Orbital ATK, Inc. (NYSE:OA) Preliminary Q2 2016 Results Earnings Conference Call August 10, 2016 9:00 AM ET
Barry Beneski - IR
Dave Thompson - President and CEO
Garrett Pierce - CFO
Blake Larson - COO
Noah Poponak - Goldman Sachs
Carter Copeland - Barclays
Joe DiNardi - Stifel
Gautam Khanna - Cowen and Company
David Strauss - UBS
George Godfrey - CL King
Michael Ciarmoli - KeyBanc Capital Markets
Good morning. My name is Kim, and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter 2016 Financial Results Conference 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.
Barry Beneski, you may begin the conference sir.
Okay. Thank you, Kim, and thank all of you who have joined us this morning as we report the preliminary financial results for the second quarter of 2016. Please note that this morning’s press release, the live audio feed for this call, and backup presentation slides are all available on the investors section of our website, which is orbitalatk.com. Following this call, an archive of the slides and a replay of the call will be available.
Joining me on today’s call are Dave Thompson, Orbital ATK’s President and Chief Executive Officer; Garrett Pierce, the Company’s Chief Financial Officer; and Blake Larson, our Chief Operating Officer. We will begin the call with opening remarks from Dave, Garrett, and Blake and then we will be ready to take your questions.
Before we get underway, I’d ask everybody to take note of the Safe Harbor paragraph that is included as chart three of our investor presentation and at the end of today’s press release. This paragraph emphasizes the major uncertainties and risks in the forward-looking statements we will make this morning. Please keep these factors in mind as we discuss future strategic initiatives, operational outlook, and financial guidance during today’s call.
And with that, I’ll turn the call over to Dave Thompson.
Okay. Thanks, Barry, and good morning, everyone. From a financial standpoint, Orbital AKT reported mixed results for the second quarter, as highlighted on chart four. Revenues were below plan but profit margins exceeded our targets and free cash flow was strong.
As Garrett will describe in more detail, two of our operating groups, Flight Systems and Space Systems, generated weaker than expected revenues due primarily to a slowdown in commercial satellite orders over the past nine to twelve months and secondarily, to lower quarterly sales in launched vehicles. On the positive side, these two segments reported strong profit margins and robust cash flow. As a result of these trends, we are lowering our revenue and cash flow guidance but increasing our margin targets for the year and confirming the Company’s previous earnings per share guidance for 2016 as well.
As the 8-K, we filed this morning, indicates company-wide review of division and program level management systems and financial processes and controls with a special focus on working capital efficiency triggered an in-depth review of one particular contract in our Defense System segment. This contract, which was awarded to ATK about four years ago, is for the production of U.S. Military small-caliber ammunition at our Lake City, Missouri plant. Our review ultimately determined that this contract had in fact been in a substantial loss position since 2014, rather than the roughly breakeven profit level that had been previously recorded. Due to a variety of unusual circumstances, material errors in cost estimating and tracking occurred as the contract ramped up in 2014, but were obscured until this intensive review brought into light. As a result, management now expects to account for this as a loss contract, primarily affecting fiscal year 2015 that is the April 2014 to March 2015 period, and to restate that year’s and subsequent period financial results to reflect this treatment. Garret will outline our current estimates for the income statement and balance sheet adjustments a little later in this mornings’ call.
Along with the other members of our senior management team, I am very concerned by this situation and absolutely determined that nothing like it will ever happen again. Over the past several months, we have carefully reviewed all of the Company’s large contracts and a majority of our mid-size ones together covering over a 30 programs. We are now completing a risk-based review of a subset of sum 150 smaller contracts. Altogether, the reviewed contracts and those in progress represent the vast majority of our current revenues, receivables and backlog. Thus far, we have discovered no material problems with any of them. Therefore, I believe the problems with the Lake City ammo contract represent a single isolated event that does not reflect on any other programs in Orbital ATKs’ dismissed portfolio.
Turning briefly to operations, development and production program performance was very strong in the second quarter. The Company conducted as the prime contractor or supported as the propulsion system provider six rocket launches. We also completed two spacecraft missions and four suborbital research flights. We delivered a near record number of tactical missile rocket loaders and warheads, made the transition from low rate to high rate production of our precision artillery guidance systems and produced and shipped about 375 million rounds of the ammunition in the second quarter. Finally, new business awards in the quarter totaled $1,845 million with each of our three business segments booking over $500 million in new orders and options. Firm backlog grew modestly to $8.48 billion while total backlog increased about 25% to a record $15.17 billion at the end of the June quarter.
Our first half total bookings exceeded $5 billion with the firm book-to-bill ratio of about 124%, so far this year. The Company’s second half outlook is for at least another $2 billion to $2.5 billion in orders at option exercises with the strong $500 million month in July, maintaining new business momentum as we started the third quarter.
To discuss our financial results for the second quarter, to address the restatements in our Army ammo program and to update our financial guidance for the year, I will turn the call over to Garrett. He will then pass the phone to Blake who will review recent operational activities and merger integration progress. And then, I’ll return to provide additional comments on new business wins and pursuits before we open it up for your questions. Garrett?
Thank you, Dave, and good morning. Please bear with me for a few moments while I repeat our important preamble for our discussion of the financial results. I want to remind you that ATK’s aerospace and defense businesses merged with Orbital Sciences Corporation in February 2015 and ATK’s Sporting business was spun off at that time. Consequently, we have reported GAAP results and adjusted non-GAAP measures in our earnings release. The non-GAAP financial results that we are discussing today have been adjusted to exclude merger transaction costs and integration related expenses that do not reflect our reoccurring operations.
We believe that the adjusted financial results provide our investors and analysts with a helpful understanding of the financial results and earning power of Orbital ATK in the current period in relation to the results of comparable periods last year. In addition, all financial information presented today includes preliminary estimated impact of the restatements that Dave discussed.
Reconciliations of our adjusted financial results to the comparable GAAP financial results are included in our earnings release and in the financial briefing charts on our website, or to the extent not addressed there but discussed on the call, will be available as an appendix to the transcript, and will be posted under the investors heading on our website. Furthermore, a complete disclosure of our GAAP financial results will be available in our second quarter Form 10-Q.
Finally, please note that the financial results that we are discussing today are preliminary, unaudited and subject to a revision due to ongoing review in connection with the Company’s announced restatement. For the second quarter periods, we have included the estimated effects of the restatement in the results.
I’ll begin by addressing our operating results for the Company on a consolidated basis for the second quarter of 2016. You will find the numbers and the chart as chart five, you should turn to that. First, as summarized on chart five, consolidated adjusted revenues for the second quarter were $1,052 million, down 2% from a $1,077 million in the second quarter of last year. As a result of lower revenues in the Flight and Space Systems segments offset by higher revenues in Defense Systems segment. Adjusted operating income for the second quarter 2016 was a $125.2 million for 11.9% of sales both up substantially from the $102.6 million and 9.5% of sales in the same period of 2015.
Our operating income and margin improvements were led by gains in the Flight and Space Systems segments and a favorable FAS/CAS pension impact. The increased operating income also benefited from stronger profit in the Defense Systems segment.
Our adjusted earnings per share in the second quarter of 2016 rose substantially, reaching $1.35 per diluted as compared to $0.98 in the comparable quarter in 2015. Again, this is largely attributable to the improved operating margins and the favorable FAS/CAS pension impact supplemented by a lower tax rate and reduced share count.
Before I start my comments on our reporting segments and other items, I want to address the situation with our Lake City small-caliber ammunition contract with the U.S. Army that Dave mentioned earlier.
At the outset, let me make it perfectly clear that over the 16 years that I have been the CFO of this Company, I’ve worked diligently to lead and create a financial organization with the highest standards of accurate reporting and accountability. The Lake City matter does not meet my standards. Furthermore, I personally led the effort of the finance team head on to complete the financial reconciliation of Lake City contract and institute the necessary corrective actions. These standards that I have outlined are sacrosanct [ph] and will not be compromised.
ATK was awarded a ten-year contract late in 2012 to produce small caliber ammunition at the U.S. Army -- for the U.S. Army and other military services, and to operate and maintain the Lake City ammo plant on behalf of the U.S. government. The fixed price contract as a total value over the period 2012 to 2022 of approximately $2.3 billion and currently generates $240 million to $250 million in annual revenue for orbital ATK that’s about 5% of the Company’s total sales.
As an earlier Army ammo contract was winding down, this new program moved into high rate production in fiscal year 2015. In order to provide the best possible value to our Military, the Company had to price the new contract aggressively. Despite vigorous and sustained efforts to achieve productivity improvements and despite realized and substantial cost efficiencies, our Lake City team was unable to reduce the production cost far enough for the contract to be profitable. At the same time, the implementation of a new ERP system in 2014 and other challenges obscured actual cost trends until our recent review.
So, based on management’s assessments and best estimates to-date, we believe that the Lake City ammo contract incurred a total pre-tax operating loss of approximately $400 million and an after tax loss of $250 million over its 10-year period. We believe it’s appropriate to recognize this loss in fiscal year 2015, which is the first year of large scale production under the contract. As our 8-K indicates, our review is still underway but the ranges of our adjustment for revenue operating income and after tax income shown on chart six are expected to bound the charges in the results for the fiscal year ended March, 2015 and subsequent periods.
Looking forward, we do not believe that these adjustments will result in material changes to our earnings for the balance of 2016 or in future years. However, the related adjustments are expected to reduce free cash flow by approximately $25 million to $30 million this year and by similar amounts in 2017 and in future years. As Dave outlined earlier, we have conducted a structured review of our contracts and have not discovered any material problems with any of them. Once this work is finished and the final accounting adjustments for Lake City are determined, we will file our Form 10-Q with the SEC as soon as possible.
Now, turning to our business segment results which in on chart five. I’ll preface the segment results discussion by saying that the Defense Systems results reflect our current best estimates of Lake City contract restatement, which does not impact either of our other two business segments. I’ll discuss this matter in more detail in a few moments.
In the Flight Systems segment, second quarter adjusted revenues were $370 million, down 5%, while the segment’s adjusted operating income rose 6% to $54.4 million on the strength of a 160 basis-point adjusted operating margin expansion versus the second quarter of 2015. A primary driver of the margin improvement stemmed from the CRS contract’s favorable contract adjustments in the quarter.
Now, turning to our Defense Segment, adjusted revenues for $441 million in the second quarter, up 9%, while adjusted operating income was $38.2 million and adjusted operating margin was 8.7% of sales. As noted earlier, we have included in the current estimates for the effects of the Lake City small-caliber ammunition contract restatement, both in this year’s and last year’s second quarters.
In the Space Systems segment, the second quarter 2016 adjusted revenues were $265 million, down 10.8% compared to the same period last year. While adjusted operating income and adjusted operating margin decreased to $32.9 million and 12.4% of sales respectively, quarterly revenues were down primarily due to the weakness in commercial satellite market, and operating income and operating margins were up significantly due to the CRS program’s favorable contract adjustment in the quarter.
Now, let me cover a couple other financial topics. The first is interest expense. Our debt-related interest expense for the quarter was about $15 million. Total interest expense of $16 million is flat with last year and includes $1 million of non-cash, non-debt interest item related to purchase accounting.
The second is taxes. Our GAAP income tax rate in the second quarter 2016 was about 28% versus guidance of 30%. This reduction, as compared to our previous forecast, is the result of better than expected benefits from research and development tax credit.
Now, focusing on cash. Our second quarter 2016 adjusted cash flow from operations was $143 million. Capital expenditures were $36 million. And adjustments for merger and other non-reoccurring costs were $4 million, resulting in an adjusted free cash flow of about $111 million in the second quarter. Free cash flow was positively impacted by a decrease in working capital, driven by lower accounts receivables in our Space Systems division, resulting from the timing of milestone payments. At the end of the second quarter 2016, our cash balance was $60 million. In addition, the Company has a revolving credit facility of $1 billion.
Regarding capital deployment, we returned $35 million back to our shareholders in the second quarter in the form of $17 million cash dividend and $18 million in Company stock repurchases. As of the end of July, we have purchased about a $125 million of common shares under the $250 million share repurchase optimization that runs through the end of 2016. We have the ability to buy back up to the remaining $125 million of authorization through the yearend.
Now, let’s turn to chart seven which summarizes our financial guidance for 2016. Primarily due to weaknesses in the commercial satellite market that we have discussed on previous calls, we are reducing 2016 revenue outlook by $125 million. On the other hand, we are raising the lower end of our EPS guidance by $0.05 and maintaining the upper end of the range driven by better margins and more favorable tax rate estimates. We are also adjusting our cash flow guidance down by $50 million to account for the effects of the weak commercial market and the reduced receivables in our Army ammo contract.
Our updated guidance at the end of the second quarter is as follows: Revenue in the range of $4,450 million to $4,550 million; adjusted operating income margin in the range of 11.5% to 12%; adjusted earnings per share in the range of $5.30 to $5.50 per share; adjusted free cash flow in the range of $225 million to $275 million which includes up to $200 million in capital expenditures. Other items include interest expense of $70 million which includes about $8 million of non-cash purchase accounting related expense. The tax rate will be approximately 28%; $80 million in FAS/CAS net pension income, which is recognized at the corporate line. We expect to pay about $70 million in dividends in 2016 and have $125 remaining on the current share repurchase authorization as of the end of the second quarter.
Thank you. And now, I will turn it over to Blake.
Thank you, Garrett.
As has been discussed, we’ve been working through Company-wide business optimization and working capital efficiency reviews, which identified the localized issue in the Lake City contract we described in our 8-K filing. This has been a three-phased risk-based process to initially review contracts of greater than $500 million in total contract value than greater than $100 million in contract value, and we are now finalizing the review of those greater than $5 million in value. This in-depth review has not identified any other areas within the business with similar issues.
We’re implementing decisive corrective actions, which involve process including systems, enhanced controls, and structure including personnel to ensure that we’re bringing best practices from the rest of Orbital ATK where we do not see these issued. We want to assure you that this issue is totally unacceptable to us, and we’re absolutely committed to improving our performance.
Moving to the operational highlights, we had solid operational performance in the second quarter and continued our priority to safely delivery innovative systems and products with best-in-class quality for our customers. We’re also delivering our merger-related synergies, which for 2016 will exceed our initial targets and which are driving improved profit margins. Orbital ATK’s second quarter operational execution led to the achievement of numerous milestones; these are summarized in chart eight and included the following important events.
In the Flight Systems Group, we completed two major ground tests of launch vehicle propulsion systems and launched several target rockets during the second quarter. First, in May, we successfully completed a 30-second on-pad hot-fire of the Antares rocket that tested the rocket’s modified first stage core and two liquid-fuel RD-181 engines as well as the launch pad infrastructure at Wallops Island, Virginia.
Simultaneously, the Company has been conducting final integration checkout of the flight vehicle that will launch the OA-5 mission to ensure that all technical, quality and safety standards are met or exceeded. Due to a variety of interrelated factors including the Company’s continued processing and inspection and testing of the flight vehicle at Wallops Island launch site and this massive scheduling of crew activities on the International Space Station in preparation for upcoming cargo and crew launches, Orbital ATK is working with NASA on a launch window in the second half of September. This would be about one month later than previously communicated, and a more specific launch date will be identified in the coming weeks.
Second, in June at our Promontory, Utah facilities, we successfully completed the final ground qualification test of the world’s largest solid rocket motor booster that will be used as part of the NASA’s space launch system. Also in the quarter, we launched a medium-range target rocket in support of a missile defense test and several short-range Coyote target missiles for the U.S. Navy. The Company also supported two United Launch Alliance missions with propulsion systems and composite structures and reached a long-term production milestone by completing its 500th large-scale launch vehicle composite structure during the quarter.
In the Defense Systems Group, we delivered about 6,000 tactical missile motors and warheads during the quarter and approximately 375 million rounds of small, medium, and large-caliber ammunition for domestic and international customers. We also supported two successful flight tests for the Missile Defense Agency of the Standard Missile-3 using the Company’s enhanced third stage rocket motor.
In addition, we achieved production milestones on several important programs, including the transition to full-rate production of approximately 10,000 annual units for the Precision Guidance Kit as well as first deliveries of the alternate warhead for the Guided Multiple Launch Rocket System.
We also successfully completed the transition and production startup of our Clearwater, Florida programs to our Northridge, California, consolidating our aircraft protection missile warning and common missile reprogramming hardware manufactures with our AARGM missile program.
In the Space Systems Group, we successfully completed the OA-6 cargo logistics mission for NASA in June which delivered a record amount of pressurized target for the space station’s onboard crew. After its departure from the station, our Cygnus spacecraft served for the first time as an in-space platform for scientific research that included first of its kind experiments, such as in-space combustion.
Earlier in the quarter, the Orbital ATK built Thaicom 8 commercial communication satellite which delivered, launched, tested and handed over to the customer for commercial operations. We also delivered the first four Iridium NEXT satellites to the launch complex with six more to follow in the coming weeks ahead of the late September launch of the first 10 satellites to replenish the constellation. We also launched two suborbital research targets, completed two high altitude scientific balloon missions, and delivered numerous satellite components for Orbital ATK spacecraft and other external customers. Finally, the Company-built Dawn spacecraft completed its historic nine-year mission to the main asteroid belt during which it returned never-before-seen images and other data about two near-planet sized bodies, Ceres and Vesta.
Moving to integration progress, in the past 18 months after closing the merger, we have essentially completed all pre and post-merger integration milestones and objectives, and received revenue and cost synergies that exceeded our plans.
Form a cost synergy perspective, after achieving $85 million in cost reductions in 2015, we are on track to exceed a $100 million in 2016, as shown on chart nine. About 60% of this savings are returned to customers through cost-type and negotiated contracts and through price reductions with the remainder contributing to increased competitiveness and the bottom line. From a revenue synergy perspective, we continue to make good progress on merger-enabled new business such as the satellite servicing contract award discussed last quarter, and we are on a path to generate a $150 million to $200 million in incremental revenue in 2016, primarily from our Space and Flight Systems businesses.
We have incurred approximately $65 million in merger related transition and integration cost to-date and are likely to expand approximately $5 million more through the remainder of 2016. We continue to focus on operational excellence and serving our customers who count on us for their important programs. Across all of our businesses, we also continued to perform well on core operational metrics such as safety and environmental excellence, cost of poor quality, supply chain efficiency and facility consolidation. This combined with our synergy savings is resulting in improved competitiveness and profit margins in our operations.
Dave, with that, I’ll turn it back to you for final comments.
Okay. Thanks Blake and Garrett.
As I noted earlier, new business volume in the June quarter totaled about $1.85 billion. This consisted of $1,590 million in firm and option orders and about $255 million in existing option exercises. About $1.2 billion or roughly 65% of the total volume came from seven relatively large new orders or option exercises, each worth more than $100 million, which I will describe in each segment’s totals.
As shown on chart 10, our Flight Systems Group contributed about $690 million of new orders and option exercises, or about 37% of the Company’s second quarter of new business total. Two large contract awards in our aerospace structures division accounted for about $500 million of the group’s new business.
In our Defense Systems Group, new business wins amounted to approximately $625 million in the quarter, or about 34% of the Company’s total volume. Two major orders and option exercises accounted for about $250 million of this total. These related to production orders for our AARGM tactical missile and operational support for several Company-supplied that light gunships in the Middle East.
Finally, in our Space Systems Group, new business wins contributed $530 million in the quarter or about 29% of our total. The contract awards from this segment included three major wins, totaling about $400 million. These consisted of one for a five-year scientific research rocket program from NASA, a second for the first satellite servicing vehicle for Intelsat, and a third for a defense satellite program.
Firm backlog at the end of June was about $8.48 billion and total backlog was $15.17 billion, as noted earlier increases of 1% and 25% respectively compared to this time last year. The contributions of each segment to backlog are also shown on chart 10. This backlog provides approximately 95% of our total projected 2016 revenues and nearly 70% of 2017 targeted revenues.
For the first six months of this year, the Company received approximately $5.07 billion in new options -- sorry, new orders and option exercises with about $2.14 billion coming from Flight Systems, $1.43 billion from Defense Systems and $1.50 billion from Space Systems. All three business segments have a positive outlook for new business in the second half of this year with over $550 million in total new business already booked in July and early August.
In summary, as shown on chart 11, Orbital ATK reported solid operating margins, earnings per share and free cash flow in the second quarter. While the Lake City contract restatement is very distressing to me, I am confident that accounting errors are isolated to this one program and do not reflect on the remaining 95% of our business. More generally, while it is certainly an unfortunate development, this single event should not overshadow an otherwise highly successful merger. And as we put the Lake City contract adjustments behind us, we continue to anticipate growth in revenues and earnings for the Company for a long time to come.
Looking to the future, we continue to build our contract backlogs with strong new business wins and to maintain solid operational performance on the Company’s major development and production programs. A year and a half into combined post-closing operations, the new Company has substantially completed merger integration and is achieving the cost efficiencies and revenue enhancements that we planned on or ahead of schedule.
Finally, as promised, Orbital ATK has implemented a robust and balanced capital deployment program with about $220 million returned to shareholders since the merger closed and another $100 plus million possible in the remainder of 2016.
With that recap, we’re now ready to respond to your questions.
[Operator Instructions] And your first question comes from the line of Noah Poponak with Goldman Sachs. Your line is open.
Hi. Good morning. When do you expect to file a 10-Q?
It’s Garrett. The answer is as fast as we possibly can. We have an extension for 90 days; we don’t plan to take that. Noah, this is -- an analysis of the Company has been on the front end of. But bear in mind, we have two sets of auditors involved. Our financial statements through fiscal year 2015 were ordered by Deloitte & Touche and the statements subsequent to that through the end of the -- well this just ended second quarter of PricewaterhouseCoopers. So, they have to go through their analysis. So, I would hope that we will be filing in the next 45 days. And I would hope it would be sooner than that. But we do that have 90 -- we’re not planning to take the 90. I will tell you that our external auditors, independent auditors are working closely with us and they are working together, so that the three entities that is management, PricewaterhouseCoopers and Deloitte are working together to get through this in the most efficient and effective manner possible.
Okay. Can you provide an update on the existing three-year cumulative free cash flow target that you have?
Noah, let me address that. As Garrett indicated, we’ve reduced this year’s target range for free cash flow by about $50 million. I would expect it will see something similar next year. And so, while we haven’t -- I don’t want to provide overly precise estimate for you. I would think that we would probably be looking at on the order of $100 million reduction over the three-year period 2015, 2016 and 2017. So, that’s coming off the prior target of about $1 billion over that same three-year period.
Okay. So, you would still anticipate pretty significant growth in free cash flow, 2017 versus 2016?
Yes, that’s correct.
What’s the variance between the 25 million to 30 million you mentioned for the Lake City revisions that are occurring versus the 50 million in the midpoints of the guidance range for the year?
Lake City represents about half the reduction, as you pointed out, most of the rest centers on the delays and the weak demand for commercial communication satellites. Historically programs in the commercial satellite sector have been fairly cash flow friendly to manufacturers with the significant early payments and with that business being weak, so far this year; we expect that some of the cash flow from anticipated orders will be deferred into the future.
So, you’re sort of rebasing -- when you talk about $100 million out of the three-year cumulative target, that’s a rebase of Lake City, and it sounds like that’s also then a rebase of commercial sat expectations for that entire period, as opposed to 2016 as weaker for comm sat and expecting that to then fully catch up in 2017 or something like that?
That’s right. In an approximate sense, we think both years will be about $50 million weaker than they were previously expected to be.
And your next question comes from the line of Carter Copeland of Barclays. Your line is open.
Dave, just at the core of the Lake City revelation, are we talking about bad estimating or actual bad actors here?
We do not believe, based on everything that we have reviewed over the last several months that there were any intentional misstatements. We don’t believe there was any fraud or any similar misbehavior. There were a number of -- as Garrett indicated, there were a number of factors that converged which in retrospect obscured the actual performance of the contract as it ramped up, beginning in2014. So, I think there clearly some -- a number of areas that require corrective actions, but we don’t think there was any misbehavior.
Okay. So, effectively, there were plans for enhanced productivity and/or volumes that just weren’t going to hit the curves that were sitting in the books?
That’s right. I mean, I would say that our Lake City team worked very hard to try to achieve the cost reductions that were assumed back in 2012 in the new contract to give the Army the best value possible, and they made tremendous progress. They just couldn’t get all the way there. It turned out to be a bridge too far. But they made tremendous progress; it just wasn’t enough.
And then, I guess as a follow-on to that from a higher level. If you look at the internal control systems that are in place for both of the legacy companies, how do they differ and what is this teach you about, pros and cons of each, and anything you can speak to there?
The control systems and the processes that we follow today represent the best practices of the two legacy companies. The systems in place premerger were not that different, but there were a few aspects of one or the other that seem to us to be superior, and those have been adopted now, Companywide. And as Blake mentioned, we have now reviewed the majority of over 30 large and midsize contracts, contracts having total value of $100 million or more and are well along in going through a risk-based subset of the 150 or so contracts that have a value between $5 million and $100 million, and no similar problems have been found. And the systems and the processes in place are working effectively and are being followed. So, this I believe is a single event and outlier with systems that as they existed for three or four years ago, might have been a bit deficient but we made sure that and are making sure that that won’t recur in the future.
Let me just add to that. The two restatements that you’re alluding to Carter, the first of which principally driven by the application of purchase accounting and the understanding the Company had, we felt was correct, and the view actually changed I think in the profession at that time. So, we adopted that. And that was the principal thing there. This item here is, as Dave pointed out, is we believe is isolated; it’s a business that’s much different than the rest of Orbital ATK including legacy ATK. It’s very high volume, a very simple product; it’s probably got six or eight parts to the building material; you are going to do $1.2 billion to $1.6 billion per year and it’s nothing on the order of what we do. So, I don’t think there is anything endemic here across the Company. And as Dave pointed out, we have looked at this vigorously. And we believe that that’s the case based upon the analyses that we’ve done.
And your next question comes from the line of Joe DiNardi with Stifel. Your line is open.
Dave, just on the free cash flow outlook again, can you just talk about what assumptions you are making around the commercial sat business for next year, maybe from a revenue standpoint or orders? And then, just on the A350 side, given that that’s been a little bit slow to ramp up, is that factored into the -- your expectation for maybe a $50 million cut next year, and does that start to help 2018 as that program eventually ramps up?
Yes. Good morning, Joe. Why don’t I address the commercial satellite side of that and I’ll ask Blake to comment on the A350 and any of the other commercial aerostructures projects we’re involved in. As we’ve discussed in the past couple of calls, the historically cyclical commercial satellite business is clearly in the down phase of a cycle. I believe that this is the result of pressure that many of the operators are feeling on their capacity pricing, compounded by new additions to their capacity that are emerging from the production pipeline now. So, I think the relatively weak demand that we saw in 2015 in which 17 satellites were ordered across the industry is likely to continue, not only this year but probably next year as well.
Now, so far this year, by our count, there have been eight commercial satellite orders across the industry. With the recent development, I am happy to report we’ve picked up our first order just earlier this month. Only one of the eight orders placed so far has been within our product category. Our forecast for the balance of the year is for another five to seven total satellite orders with one or two of those being in our glass. So, we’re still targeting two orders this year, one being booked now about midway through the third quarter and a second sometime in the fourth quarter.
Looking to next year, it’s a little hard to be -- it’s premature to be too precise about order expectations. But, I would expect that we won’t see a major recovery from the levels of 2015 and 2016 until sometime in 2018. And I hope I’m being pessimistic a bit here but that’s the current outlook in that business.
Let me now -- and with that in mind, cash flow reductions of $20 million or $25 million this year and roughly the same amount expected next year, reflect an assumption that we will book two orders both this year, and then two more orders in commercial satellites next year compared to the levels of roughly three per year that had characterized our business when the demand is on the upside of its cycle.
And, Joe, relative to the commercial aircraft and the A350 in particular, as you’ve seen elsewhere and true for us, the production ramp rate is moderating little bit as requested by the customer, our team has done a great job meeting all the ramp up and delivery requirements, we’re meaning customer deliveries. But within the quarter, we did reprofile the deliveries for the remainder of 2016 and out into 2017 as part of the result that presented. And to your point about the receivable on A350, it will spill, as we’ve talked about for some time, turn period cash positive by the end of this calendar year. But the unwinding will be delayed a little, which does put a little pressure on 2017 cash, not massively but it does have some impact there.
Okay, that’s helpful. And then, Garrett, just on the buyback, you got 125 left for the year that would imply kind of a ramp up the rest of the year to use that authorization. Is the plan to do the full authorization this year? And when does the blackout period ends that would allow you to start repurchasing stock after the quarter?
Well, we haven 12B 5 in place right now, which is a standard buyback. And so that’s in place right now. And it has a structure to it in terms of the volume that we can buy at a given price. That’s going to be the instrument what we’ll use. So, we’ll still be able to buy that stock under that regulation. So, that’s the answer to your question.
Any plan to use the full authorization this year?
Well, let the Board decide that. But obviously -- not obviously, but our stock buyback structure is the lower the price, the more we’re buying. And that’s a pretty set amount and range.
And your next question comes from the line of Gautam Khanna with Cowen and Company. Your line is open.
I had a couple of questions. First, I was wondering, could you rebase this on your CRS program margin, what you think you will exit the program at, CRS-1 that is?
Okay, yes. Good morning, Gautam. Well, we’re not for competitive and other reasons going to comment on the exact profit margins on a particular program or contract. As Garrett indicated though, with the risk reduction events, particularly the Antares hot-fire having taken place in the second quarter, we did incrementally increase the profit margin. There may well be opportunities ahead to do more of that as events take place. But, in terms of quantifying that, I think we want to avoid that for a variety of reasons.
I asked because in the 10-Q from Q1, you guys talked about 20 million EAC, [ph] mostly at Flight and Space, presumably mostly on the CRS. And after you reset the accounting on the Q4 earnings period, we know that the Q4 number is apples-to-apples to what has been reported subsequently. And so, if we did some reverse engineering, it appeared as though as of Q1, your program margin was something north of 10% and further. And -- which would justify such a large catch up in Q1. I believe in the past, you’ve talked about getting close to double-digit in CRS-1 eventually. But it appears just looking at the math that you were way above it in Q1 and obviously you derisked the program more in Q2 with the test. So, is there any sort of calibration you can give us on what you think, was it mid teens eventually or what is sort of that update because I think in the past you said close to double-digit?
Yes. That’s right. Well, I think I can give you maybe some approximations that will be helpful. When we started the CRS-1 contract back six years ago, five years ago when it was started to first generate meaningful revenue, we began to accrue at that time, at a mid single-digit rate, roughly 5%. We still had a lot of uncertainties ahead of us at that point, and so we thought it was the right thing to do to maintain a fairly hefty management reserve to address any risk that might actually materialize on the program.
As we’ve moved through it and are now approaching a relatively high percent complete on the CRS-1 contract, many of those risks have been reduced or eliminated. And there have been a number of periods over the last couple of years where we’ve incrementally moved the operating margin up, as a particular element of the management reserve has no longer been necessary because the associated risk has been mitigated. When those incremental increases happen, there is a cumulative catch up under long-term accounting. And so, the movement in a particular quarter it can be fairly large because not only is the adjustment applicable for that quarter but you are going back to all prior periods and affecting that cumulative catch up. As the contract rounds the final bend and heads for the homestretch over the next year or so, I think we will complete it in double-digits, probably not in the mid teens but certainly at levels that are comparable or slightly above the Company’s average today.
Okay. And, can you comment directionally how much room there is to go? I mean, are you at kind of 11% or 12% now? I mean, it would appear but that that’s the case. [Multiple Speakers]
That’s a reasonable range but until more work has been done and we’re smarter about how the next six to twelve months are going to play out, we would like to hold back from making any specific suggestions of where the final margins might end up.
Garrett, I just have to ask because we’re talking now about accounting that’s imperative. [Ph] In Q1, you had a launch with the new Cygnus but [indiscernible] engine technology, which kind of surprised me when I found [ph] the magnitude of Q catch up taken on the back of that launch. You are yet to launch the new re-engine RD-181. And so, should we have any concern that we have elevated the risk, because you’re at such a high Q catch margin -- take that margin now, ahead of the big event, such that anything goes poorly, it’s a long way to fall. Again, my read of Q1 and I’m just being very frank, that you pulled forward a lot of earnings by taking such a large Q catch on the back of what was a well guarded [ph] engine launch? I would love to hear your opinion on that.
This is Garrett. We have a management reserve and our estimate to complete that is highly documented in terms of the items both risks and opportunities that we see. And those are -- the foundation of that is from the engineering accounting standpoint, and it’s highly detailed as to what assumptions we’re making. And as we have successful steps tantamount to the launch, if we’re successful, part of that management reserve would be reversed. And that’s something, it’s highly judgmental, it’s laid out in very high details, specifically what needs to happen. And if we hit those milestones and it’s correct accounting, appropriate to release those or if we have some other problems set up additional reserves. So, we can go both ways and that’s how I’d answer your question.
And your next question comes from the line of Robert Spingarn with Credit Suisse. Your line is opened.
Good morning, this is Joe on for Rob. Thanks for taking my question. So, just a tie a loop on that, on the guidance, your updated margin guidance for Flight Systems implies a reduction of about a 100 basis points in the back half, even greater pressure on the Space Systems margins, down about 350 basis points. Is that just because you obviously had the favorable adjustments in the first half, and you don’t assume any in the back half, even though assuming successful launches were very likely to see those?
Yes. At this point, we are trying to take a fairly conservative outlook for all future periods, including the second half of the year. If things go according to plan with not only the CRS contract but may be some others, there could be some upside. But until we’re certainly that events in the business justify that, we would like to stay a bit on the conservative side.
And the two large contracts that together accounted for I think you said 500 million in the aerostructures bookings in the quarter, what were those programs?
We haven’t specifically -- well, I won’t break out the numbers but one was with the Rolls-Royce on engines, composite structures for aircraft engine and the other was a military program.
Okay. And then, Dave, could you just give us an update on the development programs, the three new growth initiatives?
Yes, sure. Let me just go through those one by one. Let me start with -- I’ll start with the satellite, the in-space satellite servicing project that we discussed earlier in the year. Our Space Systems Group early in the second quarter announced a five-year contract with Intelsat as the first customer for this satellite servicing system. Late in the second quarter, we completed a first system design review and placed long-lead material orders for the first of these satellite servicing vehicles, which is on track for delivery and launch in the final quarter of 2018; and after a checkout period, the commencement of service in the early 2019. Schedules, cost and the technical performance are proceeding as planned on that project at present.
In our Defense Systems Group, we at the beginning of the year initiated a three-year three-step research and development program to develop and produce advanced ammunition, particularly medium-caliber ammunition. In the first half of the year, we started testing and in the second quarter, continued with demonstrations of initial version of a 30-millimeter air burst round that works in conjunction with our own market standard medium-caliber gun systems. Also in the most recent quarter, we began detailed technical discussions with various military customers and industry partners, covering some of the work related to platform integration and related topics for this new generation of advanced ammo.
And then finally, in the Flight Systems Group, the Company and the Air Force continued to work in the first phase of what might develop as a four-year long joint development program aimed at fielding a new intermediate and large-class launch vehicle. Our investments this year, which are being strongly supplemented by the Air Force, are focused on the initial design and early development work. And in the second quarter, we complete the vehicle’s core preliminary design review in June. A joint Air Force and Orbital ATK decision about moving the program into full development is expected in mid-2017, based on our progress between now and then, and a variety of other factors.
And your next question comes from the line of David Strauss, UBS. Your line is open.
Dave, can you address -- you mentioned when you were talking about Lake City, the working capital efficiency initiatives. Can you talk about what’s come out of that besides the Lake City, potential, what you’re targeting in terms of upside on the working capital side?
Well, let me start at a general level and then I’ll ask Garrett, if he wants to add any specifics. Looking at both, the ending balances in 2015 and also total working capital at the end of the first quarter of this year, the metrics there clearly indicated some room for improvement. Part of our longer term cash flow outlook is based on improving receivables in particular. And we saw some progress in that regard this quarter, but we still have a ways to go. So, there are -- in the second quarter, the Space Systems segment made the greatest progress in that regard. And as we look out for the second half for the year, we expect to see not only more progress in that segment but also in the other two parts of the business. And I think that will continue to be a theme that we’ll talk about next year and probably well into 2018.
I’ just add to that, Blake and myself are leading this effort on behalf of the executive management to reduce unbilled receivables and looking at details of it and what actions we can take to monetize them, looking at potential contract terms that we’ve agreed to in the past that don’t enhance the ability to generate free cash flow. So, it’s a process that is moving and it will take some time. But, I’d say in the first 12 months, and we started it a couple of quarters ago or a quarter ago, I guess to say, to be exact. We’re targeting to take out a $100 million and to move on from there. That’s not the end point. We believe that the way our contracts are structured that we can improve that and also bring management focus to hitting milestones and ensuring that we’re turning the receivables and improving that.
I would just add to that David that coming off -- using our March quarter ending balance sheet as a base line over the next couple of years, we’re targeting to reduce days outstanding on receivables by almost a factor or two.
Okay, thanks for the color there. Back to Lake City, can you just comment on the magnitude of the charge? I mean, the charge or contemplating is really large. Can you -- I mean, it would seem that the assumptions around productivity or volumes were way, way off or is there some measure of conservatism here, just if you could just touch on that?
This is Garrett. We believe that we are conservative -- we want to be conservative. We don’t want to be unrealistic in terms of what we are talking about. But this is a 10-year contract. And way it works is there are delivery orders, the first seven are set to be executed over time; we’re in delivery order number four right now. And as we go from four, five, six and seven, there is a point there at point -- at delivery order seven where the customer, the DoD U.S. Army has a decision whether they are going to go on to eight, nine or ten. And they can say, we don’t want to go on for the next three delivery orders or we want to go on for one or two or all three of them, or none.
Our assumption, which I think is a good one is that they are going to want to go on to all 10 orders. This is an attractive fixed priced contract to our country. And I believe that we’ll go on through that period of time. So, every year, we’re producing somewhere in the order of $225 million and maybe $250 million in revenue over the 10-year period. So, when you look at it over 10 years and you look at the charge, it gives you a little more sense of a contract that’s $2.3 billion, and we do believe it will be executed over that time.
The fixed price contract, the largest single component in that is the material, which is brass and zinc, which translates to -- the metal that’s used brass in the bullet. That is pretty much fixed. So, the latitude we have is labor cost and overheads and the likes. And there is a lot of room to move on that. The contract also has the additional aspect that from the first delivery order through the 10th delivery order, the price drops each time. So, the price on each delivery order decreases through the last delivery order on 10. So, it’s a tough contract. Our people have worked very hard to improve the profitability. We will continue that by the way. The fact, we have set up the forward reserve is there for good accounting, but from a management standpoint, we will continue to attempt to reduce cost and improve efficiency at the facility. Blake, do you want anything to add to that?
I would just say, yes, to your point, it’s made up of a detailed review and so assumptions on operating efficiency, headcount, overhead rates, throughput and volume which this facility is very sensitive to. And to Dave’s comment earlier from the outset, the team has achieved more than half, two and half and two thirds of the objective cost reduction that the bid anticipated, but this restatement, as a result of that remaining amount not being achieved. And to Garrett’s point that we are turning over every rock and we’d be looking continuously for any economic opportunity going forward in any of internal processes or opportunities with the other customers. So, we’ll be pushing that hard.
And your next question comes from the line of George Godfrey with CL King. Your line is open.
Most of my questions have been answered. I just wanted to go back to the free cash flow reduction. And I heard your comments about the impact from commercial satellite and Lake City. And I’m just wondering, if there were any other negative influences on free cash, because if I look at your revenue guidance and the operating margin guidance, almost at all level your operating income is actually higher with the new guidance versus where it was. So, $50 million just struck me as a rather large impact. So, I just wondered if there were some other moving pieces. And then secondly, can you give us what the receivables balance was at the end of the quarter and do you have billed versus unbilled?
This is Dave. Let me try to respond to the first part of the question. We will see if -- while I do that, we can give you the numbers on the second part. No, there no other -- on a net basis, there are really no other major contributors to the cash flow change. There are always a few small puts and takes, but those pretty well cancel out and aren’t that big to start with. So, about half of the reduction this year stems from the Lake City ammo contract and the other half from commercial satellites. And we would at this point expect that pattern to largely be repeated next year. As Blake indicated, there might be a little bit of cash flow reduction coming out of our -- one of our commercial aerostructures program but that’s not going to be at the magnitude of the other two larger effects. Everything else see stable or has small few million here or there puts and takes. So, truly this is a big one.
And George, this is Garrett Pierce. We do not have a balance sheet to discuss with you today, we will when we file our 10-Quarter, but we do not have that here with us today. So, that it’s not possible to give you an exact number.
Okay. And then if I can just follow up, I heard your comments about reducing the DSOs and the working capital. What do you target for working capital as a percentage of sales or DSOs on a steady state basis? It sounded like you were targeting below a 100 days over the next couple of years.
I think that’s fair. We’ve been up around 150 or little higher. We would like to be below a 100. Exactly how much below we can go and when, we’ll have to see. But we would like to be below 100.
I think unwinding the two receivables we talk about regulatory, CRS and A350, then we would like to get the underlying business more, but you’d think of as industry normal for working capital as a percent of sales.
And your final question comes from the line of Michael Ciarmoli with KeyBanc Capital Markets. Your line is open.
Just back to Lake City, a couple of questions around it. These charges, this accounting, does it have tending impact on the commercial revenues that were being generated there and presumably the contract with Vesta? And then, the two second parts. So, is the go forward margin, presumably at zero now? And does the contract even contribute cash or is it sort of a forward cash burn profile?
Well, let me handle the first one. This restatement involves only the U.S. Army small-caliber production contract, not the commercial ammo production that we do for Vesta or any other smaller work we do in areas like non-standard ammo and so on. So, typically, the small-caliber systems division which is based in Lake City, it’s about a $600 million a year business; the Army small-caliber contract is about $250 million, and all the other activities with Vesta non-standard ammo and so on round out the rest of it. So, this affects just the Army contract.
And Michael, this is Garrett. There is two answers to your question. One, from an accounting standpoint, it will be zero margin, will not be a loss. So, we’re accruing for that now. And over each quarter and each year, it will not show any loss because the reserve will offset to the extent the embedded loss is that we were setting up in fiscal 2015. From an economic standpoint, there is negative cash flow, which we can tax effect; so when you do that, it’s about $25 million to $30 million a year going forward. And to the extent that we’ve incurred losses up to the current point, we can go back and amend our tax returns, and there will be a tax benefit that will come through to us which would offset part of this negative cash flow that I’m talking about.
Got it, okay. That’s helpful. And then, just the last one about the other pressure to free cash flow on the commercial satellite market, is that more just timing, Dave? I mean, because you guys were targeting two all year. You now basically got the one order and you could still get the second order this year. So, is it just those orders just happening much later because it seems like you could still be in position to get your objectives and your goals this year on the satellite orders?
Yes, you are right Mike. It’s really timing. Typically there within the first say 90 days of contract award, there are couple of major milestones that are scheduled, once those are completed payment events are triggered. With the second order not yet in hand and right now assumed not to be booked until the fourth quarter, we won’t have an opportunity to fully accomplish some of the early start up milestones that might have been possible, had we booked things earlier in the year. So, yes that’s mostly timing.
Okay. And then, just the last one quickly. Do we have to be concerned about the Antares launch if that slides towards the December or later, does that result in some free cash flow pressure, if that launch slides further into the calendar year?
Only if it was to really slide way into to the winter.
Got it, okay. Alright, perfect. Thanks guys.
Alright, with that, we’ll bring this morning’s call to a close. Thank you for joining us today and we look forward to speaking with you again when we report our third quarter 2016 financial results. So, this concludes today’s call. Thank you.
Ladies and gentlemen, this concludes today’s conference call, and you may now disconnect.
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