Leonardo DRS Inc (DRS) 2004 Q1 法說會逐字稿

Welcome to the Engineered Support Systems first quarter earnings release conference call. At this time all parties are in a listen-only mode. After the presentation we will be conducting a question-and-answer session. Today's conference is being recorded; if anyone has any objections, please disconnect at this time. I would like to introduce your conference host for today's call, Mr. Michael Shanahan, Chairman of the Board and founder of Engineered Support Systems. Sir, you may begin.

Thank you, Catherine. Good morning everyone. Thank you for joining us on our call today. Hopefully you have all had a chance to review our earnings release for the first quarter of fiscal 2004, which was issued earlier this morning.

We started the year well, posting record quarterly revenues of $195 million. That's a 60 percent increase above the first quarter of last year. Earnings from continuing operations (indiscernible) 57 cents per diluted share represent nearly a 75 percent improvement. All earnings per share figures in both periods reflect our recent 3 for 2 stock split which was effective November 1st of 2003.

As our release stated, the inclusion of operations from our most recent acquisition -- that being TAMSCO, EEi, and Pivotal Power -- for the first quarter, coupled with solid organic growth, contributed to the sharp increase in quarterly revenues and profits. We are off to a great start and are poised for another record year. We will discuss a few of the forces shaping our Company's prospects and the defense market outlook later during this call.

As is customary, on the call today are Jerry Daniels, Vice Chairman and CEO; Jerry Potthoff, our President and Chief Operating Officer; and Gary Gerhardt, Vice Chairman and Engineered Support's Chief Financial Officer, who will now briefly recap the first quarter's financial results.

Thanks, Mike. Before I begin, I will go ahead and read our standard disclaimer. Statements made during the course of this conference call which are not historical facts are considered forward-looking statements within the meaning of Section 27 A. of the Securities Act of 1933 as amended, and Section 21 E. of the Securities Exchange Act of 1934 as amended, and are intended to be covered by the Safe Harbor provisions created thereby.

For the first quarter of 2004, we generated record net income from continuing operations of $15.7 million, or 57 cents per share on a post split basis. Strong revenue growth resulted both from the inclusion of recent acquisitions completed within the past several months, combined with solid organic revenue expansion in both business segments. We will discuss additional factors contributing to these positive trends in a few moments.

For the first quarter our TAMSCO operation generated revenues of $55.2 million and contributed incremental pre-tax earnings from operations of $4.2 million before the allocation of corporate overhead. Several areas of TAMSCO, particularly its telecommunications and digitization business, continued to show excellent forward growth trends. TAMSCO has also been awarded a significant number of new task orders for both services and products under its multiyear rapid response, R2 contract. Working both through its independent subcontractor teammates, as well as with other subsidiaries within the ESSI family, Is flexible and well funded contract vehicle has proved to be a very valuable resource to generate incremental business for Engineered Support.

As importantly, during the current quarter we've benefited from a significant level of organic revenue growth, both within the support services and support systems segments. Radian has continued to grow its revenues across the board. Quarterly revenues of the DPGDS generator program and the (indiscernible) protection areas and throughout its business, increased more than $8 million during the period, all at excellent margins. And are online logistics business, ESSIbuy, posted nearly $1 million in quarterly revenues as reset work on the Sierra Army Depot contract accelerates.

On the support systems side of the business, revenues increased $15 million, or 16 percent, to $112 million. While the acquisitions of Pivotal Power and EEi contributed nicely during the quarter, we saw the segments' organic revenues advance solidly as well. Pivotal and EEi posted revenues of a combined $5.5 million, which contributed $1.3 million in segment pre-tax profit prior to the allocation of corporate overhead. Both firms are firmly positioned in complementary niche markets, and their outstanding technical capabilities allow them to generate very profitable returns.

Internal revenue growth in the systems segment totaled $9.5 million for the first quarter, a rise of nearly 10 percent over the prior year. The impact of the completion of the M1000 production contract midway through last year, a reduction of more than $6 million in the current period, was more than offset by increased revenues of several other defense programs, particularly for our Field Deployable Environmental Control Units, the FDECU, and the MSTAR radar system. FDECU related revenues climbed to nearly $14 million as customer demand has been accelerated due to heightened military activity abroad and surge in troop readiness levels.

The additional MSTAR work relates to an upswing in orders received within the past year from both foreign military customers for reconnaissance related work, and its increasing deployment by the U.S. military for base perimeter security missions. We believe that the future is bright for these and many of our key support systems programs, and new opportunities are emerging as support equipment spending is expected to remain robust for the next few years.

With the consolidated increase in revenues of some $74 million during the quarter, our profit levels rose sharply as well. Gross profit contribution advanced 70 percent compared to the prior year, bolstered by increased revenues, cost reductions realized under our facilities rationalization program, and stable production programs. This led to higher earnings from continuing operations as SG&A expenses as a percentage of revenue were held fairly flat.

Cash flow from operations, excluding temporary investment in working capital, was approximately $18 million for the first quarter. The growth in Accounts Receivable and contract inventories during the period are direct results of our increased revenue base, and to some degree, the contractual requirements of certain programs. We fully expect that the level of investment in net working capital will greatly diminish by the end of our fiscal year as receivables are collected and certain contract deliveries are made.

The generation of strong cash flow has always been a hallmark of Engineered Support, and it will remain that way going forward. With a solid track record of excellent financial results and a very positive about look for the Company, we possess ample flexibility to avail ourselves of adequate capital resources necessary to support future acquisition or internal investment initiatives.

Now I would like to turn the call over to our CEO, Jerry Daniels.

Thanks. Great report, Gary. Today marks my fourth quarterly earnings call since I joined Engineered Support Systems last spring, and I must say I never really tire of reporting good news.

Clearly the outstanding performance of each of our operating companies over the past several years reflects a sound business strategy in serving growing defense markets, and the commitment of management and all employees to deliver the highest quality products and services to our military customers around the globe. It is our people that make the difference, and it really shows in both our top and bottom lines. I would like to congratulate all of them on another record quarter.

During last quarter's earnings call, I outlined several macro trends surrounding military deployment and the defense industry, and how Engineered Support will capitalize on these opportunities.

First, the fundamentals of logistics support and rapid deployment that have fueled our strong financial performance have never been more relevant than they are today. Increasingly, ESSI will benefit from the increasing transformation of the armed services to a lighter, more mobile force. The more flexible U.S. force structure continues to evolve.

For example, the U.S. Army, under Chief of Staff General Schoomaker's direction, plans to reorganize its 10 divisions into 48 separate brigades, up from 33 brigades currently, and to reassign troops to positions that are in high demand in the war on terror -- military police, civil affairs and intelligence. All the more frequently, our fighting forces will be engaged in nation-building and peace keeping missions that have become the norm in a post Cold War environment. These important missions require the type of support products and logistics services that are at ESSI's core.

At the same time, it appears that military leadership will be authorizing the addition of 30,000 additional soldiers to help alleviate distress on those currently on active duty. These troops will undoubtedly require additional support equipment and logistics resources to complete their missions. And the current tendency to outsource non-essential operations from uniformed personnel to the private sector will continue to provide opportunities for our services business.

The cost of maintaining the best-trained and equipped fighting force in the world are indeed quite high. However, the cost of not providing our men and women the tools to do their jobs is much higher. In his 2005 request, President Bush has called for a defense budget of almost 402 billion, a 7 percent increase above the fiscal 2004 figure that was itself a 6.5 percent increase over 2003. And this excludes the 87 billion war related supplemental bill last year and an anticipated $100 billion supplemental expected later this calendar year.

Procurement, R&D, and operation and maintenance spending are well supported in fiscal year 2005 request. Homeland Security spending at nearly 34 billion next year is up some 10 percent as well. Clearly, it is a difficult balancing act to weigh growing budget deficits, social entitlement programs, and the protection of the American people; therefore, the Department of Defense must make tough choices on where to place its priorities in defense of our national security.

Although Engineered Support was in no way adversely affected by it, the announcement by the Pentagon of the impending cancellation of the multibillion dollar Comanche helicopter program earlier this week is significant in that it signals that the Department of Defense is indeed willing to make tough choices to support military missions to (indiscernible) today's military battlefield -- an environment that increasingly relies on the comprehensive troop support and sustaining capabilities of Engineered Support Systems.

Against this backdrop, we remain confident that moderate organic growth is a valid, achievable, and sustainable goal for our company. Without question, we are in a period of heightened military activity with ongoing operations in Iraq and Afghanistan, and we may very likely be engaged in these areas for an extended period.

ESSI has already begun to see increased arter (ph) flow, and a trend of accelerating revenue growth as a result. Contracts with the Sierra Army depot, reset of the M1000 trailer fleet readiness, and other support equipment programs, come to mind. On the strength of these existing and anticipated contract awards, we can reasonably expect customer demand to exceed our historical 5 to 7 percent organic growth trend for sometime. Although there is still much uncertainty surrounding the length and extent of these particular missions, we believe that these conflicts, the continuing war on terror, and how that war is fought, will have an enduring impact on the Company and our prospects for sustained growth.

Now along these lines, Jerry Potthoff will now discuss a few of the more significant current and anticipated program opportunities that we are involved with. Jerry?

Thanks, Jerry, and good morning folks. As discussed, during our first quarter we have received an unprecedented level of entered orders coming in at 284 million through January. We have started the year with a bang, and have our eyes set on an entered orders target approaching 800 million for 2004.

A portion of our more recent order flow has been partially related to current military deployments in Afghanistan and Iraq. We believe that incremental work stemming from these conflicts will not be a short-lived phenomena. Rather, the ongoing reset of troop readiness levels to support a heightened state of military deployment activity will occur over a multiyear period. We believe that the U.S. will continue to engage in nation-building and peace keeping missions in unstable regions around the globe. Essentially, the U.S. will continue as the world's policeman. Our support equipment and logistics services will remain a vital part of these engagements.

I would like to now briefly describe a few of the new business opportunities recently captured, and those we are actively pursuing. In what may represent a major breakthrough for the Company, we are in pursuit of a significant contract with the U.S. Army for the design of an armor solution for a substantial number of military vehicles. These armor kits would help protect our military forces from land mines and other explosive hazards that are currently being used against them by terrorists in Iraq. The overall requirement for this application is quite large, and we are hopeful of securing a long-term contract. Our Radian division's well-developed expertise in the simulation and modeling of military vehicles lead to their selection for this important task. The armor kits would be manufactured at our SEI West Plains, Missouri facility.

At the beginning of the first quarter, our online Web-based logistics support operation, ESSIbuy.com, received a $14 million contract to provide support to one of the Army's major depots for repair and reset of petroleum distribution systems that had been extensively deployed in Iraq. As a result of the program's successes, the effort has been expanded to include water purification systems and other equipment. We expect to add another 16 million to the contract value, with additional opportunity. This is truly a breakthrough for this business, which was launched just 2.5 years ago.

The $11 million Army M1000 trailer reset contract received in January, involving refurbishment of some 72 trailers to like-new condition, represents another example of our company's broad capability. A total of 2300 trailers designed to haul the Abrams tank were originally manufactured by SEI. They have evolved as real workhorses in the transport of all kinds of equipment during ongoing operations in Southwest Asia. With over 1000 of these units deployed, they are receiving heavy usage -- we expect significant follow-on opportunities to rebuild and replace many more of these trailers over the next few years. We feel that emerging reset opportunities for environment control units, fuel and water systems, and generator sets, could lead to new work exceeding 100 million in potential contract value as units are recycled in and out of theater.

TAMSCO also continues to grow in many areas. For example, its telecommunications business has expanded significantly since the start of hostilities in Iraq and Afghanistan. Currently they have over 50 multi-mode communications systems deployed throughout those and neighboring countries, supported by nearly 100 dedicated TAMSCO employees. Most of these folks gained their technical training and certification in the military and old security clearances. TAMSCO has further leveraged its communications infrastructure expertise in remote areas, as illustrated by their recent award of an $18 million contract by the Iraqi Coalition Provisional Authority, to help create a satellite-based communications system for Baghdad. Partnered with SAIC (ph) and Raytheon, this opportunity may be worth up to 52 million to TAMSCO over a three year period of performance. TAMSCO was selected for this important job based on its prior experience with rebuilding efforts in Bosnia and Kosovo.

Another future program that holds a lot of promise for ESSI is a new fluid transfer system and efficiently deployed fuel and water distribution system that replaces the equipment previously supplied by ESSI and currently used by our military. Multiyear production requirements for this system approximate 350 million.

As you are probably aware, ESSI has been a leader in the environmental control area. The Field Deployable Environmental Control Unit, awarded to our Keco subsidiary back in 1998, was expected to be worth 120 million over its contractual life. To date, they have received over 200 million in orders on the program, with the potential for an additional 50 million in the near future.

Engineered Support remains the largest supplier of mobile electric power for the U.S. military, providing an estimated 80 percent of the portable power generation required. An opportunity for the next generation of power systems is on the horizon. Solicitations for this new program are due within the next few months, with development activities occurring over at least a two year period, with multiyear production to follow. ESSI's leading position should allow us to capture a substantial portion of an expected $500 million program.

We are obviously working many more opportunities throughout the Company; these are just a few that we thought may be of interest to our shareholders. By the way, Ron Davis, who is President of our Business Development group, who is one of the busiest guys in our corporation, will do an expanded presentation on business opportunities at our up coming shareholders meeting next Tuesday. You're most welcome to attend or listen in. Ron will present a very interesting review of our business.

Thanks, and now back to Jerry to wrap up our remarks.

Jerry, thank you very much. I would like to conclude our planned remarks by commenting on our revised fiscal 2004 forecast, included in our earnings released earlier this morning.

As you can tell by what you have just heard, our financials are rock solid and our prospects for sustained growth have never been more robust. Given that, we felt compelled at this time to substantially increase our 2004 revenue and earnings forecast to reflect this additional optimism about our business. Revenue guidance has been increased 30 to 40 million above our previous range on the strength of first quarter numbers and as a result of certain unanticipated orders received thus far, or those expected within the coming months.

These higher revenues should translate into an additional 10 cents of diluted earnings per share, raising our forecast to the $2.50 to $2.55 level for fiscal 2004. This would represent about a 50 percent increase in earnings per share from the prior year. Truly, the unique positioning and vast capabilities in Engineered Support Systems relevant to today's transforming military environment will continue to drive this forward.

Now we would like to entertain any questions that our participants may have.

(OPERATOR INSTRUCTIONS). David Gremmels, Thomas Weisel Partners.

I just wanted to first drill down on a couple of the larger opportunities that you discussed. Thanks for that overview. First, on the armor kits -- can you give us kind of an order of magnitude on that opportunity, and is it competitive? And when do you expect a decision?

This is Jerry Potthoff. That is a very recent opportunity, and because of that, we are somewhat limited as to the extent to which we can discuss that program. I can only tell you that it's the result of a lot of hard work and great (indiscernible) expertise that our Radian division brought to the party. They worked closely with the Army over the years to develop improvements in many of the products that the Army has in theater. It, obviously, is something that prevents the extensive of damage that you've seen on CNN to many vehicles in theater. But it is something at this point in time that we are very limited in terms of what we can say. So other than telling you that we are excited, that it represents both engineering and real manufacturing content for our business, that is about the extent of what we can say. Next week we'll probably be in a better position (indiscernible).

Jerry, do you think we can -- within a week or two we'll be ready to say something?

Exactly, Jerry. We'll have something (indiscernible), we'll have a press release with more definition within the next week or two as that program evolves.

And another big one you mentioned was a $350 million opportunity for this fluid transfer system. Can you tell us if that is competitive, and when you would expect a decision there?

It was competitive here over the last few years. We have been in a consortium in the development and the preparation of that program. We -- within the last year we -- I can't recall exactly when we made the announcement, but we did make an announcement on getting a major development contract to complete the development, if you will, and get prepared for the production. But we are in a very unique position these days to complete the development portion and to win the ultimate long-term production contract.

So you have the development contract in hand? Is development going on right now?

We're working on the development contract right now.

Okay.

It's one of those, David, that we are -- we're a little bit limited in terms of what we can discuss at this juncture. It is a program that will last over the next 10 to 20 years, and we are just in the development stage. We are working on a (indiscernible) system at a pump station, which are two of the foundation components of the system. We have had operational trials, we have had shoot-offs with the competition, and have come out of those with flying colors.

So given your position now with the development program, you would expect to be well-positioned for future production? Would that be fair?

That would be very fair. Amen.

The same couple of questions on the $500 million generator program -- is that competitive, and when do you expect a decision on that one?

That's competitive. Again, it's something that we've been working on for a number of years. We expect the request from (indiscernible) within the next three to six months. We would expect the award sometime between this summer and this fall. It is something, again, that we'll start in a complete to development mode. It won't go into production for the next, probably two to three years. What is encouraging about that is that the guys that are working on that within our corporation are currently (indiscernible). As I mentioned earlier, 80 percent of the business is to provide portable electric power generation. And so we fully expect to participate in a big way in that program.

Turning to the financial side, I wanted to ask you about the operating cash flow number, negative 27 million versus plus 12 million a year ago. Can you give us a little more detail behind that swing?

David, this is Gary. The first quarter cash flow overall was a little lower than the previous year's due to buildup in receivables and inventory, specifically related to two things -- one of which was the increased business which resulted in some late billings in the quarter; and secondly, a buildup in working capital associated with certain programs -- example being the MSTAR program at SEI is completed in midyear, and that is a program without progress payments. So you'll see a tremendously large amount of cash inflow in probably the third quarter related to that. When the year is over, cash flow will be in excess of 75 million and working capital levels should be back, similar to where they were at the beginning of the year, maybe a little bit of growth associated with the increased revenue base. But it's just a period thing based, again, as much as anything on the buildup of working capital associated with specific programs.

And the $75 million target for the year, I'm sorry -- was that operating cash flow or free cash flow?

That would be operating cash flow.

And what's your expectation for CapEx for the year?

It will probably be somewhere in the 5 to 6 range, and that varies. Mainly, recently will continue based upon some facility changes. As far as we have obviously made some changes in the last year under project leverage, we have expanded our facility in Florence, Kentucky, and we have done some facilities, revitalization I would say, here in our St. Louis area. Excluding those items, which would be very short-term effects, our long-term capital requests -- or capital requirements are somewhere around 5 million a year on a recurring basis.

Herb Tinger, Advest.

First question -- your $284 million in orders received in Q1, can you give us some indication as to how that split between systems and services? And any indication how much of that was directly related to the Middle East deployments?

Jerry is adding up numbers here real quick.

Okay. While he's doing that let me move on to something else. Regarding the armor kit opportunity that you recently received, since this is new to the Company, what if any risks do you perceive from a manufacturing standpoint at your facility, since you've never done anything like this before?

Actually, we've done a lot of this kind of work before.

Oh, you have? Okay.

Oh yes. You would have to see our West Plains facility and have an appreciation for the kind of product that we have made over the last 20 years at that facility to recognize that, by comparison for example to the M1000 trailer and the (indiscernible) aircraft loader and other things, this would be less than a risk; this would be a very easy task for that manufacturing facility. Interestingly enough also, as I mentioned earlier, Radian has done such an outstanding job of launching it in terms of the design, it's something that we will be able to put into production very easily.

I guess I misunderstood when you commented about the program; I thought it was something very new to you guys.

No, not at all.

Good. A couple -- I guess a couple of other numbers to keep Gary busy. The restructuring charge that you took in the quarter. I was wondering what that related to, and if you anticipate any other charges in future quarters this fiscal year?

Termination associated with the closing of the Sanford (ph) facility. That's probably about all we'll see; we do not anticipate any further charges remaining (indiscernible) the year. As you remember, that facility was shut down basically at the end of the fiscal year, and there were some continuing things going on through the end of December. So again, just people termination costs and not much more for the remaining year.

We didn't get a chance to answer your first question, (indiscernible) added up the numbers, and it looks like we've got about a 50/50 split between systems and services. And then that, in terms of what is unique to the Iraqi Freedom situation, it would appear that it's 15 to $20 million of the total that I gave you. It's very hard to break that out with recognition, that -- you know, that our product really supports, in effect, infrastructure. So to say that it is dedicated just to the Iraq Freedom thing is somewhat difficult. But as I said, looking at the numbers here it would suggest that of that 280, approximately 15 to 20 of that was dedicated to -- for example, the reset hat we talked about, the reset of the M1000 trailers, which was $11 million. And then there was $6 million of activity that we got started with one of the depots to refurbish some of the fuel distribution product.

So the bottom line is, the Company's growth is still being driven by demand other than the Iraq situation, and you're still at the early stages of seeing new business as a result of us being deployed over there?

Exactly. As I said in my remarks earlier, we are in the sustainment business. And we have forecasted in the past and have made targets of 5 to 7 of organic growth, 20 percent in total. We have made that commitment, we intend to continue to. And our business, very strategically, is not based on war, is not based on the kinds of conflicts that we're experiencing just now. We are probably as optimistic as we have ever been, at least in my tenure with the organization.

Chris Donaghey, SunTrust Robison Humphrey.

First question, just taking a look at the guidance. It looks like you must be expecting some significant margin expansion over the year to hit the low end of your guidance, based on your revenue guidance as well. Can you comment on what you're expecting to see there, in terms of segment distribution between the support systems and the support services group?

This is Gary. Obviously, the margins -- as we've discussed before -- vary significantly between those 2 segments. In the systems group, we are looking at mid-teens as far as operating margins -- okay? I think in our '04 forecast, the overall number is like 14.5, overall of everything. But again, in that range. In the support side, we're looking at high single digits relative to that. What happened in the first quarter was the fact that TAMSCO had a considerable amount of additional business, some of which ran through their R2 contract. And under that contract, they will do a lot of work with subcontractors, and their involvement is not as much in those, and therefore the margin is a little bit less. And we saw a little bit less margin on the system side in the first quarter. We will also see margin expansion in some area going forward as we continue to see improvement under some of our various initiatives around here. Project (indiscernible) and everything else that are project-leveraged, and lean manufacturing -- things like that will continue to see it. But we in general don't see that margin number to be a problem, as far as reaching it by the end of '04.

I guess just based on my initial calculations, it looks like -- you are looking at about 200 basis points of margin expansion unless something is going to happen with the share count. Or is the new tax rate going to be 38.5 percent?

Two questions there. One thing in the overall margin we would have to look at is it's very contract-driven -- okay? Our margins vary considerably from contract to contract, from program to program. They have also improved as you get out and so forth. So it's an accumulation of a lot of different margins. In the first quarter there was some business that probably was not quite as high, and therefore, going out in the year we're seeing a little bit more increase in margins. An example being the MSTAR program at SEI will be a very profitable program, and we will see an increased amount of revenues going into the year, which will contribute to raising that margin. We will see some other programs happening in Radian and TAMSCO, both which will be at increased margins over what we saw at the first -- in the first quarter. Relative to the tax rate, the tax rate was taken down from 39 to 38.5. That's a result of continually looking at our tax program. We will, as a result of a conference with our auditors, look at that on a very detailed basis quarterly now going forward, and analyze what our reserves are -- whether they are sufficient, whether changes should be made to that rate going forward. I would tell you going forward you may -- there is a possibility you may see a further decline later in the year, but that's not definite right now. And it doesn't have any major impact on the forecast. It's in the third decimal point, literally.

And again, reemphasizing the strong order flow in the first quarter, can you tell us what the funded -- where the funded backlog stands right now?

Yes, we have got that number here. Hold on. Out of 7000 numbers it's the one we have got to find here. Just a second. Funded backlog as of the end of the first quarter was 633, 633 million, and the unfunded was 905, for a total of a million 538 total backlog.

Last question, and I guess this one is for Mike. Can you give us an update on your plans? Obviously a lot of insider activity over the mid-December to mid-January range. Can you just tell us what your plans are going forward?

This is Mike Shanahan. The insider activity was basically me. And I have been asked this question a couple of times privately, so I guess it is good that we talk about it publicly. And I need to give you a little philosophy here in order to answer that. And then we'll get back to what's going forward, because you need to know this.

My first activity in selling was when we went public. I was part of the green shoe (ph) back in 1985, and there always seems to be a reluctance when insiders are selling stock. I really believe don't know why because they ask you to sell it, and then you sell it, and then there seems to be some question about. And I was also part of the green shoe when we acquired SEI back in -- I guess that was '98 or '99. And over the period of my career here I have purchased stock maybe 8 to 10 times and maybe sold it 8 to 10 times -- I don't know exactly either one. I was the market-maker back then in the early '90s, because nobody wanted it.

Anyway, I have always intentionally planned sales when I was personally satisfied that business was on an upswing. And indeed, I think history will bear me out on that practice. I have always intended that any buyer of our stock should have an opportunity for growth, and I think that is there today. Another thing is I think you have got to look at the performance numbers of our company and the outlook (indiscernible) -- as Jerry Daniels said, Jerry Potthoff said, and Gary probably said it -- that they have ever been in our history. Everything looks good. The management team is solid and dedicated to continue growth.

Now that takes you into the option program. It was conceived and designed to reward key employees for exceptional performance. And then if you say -- if you have an option program, and you're bringing people into the option program and they have a common goal to the shareholder, and then you say -- but the only problem with this program is that we don't want you to sell any stock. See, that really doesn't -- it becomes very ineffective when you do it that way. So I have always had the philosophy to let people do it on an as-needed or as-will basis. And I would never -- and some of our executives that have come to us through acquisition or whatever said it's a very unusual situation, because we were not permitted to do that at company so-and-so, because it looked bad. Well, I don't think it looks bad. I think it's a part of our incentive program. I think it's something that we will continue to see.

Now, sale of stock by insiders, as you know, is governed by the SEC, and we have our own ESSI regulations and practices. Every sale made by an insider has complied with those systems and practices. And so -- we have certain windows during the year. That's why you would see maybe a bulking of the sales, because we can only transact these at certain times. And I understand there are mechanisms which could be used, and perhaps we should be using, to do it a different way, and we will look into that. But I would hope that our people would continue to take advantage of the stock option program, and I know that it has worked well for us. I hope that you buy into our philosophy, because it's made your company here grow, and it has made your key personnel -- which goes down maybe 200 people in the program, but all insiders -- it has made them, I think, more effective and it's given them a piece of ownership in this company, which I think is very, very important as a motivation, and certainly a reward practice.

You have heard today our reports, and you see where the trend is, it's up. So I think you are going to see -- continue to see insiders doing (indiscernible), doing sells. And I know -- I know the quality of the people we have; these are not bailout kind of people. They will do it at the right time and they will do it when they think that the trend is good, because I know they can do nothing to hurt the Company or the other shareholders. That would be my answer to that.

Thanks. That's great.

Michael Braig, A.G. Edwards.

A couple of questions. One question on a couple of the returning programs, and it sounds like perhaps the ESSIbuy fuel system rebuild and the M1000 refurb fall in that category. When those go back into production, do they involve any unusual startup manufacturing costs?

I don't think so, Mike. This is Jerry Potthoff. Because very frankly, most all of that while it was in production had an expectation that it would at some point in time return, whether it be building from scratch new units or just refurbishing units. So we have all the tooling, we have all the processes, we have everything in place to pick right back up on those programs. And there are some things that we have not mentioned, for example, that look exciting to us. We over the years did a lot of things for the Patriot missile. And believe it or not, there's some requirements for that on the horizon. Again, when we shut down the lines to make Patriot trailers and the canisters for the missiles, etc., we very carefully tucked away all of our processes and all of our tooling and all of the necessary knowledge that we needed to restart those programs. So I believe that we feel very comfortable with the launch and restart of those kind of things. And again, the nice thing about, for example, the M1000 -- we won't start in building from scratch in trailers, we'll set with the refurb of them. And then in time, we believe we may be building some additional from scratch new units.

And then I am curious, and perhaps you can't comment yet on the up-armor kits. Inasmuch as you are planning to source those out of West Plains, can you tell us if the armoring material is the steel that West Plains is experienced in handling, or perhaps there's some other material involved?

It's a special armor material. And we have handled over the last 20 years virtually every grade of steel that you can imagine, from super-hardened -- you know, we are in the bridge business. We have built to date, much or most of the bridging for the U.S. Army. So those programs require all different kinds of steel. All different kinds of steel were in the initial programs when we went into the Tonner (ph) project. So there's a lot of experience at West Plains to handle virtually any alloy that we may have.

Hey Mike, Jerry. We certainly know the kind of steel we want to use. We have not decided on sources yet, though; that is another question to be determined down the road a little bit.

Eric Hugel, Stephens Inc.

Great quarter. My first question - and we've talked a lot about '04, and I guess maybe we could look forward a little more. A lot of people -- given that '04 is a strong, and that a lot of the orders that you're -- the new opportunities that you're talking about like the generator may not be starting up in the '05 time frame. Can you talk -- you have the M1000 rolling off, and I do understand that there are other programs kicking in and stuff like that. But can you sort of talk in round numbers -- can we expect to continue your 5 to 7 percent growth target, even on top of just the phenomenal year that you are having in '04, into '05?

(indiscernible) Jerry. We are not quite ready to give any substantive guidance on '05 yet, but we are optimistic. Yes, I think we feel like we can meet our organic growth targets. We are having a good year of orders right now. But rather than get into anything that sounds real specific -- we'll look at the second quarter announcement, I think, Gary, if we -- depending on how things -- some of the big contracts we're looking at come to pass, we may be ready to give guidance (inaudible) the second quarter. It may be a little bit like last year. If you remember, we sort of crept into it about second quarter, and that we kept refining it in the third and fourth quarter. But we are feeling better about '05 all the time. As you know, we've got -- at present plans, that is the last year for Tonner, so we have got a hole to fill there. But it's beginning to look like the hole is going to get filled. So we're feeling pretty good.

I guess my second question -- you guys said you saw a large amount of work on the R2 contract, which comes in at lower margin. Is that something that you would expect to continue? Or is that just onetime type of stuff that you wouldn't expect to continue at the same level going forward?

It will be a mixture. Let me tell you why. There's really two types of operations under that R2 contract. One is where the subcontractor is outside the ESSI family of companies, in which that -- under those contracts, basically, TAMSCO brings the business to them, so to speak. And they will get (indiscernible) some amount of administration, and they may have zero work in that. There is some amount of work in that, okay? But it's still good business and we still get an X percentage markup on it. If it goes back to a ESSI company, the example being -- I think we have had some work at Keco done through that -- then it can be very profitable, because the Keco division itself will make a significant amount of profit on there. And then in addition, the standard R2 contract will have a markup on it, too, and so forth. So it can vary on the type of business. I think we are looking forward, as it goes forward, to both (indiscernible) and including a fairly -- it looks like a fairly significant amount of the business to other subcontractors. All of that is good business, and usually low-risk business associated with products that have been built previously by us or the large number of subcontractors with whom we are -- I apologize for a long answer -- with whom we are teamed -- and including a lot of the major, major defense contractors are on our team as our subcontractors for that R2 program.

With regards to the Air Force, there's been talk about maybe further buys of more transport aircraft meant to support deployments and all that stuff. Has there been any conversation or any hope about further Tonner acquisitions?

Yes, there's been a lot of conversation --

Yes, most of it's us.

There's a lot of conversation on that, and there certainly is a willingness on the part of the Air Force to sustain that conversation. I think what they are going through right now is an analysis to determine what their real needs are. I can only tell you that we have -- the customer satisfaction we have developed over the years with the Air Force is outstanding, and that we really are working on that as a team to determine what might evolve. But I think our guys believe that it's going to take probably the remainder of this year for this current conflict to get into some stabilized mode before a true assessment can be made in regards further from-scratch units. However, there is some talk, as you can appreciate, to advance some of the depot support associated with those units. We will have built 318 as of sometime next year, so because of the extensive use that that product has seen, it's very possible that we will see some advanced work advance of our forecast to do again some major refurbishment.

My final question, can you sort of give us an update on what you're seeing out of the acquisition environment, how pricing is and opportunities?

Yes. We continue to see a lot of great opportunities out there, both on the services and the manufacturing side, or system side. Pricing seems to remain a little constant. Services has varied, of course, (indiscernible) long history after 9/11, services -- some of those went through the ceiling. They kind of tapered off. They got high last year sometime; they've come back a little bit, and so forth. So we have seen -- and in the manufacturing side -- a little taper off since some of the escalation after 9/11. There are still a lot of good companies out there to be bought and can be bought at reasonable prices. If you look at the three we made during the last year, those were all made at very good multiples, good pricing.

Have you felt it necessary to -- you have been focused on rather small type of acquisitions. If at some point it becomes hard to move the needle doing those smaller acquisitions, have you felt that at any point -- or at what point do you envision having to look maybe a little higher up the food chain to some bigger acquisitions?

Certainly as we get bigger, as a percentage increase over years, you certainly have to look at larger companies. I would tell you that for some period of time now, our M&A group has looked at about everybody out there, literally -- okay? And keeps running books on everybody, and so do the other guys looking at us, I'm sure to some degree. We do a continual evaluation and so forth. We don't look at those relative to numbers as much as we look at the strategic fit of a company. If the company has revenue of 200 million or 20 million, it gets over that threshold and that becomes important to us. And the fact that it is accretive, and strategically it can grow along with our other companies when they come together. So yes, we -- there's a lot of targets out there that are bigger that move the needle a little bit faster that we continue to look at. But again, we don't concentrate on the number growth as we do the bottom line to make the goal that we continue to promise out there, and the fact that we make good strategic acquisitions, and continue a reasonable growth and not just to become $1 billion company or whatever number you want to throw out there.

We have time for two more questions. Robert Winslow, Orion Securities.

If I could, please, I would like to drill down on the MSTAR program. I am wondering if you provide year-over-year data on MSTAR, as far as revenues and orders, so we can get a sense of how this program has grown?

(multiple speakers). You are looking for, what? '02, '03, '04, '05?

Yes.

This MSTAR contractor we're working on now was a major increase, and I don't know what the past years (indiscernible) a fraction of that, as a matter of fact.

(multiple speakers)

(indiscernible) to ask a question to (indiscernible) or Dan Rodriguez (ph). MSTAR was basically a military oriented program through its life. And as recently as last year they found new uses for the product in, basically, Homeland Security and security -- of other nations' homeland security. In other words, just a whole new application for MSTAR. So although they could probably give you some numbers, I'm not sure it would tell you what you need to now, because it's a program that (indiscernible) on the growth, just like the Minuteman which has made a revival. So it's sort of that kind of thing.

Okay. That's fair. And how does MSTAR look going forward then, into '04? I guess you don't have visibility into '05 at this point.

We have visibility from looking at all the potential applications for the product now around the world. It's a product that we licensed back in the early '90s. So here we are 10 years later with a much improved product, lower profile, less weight, more efficient, and with wider applications. So I can only tell you that the guys in business development have on their target a whole listing of foreign countries, along with, obviously, the Homeland Security and the perimeter security type of applications. So it's a product that's really got some legs on it.

Lastly, did I hear you indicate that the MSTAR, the current orders were wrapping up in midyear? Did I hear that right?

Yes. They're ramping up as we speak.

They're ramping up -- okay. I thought I heard that they were completed in midyear.

No. They are just ramping up as we speak.

Selman Akyol, Stifel Nicolaus.

Very nice quarter. First question, if I may, just on the cash flow from ops number. It sounds like most of that buildup is in relationship to MSTAR. Is Q1 a peak, or should we expect it to be negative again Q2 to a higher dollar?

Start out with the number I gave you before. I think I said it was ops, it's actually free cash flow. Ops will be in excess of 100. But as far as the second quarter, will we still see negative? We will not see -- are getting to the numbers that we expect for the year until the third quarter, but the negativism in the second quarter will not be as bad as the first quarter. We are (indiscernible) selling -- not to make a long story -- we are, obviously, on that MSTAR -- that program does not have progress payments. And you want a great program at great profits without it. We took it, obviously. And there will be significant inventory buildup and there will be a lot of billing which will be paid in the third quarter. So third quarter is going to see one hellacious (ph) amount of cash flowing through here.

Fantastic. Jerry Daniels, this is a question for you. In your opening comments, you guys talked about the military outsourcing nonoperational activities. Can you be a little bit more specific on what opportunities you see out of that flowing to Engineered Support?

I think more and more, you are going to see the focus of the uniformed personnel on things that only the uniformed personnel can do. We are seeing opportunities, everything from pretty technical things like engineering support, operation of our satellite communications equipment, to taking care of warehousing, to supply chain management -- some actually a very, very broad range, but more and more, where the uniformed men and women are going to do the things that only uniformed men and women can do. I believe with the increased depot activity it will open up activities for us, not to disrupt the balance of the 50/50 depot caucus agreement, but some of these depots are going to be loaded down quite heavily, and maybe overloaded. And we will see outsourcing opportunities there. So a pretty broad range of the stuff we're already doing that I think is a trend that is going to continue for a long time. This is not just something to do with the Afghan and Iraqi situation.

Just going back to the up-armoring opportunity out there, and you're going to be doing this out of West Plains -- was there large incremental cost up there, in terms of gearing up for that?

No, very minimal.

Very minimal. We have got all the equipment in place, and we have actually gone through -- beyond the development. We have gone through a program where we have really verified that we could produce this product, these kits, right on through the installation of it on the vehicle. So we feel pretty confident that we are in a position to execute.

On your 350 million fluid transfer system opportunity, is that basically the (indiscernible) that you were showcasing at AUSA?

It sure is, yes.

On the R2 contract -- it was 2.9 billion in total. Any idea how much has already gone through that, and what year you are in on the contract?

79 million through 2003, and there may be another 10 or 15 in the first quarter. I don't know. The 2.9 is an estimate, is it not? Or is that a ceiling?

But that would be across all the contractors, right?

No, no. Everybody has got a multiple of that number. That total contract is worth 10 billion or something like that. If we see the 2.9 billion, there will be a lot of happy people on this thing here. We will see a lot of business. Not to make a long story -- that is a fabulous contract. It has been a great thing for us that will continue to be a great avenue to get business through the government. They've done a good thing as far as helping themselves, and contractors and so forth. Sometime if you come in here or something we can talk more about that. It's a great thing.

Just so I understand -- your total opportunity under that contract could be as much as 2.9 billion?

Certainly, yes.

Okay. I thought the whole contract was for 2.9. Thanks.

This concludes the question and answer session.

I would like to say something if I could. This is Mike Shanahan. At the risk of say something I shouldn't say -- which if I do it won't be the fist time -- there's a bunch of us sitting around table aware that one of the callers, this may be his last call with us because he's going on to bigger and better things. And if he's been anything, he's been a wonderful advocate of the shareholder and a man of high integrity, and he's been fair with our company. And he knows who he is and we know who he is, and we wish him all the best.

Thank you all for being on this call.