L-3 Communications Q2 2008 Earnings Call Transcript

L-3 Communications Holdings, Inc. (LLL)

Q2 2008 Earnings Call

July 24, 2008 11:00 am ET

Executives

Michael Strianese - President and Chief Executive Officer

Ralph D'Ambrosio - Vice President and Chief Financial Officer

Karen Tripp - Vice President of Corporate Communications

Analysts

Rob Springarn - Credit Suisse

Joe Nadol - J.P. Morgan

Myles Walton - Oppenheimer

Cai Von Rumohr - Cowen and Company

Ron Epstein - Merrill Lynch

Presentation

Operator

Good morning, my name is Kristen, and I will be your conference operator today. At this time, I would like to welcome everyone to the L-3 Communications Second Quarter 2008 earnings conference call. (Operator instructions) Thank you Miss Tripp, you may begin your conference.

Karen Tripp

Good morning, everyone and welcome to the L-3 Second Quarter conference call. With us today are Michael Strianese, President and Chief Executive Officer; and Ralph D'Ambrosio, Vice President and Chief Financial Officer. As always, after our formal presentation, we will be available to take your questions.

During this call management will reiterate forward-looking statements that were made in the press release we issued this morning. Please refer to this press release as well as our SEC filings for a more detailed description of the factors that may cause actual results to differ materially from those anticipated. Please note that this call will be simultaneously broadcast live over the internet. I will now turn the call over to our President and Chief Executive Officer, Mr. Michael Strianese.

Michael Strianese

Good morning, everyone and thanks for joining us for the conference call. Results for the second quarter were released this morning. Overall we had a very strong second quarter and of course, I would like to begin by thanking the 64,000 men and women at L-3 for their hard work this quarter where we had excellent performance.

The funded orders were 4.2 billion in the quarter. It was a quarterly record for L-3. We thought the first quarter was strong, but that trend is continuing. The book to bill ratio or orders out-paced sales by 13%, 1.13 was the book to bill ratio, which is very strong. Funded backlog is up to $11 billion, that is up 15% from the beginning of the year. It is also a record number for us and it sets us up nicely for the rest of 2008.

Sales grew about 9% to 3.7 billion and for the second quarter our earnings per share grew 12% to $1.67. That excludes the unusual items in the quarter which aggregated a net gain of $0.57. Margins, excluding those unusual items, improved by 10 basis points, to about 10½ %. However, if you went to the segment details you will notice we settled several claims during the quarter. So operationally the margins are actually up 50 basis points, excluding the claim settlements. So operationally we continue to achieve efficiencies.

Free cash flow was exceptionally strong in the quarter. Again, a quarterly record, north of a half of a billion dollars in free cash flow for the quarter. We were a little low in the first quarter, so we are exactly where we want to be here at the half, actually a little ahead.

During the quarter, I am sure everybody has seen the release, but back on June 27^th the U.S. Court of Appeals for the Second Circuit issued a Judgment reversing the $126 million jury verdict against L-3 received back in May 2006. That was significant for us. The Appeals Court ruled that L-3 did not breach its contract or commit fraud among other things. And we were all very proud of this development which underscores that L-3 is a good and law-abiding company. It also eliminates the cash overhang that we have had. So of course, the gain relates to that item.

We had numerous new awards and business wins. When you look at the first half, we have over $8.3 billion in first half orders and the book to bill for the half is 1.15. Orders outrunning sales by 15%. We expect this to moderate in the second half, but still be strong because some of those orders came in earlier. They were originally forecasted in the second half and showed up a little bit early. But we did have some notable wins.

Basically across the whole company on the follow-on orders. We had additional joint cargo aircraft orders were placed. More work on rivet joint, more work on fab T (ph 00:04:31), Big Safari, T3 work, Flight School 21. More work for Bradley Transmissions, electro-optical infrared turrets. You have probably seen in the press that the TSA is installing new passenger scanning equipment in airports. We are participating in that program with our pro-view imaging system using millimeter wave technology to scan passengers. We have been talking about this over the past year with you and we are starting to see progress in that area. In addition our SAM electronics business in Germany is doing very well too. That is commercial electronics equipment for ships.

In terms of re-competes for 2008, we had two major ones, with very different dynamics. One of them has already been decided and we did retain our incumbent's position on contract field teams. That is a multi-source program for major incumbent suppliers including L-3. That was announced by the air force about a week ago. In terms of our content we do about $450 million in sales a year on CFT. Currently it is our largest program in terms of annual sales. There will be more competition on the new contract which begins in October. So the winners will compete for task orders. But again, it was very important for us to retain our incumbency.

The other re-compete will be later this year. It is JOG or the Joint Operating Group. That is also a contract with SOCOM for the special operating forces, elections in Kentucky. We expect the final request for proposal to come out on August 1^st. The current contract ceiling is about 2.1 billion, with annual sales of about 350 million. We expect a new contract will be $5 billion over 10 years and should be awarded by the end of this year. Or it could slip into the first quarter, but I think they are going to stay on track with this one. It is an important contract for us and we have everybody focused on bringing that one in and winning.

Joint cargo aircraft. Again, a new program. Won last year. Our first delivery is due in September. Their performance continues to be very good and I expect the first aircraft to be delivered to the customer on time at the end of September. So our partner, Alenia is performing very well. We received funding for the next four aircraft back in April. That was approximately another $130 million, which included logistics support. There has been a bit in the press about the production status which is really the contract between Alenia and Boeing. And I think there is some misunderstanding about how that relates to our JCA program, so let me talk about it for a minute so everybody's on the same page.

The deal between Alenia and Boeing for U.S. production relates to the entire C-27J aircrafts. We, L-3, as prime on JCA, are a customer of that proposed venture to buy C-27Js and make JCAs our of it. So that arrangement is not solely a JCA issue and we are fully confident that Alenia will make its agreements with Boeing and have them finalized shortly or make other arrangements. So this, in our view, is not an issue for our program at this time. And if it slips beyond the point where we think it is acceptable, we will step in and work with Alenia. And I think Alenia is really doing a great job on it and I expect this to be concluded shortly.

Significant other new DOD programs where we are participating. I think you know most of them. But BAMS was awarded to Northrop. We have a significant role on Northrop Grumman team, as the communication suite integrator. That is under protest, but that should be resolved shortly. I think it gets resolved in August.

Aerial common sensor. Again, our integrated systems business is teamed with Northrop to the airborne signals and intelligence work. Also, our Communications Systems West business should have a strong position for data communication on multiple teams on that program. The EPX, the electronic variant of the P-8 or the new P-3 if you will. Again, we are teamed with Northrop. We believe we have a great solution together and that should get decided, we would hope, later this year.

Joint light tactical vehicle, JLTV program. Replacement for the current HUMVEE. We are on multiple teams for semi-active suspensions and potentially for select electronics. That program has been moving to the right. But the point to keep in mind is that we are multiple teams for this program and we expect to have a decent share of content when it goes forward.

Operationally, we have continued to consolidate operations. The government services realignment is going very well. It is progressing on plan. The margins have been coming up and it's really been doing everything we expected in terms of bringing more focus to the business and more of a consolidated one face to the customer look.

The marine and power systems group consolidation which we announced at the end of the first quarter, the beginning of the second quarter, also is doing very well. The group is very focused on both the United States naval business as well as the international shipbuilding market. Significant contracts are being worked with some of the major international builders, such as STX and Hyundai of Korea and also in China. We are able to provide a complete systems solution. Moving up the food chain from black boxes and power converters this is a complete solution from bridge to propeller for commercial and naval ships.

We updated the 2008 guidance today, increasing our sales and EPS outlook. We're now expecting at least 14.7 billion in sales for the year, with earnings of between 671 to $6.75 a share, excluding those second quarter items and free cash flow guidance remains at $1.2 billion. Organic growth, excluding the Linguist recomp, the loss is expected to be in the 6 to 8% range. Guidance assumes we end 2008 with more than 1.1 billion of cash after re-purchasing $600 million worth of our stock and that is what is in the guidance now. Ralph will give you some more detail on that guidance when he speaks with you.

In terms of deploying capital. We continue to be active in acquisitions but again we are maintaining our discipline. In April we acquired the Electro-Optical Systems business from Northrop Grumman for $175 million. We have other acquisitions of a similar size. Niche companies that fit well at appropriate prices. We think that we will have at least one more, possibly two by the end of the year. Our guidance for 2008 now assumes, as I mentioned, 600 million of stock gets re-purchased. For the second quarter though, we re-purchased $217 million bringing the year-to-date total to a half a billion or $500 million.

Upside would be to complete the entire $750 million authorization this year. As you recall that was a two-year authorization, but we're running ahead of schedule on it and given what we see in the M&A space right now, there's a very good chance that that gets done this year. As we have been saying all along, the objective for our M&A program would be to buy qualified candidates at reasonable prices. The strategy continues to be niche companies. We would consider larger ones but they are really not there at this time. Complementary to L-3's existing core businesses, adding important new technologies, products, programs for customers.

The pipeline for the middle market companies and those are companies I would say from 1 to 500 million, $600 million, continues to be pretty good. They are mostly privately owned. And we are going through them very diligently and we find companies that we will attempt to acquire them. Valuations can still be a little bit rich and will likely be that way for the rest of 2008.

On the divestiture side, we have about five small peripheral non-core businesses or product lines in the process of being sold. We completed a transaction in May. It was a microwave device product line, generating about $18 million in annual sales. Net proceeds from that sale were about 12 million. It was all gain and it is one of those non-referring items that we talked about earlier. Two more possible transactions can get done this year on divestitures given the difficult credit financing environment, it has been slower than we had hoped. But again I think they will both get done. At least one of them in this year, probably in the fourth quarter.

I think I have covered--I wanted to give you a little bit of color on the orders and then we will turn it over to Ralph. The orders were very strong in the quarter. Our C³ISR Segment had an increase of almost 50% in orders from last year's second quarter. And it was across the board in terms of communic (ph 00:10:26) data links, communication products, ISR systems and special aircraft, which was about half of the increase. Special reconnaissance, tactical reconnaissance systems aircraft. Government services grew at 10% or over $100 million in volume from about 1.1 to 1.2 billion and that includes the drop off in Linguist revenue. If you excluded the effect of Linguist the balance of our government services segment actually grew at about 20% in the quarter.

Aircraft maintenance and modernization segment grew about 30% and that was the additional orders for joint cargo aircraft, center barrel replacements for the Royal Australian Airforce's FA-18s, those are the A&B models and just general other platforms, so we were happy with those results as well. Specialized products grew at 20%, pretty much spread across the portfolio that we have. So overall, the consolidated growth in orders for the quarter were up 22%. Again, book to bill was 1.13. On a trailing basis, our book to bill is about 1.08, still strong. And for the six months it is 1.15.

With that, let me have Ralph give you some more color on the numbers and then we will take your questions.

Ralph D’Ambrosio

Thank you, Mike. I will comment on some key points about the Q2 results and cash flow, the June balance sheet, and finish with the changes to our 2008 financial guidance. I will begin with the Q2 items that Mike mentioned.

We had three items which added to a net gain of $117 million pretax, or $0.57 per diluted share. And they were comprised of two gains and one loss. We do not believe they are indicative of normal, recurring, operations for L-3. And this is why we disclosed them, separately, as the Q2 items. They all pertained to discrete, external, third party events which occurred during Q2. And they were also not included or assumed in our prior 2008 financial guidance.

So let me give you some more color on each of those three items. The first one, which Mike talked about, the litigation gain, that was comprised of two items. We reversed a $126 million liability that we recorded back in Q2, 2006. And we also reversed 7 million of related accrued interest expense. Together they were a pretax gain of 133 million or $0.65 per share. The gain is non-cash, obviously, but it removes a significant cash flow overhang that we had.

The second item, which was the product line divestiture gain, as Mike said we completed that sale in May. And it resulted in a gain of 12 million pretax, or $0.06 per share. The net cash proceeds from the sale were also 12 million and they are included in the investing activity section on the cash flow statement and not within free cash flow.

And the third item was the impairment charge where we had a non-cash impairment charge to write-down a capitalized software development asset. The charge was for $28 million dollars pretax or $0.14 per share. The write-down was triggered by a competitive event which occurred in Q2 and caused us to lower our sale price. Most of those software costs were capitalized in 2005 and I definitely view the Q2 software asset and impairment charges as a significant anomaly and one that I do not reasonably expect to occur again in the future. The remainder of my comments on Q2 will exclude the impact of these Q2 items.

Our diluted earnings per share grew 12% to $1.67 from $1.49 from last year. The EPS growth was driven by a 10% increase in operating income and 2% reduction in diluted shares. The growth in operating income was driven by sales growth of 9% and margin improvement of ten basis points. Lower interest expense was offset by a higher tax rate this quarter versus Q2 of last year.

As Mike commented, the EPS of $1.67 includes $15 million of pretax charge for estimated costs to settle certain claims. That reduced EPS by $.08. Most of that $15 million is included in the aircraft modernization and maintenance segment and they all pertained to preexisting litigation matters, which we now intend to settle. Those two Q2 litigation costs were not assumed in our previous guidance for 2008. However, our Q2 operating performance was strong enough to offset that 15 million and we are now including it in our 2008 guidance update.

I am moving on to sales, organic growth in the quarter was 7%. If you exclude the Linguist contract from both periods, it was 9%. We had organic growth in three of our four segments, with the highest growth rate in C³ISR and specialized products, actually-- although it had a lower growth rate, it contributed most of the organic growth dollars in the quarter. C³ISR grew 18% organically and that was up significantly from 2% that we did in Q1. It was driven by continued strong demand for network communication systems on UAV’s, the Rover Man Pack and we also had Q2 increases in airborne ISR systems as well as classified work. We expect the growth in C³ISR in the second half to be above 8% even though we have a very tough comparison in Q4 when, if you recall, Q4 of last year, we had some very high, unusual sales in special aircraft sales due mostly to timing.

Specialized products grew 17%. 11% of that was organic and it was driven by strong performance in para-run control systems, microwave, precision engagement and the EOIR business area. Acquisition and growth was 6% in the quarter there and most of it came from the EOS business, which we acquired on April 21^st.

Government Services’ organic growth was actually minus half of a percent and we had about 2% growth from acquisitions there. The Linguist sales totaled $117 million in Q2 of this year. They were higher than we expected because we ended up having higher sales on our prime contract, which ended on June 9^th. Still, Linguist sales were down 69 million compared to Q2 of last year and again, if you strip out Linguist from both periods, the segment grew by 7% organically. Looking into the second half of this year, we will have a sales head win on Linguist of about $150 million for both Q3 and Q4.

In the Aircraft Modernization and Maintenance segment, we grew 2% organically. And what happened there was, while we had increases on joint-cargo aircraft, Fort Rucker, contract field teams and JOG, those increases were offset by declines on International C130 modification work as well as lower sales on the Canadian Maritime Helicopter Patrol Program. We are expecting organic growth to increase slightly in the second half in this segment because of higher sales coming from our Canadian operations.

Moving on to operating margin, as Mike commented, we had ten basis points of margin improvement. The margins improved in every segment except for Aircraft Modernization and Maintenance. We had the highest improvement in Government Services where the margins increased by 180 basis points to 11.1%. Most of that margin improvement came from lower overhead to sales ratio, arising from the business re-alignment and consolidation activities that we began in Q4 of last year. We also had some higher profit margins on some fixed-price contracts at MPRI, which contributed to some of that improvement.

For the second half, we are expecting Government Services margins to be a little lower than they were in Q2 because, right now, we are not anticipating to have any favorable contract adjustments like we had in Q2 repeat in the second half. C³ISR margins improved by 50 basis points to 10.9%. Most of that improvement came from better labor productivity in our hangar dock and line operations for airborne ISR systems.

The margin has declined significantly at Aircraft Modernization and Maintenance. About half of it was attributable to 13 million of the 15 million of litigation charges that we took in Q2 and the rest of it was attributable to a change in sales mix to more lower-margin work. For the second half, we are expecting the Aircraft Modernization and Maintenance margins to increase to about 10% because of more favorable sales mix and we are also expecting some award fees on a couple of programs and some better contract performance in the Canadian Operations.

Moving on to cash flow, as Mike said, our Q2 cash flow was excellent. It was better than we were expecting with 502 million of free cash flow, which represented more than two times our net income for Q2. But, the strong cash flow is not a surprise. Basically, what we expected to happen in Q2 happened. As you know, our Q1 cash flow was unusually low at 55 million due to unfavorable timing on receivable collections, where we had several collections that we were anticipating to happen at the end of Q1, slip into the first week of Q2. So, receivables caused most of the swing between Q1 and Q2 cash flow, changing from a use of cash of 250 million in the first quarter to a source of cash of 150 in Q2. And most of that change was swing to curve and billed receivables.

So, with the Q2 scroll on free cash flow, we ended the first half with free cash flow of about 557 million and that is almost half of our full year guidance of 1.2 billion, so we are nicely on track when it comes to free cash flow for the full year 2008.

On the balance sheet, we ended June with 622 million of cash. We expect it to increase to about 1.1 billion by the end of the year. That assumes that we do not make any additional acquisitions. If things go well, there should be one or two more small M&A type transactions that occur. Our bank leverage ratio improved slightly to 2.2 times down from 2.3 times at the end of December. Our debt balance, as you know, was unchanged at 4.5 billion.

In terms of our changes to the full year financial guidance, we increased our sales guidance to at least a 14.7 billion, up from 14.5 to 14.7 billion. We are expecting about another 100 million more in sales in Specialized Products and another 100 million in Government Services, including about 50 million more on the Linguist program.

Our new EPS range, excluding the Q2 net gain of $0.57 per share is $6.71 to $6.75. We raised our EPS guidance range by $0.15 in the low end and $0.05 in the high end. At the mute point, it is up $0.10 and it is being driven primarily by three items. Number one, the increase in estimated sales for the full year, plus margin improvement mostly in Government Services, offset by the 15 million of litigation charges is adding $0.06. Lower diluted share count, including the additional share purchases is adding $0.05. And the divestiture of that product line, where we are going some operating income subtracts a penny.

Operating margins, we are holding them at 10.5% so we think we are on track to get 30 basis of points of improvement compared to last year’s 10.4. The estimated full year tax rate also stays at 36.6%. Again, it assumes that the federal R and E tax credit is reenacted in Q4. The estimated full-year tax rate also stays at 36.5%. Again, it assumes that the federal R and E tax credit is reenacted in Q4. If it is not, the tax rate will go up by about 70 BPS, and that will cost us about $0.05 of EPS. Even if that were to occur, I think we will be able to stay within our guidance range for EPS.

Free cash flow stays at $1.2 billion, and the full-year segment sales and operating margin guidance is detailed in the earnings release, so I am not going to cover it now.

We did not provide any guidance on Q3 in the earnings release, but we are expecting Q3 sales to be somewhere around $3.7 billion with EPS close to $1.70, and free cash flow should be at least $250 million in Q3.

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

Karen Tripp

All right. We are ready for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question is from the line of Rob Springarn with Credit Suisse.

Rob Springarn - Credit Suisse

Morning, guys.

Michael Strianese

Hey, Rob.

Rob Springarn - Credit Suisse

You have certainly covered a lot of material there, both you and Ralph, so we appreciate the detail. Could you talk a little bit more, either Michael or Ralph, on the AM&M margin in the second half? You talked about mix. You alluded to mix and just how JCA flows through there and a little bit more color on some of the award fees, et cetera.

Ralph D’Ambrosio

In terms of the sales mix, which resulted in lower margins, one, we had more sales in the base support operation work. That includes the three big programs: Fort Rucker, Contract Field Teams and JOG. Those contracts, which are either cost type or timing material, carry lower margins than the fixed-price work that we do on MHP and the foreign C130 work in Canada. And as I said, those sales declined in the quarter.

Additionally, we had sales on JCA and on the JCA contract although I am not going to go into specifics as to what we are earning on it. We said already a few times that we are earning a margin that is less than the composite margin in the segment. But that is what driving the reduction in the aircraft mod and maintenance segment.

Rob Springarn - Credit Suisse

Did you say you would have some award fees in the second half?

Ralph D’Ambrosio

Yes, the Fort Rucker contract, which includes award fees as well as some incentive fees, is a physical year contract. Most of those fees are awarded in Q3. Historically, we have had award fee improvements in Q3, and I am expecting that we will have some of that again Q3 of this year.

Rob Springarn - Credit Suisse

OK. Mike, there has been some talk about rivet joint in the U.K., opportunity there. Could you speak to that, and is there any impact on Nimrod?

Michael Strianese

Well, yes, that is exactly the point, Rob. The MOD has been, as you know, last year we won the role as prime contractor on the Helix Program. Helix was upgrading the electronics surveillance suite on the Nimrod aircraft.

The U.K. has been reconsidering that decision, and as we understand it, considering purchasing rivet joints instead. There are a couple of reasons for that, and again, they are working in out with the Air Force with our support.

One, there was a crash of a Nimrod in Afghanistan last year, and the subsequent investigation disclosed that the condition of that airframe was not quite as good as they though, and they were starting to rethink whether it made sense to invest heavily in upgrading the electronics suite, one.

Number two, participating in the U.S. rivet joint program would really help in terms of, one, interoperability with U.S. forces, which is a very desirable thing to have in the U.K. Number two, it provides some levering for the U.K. investments for a spiral development for future threats. And three, they’d probably be able to start to co-man the U.S. rivet joint platform with U.S. troops and effectively get hands-on training, if you will, way in advance of any delivery.

So that is the decision that is being worked. I expect that to get--as you know, I was over in the U.K. last week as well for Thornborough and Riat (ph 00:30:14) and was party to a number of these discussions. I believe that that decision will get finalized. It is at what is known as main-gate approval right now within the MOD, and we will probably get a green light in the spring.

In the meantime, we are operating under a study program that was awarded as part of this Helix program that we won last year. So it has not caused any slowdown for us. I mean we are where we are, but there could be a shifting in the airframe, which is fine with us. And as I have told representatives at the MOD, it is a very low-risk way to get that capability in theater now. Because, you know, we can envision with great certainty that we would deliver this airplane on time and operational as we always try to do. Because it is going to be the existing baseline that is in use where we have 18 of them here in the U.S. flying.

So that is everything I know that I could tell you about where we are going with that program.

Rob Springarn - Credit Suisse

That is a fair amount. Thanks, Mike. Thanks, Ralph.

Ralph D’Ambrosio

You are welcome.

Operator

The next question is from the line of Joe Nadol with J.P. Morgan.

Joe Nadol - J.P. Morgan

Good morning. First question is on the services business. I believe, Ralph you went through a lot of stuff there. I believe you said the MPRI there were some higher margins, and that’s kind of what drove the benefit in the quarter? Any more detail or color you could give there and, you know, what the opportunity is there going forward?

Ralph D’Ambrosio

Sure. Well, the margins were up 180 basis points. About 40 BPS came from the better performance in the MPRI at fixed-price contracts. The rest of it was really overhead cost improvements that came from the business realignment activities that we have been working on now for nine months.

Joe Nadol - J.P. Morgan

So a bigger bump than you expected from the realignment? That is actually more than I would have thought.

Ralph D’Ambrosio

It is definitely an earlier bump than we expected. So originally, we thought that most of the benefits we would start realizing next year. But we are seeing the benefits sooner, and it should continue in the second half.

Joe Nadol - J.P. Morgan

So really, as you look at the margins, I mean the sales were OK. Obviously, you had the headwind from Linguist, the absorption, but I mean really very little of this was what you would consider to be kind of contract adjustments and really should not expect margins to come off all that much.

Ralph D’Ambrosio

Yes, but like I said, I do not think they are going to be 11% the full second half. We will probably get close to 11%.

Joe Nadol - J.P. Morgan

OK and then just secondly, Mike, on the General Aviation product, you know, just wondering if you could give any color there on the future of that business. It is a little differentiated from everything else that you guys do. You have some other commercial aviation businesses, but it is pretty small. What are you thinking there?

Michael Strianese

Well, Joe, the commercial avionics that we do is generally geared towards the large body transport, right? Not the GA market. This was a product that was acquired as, you know, was part of an acquisition, and we stayed with the R&D.

And the product is still being marketed. It is just that the launch customer, it is not the place where we thought it would be. And while the FAA certified the system, the sales outlook for a variety of factors is not what it was thought to be. The product is applicable.

You are correct. This is outside of our core area. The balance of that business unit is operating fine. Margins are well north of 20%, but you know, most of their products are applicable not only to GA. They are applicable to, you know, transport as well in terms of standby instrumentation. As you know, we evaluate all our businesses in the portfolio, and we have not missed this area as well.

For the year on our aviation products business, you know, our outlook is, you know, margins north of – sales are just under half a billion dollars in this group. Margins are between 20% and 25%, and the growth rate should be around 7%. So overall, the group is performing well, but we are fine-tuning it, and with these changes, I think those margins will start heading to between 25% and 30%.

Joe Nadol - J.P. Morgan

OK and then just one final one. You called out in products your lower margins on acquired businesses, and I’m wondering if that’s the, you know, the Northrup business, and going forward what, you know, what kind of margin improvement you think you can generate and how quickly?

Michael Strianese

We think by next year, by the second half of next year we would get the margins. The answer is yes, it is the Northrup business, by the way, and by the second half of next year, we would expect to get those margins into where north of the composite for that group, which is north of 10%.

Joe Nadol - J.P. Morgan

OK, thank you.

Michael Strianese

Thanks, Joe.

Operator

(Operator instructions) The next question is from the line of Myles Walton with Oppenheimer.

Myles Walton - Oppenheimer

Morning.

Michael Strianese

Hi, Myles.

Myles Walton - Oppenheimer

The prior guidance, I think, included about 240 million of acquisition growth. Now, I think you are looking at $300 million, so I guess following up on Joe’s question, is that mostly the Northrup business? Now that you have had it under your belt for a little bit you are seeing more or is it from the 2007 acquisitions?

Ralph D’Ambrosio

We say we are expecting another 100 million in specialized products. It is coming from our base existing businesses.

Michael Strianese

Let us just get the ground rules. Our guidance only includes acquisitions closed. It does not project any more acquisitions.

Myles Walton - Oppenheimer

Sure. I am just saying this, at least the note in the press release, says it includes 300 million of sales growth from business acquisitions in the last quarter. The note said 240 million.

Ralph D’Ambrosio

I do not believe we said 240 million, but we included the EOS acquisition in our previous guidance, which we published in April when we released Q1 earnings.

Myles Walton - Oppenheimer

OK. I guess I will just follow up with you after the call on that particular question. The other one I had for you was given the strong order growth you have had year-to-date, Mike, do you expect the book-to-bill can be sustained here above one for the rest of the year?

Michael Strianese

Yes.

Myles Walton - Oppenheimer

For the remaining six months?

Michael Strianese

Yes, I think we will end the year, you know, north of 105, between 105 and 110. So it will not be 115, but I think it is north of one virtually in every business area for the second half.

Myles Walton - Oppenheimer

OK, that is great. Thank you.

Operator

Your next question is from the line of Cai Von Rumohr with Cowen and Company.

Cai Von Rumohr - Cowen and Company

Thank you very much. Can you give us some more specifics on what the litigation settlement is related to? And secondly, how much the write-off of the capitalized software might have saved you in terms of amortization costs in the second half?

Ralph D’Ambrosio

On the first question, on the litigation, estimated settlement cost, I do not want to go into too much detail because we are still negotiating with the third parties. I can tell you generally, what they pertain to. One is a contract billing dispute. Another is a dispute on a statement of work issue on a modification contract. And there is a reliability issue on a commercial product that we previously discontinued a few years ago.

Michael Strianese

That is not under warranty anymore, but you know, we think we are being prudent here in covering it, so go ahead, Ralph.

Ralph D’Ambrosio

And the question about the reduction in software amortization charges, this new product for the GA market, we expect to begin shipping it by the end of the year. So probably we will avoid about half a million in amortization expense pretax coming from the write-down. Then a bigger benefit next year. You know, next year could be three or four million of pretax income and then prospectively as well.

Cai Von Rumohr - Cowen and Company

Terrific and then you had mentioned that you had five more potential divestitures. Do you expect to get gains on those divestitures. And if so, do you have other kind of special, you know, items on the negative side to offset against them?

Ralph D’Ambrosio

On the remaining things that there could be some gain on some of them, and right now, we are not aware of any special items that we would offset against them.

Michael Strianese

Yes, let me get me clear, Cai, on this question because it was a little bit leading. While it looks like a matter of convenience, the charges in the quarter are discrete events and it is not that the charges are related to the gain. All three of these are either actively litigated. Two of the three are settlement offers that are actually occurring. So these aren’t loss provisions for future event. These real losses are occurring in the quarter.

OK? So we are not – there are no other items that I am aware that would be charges that we would be holding to offset against the future gain. It is just not the way we operate.

Cai Von Rumohr - Cowen and Company

Got it. And then you know you have done particularly well on realignment. Can you update us on any other potential – you know, is there more potential here? Other operations in which you may make some realignment changes?

Michael Strianese

We are actively looking at at least two other significant areas. I do not want to get into the business areas of it because every time I do, I upset a bunch of employees, but these realignments have minimal displacement effects on employees.

We have tried to get people relocated at other parts of the company or get them placement counseling and the like, and it has been in services. We really need everybody we have, so there was not really a – you know, we had some management retirements and some people that moved around, and it did help the overhead. So I would rather name the areas, but you can bet that we are not done consolidating. There are at least two other significant areas we are looking at and probably more.

Cai Von Rumohr - Cowen and Company

OK and just a quick one on M&A. Are you seeing more of interest? Less of interest? What is your sense?

Michael Strianese

Meaning M&A in terms of--

Cai Von Rumohr - Cowen and Company

In terms of interest for you to purchase. I mean are you more excited, more opportunities, fewer opportunities?

Michael Strianese

There are a number of good companies there, Cai. But the caution that I see the whole industry exercising right now, and I think everybody saw that by deals that didn’t get done last quarter or didn’t get challenged by interlopers, is that the core defense industry here, given that we’re on the cusp of election and a new administration and a new budget and things that are batted around. And what is going to happen in Iraq and Afghanistan and the future of supplemental and changing priorities, I think everybody is basically staying the course and keeping their powder dry right now. Nobody wants to be the last guy to pay the top multiple. So that is the headwind against the M&A right now.

We are finding reasonably good deals, some of which are priced in areas we are not going to pay, certainly not now because, you know, certain of these areas could be cresting. But, you know, we are finding deals like the EOS business that we believe was reasonable for both us and Northrup as the seller and fits much better in our portfolio in our ERS/EOS product line and gave us critical mass of over $800 million.

There are at least one other one in that size class in those price multiples and with that kind of synergy with L-3 that I am expecting to have done by the second half and possibly two.

Cai Von Rumohr - Cowen and Company

Excellent. Thanks a lot.

Michael Strianese

OK.

Operator

Your next question is from the line of Ron Epstein with Merrill Lynch.

Ron Epstein - Merrill Lynch

Good morning, guys. Could you maybe give us some color on the Homeland Security Activities and, you know, your potential growth opportunities there?

Michael Strianese

The Homeland Security marketplace is undergoing some upgrading at the checkpoints in the airports right now. So whereas in the past, our growth came from the checked baggage machines, the large CP scanners, the focus now has become on the checkpoint where, as you know, the equipment is old. The threats have changed, right? We have gone from metallic to liquid, and the detection capability of the current technology offers better detection capability than the carry-on scanners or X-ray machines that are sitting there today.

So what is happening is there is an upgrade program underway to change the X-ray machines for scanning carry-on bags. They’ll offer dual view technology that gives the operator, you know, differing views of the contents and allows them to pick up threat items much, much more easily based on the single view that’s there today.

In addition, for secondary passenger screening right now, they are testing both millimeter wave as well, which we offer, as well as backscatter X-ray. They both have their pros and cons. They both have privacy issues that I think the TSA has well addressed in the way they are operating them. And I think travelers have generally been positive and I say generally with a capital G because you do have, you know, people that do not like it. But, you know, they are given a choice between a full-body pat down and walking through the portal, many people are choosing the portal.

In terms of upside for L-3, we play on both those spaces. We have a dual view machine that we are offering. We believe ours has a smaller footprint than the competitor’s, but the lanes in these checkpoints are tight, but we think we have a good opportunity there as well as our ProVision scanner.

I think many of you have seen it. We have had it at both shareholder meetings and investor days and some of the trade shows. It is working very well. It does offer automated detection. So not only can an operator look at the image to spot something, but the software, the algorithms, can actually identify with a circle or an X things that don’t belong on a person.

In terms of the upside, the security and detection business this year is fairly flat with about a 3% to 4% growth rate. We expect a share of orders in all these programs for next year, and I expect that growth rate to head more towards the 10% or north range.

Ron Epstein - Merrill Lynch

Ten percent or north? OK and does that include the stuff you guys are doing in port security?

Michael Strianese

Port security there are no major mandates that I am aware of in the U.S. side. There are sporadic programs that come up internationally. I would not bet on that as a growth engine for us right now.

Ron Epstein – Merrill Lynch

OK, great. Thanks, Mike.

Michael Strianese

Great.

Operator

There are no further questions at this time. I would like to turn the call back to management for any closing remarks.

Karen Tripp

Mr. Strianese will now provide his concluding remarks.

Michael Strianese

Well, thanks for joining us this morning. I hope we were able to answer all of your questions. I guess the only other thing I would say is that, as you know, before the 4th of July weekend, the supplemental of about $160 billion was passed by Congress. It included, you know, $90 billion for the global War on Terror in war supplemental and about $70 billion for an ’09 bridge, which should carry everything through the first calendar quarter of next year to get us through the election.

It is uncertain whether an actual defense budget will actually get done this fall, you know, the ’09 budget and may get done through just a continuing resolution, same level of spending with no detail.

The first budget that will come out that will really tell us new priorities and directions will likely be the ’10 budget, so we do not see any occasion right now to change anything in our model. We think L-3’s diversity and flexibility will allow it to do well under either administration, and again, the flexibility will allow us to do any fine-tuning that we find necessary.

So we have a very strong backlog going into the second half. We believe we will close 2008 on a strong note, and we think that 2009 is already looking pretty good for us. So with that, we look forward to talking with you on the third quarter.

We expect to, at that time, start to talk about 2009, and as we have done in the past, our tradition was to have an Investor Day to meet with you all, and we expect to have that around November 13th, so mark your calendars. We will get the notice out, you know, as soon as we lock up the space.

So that is what we are looking for for the next couple of months, so thank you. Bye-bye.

Operator

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

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