L-3 Communications Holdings, Inc. Q4 2007 Earnings Call Transcript

L-3 Communications Holdings, Inc.

Q4 2007 Earnings Call

January 31, 2008 11:00 am ET

Executives

Eric Boyriven – FD Investors

Michael Strianese - President and Chief Executive Officer

Ralph D’Ambrosio - Vice President and Chief Financial Officer

Karen Tripp - Vice President of Corporate Communications

Analysts

Cai von Rumohr - Cowen and Company

Joe Campbell - Lehman Brothers

George Shapiro - Citigroup

Steve Binder - Bear Stearns

Myles Walton – Oppenheimer

Joe Nadol - JP Morgan

Cory Koenig - Lehman Brothers

Presentation

Operator

At this time I would like to welcome everyone to the L-3 Communications Q4 2007 Earnings Conference Call. (Operator Instructions) I would now like to turn the call over to Eric Boyriven of FD.

Eric Boyriven

Good morning everyone and welcome to the L-3 Conference Call. Here to discuss the company’s 2007 fourth quarter results reported this morning. With us from management today are Michael Strianese, President and Chief Executive Officer, Ralph D’Ambrosio, Vice President and Chief Financial Officer and Karen Tripp, Vice President of Corporate Communications. After management has made their formal remarks we will take your questions. The operator will remind everyone at that time how to ask a question.

A brief note that today’s call will be limited to 60 minutes in length to ensure that at many participants as possible get to ask a question we would ask that questioners limit themselves to one question each. You are welcome to rejoin the queue and we will be happy to take additional questions once everyone in the queue has been addressed once.

In addition, please note that during this call management will reiterate forward looking statements that were made in the press release. In accordance with the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995 I’d like to call to your attention to the risks related to these statements which are more fully described in the press release and in the company’s filings with the Securities and Exchange Commission.

I’d now like to turn the call over to Mr. Michael Strianese.

Michael Strianese

Good morning everyone thanks for joining us for our fourth quarter earnings call. We are very pleased with the results we reported this morning. A lot of record numbers for L-3 and a strong outlook for 2008. For the quarter our orders were $3.8 billion in the fourth quarter and more than $14.7 billion for the year. We closed the year with a funded backlog of $9.5 billion.

The book to bill ratio for the fourth quarter was just even at one however if we remove the affects of the Linguist Program it was actually was 1.05. As you know the Linguist Program, its still in a state of disarray in terms of the source selection is not included in our 2008 guidance except for the extension period which I believe will be through March but Ralph will take you through those numbers later.

For the full year our book to bill was 1.06 which sets up 2008 for additional growth. Sales growth in the fourth quarter was 12.4% and about 11.4% of that was organic growth. That was our strongest growth quarter comparison for the year. Full year growth was just under 12% at 11.9% of which 9.6% was organic.

Our earnings per share fourth quarter earnings grew at 19% to $1.63 and the full year was $5.98, that’s up 18% year over year. I’m very pleased with those results as is the entire management team and I would just like to extend the appreciation here to the dedication and hard work of our 63,000 employees, many of whom I hope are listening to this call and the leadership of our group presidents who all had excellent performance this year. It was truly a good year for us in our view.

In terms of some highlights, capital deployment 2007 we generated north of $1.1 billion of free cash flow and we’ve been working to deploy that cash flow in a very disciplined manner. In terms of acquisitions, we acquired four businesses in 2007 for an aggregate purchase price that was just above $200 million and that included a company called MKI in December. That was a logistics company that will join our services group. We expect these businesses collectively to generate $175 million of sales in 2008 but more importantly on average we paid EBITDA multiples of about eight times. We bought companies that we believed are excellent fits at L-3 at prices that we believe are very reasonable.

Share repurchases in the fourth quarter we purchased an additional $214 million of our stock which brought the total for the year to $500 million. We completed the share authorization that was put in place at the end of 2006 in 2007, we completed the entire authorization and I’m sure as you know our Board in December authorized a new share repurchase program for two years for up to $750 million of additional common stock repurchases.

When you look at the repurchase for 2007 that would bring the total cash return to shareholders in the year included dividends to over $625 million. That represented 56% of our free cash flow and was over a four fold increase from cash returned to shareholders in 2006. That was a significant change in the way we were dealing with our capital allocation. Our guidance for 2008 assumes that we repurchase $400 million of common stock in 2008 and in January alone year to date we have already purchased over $200 million against that authorization.

For 2008 we are expecting north of $14 billion, about $14.2 to $14.4 billion in sales with earnings per share falling between $6.48 and $6.62. Free cash flow should be at least $1.2 billion. If we exclude Linguist which is such a significant affect on our numbers year over year the organic growth would be about 6% to 8% but the new guidance assumes also that we would end 2008 with more than $1.5 billion of cash on the balance sheet after repurchasing the $400 million of stock I just mentioned.

This leaves a lot of extra cash to either acquire most stock or to buy companies where we find companies that fit our model of what would fit L-3 best. There is plenty of opportunity for us to continue to deploy that cash to increase shareholder value and grow L-3 and that is part of our plan and objective. Ralph will give you some more detail on the guidance for 2008 later.

From a program standpoint I would characterize 2008 a little different than 2007, if you remember there was some major contracts we were pursuing as new winds like JCA, Project Helix, etcetera. Two thousand eight is a bit of a different apple in terms of de-wind is a lot smaller programs that we are pursuing either as prime or teamed with other companies both in the US and internationally. In addition there are two programs that will be in re-compete that are L-3 programs and let me tell you about them quickly.

First of all, whether or not these are one or not, these are not ’08 events, the re-compete may be an ’08 event but we’ll have the full year revenue that we have in our plan as soon as secure. First was Contract Field Teams, that’s a multi-source program with four major incumbent suppliers including L-3, that’s an AM&M program. It’s already in source selection, we do about half a billion dollars in sales on CFT (Contract Field Teams).

We expect all four major incumbents to continue on the new contract plus the customers adding about three or four small business center size. We expect to retain a significant share of that contract and don’t expect that to be a material event in 2008 and we’ll keep you posted.

The second one is JOG (Joint Operations Group) that’s our Lexington, Kentucky facility that does work for the Special Operating Forces. It’s a sole source contract, OSD is still sorting out the procurement strategy, and we expect to see RFP in the second half of 2008. This re-compete may slip out of ’08 but again I just wanted to put it on the radar screen of significant contracts. The current contract yielding is $2.1 billion with annual sales of about $350 million.

What’s happened there is it’s running out there faster than it should have because the contract has grown faster than it was expected when it was originally won by L-3 and that was primarily driven by the [inaudible] and the war in Iraq and Afghanistan. It’s been increased on a couple of occasions and we still think that we are pretty secure for all of 2008. We also expect a new contract to have a larger ceiling.

Joint Cargo Aircraft; let me say a few words on that because that was a very big one for us in 2007. We recorded $78 million in funded orders in ’07 which represented the first two aircraft that we expect to deliver on time and on budget in the third or fourth quarter of 2008. That sales profile of course is going to start ramping up as we get out in to the future. We are looking at probably $85 million in 2008, $150 million in ’09 growing to $260 million and then $350 million. It’s going to ramp up significantly.

Major outstanding bids, there’s no single bid I would pull out individually as being a significant event for 2008. Although there are a lot of new programs that are out there where we’ve teamed or partnered and the ones to watch would be, first of all Arial Common Sensors, it’s the replacement for the Guard Rail Program. It had been awarded several years ago and then was terminated, its back, we have announced a teaming agreement with our partner Northrup Drummond. We have a significant role on that team and we are very optimistic that we have the right solutions that the Army wants for the ACS program.

In addition, the other programs to watch the air would be the EPX which is the Electronics Surveillance Version of the E-3 upgrade which is now called the MMA (Multi-Mission Aircraft). We have content on the tanker programs on either team varying levels of content. BAMS (Broad Area Maritime Surveillance) Program again you may have seen in January there was a team agreement announcement with Northrup Drummond again. It’s a lot of electronic surveillance gear that would be handled by our Integrated Systems facility in Waynesville, Texas.

Deployed by Tactical Vehicle, that’s a little further out, that’s the Humdever placement program where we are positioned to supply components on various things we are however, have the most content with the GD Team which is GD and the incumbent on that program is AM General. So it’s AM General GD and L-3 for some of the components including some electronic compulsion, hybrid drives and the like.

There are plenty of opportunities for us both as prime and as a team member on other programs. The strategy in Europe continues to be working with the UK and generating more important winds for us last year. In addition, we announced at the beginning of this year significant win in Australia on JP2048 which is our copies division installing shipboard, both ship to shore and shipboard communication systems on two ships. We think that again 2008 is going to be a very strong year the way we see it set up now.

In summary we expect growth of about 6% to 8% at this point and that’s excluding the effect of Linguist for 2008. We expect our operating margins to increase 30 to 40 basis points depending again on the Linguist outcome. Earnings per share should increase in ’08 at least 10% over where they are in 2007 and our free cash flow should be at least $1.2 billion. Just on the focus and strategy, we are going to continue to focus on the disciplined capital allocation and be very disciplined in the companies we buy and how we return cash to shareholders but we do have significant free cash flow that we can use to grow the company and our earnings.

Most importantly we are going to focus our program performance, it’s always been a hole up here at L-3 and we are going to continue to do that with the special emphasis this year on the new winds from 2007 that these programs get off to a healthy start and we keep them on tract and out of the gate. We are going to focus on them regularly during 2008 just to make sure that everything is in place to have a successful program. We are going to continue our efforts to continue to reduce overhead by consolidating business units, streamlining operations and developing more internal synergies where it makes sense and those efforts have been paying off because you see it in our margin expansion that we are projecting.

We are going to continue to focus on growing our international sales both in Canada and the United Kingdom, Australia which are our key markets but also in the Asia/Pacific region. In summary, we expect to have a very strong year of growth in 2008 and continue with the excellent program performance that’s really versed where we are today.

With that let me let Ralph take you through some of the color on the numbers and then we’ll spend some time in Q&A.

Ralph G. D'Ambrosio

Thanks Mike. I will hit some points about the Q4 results, the year end balance sheet and then finish up with the revisions that we have made to our 2008 financial guidance.

If you take a look at our organic sales growth in Q4, we grew organically in every segment. We had the highest growth in the C cubed ISR segment, which grew 29% organically. Frankly, it was stronger than we expected.

We had a few aircraft deliveries that were anticipated for January happen early and they added about $80 million to sales in Q4, which represented about half the growth rate in that segment. Take it out and we still grew about 15% organically in C cubed ISR and that was very pleasing to us because we had been struggling with the organic growth there a couple of the past quarters.

Government services grew 12% organically; sales on a Linguist contract added about $65 million more than we expected, and that was due to the extension of the Iraq contract work beyond December 9th. As expected, we had the lowest organic growth in aircraft modernization and maintenance at about 1% and there, as we had expected, international aircraft mods had been declining from where they were in the first half. It is mostly a timing item.

Specialized products grew 8.5% organically, and we had very strong performance across several business areas. For the full year, sales were $13.96 billion and that exceeded our guidance by more than $200 million. The upside came from the early aircraft deliveries in C cubed ISR, the Linguist extension and another $100 million or so across several business areas.

Companywide, full year organic growth, as Mike mentioned, was almost 10% and that exceeded our targeted range of 7% to 9% for 2007.

If you look at our operating margins, they improved 30 basis points Q4 of ’07 compared to Q4 of last year. Generally speaking, contract performance is improving in several areas and we are continuing to grow our sales at a faster rate than overhead costs.

At the segment level, margins improved in all segments except for aircraft modernization and maintenance. Margins there were down 200 basis points due to a decline in the international aircraft modification work that I just mentioned, and additionally we recorded a loss provision on a contract related to a sales price dispute with a customer.

The lost contract is a built to print assembly contract that relates to a business that we acquired in 2006. We are still negotiating with the customer and we expect to reach an amicable settlement. We don’t consider it to be a [read] program in terms of technical or any development type issues.

At C cubed ISR, margins improved by 70 basis points, mostly on improved contract performance for ISR systems and in particular for foreign customers. We continue to pour money into product development, including the secure mobile environment product at CS East, but unlike the first nine months of 2007, we didn’t have a negative comparison in Q4 compared to last year. Those development costs actually declined by about $1 million in Q4 year over year.

Government services margins improved by 90 basis points on better contract performance, mostly at MPRI. In that segment, we also absorbed about $4 million of severance costs, or $0.02 of EPS for business realignment costs. We are in the process of consolidating three divisions in that segment. The consolidation will take most of 2008 to complete, so we will have another $1 million or $2 million of severance costs later this year.

However, once completed we expect that consolidation to reduce our pre-tax overhead cost by at least $20 million before you factor in the segments’ cost reimbursable contract type sales mix and probably $12 million or so after it.

On a full-year basis, margins increased by 10 basis points and you probably noticed that was below our guidance for 20 basis points of improvement. However, if you take a close look at our most recent guidance for 2007, you will find that operating margin guidance was teetering between 10.4% and 10.5%, rounding up to 10.5%. The additional Linguist contract sales following the extension pushed the full year margins down to 10.4%.

On that point, if you take Linguist out of 2007 and 2006, we improved operating margins by 20 basis points, which was what we were targeting for the year.

Free cash flow, as Mike commented, was very strong. Again, earnings to cash flow conversion was a very healthy 138%. We are continuing to make progress on working capital. For the year, working capital as a percentage of sales declined to 9.6% from 10% a year ago.

Receivables and inventory grew about $79 million in Q4, which was to support the organic growth which was almost $390 million in Q4.

A couple other points around cash flow. Deferred taxes were $43 million in Q4. Cash tax payments were $65 million; $5 million more than we anticipated. Pension funding was $55 million, in line with our expectations.

If you look at the balance sheet quickly, we continue to increase the cash balance while maintaining debt where it is with declining leverage as a function of our increase in earnings. In the future, earnings growth will continue to reduce our leverage.

In terms of the 2008 financial guidance revisions, we added $200 million to our sales range, which is now $14.2 billion to $14.4 billion; $150 million of that came from the Iraq Linguist contract extension to March 8; $40 million came from the MKI Systems acquisition which we made on December 3^rd.

EPS, we increased both ends of the range by $0.07. Three things drove that. Number one, the Linguist extension which adds about $0.04; the MKI acquisition which adds about $0.01; and then we have $0.02 coming from everything else in the company.

Operating margin guidance was reduced by 10 basis points to 10.8%; that is entirely a function of the Linguist extension which means we are still anticipating about 40 basis points of improvement in ’08 versus ’07 on margins. To the extent that we receive any additional Linguist extensions, margins will likely be lower than 10.8% for 2008.

A couple of points on the tax rate. We are estimating it to be 36.5% for 2008. That is up from 35.6% in ’07. If you recall, in ’07 we had a couple of tax years close out and they reduced the tax rate by 100 basis points and added about $0.10 to our EPS.

The tax rate for ’08 assumes that the R&E credit is reenacted, and that is what we had assumed in our initial guidance in November as well. If the R&E credit is not reenacted, it would increase the tax rate by about 70 basis points and cost us about $0.07 of EPS.

Free cash flow, we increased it by $50 million to $1.2 billion. $10 million of the increase is coming from higher EPS guidance; $10 million from lower CapEx and $30 million from less working capital.

Some other key points about ’08 cash flow. Tax cash payments will be higher by about $150 million. CapEx will increase by about $20 million and we expect pension funding to decline by $30 million to about $65 million.

The segment guidance update is in the earnings release. I won’t cover it in detail. We didn’t provide any Q1 guidance in the release today, but we expect Q1 for 2008 relative to full year 2008 to be similar to what it was for Q1 in 2007, which means we should get about 22% of our EPS growth in Q1; or 22% of total EPS rather for the full year in Q1. We expect sales to be close to $3.6 billion which would be up around 9% or 10% compared to last year, and the tax rate is going to be a little higher in Q1 than our full year guidance because we don’t expect the R&E credit to be extended until the end of 2008.

That concludes my comments. I will turn it back to you, Mike. Thank you.

Michael T. Strianese

Operator, we are ready to go to questions.

Question-and-Answer Session

Operator

Your first question comes from Cai von Rumohr - Cowen and Company.

Cai von Rumohr - Cowen and Company

Can you give us some update on the Linguist? You had mentioned that basically the situation is in some turmoil, but can you frame that a little bit for us?

Michael T. Strianese

Sure Cai. As you recall, since we have spoken last, let me just get the frame of reference when we last spoke. We announced in December, if I’m not mistaken, we did not win the source selection. However, after evaluating the debrief, we did protest again because we felt most source selection criteria was not followed again. This time instead of taking 100 days, it took 30 days for the Army to voluntarily agree to take corrective action, yet again.

So, that’s the state of play at the moment. Yesterday revised proposals were submitted. We don’t know the exact timing of another award decision. But I wouldn’t expect it to take too long. As you know further, it is not in our plan for 2008. The fact that the source selection criteria has not been followed is the cause of the protest. So we had to spend a lot of time putting these documents together that are literally thousands of pages, which is very expensive and time consuming.

So, it is important to us. We don’t mind losing. We win programs and lose programs all the time. But it is important to me personally that the criteria, that the rules that were laid out are the rules that are followed. That has not been the case today, which is why we’ve won three protests in a row. So we hope that this gets resolved in a timely fashion. We’re willing to help in the transition in any way we can, and of course, we continue to work on the program, which is a difficult program in terms of recruiting people because many of these individuals are targeted for assassination by insurgents and it has been getting increasingly difficult to recruit people in countries for these roles.

So, that is everything I know. We will, of course, let everybody else know -- our investment community and shareholders and stakeholders -- as soon as we know. We put press releases out very quickly when we get information, and we expect to do that in this case as well.

Cai von Rumohr - Cowen and Company

Is there any chance if the Army has volunteered corrective action that the corrective action would take some kind of negotiated settlement where you and DynCorp combine or something like that as opposed to another winner take all?

Michael T. Strianese

You know, it certainly sounds like a logical solution, but I don’t know that they are considering it. We don’t know because they just haven’t told us that. But it certainly would be a way to get on with it.

Also bear in mind that since we are the incumbent, the contract goes on. It’s not that the military is being deprived of a new platform or program because we are still in bureaucratic neverneverland with this, we are on the ground working everyday. I would hope that this gets resolved quickly. But we don’t know that answer. But I’d tell you it’d make sense to me I guess if that was a consideration that the Army had. I would understand it.

Operator

The next question is from Joe Campbell - Lehman Brothers.

Joe Campbell - Lehman Brothers

You’ve given us a lot of granularity about all the various puts and takes that you had both in the quarter and that you see in the outlook. Are there any more macro things that you are seeing either with regard to how things are anticipated with regard to potentially pulling troops out in Iraq, anything in the sort of ops tempo? Or is there anything with regard to getting these foreign programs up and running that as a macro challenge makes ‘08 different?

Michael T. Strianese

No, not really. I mean on the first point Joe I think everybody is anticipating General Petraeus to have another report in the spring I believe that report will say that the surge was successful, and that perhaps during ‘08 troops are drawn down to the pre-surge levels. You’ve got the election wildcard in there whether there is anymore, but that would be not a material change as far as we can see in that regard.

The requirements for equipment continue similar to the rates that they were continuing in 2007 whether it’s communications, gear, rovers, et cetera. I mean it is pretty steady-state.

On the international programs, international programs generally have a longer ramp up than US programs. Having said that, we’re working closely with our customers in the UK, Canada and again in Australia on our new starts just to make sure that they are planned correctly. We try to anticipate any obstacles that may be there, and that we get them off the ground as quickly as possible so we can get working.

In that regard, we expect to see progress made on project HELIX this year. We were down-selected in project LISTENER to one of two final competitors. We’re working on technical documents for that down-select, which should be later on this year. So all in all we see it fairly steady-state in terms of the ops tempo both in the US and in our international markets where we are playing.

Joe Campbell - Lehman Brothers

Are there any issues with the Finmeccanica airplane?

Michael T. Strianese

No, not that I’m aware. In fact, we will be visiting in the not too distant future the plant in Turin with our partners from Alenia and Finmeccanica to have a very transparent discussion about progress and see that that plane is delivered on time. Again, we have seen the plane. I know you have seen it fly at the air shows over the years, so that is a product that exists that is not being invented today.

True, that the avionics suite is being upgraded. Our partner Honeywell is working on the avionics. We know of no major delays that will be caused there. There are some future upgrades on that program in terms of engines, but that does not affect the first two aircraft to be delivered this year.

We’re expecting to be on or very close, and let me underline on schedule this year. It’s very important to us at L-3 and to me in particular that this program be delivered on time, on schedule. It is our first foray as a platform prime, and I would like to be able to demonstrate we can do it and we know how to do it well. So that is our plan.

Operator

The next question is from George Shapiro - Citigroup.

George Shapiro - Citigroup

Fund for about the $7 million sales dispute with the customer provision you took, Ralph, does that assume some sort of outcome with the customer, or you’re just writing off what you apparently would lose if there was not any resolution?

Ralph G. D’Ambrosio

It assumes some resolution with the customer, some recovery on our part.

George Shapiro - Citigroup

So depending on what that turns out to be, there could either be a little bit of adjustment made either way to that number?

Ralph G. D’Ambrosio

Yes, and the downside is very minimal; or upside I would have to say.

George Shapiro - Citigroup

What percentages of sales in ‘07 were international, and what do you expect that to be in ‘08?

Ralph G. D’Ambrosio

International sales were about 14%. We expect it to be very similar in 2008.

George Shapiro - Citigroup

Anything new in the Homeland Security area from when we spoke last?

Michael T. Strianese

Well, we continue to have two products tested or being trialed in airports. One of them is the portal that you probably have seen either at one of our shareholder meetings or at one of the air shows, known as the object detector or body imager that uses active millimeter wave technology to detect concealed objects on a person. This would be effective, for example, for not only metal because we have metal today, but it would be effective for things like liquid explosives or plastic that would not trigger an alarm on the magnetometer, but would only be detectable in a full body pat down.

Currently those have been operated as an alternative to when somebody is selected for secondary screening they would get the option -- I think they did this in Phoenix for example -- to go with the full body patdown or elect to use the millimeter wave portal. The feedback so far is the machines are working as intended.

Obviously there are user training issues that need to get addressed, but we are optimistic that these could be have the potential to be deployed starting as late as the midyear if the PSA were to decide that they wanted these machines in airports either as a primary device or a secondary device.

I mean it may ramps slowly as a secondary device before it becomes the standard because it’s very hard to make changes like that given the throughput of passengers on a daily basis. But we believe that this will hit ground.

In addition, we have also introduced an energetic material detector that would either supplement or replace the current puffer booths that you might have encountered where currently you stand in booth and have air blown on you, and maybe 15, 20 seconds later you get the green light to go, or you get the red light and you don’t go because you have been on a golf course that has recently been fertilized. It’s true. That happens.

It will replace what I believe the PSA is looking for, that regard is something to speed things up and with taking shoes off, perhaps it is applicable to detecting residue on shoes or on any part of the body or the current operation is either you go in the buffer booth where you get the swab, they swab the handle of your bag and things like that, and that goes in a machine.

So, both of these are new technologies. Introducing new technologies in airports does not happen rapidly. But again, we think we are out in front on these technologies, and we are optimistic that we will start to get traction in both those areas.

George Shapiro - Citigroup

Have you built in any revenue growth from this business in ‘08?

Michael T. Strianese

There is very modest revenue growth again. The entire business line is approximately in the $300 million neighborhood in a $5 billion segment of a $14 billion company. So, it’s not going to move the needle that much this year is the best way I can describe it. But again, you have to be out there with new products to get that business to continue to grow, and that is what we’re doing.

Operator

Your next question is from Steve Binder - Bear Stearns.

Steve Binder - Bear Stearns

As far as M&M, you did not cite JCA in the quarter, but I imagine the process has lifted. So I imagine you had some sales in the quarter on JCA. Is that correct?

Ralph G. D’Ambrosio

There was about $12 million. It was really too small to talk about.

Steve Binder - Bear Stearns

Mike, you touched earlier on JCA as a fixed-price contract. It’s going to be kind of by far and away the largest program at L-3 over time. I’m just wondering how is your involvement on that program really different than, how will it be different than on some of your other programs?

Michael T. Strianese

Well. It’s different in a sense that we’re managing, let me give you something that is comparable. The ASTOR program, where we are a sub to Raytheon UK Limited. ASTOR is the airborne standoff radar aircraft for the UK where we are just a subcontractor putting electronic equipment on an airframe. In this case, not only are we going to participate or be responsible for the final assembly and test and installing the equipment, but we are responsible for delivering the aircraft to the customer. So again, we are in the prime role with overall responsibility for both the Army and ultimately the Air Force as well at some point.

So, the principles of program management are in play in a larger scale here since it’s not only worrying about L-3’s content in our vendors, but it is really worrying about Alenia’s performance and their subcontractors are meeting their schedule since it’s such a big component of the program. So, we need to be more diligent in our reviews. And again, we have a great working relationship with Alenia and Finmeccanica, and I don’t perceive any problems on this program.

Steve Binder - Bear Stearns

I actually meant your involvement, not L-3’s involvement. That is fine. Just a couple of things, Ralph. You touched on MPRI accounting for a chunk of the margin improvement in Government Services in the quarter. It looks like when you back out Linguist, you had 120 basis points of improvement. Last year’s fourth quarter, you did touch on some costs that not only did you have $4 million of consolidation costs last year, but you had costs and expenses associated with some introductions from security video product costs. So, I’m wondering was that a challenge that those costs year-over-year, or was it largely MPRI?

Michael T. Strianese

On the severance costs, as you know, there was both $4 million in Q4 of this year and $4 million Q4 of last year. So that was a non-event in terms of total dollars. The video product introduction costs were probably $2 million less than they were a year ago. So, it is mostly MPRI yield. We have the good fortune there of having a lot of fixed price work, and even though the entire segment is probably 40% cost reimbursable, there is not much cost reimbursable work at MPRI and therefore, we structurally have most margin upside in that business.

Steve Binder - Bear Stearns

Ralph, can you just touch on your pension assumptions? What did you do to your discount rate?

Ralph G. D’Ambrosio

The discount rate, we raised by 50 basis points. It is going from 5.9% for ‘07 to 6.4% for 2008. We didn’t change any other assumptions. Asset return remains at 8.5%, and the compensation increases remained at 4.5%. Now the benefit from the lower discount rate was largely offset by asset return performance in ‘07, which lagged our assumption. I really did about 5% versus the 8.5% asset return assumption, so they tend to offset one another. All told the FASB 87 expense was $93 million in ‘07. We expect it to be about $87 million in ‘08. So, it is coming down by about $6 million, which is roughly $0.03 of EPS.

Steve Binder - Bear Stearns

How about FAS expense?

Ralph G. D’Ambrosio

It is going to track the FAS expense very closely.

Michael T. Strianese

I just wanted to add, now that I heard the other part of your question on JCA. I’m personally involved in doing the program reviews. As I mentioned, I will be going over to Finmeccanica in a couple of weeks to do our first on-site plant and tour. So, Bob Drewes and I spent a lot of time together on this program, and it is getting an appropriate level of oversight from my level as well.

Operator

Your next question is from Myles Walton - Oppenheimer.

Myles Walton - Oppenheimer

A couple of questions on government services new contract opportunities, are you planning on competing on a civilian police contract? It looks like that would be a pretty large opportunity if you chose to pursue that through MPRI?

Michael T. Strianese

Well, we already do work with civilian police through a joint venture that we have at MPRI, but we don’t consolidate those sales. We’re not pursuing any large civilian police work outside of that JV right now.

Myles Walton - Oppenheimer

So that the Iraq CIVPOL police would be pursued through that JV, and you only consolidate the earnings, I guess?

Michael T. Strianese

On an equity basis, yes.

Myles Walton - Oppenheimer

Mike, on the Linguist program, how has the recent performance been on the DynCorp call this morning, they mentioned they thought that L-3 recently received a cure notice in the last couple of months, and I don’t know if that is accurate, but if you could give some clarification there?

Michael T. Strianese

Sure. Where we are on that is that subsequent to losing the last round, maybe a week after that, we did receive a cure notice. And the topic was that the fill rate, meaning the percentage that were actually hired versus the target was at about 84%, then which, of course, is the desire to be at 100%. It is actually true, but again, as I mentioned, it is in a war zone, and people are targeted for assassination. It is not like you are recruiting kids off a college campus. It is a difficult environment. We believe that rate represents an excusable delay, and we believe that there are not any monetary consequences or legal remedies available to the Army in this circumstance.

In fact, we had filed a notice I think back in August about the difficulties of filling this and achieving this fill rate. So, the answer to the question, direct answer is yes, but again it was rather curious to me that this came days or a week after we had already lost the contract. Because a cure notice, if not cured, is the prelude to being terminated, which we already lost. So you can connect the dots yourself, I’m going to leave it at that.

Operator

And next question is from Joe Nadol - JP Morgan.

Joe Nadol - JP Morgan

Ralph or Mike, I guess going to C cubed and looking at the sales profile, when you look at the last couple of years between Q2 ‘06 and Q3 ‘07, you had six consecutive quarters where you are bouncing around $500 million of sales and $550 million more or less, and you shot up really significantly over $700 million this quarter.

You’re looking at about 10% overall for the year next year. Can you give a little bit more color on what really fueled that that the almost 40% sequential growth Q3 to Q4, and then what is the sales profile look like on a more or less quarterly or first-half, second-half basis in ‘08? Are we going to have the same sort of distribution?

Ralph G. D’Ambrosio

Joe, the first point is what I briefly commented earlier on, is in Q4 we had about $80 million of sales that happened earlier than we expected. So if you take those out, sales per segment were about $630 million, still a significant increase sequentially over the almost $520 million that we did in Q3.

Actually what is driving the increase in sales there, including what we see happening in 2008 is we are doing a good amount of more classified work on ISR systems. We recently won the JP 2048 Communication System. That’s for the Australian ship program. And if things go well, we will start having some sales on the SME product later on in 2008. We also have some other programs at Camden that are going to be transitioning from development into production.

So those are the major drivers as to what is fueling the increase in sales, and of course, at Comm Systems West where we do our data links, that business continues to do very well, and it’s going to have good growth again in 2008. So that’s what going on there, Joe.

Joe Nadol - JP Morgan

Should we expect in ‘08 a much lower Q1 than the remaining three quarters? I guess, it’s a big step up between Q1 and Q2, and then again probably flat in Q3 and up again in Q4?

Ralph G. D’Ambrosio

Yes.

Joe Nadol - JP Morgan

Mike, you guys have been talking about some divestitures. I know they are relatively small, but for awhile I’m just wondering if the credit markets, the loss of a private equity bid or anything that is complicating matters or if these things just take time?

Michael T. Strianese

Joe, you’re right on point actually. In fact, we did close a small, small divestiture in December. It was a company called Hygenetics that we have owned since we acquired ILEX, which is almost 10 years ago by now. But it’s an environmental consulting business that really, obviously, does not fit in L-3. But it is an example of the types of things we are trying to do. There are six more. I can say on two of them credit markets are impacting the buyer.

Operator

Your final question is from Cory Koenig - Lehman Brothers.

Cory Koenig - Lehman Brothers

Last quarter you guys discussed going back to the rating agencies with a goal of achieving investment-grade status. Can you please provide us with an update?

Ralph G. D’Ambrosio

Sure. We did meet with one rating agency in Q4, but we never had a goal of trying to obtain investment-grade ratings. I’m not sure where that came from. It didn’t come from L-3. We had a very productive meeting with them. The concern continues to be that L-3 in the future may make significant business acquisitions and I think that is giving some of the agencies pause, particularly when you consider what happened with a lot of their ratings this year in other parts of the credit world.

On the M&A front, we expect most of the growth to be in niche acquisitions. But as Mike has said repeatedly over the past year or so, if a large opportunity comes along that fits into one of our core businesses, we are going to pursue it if it makes sense. So take that and then add the fact that we began repurchasing our common stock last year or early in 2006 for that matter, and that’s what’s giving pause to some of the rating agencies.

Michael T. Strianese

Let me weigh in on that too because I was disappointed that we didn’t get the upgrade. I think it was more the environment that the rating agencies are in right now. I don’t know that I agree with the posture that because there is potential we may have a significant acquisition sometime in the future to hold our rating back.

Our leverage has declined steadily through operations over the past several years. I think 2007 demonstrated clearly a change in strategy to slowing the M&A down a bit and using other means such as share repurchases, returning cash to shareholders and increase shareholder value.

So we will try again. It has never been an objective for us in and of itself to get investment grade status, although it is something that would be nice to have. We certainly expected movement, and we are disappointed that it didn’t happen. So we will continue our dialogue with the rating agencies. Again, I think there were a lot of other things going on in the kitchen there for us to get a fair evaluation and focus, to be honest with you. That’s where we are.

Operator

There are no further questions at this time.

Eric Boyriven

If there are no questions, we will turn the call back to management for closing remarks.

Michael T. Strianese

Well we expect a strong 2008. Understanding that we are in an election year and that may cause some volatility for the sector, we continue to believe and hear from all the candidates as we all hear that strong military and strong national security policy is of paramount importance. That is universal on either side of the aisle. That gives us confidence that defense is going to be a strong business in 2008 and beyond.

We will keep you updated on the status of 2008, and look forward to talking to you in the first quarter. Thank you.

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