that area.

In terms of capital allocation, we always have been disciplined to how we deploy capital to create value for shareholders. The quarter, we repurchased $138 million of common stock. We also paid dividends of $49 million. Back in February our Board of Directors increased our quarterly cash dividend by 11% to $0.50 a share, quarterly, $2 for the year. This dividend marks our eighth consecutive increase and reflects our commitment to shareholder value.

We'll continue to pursue market leadership in the business by anticipating evolving needs of our customers, continuing our investment in growth areas and maximizing operational efficiencies, which is becoming increasingly important in the current environment. Innovation and program excellence combined with strong operating performance and disciplined capital allocation, we believe, will be what will drive shareholder growth for us -- share growth going forward.

I'm going to turn it over to Ralph to discuss the numbers in a little more detail, and then we'll be happy to take your questions. Go ahead, Ralph?

Ralph G. D'Ambrosio

Thank you, Mike. Good morning. I'll add some comments about the first quarter results and our 2012 guidance update. First quarter diluted earnings per share was $2.1, up 9% versus the 2011 first quarter, and better than we expected driven by higher sales in margin. First quarter sales of $3,588,000,000 were almost flat compared to the 2011 first quarter and higher than we expected by about $100 million mostly for better performance in C3ISR plus $26 million for the Kollmorgen acquisition in Electronic Systems, and that was not in our guidance that we had provided into January.

Some other important first quarter sales statistics are that commercial sales grew 13% to $387 million. And sales, excluding Engility, grew 3%. Segment operating margin declined 70 basis points to 10.1% from 2012 first quarter versus last year's first quarter, but margin was also higher than we expected mainly due to some better performance in Aircraft Modernization and Maintenance. We also have very strong orders for the first quarter, which Mike talked about. They totaled $4.1 billion, and were about $800 million higher than we expected for the first quarter. Three competitively won new international contracts that will upside items in our 2012 plan added about $300 million of orders with $240 million of it in the Aircraft Modernization and Maintenance segment and $60 million in Electronic Systems. Additionally, we received about $0.5 billion of orders earlier than we expected mostly in the Government Services and Electronic Systems segments. The segment quarter-over-quarter results and trends are covered in the earnings release.

Moving on to the 2012 guidance update. We increased it primarily for the KEO business, which we acquired on February 6. Sales guidance was raised $150 million and the new range is now $14,550,000,000 to $14,750,000,000, which is a decrease of between 3% and 4% versus 2011. Excluding Engility that we expect to spinoff this summer, we expect sales to be about 1% below 2011.

At the segment level, Electronic Systems sales guidance was increased $250 million, with approximately $150 million for the KEO acquisition and another $100 million for the realignment of our U.K. TRL business from C3ISR Electronic Systems. So operationally, there was no reduction to 2012 C3ISR segment sales guidance. You'll also notice that our first quarter sales growth in C3ISR at 16% is significantly higher than the 2% full year midpoint guidance growth versus 2011. The C3ISR higher growth rate for the first quarter was due to timing items and an easier quarter-over-quarter comparison. That said, we do have a few new opportunities in the classified ISR area, which depending on when and if they happen, provide upside to the segment guidance for this year.

Government Services and Aircraft Modernization and Maintenance segment sales guidance was unchanged. With respect to the Aircraft Modernization and Maintenance segment, you may recall that L-3's 2 largest contract recompetitions for this year are in that segment. They are the contract field teams Southwest Asia Task Order and the Army Aviation Fort Rucker Maintenance contract. While the size of these 2 recompetes varies, based on the start dates of the new contracts, each contain about $100 million of sales risk to 2012. I also previously explained that our segment sales guidance was appropriately factored for those 2 recompetitions. The update on them is that in March, we lost the Southwest Asia Task Order and the Fort Rucker contract is in source selection expected to be awarded by the end of July.

The other Aircraft Modernization and Maintenance update is that Platform Systems is performing very well, highlighted by those 2 international contract wins in the first quarter. So our current assessment for this segment is -- that even if we were to lose the Fort Rucker recompetition, and we don't expect that we will, but even if we did, we should be able to maintain our segment guidance range for Aircraft Modernization and Maintenance.

Consolidated 2012 margin guidance remains at 10.1%. Excluding Engility, we expect that the margin will be about 10.3%. I also want to explain some important points about our operating income trends.

While our margin and operating income are declining this year and also decreased last year, the majority of that decrease is occurring in our service businesses, both in the Government Services segment and in the Aircraft Modernization and Maintenance Logistics Support. Higher pension expense is also lowering 2012 margin by about 30 basis points. Beginning next year, these operating income headwinds should abate because our services sales will be a smaller portion on a relative basis of our total sales due to the contract recompetition attrition that we've experienced and the impending Engility spinoff. Service margins should also bottom in 2012. And pension expense should be a tailwind for 2013.

Additionally, when you take a look at our products business margins, they have not been bolstered by cumulative catch-up of contract accounting adjustments because of the short or early cycle nature of our business plus the fact that were not a Platform OEM, as well as our merchant business model. So we don't have to depend on recurrent cumulative catch-ups to maintain margins.

Free cash flow guidance is now $1,180,000,000 and continues to be very robust. If you look at our free cash flow on a per-share basis, we expect that for the full year 2012, it'll be about $12 per share with Engility, and without Engility, it's about $10.80 per share.

Finally, taking a look at the second quarter outlook, we expect sales between $3.5 billion and $3.6 billion; earnings per share, between $2 and $2.05; free cash flow in the low $200 million range; and operating margin should be in the low 10% range. The book-to-bill ratio for the second quarter should be about 0.90, and we now expect the full year book-to-bill to be about 1.0.

That concludes my comments. Thank you, and we'll go to the Q&A now.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of George Shapiro from Shapiro Research.

Unknown Analyst

Ralph, with the 10.3% margin in AM&M in 1Q and CFT obviously declining in subsequent quarters, why didn't you increase the margin guidance from the 8 5 to 8 7?

Ralph G. D'Ambrosio

Well, there's some trend differences among the 4 quarters, which make the first quarter the strongest quarter with respect to margin in the Aircraft segment. And additionally, we had some better contract performance in Platform Systems, and we had a sales price adjustment on a logistics support services contract, which helped the margin in the first quarter. As we move throughout the year, the margins on the CLS business become more challenging. So that's essentially what's happening there. And if things continue to go well, like they went in the first quarter, we'll up the guidance for margins later on in the year in that segment. But right now I think they're appropriate, maintaining them on what they were in the last guidance update.

Unknown Analyst

Okay. And Mike, one for you. This quarter, you, Lockheed and Raytheon all beat revenue estimates, which has not happened in a long time. You think that has to do with more expectations being set low because everybody missed last year? Or is there something fundamentally happening where the order flow hold up the past few quarters has actually been improving?

Michael T. Strianese

Well, I can speak for us, George. I think it's a combination of both items. I think having seen things slipping to the right every single quarter for the, maybe the last 6 quarters took slightly more conservative view. At the same time, if I'm not mistaken, the pace of shipments are up, but that's reflective of, perhaps, things catching up to a normal shipment pace with our customers. Paper log -- the paper backlogs, rather paperwork backlogs and things like that. So we are all happy and I hope this trend continues.

Operator

Our next question comes from Cai Von Rumohr from Cowen and Co.

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

So I'm a little still confused about AM&M, you got $240 million of international orders. You lost contract field teams but presumably that was factored. So how -- and sales were better than expected in the first quarter. So how come the sales guide didn't go up, and does that have opportunity?

Ralph G. D'Ambrosio

Well, when you look at those 2 new international contract wins, which are $240 million, the period of performance on them is a little more than 2 years. And together they're only going to add $35 million to this year's sales in that segment.

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

Okay. And so are there any other recompetes, you mentioned those 2 big ones, are there any other recompetes we should be aware of or any other new business opportunities like you just won these international awards that I don't think were expected?

Ralph G. D'Ambrosio

Well, in terms of the recompetitions for this year, CFT, Southwest Asia and Fort Rucker, continue to be the only major recompetitions. And I recall -- I define major as a recompetition that has $100 million of sales or more on the contract. We do have several other recompetitions but they're mostly small in size and dispersed across several businesses. So really nothing new on the major recompetition to talk about, Cai. And in terms of new business, I did mention some classified ISR items that are currently in flux in the C3ISR segment. And if those happen, and they would happen in the second half of this year, that could give us some upside. Most of it on the orders for 2012, and we'll have to see how those opportunities play out.

Operator

Our next question comes from Myles Walton from Deutsche Bank.

Myles A. Walton - Deutsche Bank AG, Research Division

I was wondering if maybe, Mike, you can talk about the Thales acquisition in the context of where you want to take your commercial sales exposure. You highlighted, I guess, it's roughly 10% of your sales, up 13% in the commercial area. Thales feeds into that. When you look out a few years, where do you want that commercial mix to be?

Michael T. Strianese

Well, so we think about that all the time, Myles. For many years, the mix had been 85% U.S. Government, of which 75% was DoD and 10% was other agencies, state, the intel and Homeland Security and the balance, the other 15%, was international and commercial. And I had said, we're going to try to move that needle a little bit and get a little more balance in there. Where we think we'll be this year is that mix should be more like 75%, 25%, so 75% U.S. Government, 25% commercial. And I think given the current environment we're in, we will continue to lean that way to acquire companies where there are dual-use technologies just like this Thales acquisition, where maybe 35%. It's kind of a gradual process. We are not going to do a single transaction that's going to dynamically change us into a commercial company that's not the types of things we're picking up, because we have very strong proprietary positions in many of our DoD markets whether it's data links or airborne ISR or sensors, et cetera. But it's a gradual process of shifting that portfolio and weighting it a little bit more heavily especially out of services into more proprietary defense solutions and into dual-use technology where we can get a piece of the faster-growing commercial marketplaces. You asked about the Thales acquisition. It was a perfect example of this type strategy and it goes incredibly well with the Link business. The Thales Training and Simulation business is the #2 global manufacturer of civil flight simulation equipment. They have an installed base of about 540 simulators globally, of which 353 of them are full-flight simulators. 67 [indiscernible] customers since 1990. They're also a provider to the Thales Military Training and Simulation business and they have a training center, a pilot training center, in Thailand. The installed base really runs the full gamut of platforms. They have just about -- they are to the commercial world what we are to the military world, where I could say we have just about a simulator for every fast jet. They have a simulator for just about every commercial airplane whether it's A320s, 330s, 350s, 380s and for Boeing the 737, 777, 87, the Thales military side, the A400, the MRTT, et cetera. So it's very broad customer base really has us excited as to what we can create with both our Link business in Thales. They bring to Link the full-motion platform that we had been buying for all products, and we bring to them the outstanding display graphics, high definition systems and other proprietary database systems that we have. And we think when you put it together, you got a tremendous business with lots of opportunities. That's where we are.

Myles A. Walton - Deutsche Bank AG, Research Division

That's helpful. How quick can you get the margins of that business to Electronic Systems?

Michael T. Strianese

Get it to their level?

Myles A. Walton - Deutsche Bank AG, Research Division

Yes.

Michael T. Strianese

Well, they had been in development on a new product and they're just about done. So our plan would be perhaps 18 months could be...

Ralph G. D'Ambrosio

About 2 years or so.

Michael T. Strianese

Ralph is going to tell you 2 years. My goal is 18 -- like I said Myles, 18 months and I would like to see -- the new technology was known as Reality 7 [ph] systems. And again that had been a multi-year investment program for the business, and it's been successfully completed. There'll be some trailing expense, but I think they're pretty much done. So I'm optimistic that this will fold right in and be consistent with our margins.

Myles A. Walton - Deutsche Bank AG, Research Division

And then just a clean-up one, Ralph, on -- actually 2 clean-ups, one on AM&M. I think your previous guidance could absorb one of the recompetes. But now sounds like you can absorb 2 of the recompetes, and you got some help from these international wins that came in the quarter but doesn't sound like it was covering the whole incremental $100 million of exposure, have I got that right?

Ralph G. D'Ambrosio

Mostly. The last time I said that, I quote, "We had appropriately factored," for the recompetitions and with the international wins, I said, even if we lost Fort Rucker, we'll be able to maintain guidance range. And if we win it, we should beat the high end of it and, possibly, exceed the guidance range in that segment.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. And the other clean-up on Engility. What's the current thinking about how much leverage Engility would carry?

Michael T. Strianese

Between -- roughly about 3.5 tons [ph]. That's our target, Myles. I mean that's subject to rating agencies, the lending environment, speaking to the DoD. They're routinely reviewing these types of transactions for leverage, so that's our goal. We'll take that as a goal.

Operator

Our next question comes from Howard Rubel from Jefferies.

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

Your share repurchase have slowed a little bit yet the stock prices is the same. Is this attributable to a little bit more effort on the M&A side of the world?

Michael T. Strianese

Yes, Howard. Again, we always advocated balanced approach. First quarter cash flow is a little lower too. As you've seen, we are still committed to the guidance, which, Ralph was certain, what?

Ralph G. D'Ambrosio

$800 million.

Michael T. Strianese

$800 million neighborhood performance for the year and depending on where the price is, we'll speed it up or slow it down as we see fit. When see great opportunities like we saw with both the Kollmorgen and Thales business. We still believe that growing L-3 is also an important part of that strategy, so...

Ralph G. D'Ambrosio

And also I'll add that, while the share repurchases for the first quarter were just about $140 million, we did pick up the pace in the month of April, and we already repurchased about $60 million or so in the month of April. So, just to give you a little more color on that, Howard.

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

I appreciate that. And then on the other item on guidance is just a small item, you continue to deliver a little bit better despite taking the Engility expenses. So again it would seem that you're really more likely to be at the high end of where you are, you're probably have one more quarter of Engility and then you're home free?

Ralph G. D'Ambrosio

Well, the EPS guidance range is what it said it is. So right now we're comfortable at the middle of it. If things keep going well, we'll be at the high end of it.

Operator

Our next question comes from Joe Nadol from JPMorgan.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Mike. So L-3 has a differentiated business mix than a lot of the other large defense companies out there, just more of a merchant supplier and more of a supplier, in general, than the other guys. I'm wondering as you approach this year end issue and sequestration and everything else happening, what you think you have to do differently to prepare for it than the Lockheeds and Northrop Grummans of the world.

Michael T. Strianese

Well, Joe, we've been preparing for the slowing budget environment all along. So as you know, we have no major platform production problem -- programs, that's a Freudian slip, but the programs in-house. So we're not dealing with huge facility or headcount issues, and we run pretty lean to begin with. The merchant story really, over the years, we've gravitated more as a prime even in some of our product areas whether it's data links or some of the sensors with government because the end users are buying them directly. We're all really directed South, which to me is almost as good as being prime. Over 70% of our sales in factor in that category are DoD sales. So if I could read into your question, you're saying, are we concerned that we may -- some of the primes they want to keep more in-house and slow us down? I could tell you they're already doing that anyway. So...

Joseph Nadol - JP Morgan Chase & Co, Research Division

What I'm really getting at is it better or worse to be where you are than -- it's an honest question.

Michael T. Strianese

Well, it's going to be in the eyes of the beholder. I will tell you, I am very comfortable where we are for the reasons I started to say that we have no large platform productions, whether it's playing ships or tanks for that matter, where we have a huge marching armies of people that we have to adjust to dramatic changes in quantities we were expecting. We just don't have it. We have a much more flexible business structure. And we usually -- one of the major focuses is staying in front of it, so that the businesses are continuously scaled continuously to what we see as the orders outlook. So I will tell you, I'm very comfortable with how we address it and how we're positioned. I think we're positioned very well.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Okay. And then just for Ralph, a detailed question on sort of the back of your slides. Just where you break out in the select financial data, the Engility and NSS, and I think this excludes -- these numbers exclude the spinoff costs. Looks like operating margin was 5.5% for NSS in the quarter, and your guidance is about 120 bps higher for the full year. Just wondering was there anything in the quarter that lowered the numbers, am I reading this right? Why do you think margins are going to pick up?

Ralph G. D'Ambrosio

Most of it is timing in award fee -- award fee being earned. And we record them in the quarter that they're received as opposed to accruing them.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Okay. So the full year number is a much better concept of your run rate than what you did in the quarter?

Ralph G. D'Ambrosio

Yes.

Operator

Our next question comes from Robert Spingarn from Credit Suisse.

Robert Spingarn - Crédit Suisse AG, Research Division

Just on the back of Joe's question there, same slide. I see that it looks like NSS is performing about as you had expected, but it's still under a fair amount of pressure being in that Government Services segment, we've talked about this before. Mike, are you starting to see, notwithstanding the answer to last question, some stabilization in this business that really distinguishes it from the other business that's being spunoff?

Michael T. Strianese

Yes, Joe we are. Actually, I would tell you that we're seeing that in both businesses. This maybe the bottoming this year looking out -- they came down heavy the last 2 years, came down hard in the last 2 years. And a combination of the OCO budget, the better buying power initiatives where just about every large program we've had has been recompeted on a multi-award basis ID/IQ basis, if you want to call it, where even if you win, you lose, because you lose as much as 75% of your content. And there's a flip side to that, is that we start going after other people's programs, other company's programs that have been broken into pieces, and we're winning some of those. The last 2 years have seen us take out a substantial amount of cost since all these competition -- recompetitions and recompetitions are becoming price shootouts, just low price wins in every [indiscernible]. And I think there's a pendulum effect here to. Eventually you get to a point where there's low price all the time model plus it worked, because it doesn't work and we know this historically. And best value will start to have a role again, because if the model were to continue perpetually as low-cost wins all the time and becomes a commodity, not a very interesting model.

Robert Spingarn - Crédit Suisse AG, Research Division

But Mike, have you been surprised to the downside about how important that is? I mean, clearly, that was the topic of discussion yesterday in the services, on the services side, for GD, for example?

Michael T. Strianese

I was -- what surprises me is the velocity of the decline that certainly is about twice as fast as we would have expected initially on it. And go ahead, Ralph.

Ralph G. D'Ambrosio

I mean, I wouldn't say we were surprised because what happened to Armed services top line with the declines in the first quarter is spot on with our guidance. So I think we've been [indiscernible] situation.

Michael T. Strianese

We forecasted it correctly, but I would say that it's still been very disappointing at the speed of which this budget has come down.

Robert Spingarn - Crédit Suisse AG, Research Division

No, but I think it's safe to say that given your strategy with the spin, you're at least more ahead of this than some. Ralph, did you mention -- this is my second question, I can't recall if you talked about what Thales does for guidance. And then the other thing I wanted to ask you is, what kind of a risk have you embedded for a CR in the back end of the year, if any?

Ralph G. D'Ambrosio

Okay. So when we announced the agreement to acquire the Thales business on April 11, in that press release, we said that we expect that business to generate about $150 million of sales for the full year of 2012. We expect that it's going to close sometime the middle of this summer. So it's likely to add about $70 million or so to our full year sales guidance when it closes. The margins are presently low single digit. That includes -- there's some purchase accounting around the tangible amortization. But the business has a healthy improving margin trend the next few years that we talked about earlier. And on top of that, we expect this business to comfortably grow in the mid single-digit range the next few years. And if it does better, it will be closer towards the high single-digit range. So between the growing top line and the improving margins there, it's going to be -- it should be a nice addition to the Electronic Systems segment. Also the purchase price was about $130 million when you convert to U.S. dollars. And we also were able to favorably structure that acquisition substantially, all of it as an asset purchase for income tax purposes. So there's a nice tax shield there and depending how you MPV the tax shield, it's worth about $20 million. So net-net the economic price is more like $110 million, which makes the EBITDA multiple, even in 2012 very attractive at around 8x and it gets lower as the business grows the next few years.

Robert Spingarn - Crédit Suisse AG, Research Division

So what kind of earnings accretion does that get you to?

Ralph G. D'Ambrosio

For this year, it's going to be a few cents. Next year, it will be [Audio Gap] at least $0.10.

Robert Spingarn - Crédit Suisse AG, Research Division

Okay. And then just on the CR?

Ralph G. D'Ambrosio

On the CR, I wouldn't say that we made any special provision for CR. But when we prepared our guidance, we think we did it conservatively and appropriately for the current environment, where we've had CRs for each of the last 2 years. So to expect that we if we wouldn't have one in 2013 was -- would have been an optimistic assumption, I suggest to you, so.

Operator

Our next question comes from Carter Copeland from Barclays.

Carter Copeland - Barclays Capital, Research Division

Just one quick one. I want to kind of revisit what Joe was asking about on the end-of-year question on how to get our arms around and what to expect and ask it from another angle and ask what you see that the DoD customer doing from a contingency planning standpoint, what sort of changes you foresee as we move later into the year whether they be on the contracting environment or anything of that nature as we get further through the year? Or what sort of things you think the DoD might start doing that we'll have to deal with?

Michael T. Strianese

That's a tough one, Carter, because there's a lot of different scenarios you can play out in that case. One positive would be to try to get all funds obligated by September 30 as fast as possible. It becomes a paperwork manpower as you are [indiscernible] customers. So that would be on the plus. On the minus, the sequestration equates to approximately, way this is done, about 8% of every single line item in the budget, as I understand the mechanics of it. At the same time, the President has come out and said that they were going to give relief to the Pentagon to allocate that, so it doesn't hurt the manpower, if you will, which leaves it only one other place to go, which would be contractor side. So it's pretty hard even measure how much we're talking about in fiscal '13 and how fast customers are going to be able to reflect these cuts in actual contracts. So we have a sense for the areas we are that could be hit more than others. And in no case, for example, do we see any business units that are in jeopardy of shutting down or anything, and we have a pretty diverse book of business and quantities could drop in certain areas, but we think that, again, we don't have to deal with some of the bigger issues like large marching armies and factory or facility issues. And throw in all the other factors of this year such as the election and another negotiation on the debt ceiling and legislation will be needed to stop the sequestration, which I don't think is likely to happen before the election, and then after the election you have that November to January period that you also may not see anything happening. So it's a difficult call for both us and our customers as to exactly how to prepare for it other than to just stay current every day as to what the current state of affairs is going to be.

Carter Copeland - Barclays Capital, Research Division

That's fair. And one just sort of final follow-up. I know you talked about the competitive environment, and I wondered if you could speak directly to the Southwest Asia Task Order, and what kind of exposed devaluation there was? Was that simply more of the same in terms of share price competition?

Michael T. Strianese

Yes, it absolutely was more of the same. And as I've said before that you get to a certain level, I mean how much is low enough to be doing aviation aircraft maintenance in theater. I mean that's not a business that we're interested in doing for 1%, it's simply not. And we were pretty low single digits on this recompete, yet in this environment someone's always willing to go lower. I will tell you that sure as we're sitting here that there will be an occasion when this happens and you're going to get a contractor that's going to not be able to execute when they lowball something, either they'll default on it or the work won't get done and the customer will default and they'll have to negotiate a higher price. And we're watching this one with particular interest because as the recompete transitions, as the program transitions, the same workforce has to transition to the new contractor and accept a much lower compensation package. So it's going to be really interesting to see how this is exactly done given the low price that was bid for this work. So when I keep saying I think this pendulum has gone a little bit far one way that the risk to the customer having its mission complete and, in this case, this is flying aircrafts in theater which is a critical mission, is going to be interesting. We're watching it very carefully.

Operator

Our next question comes from Noah Poponak from Goldman Sachs.

Noah Poponak - Goldman Sachs Group Inc., Research Division

I wanted to go back to the Government Services rate of decline topic. And I guess I'm wondering if you have any thoughts or ability to forecast when the bleeding stops. Is this -- is 2012 the last year of these large declines? Do we need another 10% organically down in 2013? Because I agree with you that the pace here looks rapid, but it's a business that had very, very strong positive organic growth for a pretty long period of time. So I'm just sort of wondering if you have any thoughts on how much longer this needs to happen.

Michael T. Strianese

So, I'll let Ralph answer that, but again what I said earlier is there are really 2 effects happening at the same time. You had the drawdown, which was rapid over the course of 18 months, in terms of some of the contracting. At the same time, as things came up for recompete, you had a much tougher bidding environment because of things going to ID/IQ with multiple awards. So even if you are winning, you were losing -- you either lost and lost or you won and lost. So you're losing on both sides. So having said that, my gut is that it's bottoming this year but you have the sequestration well caught out there and services are a nice target to go after, but let me let Ralph give you some more color there as well.

Ralph G. D'Ambrosio

Sure. So certainly, in 2012, we're seeing a very sharp decline in our top line in government services, and it's more pronounced in Engility business and that's, frankly, because they have or had more exposure to the drawdown from Iraq. And now the beginning of the drawdown from Afghanistan. So going into next year, we think there'll be less drawdown exposures, certainly for L-3 x Engility. And the business has also been adversely affected the last couple of years or so from the OSD initiatives with the government trying to stretch its budget dollar, and they've been breaking up single award contracts into multiple award contracts and, frankly, we've had some large single award contracts that have been targeted and broken up. But once we get past this year, there isn't much other large contracts like that, that we have. So I see us having less exposure in that regard. And then the budgets still look like they call for some reduction plus the efficiency initiatives, which are not going away. So we could have some more declines of the top line, but it's not going to be anywhere near what we're experiencing in 2012. So that's my view and, by nature, a little more conservative than Mike's, which is what it should be for a CFO versus a CEO.

Michael T. Strianese

Well really there are 2 other things to think about too that had always been expected but didn't happen. One was that some of the services that were being provided such as training, security, leadership, development, standing up rule of law, standing up DoD and acquisition would be direct contracts with the government of Iraq. That didn't happen. And so it didn't happen in any material respect. And there's also a big bow wave of reset, taking the equipment that's been used in a theater and resetting it to its state before it was used in theater, that's not budgeted nor has that happened yet. So those had always been natural offsets that we had expected, and I think they'll happen at some point but they're not happening today.

Noah Poponak - Goldman Sachs Group Inc., Research Division

If I can ask one other thing, another follow-up on the discussion of the mix of government versus commercial, just when you're thinking about that, are there other commercial businesses at the top of the list of potential M&A candidates you're looking at right now?

Michael T. Strianese

Yes, there are but I don't want to speak specifically because I'll just drive the price up. And that won't be good for any of us. But yes, I mean we are very mindful of the environment we're in, situational awareness and, again, gradually shifting the portfolio towards more of a balance in commercial versus DoD/military. It's kind of a natural reaction to where we are, but we are very committed to not make any mistakes in doing that. So it's got to be close in, in things that we do really well where we could be a very, very strong player, which is, again, the thesis behind the Thales acquisition.

Operator

Our next question comes from Yair Reiner from Oppenheimer.

Yair Reiner - Oppenheimer & Co. Inc., Research Division

Just to follow up there on the M&A question, so you've done a couple of deals here recently and if you're finding things, attractive prices. Now as nerves apparently get frayed here as we head into sequestration, it looks like we may have some assets coming on in the market from the defense side that could be attractively priced. Any appetite for looking at, in that direction? Or you're going to see where the chips fall before becoming more active in that market?

Michael T. Strianese

We're always going to -- look, we always have an active curiosity to see what's out there, how it fits and what we can do with it in our portfolio. The risk of not doing as well as you would hope is much higher now given the sequestration and that has to be -- that risk has to be reflected in the price, of course, and that's creating a bit of a gap in expectation between buyers and sellers. And you could see the argument well, it's not going to be that bad. No, it's going to be worse and it goes. So I think we're going to have to get a little bit closer in terms of exactly what we are staring at in terms of 2013, unless you have some very, very motivated sellers that are willing to accept a buyer's assessment of what it's going to be. And that's just simply what it is. On the Kollmorgen deal, I mean we paid what was a fair price. That was very Virginia class focused and that's an area of the budget that we all could agree was doing pretty well under any environment. So that's why that one was so easy and Thales, of course, was commercial. So just wanted to give you that color behind how those went.

Operator

Our next question comes from Robert Stallard from Royal Bank Canada.

Robert Stallard - RBC Capital Markets, LLC, Research Division

First of all, Ralph, I was wondering if you could give us an idea of what your best estimate for the pension tailwind in 2013.

Ralph G. D'Ambrosio

Well, as of today, I would put it somewhere in the $15 million to $25 million range of operating income. And then beyond that, barring any disruptions in the capital markets, our pension expense should continue to gradually decline because we froze our defined benefit plans to new hires in 2007. So gradually as the active employees without pensions begin to retire, we should have a commensurate reduction in our pension expense. So I guess discount rates could go lower, but I don't know how much low they can go. If discount rates or the interest rate environment up ticks, the pension expense and liabilities from the pension are very levered to interest rates. So that, that could cause an even more rapid decline in expense, and I'm not factoring in -- that into the $15 million, $25 million that I gave you.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Okay. And then secondly, Mike, you mentioned that the Southwest Asia contract, whoever won it is only going to make 1% or something...

Michael T. Strianese

No, I have no way of knowing what they would make. But so I don't know, because I don't know their cost structure. But I was saying, there wasn't much more price leverage we had other than we're not interested in earning 1% on it. We're already below 5% on something like that. It's just not interesting for us to be repairing an aircraft in theater for 1%. Just kind of giving you an example.

Ralph G. D'Ambrosio

And also, I'd add to that, in addition to watching what happened to margins on the services work, we also pay attention to the return on invested capital. So there's no free riding capital on services work. You're going to make investment in receivables, in some cases inventories, and we're not interested in doing work where we get returns in capital below our cost of capital. It doesn't make any sense for us or for our shareholders.

Robert Stallard - RBC Capital Markets, LLC, Research Division

Yes, okay. Do you see this similar sort of discipline on Fort Rucker? I mean it is a slightly different set up than the Southwest Asia contract?

Michael T. Strianese

Well, when you say structure, I think the acquisition structure is different at Fort Rucker than it is -- that it was under that task order, where I think that the customer is going to be a little more attuned to watching for an under bid and actually undermines the mission where they're taking on risk. I think that customer is just going to be much more risk-averse as to who they may select. But again that's my hope and, having said that, the cost environment, the bidding environment for programs of this size is very, very competitive. We hang our hat on as we think we have a great proposal, and we think our past performance has been outstanding. So those 2 factors in the traditional world of defense contracting are very, very strong winning combination, and that's what we're hoping for.

Operator

Our next question comes from George Shapiro from Shapiro Research.

Unknown Analyst

Ralph, in Electronics, you had what looked like around $25 million of charges. Can you discuss a little bit more what was involved in those. And then without it, the margin would have been 13.6%, which is certainly a lot higher than what your guidance is, so if you can go through that comparison a little bit.

Ralph G. D'Ambrosio

Okay. So first of all, I'll explain to you that it wasn't $25 million of charges, and there was a combination of having certain favorable contract adjustments in the first quarter of 2011 that didn't repeat in this year's first quarter. And then on top of that, we did have some cost growth on 2 or 3 contracts, which add to about $10 million or $12 million in total. So that's what's going on or what's happening in the segment margins there for the first quarter, George.

George D. Shapiro - Access 3:42, LLC

Okay. And then though -- I mean if you added that back, you're going to still -- probably you're going to run somewhat above what your guidance is for the year. So is there some opportunity there or there's something you see mixed going forward?

Ralph G. D'Ambrosio

There's going to be a change in sales mix on a couple of high margin product lines. And you may recall that I talked about our aerostat EO/IR [indiscernible] declining in 2012 versus 2011. Well, they actually grew in the first quarter. So I'm going to have that divergent change in trend after first quarter that's going to affect the sales mix and have an impact in the margins in that segment.

George D. Shapiro - Access 3:42, LLC

Okay. And then again another one for you, Mike. Just follow on this comments with the contract field teams, I mean, effectively, you lost that, you lost Linguist, you lost SOFSA. I mean, and this may be smart choices, but is there any way you look at that business differently given the contracts that you probably didn't expect to lose ahead of time?

Michael T. Strianese

Look at it differently in terms of...

George D. Shapiro - Access 3:42, LLC

I mean, is there a way you change your cost structure or you just kind of acknowledge if people want to bid at low prices and let them have it.

Michael T. Strianese

Yes. Again, I said there's a price below, which we're not going, and we and are looking at it differently. In one major way that will look at it differently is Engility. It's in saying that, Okay, there's 2 things going on here. The OCI problem is causing us to bid less of a universal programs and the competitors that we're facing are typically pure-play service companies that have different cost structures. And rather than create 2 cities within L-3, it was easier to set it up as its own separate company. When you go back to the factor the Linguist and jobs of the world, again, this part of the contracting environment, sometimes changes are going to happen regardless of past performance and regardless of price because it's just the customers like change sometimes in those areas. And they're almost being told to change rapidly. We think we'll have another bite at the apple someday on jobs. With Linguist, no. The last bid on Linguist -- which program was that called. Do you know the name of it? The DLITE program. Again, you would have to bid that so low that it was a piece of business that was not for us. Engility wants to pursue it going forward, that's certainly up -- an Engility piece of business but they'll structure for that eventuality. We know the market has changed fundamentally when you're not coming up against your traditional competitors. So that does cause us to think about it very differently.

Operator

We have no further questions. I would now like to hand back over to service Michael and Ralph.

Michael T. Strianese

Thanks, everybody, and thanks for the robust Q&A. We really do enjoy having a dialogue with you. This is a year of mixed messages. You saw a strong first quarter pretty much from many of the larger players in the industry yet we have this budget concern that we're all going to deal with at the same time. So it's one of the more challenging years for all of us. In terms of our positioning, we think that the areas that we are in, many of them, are for the most part are areas that are still very important to our customers and relevant. Very strong sales force position in many of our products in our ISR areas that are going to be increasingly needed in -- at a time of increasing geopolitical threats but less manpower available. And all in all, we're comfortable with the model. We'll make some fine-tuning adjustments as we go along. We'll add companies as we see where we can add value, and we're going to continue to acquire stock as we have always been. So all in all, I think we're very comfortable with the model, and we look forward to speaking with you again in July. So thank you.

Operator

Thank you, ladies and gentlemen, that concludes your conference call. You may now disconnect. Thank you all for joining and have a very good day.

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