Leidos Holdings Inc (LDOS) 2009 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the SAIC second quarter fiscal quarter 2009 earnings conference call.

I'll be your coordinator today.

At this time, all participants are in a listen-only mode.

We'll facilitate a question-and-answer session towards the end of this conference.

(OPERATOR INSTRUCTIONS)

I would now like to turn over the presentation over to your host for today's call, Mr.

Stuart Davis, Senior Vice President of Investor and Employee Owner Relations.

Please proceed.

Thank you, and welcome everyone.

Here today are Ken Dahlberg, our Chairman and CEO, and Mark Sopp, our CFO.

Larry Prior, our COO, is on a well-deserved vacation and will be back with us for the December call.

During today's call, we will make forward-looking statements to assist you in understanding the company, and our expectations about its future financial and operating performance.

These statements are subject to a number of risks that could cause actual events to differ materially, and I refer you to our SEC filings for a discussion of these risks.

In addition, the statements made represent our views as of today.

We anticipate that subsequent events and developments will cause our views to change.

We may elect to update the forward-looking statements at some point in the future, but we specifically disclaim any obligation to do so.

With that, I'll turn the call over to Ken.

Thanks, Stuart, and good afternoon, everyone.

Our efforts to drive top line organic growth and improve margins in cash flow resulted in another strong quarter of execution in our core business.

Internal revenue growth for the quarter was again above our long-term financial goals.

Contract performance was strong and cash collections increased handsomely.

We also enjoyed another strong quarter on the business development front.

Now halfway through the year, we are increasingly confident of achieving our financial goals for the fiscal year 2009, and we have begun to build a very solid base for fiscal year 2010.

With respect to the government funding environment, the President signed the Supplemental Appropriations Bill, which fully funds the wartime expense for the current fiscal year and also provides bridge funding into the spring of 2009.

Although the June passage was somewhat delayed, we saw little, if any, evidence of our customers holding back funding, as evidenced by our strong revenue and bookings in the quarter.

There are some indications that Congress will try to pass the government fiscal year 2009 Defense Appropriation Bill in September as a stand-alone bill.

Even if the defense bill is not passed, given the progress to date it is likely that any continuing resolution would reference not last year's levels, but the latest versions of the defense bills as marked in the House and Senate, so that important programs can be funded immediately.

The other appropriate bill that has a shot at passing is the Military Construction and VA Bill.

For the rest of government we will almost certainly begin the year with a continuing resolution, and it is unlikely that any new non-defense appropriation bills would be enacted before the March or April 2009 time frame.

Whatever the scenario, our fiscal year financial outlook is intact.

On top of many investors' minds is the Presidential election, including me.

Although the two candidates will surely have different priorities, we do not have different growth expectations depending on the candidate.

We expect that neither will dramatically shrink defense spending, and that both will increase spending on cyber and homeland security, energy and the environment and veterans health.

Similarly, we expect both candidates to scrutinize large programs, but it is unlikely that any major changes will be made until the government fiscal year 2011.

Now on to new business.

As I mentioned earlier, business development continued its upward momentum, especially in our defense and intelligence areas.

New business bookings were $3.3 billion for a book to bill ratio of about 1.3, which puts us ahead of our target pace for the year and well ahead of last year.

Key wins for the quarter involve the $450 million AITS award for the Army National Guard, which is completely new business, a $300 million intelligence program, and several design and build jobs that again demonstrate the synergies of the recent [Benem] acquisition.

Also the sale of five VACIS units to Dubai Customs demonstrates market acceptance of our latest product line, which integrates the high energy x-ray inspection and the next generation of radiation detection into a small, self-contained portal, requiring no additional shielding or exclusion zone.

Based on the strength of these wins, backlog at the end of the second quarter was up to $15.9 billion, up 13% from Q2 of last year.

Funded backlog was $5.4 billion, up 20% year-over-year, again consistent with the strong funding environment.

Again to reiterate as we have done in previous calls, the backlog does not include any value for anticipated task orders on IDIQ contracts.

In this second quarter, we won IDIQ vehicles with an expected value of over $1.4 billion, including our estimated portion of the $12 billion Encore II award, the recompete of our large Guardian Force protection program, and a new program with the Space and Naval Warfare System Center, Charleston, that will partially replace the [AMRAD] integration work as it winds down later this year.

We continue to see great opportunities in inspection and detection systems.

For example, we expect decisions on about 90 VACIS units over the next three months.

While too early to tell, we certainly have the opportunity to post another strong bookings result in the third quarter given the magnitude of our outstanding proposals and pipeline.

We have already announced that we won a $400 million IT support program for the Army, and a $7 billion FAS 2 IDIQ with the Air Force.

In addition, we won $170 million classified cyber security program that positions us well in this fast-growing market.

Our submitted proposals awaiting adjudication at the end of the second quarter were well over $14 billion, including 29 opportunities north of $100 million.

Needless to say, our proposal tanks are full.

We expect to have submitted another 30-plus proposals greater than $100 million by the end of October.

So with that, our Federal business continues to be very robust.

Our commercial business was up sequentially, but commercial segment margins to be consistent with the government business for the rest of the year.

In the important employee recruiting and retention, this whole area continues to improve.

For the third straight quarter, involuntary attrition was down and hiring was up from the comparable period last year.

Our employee engagement efforts are certainly bearing fruit.

Voluntary attrition is now running about 13%, which is very good for our industry, especially considering our large footprint in the intelligence and our large population in the D.C.

metro area.

We are taking a number of steps to ensure the long-term health of the business, many of them under the rubric of project alignment.

With project alignment, we will improve the quality and effectiveness of the transactional elements of human resources, finance and information technology to create a more productive work environment and to free savings to invest in our people and our businesses.

We recently set up our new shared service center at our existing facility in Oak Ridge, Tennessee, and are in the process of moving our human resources records management, corporate purchasing and accounts payable activities to that site over the next few months.

We also moved some of our corporate IT functions to line organizations, where we believe they can better leverage technologies and be more efficient.

We are also now taking a hard look at our real estate.

Currently we have too many small locations, and space utilization is not efficient in many of the locations.

We are reviewing all of our key locations to determine where best to conduct our business.

Our Virginia Beach property is currently for sale, and we plan to sell or lease our Vienna, Virginia campus and one building in our San Diego headquarters campus, and relocate those people to adjacent facilities.

Finally, we did have two issues arise in this quarter in the organizational conflict of interest or OCI arena.

On the first, a jury rendered a verdict in favor of the government, finding that we had OCIs that might have impacted our work for the Nuclear Regulatory Commission in the 1990s.

We are deeply disappointed by the verdict, and we believe there are substantial grounds for an appeal, which we intend to pursue vigorously.

It is important to note that the high quality of our work was uncontested.

The second issue, which is totally unrelated to the prior issue in substance and separated by nearly 10 years in time, we learned that questions had been raised about our involvement in a request for a proposal prepared by the Federal Emergency Management Agency.

We launched an internal review, and as a result withdrew our proposal and took appropriate employee actions.

The financial impact of walking away from this work is minuscule, but we acted decisively and appropriately to demonstrate our conviction to perform in a completely ethical manner.

We see that sensitivity around OCI increasing in importance going forward, and could become an advantage for our company.

We believe that the government will take OCIs much more seriously, which means that some of the firewall strategies that companies have employed to do both oversight and analysis work on the one hand and development work on the other hand will no longer work.

Our platform independence should be an increasing advantage going forward.

The company is taking a proactive approach to this issue so that we can limit legal risk and make the right strategic decisions for what pieces of work to bid.

With that overview, I'll turn it over to Mark for the financial details.

Great.

Thanks, Ken.

On balance, we had a solid quarter financially.

We have continued our momentum in the marketplace, posting double digit revenue growth for the second straight quarter, and also securing bookings well over $3 billion to drive future revenue growth.

We had some special charges in the quarter which diluted profitability, but the strength in our underlying core operations gives us confidence that we can recover and still hit our operating margin improvement goal of 20 to 30 basis points for the full year.

As we set out to do, we generated over $200 million of operating cash flow in the quarter, reflecting strong cash earnings coupled with a reduction in day sales outstanding to 66 days.

We deployed roughly that same amount by completing one acquisition and through continued stock repurchases.

As Ken mentioned, we are operating consistent with our overall business and financial plan and, in light of the momentum and visibility we have looking forward over the next six months, we are reaffirming our financial guidance for the year.

Before I discuss our results and our forward outlook, I do want to spend a moment to address the restatement of financial results that we announced a few weeks ago.

As a reminder, this corrected an error in the calculation on our gain of the sale of Telcordia in March of 2005, all of which was recorded in discontinued operations.

First, we filed the appropriate restated financial statements last night with the SEC.

We will file our second quarter 10-Q later today, which will properly reflect the appropriate restated prior period amounts.

Second, let me spend a moment and just cover a few more points on the restatement itself as additional commentary.

First, although we recently just discovered the error, the error that caused the restatement regarding the tax gain on the sale of Telcordia originated in fiscal 2005.

That's within the same fiscal year that we previously announced a material weakness in our tax accounting function.

We believe the recently discovered error was the result of the same control weaknesses that existed at that time.

Many changes were subsequently made to strengthen our controls after that period, most notably new controls and disciplines put in place leading up to our first SOX 404 assertion and attestation in fiscal 2007.

In making those assertions, it goes without saying that we believe our tax accounting controls have been adequate since then.

In concert with the Telcordia adjustment, we also adjusted for the classification of some minor business activities that had been reported in our commercial segment and should have been reported in our government segment.

After this change, the only business activity within the commercial segment is our commercial IT outsourcing and consulting business unit, which serves oil and gas, utility, life sciences and state and local government organizations.

Finally, the restatement displeases us greatly.

Nothing is more important to us than producing accurate, timely, consistent and transparent financial results and related disclosures.

We have and will continue to expend great efforts to meet this imperative because we're accountable to do so and also because we take great pride in doing so.

With that stated, let me now add some color on your financial performance for the second fiscal quarter.

Revenues, as Ken mentioned, totaled 200 -- or $2.56 billion; that's a record result for the company, with total growth at 15%, 5% of which was from acquisitions, 10% of the growth was internal.

Revenue growth from existing programs continues to be strong.

As an example, about a quarter of the 10% internal growth was contributed collectively by three of our largest revenue-producing contracts, [CPORT E] with the Navy, future combat systems with the Army, and AMCOM Express, Army and Missile Command Express, all of which have been in our hands for several years.

This demonstrates that our largest customers have confidence in us, and we can market and deliver new solutions to them as their needs change.

We continue to see strong growth from new contracts as well, as you'd expect, from our strong bookings performance all year.

Our two MRAP contracts contributed another quarter of our 10% internal growth, with the remainder coming from a combination of new contracts and expansion on numerous smaller, existing contracts.

Revenue mix by contract type was effectively unchanged.

Labor-related revenues comprised 60% of total revenues, and revenue growth was essentially split between growth in our labor base and growth in materials and subcontractor revenue elements.

Operating profits came in at 7.3% of revenue, which was consistent with our first quarter results, but down 50 basis points from our second quarter last year.

The reduction was due primarily to lower year-over-year shipments of our more profitable VACIS [border port] and mobile security products, and higher sales general administrative expense, SG&A expense, driven by nonrecurring charges for litigation and restructuring.

Our schedule for VACIS deliveries is essentially settled for the year.

We expect to ship about 20% more this year over last year in total.

Because the deliveries are more weighted to the second half of the year compared to last year, this becomes a primary contributor to higher expected margins over Q3 and Q4, and I'll describe that a little bit more later on.

Part of the increased SG&A expense was foreseen last quarter, when we announced that we would be incurring charges in the second quarter to improve our cost structure and our commercial business.

That did occur as planned.

We took over $2 million in severance and other related charges in the quarter, and at the same time we narrowed our commercial business focus to fewer market areas.

Despite these charges, the commercial business improved margins to just about 6% for the quarter and we have higher expectations as Ken mentioned going forward.

We also incurred about a million of severance and related charges during the quarter in connection with the decision to move the initial complement of services that Ken mentioned with respect to our new shared services center in Tennessee.

On the government segment side, we took an unplanned litigation charge of $6 million from the NRC case.

The charge represents the maximum damages that can be awarded to the government pending the formal entry of judgment which is expected to occur in our third quarter, i.e.

shortly.

Given the unallowable and mostly nontax-deductible nature of the charge, the consequences to our second quarter results were quite significant.

Operating margin was adversely affected by roughly 20 basis points on an effective tax rate now at slightly above 40%, and diluted earnings per share was affected by about a $0.015.

Finishing up the operating margin area, our SG&A expense, as planned, continues to reflect investments for future growth.

In the second quarter, bid and proposal costs rose $6 million, up about 20% from last quarter, and IR&D, international research and development costs rose $4 million, up about 50% from last quarter.

We also continue to invest in modernizing our IT infrastructure with our next group of business units, making the conversion to our new financial systems platform next week.

In terms of nonoperating items, all pretty much went as planned in the quarter with interest income down on a full quarter's worth of lower rates and lower cash balances, and interest expense slightly up due to more days in the period.

Other income normalized back down to $3 million from an unusually high result we had in our first quarter.

Diluted earnings per share from continuing operations came in at $0.26 per share.

That's up 8% in the same quarter last year on a diluted share count of 403 million shares.

Concerning cash flows and liquidity, we had success in billing, collecting and working through some problem areas that we had been experiencing, generating roughly $230 million of operating cash flow.

We resolved our primary internal issues, but continue to be adversely impacted by the ERP implementation at one of our more significant customer payment offices.

We finished the quarter with just shy of $700 million of cash on hand, and our previous comments we've made concerning our desired credit rating, our minimum cash balances, our credit capacity and our credit appetite are unchanged.

Now, let me wrap up with our look going forward.

With strong revenue performance, contract wins and margin improvement expectations, we do project our fiscal '09 results from continuing operations to be within our set of long-term financial goals.

As a reminder, these are internal growth between 6 to 9%, operating margins up 20 to 30 basis points over last year, earnings per share from continuing operations growing over last year between 11% and 18%.

We expect internal growth to slow somewhat in the second half of the year.

This is partly due to a more uncertain -- to a more uncertain funding environment starting on October 1, and partly due to flattening of some of our larger growth contracts such as MRAP, where our communications integration work will start winding down in our fourth quarter.

Even with that slowdown, we expect to be comfortably in our revenue range, given the 12% internal growth we've experienced in the first half.

For operating margins, we project improvement in the second half, primarily from significantly more higher margin VACIS shipments, improvement in our commercial operating margins after the cost reduction efforts that we just undertook and finally, a net favorable swing in indirect rate variances that we historically generate in the second half.

The expected performance on revenue growth, operating margin improvement and share count levels drives our projected EPS growth comfortably within our targeted range.

In putting together our forward view, we have taken a conservative stance in projecting the ramp up of some of our new programs, such as AITS and [Polcam], as well as the materials pass through activity on those contracts and others in the second half.

It is certainly possible that the new programs contribute more as the government rushes equipment purchases for the end of its fiscal year in September, and if the funding environment permits continued equipment purchases by the government during our fourth quarter.

If so, we could exceed the top end of our revenue range, which could put some pressure on the operating margin expansion goal, but would be a net favorable to earnings per share.

Finally, we expect our operating cash flow to be consistent with the model we discussed at the beginning of the year.

This model takes net income, adds back depreciation and amortization, and adjusts for special items planned for the year.

This year's planned items are an extra payroll cycle due to calendar timing of roughly a $125 million payment on the final day of the fiscal year that we've discussed before, so that's an outflow of $125 million, but an inflow of $75 million from a planned three days reduction in days sales outstanding.

So those things together net a minus $50 million from the net effect of the special items, starting with net income and adding back depreciation and amortization as I said earlier.

That's the cash model for the year and we're tracking well in accordance with that plan, as you saw in our DSO numbers.

That wraps up my financial discussion.

I'll turn it back over to Ken for his closing remarks.

Thanks, Mark.

In summary, and from the statistics that Mark has shown, our business is strong.

Our contract execution continues to be excellent, and that's leading to good financial results in our ability to win new business and capture market share.

If you want to learn more about what's driving our performance, I urge you to join our management team at our upcoming institutional investor conference on the 14th and 15th of October in McLean, Virginia.

We welcome attendees both in person and via the web for a top-to-bottom review of the businesses with a focus on some of our key new business campaigns.

Space is limited, so if you're interested in attending the event, please contact Stuart Davis.

With that, we're ready to take questions.

(OPERATOR INSTRUCTIONS)

Your first question comes from the line of Laura Lederman with William Blair.

Please proceed.

Thank you.

Can you hear me?

Can you hear me?

Can you hear me?

Can you hear me?

Yes, we can.

Okay.

Sorry.

I have some weird phones here.

Just a few questions.

This one's for you, Mark.

If you look at the $0.01.5 that the NRC led to, what is the total amount of charges?

If you look at the movement of people and all of the unusual items in the quarter, so we can have a sense of what the business profitability would have been without all the different charges in the period?

Laura, in my mind, we had, as I said, $6 million for NRC, which was unexpected.

We also had nonrecurring severance charges of $3 million in the quarter.

B&P and IR&D move up and down.

B&P was pretty high, but I would not consider that nonrecurring, of course, it's somewhat cyclical, so I would to the $9 million comprised with the 6 NRC and the 3 in severance to adjust out if you chose to do so.

Okay.

Thank you.

That's helpful clarification.

Can you also talk a little bit about the churn plans, the voluntary turnover of -- 13% is great, but I also heard that you guys were looking to go down to 12.

Is that sort of still your goal for the year?

And one final question, which is acquisition pricing -- one final question, which is acquisition pricing, how are the levels versus a year ago?

Thanks.

I'll take the voluntary -- involuntary attrition.

Certainly, yes, we have established a pretty significant goal to reduce year-over-year our attrition by 1.5%, and while we're halfway through the year, we're seeing a good, positive trend downwards and our employee engagement activities, I think, are really working and, frankly, there's nothing like winning and growing the business with the kind of work that we're doing to keep people really excited about working at a company like Science Applications International.

So I think it's a stretch goal, but one that still looks like it's in the art of the attainable at this point.

And the competition pricing -- and while I still have you, why not follow up on the [Dell tech] and how that's going in terms of getting that up and running.

Four questions, that's good.

Fast, really, really fast, so --

Dell tech continues to progress well.

As Mark mentioned, we're doing our next wave, wave one, next week.

Mark and I were just talking about it before the call.

He's very bullish about the preparation that the business units, some half a dozen, have made to transition off of legacy to cost point Dell tech, so we're positive about that.

Acquisition premiums, if you're talking about the 40% premium that SI International got from CIRCO, wow, exciting times.

We're still actively involved in looking for acquisitions that have real strategic merit for us.

Our pipeline of potential acquisitions is still looking good and we're engaged in dialogue that I can't really talk about.

Thank you so much.

You're welcome.

And your next question comes from the line of Jason Kupferberg with UBS.

Please proceed.

Thanks.

Good evening, guys.

Good evening.

So on EPS for the year, I guess year to date you guys are up about 21% year-over-year, if I am not mistaken.

Obviously you're keeping the guidance at 11 to 18.

I understand you would have some conservatism, especially looking ahead to your fiscal fourth quarter, but is it fair to say that the high end of 11 to 18% is now a lot more likely, just given where you are year to date or should we not make that conclusion because it's simply premature given some of the funding uncertainties around the CR?

Our approach is to stick with our guidance and, you know, let the numbers and our results reflect where we might be in that range.

But that's more up to you to determine.

Okay.

And in terms of some of the real estate actions that you made reference to, can you give us a sense in terms of potential proceeds or cost savings that might yield from this -- this program?

Certainly, Jason.

The -- some of the facilities that we mentioned in Ken's remarks are currently not occupied, but some are, and we certainly expect to pick up efficiencies under the project alignment umbrella by having greater density with our folks both on the east coast and out here in San Diego.

So that's part of our overall margin improvement and project alignment plan that is long-term in nature that we talked about.

We -- just like most nonoperating items, we don't have any projections for gains or losses on sales of real estate baked into our guidance.

I think you know in general we are positioned well in our real estate for a cost versus fair market value, but we aren't counting on any uptick from selling at gains as part as meeting our financial objectives.

So hard to predict when such sales can take place and at what prices, so we'll just let those fall out as they occur.

That's helpful.

So just so we understand, what you're saying is that this is all part of your ongoing 20 to 30 basis points of annual improvement, is that - we shouldn't think of this as something incremental on top of what's already going on with project alignment?

I think our margin improvement plan was articulated before project alignment existed.

Project alignment does include a more aggressive approach to our facilities management, and we're doing project alignment in order to be more competitive in the marketplace on several fronts.

Okay.

And just last question, can you tell us the mix of new versus renewal bookings in the quarter?

Jason, this is Stuart.

If you look at the very strictest definition of what's a recompete, almost nothing was recompete business; that is, it's all new.

But when you look at really what's the same kind of work done for the same kind of customer, that's really kind of an extension of what you're doing.

You know, it's again more rich in terms of new business, but there is a reasonable amount of recurring business.

So as an example, the large intel job that Ken mentioned, it's a new contract vehicle, so it's not a recompete in any sense, but it's still employing the same people doing the same kind of things.

And maintaining a similar revenue run rate?

Yes.

Thank you, guys.

I might add, I'm sure we'll get asked this question, our recompete win rate continues to be high.

It was 90% for the quarter versus dollars and 93% versus the number of wins.

So we're continuing to, you know, hit the ball out of the park with regard to recompetes.

Next question.

Your next question comes from the line of Cai von Rumohr from Cowen and Company.

Please proceed.

Nice quarter, gentlemen.

Thank you.

VACIS, you mentioned second half should be stronger than the first half.

Could you give us some color on how many you shipped in the first half and about how many you might do in the second half?

In order of magnitude, probably 10 in the first half and we have scheduled about 40 in the second half.

Actually 42.

To be precise.

And to give you a comparison for last year, our second half this year has about 15 more units in it than the second half of last year.

Okay.

Got it.

And of the 90, I mean, what should we expect in terms of a capture rate?

I mean are some of those high probabilities so that -- I mean, does this all imply good probability of strong growth in this business next year?

Well, certainly it depicts good opportunities.

Of the 90 units we have, you know, roughly 35 that are -- could be international and, you know, there -- that's in Brazil, to be honest.

We're, right now, submitting a bid there.

And the others are the military mobile units, which could be upwards to 50.

So, you know, our chances are probably better domestically than international, but we're going to swing the bat and see what we can do in Brazil.

Excellent.

Thanks a lot.

And cash flow, I think, the Telecordia, my understanding was you might have to pay $25 million or so in the second half, and could you give us some color on, you know, maybe a range on what you might get in cash from the real estate actions?

Well, let me clarify, Cai, that we expect to cut a check for about $35 million with interest to the IRS when we settle our tax year '06.

That we expect to occur in the second half of the year, and that will show up geographically in cash flows from discontinued operations, so it has no effect on the model I talked about in my earlier remarks and our guidance for operating cash flow.

With respect to real estate, we prefer to not disclose what prices are associated with specific pieces of property because we're in negotiations.

Okay.

And then last one, you bought a little more stock than I had guessed, 8 million shares again, 150, you know, I think you had kind of cautioned going into the quarter that you wanted to keep a cash balance of over $500 million, looks like cash flow might not be quite as robust in the second half.

How should I -- how should we think about, you know, your stock repurchase plans for the second half?

First, I would say our cash flow is pretty robust in the second half.

It's, you know, about the same as the first -- as the second quarter, we'll do about that same amount for the rest of the year, roughly speaking, so we do expect strong cash flow for the year.

We do uphold the principle of keeping at least $500 million of carbon hand, so that's a regulator, and we continue to meet quarterly on our repurchase strategy with our Board of Directors.

And as you recall, that's kind of the third priority.

First is to invest in driving organic growth, which is paying handsome rewards to date, second strategic acquisitions and then to acquire when we feel the price is right.

Okay.

Excellent.

Thank you very much.

Your next question comes from the line of Ed Caso with Wachovia Securities.

Please proceed.

Thank you.

Let me add my congratulations.

What percent of revenue was from commercial?

Give me one moment.

5%, Ed.

Any major recompetes that we should be watching in the next -- sort of through the end of FY10?

Through FY10?

FY10.

The next six --

The major recompetes for FY09 are about a half a dozen.

We have an STOC 2 award that's expected in September for about $500 million.

We have a [SEACOM ARC 2] award, which is a multiple IDIQ award, in December for about $750,000,000.

Those are really high.

The rest are, you know, in the order of under $200 million.

When you go out a little bit further, Cai, then that's when you run into united -- I'm sorry, Ed, that's when you run into unites and a little bit later on, the recompete of our work, which are the big, big ticket items.

And last question, New Orleans, any issues in that part of the world given the recent storm?

Well, certainly our [Enterge] customer seemed to have fared better this time with Gustav.

On a personal note, we had 800 to 900 people in the affected area and so far, knock on wood, everything seems to be okay, but we're still assessing, you know, property damage.

Thank you.

Your next question comes from the line of Joe Nadol with JPMorgan, please proceed.

Good afternoon.

It's actually Seth for Joe this afternoon, and good quarter.

Just wanted to ask a quick question about margins.

With the charge related to the NRC in this quarter and the commercial severance actions sort of depressing the margins, does that mean that there's room for maybe more than the 20 to 30 basis points of margin expansion when we look to next year?

Well, we -- we're confident in our recovery for the rest of this year for the reasons I set forth.

Next year will depend on our mix, our product mix in particular.

We do expect to continue to be more efficient in the SG&A area over time, and we expect our commercial to get recovered and stay recovered.

I think it's possible to have some upside to those numbers, but that's not part of our base plan.

We're sticking to our 20 to 30 basis points as we set out to do, and if there's any change to that, we'll comment in our December conference call when we provide our first fiscal '10 guidance.

Sure.

Okay.

And then are there sort of ongoing -- I know that there were - some of the severance costs in this quarter were not associated with the commercial actions, but more with project alignment.

Are there sort of sustained costs associated with project alignment and, if so, can you give us sort of the ballpark of what they are per quarter or is it sort of it will vary by quarter?

Our general model with project alignment is that our investment will be offset or more than offset by savings generated in the program.

So this quarter is only about a million, and we might have had some smaller savings buried in the operations from some of the things we've done under project alignment, but generally speaking --

Pays for itself.

It should pay for itself going forward and we don't expect at this point, and we'll provide quarterly updates on this, any real clumpy charges on the horizon.

Great.

And then just a last quick one.

Is it correct to assume that the MRAP revenue this quarter was about $85 million and, you know, if so, over what period of time -- I know the ramp down you said would start in Q4.

Sort of over what period of time do you expect that to ramp down?

Well, it really starts ramping down in the fourth quarter and, you know, will eventually go to zero pretty quick as, you know, the vehicles get integrated with the coms equipment and we ship it to Kuwait for disposition in Iraq and Afghanistan.

Now, that's the vehicle side.

We do have the logistics piece, which, you know, we won some time ago, which will continue, and if we win the recompete, that will give us sustainable revenue going forward of about $100 million-plus.

On an annual basis.

On an annual basis, right, not on a quarter basis.

Just to correct, the quarterly amount, we have two programs, they together are 55, $60 million per quarter in the second quarter.

55 to 60 in total?

In the second quarter, yes.

Great.

Thanks very much.

Your next question comes from the line of Dhruv Chopra with Morgan Stanley.

Please proceed.

Good afternoon, gentlemen.

Nice work.

It's Dhruv Chopra.

I was wondering if, Ken, if you can speak about the commercial business.

What types of actions did you take, how are you going to compete more effectively with, you know, some of the offshore providers, and what's the long-term strategy for the commercial business?

Good question, and it has caused us, because of the downturn in business with some of our core customers, like BP and Scottish Power, to reinvigorate our thought process around the strategy, and really what we've reconciled is we really want to move up what I would call the noble work business, and not get into the fray of being commoditized in the pure IT services outsourcing.

That has historically been good business for our company, but again we've got way too many competitors and the international implication, India, China, you name it, suggests that this is going to be pressure on margins and become a much, much lower margin business.

Having said that, we have a wonderful science-based consulting business in oil and gas, in utilities, in life sciences, in -- even in the public service sector that we are investing in, really trying to develop more and more opportunities.

So we've basically realigned our SG&A to focus on those markets and to continue to serve our key customers in the IT outsourcing, but to -- not to pursue that as vigorously as we've done in the past.

So it's still a business that I like, it should come back to margins that are as good, if not better, than our government segment, and we are still recognized in those four market segments as being very, very good domain experts and thought leaders, and we want to continue in that vein.

That's very helpful.

Just to clarify, can you provide some color on the split between how much ITO work you do versus some of the more noble type work?

No.

Okay.

Great.

Thank you very much.

Your next question comes from the line of Joseph Vafi with Jefferies.

Please proceed.

Hi, gentlemen.

Good afternoon and good results here.

I was wondering if we could talk -- we're sitting here in early September, the end of the government's fiscal year and, Mark, you said you were a little bit conservative on some of the new project ramps or the new contract ramps, but what are you seeing out there in terms of budget flush here at this point at the end of the fiscal year?

We're seeing a strong funding environment, but we personally haven't seen a glut of material equipment buys thus far.

We still have a full month to go here in September, but it's been pretty much business as usual through the summer as far as we can see.

I would just add, the adjudication process just seems to be a little bit slower and, you know, that doesn't cause us alarm, but if they really want to get these things funded, they only have the better part of, you know, a month to get things done.

So hopefully we'll see a little more heightened activity, and that's why we're somewhat bullish if that portends, then we might have a very, very strong third quarter.

But Mark's right.

We want to be vigilant and conservative going forward because we just don't know the unknown unknowns.

Okay.

So just so we understand, so, Mark, you were saying that you're seeing a good funding environment, but, you know, at the same time I think Ken just said that there's some slowdown or there's some delays in the funding.

So --

In decisions.

In decisions, okay.

And the funding, then, is actual live awarded funds for existing contract vehicles, then, the way that -

Correct.

And the funding of new awards once they're decided.

Okay.

All right.

That's helpful.

And then I'm not sure if I missed it or not on VACIS.

I know obviously the second half is going to be bigger than the first half, but do you have visibility how the quarters in the second half will play out there?

Well, we have a shipment schedule that is firm.

We have had pretty high predictability of that in the past, and so we're confident that our team will deliver in accordance with that schedule and deliver the 40 units or so in the second half, and that's the basis of our forecast.

Okay.

But you're not really sure yet if that's really -- if we're going to see more revenue in Q3 or Q4 from those - from those sales?

Well, again, our projections are based on that shipment schedule.

To the extent that there are new orders received, the lead time is, you know, significant and would not affect until next fiscal year.

All right.

Fair enough.

And then, you know, finally, on this conflict of interest issues, obviously this is -- this is pretty old and coming up now.

Is there anything else we should be aware of or that might be out there from a conflict point of view that -- you know, that is something that you're working on or being -- having to address with the government at this point?

With the government?

I mean similar cases or something to that effect?

Well, I think lots of companies have similar issues to this.

I think there's just a growing awareness that, you know, the firewalls that traditionally allowed companies to do, you know, front end work as well as get into the development are now perhaps being scrutinized by Congress, et al, and viewed as something that they might want to change.

If they don't change, our business doesn't change whatsoever.

If they do change, perhaps we have a little bit more upside because of the platform independence as I stated in my opening remarks.

Okay.

Very good.

Again, good results.

Thank you.

Thank you.

Your next question comes from the line of Bill Loomis with Stifel Nicolaus, please proceed.

Hi, thank you.

Just looking at the VACIS systems, of the 90 that you expect to be decided on in the next three months, the -- you mentioned that roughly 50 were the military mobile VACIS and then the 35, which I guess you said were primarily Brazil, was that the IP6500?

It's a combination.

Brazil are looking for some fixed sites as well as mobile.

So the -- the 35 actually are comprised of three different variants of our detection products.

So as I mentioned, we're going to swing the bat and see if we can win one, two or all three.

All three would net us, I think, actually 37.

Highly unlikely, but, you know, the opportunity is there.

I like it in that it's really penetrating the international market.

If we win some here, we've got five units that Dubai Customs has ordered, that gives us a good footprint to expand internationally.

Okay.

And then just following up on the Dubai five, do you -- I mean obviously there's some very big ports around in the Middle East.

Do you see additional sales to the Middle East?

Are these basically, if you will - you know, are they testing them with an eye to a much greater number down the road?

I think we've found Dubai is a much more forward-leaning country and wants more advanced state-of-the-art, especially in their port security.

So I would anticipate, especially in that area, that there will be a lot of interest once we have those up and operational and people see that we don't impede commerce, and we actually can provide a lot more security at a relatively low cost.

Okay.

And just going to the [Polchen] and the Michelin tire contract, what was the revenue contribution?

Was there any in the quarter, and what do you see for the year on those logistics programs?

Bill, Polchem has shifted to the right.

I earlier advised that the revenue estimates for this year I think would be 50 to 75; we're looking at about 25ish if things go well from this point forward, and there was negligible revenue year-to-date including the second quarter, of course.

So that, we'll just keep you posted on.

Conversely, things are going very well for tires.

The team has done a remarkable job.

We're delivering double-digit operating profit or contract fees on that opportunity.

The revenue is not that big, but the contribution to economic profit and margins is very healthy.

Okay.

So how you're accounting for the MIchelin tire contract, that's -- the assets, the tires are now passing through, you're just capturing the fee in revenue and that's why it's high margin?

Essentially.

Okay.

Is that the way -- same way Polchem is going to work for you?

No, Polchem, we will have pass throughs of higher revenue, lower fees.

Okay.

Thank you.

Your next question comes from the line of George Shapiro with Citigroup.

Please proceed.

Good afternoon.

Good afternoon.

If I look at your guidance of revenue growth, even at the high end of 9%, given what you've done in the first half implies only about 6% growth in the second half.

Now, would that be more in the third quarter and less in the fourth because in the fourth you've got the tougher comparison on MRAP?

Go ahead.

The effect would be in the fourth quarter.

We typically have a pretty strong third quarter and our measures of conservativism concerning the funding environment as well as the MRAP wind down, as well as the slower ramp potentially on new programs as attributed to the fourth quarter, in addition to the higher comparative prior year that you mentioned.

Okay.

And then on the other side, on the margins, to kind of get your 20 to 30 basis point improvement, you've got to average a little over 8% in the third and the fourth quarter.

Traditionally, your third quarter has been much stronger.

I mean will that be the same this year or will both quarters be over 8%?

We don't -- don't want to say too much about individual quarters, but obviously we do have to run above 8%.

We're confident in doing so.

I would say that in the four metrics we have, revenue, earnings per share, cash flow and operating margins, the margin one would be the toughest one for us to achieve given where we are, but we have a road map for the elements that I laid out earlier and, you know, pending no surprises and pending our delivery of the product shipments as well as our normal, more favorable labor utilization and our turnaround, the commercial will make it.

But we don't want to point it heavily to one quarter or the other in Q3 or Q4.

It's got to be strong in both.

I guess in general, I mean it certainly looked like that the bias would be that you might do a little better on revenues and a little worse on margin, but you've not changed your guidance to reflect that at all.

We believe looking at our plan going forward that we still can fall within the guidance that we gave.

20, 30 basis points, 6 to 9%, 11 to 18 EPS, George.

Okay.

Thanks very much.

You're welcome.

Your next question comes from the line of Erik Olbeter with Pacific Crest.

Please proceed.

Nice quarter, guys.

Quickly on the security initiative you were talking about, Mark, you had mentioned earlier that you were hoping to bid on a couple of large opportunities in the intel community, and also you discussed possibly needing to increase your R&D expenditures or being an area that you might want to focus on.

Have you seen those RFPs or RFIs start to come out?

Are you still confident that by the end of your fiscal year you could possibly be bidding on a couple of big opportunities?

And which would you expect in terms of R&D?

I'll cover part of the question.

Ken may want to comment on the larger initiative.

But as you might have picked up in Ken's remarks, we did win a cyber-related procurement in the intelligence arena, significant, north of $100 million in the second quarter, we're really pleased with that.

Can't talk a lot about it above that, but certainly off to a good start there.

I did mention our R&D investments upticked quite a bit in the second quarter.

We generally expect a run at that pace or slightly above that pace for the rest of the year.

Part of that investment clearly is going to our cyber initiative, which we think is a huge opportunity for us, so it's getting a lot of focus in terms of our science and technology community that's focused in our intelligence group, and so far they're off to a great start.

I think Mark hit it.

We're getting ourselves well positioned to exploit every opportunity that meets our company's competencies in the cyber area.

We have a couple of outstanding bids, one of which we just won, the cyber security opportunity that was north of $150 million, and so I'm pleased where we are.

You know, the conundrum on the IR&D early in the first half is we were bidding so many opportunities that we really prescriptively slowed down our IR&Ds so that we could put the talent that we needed on those opportunities, and that's really starting to pay off.

Typically third quarter, fourth quarter, we start seeing, you know, the RFPs slow down and we'll regroup and continue to invest in our R&D programs.

Great, guys.

Thank you very much.

We have just time for one more question.

And your final question comes from the line of Tim Quillin with Stephens, Inc.

Please proceed.

Hey, good afternoon.

Good afternoon.

You know, I think this has been asked a couple of different ways, but I was just hoping you could put some meat on the bones of project alignment in terms of what it means or how we can quantify that potential, you know, incremental savings on top of the 20 to 30 basis points both on, you know, facilities management and shared services?

I'll try again, Tim, this is Mark.

We articulated our margin improvement program a long time ago, and all of those elements are still intact, a combination of improving fee, improving mix, and taking cost structure out mostly from IT modernization efforts.

Project alignment was designed and continues to be designed to generate $100 million per year out of our cost structure, which we want to preserve the option of adjusting our pricing structure in the marketplace, reinvesting in our people, spending more in business development, spending more in IR&D, et cetera.

So we are gearing that savings to reinvest into the business and we're not directionally -- directionally intending to drop that to the bottom line, although it's certainly possible that some of that occurs, but it's not a part of our EPS growth story that we articulated in our IPO and since then.

Having said that, if you lower your infrastructure costs by $100 million and continue to grow top line, incremental margin will expand, which has a positive impact.

Right.

That's -- that's what I'm trying to figure out.

Thank you.

You're welcome.

Okay.

I think that's all we have time for today.

On behalf of the team here, I really want to thank you for your interest in the company and feel free to give us a call over the next couple of weeks and again, hope to see many of you in October.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.