Leonardo DRS Inc (DRS) 2005 Q2 法說會逐字稿

Welcome and thank you for standing by. Good morning and welcome to the Engineered Support Systems second-quarter earnings release. (OPERATOR INSTRUCTIONS). Your host for today's conference call is Mr. Gerry Potthoff, Vice Chairman and Chief Executive Officer. Sir, you may begin your call.

Thank you, Dennis, and good morning, everyone. Thank you for joining us. I am accompanied on today's call by our CFO Gary Gerhardt and Dan Rodrigues who recently took over as the Company's President and Chief Operating Officer after doing an outstanding job as President of our Support Systems Group for the past couple of years. I am glad to have Dan as part of our office of the Chief Executive. Dan and I have worked side-by-side for the last 18 years.

In this morning's announcement, we reported that our earnings for the second quarter ended April 30, 2005 were below our expectations. While net revenues of 264 million for the quarter grew more than 25% compared with prior year, net earnings from continuing operations came in at $0.46, below the earnings level anticipated for the quarter but 10% over the previous year's second quarter.

As was evident from our earnings announcement other than what we believe to be the temporary impact of recent developments on a singular contract, we posted an excellent second quarter with record revenue gains, great free cash flow, record backlogs and the initial integration of our recent acquisitions, Spacelink, PCA, and MSI.

Revenue and earnings for the quarter were impacted by reduced production activity on the Deployable Power Generation and Distribution System or DPGDS. Various performance issues were discovered by end-users and members of our team after the system's primary power unit, or PPU, a key component of the system had been initially deployed in the field. In response jointly with our customer, earlier this year we began a thorough systems analysis resulting in the development and implementation of an extensive corrective action program.

During and since that time, production of the new PPUs have been curtailed. These delays resulted in lower than anticipated DPGDS-related revenues in the current cared period. DPGDS-related revenues generated for the current quarter were comprised entirely of secondary distribution equipment and related ancillary equipment to the PPUs, none of which are experiencing any performance in the field.

As a result of these reduced revenues, quarterly net income from continuing operations was negatively impacted. Certainly with an overall profit margin that it has been a major contributor to earnings, any material increase or decrease in DPGDS-related revenues can create sizable variations in profit period to period. We had been anticipating a significant amount of DPGDS-related revenues throughout 2005, and that assumption was inherent in our financial guidance.

Compounding the temporary adverse impact of the program during the second quarter, we booked a substantial provision for anticipated rework cost on (indiscernible) units. Dan Rodrigues will explain this situation in much more detail shortly.

One important fact that I cannot stress enough is that revenues and earnings on our DPGDS program have not gone away. Orders and deliveries have just moved to the right, temporarily awaiting a successful implementation of the corrective actions.

It is also very important to note that inherent within our revised earnings expectations for 2005 you will find that we have replaced a substantial portion of the temporarily delayed revenues and earnings associated with the program with a multitude of other positive pieces of new business. We are essentially replacing nearly $10 million of DPGDS-related earnings that have moved into future years with a variety of programs that include additional (indiscernible) business, equipment reset activities and telecommunications support work. This reflects the strength of our market positioning and the ability to leverage ESSI's collective capabilities.

Before I turn the call over to Dan to provide a detailed update on the program, I would like to take this opportunity to put the second quarter's developments in perspective. Obviously we understand that shareholders become concerned anytime a firm reports lower than expected financial results. We are fully aware of the environment in which we operate, especially today's stock market. We are sensitive to the concerns of our shareholders as we too have a great deal invested in the Company. We hope that our discussion today helps to alleviate any uncertainty our investors may be faced with, and we appreciate your patience in listening to extended commentary on our part this morning.

Over the past six years since I have had the privilege of being a part of Engineered Support's management team, our Company has put together a track record of outstanding financial performance and profitable business growth quarter after quarter year after year. We have been somewhat fortunate. With literally scores of individual programs and a large cross-section of the defense and government customers, we have avoided major negative financial impact from any programmatic difficulties. We are quite proud of this accomplishment.

We're facing as many obstacles and succeeding. I applaud the efforts of our entire team in delivering exceptional financial and operational performance throughout my association with Engineered Support.

And folks, I think once you hear Dan's report on the improving status of the DPGDS program and Gary's report on our financials and the state of our business, I'm sure that you will find highly confident and feel most assured that we have the right team, including both extremely supportive customers, very capable subcontractors, right solutions and super employees, to meet current and future challenges. Now over to Dan.

Thanks for your support, Gerry. Since this is my first opportunity to publicly do so, I would like to thank our Chairman Michael Shanahan, Gerry Potthoff, Ron Davis, Gary Gerhardt and the Board of Directors for expressing their confidence in me by naming me President and Chief Operating Officer. Also, I would like to express to our shareholders and employees my total commitment to the continued success of ESSI.

That said, let me get to the topic of DPGDS. As you are aware, Engineered Support has been providing power generation and related distribution equipment to the U.S. Air Force and the U.S. Army under the DPGDS program since the acquisition of Radian some three years ago. During this period we have received orders totaling well over $250 million for the system and its various components in support of U.S. forces deployed around the globe. DPGDS has been a major contributor to our reported revenues and earnings for the past three years, and any significant variation in the program's revenues certainly can have an impact on our profitability.

In 2004, for example, DPGDS-related revenues totaled to approximately $79 million with program margins above 30%. And through the first quarter of this year, we were on a pace to reach similar levels of revenues and earnings on the program in 2005 as well. It is our operating philosophy at Engineered Support to stay in close continuous contact with our military customers, and as such we have been fully engaged with the Air Force to achieve DPGDS not just as an acceptable capability, but as an optimum capability for expeditionary power generation and distribution.

First, a bit of background. Before the initial delivery of the system, DPGDS completed several rounds of contractor demonstration and testing and passed the Air Force conducted qualification operational test and evaluation tests. Since then, performance of the system's electrical distribution components has met very effectively the customers' needs for performance and reliability, and these components are currently fielded and in use by our military.

However, several reliability issues were identified by our Air Force and Army customers during operation of the fielded primary power units or PPUs. Pending the completion of efforts to address these issues with the full agreement and support of our Company, the Air Force issued a stop work order on the primary power unit production. Thereafter, these and other issues were further identified and defined in a thorough systems analysis our team conducted. The major problems primarily concerned excessive loading and heat buildup in the engine, as well as other performance issues elsewhere within the overall system. We identified a number of immediate product improvements which are being implemented as we speak and then set forth a retrofit program which is underway to address the remaining reliability concerns.

As I said, we are addressing all known customer concerns, and we believe that when this process is complete we will enjoy tremendously high confidence in the PPU's performance and reliability as will our customers. During the summer, a reliability audit will be conducted, and we expect at that time to fully validate the process, product and reliability improvements we will have installed in this system. At that point DPGDS will still exceed the power requirements the Air Force originally set forth for the system, and it will continue to represent a significant leap forward for expeditionary power capability. Then, once we successfully complete the reliability audit, we expect the Air Force will lift the stop work order on PPU production.

As we currently have $44 million in funded backlog on the program with the receipt of significant additional funding awaiting the full implementation of our solutions, we should be able to generate a meaningful amount of revenue on the program during the fourth quarter of 2005 to help meet our revised revenue and earning targets. Beyond that, we expect to see additional orders from both the Air Force and the Army in fiscal years 2006 through 2008 time period. If the current level of deployments continue, then it is very likely that orders would continue beyond the fiscal year 2008 time period.

I certainly appreciate the support that our valued Air Force and Army customers, our partner Caterpillar and other key suppliers have provided us during this process of determining the appropriate solution set to address the performance issues with the PPUs. And most importantly, I would like to give a hearty thank you to the great number of individuals within the ESSI family of companies who have worked tirelessly on this project. We are close to getting the DPGDS program up and running again, and I am grateful to those who have contributed.

Now I would like to turn the call back to Gerry.

Thanks, Dan. We all appreciate the great work that you and the team have been doing to get the program situation turned around. The SET (ph) in partnership with the committed customer and great subcontractors are on their way to getting things back on track.

At this point in our call, we believe it is very important to note that we remain very optimistic about the second half of the year and even more so for our prospects of continued business growth and as importantly execution of the business we win as we move into the next year and beyond.

For example, recent large multiyear contract wins on a modular fuel farm. Multinational Forces communications support and generator reset are certainly positive developments for ESSI and illustrate the breadth and depth of our capabilities as an organization. With more than a $2 billion long-term contract backlog and more new programs on the way, we believe we are well positioned to continue the profitable growth of Engineered Support Systems.

Now I would like to ask Gary Gerhardt to break down the financial impact of the DPGDS delays and other items affecting our second quarter's results and to outline where we expect to end up the year as we face -- see things right now. He has an outstanding review that provides very valuable insight into our current and future business. Gary?

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

As we reported earlier today, during the second quarter of 2005 we posted net income from continuing operations of $20.1 million or $0.46 per share on a post-split basis. Although the quarter was negatively impacted by reduced production work on the DPGDS program as explained in this morning's release, we did experience solid organic revenue growth on a variety of other new and existing programs. Increases include additional vehicle up-armoring of approximately $20 million for the quarter and an increase in M1000 trailer refurbishment work for about $10 million for the period. These quarterly gains were partially offset by reduced revenues on the Tunner Cargo Loader, which decreased about $8 million, and the last production unit was delivered in March of this year.

MSTAR deliveries were also lower this year by approximately $19 million as the prior year included the large Northrop order. Other revenue increases were noted in telecommunications support activities, as well as the asset protection work which both contributed nicely to our reported results for the period. Postacquisition contributions from PCA and Spacelink accounted for a combined $25.4 million of the quarterly increase in revenues. Despite more than a 25% overall growth rate in quarterly revenues, the temporary reduction in DPGDS-related work and the associated increase in costs this quarter negatively affected operating income in the current period. As all production work on the primary power units was essentially ceased during the quarter, we only generated $8.5 million in DPGDS program revenues.

Our internal forecast for 2005 had targeted a total of approximately $26 million in revenue for the second quarter of this year. This variance in operating profit contribution when combined with a provision for estimated program costs of approximately $3 million associated with the ongoing testing and retrofit required for over 100 fielded PPUs accounted for approximately $8 million in reduced pretax earning contributions during the second quarter. Excluding the significant DPGDS shortfall, consolidated operating profit would have been substantially higher than the $33.3 million reported for the second quarter.

During the period the recent acquisitions of PCA and Spacelink contributed over $2 million in combined operating earnings and nearly $4 million in combined EBITDA. Net income from continuing operations totaled $20.1 million, about 10% higher than the second quarter of last year. Overall net income was negatively impacted during the second quarter by an after-tax non-cash charge of approximately $1 million or $0.02 per share from settlement of litigation associated with the sale of our former plastics business unit in 2003. The reserve for potentially uncollectability concerns we have reserved for approximately one-half of the $3.3 million in restructured note obligations now due ESSI in 2009. As a result of the above, net income totaled $19 million or $0.44 per share on a post-split basis for the second quarter of 2005.

Free cash flow was very strong in the second quarter at a robust $31.1 million as working capital levels came down during the period. Despite spending $137 million in cash for the acquisition of Spacelink in early February of this year, our level of net debt at quarter end stood at about $90 million significantly below our trailing four quarters EBITDA figure of nearly $150 million.

Just after quarter end, we did use approximately $16 million in cash on hand to fund the acquisition of Mobilized Systems Inc., MSI. MSI's operations will be included in our results for the second half of the year.

In our release we provided our revised revenue forecast of between $1.02 billion and $1.05 billion for 2005, a fairly sizable increase over the level previously forecast for the year. Given some of the developments within the Company during the past few months however, composition of this business has been altered somewhat. I will now run through the items affecting our previously forecasted -- for 2005 as well as our impact compared to our previously existing expectations.

As we pointed out, our revised revenue and earnings forecast for the remainder of fiscal 2005 year will continue to be adversely impacted by the delays in the DPGDS program, particularly in the third quarter until PPU production comes back online which we will expect to occur later this year. There to our original 2005 revenue forecast of approximately $70 million for the program, DPGDS-related revenues are now expected to approximate $35 million for 2005, roughly half of what we were expecting. This temporary reduction in program revenues plus the estimated cost of retrofitting and testing will have an approximate $14 million impact on pretax earnings for the year. On the bright side, we should see significant earnings contribution from the DPGDS program in fiscal 2006 once the current situation is behind us.

Several recent developments will also positively affect our results in the second half of this year, and these include incremental revenues which are expected to now be above our original 2005 forecast for vehicle add-on armor kits of $45 to $50 million. The two letter contracts for Up-Armor kits we’d take on what will soon be definitized at an expected combined value of approximately $73 million. Considering the revenues related to the Up-Armor work already completed so far this year, 2005 Up-Armor revenues should well exceed $80 million. This is substantially above our previously expected level of approximately $35 million in Up-Armor revenues contemplated within our original 2005 forecast. So clearly this upside will help offset the temporary reduction in DPGDS revenues and earnings for the year.

Additional telecommunications support work. Recent contract wins in this area of our business including a two-year $172 million follow-on contract with the Army to provide telecommunications support services under the R2 contract are now expected to contribute incrementally to our 2005 revenues and earnings.

Revenues for generator reset. This large multi-year time and material-based contract is just kicking off in the second half of this year. We expect nominal revenue and earnings contributions during the 2005 startup phase of the program occurring over the remainder of this year. However, with an identified effort to refurbish, prepare or remanufacture an estimated 4000 generator sets deployed in Southwest Asia included within the scope of the program, significant revenue and earnings contributions are expected to commence beginning in 2006.

In addition later this year, the Army is looking at funding a large reset effort for environmental control units used by our forces in Iraq. As the leader in military ECU design and production coupled with our logistics support capabilities, we are positioned quite well to secure this emerging opportunity.

The MSI acquisition. We expect that the recently completed acquisition of Mobilized Systems which closed at the beginning of the third quarter will add approximately $13 million to our 2005 revenue base at reasonable margins.

In summary we are looking at the upside I just mentioned to add an incremental $40 to $50 million in revenue above our most recent 2005 forecast with reasonable contributions to earnings. Our revised revenue guidance for 2005 represents a 15 to 19% increase in revenues on top of the exceptional growth we achieved in 2004. Based upon this revised forecast, organic revenue growth for 2005 should be between 4% and 8% largely on the strength of our rapidly expanding services business.

As a result of the above, for the entirety of fiscal 2005 we now expect earnings per share to be between $2.00 and $2.03 per share on a post-split basis based upon forecasted net income from continuing operations of approximately $87 to $88 million. This performance is obviously below our prior expectations for the year, but considering the unforeseen impact of the DPGDS program we believe that these revised earnings targets are realistically based and reasonably achievable from existing operations and programs.

Operating cash flow for 2005 is now expected to reach $90 million with free cash flow of approximately $75 million despite our spending around $15 million in capital expenditures this year, a relatively high amount for our firm compared to historical trends. Our revised outlook actually represents a sizable improvement from the $60 million in free cash flow included within our previous financial forecast.

Year-to-date entered orders although near their planned levels through the April quarter, will become much stronger for the balance of the year. Total bookings continue to be targeted at $1.1 billion for 2005 pending the successful outcome of ongoing DPGDS testing.

Now I would like to turn the call back to Gerry Potthoff who will wrap up our remarks.

Thanks, Gary. Well, despite the delays with the DPGDS program, our forecasted financial results for 2005 still represent another record year. And the good news is that once we get this program back online, it should continue to provide significant production revenues to our businesses over the next several years at very solid margins. That prospect coupled with a host of other recent positive developments at ESSI and within our particular niche of the defense industry bodes well for a prosperous future.

Now I would like to take this opportunity to reinforce three important indicators of the long-term financial strength of our business. First and foremost, our strong cash flow. As we stated in our release for the second quarter, we reported free cash flow of approximately 31 million. This is despite the earnings shortfall for the second quarter, stemming from the reduced contributions from the DPGDS program. So we are generating substantial cash flow, the lifeblood of any business, and we are well on track to achieving exceptional free cash flow for fiscal 2005.

Secondly, we have announced several significant multi-year defense programs in recent weeks that have added substantially to our total backlog. 279 million for communications work, 204 million on the modular fuel farm, and 151 million for generator reset, all programs that illustrate our solid positioning within the military sustainment marketplace and the breadth of our Company's capabilities. These awards and many others have pushed our total backlog at quarter's end to in excess of $2 billion for the first time in the Company's history.

And thirdly, the long-awaited '05 supplemental bill was finally signed into law last month. Clearly a meaningful portion of the O&M and procurement-related spending contained within this $82 billion spending bill directly relates to many of our existing product and service areas. Supplemental spending is earmarked for generators, trailers, target acquisition systems, protection systems, decontamination systems, fuel and water systems, environmental control systems and a variety of support equipment that ESSI companies provide, while telecommunications and logistics support efforts will continue to receive emergency incremental funding for the foreseeable future.

We typically do not include any new work in our financial forecasts until we actually have received a contract solicitation from a customer. So very little if any supplemental spending is included within our revised 2005 earnings forecast which Gary just laid out for you.

In effect we are just starting to get some visibility on the supplemental. But our 2006 budget, which we have started to develop as part of our annual planning cycle, will undoubtedly be bolstered by some of these new opportunities as they begin to take shape over the coming months.

We also understand that we may be seeing bridge funding of another 45 to 50 billion in the 2006 federal appropriations bill to help fund the ongoing war effort. Regardless of where the money comes from, it is apparent that the Pentagon continually requires incremental funding for some time just to help repair and replace a large amount of equipment receiving heavy use in Iraq.

With the anticipated expansion of our business base from these new organic revenue sources, as well as the continued growth by our synergistic acquisitions, we will not lose sight of maintaining efficient and cost-effective business operations. Today our SG&A cost base remains below most of our defense industry peers, and we are committed to rebuilding our efforts to leverage the Company's existing cost structure to maximize earnings performance. Efficient execution and continuous improvement remains as a primary focus for us.

Before we open the call for questions, I would like to briefly comment on the recently announced BRAC selections. The list is out, and we have seen that the planned level facility cuts is much less broad than some of the military and Congress initially feared. Our belief is that regardless of what transpires with BRAC the essential functions of the military will continue unabated. Some bases may see their operations greatly curtailed, while others may undergo major expansions. The process involves not only base closures, but also realignments.

We believe that a key offshoot of BRAC will be the spread of the outsourcing and logistics activities and support services for military depots and similar operations to contractors such as ourselves.

Uniform personnel will continue to increasingly focus on handling the much more critical war fighting activities. BRAC will only accelerate this long-term outsourcing trend. Certainly with all the reset and recapitalization activities beginning to heat up as used and damaged equipment returns after extended deployment, new outsourcing work will be becoming our way. An example of this being the recently awarded generator reset program.

Regardless of what happens, everyone must keep in mind that any proposed changes under BRAC won't take effect for a period of years once the measure is signed by the President this fall. So our interpretation of BRAC relative to ESSI is very positive.

With that, thanks for your patience in listening to a relatively long call. We will now begin the Q&A portion. Thank you.

(OPERATOR INSTRUCTIONS). Selman Akyol, Stifel Nicolaus.

A couple if I may. First of all, Gary, when you refer to (indiscernible) on the reset opportunity, how large was that?

I don't think there was any (indiscernible). Their generator set reset program, which is substantially large, there will be some -- there will be an ECU, Environmental Control Unit, reset program which could potentially involve not only (indiscernible) but other types of wheat manufacturing over the years. That will be a new program very shortly. We think we are a kind of the key guy out there to be able to win that for a whole bunch of reasons and so forth.

Selman, we don't have a number on that. We can only speculate it is going to be at least in the 10s of millions, and will it be over 100 million, we don't know right now. It will be a long-term program just like this generator reset program is though, and it will be a good program.

They are continuing to buy new (indiscernible) meanwhile, of course, just as they are continuing to buy new generators to take care of the losses over there that some of these units coming back are not reparable. But in general the reset activity, a lot of which relates to our products, our capability, is huge over the next few years, extremely huge.

Okay. Just a couple of questions on the DPGDS if I may. First of all, is that the Air Force or the Army or was it both the customers that were having problems with it?

It was both the customers. This is Dan Rodrigues.

What other choices do they have that is out there? Is there any other products they can bring in, or is there anyone else that can ramp up in terms of manufacturing?

Presently there are no other products that would meet their requirements that they have identified for what is known as a bear system. And generally speaking, you know this is such a leap ahead in technology that frankly, if they were to initiate such an evaluation looking for a new solution, they could be three or four years away.

Got you. And then in terms of your lost revenue for this year, would you expect it to just all shift to '06 and then sort of another 70 million in '06 as well if we use that as a run-rate?

I don't know that I would get that to 70 million, Gary.

We don't have our number for '06 yet, but with what we know now, I think you're probably in the range. Your original number is yes, we are going to lose 35 million in this year that will go into '06. It won't go away with right now. There is again a sizable amount of funded backlog setting on the books once this thing gets going again and understanding, and there is a considerable amount of funding sitting out there waiting to buy additional units once everybody agrees and that the testing is complete.

So yes, the number in ‘06 could be very substantial as far as revenue on DPGDS. It is a program that, and Dan described it very adequately, having done a lot of research recently on this, there are no other alternatives rightly or wrongly. And so for this Air Force contract, the Army uses it extensively, and I think the solution that is coming out of this is going to make them an excessively happy customer if they are not there already. There is not only no other alternatives, they are not going to go anywhere anyhow because this takes care of their needs very adequately.

All right. Thank you very much.

Chris Donaghey, SunTrust.

I guess I can understand the hesitancy in baking in supplemental funding into your forecast, but can you talk about your bookings forecast, the $1.1 billion? Does that include anything from the supplemental?

This is Gerry Potthoff. If it does, it would be really at the end of the fiscal year, and we would not expect to get any just limited revenue from supplemental for this fiscal year.

The other thought would be that as the supplemental gets lined up and as we just -- as I indicated as we just started to get some visibility, we also need to tie down exactly how the supplemental is going to be spent.

You know there is -- you talk about the color of money. Is it going to be from the procurement? Is it going to be from O&M? Is it truly distinct and reserved just for supplemental? So I think again, Chris, and I understand your question, it is an excellent question, but we continue to be hesitant because we actually just saw the initial list of opportunities that we might get out of supplemental last week. So it is at this juncture just getting some real visibility.

And as I think, for example, by the time we get into our third-quarter report, when we talk to you three months from now, I guarantee you we will have a lot more definition on supplemental. And again not just for '05, we will have more definition on the bridge you're talking about. We will have definition on the '06 supplemental. Because the broad numbers that we're now looking at says that if there is a range of supplemental coming out of '05 of somewhere between 100 and 180 million in '06 there is something in the order of 100 million. Beyond that, we have very limited visibility.

Okay. And assuming the operational tempo stays where it is and we continue to live with this supplemental environment, your typical organic growth outlook -- you know obviously with Tunner and MSTAR this year negatively impacting, but if you would look at 2006, if your normal outlook is 7 to 8% on the organic side, do you have a feel of how 2006 might begin to shape up from an organic growth perspective? Are we looking at something higher than normal?

Boy, that is really tough, particularly when you think about 2004. Because we had such phenomenal organic growth then I think, Gary, in the order of 20%?

Yes.

You know, it is so hard to forecast that. But I would say this, I would speculate that as we drive through our planning process and develop our '06 budget, I think that it would not surprise us if we came up with organic growth in excess of 48% range that we typically have been targeting ourselves for. That certainly is not beyond our expectations at all. We just don't yet have the '06 definition.

Okay, that is fine. And one last thing, the retrofit activity was a $3 million impact in the second quarter. Is that work complete, or is that continuing into the third quarter as well?

That work will continue into the third quarter. However, we have recognized what the full impact of the retrofit activity is in our second-quarter results.

Okay, great. Thanks.

All testing and everything else associated with the program was recognized in the second quarter, so there will be no further additional charges on the program after this quarter that we can foresee.

Okay. So then the additional $6 million if you're talking about a $14 million operating profit impact, that is just the lower volumes then in the third quarter?

Yes, it is the shift of the revenue in the second quarter out into the future.

David Gremmels, Thomas Weisel Partners.

Just one on DPGDS. You said you were anticipating 35 million in revenue for the year. I'm just wondering what does that assume with respect to the timing of the stop work order being lifted?

We presume that that stop work order will be lifted, and we will be back in production in the fourth quarter of fiscal 2005.

So you are assuming the stop work order is lifted by the end of the third quarter and you are back in production for the fourth quarter?

Yes.

Okay, great. And then just to kind close the book on Tunner here, is that production program now completed? And if so, what is the ongoing Tunner revenue contribution from spares and support and things like that?

The production contract is, in fact, completed. We have delivered the 318 floater to our Air Force customer, and we will continue to see on the order of $10 to $12 million worth of spare support and logistic support ongoing. That will lead us to the depot activities.

And was there a closeout benefit in the quarter, a closeout fee?

No, not to any great extent, David. We have done a pretty good job as far as monitoring any kind of reserves and flooding them out at the proper timing so there was not a tremendous windfall or anything closing the program.

Okay and then on the margins going forward, it looks like the operating margin would have been 14.5, 15% if you had hit the DPGDS plan. Is that fair? And with Tunner and MSTAR down and Spacelink up as a lower margin business, should we think about run-rate operating margins dropping below 14% going forward?

Well through '05, basically no. We're still looking at the same run-rate there basically. In '06 just to get a little bit of insight, right now with the visibility we have we are probably still in that range, David. We don't have anything that sees differently.

Some of the growth in the services side of the business is on things like telecommunications and some of which is fairly profitable business. It is not the normal selling bodies at 6%, so a lot of our growth is at good profit margins. So we would hope to be able to continue to do that. And again remember that on the services side, the DPGDS is actually on the services side. So next year could be a very large year as far as revenue at a very good margin, so that could have a very significant impact next year on the services margins.

Okay, that is great. And then last one for you, you talked about new order bookings of 1 billion 1 for the year. And historically your bookings have been front-end loaded in the year as you look past over the last three to five years, and this year looks like we are going to see the opposite of that pattern. What is different now? Is it (multiple speakers) revenue? Is it the timing of the supplemental? What has changed?

David, actually there is one major differential. Tunner was always something uncharacteristically and unlike most of our other business came in in the first quarter. It always came in very early, and that had a tendency to frontload our Internet (ph) orders. But I would say that the intake of Internet orders that we are seeing is fairly consistent with historically what we would anticipate.

And the 1 billion 1, you mentioned that there is not much assumed in your revenue plan from the supplemental. Does the 1 billion 1 in planned new order activity make much of an assumption with respect to the supplemental?

Sure could be some supplemental impact, certainly. But again, I think the key there is it is going to be year-end type of Internet orders.

I'm sorry. Would the supplemental impact be (multiple speakers) incremental to the 1 billion 1 or included (multiple speakers) in the 1 billion 1?

Supplemental.

It is incremental?

I said from supplemental. Fourth-quarter type of Internet orders from the supplemental budget.

Eric Hugel, Stephens.

How much of the backlog increase for the quarter came from Spacelink?

Eric, we're going to look here kind of quickly. If you have got another question and see I don't know that -- somewhere in the $80 million range it looks like here. That was not under (multiple speakers) we had very quickly and so forth so.

But most of that is unfunded?

About 50-50.

50-50.

50-50.

In terms of maybe a little more depth in terms of the free cash flow in terms of the improving, can you be maybe a little more specific in terms of where you are seeing better-than-expected -- are you getting -- will you be able to cash collect -- are you just collecting the cash better, where working capital management -- sort of what specifically is going on that you're able to raise your free cash flow despite the DPGDS shortfall?

Well, if you remember going back to our original forecast for '05, we had a fairly significant decrease in working capital, and it was kind of loaded toward the end of the year. So we're not seeing too much different than what we originally anticipated, other than we think it is going to be stronger than we originally anticipated.

So we are seeing a decrease in working capital across the board in general. There are some areas that are not, but just there was some increased buildup at the end of the year based upon things like the Up-Armor contracts and some of those contracts. Some of those did not have progress payments and, therefore, great programs, but we ended up having to finance them. We ended up with some inventory on the books and so forth. So that is part of the decrease which would go across several divisions and so on.

We have been working for, oh golly, at least a year, Eric, in reference to collection. And when I say that, on the services end of the business, it is always a little more complex in dealing with the federal government in respect to documentation. We have done a lot, especially in the last six to nine months of improving that process and our ability to collect money on the services side of the business has improved dramatically. Although we have worked it across the whole business. It is a big subject around here. It has been for some time. Everybody in the whole Company knows cash flow and knows it is very important.

So again, in general we plan to have a good year in cash flow. It looks like it is going to be better than we had. The turnaround in the second quarter was a lot to do with working capital changes, and we are seeing system changes that are going to improve our cash collection timewise going forward, so.

In terms of looking out there for the rest of the year in terms of sort of timing of programs in terms of how that is going to affect earnings, should we sort of be expecting results sort of in the third quarter flattish, but still absent the DPGDS with a strong boost in fourth quarter? Really the factors sort of moving the earnings needle would be DPGDS. Is that sort of a safe way to sort of look at it?

Well, we had not given guidance by quarters, and we won't be providing that at that time. But certainly the indication would be that the fourth quarter is going to be stronger than the third quarter for a whole bunch of reasons. Not only DPGDS, but just going through the programs as far as the operational results that are going to happen would indicate that the fourth quarter is going to be considerably stronger than the third quarter.

Do you have any sort of information on your backlog in terms of how much is deliverable in '05 and '06?

How much would be flowing out in '05 and '06?

How much of that backlog would be turning into revenue in '05 and '06?

Eric, we don't have that number exactly. (multiple speakers)

(multiple speakers) -- in regards to the CapEx. Did you sell any assets this quarter that will be netted against your spending?

No, not anything sizable. The main portion of the CapEx relates to the hanger down in North Carolina. Remember TAMSCO was involved in Elizabeth City down there, which is a Coast Guard operation, and that is for KC-130s and hopefully other airplanes as far as doing some mods, upgrades, things like that. We think that has a great future, and that is where most of the CapEx increase or delta has been over the last, say, roughly six months. I think that the hanger is scheduled to be complete sometime this fall.

Cai Von Rumohr, SG Cowen.

Cai Von Rumohr Yes, could you tell us what were DPGDS sales for the first half, and when did you get the stop work order and know that you were going to have to take this charge?

The sales were about 25 million in the first six months' revenue. You want to take --

I will go ahead and answer the question. The stop work order was issued at the end of November of '04, and we truly did not come to grips with what the impact to the program would be until very recently in preparation certainly for the closing of our second-quarter activities.

During the course of that, we obviously were engaged in running some reliability tests and overcoming some of the failures that occurred in those reliability tests and then trying to come to grips with what the corrective actions would be and what the impact of those corrective actions would be to the overall program.

Okay. My understanding -- correct me if I'm wrong -- was that the issue was that the unit could meet peak power requirements but that the customers were basically running it consistently at peak power requirements. Did and does the original unit meet the specs in terms of sustaining, or is it kind of vague in terms of that they are able to run at peak power for this consistent rate?

There is a duty cycle that is identified in the contract which really would only account for running it at peak power requirements I believe one hour in every 24. (multiple speakers)

I guess where I am going with this is, my understanding is they were using it more than one hour out of 24, and that, therefore, the unit you were providing them, while it did not satisfy the way they were using it, in fact, met the specs. And, therefore, the question is, do you have any relief from the stop work order in this delay because in effect your unit did meet the contract specs?

I would tell you that I have not seen anything that would lead me to believe that that set of facts were correct, that they were using it in excess of the prescribed one hour in every 24.

Okay. And then I guess I'm a little confused if, in fact, we did 25 million in the first half and we're doing 35 in the second half, it sounds like you cannot be assuming much in the way of deliveries in the fourth quarter?

No, the 35 is total for the year. We originally projected 70 million of revenue for the whole program for the whole year, and we are now saying roughly 35 million which does not say there is still -- there will not be a lot of revenues in the fourth quarter, but there will be some amount of revenues in the fourth quarter.

Okay. And then the Up-Armoring is all -- what portion of that increment falls into the October timeframe, or is this kind of you're going at a consistent rate? Because I know usually when they want this stuff they want it stat, immediately. Can you give us any help on that?

The deliveries of our Up-Armor requirements will be complete before the October timeframe of this year.

The current requirements. (multiple speakers) in this fiscal year (multiple speakers).

We are looking for a substantially lower number. How much of the increment to your guidance from 35 to 80 happens in the fourth quarter? I mean any rough -- is it relatively level? I mean because I know at one point they hoped to complete this by August, which would say you get a huge balloon in the third quarter. Is this roughly -- the third and fourth roughly the same, or you know any -- --?

I don't know. I don't think we have got that data here. I would tell you third quarter will be strong relative to Up-Armor. No question about it. There was some sizable amount of dollars in the second quarter in Up-Armor. The fourth quarter will be, too. Is third quarter larger than the fourth quarter? We don't have that data here to be honest with you.

Okay. And do you expect any incremental orders for Up-Armoring out of the supplemental?

I think there is a good possibility. There is a lot of dollars in there for Up-Armoring, and let's call it the philosophy of the military, especially the Army since most of these vehicles are Army, is always fluid to some degree as far as they handle that. And I think we kind of take that as very positive as far as what they are doing going forward and so forth. We think long-term there is amazingly a lot of opportunities out there long-term for us along with other people, but we think we are very strong where we stand, what we've done.

One thing we have done that has been very great, we can pat ourselves on the back, is that when the Army has had a problem, they’ve come to us. We have solved it. We have performed and we have delivered and offered them -- given them a quality product that has met all the requirements and so forth. That puts us up very strong in their eyes in reference to any kind of future activity on armor.

So I think long-term there is a lot of possibilities out there. Certainly the supplemental is going to have some dollars, is going to go for Up-Armoring to someone out there, and even after that, we think there's still possibilities.

Matthew Maki, Jefferies.

Just one question on DPGDS and then I will lay off this horse for a while. In your minds -- it is really a follow-up to the last series of questions -- in your minds was the issue really on the Company's side in terms of there was some -- I know you passed the test in terms of the product met the test requirements -- but is something inherently in the design of the product, or was it something in the production side, or was it something on the customer's side where either the requirements were not set properly at the front end? Or again as sort of highlighted before, maybe they were not using as they originally thought they might be?

This is Dan Rodrigues. I would tell you that the acquisition philosophy for this piece of equipment is it was bought under a FAR Part 12 format, which says it was bought as a commercial piece of equipment. And while there was QOT&E testing done by the Air Force in the early part of the program, it did not include a full reliability set of tests that we might see in a normal DOD design development program. And, therefore, you know today I would say that what we're seeing in the field is essentially the result of infield reliability tests. We are getting that feedback from the field, and we're taking the appropriate action. Because the absolute overarching goal that we as a Company want to make sure we achieve is to provide our customer with a quality product that meets the requirements that they have for expeditionary power, and that is really where our mind is right now on the program.

Okay. So in the eyes of the Army and the Air Force, they recognize that hey, you know what, maybe we did not completely take this and test it completely on the front end. And, therefore, now it would have been great to have a product that worked 100% on the front end. It is a reasonable issue that we -- that is being confronted here?

I think we, frankly, have the full support of our customer community as to where the program is today and where we are headed in terms of implementing the changes that we collectively agree will enhance the performance of the unit. And in our July reliability audit, I believe we will all come out of there with a unit we are ready to field and be proud of.

Great. Then the 40% year over year increase in backlog, I know you guys have won some sizable contracts recently. Just any additional color on that backlog? For example, have you put the full amount of the recently won contract into unfunded or any breakdown between sort of the products and services side, you know when you might see some of the unfunded move over to funded? You know, you know just any color you could provide would be great.

Okay. There is about 47 questions there. I'm going to answer only 46 of them. I'm not sure which one I will pass on.

To give you a little bit of insight into it, as far as the break between systems and services side, as far as that backlog, it is a little bit more oriented toward the system side, okay, overall. Just like 55/45, a little bit of break.

As far as your question, Matthew, did we put all of it in there? Yes, except -- and when I tell you except -- some of these contracts were -- two things will happen. Number one is, if there is not a specific identified amount, then we take a very cautious approach relative to what we put in unfunded backlog.

And the second thing related to that is what we have seen historically, and that is we consistently have a lot of -- continually have a lot of contracts whereby the government will issue orders in excess of what that original estimated value was. If the contract is estimated on $150 million, you may see contracts issued on that thing under 300 million and so forth.

So the numbers out there could be very conservative we think. And not to make a long story, but we have always kind of tried to express that to the people who watch the defense industry. Because some people take a very lenient approach to that as far as what they define out there. It is sometimes extremely difficult to get a fair and reasonable number especially in unfunded. Funded is a little more specific. And quite frequently, especially on our books, I would tell you that unfunded is underestimated, understated compared to what it could really be because we do not take those broad approaches like some people do.

So it is an unaudited number. You know, the auditors are not going to come in and wave their hands and say that is a good number, so it is solely up to the guys that have given the numbers out and we as we normally do take a conservative approach, and therefore, it is probably a conservative number.

But we have won a lot of long-term large contracts recently. The visibility of which we see indicated that those contracts will be at least the size that have gone into backlog if not higher.

Okay, great. And then just sort of timing, when a lot of that unfunded can actually get booked and put into the funded side?

You know it varies. We have given various statistics out that will vary every year. Basically some of those contracts are up to 10 years out there and so forth. But usually as far as the funded portion of the backlog, most of that is usually gone in somewhere between 12 and 18 months, okay? 75% of it may be gone in about 12 months as far as the funded.

But again, you put statistics in it, but those statistics are not anything you can necessarily put trend data with or anything else because it will vary on some of these contracts. Some of these things will have funding that will go out for in funded for three years, and if you get on the service side of the business, some of those things are funded every three months. We will continue to get funding on some of those things every three months. So you get three months worth of funding, so.

Okay, great. That is very helpful.

I think the only (indiscernible) that you can tell out of this thing, and we do a lot of –- I have historically done a lot of trend analysis on backlog, and you can come up with more figures and convince yourself of a lot of funny things sometime that don't make sense. But in general right now we are seeing a lot of strong long-term business happening, which is having an impact on that unfunded portion of it, which is going to continue to allow us to grow and means good strong '06, '07, '08 is kind of the biggest thing I think you can get out of it right now.

Okay great. And then just sort of finally turning over to the services side, if you could talk a little bit about what you're seeing in the pipeline of opportunities? You talk about you expect to see a lot more potential bookings in the back half of this year, but also maybe looking out even a little beyond that. Do you see, for example, other service companies out there talk about another (indiscernible) wave of opportunity that is coming through the pipeline? Are you guys seeing something similar on the services side? Any kind of way to quantify it would be appreciated.

This is Gerry Potthoff. And by the way, we will have to cut you off with this question. We are about to run out of time. We apologize for that.

Having said that, just thinking about the services side and what I said in my opening and I think closing comments, a lot of it has to do with BRAC. We have been anticipating that for some time. It will go forward. We think there's a lot of work in support of depos. We think there's a lot of ongoing work associated with the communications business. We think there is certainly work that will come to us via the BRAC thing over the years that really suits our protection kinds of business, our securities, our asset protection.

So we obviously also think there will be a lot of opportunity in spares. We are uniquely qualified to support spares, and I think maybe where the fact that we started our own Web-based logistics business here called ESSIBuy.com, and the foundation for that business is really spare support. You can only imagine the spares associated with not only our product, but many other products that we can drive through that Web-based service. So just a lot of opportunities in the services side of our business, and I know I'm incomplete because it is so diverse in what we do with in services. What a great question and we thank you.

Karl Oehlschlaeger, Banc of America Securities.

Just a question on DPGDS again, sorry. The $3 million that you mentioned in terms of estimated costs to complete, what gives you comfort that that is the right number? I guess I'm asking that with respect to the reliability audit as well as this coming up at the end of summer? If that does not go towards how you think it will go, will that $3 million increase at all, or is that just kind of a onetime thing?

This is Dan Rodrigues. I would tell you that the confidence that I have is that we undertook from the February, frankly, through May timeframe a complete systems analysis of the PPU unit and literally went from corner to corner with that item to include, frankly, the use of some external expert resources that we put under contract to give us as objective a view as we could in that analysis.

So I would submit to you that we have addressed all the known field issues that our customers have reported to us both on behalf of the Army and the Air Force, as well as then those areas where our own systems analysis suggests that we could strengthen the operation of the system. All that being accomplished and included in the system that we take to the reliability audit in July leads me to believe that we will see tremendous improvement in the reliability of the unit, and I'm very confident that that will be the solution.

And the 3 million was obviously a very conservative number relative to our anticipated cost. We would probably anticipate it being less than that, but we think we're more than covered relative to that as Dan adequately described that.

Okay. And then going forward, I'm assuming the margins will continue to be where they have been in the 30% plus range?

I don't think we see anything that would anticipate margins being any different right now. One of the good news, of course, is like a lot of programs that we do very well on is we start getting well into production and the quantities start getting big. We continue to improve margins. Is there a possibility for improved margins? I don't know. It is awfully good so far.

But nothing out of this effort would indicate something to say all of a sudden the reoccurring margins are going to be impacted on this program.

Okay. And then one final question on M&A. I know you mentioned synergistic acquisitions as something you still kind of look at. What is the current environment like now that you are seeing, and how is pricing, and how does that -- how aggressive are you I guess in terms of M&A?

Again, you are exactly right relative to something that is synergistic gets over that initial threshold. If it does not get over there, then it does not make sense. We've got quite a few -- several companies we're looking at right now. Are we going to go forward with them? We will see. We're in various stages of looking and seeing, discussing and everything else and so forth.

I don't know that pricing has changed a lot recently. Pricing is it has always been highly determined by the previous owner or owners and investment banking community and everything else. It is like anything in life. Some days you are amazed at how expansive things are and amazed sometimes at how things are reasonable.

So I don't know that we have seen a lot of things change, and so there is certainly some still high prices in some of these services end of the business. And as bigger transactions come down and high multiples, especially in the services side of the business, that only impacts the expectations of current owners. So there is still a lot of good companies out there reasonably priced that make a lot of sense relative to what we're doing.

That concludes our question-and-answer. Thank you very much.

Thank you. At this time, that does conclude our conference. All parties may disconnect.