Leonardo DRS Inc (DRS) 2007 Q1 法說會逐字稿

Good morning, everyone, and welcome to DRS Technologies' conference call. At this time all participants are in listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (OPERATOR INSTRUCTIONS). As a reminder, ladies and gentlemen, this conference call is being recorded. At this time for opening remarks and introductions I'll turn the call over to Ms. Patricia Williamson, Vice President of Corporate Communications and Investor Relations for DRS Technologies. Please go ahead.

Thank you, Lisa. Good morning and thank you for joining us on today's conference call to review DRS Technologies' financial results for the fiscal 2007 first quarter ended June 30th, which were reported earlier this morning. Hosting today's call are Mark Newman, Chairman, President and Chief Executive Officer of DRS; Rich Schneider, the Company's Executive Vice President and Chief Financial Officer; and Bob Mehmal, Executive Vice President and Chief Operating Officer.

Before we begin, I'd like to remind everyone that we are providing a simultaneous broadcast of this call to the public. An archive of this webcast will be available later today on our web site. Today's remarks may include some forward-looking statements and certain non-GAAP financial metrics. For more information regarding the Company's definition of these metrics and their usefulness in interpreting DRS' financial results, please refer to today's earnings release and our filings with the Securities and Exchange Commission available on our web site.

In accordance with the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, please note the risks and uncertainties related to forward-looking statements, which are more fully described in our news release and in the Company's SEC filings. The Company does not undertake any obligation to update any forward-looking statements whether as a result of new information, future events or otherwise. I'd now like to turn the call over to Mark Newman. Mark?

Thanks, Pat, and good morning to everyone, and thank you for joining us on today's call. As you saw in our news release this morning, we reported a record first quarter with higher revenues including double-digit organic growth and stronger profitability year-over-year. We also set a quarterly record in new contract awards driving funded backlog at June 30th to the Company's highest level today. I'd like to spend a few moments touching on some of the quarter's metrics, providing some operational highlights and discussing our new guidance; then Rich, Bob and I can take your questions.

Revenues for the quarter were up 86% over the same quarter last year with strong organic growth accounting for 15% of the increase. Our legacy operations posted strong metrics in the quarter, with both the C4I and Surveillance & Reconnaissance segments generating higher sales. Revenues from our Surveillance & Reconnaissance Group were exceptionally strong, up 30% from last year's first quarter. The S3 Group, formed primarily by our acquisition of Engineered Support Systems in the fourth quarter of fiscal 2006, contributed $243 million in sales to the period.

Consolidated operating income was 85% higher, representing a 10.3% operating margin. Without the added profit from the S3 segment, operating income increased by 15% over the prior year's first quarter. Significantly higher EBITDA was 13.3% of sales. Net earnings were 52% higher than last year, and diluted earnings per share of $0.52 exceeded the high end of our guidance by a penny. Diluted EPS includes a reduction of $0.03 as a result of the Company's adoption of FAS 123R for expensing stock options.

As expected, free cash flow was a negative $39 million. The major driver was an increase in working capital to support the sales growth in the quarter and beyond. DRS captured a quarterly record of $782 million in new contract awards during the three-month period, 50% higher than a year ago. That's a book to bill ratio of 1.24 to 1. At June 30th, funded backlog of almost $2.6 billion was 71% above backlog at the same time last year.

There were a number of important milestones achieved in the first quarter that I think are worth mentioning. Our C4I Group was awarded a key $396 million multiyear IDIQ contract for the U.S. Army's FBCB2 computer system and we received initial funding of $80 million on this award. The FBCB2 systems are being installed on over 40 vehicle platforms types, as well as at tactical operations centers and other command post platforms. They support the Army's Blue Force tracking requirements and are making a critical difference in the operations in Iraq, contributing to the military's battlefield visualization effort.

Thousands of DRS built Appliqué computer systems have been fielded successfully under this program and this new contract ensures they will continue to serve as crucial assets for our forces as part of the Army's network-centric communications infrastructure. Our C4I Group was also selected by General Dynamics Bath Iron Works to provide both the electric power distribution system called the Integrated Fight Through Power system and the motor controllers for the U.S. Navy's new DDG-1000 class ships, formerly known as DD(X). The combined potential value of these programs was about $195 million.

Our power systems solution offers proven technology that will result in lighter, smaller and more power dense equipment than any shipboard electrical architectures available today. Our C4I segment also completed a successful demonstration of our new X-Band Satellite Communications-on-the-Move terminal for the Army's Communications Electronic Research and Development Engineering center. This joint service interoperable technology supports some of the Defense Department's most critical emerging programs including the joint network node and deployable joint command and control programs.

At our Surveillance & Reconnaissance Group, we made a number of strides on our common electronics architecture initiative. Key among these was being selected to lead the Army's condition-based maintenance operations initiative. This accelerated brigade level demonstration involving more than 200 Bradley and Abrams tanks will wirelessly connect vehicle health management systems and logistics information with the vision support tools to provide commanders and logistics managers with data to improve equipment reliability, availability and maintainability.

We also had strong bookings in the quarter for our embedded diagnostics equipment, which brought the number of funded units to equip Bradley fighting vehicles to over 1,000. The U.S. Army is funding our development of a common embedded diagnostics architecture for the M88 Recovery Vehicle, which recovers damaged vehicles from the front line while under fire, and for the M113 Armored Personnel Carrier.

The Surveillance & Reconnaissance Group also completed the critical design review on the Neptune™ Unmanned Aerial Vehicle, initiating the production phase to deliver over 20 Neptune™ UAVs. The Neptune™ is an unmanned tactical air vehicle optimized for at-sea launch and recovery, which is compact for easy transport and designed for expedient launching without a runway.

During the first quarter we completed qualification testing and delivered the first Thermal Weapon Sights production units on the TWS II program. We also completed the critical design review with the customer on the Army's Digitally Enhanced Night Vision Goggles development program.

As part of our interest in addressing the evolving homeland security market, DRS is pleased to be part of the Boeing Integrated Defense Systems team bidding on the $2 billion Secure Border Initiative Network or SBInet program, sponsored by the Department of Homeland Security. SBInet will be a comprehensive approach to immigration enforcement focusing on controlling the border and enforcing immigration control within the United States. SBInet will integrate personnel, infrastructure, technology and rapid response capability into a comprehensive border protection system. The customer down select is expected in the next few months.

The S3 Group had strong bookings during its first quarter of operations with DRS. In addition into the awards outlined in today's release, this segment recently received a contract modification to increase the ceiling value of the Integrated Commercial Intrusion Detection System III program, or ICIDS III, by $69 million, bringing the total value to $122 million. The ICIDS program supports a cost-based approach for providing a joint service system for protecting high-value critical defense-related activities and other government assets.

Highly secured and standardized using state-of-the-art technology, ICIDS replaces aging equipment and upgrades installation security without an increase in manpower. Under this contract, the S3 segment designs, installs and maintains a wide range of electronic physical security equipment at a number of Army facilities. S3 has been supporting ICIDS III contract or four years and serves as the principal security systems integrator for the entire U.S. Army.

The S3 Group also successfully completed the preproduction readiness review with Northrop Grumman on the Minutemen Weapon System Life Extension Program for the U.S. Air Force. S3 will deliver more than 500 environmental control systems over a five-year period on this program. And recently S3 was awarded a $16 million contract to provide border surveillance equipment and support to the Afghan Border Patrol.

As we mentioned last quarter, since forming the S3 Group we made some significant progress in our efforts to integrate this business with DRS, consolidating certain operating units in May that had similar product lines, business services and customers within each of the two strategic business units that comprise S3. Such measures are being implemented to develop a stronger competitive industry profile over the long-term, increase operational efficiency, ensure alignment with customer priorities and improve customer Interface. There is more work to be done and we'll continue throughout fiscal 2007 with this integration process.

We're also continuing to implement strategies to encourage coordinated common pursuits between all three of our operating segments, leveraging the full strength of the Corporation by applying integrated systems and services solutions. These efforts are part of our ongoing initiatives, as we've mentioned in the past, to remain highly competitive, adaptable and responsive to our customers and to ensure our operations continue to be focused on customer priorities.

As you saw in our earnings release this morning, we tempered our outlook for fiscal 2007, while still anticipating another record year in revenues and earnings and targeting an operating margin exceeding 11%. We expect significant top and bottom line gains year-over-year now estimating a 56% increase in sales, about a 40% increase in net earnings, and a E6% increase in diluted EPS which includes a $0.10 to $0.12 impact from the adoption of FAS 123R.

We're now expecting sales of 2.7 to $2.75 billion and diluted EPS between $2.80 and $2.90 for the fiscal year ending March 31, 2007. These expectations reflect our modified outlook, as we felt it was prudent to adjust our full-year guidance at this time. We felt these adjustments were necessary in light of government funding delays that have become apparent, which include delays associated with the passing of the government's 2006 Emergency Supplemental budget and the Operations and Maintenance budget constraints and scale backs announced by the U.S. Army on July 19th.

While all three DRS Groups are affected by these developments, a majority of the funding delays are concentrated in the S3 Group, primarily in the Sustainment Systems strategic business unit. These delays, coupled with some competitive program losses and an unexercised contract option, are expected to impact our prior fiscal 2007 revenue forecast. We're working hard to compensate in other areas of our business and to take actions to help mitigate the cumulative effect of these factors on our Company.

Our initial guidance for the second quarter reflects the factors I just mentioned. We expect revenues of $635 million to $660 million and diluted EPS of $0.52 to $0.54, including a $0.03 reduction from the adoption of FAS 123R.

Before I turn the call over to questions, let me just add that DRS remains a strong, diversified Company, well positioned in the marketplace as a major supplier in Armed Forces modernization, personnel mobility and O&M support with opportunities for growth across all of our strategic business units. Although funding for the War on Terror, higher government operating costs and political factors have placed pressure on the 2007 defense budget and delayed the passage of the 2006 Emergency Supplemental, and the President's Bridge Supplemental budget, the 2007 request was nearly $20 billion higher than actual funding for last year.

DRS is keenly attuned to our customers' objectives and requirements and many new opportunities are being pursued by us. The likely outcome for an ultimately higher defense budget than last year coupled with our record funded backlog at the end of the first quarter and the strong track record of our management team are providing confidence for the Company's growth in fiscal 2007. With that we can now open the call for questions.

(OPERATOR INSTRUCTIONS). Greg [Alexopoulos], Morgan Stanley.

Thanks, guys. I appreciate it. Can you give us a little bit more color on the government funding delays that you talked about, Mark?

Yes, basically what we found was there have been some funds that have been reprogrammed because funding was being delayed in getting out to the war. So the Army was taking money that should have been used to fund some programs to fund some other concerns that they had. And I would say about half of what we're looking at is tied to the reprogramming of funds and that money will come back at some point. We don't think it's lost forever. We just feel at this point it was prudent to adjust where we were.

We did lose a few things, which everybody knows already, but that isn't as significant as the reprogramming of funds. There was one option that wasn't exercised on a program that normally would have been exercised immediately and that had a little bit of a hit, and it had to do with some up armoring capabilities that we entered into in Iraq, and I can't really go into more detail on that. And then there was a minor cancellation of something.

But the biggest chunk was the reprogramming of funds, and I think as you’ll see more money added to the Supplemental, which is the direction Congress is trying to go right now -- in fact, just the other night they were talking about adding another $13 billion to the Supplemental -- I think you will see some of that start to come back to us.

Okay. And a second question on the Supplemental -- is any of this impact due to the effects on the Supplemental?

Yes, that's what I'm saying. With the delay, it's not that there won't be money in the Supplemental, but with the delays that they've had, by the time they start the contract for some of this stuff it ends up getting slipped into another period. That's really what's happening.

Okay, all right. Thank you.

Patrick McCarthy, FBR.

My first question is -- are you still looking for bookings for the full year at one to one based on the previous guidance? Or would you also think that the bookings for the full year are going to come down?

That's hard to say right now. With some of the delays we're taking the approach that we'll still be in the one to one region with the sales that we're showing for the fiscal year -- the sales that we're forecasting, the 2.7 to 2.75 region. It is possible that we could see bookings in the fourth quarter if that money starts to come in faster. That could increase the bookings to the levels we were talking, but I think it will come in to late to affect the '07 sales; it would then slip into '08.

Okay, thanks. And my second question is based upon the current backlog that you have, how much of that do you expect to happen in your fiscal '07? I'm just trying to get a sense as to how much really for '07 is already in the bag, if you will.

We usually sell off about 75% of our backlog in any fiscal year. And what you saw was in the first quarter we more than replenished what we sold in the quarter because we had such a high book-to-bill ratio. So, I think as we forecast, we're in a pretty good position. Some of these sustainment jobs that we have as part of S3 tend to turn over faster, there's more of a book-to-bill kind of ratio, and they impact us faster than some of the more conventional programs that we have that have been booked for quite a while and now just dribble out through the quarters. So, I think it's that combination that has affected this thing.

Okay. And one more quick question. In the past couple of quarters you've announced a couple of strategic partnerships -- the one in Canada, the one previously in Israel. And I'm just wondering, is that really kind of the focus of your growth now on the international side, doing it through partnerships and are you looking at other specific potential partnerships? Thank you.

Yes, actually we are looking at other partnerships, and I think that's going to be a very interesting way for us to approach the international market. Because we can be a conduit in the U.S. and, by the same token, there are things we can offer overseas through some of those partners. So, I think that's something that we're going to continue to move out on.

Thank you.

Ferat Ongoren.

First question on the revenue guidance. When did you feel that you guys were having problems in terms of the year in your original goals for the year?

Probably about a week ago because what we were doing is while Farnborough was going on, we were running reviews back home and Bob Mehmel was heading up those reviews, and we started to take a look at what the real impact for the future would be on the delays of some of these programs and some of the reprogramming of funds that we saw because of those delays. And we came to the conclusion during the week last week that it would be virtually impossible to continue with the guidance that we had.

As I say, most of this stuff is not lost, it's just stuff that's going to come at a later date. And in trying to figure out when it would come in verses when it would be sold, we started seeing things pushing in to fiscal '08, and we thought it was prudent at this time to modify the guidance.

And could you update us on the Engineered Support -- or the S3 segment margin? Because it appears O&M is creating the delays here. Are we going to see an uptick in the margin or are you still guiding for 10 to 10.5%?

Yes, the margins actually are quite good. So, do you want to just address that for a second, Rich?

Yes. The margins overall were a little better than 10% for the quarter. And as the impact of some of the implementation phase in with the integration starts to take hold, we should see those margin start to creep up a bit.

But are you expecting the margin to be closer to 11% now on Engineered Support, or are you sticking to your original guidance? Because it seems service type revenues will be delayed and those had lower margins. Or are you seeing weakness throughout the business?

No, actually -- let me just say, most of the delays that we're seeing are really on the Sustainment side, not on the Services side. The Services side has actually been pretty strong.

And in terms of the Engineered Support, if you kind of try to think about your margin and look at organic growth embedded in Engineered Support, it seems it will be about $1 billion or less now. Are you basically seeing that business flat or slightly down, compared to the past 12 months, including the month that you didn't consolidate the business?

Actually when you realize that they used to be on an October year-end, and they hit $1 billion for the first time for the October '05 period, even if they do $1.050 billion, let's say, for this year, that's still an increase over where they were. And if you look at them historically, they were doing about 20% growth, but some of that was coming from acquisition anyway, and we don't anticipate any acquisitions related to that right now.

So, I think they're actually showing some growth going into this fiscal year based on the revised guidance. So, I'm pretty bullish on where they're going, and I'm pretty bullish on the business in general. I think what you're seeing here is just the fact that this kind of business tends to book and ship faster. And so, there was more of an impact when you look at some of this reprogramming of funds.

And also keep in mind that the beauty of being diversified in the defense business as we are today is that this can happen to any segment or program or what have you. And by having the diversification, we cover all the aspects of the defense budget. So, we're still pretty excited about the fact that we've joined forces with those guys.

And final question. Rich, what will be the tax rate for the year?

You should expect the tax rate to be about 40% going forward -- a little bit higher than it was in the first quarter.

So, was there a benefit in the first quarter?

Yes. There were some R&D credits that were flowed through in the first-quarter provision. It was a one time event.

Thanks.

Steve Binder.

Mark, can you maybe -- or Rich -- you've taken a 150 to $200 million revenue revision for the year -- downward revenue revision. And from the language, I'm assuming, based on the 1.05, almost the entire amount is coming out of S3. Is that, number one, correct?

Well, no. It is a mixture there, but the bulk of it I would say would be coming out of there.

And how -- out of the $150 million revision for S3, rough order of magnitude, how would you table that? How much of that -- because you figure the Army business is running about -- Army represented about 40 plus percent of the revenues, right? The Services component was about --probably about half of their business was coming out of the O&M budget, right?

Right.

So, when you kind of look at that $150 million revision, how much of that $150 million is really delay related, number one? And two, is that delay pretty much all coming entirely out of the Army side of the business?

The bulk of it is through the Army. I would say about half of it is coming from actual funds being reprogrammed. And then I would say that maybe 25% came out of one option that wasn't exercised; so that actually would have been lost. Although that could even be tempered, but that's the view that we see right now. So, I would say about half of it came from reprogramming of funds. There was another few million that came from some delays. There are a number programs that they have that are really well liked by the Army, and they're just getting slipped a little bit. So, I think what you see is it's really lost sales for this year, but it's not sales that have gone away permanently.

Right. But is this affecting both the product and services lines?

No, the only thing that was in the Services area was on that option because they're the ones that contract for the up armoring.

Right. And then I missed your answer. Is the entire revision pretty much all Army related?

I would say the bulk of it is Army related, yes. And by the way, if you take a look at the $13 billion that they're talking about adding to the budget, about $8 billion is coming to the Army for reset, by the way. And some of the stuff that we've seen flip, they are reset dollars.

Are you making an assumption here that -- because the Army's under pressure for the last couple months of the fiscal year because of timing of the Supplemental and so forth, and there's no doubt, they put a freeze on a lot of different items through the end of the fiscal year. Are you making assumptions that this whole thing is just sliding two to three months to the right? Is that what your revenue forecast is now assuming?

I would say that whether it's three months or six months it's hard to say sitting here today, but I think that's what you're seeing is some programs sliding to the right. I can't be totally precise. Keep in mind that, as you know, we're on a March 31 year-end, and we go into our planning cycle beginning next month, and we work on that for about three months. So, it takes us a while to come up with a detailed program-by-program forecast for next year. But I would say in a macro sense what you're saying looks about right.

And you talked about program losses on top of the unexercise of the option. Those program losses we knew about when you gave the guidance out a few months ago. Were there additional program losses on top of FDECU and the shelter program?

Nothing that actually came out -- those are the only two. And those don't have a huge impact on the fiscal year, but they have some.

All right. And lastly, Rich, can you maybe just touch on the working capital performance? It looks like, I'm guessing, working capital is up to a good $70 million or so?

Yes, that's exactly right, Steve. It's almost exactly $70 million. The big drivers were receivables were up about $21 million, inventories were up about $11 million, accounts payable were down about $30 million, accrued liabilities and expenses were down about $12 million, customer advances were up about $10 million and the rest kind of rounds out.

I mean, any reason -- I understand first quarter is usually your ugliest quarter for cash generation, but this working capital increase is unprecedented. I understand you've got S3, but still it's a good $30 million above even what we've seen in the past. So, any color on why it's quite this bad?

On the receivables side, we have two big programs that -- just the contracts have been negotiated without progress payments, they're short duration and you'll see the receivable balance come down in the second quarter as those collections come in. On the payables side, which was the biggest driver, we had a very strong fourth quarter and some of those bills had to get paid and they got paid in the first quarter, and that's not unusual for us. Payables always come down after the fourth quarter. The fourth quarter is always our biggest revenue quarter. And as we become more profitable, obviously our taxes increase.

Right. So, is the right way of looking at your revision in your cash flow forecast, is it really just earnings driven, is that correct? I think you brought up the [undecipherable] is that right?

Yes. It's earnings driven, and I would expect that we'll modify the cap ex a little bit as a result of this. So, I don't think it's dollar-for-dollar down because of the earnings modification, but that's the primary driver.

All right, thanks.

(OPERATOR INSTRUCTIONS). Alok Chopra.

Could you comment on what (indiscernible) discussing something with the Supplemental got passed this week and when the House comes back after recess in early September and they've got a version of their bill, what's your visibility based on what you're seeing in the two versions of the bills and what do you think the chances are that we get something passed before they go off to do their campaigning for the elections? I mean, last year we didn't get a budget until December 31st, and what are the chances that something like that happens again this year? I'm assuming it's pretty low, but do you have any visibility into that?

I don't think we have any more visibility than you have. Congress does what Congress does, and they operate in good faith, they want to get it done and you just don't know what will happen. You would hope that seeing as we're in a war right now they would be acting quickly to try to get funds to the military. But Congress is an independent body, and I wouldn't even begin to opine on what they're going to do. But we're hopeful that they'll do the right thing.

One other question, Mark. In terms of integrating EASI into the Company, I think you talked at the last call of cutting down the number of operating units and synergies and all that. When is all that going to be completed? How long will it take? Is it the next couple of quarters, so that we see it in the fourth quarter of '07, fiscal '07 or is it going to be sooner?

Oh, no, we're doing it in this fiscal year. And we took major steps already in the first quarter. So, from a personnel standpoint, I think we've eliminated about 200 positions, and we've already set up a management structure to manage groups of plants under one person. We have never been talking about plant shutdowns or anything like that; it's really the way that we're going to manage the business under the two strategic business units that comprise S3.

So, I would say we're probably 75% along in our efforts. And now it's a question of getting everybody working together under that new mandate. So, we're very, very pleased. I will tell you that this is probably the fastest that we've ever operated or acted on a consolidation within an acquisition. So, everyone has been pretty enthusiastic, working closely with corporate, and I think we're making great strides.

Okay, thank you very much.

Steve Levenson.

I guess we've heard plenty about the Supplemental. Can you give us some indications on what you see the opportunities are for the UAVs? I think this is the first did you say production order for Neptune™?

For Neptune™, yes. That's the first major production order. We had one before where I think we produced about ten of them, and they were really well liked, and it took a while to get this next 20 under contract. And by the way, when they do that they even put some modifications into it. So, there's a little bit of engineering work that went in, as well. And we're starting to see a nice pick up there. We have another vehicle that's also getting some good attention. So, I think we're starting to see a pickup in that business right now.

And going forward, do you see bigger opportunities on new platforms or do you think it's still upgrades that is going to drive things going forward?

Are you talking about UAVs or --?

No, generally.

I think there are number of new contracts that we're going after. I mean, I can't guarantee, for example, we're going to win SBInet, but certainly we'd have nice content there. So, that's a whole new area that we're bidding on in support of the Boeing team. And we've got lots of other things we're bidding on. We've got lots of platforms that need to be upgraded and filled, that's a good part of our business, and there's lots of new stuff that we're constantly going after.

So, the mix of business is tremendous. The business in general is tremendous. All we're saying today is just based on some of these things slipping out a little bit, we think it was prudent to just modify where we're going to be. So, instead of growing from $1.7 billion to $2.9 billion we're going to grow from $1.7 billion to $2.75 billion. It's still created a very, very competitive, exciting, dynamic company here, and we're pumped.

Last question is on electro-optical thermal imaging stuff; do you see any international opportunities coming up? Are there any products coming in that will be available for that market? Anything new?

Well, we're looking at some export ideas for that stuff, that's always ongoing. But keep in mind that the huge market for that kind of equipment is right here in the U.S. And we are just scratching the surface on where that market can go.

Okay, thanks very much.

My pleasure.

David Gremmels.

Thanks, good morning. Just to follow-up a point you made earlier about S3 seasonality -- I mean, EASI’s been on an October fiscal year, so historically, their full-year revenue profile is weighted toward October. Now that it's part of DRS with your March fiscal year, do you expect that the S3 revenue will be weighted toward your March quarter?

Well, that's a wonderful question because it's one that I grapple with all the time in our whole business is to why there should be any seasonality. But they've forecasted where they believe they can go. We've put out a forecast for our second quarter. October would only be one month into our third quarter; so I can't sit here and say that they're going to have a big bang up October. I think it's just natural that people forecast quarters based on the fiscal year that they're in, and I don't know if what you're saying is driving them.

Just keep in mind, they had October, then they had stub period that went from November 1st to January 31st, and then they had a second stub period from February 1st to March 31st, which was what we included in our fourth quarter. So, I think they've had so many stub periods that they don't know what they're striving for in terms of where they want to have their biggest quarter. So, I think they've created a plan for our fiscal year, and they're going to execute on that plan. And if they complete the year at $1.050 billion, I would say they've had a good year. That's what we've got to focus them on.

We do see it relatively level -- a slight increase. Previously, the forecast showed a big second half ramp up, and that's really what we've modified. The Services part of the business is pretty level, and the product side is lumpy on the booking side. And if there is a ramp up, it will come on that part of the business, but we're not anticipating a significant ramp up.

Got it. Okay, that makes sense. And then on the unexercised up armor or contract option, just to clarify, did that go to someone else or is it just delayed and you still expect to get it or (multiple speakers)?

What happened there was the prime contractor decided to do some of that work themselves. And it had to do a lot with the installation. So, it's just one isolated program, but had we gotten the whole program it would have given us about another $30 to $35 million. But it didn't go to somebody else; they just decided to do it themselves.

And I'm wondering, obviously Engineered Support had been active in that armored area and your press release highlighted a $40 million armored contract.

Right, and that's what we got, by the way. We actually had that amount.

Right, right. So, I'm just wondering -- those budgets seem to have remained fairly healthy here. So, as you look forward over the next couple years, do you see that as a potential -- continuing to be a growth area or has that -- maybe the armor opportunity has kind of peaked for you?

No, we still see opportunity, and we're still working with various primes in that area. We think that's going to be a good area for our future. Do you want to add anything, Bob?

David, you're familiar with LTAS, which is the Long-Term Armoring Strategy -- so on the U.S. side, we're putting partnerships together to be able to participate. Again, it's not going to be a $100 million business tomorrow, but the point is if we can get a good $30 to $50 million a year out of it making good margins that's what we're shooting for.

Great, and then last one. On the Engineered Support integration, I mean obviously there's always potential for some disruption when you go through something like this. Have you looked at or would you say that any of the issues that you've discussed today are in any way attributable to integration problems?

No, none of it has to do with integration problems. I think a forecast was put together; they started acting on that forecast, and when they saw some of these slippages they realized there were no other places to make it up. And so we just came to the conclusion that it would be prudent to just take down their forecast a little bit. It may have been too aggressive in the front end. That's the only conclusion that I could come to because the integration is going smoothly. We love working with the people there, they love working with us. We're seeing interaction between the Services business and the rest of our business on a daily basis, and we're seeing lots of opportunity.

So, I don't think it's an integration problem at all. I think it's just we've got to work hard to make sure that we get those things back into the Company, those things that have been slipped out.

Okay, thanks very much.

Myles Walton.

Good morning. Could you just give us what the cost-plus/fixed-price mix was for the quarter?

I don't have the exact number, Myles. I would estimate it at about 70%/30%.

All right. The reason I ask is if you look to Q2, your guidance there, it looks like the margin implied is flat to down. I'm not sure you've had sequential declines in margins since the second quarter before, and I'm just wondering if that's mix and is it largely attributable to the mix, particularly at S3 into the second quarter?

Pretty much. It's dominated by mix.

Okay. All right, that's all I have.

Michael French.

We don't hear anything.

Good morning, gentlemen.

Oh, good morning.

I had a question on the Secure Border Initiative that you mentioned. What would be the approximate value to you if you're successful in getting the $2 billion contract?

I'll let Bob answer that.

Hi, Michael. Obviously in the competition right now, so giving out specific numbers is not a wise thing to do. But needless to say, if you saw the press release, we got a good mention as one of their lead teammates. So, I could tell you just that they look at us as having an important part of their program, and we think as they go we'll have a good part of that program. So, it should be -- and again, if we win, over time it could be a nice plus for DRS.

Okay, good luck. And you mentioned they'll be making a down select in the next few months. Will they actually publicize that when they do it or will it just be something that they (multiple speakers)?

It will be publicized. Keep in mind; this is going to be the first combined major program that [the Department of] Homeland Security is going to come out with. There's lots of stuff they do within the Department, but this is probably the first real publicized program. And this has gotten the attention of everyone right up to the White House. You've heard Bush talk about new technology that's going to come to border patrol and that kind of thing. It's all wrapped up in this program.

So, given the fact that this has high visibility and given the fact that the Department is kind of new to this, it's hard to really forecast exactly when it will be let. But right now, they're expecting within the next few months.

Okay.

And there could be, by the way, a down select of a couple of contractors. We don't know yet.

All right, well I'll stay tuned. And one quick housekeeping item. On the free cash flow and the reason it was negative for the period, was there was a change in assets and liabilities that was significant. And I assume that's a one-time item that's not going to happen again, right?

It should not happen again in the next three quarters, that's correct. It does seem to happen every first quarter for us just with the nature of our business.

Okay, great. Thank you.

Patrick McCarthy.

Can you talk about the balance sheet for a moment? It looks like debt went up a little bit sequentially, and I'm wondering whether you've changed your expectation for how much debt you expect to pay off during the year. And are you still at kind of the $120 million [level] in interest expense for the year in your model? And then a follow-up question, could you give us the organic growth rates by business segment? Thank you.

Okay. Well, first to the interest question. Yes, our model is roughly the same as we stated previously. Our focus is still on debt reduction. With the $90 to $115 million free cash flow guidance, we still expect to use that free cash flow to pay down debt. And with respect to the organic growth, the bulk of the organic growth was from the S&R segment. They reported 30.4% organic growth, and C4I was about 2.6%. It's almost exactly the opposite of last year, where the C4I Group had major organic growth and the S&R group was at the front end of their development programs that have now turned into production.

Sanjay Ramakrishna.

Thanks for taking my question. What would you say your capital spending plans are for the rest of the year?

In total our expectation for the year on the cap ex is about $50 to $60 million. In the first quarter, we spent about $13 million. So yes, somewhere in the area of $40 million for the balance of the year.

And to go back to the leverage question again. So, you see yourselves -- you increased the draw of the revolver this quarter. Do you see yourselves bringing down that draw to a close by the end of the fiscal year or do you see yourselves moving at a run rate of around this much?

If we make our projections on the free cash flow, and we expect to make them, the revolver balance at the end of the year would be zero.

Thank you very much.

Greg Alexopoulos.

Thanks. Can you give us a little bit of color on how the two programs on ESSI are progressing -- Fuel Farm and I think RIFTS?

Both programs are in development phases. Both programs are coming off of kind of, let's call it, critical design review activities and progressing further in their engineering and manufacturing development phase. Both programs are front-line Army programs and I think, again, we feel very good about both those programs given that they have pretty large potential as they move through a more production environment.

And when do you suspect that they're going to move into production?

I would say hopefully by the time we get out of this fiscal year; '08 is starting to see those programs kick up.

Okay. And one other one on Ferat's question. I'm not sure I totally understood. The Sustainment business was a much larger margin business than the Services business and it looks like the impact is happening in Sustainment. So wouldn't one suspect that margins could be lower in S3 overall?

You're correct that in the past with some of their big programs, like the Tunner and MSTAR, it was a bigger part of their business. We were already reflecting that part of the business being lower in our projections for this year. Now, we have taken it down a bit more, but with some of the cost cutting that we've also implemented, we should be able to neutralize some of that margin mix erosion.

Okay, great. Thank you.

(OPERATOR INSTRUCTIONS). Jason Horowitz.

Just a couple of questions. I think you said stock option expense was $8 million or so for the year. So was it $2 million in the first quarter and was there nothing in the year ago period?

There was nothing in the year ago. For us, the expensing of stock options was a first-quarter event. The expense for the quarter, as we said, was $0.03 a share, which equated to about $1.8 million for the quarter. It will be higher in the subsequent three quarters because some of the option -- because of an option grant that was made during the first quarter -- at the very end of the first quarter.

Okay. And then the only other thing is can you try to give us an estimate now as to what you think your pro forma LTM EBITDA is? I know it's hard to break out with the acquisition.

I'd have to give that some thought. I wouldn't want to just do that off the top of my head.

Maybe we can follow-up later then. Thanks very much.

David Gremmels.

Thanks. Just one program-specific follow-up. FBCB2, that's been an exceptional contract for the Company. Can you just talk about how far into the program we are, how many vehicles were upgraded, how many are planned and when that might start to ramp down?

Well, we're talking thousands and thousands of systems that have been already sold, and we're talking about almost a $400 million contract that we just won in the quarter, of which they've exercised or contracted for about $80 million under that. So, I would predict that this is going to go on for a number of years to come. So, I think we're in the production phase of this program right now. Did you want to add something, Bob?

Yes, David, as this gets proliferated throughout the Army and Marine Corps, in particular, they're finding more and more uses for it. What you'll see is this will over time evolve to the dismounted soldier, as well as well as vehicle-mounted [applications]. So, this is in the very early innings of technology spiraling into things. So, we look at it this way, beyond just the contract we just booked.

Perfect, thank you.

(OPERATOR INSTRUCTIONS). And it appears there are no further questions at this time.

I want to thank you all for joining us on today's call, and I look forward to speaking with you again soon. Take care.

And that concludes today's teleconference. Thank you for your participation and have a good day.