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Executives

Karen Tripp - VP of Corporate Communications

Michael Strianese - President and CEO

Ralph D'Ambrosio - VP and CFO

Curtis Brunson - SVP - Corporate Strategy and Development

Analysts

Cai von Rumohr - Cowen and Company

Joseph Campbell - Lehman Brothers

George Shapiro - Citigroup

Steve Binder - Bear Stearns

Robert Spingarn - Credit Suisse

Howard Rubel - Jefferies

Joe Nadol - JPMorgan

Ronald Epstein - Merrill Lynch

L-3 Communications Holdings Inc. (LLL) Q1 2008 Earnings Call April 24, 2008 11:00 AM ET

Operator

Good morning. My name is Kristen and I will be your conference operator today. At this time I would like to welcome everyone to the L-3 Communications first quarter ‘08 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session.

(Operator Instructions) Thank you. I would now like to turn the call over to Ms. Karen Tripp, Vice President of Corporate Communications. Ma’am, you may begin your conference.

Karen Tripp

Thank you, Kristen. Good morning and welcome to the L-3 first quarter conference call. With us today are Michael Strianese, President and Chief Executive Officer, Ralph D’Ambrosio, Vice President and Chief Financial Officer and Curtis Brunson, Senior Vice President, Corporate Strategy and Development. We will be available to take your questions following the formal presentation.

During this call management will reiterate forward-looking statements that were made in the press release we issued this morning. Please refer to this release as well as our SEC fillings for more detailed description of the factors that may cause actual results to different materially from those anticipated. This call will be simultaneously broadcasted over the internet.

I will now turn the call over to our President and Chief Executive Officer, Michael Strianese.

Michael Strianese

Good morning, everyone and thanks for joining us for our first quarter call. We have a strong first quarter with funded orders reaching $4.1 billion, which is a quarterly record for L-3 and the book to bill was 1.16, the orders out ramped sales by about 16%. Funded backlog also was a record increasing to over $10 billion, up 6% sequentially from December and setting us up nicely for the rest of 2008.

Sales were up about 6% to $3.5 billion and margins improved by 60 basis points. The margin improvements were pretty much across the board, three of the four segments posted increases. In margin, just our Government Services were flat this first quarter versus last year’s, due to some consolidation costs that we incurred, but again they were flat, and overall were up 60 basis points.

Earnings per share growth was 19% to $1.54 share and free cash flow was $55 million, but that was affected by the timing of our first quarter close and it was related to receivable corrections. There is no change to our guidance for the year, which is still $1.2 billion and Ralph will, I am sure, cover that in some more detail there. Again, these results are due to the hard work and dedication of our 64,000 employees and I would like to thank the leadership of Group Presidents, who all did a just a great job this quarter, as they always do.

We have some significant new awards and new business in the quarter, just to name a few of them. TVCS is our Marine Corps training program. That is based on our Praetorian software. It’s over $300 million, it’s a new program.

Our team met Northrop's team on the BAMS program, which you saw couple of days ago, Northrop won. And we are the integrator for the COMS suite, which is a very nice place to be. (Inaudible) to help fire, electronic safe and arm device, F-16 Denmark training simulator to name a few.

In addition, again across the board, we had significant follow-on orders in the quarter on many legacy programs to name a few, communication systems for UAVs, Compass Call aircraft, contract logistic services for aircraft relating to the Air Force and Navy, P-3 work, SOCOM work, Hercules engines, (inaudible) transmissions, examiner service work for with TSA, Mine Detection Equipment, and of course continued strong performance by our SAM Electronics Business in Germany for commercial ship building, which continues to be strong.

We have some significant outstanding business as well for the balance of the year and a couple and I would keep my eye on first of all these two recompete, what is the JOG or the Joint Operations Group. It's a recompete, where we are the incumbent should be awarded in the second half of this year and also our Contract Field Teams and I will give you a few points on those in a minute.

F-16 Machine Trainer about $600 million opportunity should be in Q3, Royal Australian Air Force project AIR 7000 should also be in fourth quarter etcetera. We have a B-2 Aircrew Training and Maintenance System award we are expecting in the fourth quarter later this year.

So there is still, the year is dominated by a lot of opportunities right across the business. We do have to recompete that we are focusing on, let me say two words about them. So, you know what they are, and what the effects could be. The different competitive dynamics first of all, and by the way whichever way they go, there is no impact for 2008's plan, but there would be future events.

So first, Contract Field Teams that is a multi-source program with four major incumbent suppliers including us at L-3. We expect to award in the third quarter. We do about $475 million of sales Contract Field Teams. We expect all four major incumbents to continue on the new contracts plus they are adding about 3 or 4 small business slots.

The second one was the Joint Operations Group, its sole source contract. OSD recently sorted out the procurement strategy and we expect to draft our in the next month. The current contract sealing is $2.1 billion. It does about $350 million, cost of annual sales. The new contract likely will be larger and it could be awarded before the end of this year. So, we are very focused on those two re-competes.

As you know on Linguist, that situation was resolved last month in March. Our contract for the Iraq piece of it was extended from March 8th to June 9th. We also entered into a subcontract with GLS and withdrew our protest that we filed in February. We expect the subcontract to generate about $150 million of annual sales and we are in process of transitioning our work to GLS. We expect to be completed with that process around June 9th. I could tell you that the relationship with GLS and the customer is very good and we are working hard for an orderly transition and to continue with the success on this program and I think this is the best strategy for everybody involved.

Next topic. Joint Cargo Aircraft as you know was a major win last year. We visited the Alenia plant in Torino during the first quarter. The first two deliveries are on the production line. We did review the program with our partners, the contract performance is very good and we are on track for the first two aircraft deliveries late this year. We also expect funding for the next four aircraft during the second quarter.

There are also a number of new DoD programs, where we are participating as a teammate on various teams and I had mentioned BAMS, which did include a significant role for L-3 as the communication suite integrator, but also our Aerial Common Sensor.

Our integrated systems business is a member of the Northrop team for (inaudible). And in our Communications Systems West division, we expect to have a strong position on every team in the program for the Data Links. The EPX were also a member of the Northrop team and for the Joint Light Tactical Vehicle we're on multiple teams primarily for suspension and other electronic components.

The outlook for the balance of 2008, it's in our press release. But we updated our guidance today for the final resolution of Linguist and the acquisitions we've completed to date. So we’ve increased our sales and earnings per share guidance. We're now expecting between $14.3 billion to $14.5 billion in sales, with earnings per share of $6.52 to $6.70 a share, and as I mentioned, free cash flow of $1.2 billion. We expect the sales growth excluding Linguist, to decline. We're expecting to be in the 6% to 8% range. Our guidance assumes that we end 2008 with more than $1.3 billion of cash on the balance sheet at the end of the year and that's after repurchasing a planned $400 million of our stock. Ralph's going to cover some more details on the guidance, when he goes through the financials.

In terms of capital deployment, year-to-date per acquisitions, we acquired two niche businesses for an aggregate purchase price of about $190 million, that was the Electro-Optical Systems business of Northrop and HAF as well. We expect these businesses to add almost $150 million of sales in 2008. I think on an annual basis, they probably together run about $225 million, but for the (inaudible) of 2008, L3 will probably pick up about $150 million more sales, that is in the updated guidance. On average, we paid multiple on 2008 EBITDA of slightly above eight times. Our guidance for 2008 assumes we repurchased $400 million of stock during the year. For the first quarter, we have already repurchased $283 million against that $400 million.

The objective in acquisitions, we continue to look at many-many companies, but we are being very selective, both on fit and price and technology and customers that we like to have. So, the pace is slower than you are used to seeing over the years. But it would be nice if we can acquire a few more companies this year and add about a $0.5 billion more sales for next year, $500 million to $700 million would be nice. But again, it is subject to the availability of qualified candidates with prices that are prices we are willing to pay.

The companies we are looking at, again, are ones that are complementary to our existing businesses, that are core to us in technologies and customers that we understand and have relationships with, and thereby adding new technologies, products, programs and customers.

The pipeline, like I said, is pretty good to several companies and they are mostly privately owned. We continue to see good candidates. Valuations still could be rich in some cases and we think that will continue for the balance of ’08. So again, we are being very selective and measured in our approach to acquisitions.

On divestitures, we have completed a couple. So far we still have about five small peripheral non-core businesses or product lines that are in process. We expect at least one transaction to close in the second quarter. I think the combined sales of those units are not terribly significant. It’s about $125 million in annual sales. We expect sales proceeds of these transactions as based on where we are today, in the $140 million to $150 million, neighborhood.

So, let me turn over to Ralph to go through the financial and then we would be happy to go through the Q&A with you. So go ahead, Ralph.

Ralph D'Ambrosio

Thanks, Mike. I'll comment on some key points about our Q1 results, cash flow, the March balance sheet and wrap up with some details about the changes to our 2008 financial guidance. On sales, Q1 organic growth was 5%, plus 1% from acquisitions and that gave us a total sales growth of 6%. We had organic growth in every segment with the highest growth in government services and specialized products.

The government services organic growth was 7% and the MKI acquisition from last December added another 1%. Sales on Linguist contract were $183 million, that was $33 million more than we expected, because of the extension, and $6 million more than Q1 of last year. Within specialized products, total sales growth was 9%, 6% was organic led by power control systems, microwave and precision engagement. And we had 3% growth from acquisitions, most of it coming from the GCS Company that we acquired last May.

C3ISR had 2% organic sales growth, and what happened there was we had increases in network communication systems including UAVs and ROVER/Manpack, and we also had higher sales for secured terminal equipment. But those increases were partially offset, or largely offset rather by fewer deliveries of airborne ISR systems. And if you recall, last December, we had some earlier than expected aircraft deliveries, which increased Q4 '07 sales in the segment by about $80 million. While those early deliveries negatively impacted Q1 ’08 ISR sales, resulting in lower organic growth for both the segment and consolidated results on Q1 of this year.

So we expect higher C3ISR organic growth for the next three quarters in ’08, but we don't expect to have any more increases on the STEE product.

Within aircraft modernization and maintenance, sales grew 3% organically. We had increases on the Joint Cargo Aircraft, Fort Rucker and JOG and those were offset by declines on international C130 aircraft modifications due to contracts nearing completion and sales were also lower on the Canadian Maritime Helicopter Patrol contract, due to less work scope in 2008, which was expected.

On operating margins, my comment is that we had 60 basis points on a consolidated basis of improvement. Most of it came in C3ISR, where margins improved by 220 basis points to 11.2%, and that was driven by three items. First, we had improved contract performance on ISR systems, mostly labor productivity. Second, we had higher sales for the Networked Communication Systems, NST, and third we had lower development cost for our new secure Mobile Environment Product of about $2 million.

Within aircraft modernization and maintenance, margins were up slightly by 10 basis points on some price increases and Mike already talked about the margins being flat in government services, where we absorbed $2 million of additional business realignment or consolidation cost, most of it for severance.

If you take a look at our free cash flow, it was $55 million for Q1, that was down from $196 million from Q1 of last year and the timing of billed receivable collections on handful of programs was the primary reason for the decline in cash flow. Billed receivable actually increased by $149 million Q1 of this year, compared to a decline of $20 million in the first quarter of 2007.

I will tell you that we don't have any customer credit or L-3 contract performance problems within the increase in billed receivables and in fact we collected most of the increase and receivables at March 28, the first few days in Q2 beginning on March 31st and the first couple of days in April.

The secondary reasons for the lower cash flow in Q1 were higher income tax payments of about $43 million and higher CapEx of $9 million. For income taxes we paid $69 million Q1 of this year compared to $26 million Q1 2007 and as I commented during the Q4 earnings conference call, we are expecting cash tax payments to increase by about $150 million in 2008 versus 2007.

And those higher tax payments are front-end loaded with about $120 million happening in the first half and only $30 million in the second half. So, cash taxes will be a bigger headwind in Q2 at about $77 million and then we had the seasonal increases in the quarter that typically have an unbilled contract receivables and inventories, which together used about $154 million in cash, but those are mostly offset by increases payables, accrued expenses and customer advances.

And we expect the increase that we had in receivables and inventories to decline and actually reverse themselves, as we move and progress throughout the year. And then of course, the last item affecting Q1 cash flow is accrued employment cost, which is all the use of cash because we pay our annual incentive bonuses in March.

On the balance sheet, we ended the quarter with $536 million in cash and as Mike said, we expect that to increase about $1.3 billion by the end of the year, assuming we don’t make any more acquisitions. That was unchanged at $4.5 billion and our bank leverage ratio remained at 2.3 times. Depending on what happens with the acquisitions for the rest of this year, we are likely to repurchase more common stock and $400 million in the guidance.

Moving on to the changes to our 2008 full year guidance, as Mike commented, we had a $300 million to both end of our sales range, $170 million came from Linguist contract extension and the subcontract with GLS. And another $145 million or so is coming from the EOS and HSA acquisitions. Our both of those acquisitions are in specialized products and as you know we acquired EOS on April 21 and we acquired HSA on March 14.

Our new EPS range for 2008 is 656 to 670. We raised it by $0.08 on both ends, $0.04 coming on Linguist and that subcontract and the other $0.04 comes from the two acquisitions. Operating margin guidance, we lowered it by 10 basis points to 10.7% and that’s due entirely to the additional Linguist sales. And the margin on the new subcontract is actually going to be a little lower than what it is on our existing prime contract. But overall we’re still anticipating about 30 basis points of improvement for the full year, and a lot of that came in the first quarter.

The tax rate, we are estimating it to be 36.5% that assume that the Federal R&D tax credit is re-enacted sometime in Q4. If it doesn’t get re-enacted the tax rate will go up by 70 basis points, that would cost us about $0.07 EPS. We can definitely contain that within our guidance range.

Free cash flow guidance remains at $1.2 billion, some additional points about the cash flow and I already commented on, is that the GLS subcontract Linguist Services, which we added to our guidance, is probably going to require about $20 million of working capital and all of that will happen in Q2 because when we will transition to that subcontracts and more contract. And we are also anticipating lower pension funding of about $30 million.

That concludes the comments I have and I will turn it back to you, Mike.

Karen Tripp

Kristen, I think we are ready to proceed with questions.

Question-and-Answer Session

Operator

(Operator Instructions). The first question is from Cai von Rumohr with Cowen and Company.

Cai von Rumohr - Cowen and Company

Maybe a number of other companies have indicated more billing days or working days in the quarter, was that a factor at all for you guys?

Ralph D'Ambrosio

Cai, it was a factor in that, we actually had one less day in Q1 of this year versus last year. It probably has impact on sales, about $50 million and we think it definitely impacted the timing of our cash collections and receivable. So, we are not going to make up that one day until we get the Q4 of this year.

Cai von Rumohr - Cowen and Company

So, basically the other quarters more or less are the same except for Q4.

Ralph D'Ambrosio

Q2 and Q3 will be the same amount of days and will have an extra two days in Q4 because this year is a leap year.

Cai von Rumohr - Cowen and Company

Got it, okay. Okay great. Thanks a lot.

Operator

Your next question is from the line of Joseph Campbell with Lehman Brothers.

Joseph Campbell - Lehman Brothers

Good morning.

Michael Strianese

Hi, Joe.

Joseph Campbell - Lehman Brothers

Hi. Hey Mike, we heard the comments and we knew you had gone over to Torino to check out the Alenia airplane product. Could you tell us what’s happening kind of on the other end of this with regard to what goes in the airplane and the systems; just tell us about what’s happening on Joint Cargo Aircraft other than the airplane side?

Michael Strianese

On our side?

Joseph Campbell - Lehman Brothers

Yeah.

Michael Strianese

Yeah, well just sure I went over with the team by the way, which included a couple of people from here from Integrated Systems as well as people from Alenia North America. We just started from the beginning and -- that is a existing airplane that does have some unique requirements that have to be built in advance must receiving the plane over here in Greenville such as wiring and shielding and things like that.

When the planes are received on our end, there is equipment. Some of it is quite supplied, but the things I could tell you that would be the obvious thing, Self-protection Equipment, Avionics Equipment, and so Communications Gear would be put on as well as preparing for certification and any other special customer requirements depending on the end-user right now, the army, but there are other end-users in this program that will have different requirements, Joe.

So, there is a green airplane sitting in Greenville today. That is being used to test those installations that we and Alenia agreed with a great tool for risk mitigation. So, we don't have to wait until we see that first Plane in June or July and August rather to start installing equipment on. So, again everything is working pretty much on schedule.

Joseph Campbell - Lehman Brothers

So the big item I didn’t realize was that, rather than waiting for the first real airplane to come, they have given you one to work on. So that you have taken that waiting period for the airplane, not out of the L-3 side of the equation, so that the Greenville guys can get going?

Michael Strianese

That’s absolutely true, Joe. And that plane was jointly funded by us and our partner Alenia with this risk mitigation in mind. So and things are going well, so they are able to install, test and make ready for the deliverable aircraft when they arrive this summer. So the answer is yes, that was always part of the plan and we intend to stay very close, if not exactly, on the delivery dates in the contract.

Joseph Campbell - Lehman Brothers

Perfect. Thanks Mike.

Michael Strianese

Thanks Joe.

Operator

Your next question is from George Shapiro with Citigroup.

George Shapiro - Citigroup

Mike, are you sure, the baggage or the passenger detection is being installed in LA and New York in addition to Phoenix. Can you tell us how much it means to you if we start and what the timing might be to get it installed in most of the other airports and what kind of demand internationally?

Michael Strianese

George, I would hesitate to project those numbers, but let me tell you how we are looking at it. First of all, these tests are being tested in a national environment in the airport. So sometimes things come up that may require adjustment. But it’s all very positive that they are actually in airports now and being used. Of course they are being used, as I understand, as a secondary screening tool. So where a traveler goes through the primary that’s there today and is selected for additional screening. That is being either offered as an option versus a full [wounding] back down and we expect that feedback as the year progresses and we will probably request to change some things and the like.

As far as the US incorporating this into, what I would call, the market being every lane, and every terminal and every airport, it’s a fairly sizable market as you know. But I don’t expect that rollout to happen fast. So, again, that’s probably in ’09 and beyond. I could see that getting to north of $100 million a year at least in new business if we certainly go that route and international, probably the same thing. There are other technologies there that are being tested in the similar fashion, like back-scatter X-ray. We believed ours to be more traveler-friendly and that is non-ionizing radiation. Ours is using millimeter wave, which is similar to the emission of a cell phone to get an image. I would expect that this is an evolving product and there will be more worked done on image with threat detection and identification in an automated fashion, versus having an operator have to look at the image and detect the threat themselves. So, it’s very positive. It’s been deployed and being tested and that's the precursor to getting into a production mode. But as for the numbers out today, I think that's the closest they are going to be able to come.

George Shapiro - Citigroup

Okay. And is there anything new on, you had tested at one point a system for mass transit, as well. I thought you had tested at one of the PATH stations. Is there anything new there?

Michael Strianese

That system also, with that is the EMD or the Energetic Material Detector, which is a turnstile type system that collects particulate from a traveler as they would walk through it, and do an immediate analysis of whether or not there is a presence of an energetic material, also known as an explosive.

The difference between what's done today, I think is at Washington National when you go through the shuttle. You step through the puffer booths. If you have been through that exercise, it takes probably 15 to 30 seconds to stand in there and get the puff, have the analysis and then clear. Ours is almost instantaneous, because it works differently. Again, that's in test, the device. It's also for airports, not just mass transit. And I think the take-up would be certainly faster in airports. There are also two versions of it, George, there is the turnstile I described, that you push with your hands, so it takes samples from your hands and as the air-blade that goes across the lower part of the body, which is typically where the particulate would be.

As you probably also experienced in the airport, they would want your baggage. They have one with a little pad on it, they move over the handle, and then they put it in a desktop machine to determine what do you have. There is also a desktop version of that that is also in tests. So again, these are most products that I expect future sales on, although I can't tell you they will be this year. I ultimately believe they will be in airports soon over the next couple of years.

We are developing and getting out of the lab and into the field on both of these products. And it's hard to predict how quickly they get fine-tuned to the point where the TSA wants as a production unit. But the signs are very positive. So, that's what they both are with. And you can link them together, and you can form what we have called our integrated checkpoint solution as well, someday. But again, that's a big change from the operation today as to what happens when you go through and as you know in airports, those changes are going to be evolutionary, not revolutionary. But I will tell you we are on the forefront of the products that will be there when they change.

George Shapiro - Citigroup

Okay. Thanks a lot.

Operator

Your next question is from Steve Binder with Bear Stearns.

Steve Binder - Bear Stearns

Can you maybe just touch on, when you look at the billed receivables that slipped into the second quarter, I mean, was that largely coming from the primes? Is that coming from DoD, is that coming from international, where was that slippage?

Ralph D'Ambrosio

Steve, it’s mostly coming from the DoD, and I said there was a handful of programs and here are the programs; on JCA it was $45 million, it was $25 million on Fort Rucker, $14 million on the Canadian F-18, $8 million on the H1 program and $6 million for the C130 work for the US. And then we commented on very strong sales that we had at SAM Electronics in Germany for commercial shipbuilding. Well they had some very substantial sales increases and shipments of product in March and we weren’t able to bill and collect those by the end of March, and that was about $23 million.

Steve Binder - Bear Stearns

You had pretty good strength and book-to-bill over specialized products. It was pretty across the border; are there any big notable orders in the quarter?

Ralph D'Ambrosio

We had very strong orders in SAM Electronics and then it was pretty much across the board, in most of the business areas. And Mike hit on lot of those orders on follow-on side in his commentary.

Michael Strianese

Steve, I will give you a couple of them, but additional work from our Combat Propulsion business, it's the Hercules engines, Bradley transmissions, more CSEL radios out of our IEC business. Those are the Combat Survivor and Locator radios.

Services component of our TSA -- our installed base on examiner Bomb Detection Equipment, more Mine Detection Equipment also. These are the handheld mine detection for use obviously in the Afghanistan and Iraq. It is and again once you get beyond those big ones, its pretty much across the board, we’re pretty happy with the performance that is not any single one item. It was pretty evenly spread. So, we are happy with the way the years looking right out of the gate.

Steve Binder - Bear Stearns

And going back to JCA, I mean you clearly first out your initial observations on the program. Your answer to those questions is when you look at the kind of the risk profile to that program and you look at it as fixed price, when you look at cost related issues. I mean what are the big milestones, is it delivery related or where the milestone that you feel like. You are looking at today that you will know when you really over the hump from a cost standpoint.

Michael Strianese

I’d say for full integration and test of the new Avionics that are going into this aircraft. But again our teammate is Honeywell. They've been a great teammate. They are doing a fabulous job. I mean the team Steve I watch this weekly is working together again and issues reported -- Bob Drewes is audit on everyday as well. And we are not letting it get away from us.

So, but it’s not suit until the Avionics run self protection gear, the COMS and everything works right together. It’s the integration of everything at the same time that I’d call the hump, getting what we have to get over. And again this is what the hallmark of what we do in Greenville is missionizing airplanes and I don’t see anything in here that would concern me, as being a major risk.

There is not half a million lines of software you have to write or new equipment that’s untested, that’s going on. It's really existing equipment on a new airplane. So, I don’t view this as a terribly high risk profile, but again we are keeping. We don’t want to leave with chance either, which is why we are managing it so closely.

Steve Binder - Bear Stearns

Thanks very much.

Michael Strianese

Okay, Steve.

Operator

Your next question is from Robert Spingarn with Credit Suisse.

Robert Spingarn - Credit Suisse

Hi, Mike and Ralph.

Michael Strianese

Hi, Rob.

Robert Spingarn - Credit Suisse

Looking historically, you’ve always started the year with a lower margin and ramps throughout the year. This year you’re closer to your guidance with a pretty strong first quarter margin. So, are you being conservative and more specifically, what gets you to the high end, for example of your specialize products -- margin guidance?

Ralph D'Ambrosio

With this specialized project, we get to the high end, when we see increases in sales volume, which we expect to happen during the next three quarters. One of those businesses is very sensitive to volume.

Robert Spingarn - Credit Suisse

Ralph, can you talk about a couple?

Ralph D'Ambrosio

For example, most of EO/IR business the Undersea Warfare business area, the Commercial Aviation Product businesses and a lot of areas we peer expense one of our SG&A cost. So, when you ramp your sales or [roll] your sales, the incremental gross margin drops right down to operating income, and that requires the increases in the operating margin.

Robert Spingarn - Credit Suisse

So, it’s an absorption story in that segment.

Ralph D'Ambrosio

Yes.

Robert Spingarn - Credit Suisse

And on the first thing I mentioned, either you or Mike. Yeah, is there conservatism built-in here, because it would seem to me that a normalized ramp could – you do a little better than what's been talked about, overall, across all four segments?

Michael Strianese

I'll tell you, Bob. If you look at the history, we do start lowered ramp up, yes but again there were -- it was an easier comparison this first quarter than last year's because of the SME PED development costs. So, we had some productivity issues in hangar, dock, in line at Integrated Systems. So, we did get that big pop in C3ISR.

But also remember there is guidance for '08 excluding Linguist by we’re putting it in incrementally. That the guidance includes it for the balance of the year and under the subcontract as Ralph mentioned, get those carry lower margins. So, that is the reason why it's looking like maybe there is more incumbent, really we are expecting pretty much what the range is. I could tell you historically while we always try to give guidance that's the minimum we can do, and we generally try to do a little bit better and in most cases we do.

We don’t really blow away the numbers on the upside either. I mean I think we are pretty much down the middle on the numbers that we gave you, the ranges and the risks associated with them. So, while we are hoping for a great close to '08. We are not ready to put it in the numbers yet, but in a sense that it would really move those margins materially. As we set out in our long-range guidance we are trying to move those margins incrementally every year through consolidation and more efficiencies, but I think that's where we are today. Ralf?

Ralph D’Ambrosio

I agree and don’t have more to say on those things. We think the margin guidance that we have right now, is reasonable, this time in the year. And we will try to do better, but we'll see what happens.

Robert Spingarn - Credit Suisse

In fact, if you.

Michael Strianese

Look, we also Rob, I think Steve and Joe everybody asked [JO] questions. Well, we still have work to do there and it is a fixed price. So, now it is a lower margin -- but there is still margin there that we -- as risks mitigate over the year -- we have a bunch of new starts actually. We have the Integrated Broadcast System in the UK. We have work on Helix. We have the Marine Corp TV, The YES Program and the like. I mean there is opportunity sure, but it’s a little early to start saying those risks are mitigated. So, we are very comfortable where the ranges right now.

Robert Spingarn - Credit Suisse

Okay. And then did you say in the past that you’re targeting the CECOM R2 program that we can beat there?

Michael Strianese

I’m not sure which one that is, Rob.

Robert Spingarn - Credit Suisse

The R2-3G?

Michael Strianese

That’s not ringing a bell here, so probably not us.

Robert Spingarn - Credit Suisse

Okay. And then just one last thing more of a broad based longer term kind of question, Mike -- if the Democrats win here and they stick to this withdrawal plan that they’d like to talk about, is that an up-tick for you down the road in business with the reset or is it realistically a lower number?

Michael Strianese

Let me give you some of the variables. We think about this all the time really what it means. And I don't think anybody can really answer that with any degree of certainty or position for the following reasons. One, when you say withdrawal, its withdrawal doesn’t mean 130,000 to 0, it means a number and we don't know the number, whether it is 70,000, 50,000, 30,000.

We don't (Inaudible) everybody believes that’s possible. So, the first thing is that, what is the sustaining level, if you want to call it that that we would get to. And then the second question I pose is that, well does that create an opportunity for more contract to services, which there were certainly be voids left in some of the leadership development and training and standing up by a stronger Iraqi military civilian police force, our procurement system etcetera, etcetera.

So there are a lot of variables in there. What I can tell you with some confidence is I don’t expect it to go off the cliff at the end of any one month. That certainly it’s not going to happen. So I hate to be vague with that kind of an answer. But I don’t think I could take myself into a corner in taking a position on it, because we just don’t know the direction. I could tell you it’s hard to make a sharp turn with a big ship, and that’s really what we have here. So anything that will happen will be gradual. But you will certainly be the first to hear it from us as soon as we get some visibility into how those things play.

Again, the size, the timing and the size of the drawdown is factor one and then factor two is whether that indeed opens up opportunity for more contract to services, which by the way I believe it will, but I certainly can't prove it to you. But I can also tell you that in terms of contract, in the air or on the ground; we've an excellent position to fill some of that requirement.

Robert Spingarn - Credit Suisse

I think that’s a fair answer. And one thing you are highlighting here is your various types of exposure to the situation. You talked about the contractor activity over there. But then there is also the equipment reset over here.

Michael Strianese

I forgot that part. And indeed the reset opportunities in our both AM&M business and in our combat propulsion business, would also be upticks. So there are puts and takes and I can't tell you which way the ledger is going to balance when we add them all up. But I don't expect it to be a dramatic negative -- I also don't think it's going to be a dramatic positive either. I mean, it will be gradual, no matter which way it goes.

Robert Spingarn - Credit Suisse

All right. Well, I appreciate the answer. Thanks guys.

Michael Strianese

Thank you.

Operator

Your next question is from Howard Rubel with Jefferies.

Howard Rubel - Jefferies

Thank you very much. Actually I want to return a little bit to the Iraq question, and we just went through a fairly large surge and Mike, you alluded to the reduction of roughly 30,000 troops. What did you see in terms of their draw on your services and now that we're at a lower level, are you really seeing any change in business activity?

Michael Strianese

No, in fact, we're not. At all, and in fact (inaudible).

Ralph D'Ambrosio

On a couple of contracts that most people associate were being highly correlated at the troop levels, including Linguist. The requirement actually has increased, even though troop levels have come down and that's because the combat commanders are demanding select a bit more services. So the troop level at Linguist actually went up, even though we drew down, I think, 15,000 troops over the past three months,

Howard Rubel - Jefferies

So, in fact we're replacing civilians to some degree or your services to some degree with US forces? And that would --?

Ralph D'Ambrosio

Right, and we also have another internal support contract that's closely related to Iraq and we're expecting that contract to grow about 20 million this year, which is about 15%; even though we are drawing down troops. So, it is very difficult to make any general assumption about what happens to services or sales levels. When troop levels come down, you have to really get into the nuts and bolts or the specifics of the underlying programs to understand what's going to happen.

Howard Rubel - Jefferies

What more, or in fact, sort of bearing out what Mike's pointing out is that they're going to require more of your services as we withdraw?

Michael Strianese

Right, I mean, even just in terms of that infrastructure protection, surveillance. You just think of the whole infrastructure system around the government military facilities and as well as the workings of the Ministry of Defense, with procurement and all, I mean, that's really in MPRI's domain to help with that changeover from US troops to the Iraqi nationals, and that is an occasion for additional services because we are being very cautious on this. And again, there will be pluses in some areas and there are certainly going to be minuses in others and on balance I think we are in as good a position as we can continue to provide support services, at least at the levels we are at right now.

Howard Rubel - Jefferies

I just have two more questions. One on C130s, you talked about lower volume there, and that is much more of a backlog driven business than some of your others. What do you see in terms of the market and do you see a quarter that may be down in revenues, because of either an aircraft, couple of shipments of some aircrafts or something like that?

Michael Strianese

Well no, it's manageable within our numbers. There will be a very modest impact in AM&M as contracts complete, new ones come online. I think the way we look at that market though is that the market for upgrade lifecycle support, life extension work on C130s internationally is a large market. The sales cycle with international customers is a longer cycle. So it's hard to get them to match up perfectly. One comes up and you are starting a new one. But that's what we do, and we are trying to keep the pipeline as full as we can, so we keep the workforce working on these programs. I don’t think this is something that's going to drive our numbers though in an unpredictable fashion. So we are pretty confident that we will be in pretty steady state.

Howard Rubel - Jefferies

And then Mike thank you, and then last on the ISR business. C3ISR business, it tends to be a little bit lumpy. When we look at what is happening with those assets, they have been highly stressed and you are in the middle of that market. Is there opportunity for more business? I mean, can you increase the turn times? Could you elaborate a little bit on what you see there, please?

Michael Strianese

Well, right now if you take (inaudible) churn for example, they are being used more than they have ever been used before and the turn times have already been improved to get them rotated back out into the field, in accordance with the customer’s request. The need for the persistent ISR surveillance is really unabated. I mean, you could even envision this as being even more important as troops draw down to keep the ISR assets in the air.

I think the limiting factor more than the availability equipment is going to be the infallibility of operators really and both Linguist to deal with the translation of infill data as it comes in, as well as pilots and air crews, because they are using up the resource. But we are running through people for a much longer period of time than ever before, which creates opportunities and more automation, more from UAV systems, more ground station support.

So, we continue to believe that our ISR in general and L-3’s ISR position in particular, will continue to grow, as we continue to fill the gaps that are needed because even if you look at the unlikely scenario going off a cliff in Iraq. The ISR requirement does not go away, just it continues on and on and on.

And I mean just look at the size of this BAMS program that north of one recently that is an ISR program for Broad Area -- BAMS is Broad Area Maritime Surveillance. That's an adjunct that -- there is not currently an aircraft doing that mission really other than the P3 and this certainly extends that because it’s recognizes how important this persistent surveillance is. So, we see this is going on and on and on. A lot of opportunities for L-3 going forward, not just Iraq related, but just broadly over globally.

Howard Rubel - Jefferies

Thank you very much.

Michael Strianese

Okay.

Operator

Your next question is from Joe Nadol with JPMorgan.

Joe Nadol - JPMorgan

Hi.

Michael Strianese

Hi, Joe.

Joe Nadol - JPMorgan

Okay. First question is on share purchase. Ralph, if you noted that you probably going to do more than 400, but I’m just wondering bigger picture, how do you approach share purchase quarter-to-quarter, is it opportunistic, is it just depending on everything else going on with M&A opportunities. Is it really it’s a cash flow in the quarter, because it really has bounced around a little bit the last 12 months or so.

Michael Strianese

Let me start off, Joe. We started out with a plan to the year, everybody saw where the market was probably in the year, as we were coming out of '07 going into '08. And I could tell you what is opportunistic to some degree. I think the average price for the share repurchase of this year is around a $105 a share. I mean, we know, where we want to be, for the year, and we view that again, this is all judgment. This is a lot of ways to do this.

It could be spread ratably over the year. We don’t correlate it to cash flow. We do keep an eye on acquisitions and what’s over the horizon and so we do, that is our cash balances. So, we can close our cash on hand. Like, in this environment with credit markets where they are, I think there is lot of value to having cash on the balance sheet, which we will be doing. So, there is a lot of area both (inaudible) Joe.

Joe Nadol - JPMorgan

Okay. And then secondly Mike, can you talk about your strategy for the EO acquisition, and how that kind of fits in to what you are doing, lot of night vision in there I think and it is a margin opportunity, is it a market share opportunity, what you’re looking at there?

Michael Strianese

It’s all the above and a little more Joe. First of all, as you know EO/IR business that we have in L-3 was, I say, running $500, $600 million and probably comprised of 6 to 8 different companies, all in the small size. But really cutting of course old technologies, we have one of the best stabilized (inaudible) on UAVs, or on the new MMA, perhaps a lot of different platforms.

But, there are gaps in technology on the ground side and on the army equipment If you will and this was just being opportunistic, the Northrop business is a great business. It’s sort of neck in neck with ITT or Night Vision systems for the dismounted solider. It’s a $200 million footprint by far margin than any of our other EO/IR companies.

So, it does give us an $800 million business, which would much more in terms of resources, customer reach, IR&D sharing and the like. It's just a natural fit, and it’s exactly the pipe things they had been saying that we would buy. And I think that, when we get the synergies worked out, there is margin potential there for margin expansion, that's the name of the game here, is to get the businesses running synergistically and more efficiently

And I’m sure under Jim Dunn, who is our Group President in that area and his team, that they’re just really to do a great job in integrating and developing a stronger player in this marketplace. We view this, by the way, as a very important market for us. So, delighted to have our first footprint now with $800 million, and given our growth rates I hope in another year we're at $1 billion in this space.

Joe Nadol - JPMorgan

And just one more for Ralph, just more for clarification than anything, in the C3 segment, the 140 basis points, is that a team adjustment, or is that what you considered to be a sustainable improvement?

Ralph D'Ambrosio

Those are sustainable improvements, John. There was no team adjustment pick-ups there.

Joe Nadol - JPMorgan

In the way you’re looking at margins guidance for the rest of the year, as you just kind of backing out the STE, which is you said kind of nonrecurring, or it is blip up in Q1 and then because you went to tangent set.

Ralph D'Ambrosio

Yes, it means. We were talking about STE declining for years and the last year we did about $62 million in sales for the full year on STE. This year it's going to be about $30 million less, but we happen to have a favorable comparison in Q1 year-over-year, which we are not going to have the remainder of 2008.

Joe Nadol - JPMorgan

Okay.

Ralph D'Ambrosio

That's kind of a nonrecurring item in Q1, but the rest of the margin improvements in C3ISR are just sustainable and we expect them to be recurring. In fact they could even get better, depending on how the remaining developments and certification efforts workout on the secure mobile environment product.

Joe Nadol - JPMorgan

Do would say this is a segment, where you could be towards the top-end or even above the top-end if things go right in terms of margins for the year.

Ralph D'Ambrosio

Yes and we look at all four of our segments. Structurally or naturally, you would anticipate that we'd have the best margin expansion opportunities in C3ISR and specialized products, because those businesses are more product oriented, where we have more adorable, sustainable competitive advantages. Whereas in government services and on the maintenance and CLSI with an aircraft Mod and Maintenance, it's mostly services, and those businesses tend to be more commoditized, even if they are not commodities, every time at a major competition, someone shows up with some type of qualification and a low price and also as a viable competitor.

Joe Nadol - JPMorgan

Right.

Ralph D'Ambrosio

So, it is much more important. Our price is much important in those two segments and that's why it tends to put a dampener on the margin expansion and the servicing work.

Michael Strianese

Okay. Thank you.

Operator

Your final question is from Ronald Epstein with Merrill Lynch.

Ronald Epstein - Merrill Lynch

Yeah, hey good afternoon guys.

Michael Strianese

Hey Ron.

Ronald Epstein - Merrill Lynch

And Mike yeah, congratulations on the Semper Fidelis award.

Michael Strianese

Thank you.

Ronald Epstein - Merrill Lynch

Yeah, just to get some clarification, because I think there has been a couple of questions kind of going down the same path. So when we think about L-3s exposure to the army. How should we think about that?

Michael Strianese

You say exposure to the army, you mean exposure to Iraq?

Ronald Epstein - Merrill Lynch

The army in general. I mean, just how much your business is, that goes to the army end customer?

Michael Strianese

Well, we have on it our chart.

Ralph D'Ambrosio

In 2007 it was 27% and that included 5% on Linguist.

Michael Strianese

Right.

Ralph D'Ambrosio

So if you take out Linguist, the army is probably the largest or the same size as the Air Force in terms of total consolidated sales.

Michael Strianese

What Linguist, tells that on us when we get to our steady state now, at about $150 million. Air Force was probably into that by a couple of percentage points. It came in at about 20%ish number, could be 21, 22. And as for the spread, pretty broadly among a lot of different programs. Everything from Fort Rucker and the helicopter work we do there, to the Mine Detection Equipment, to the guard rail work and it's pretty much all over it. If anything we'd like to have more exposure on the programs in particular, some of the new vehicle programs that are coming up like, JLTV, that will be long term and sustainable. So a strategy, if that's where we're going with this, would be, again, we're not going to go into the vehicle business of course.

Ronald Epstein - Merrill Lynch

Sure

Michael Strianese

But we would like to team as best we can, with some of our electronic content, whether it's the electronic suspension systems. We have COMS on the MU [Modernized User] equipment that can go on, and we have night vision equipments to go on. We have displays that can go on, and that’s our sweet spot and I'm really very strong on sticking to our knitting in this space. Let's put together the best competitors of electronics that we can, to offer on these vehicles. These are avocadoes bundled tougher. We do a lot in that sense. So that's where I am taking us in terms of strategy. They have more than you want to ask there.

Ronald Epstein - Merrill Lynch

Yeah, it's sort of related then, kind of jumping over to the Navy now. On the BAMS Northrop win, you guys are on that team. How big is that when we think about sizing it in our models for you guys?

Michael Strianese

I have Curtis Brunson who was formerly (inaudible) and is here with us on the call. And I was expecting that question. So here's Curtis, who was at Comm West when this was bid.

Ronald Epstein - Merrill Lynch

Okay

Curtis Brunson

Yeah Ron. It's due to -- well, if you’ve looked at what was announced, about a $1.1 billion, somewhere in that neighborhood. And we are roughly, I think, our number about roughly 9% of somewhere in the 9% range on the initial contract. But we are Combat Systems integrator, which gives us a very good position, because its product’s is both on the air and the ground and probably peripheral products also.

Ronald Epstein - Merrill Lynch

Okay, okay, great. And then Mike, just one last final question, when we think about over the next say, 9 to 10 months, what are sort of the big prices out there on the horizon that we should keep an eye for you guys?

Michael Strianese

The prices on the horizon, well, first of all.

Ronald Epstein - Merrill Lynch

Potential prices, I guess I should say.

Michael Strianese

The recompletes, first of all, are extremely important to us, both (technical difficulty) Contract Field Teams. The F-16 Mission Trainer, Lockheed Martin, new incumbent there we are competing on it. It would be a nice win as far as up-tick for future years.

In Australia, the project Air7000, where we are teamed with BAE systems, I think it would be a nice up-tick going forward. There is a B-2 Aircrew Training and Maintenance System on some of the larger platform, as I mentioned, where we have the team. The Aerial Common Sensor, obviously, would be a critically important program. Again we are teamed with Northrop on it. We think we have a lot of Northrop team is, we think is a very strong team, also the JLTV.

We are on multiple teams there. So, I don’t want to talk too much about what we have on each team, but some we have more contents and than others, that will be a long-term opportunity for us. Unlike last year, where we talked about HELIX and JCA, we have these large discrete ones. This is a more balanced year, and I would tell in terms of opportunities being spread across the company, while most exciting for us all to watch is less risky for us to manage, because there is a very broad portfolio of opportunities for managing, and I think it's less binary that it was last year.

Ronald Epstein - Merrill Lynch

Okay. Great, thank you.

Michael Strianese

Okay.

Karen Tripp

Thank you. This concludes our call.

Operator

This concludes today's conference call. You may now disconnect.

Michael Strianese

Thank you.

Karen Tripp

Thanks Kristen.

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Source: L-3 Communications Holdings Inc. Q1 2008 Earnings Call Transcript
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