Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

L-3 Communications Holdings (NYSE:LLL)

Q3 2012 Earnings Call

November 01, 2012 11:00 am ET

Executives

Eric Boyriven - Managing Director

Michael T. Strianese - Chairman, Chief Executive Officer, President and Member of Executive Committee

Ralph G. D'Ambrosio - Chief Financial Officer and Senior Vice President

Analysts

Amit Mehrotra - Deutsche Bank AG, Research Division

Christopher Sands - JP Morgan Chase & Co, Research Division

Noah Poponak - Goldman Sachs Group Inc., Research Division

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

Kristine T. Liwag - BofA Merrill Lynch, Research Division

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

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

Brian W. Ruttenbur - CRT Capital Group LLC, Research Division

Jeremy W. Devaney - BB&T Capital Markets, Research Division

Operator

Welcome to the Q3 2012 L-3 Communications Holdings, Inc. Earnings Conference Call. My name is Yvette, and I will be your operator for today's call. [Operator Instructions] Please note that this conference is being recorded.

I will now turn the call over to Eric Boyriven of FTI Consulting. You may begin.

Eric Boyriven

Good morning, and thanks for joining us for L-3 Communications' third quarter earnings conference call. With me are Michael Strianese, Chairman, President and Chief Executive Officer; and Ralph D'Ambrosio, Senior Vice President and Chief Financial Officer. After their formal remarks, management will be available to take your questions.

Please note that during this call, management will reiterate forward-looking statements that were made in the press release issued this morning. Please refer to this press release as well as the company's SEC filings for a more detailed description of the factors that may cause actual results to differ materially from those anticipated. Please also note that this call is being simultaneously broadcast over the Internet.

I'd now like to turn the call over to Mike Strianese. Mike, please go ahead.

Michael T. Strianese

Thanks, Eric, and good morning, everyone. Thanks for joining us today. As you know, we rescheduled this earnings call from Tuesday due to the hurricane and the aftermath of this devastating storm. We hope that everyone, our investors, analysts and their families, are safe. We have many employees who were impacted by the storm and our thoughts and prayers are with them. Just judging by the headcount this morning on the call, it's about 1/3 of what we normally get, so I gather there is continuing issues across the community.

We had a solid third quarter. We performed well in our core areas across the company. We continue to execute well on our strategy of staying agile and adaptable and remain focused on growing market share and increasing our value for the shareholders. We achieved this by delivering cost-effective solutions and maintaining our excellent customer relationships across all our business lines. Our employees and management team are doing an outstanding job of increasing efficiencies, encouraging collaboration across the business and increasing market share in several areas, at all times performing with excellence, integrity and accountability.

Net sales for the quarter were $3.3 billion. That's down slightly from the third quarter of last year. We had diluted earnings per share from continuing ops of $1.98 compared to $2.02 for the same period last year. We reported funded orders of $3.2 billion, resulting in a book-to-bill ratio of 0.99 for the quarter. Our book-to-bill for the 9 months ended September 30 was a very strong 1.09, however. Funded backlog at the end of the quarter was $11 billion. That's up 11% compared to the beginning of the year.

Free cash flow for the quarter was $309 million. Regarding the Engility business, which was spun off back in July, our third quarter and year-to-date results for all comparative periods reflect Engility as discontinued operations.

We used a portion of the $325-million cash distribution from the spin-off to retire $250 million of debt. We plan to use the remainder to repurchase outstanding shares of common stock.

We also continue to evaluate our business portfolio and have been expanding offerings on our commercial and international business areas.

During the quarter, we also completed the acquisition of the commercial aircraft simulation business of Thales Group, which we now call Link U.K. I had the opportunity to visit the business last month in the U.K. I met with many of the employees there. All I can say is it is a terrific acquisition for L-3.

For our business segments, Electronic Systems sales for the quarter were up slightly due to increased sales in Microwave Products for both military and commercial applications; Sensor Systems from our acquisition of Kollmorgen Electro-Optical and Link U.K. We also had some declines in our Marine & Power Systems business due to lower demand for commercial shipboard electronic systems and reduced shipments of tactical quiet generators for the U.S. Army.

Sales of airborne ISR systems led our C3ISR business, whose net sales for the quarter increased by about 1% compared to the third quarter of 2011. These increases were partially offset by lower sales for network communication systems.

In our AM&M segment, net sales for the quarter increased by 4% compared with the third quarter of 2011. In addition to the Fort Rucker win and our support of U.S. Navy and Air Force aircraft sustainment programs, we also had strategic business wins in the international arena, with new work in both Korea and Canada.

Net sales in our National Security Solutions business declined by 16% due to decreased demand. We were selected for a quick-response cyber program for the U.S. Air Force and received a new IT support services contract with the U.S. Department of Veteran Affairs. Additionally, we received -- we recently opened our new National Security Solutions center in conjunction with Virginia Tech. This innovative partnership provides L-3 with access to R&D facilities and exclusive licensing rights to the products and services developed there.

Regarding the DoD budget and sequestration, unfortunately, there is still very limited clarity on the fiscal '13 budget and whether or not sequestration will be implemented on January 2. Politically, this uncertainty remains, and we're staying tuned to new developments and directives as they become known. In the post-election session of Congress, we expect that short-term solutions to sequestration may emerge to be followed next year by larger scale, longer-term deficit reduction efforts to be offered by the Congress. Recently, conflicting interpretations with respect to WARN Act guidelines have not served to clarify the situation.

In the meantime, we're monitoring everything closely. We're planning for how best to moderate the impact of sequestration should it occur. We are continuing to align our businesses for the long term to capitalize on growth and acquisition opportunities that may arise as a result of sequestration and any policy changes by a new or reelected administration.

In terms of awards or milestones during the quarter, I'll briefly make note of some of the more significant ones. In C3ISR, we received a full rate production contract for the U.S. Navy's CDL Hawklink high-speed digital data system. We also received an order for continued support of our ROVER products. I'm pleased to report that our new SPYDR platform successfully completed a training exercise for a NATO program in Europe, and we're providing continuous sustainment and technology insertion work on the Constant Hawk Program.

In Electronic Systems, our Microwave group received orders for our SATCOM equipment for use by the Special Operations Command, which included an increased contract ceiling that raises the total contract value to $600 million. The TSA selected us for an ID/IQ contract to supply medium-speed explosive detection systems, as well as our next-generation AIT technology, the ProVision 2. As we recently heard from news accounts, due to ProVision's safety, privacy and speed, the TSA is shifting to our millimeter wave technology at America's busiest airports.

We continue to receive strong orders for our Warrior Systems products for both military and commercial users. This includes an order for third-generation night vision systems for U.S. Army aviators. The Navy chose us to develop an undersea training range as well. Our newest acquisition, Link U.K., was selected by China Spring Airlines to provide 2 A320 Full Flight Simulators and 1 A320 Flat Panel Trainer system. We also delivered a system to a domestic airline in Russia.

The Marine Corps awarded us an order for our VideoScout products and related upgrades and support. We were selected by NASA to provide communications for the international space station, and we are providing continuing support of the WIN-T program.

For AM&M, we delivered the first aircraft as part of the SMIP 2 program, which provides aircraft sustainment services for the U.S. Navy's fleet of P-3, EP-3 and NP-3 aircraft. This sustainment work was completed 43% faster than previous processes, and we successfully fulfilled the customer requirement for more efficient turnaround time.

For Poland, we provided center wing box and avionics upgrades for a fifth C-130 aircraft, delivering the entire fleet of 5 aircraft ahead of schedule. We won a 5-year recompete for U.S. Navy and Air Force training aircraft for the aircraft intermediate maintenance depot. We were also selected, as part of a team, for a mission systems upgrade program for the P-3C aircraft for the Republic of Korea Navy. For the Canadian CC-150 Polaris program, we were selected for the interim support contract for both government and VIP transport and are performing very well on this program.

In National Security Solutions, the business was awarded an ID/IQ contract under the Agile Cyber Technology, or ACT program, a quick response cyber initiative. Several L-3 business units are members of this team, providing both hardware and software expertise. This is a 5-year program with a total contract value of $300 million.

As part of our ongoing commitment to shareholder value, we continue to take a disciplined approach to deploying capital and free cash flow to enhance our operations and return cash to shareholders. During the quarter, we repurchased $189 million of our common stock and paid dividends of $51 million. We continue to deliver a significant portion of our cash flow to shareholders through both our share repurchase program as well as our cash dividend, which has seen annual increase over the last 8 consecutive years. We remain strongly committed to this disciplined capital strategy.

Overall, we've returned $653 million in cash to our shareholders year-to-date. Our strategy for long-term capital allocation is a balanced program of share repurchases, dividends and a disciplined and focused approach to M&A. Our criteria for M&A remains to find companies that are good strategic fit, providing opportunities for collaboration with other L-3 divisions and to increase our market share.

As portfolios continue to be reshaped across the industry, the number of companies in the second tier continues to grow. We expect to see more companies become available as budget issues reach resolution. Over the past year, we have received dozens of opportunities that have resulted in 4 completed acquisitions to date this year. We'll continue to be disciplined as well as opportunistic in finding the right matches for L-3 going forward.

Ralph will now provide a review of the financials in greater detail, and then we'll go on to take your questions. Go ahead, Ralph.

Ralph G. D'Ambrosio

Thank you, Mike. I'll cover some more details about the third quarter and review the 2012 guidance update. Overall, we had a good quarter with results meeting or exceeding our expectations.

Diluted earnings per share were $1.98, down about 2% versus the third quarter of last year. And while there were several moving parts in our EPS comparison, essentially what happened was that lower operating margin was offset by a 7% decline in the shares outstanding. Consolidated sales were just under $3.3 billion, with only a modest 0.5% decline versus the third quarter of last year, and sales increased 4% sequentially versus the 2012 second quarter. We also continue to make good progress with our commercial and international sales, which grew 19% to just over $800 million and represented 25% of our consolidated sales in the third quarter.

Segment sales. We had modest growth in 3 of our segments, offset by a 16% decline in NSS. Consolidated operating margin declined 80 bps, but was still healthy at 10.1%. And what happened there was higher pension expense reduced margin by 40 basis points. And within the NSS segment, we took a inventory write-down charge and incurred some legal expenses, which reduced margins by 20 basis points. And sales mix changes, mostly in Electronic Systems, accounted for the remaining 20 basis points of decline in margin. Free cash flow was very robust at $309 million, and we converted 159% of our earnings to cash flow.

Moving on to the 2012 guidance update, we increased our EPS by $0.07 at the midpoint due to non-operational items, which are explained in the earnings release. We also tightened our consolidated sales guidance range to $13.0 billion to $13.1 billion, and there was no change in the midpoint versus the prior sales guidance.

At the segment level, sales guidance ranges were also narrowed to $50-million ranges. And at the midpoints, we increased Aircraft Modernization and Maintenance and NSS each by $25 million and decreased C3ISR and Electronic Systems each by $25 million.

The Electronic Systems segment guidance now also includes the Thales commercial aircraft simulation acquisition, which closed on August 6, and that will add between $60 million and $70 million to this year's sales. Also in that segment, we had a $70-million reduction to guidance for some DoD funding softness and less book-and-ship orders, which are really a very small reduction and I would say characteristic of the defense down cycle and not a surprise. The weaker euro also impacted our commercial marine business and is lowering sales this year by about $20 million.

Consolidated operating margin remains at 10.3%. And at the segment level, we had increases in C3ISR and AM&M, which were offset by decreases for Electronic Systems and NSS. Free cash flow stays at $1,045,000,000, and it's approaching $11 per share.

If you take a look at the fourth quarter outlook, and you can calculate this by subtracting our 9-month results from our guidance, sales will be somewhere between $3.4 billion and $3.5 billion, margins about 10.4%, with EPS between $2.05 and $2.15. Free cash flow is going to be very strong at about $470 million, and we expect the book-to-bill ratio to be 0.9.

I'd also like to share with you our preliminary outlook for next year. The major assumptions in this outlook are that the sequestration cuts are avoided and that there are no meaningful reductions to the DoD FY '13 plan and budget.

For sales, we expect a decline of about 3%, and that's going to be due entirely to the Afghanistan drawdown. Margins are going to be lower by about 30 basis points to 10%, with minus 10 bps coming from higher pension, and the rest of the reduction, which is 20 basis points, from changes in sales mix. Earnings per share, we expect to increase between 2% and 4%, and our free cash flow is going to continue to be very healthy, over $1 billion and about flat with 2012. We'll provide you more details about 2013, including the segments, at our Annual Investor Conference, which will be held next month on December 4.

I'd like to conclude my financial review with a few thoughts. The current environment is challenging, but it is also manageable. L-3 is very healthy, and we're doing a very good job of managing in this defense down cycle. We're continuing to generate solid financial performance, and we are getting stronger with our recent market share gains and disciplined capital allocation, including the portfolio-reshaping actions that we took earlier this year.

Thank you, and we'll go to the Q&A now.

Question-and-Answer Session

Operator

[Operator Instructions] We have Amit Mentura (sic) [Mehrotra] from Deutsche Bank.

Amit Mehrotra - Deutsche Bank AG, Research Division

It's Amit Mehrotra here for Myles Walton at Deutsche Bank. Can you just comment on the acquisition pipeline? If I remember correctly, you were in the early stages of some discussions last quarter. So can we expect some announcements in the relatively near future?

Michael T. Strianese

There's nothing that I would call significant in terms of size, although there are several companies we are -- as we always are, in discussion with. And it's really not at a point where we can comment about whether there'll be anything impending before year-end. We'll provide further updates. I guess, the next time we'll be talking is the Investor Day coming up in early December. I'd say, as a general note, those that are out there in the marketplace in the sell process are anxious to get transactions completed by the end of the year due to their planning and tax considerations. So it's quite possible that we see something in the $100-million neighborhood, but I can't commit to it at this point. So we're always looking in this area.

Amit Mehrotra - Deutsche Bank AG, Research Division

Okay. That's helpful. Just one follow-up on margins. You guys have done a great job in managing margins in a tough environment. But in an environment of sequestration or continued revenue declines, how should we think about the margin trajectory and the ability to, sort of, hold the line, so to speak?

Ralph G. D'Ambrosio

Well, our objective when it comes to operating margin is to hold them at, at least 10%. And while there's a lot of uncertainty out there with sequestration looming, when we take a look at our cost structure across our business units, what we think, it's very flexible and adaptable. Ultimately, if you take a look at what's truly fixed versus variable cost, we only have about 5% of our cost structure at the operating income line that is truly fixed, and that would include the corporate spending as well. So we think that gives us the ability to react quickly to resize our businesses, should we have to in the face of any future budget cuts.

Amit Mehrotra - Deutsche Bank AG, Research Division

Okay. Just a last quick question on cash return. I know, strategically, it's targeted to be balanced. But I guess, in light of a top line-constrained outlook, how do you think about the growth in that cash return to shareholders?

Michael T. Strianese

Well, I -- it's going to be a function of, of course, what the free cash flow is, which is going to be driven by volume and our operating income. There are no plans to change that strategy. Namely, we've gone through 8 consecutive years of increasing our dividend. That is still our plan, to increase the dividend. And in terms of the share repurchase program, where -- we're in an environment where acquisitions, the number and amount spent annually is decreased in this environment. We've always used the cash there to repurchase stock, and that is not going to change. As we've seen in the past, historically, for declining defense cycles, there will be acquisition opportunities that will present themselves. We have sufficient dry powder to be opportunistic in that area. As you might recall, L-3 was formed and founded during the last -- one of the last down cycles, and some of the most important, larger acquisitions we've done have been during down cycles. So we're optimistic that, one, we will continue to provide an increasing dividend; that we'll stay focused on returning cash through our share repurchases; yet, we'll stay flexible to address acquisitions as they become available.

Operator

Our next question comes from Joe Nadol from JPMorgan.

Christopher Sands - JP Morgan Chase & Co, Research Division

It's actually Chris Sands on for Joe this morning. A quick question for you. It looks like the inventory and legal charges were only about half of the reduction in margin for NSS for the year. I'm just wondering if you could comment on if you've seen labor turnover or voluntary attrition, or if there's any productivity issues there.

Ralph G. D'Ambrosio

Sure. Well, let me take you through the entire change in the margin guidance for NSS. So the inventory charge and legal expenses reduced the full year margin guidance by about 50 basis points. We're probably going to have another $1 million-or-so of legal expenses in the fourth quarter. And additionally, we're seeing some higher volume of material sales in our enterprise IT business. It's essentially IT equipment, and those sales come with very low or no margin, and that's also the diluting the margin there by about 10 or 15 basis points. So -- but those are the major changes in the NSS segment guidance. With respect to the rest of your question, we're not really seeing any increases in turnover, including on a voluntary basis.

Christopher Sands - JP Morgan Chase & Co, Research Division

Okay. And -- no productivity issues either?

Ralph G. D'Ambrosio

No. And in fact, we've been continuing to reduce and resize that business the last couple of years for the decline in volume that we -- that we've had there.

Christopher Sands - JP Morgan Chase & Co, Research Division

Okay. And then, a quick follow-up on share repurchase for this year. It seems like the guidance implies there will be a big pop in Q4 relative to where it's been in the last 3 quarters. Is that correct? And any reason it's like that?

Ralph G. D'Ambrosio

Well, that is correct. We still expect the share repurchases to be about $875 million this year, and it's actually in our web charts for the third quarter, which are posted on the website. And the reason we're going to have more in the fourth quarter -- it's going to be just above $350 million -- is that in the third quarter, not only did we complete and pay for the Thales commercial aviation simulation business, but we also repaid $250 million of our debt. So we have a balanced approach to cash flow and deployment, that is. And for that reason, we'll be doing more share repurchases in the fourth quarter.

Operator

Our next question comes from Noah Poponak from Goldman Sachs.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Just another -- I wanted to try another capital deployment question, which is, the total free cash flow and total return to shareholders is clearly very strong, but the mix of dividend versus buyback there -- the dividend yield is still one of the lower ones in the group. I'm just wondering what investors are saying to you with regard to that, and how the board and yourselves are thinking about that dividend yield.

Michael T. Strianese

Well, generally, no, we don't really discuss individual discussions with investors. But I will tell you, in general terms, there's mixed views between more share repurchase, more dividend or more acquisitions, for that matter. This year, we heard a number of comments about investors generally loving the Thales acquisitions and "Please do more like that." Now it's not quite that easy. You have to find the companies. In terms of the considerations that the board goes through every year, when we discuss whether and how much do we increase the dividend, is the business outlook. And as you know, over the last year or 2, the business outlook has been dicey because of sequestration and the budget. And taking a realistic view, it wasn't necessarily the best occasion to have an above-average or above-the-normal run rate increase to the dividend. I think that, as things settle down, there's that possibility. But our long-term goal is to provide increases similar to the increases we've had in the past and to do so consistently and to stay on that track.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay. That's helpful. Is it safe -- it sounds like it's safe to assume the '13 -- 2013 2% to 4% earnings growth that Ralph just mentioned includes a pretty similar split between buyback and dividend payment and a roughly similar absolute share repurchase dollar number compared to 2012.

Ralph G. D'Ambrosio

Actually, the dividends are fairly consistent, but the 2013 outlook for EPS only assumes $0.5 billion of share buyback next year compared to the $875 million that we're doing this year.

Operator

Our next question comes from Michael Lewis from Lazard Capital.

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

Michael, I was wondering if we could talk about market share. I guess, what segment within the portfolio do you expect that you'll see the strongest momentum on takeaways from peers as we progress over, say, the next 2 to 4 quarters, setting aside the sequestration?

Michael T. Strianese

Well, we've been having the best experience at the moment in the AM&M segment, where we have been growing both domestically and internationally in a variety of areas, from base support operations through VIP/Head of State aircraft to the program in Canada, where we're taking care of the Head of State/VIP. In the -- and then, there's pockets of growth when you go through Electronic Systems. For example, I mentioned during my commentary that the ProVision system is now being expanded in terms of deployment across some of the major U.S. airports, where it used to be a [indiscernible], consistently growing market share there. In terms of the simulation and training business, with the Link acquisition, we are first adding a whole commercial line of commercial aircraft simulators, as well as -- which is new for L-3. But in addition, we've been winning more business because our focus is somewhat different than the Thales focus in terms of being aggressive in pursuing markets. It is an important line of business for us as well. We are always looking to expand the ISR business, especially airborne. It may not always be apparent in the numbers because we're dealing with headwinds related to the OCO account. But nevertheless, we've been pretty much able to offset some of those headwinds. In the marine electronics business, we've been expanding in areas for hybrid electric drive, for example, the DDG-51 program as well as the generator system for the LAMPS helicopters. So those are some of the areas. Obviously, it's our goal to expand market share everywhere in the company that we can because given the flat-to-down budget -- really a down budget, when you take the OCO into account -- other than getting additional awards and growth in our existing programs, the only way to really grow is to take market share from others. So that's a big focus for us right now.

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

That's very helpful. I appreciate that. And then, just one follow-up for Ralph. Ralph, as we look at NSS, with the business now core, are there any major recompetes that we should be focused on right now over the next 2 or 3 quarters?

Ralph G. D'Ambrosio

Sure. There's one major recompete that we have at the end of next year at NSS, and I talked about this one on the last earnings call. It's a IT support job for an Intel-type customer. It's about $200 million a year in sales. And if the recompete remains on schedule, the new contract will start October 1, 2013. At this point, there's a possibility that, that could be stretched and our incumbent contract could be extended another year. But the key point for L-3 is that, that contract is the only major recompete of any kind with -- of a contract that generates $100 million or more a year in sales, for the next several years. So with the Fort Rucker win behind us, we don't have any major recompetes approaching that size for several years.

Operator

I have Kristine Liwag from Bank of America.

Kristine T. Liwag - BofA Merrill Lynch, Research Division

My question has to do with C3ISR. So when we kind of look at your guidance through the year, it's kind of trended down since you first provided 2012 guidance and it seems like it's mostly due to sales mix. So I was wondering if -- is this kind of the longer-term trend? Is there more demand for the lower entity [ph] through ISR? Or are you seeing more pressure in contracts in general? So I was wondering if you could explain if you know what you're seeing in that environment.

Ralph G. D'Ambrosio

Well, Kristine, are you asking about the sales or the margin or both?

Kristine T. Liwag - BofA Merrill Lynch, Research Division

I guess, both.

Ralph G. D'Ambrosio

Okay. So let me handle the sales first. And if you look at how we've updated our guidance in that segment this year, we've only reduced it by narrowing the range by $50 million and taking that from the high end. And the reason we do that -- we did that is because, this year, there were a number of orders that we were pursuing, and we in fact recorded those orders, but they happened later than we thought they were going to happen. And the 2 big ones were the data links for the Grey Eagle and the Shadow program. And as a result, some sales that we thought that would have been happening this year are going to be happening next year in that segment. That said, the growth rate has slowed, but we still expect it to be a modest grower, prospectively. With respect to the operating margin, we did have a sales mix change this year, and I talked about this earlier in the year as well and it pertained to a change that we were seeing in the small ISR aircraft business, where we were transitioning from modification work to more sustainment and fleet management support work, and that carries with it lower margin. And then, of course, we did have a big impact for higher pension expense in that segment. In fact, that segment is bearing the brunt of our higher interest -- higher pension expense for 2012 versus 2011. Prospectively, and we'll get into these details at the investor conference, we expect the margins to modestly improve in C3ISR.

Operator

Our next question comes from Peter Skibitski from Drexel Hamilton.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

I guess, kind of dove-tailing off the last question but more so looking into 2013, Mike or Ralph, the 20 basis points of headwinds to the margin rate that you cited from sales mix, is that just you're getting greater margins on product you're supplying into Afghanistan, and with that coming down, that's pressuring margins? Or is it something else?

Ralph G. D'Ambrosio

That's the major driver behind it, Pete.

Peter J. Skibitski - Drexel Hamilton, LLC, Research Division

Okay, okay. Do you guys see any opportunity to that guidance in terms of cost takeout or other opportunities to beat that margin rate that you cited?

Ralph G. D'Ambrosio

Well, we always try to beat our margin guidance. But there's a lot that has to happen between now and the end of next year, and a lot of it we can't control when it comes to the budget situation. So I think it's about right for what we're currently seeing and anticipating at this point in time.

Operator

Our next question comes from Bill Loomis from Stifel, Nicolaus.

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

I have a couple of margin questions. So first on NSS, even if we take out the 2 onetime events, it looks the margin was around 5.8% but the guidance implies improvement to roughly 7.5%. I wonder what's -- are you saying -- is that because of costs you've taken out of the business? What are the key drivers there outside of the 2 nonrecurring events not happening in the fourth quarter? Plus, you -- I think you mentioned $1 million in legal expenses in that, too.

Ralph G. D'Ambrosio

Bill, the key driver in the fourth quarter margins of NSS is going to be the timing of when we earn award fees. And the award fees tend to be very lumpy and we recognize them into profit when they're actually awarded. We don't accrue award fees.

William R. Loomis - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then, just another margin question on AM&M, just kind of just the opposite. It looks like the guidance is implying a softening in the fourth quarter below what the run rate's been. What's the key issue there?

Ralph G. D'Ambrosio

A couple of things there. First of all, we've had very significant contracting improvement -- contract performance improvement driven by operational and cost efficiencies the first year of -- the first 9 months of this year, and that's not the type of thing we want to continue anticipating in the margins. And secondly, as we start working on a couple of the new sustainment or CLS programs, the margins are a little lower. And so that's what's driving the lower margins in the fourth quarter.

Operator

Our next question comes from Yair Reiner from Oppenheimer & Co.

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

Just, first, a follow-up on the margin question. Can you talk about the sales mix that's bringing the Electronic Systems margin down? Exactly what's going up in the mix and what's going down?

Ralph G. D'Ambrosio

You mean for this year or for next year?

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

I guess, if there's a -- I guess, for both.

Ralph G. D'Ambrosio

Okay. Well, for this year, the major driver is that we had volume declines versus 2011 in our tactical quiet generator product line and also in the night vision image intensification tubes. As we move into next year, the change in sales mix is going to be on some of the EO/IR turret work, namely on the aerostat programs. That is going to decline very rapidly given that the ISR surge in Afghanistan is largely behind us, and they've deployed most of that equipment in theater already. So that's what's going on there. It's volume in a couple of those product lines.

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

That's helpful. And then, just a question about the DoD contracting environment. Have you seen any change in the last couple of months as we head closer to the end of the year and kind of closer to January 2?

Ralph G. D'Ambrosio

Well, what we're seeing is generally what we expected to experience this year given the backdrop of the overall environment. And our orders have actually been a little stronger than we anticipated, with a lot of that strength coming from market share gains that Mike talked about earlier, particularly in the AM&M platform systems business and in the broader international sales that we have.

Operator

Our next question comes from Brian Ruttenbur from CRT Capital.

Brian W. Ruttenbur - CRT Capital Group LLC, Research Division

This is for Ralph. I wanted to understand, kind of going forward -- if you keep a downward trend on revenue of a couple of percent going forward and margins -- operating margins flattish from -- '13 levels around the 10%, what you gave guidance on, how long can you keep earnings growth -- earnings per share growth? I'm just trying to understand the leverage that you have by buying back shares and using your cash wisely down the road. Can you continue to grow for the next -- earnings for the next several years? Can you give some kind of estimate on that?

Ralph G. D'Ambrosio

Brian, excepting any major disruptions with the DoD budget, we think that we can continue to sustain low-single digit EPS growth. And at some point, the pension expense is going to go from a headwind to a tailwind. We thought that would happen in -- going into 2013, but we had a big reduction in the interest rate environment and that's driving down our discount rate about 80 basis points. And that's why, for next year, instead of seeing a $15-million to $20-million reduction in pension expense, we're going to see the opposite, a $15-million to $20-million increase. But at some point, the pension is going to turn around. It has to because we froze the pension plans to new hires in 2007, and I really don't see a situation where interest rates continue to go lower from where they are right now. But we'll see what happens in the future.

Operator

Our final question comes from Jeremy Devaney from BB&T Capital Markets.

Jeremy W. Devaney - BB&T Capital Markets, Research Division

First question is actually for Ralph. I was wondering if you could talk a little bit about the cash return to shareholders versus debt pay-down. Previously, you've indicated that debt pay-down would be a bit of a higher priority. Is this still the case? And what's your plan for debt pay-down going forward?

Ralph G. D'Ambrosio

Well, what the -- the reason we're doing some modest debt repayment is because one of our financial objectives, which we talked about in the past, was to -- is to maintain or preserve our investment-grade credit ratings. We became an investment-grade credit at the end of 2009 at the first tier, which is BAA3 and BBB-, and that's where we want to stay. We think it's important to have the investment-grade credit rating, especially that's what the crisis taught us from a few years ago. And at some point, we're going to start growing our operating income again. But as we're going to come out of the cycle at some point, it's going to turn. And when it does, we're probably going to take up our leverage and stay within that credit rating, so that we'll have the added financial leverage from using debt more efficiently on our capital structure. So prospectively, we see a little more debt reduction but not a lot more. And once we gain some confidence that the cycle is going to turn, we'll quickly, quickly adjust our cash deployment strategies accordingly.

Jeremy W. Devaney - BB&T Capital Markets, Research Division

Many thanks for that detail. Mike, when you look at FY '13, the preliminary guidance that Ralph provided is excluding sequestration. But in your earlier comments, you didn't sound overly optimistic that a resolution was pending. Could you give us some color on the discussions that you're hearing in Washington? And then also, what would your plan look like for next year on a preliminary basis if sequestration were to happen?

Michael T. Strianese

Sure, Jeremy. The discussion that that's kind of widely circulating, I think it's in the financial press as well, is that regardless of the election outcome, some action will be taken. In fact, at the last debate, if I'm not mistaken, the President actually said that sequestration is not going to happen. Now notwithstanding the fact that, that is enacted law, what seems to be the order of the day is that there will be either a short-term measure put in place that will defer, delay the actual implementation of sequestration while longer-term plans are being developed. As you know, there's a lot of moving parts at the moment, notably the expiration of the Bush tax cuts, if you will, the need to increase the debt ceiling, as well as sequestration. So there's a number of moving parts that I think will be part of a longer-term negotiation/resolution. So the way we view this is that, given that it is enacted law and given the fact that there is not a plan in place right now on how mechanically this gets averted, we are not taking an optimistic view until we hear something to be optimistic about. Notwithstanding that, we believe that if there is in fact sequestration, that the effects would taper in during the course of '13 and not be the full-blown 10%, 12% hit that it would otherwise be for a full year. So I could kind of bound the problem by about that amount, and I will tell you that we would expect it to be less just because of the way it would bleed in over the course of the year.

Okay. As that was our last question, just a concluding remark or 2. One, we will continue to deliver solid performance across our business segments, notwithstanding the persistent and challenging environment. Performance is evidence of a clear strategy, a committed workforce, strong program execution, customer focus and agility, which are the key discriminators for L-3. We'll continue to build lasting customer relationships, which do drive our business; and preserve and expand our strong market positions, which I think you've seen us do this year, when you look at some of the increases. And sometimes it gets lost, the fact that we're facing headwinds across the board, yet we're still able to post numbers that are somewhat flat to slightly up. So there has been expansion in a lot of our business areas.

In terms of optimizing the portfolio, we continue to focus on what the future is going to hold and to make sure that our portfolio is positioned correctly in the right places, at the same time, staying well positioned to take advantage of growth opportunities, whether it's market share-related or acquisition-related, as they present themselves.

So we look forward to seeing everyone at the Investor Day that's coming up on December 4, where we are happy to have a more in-depth discussion. It'll be on the other side of the election, so I'm sure there'll be new views that are going to be talked about. And of course, you'll hear from some of our folks in Washington that will be sure to have some interesting things to say. So with that, thanks for joining us, and we'll see you on December 4.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: L-3 Communications Holdings Management Discusses Q3 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts