Leidos Holdings Inc (LDOS) 2014 Q2 法說會逐字稿

Thank you for standing by.

Welcome to the SAIC fiscal year 2014 Q2 conference call.

During today's presentation, all parties will be in a listen-only mode.

Following the presentation, the conference will be open for questions.

(Operator Instructions)

This conference is being recorded today, Wednesday, September 4, 2013.

I would now like to turn the conference over to Paul Levi.

Please go ahead, sir.

Thank you, George and good morning.

I would like to welcome you to our second-quarter fiscal year 2014 earnings conference call.

Joining me today are John Jumper, our Chairman and CEO, Stu Shea, our COO, and Mark Sopp, our CFO, and other members of our leadership team.

During this 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 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.

I would now like to turn the call over to John Jumper, our Chairman and CEO.

Thank you, Paul, and welcome, everyone.

In the second quarter, our performance was impacted by a number of discrete items.

These included costs related to the planned separation of SAIC into two companies, four underperforming programs, two fixed-price foreign development contracts, a biomass plant construction contract, and an IT services contract with a state and local customer, and a non-cash intangible impairment of Reveal Imaging Technologies, a provider of threat detection products and services that we acquired in August 2010.

Looking at the results for the quarter, revenues were $2.5 billion, down 15% year-over-year on an internal basis.

This was in line with our expectations, given previously announced contract reductions.

The anticipated draw down of joint logistics integration, or JLI, reduced revenues by $64 million.

As you know, JLI is directly related to the US military withdrawal from Southwest Asia.

Revenue was further reduced by the loss of the DISN Global Solutions or DGS contract a year ago, an $85 million impact.

Together, these two items account for almost half of the internal year-over-year decline.

The remainder of the revenue decline was primarily driven by the impact of sequestration, which reduced the tasking levels on current contracts, lowering the levels of award, resulting in delayed decisions and imposing significant caution throughout the contracting process.

Operating income was lower than the prior year, significantly impacted by the cost of the separation and the discrete items discussed above.

Despite all of this, our operating cash flow was strong for the quarter at $217 million, in line with our expectations, and demonstrating the underlying resiliency of our Company, even in difficult times.

While we used all of the available information to factor in the full impact of sequestration in our earlier guidance this year, we need to be even more cautious, based on our current outlook for the second half.

Recent wins are in protest, award decisions are being increasingly delayed, and the spillover effect of government spending cuts to our commercial health business, while we believe temporary, has been factored into our updated expectations.

As a result, and in light of our first-half performance, we are reducing our fiscal 2014 guidance today.

Mark will outline the details later in his remarks.

I should note that after the quarter closed, the Company has had some notable wins of new business opportunities.

Specifically, we were the only contractor awarded the NASA Human Health and Performance contract, an IDIQ single award value of $1.8 billion.

We also won a new engineering program with LSB Industries for over $100 million, with the potential of additional business for this client.

These contract wins indicate that our pipeline remains strong, and we continue to win in the marketplace.

We are excited about moving closer to accomplishing our separation.

I'd like to point out that the separation gave us an opportunity to redesign the cost and rate structure of both companies.

The benefit of which will be more visible as we complete this split and shed the burden of our separation and transition costs this year.

Now, I'd like to turn the microphone over to our COO, Stu Shea.

Thanks, John, and good morning, everyone.

For the next few minutes, I'd like to share with you how we are dealing with several operational matters that affected our performance this past quarter, discuss a little bit about the lessons we learned, and highlight for you how we are going to better mitigate similar risks like this into the future.

With roughly 9,000 contracts in SAIC today, we have an excellent track record of strong program performance.

One of the many benefits of the separation of SAIC and Leidos is that we got an opportunity to take a deep look at where every one of these programs were being executed within the Company.

In preparation for the separation, every contract was repositioned to where it best fit the new structure, not necessarily leaving them in the part of the Company that won or that were executing the contract.

To that end, the movement of the contracts to their new locations drew additional focus to ensure that we had the right solutions and execution teams involved to deliver on our commitments.

As part of that additional focus, there were two programs that required additional technical effort.

These two programs were on our watch list, and as we continue development and testing during the second quarter, we identified performance issues that required technical redesign and an associated schedule slip.

Of the four underperforming programs that John mentioned, all were fixed price development contracts that shared some common attributes.

First, these programs were all with new customers, outside of our core markets.

Two of the efforts were delivered in foreign countries, another with a state and local customer, and a fourth with a commercial power plant developer.

In each case, there were some challenges translating the project requirements to appropriate solutions by the project team that only became apparent as the programs were being executed, designed and tested.

In addition, on two of the contracts, the project teams themselves were not the best suited in the Company to execute the programs.

There were others in the Company that were better suited to have taken on these efforts, because of their core skill sets and track record of performance on similar efforts.

The combination of these two factors ultimately resulted in us identifying the program issues that translated to an increase in cost.

We ultimately took write downs as our estimates changed to accommodate these impacts.

Subsequently we initiated a review of all programs across the Company that shared similar attributes.

We believe we have better matched the difficult programs with the appropriate teams to best steer these programs to conclusion.

In addition, we have scrubbed our business development pipeline to limit our exposure on programs such as these.

These actions have addressed the current portfolio, but we've also taken a hard look at the composition of new SAIC and Leidos going forward, and what decisions we can make to ensure we are more effective going forward.

To that end, we've made some changes to our individual operating philosophies, and these will roll out over the coming quarters.

First, I can assure you we are both going to stay laser focused on our core businesses, and within those businesses, we will choose carefully what type of contracts we will take on.

We will also be more active in the divestiture of non-strategic or non-performing businesses.

We've placed into discontinued operations one line of business in Q2, and we are evaluating the potential exit from a few select areas in the second half of this fiscal year.

We will balance our emphasis on top line growth with a focus on year-over-year improvement of economic profit.

Our key measures of success and incentives will be structured to drive year-over-year profit growth, and capital efficiency.

We will expand our culture of continuous improvement and operational efficiencies to continue to drive costs out of our SG&A.

Both companies will have ongoing programs to continue to drive down our wrap rates to improve competitiveness.

We have achieved significant reduction in our wrap rates over the past year, but are targeting even more over the coming year.

And finally, we will be much more focused on using our capital to benefit our shareholders.

We do not plan to build excess cash on our balance sheets going forward, and we expect to return significant value to our shareholders.

Moving now to our business development results.

Net bookings totaled $1.9 billion in the second quarter, and produced a book-to-bill ratio of 0.75.

We ended the quarter with $15.9 billion in total backlog, $4.6 billion of which is funded.

I would note that our largest single award in Q2, a $500 million-plus classified intelligence program, was protested, and a stop work put in place.

If this award was not protested, our book-to-bill would have reached 0.95, a significant improvement in the trend.

Protests continue to dominate the acquisition process.

We currently have 18 programs under protest, with the combined award value of $1.2 billion.

Award decisions and the resultant pace of bookings from our US government customers continue to slow.

To put that in crisp perspective, in fiscal year 2013, our average contract award from time of proposal submission was 121 days for standard contracts.

This fiscal year, that timeline has slowed to 284 days.

IDIQ awards have only slowed from 283 to 296 days.

Clearly, the acquisition system has stagnated in reaching decisions.

These delays exist for all contract sizes, from task orders under $5 million, all the way to large $100 million programs and above.

Although some of this delay is due to the lack of specific sequestration guidance given to acquisition offices from their own agencies, much of it is the result of many smaller awards of shorter duration being made, and an ongoing fear of larger award decisions being protested.

Despite the conditions in the acquisition system, we did see a small uptick in book-to-bill in each of the three segments in the quarter, and although we are not counting on any large government flush of dollars at the end of the year, we are encouraged to see some level of increased activity across the board.

At the end of the second quarter, we had over $27 billion in outstanding bids.

That includes $15 billion in IDIQ bids, and about $12 billion in definite delivery bids.

During the second quarter, we won two programs valued at more than $100 million each.

So far, during the third quarter, we've added one more $100 million program.

At this time we have over 280 opportunities in our pipeline with contract values over $100 million.

With the average time from submission to award for $100 million programs averaging nearly twice as long as just a year ago, we are, however, realistic in our view of their potential contribution to our fiscal year 2014 revenues.

Finally, I'd like to take just a moment to provide you an update as to the status of the split.

We are nearing the finish line, and we have completed all the necessary design objectives.

Employees are prepared and eager to get on to their new companies.

Functional teams are stood up and are already operating as independent teams.

IT system cutover plans are in place, tested and ready to go, and separation agreements are finalized.

To that end, both companies are hosting an Investor Day in New York City on September 11, where the two management teams will highlight the respective investment merits at each of the two organizations.

It is fair to say both Leidos and new SAIC teams have been extremely busy preparing for the separation.

The Leidos team has moved into its new building in Reston Town Center while new SAIC is in the process of repositioning their team to their headquarters in the existing SAIC McLean Towers.

We look forward to having the split behind us, and enjoying the benefit that the split will bring to both organizations.

With that, I will turn the call over to Mark, who will discuss the financials for the quarter.

Thanks, Stu.

I'll again call your attention to the supplemental earnings presentation on our website, which provides additional color on our results, and also our outlook.

John did cover the revenue story pretty fully, so I'll focus on profitability, cash and forward guidance.

On the profitability side, as previously mentioned, we are in a transition year, where we are incurring substantial costs and undertaking various actions to prepare for the future.

Reported operating margin for Q2 was 3%.

Our separation-related costs totaled $35 million in the second quarter, which diluted operating margins by 1.4%.

We also had other preparatory costs related to the separation, mostly IT focused, of $14 million, impacting margins by 0.6%.

Assuming actual separation occurs soon, these separation-related costs should peak in Q3 and then wind down completely in Q4.

As John mentioned, we took a $30 million impairment charge on the Reveal Imaging acquisition, reducing overall margins by 1.2%.

While Reveal and the engineering products business are our most profitable, we did not ship nor expect to ship enough units near term of Reveal units to produce the financial results necessary to support the purchase valuation a couple of years ago.

Finally, the net contract write downs of $32 million, impacting margins by 1.3%.

Those write downs were concentrated on the four fixed price contracts that Stu mentioned earlier.

Total net contract adjustments were $44 million on these four programs, offset by various write ups elsewhere.

Putting these write downs into context, without the adjustments on the two foreign development programs, net contract adjustments would have been zero in the quarter.

Operating margins did benefit by favorable cost variances related to the significant cost reductions we've been making all year, helping to offset some of this impact.

These discrete items collectively diluted operating margins by 4.5%, without which profitability would have been at a more normative level.

We are very focused on the performance issues and will build on Stu's remarks about how we'll operate going forward in next week's investor conferences.

We had a solid quarter for operating cash flow, which exceeded $200 million in Q2.

In light of this and given the nature and timing of some of the items impacting our profits this year, we are keeping our existing guidance of operating cash flow at $450 million-plus for the year.

Now some major takeaways for our operating segments, starting with health and engineering.

Revenues increased 8% on a total basis year-over-year, but were down 8% on an internal basis.

Sector performance was driven by commercial health, where revenues declined against a very difficult comparison, where it increased 35% in the prior year period.

We saw a slowdown in hospital IT spending, which we believe was attributed to lower government Medicaid and Medicare reimbursements to hospitals, arising out of sequestration cuts, and also the one-year delay of implementation of the revision to international classification of disease codes referred to as ICD-10.

While it's hard to predict how long this will last, we are indeed confident in the growth prospects for our solutions in the electronic health records market, with respect to digitization, integration and exploitation needs over the coming years.

This all results from legislation requirements and customer demands for more efficient and effective healthcare, which is enabled by IT modernization.

The profitability to health and engineering operating income decline was dominated by the impairment charge on Reveal.

Moving on to our national security solutions segment, revenues were down 15% year-over-year.

The JLI contract ramp down alone reduced revenues this quarter by about $65 million year-over-year, or more than one-third of the percentage decline.

We also saw declines concentrated in reduced spending in Middle East operation support, and also reductions in scope across the space related to federal budget cuts.

Operating margins were just under 8%, adversely impacted by the two foreign customer fixed price write downs.

On a normalized basis, excluding contract write ups and write downs, operating margins would have been roughly 9% for this segment.

Higher net fees across-the-board helped minimize the effect of the write downs enabled by cost reductions and solid performance in our core intelligence programs.

For the technical services and information technology segment, which will become the new SAIC, third-quarter revenues were down about 16% compared to the prior year.

The loss of the DGS contract accounted for almost half of the decline, with the ramp down in war efforts and sequestration-related cuts accounting for the remaining amount.

Operating margin was 6.7% fairly normative given the current portfolio of contracts in the sector, and reflecting the ramp down in the higher margin DGS program.

That covers a review of the operating segments.

Non-operating items were as expected, so the EPS shortfall was entirely attributed to the discrete operating items I just discussed.

As a reminder, our effective tax rate is expected to be in the 31% to 32% range this fiscal year, which is about 4 to 5 percentage points lower than our normative rate, reflecting the deductibility of part of the special dividend we paid earlier this year, and also some other tax adjustments.

I mentioned free cash flow was strong at $200 million.

DSOs ended at 72 days, and crept up a bit since last year, due to the termination of the federal accelerated payment program, and also some effect of slower payments stemming from recent government furloughs.

Now let me move on to guidance.

With respect to forward guidance, let me first remind you that our guidance assumes SAIC operates the full fiscal year 2014 as one Company, the one Company as you know it today.

Once our Board formally approves the separation, we expect to issue standalone guidance for the two separate companies thereafter.

Guidance is always on a continuing operations GAAP basis, and fully includes the non-recurring costs to prepare for and execute the separation transaction.

For revenues, we are reducing estimates in the second half due to concerns that government spending will be worse than our original estimates.

We enter the fiscal year with known reductions like JLI and DGS, but with a strong pipeline of outstanding bids.

The environment we're now seeing gives us less confidence that enough outstanding bids will be awarded and/or get through protests to generate meaningful revenue this year, making the known declines like JLI and other OCO-funded efforts most likely unrecoverable in the short-term.

Our fiscal 2014 revenue guidance is now expected to be in the range of $9.7 billion to $10.2 billion.

We expect operating margins to be off our previous expectations by about 80 basis points.

This is driven by the write downs we saw in Q2, about $18 million more in separation and related transition costs above our previous $140 million estimate, and volume reduction in our higher margin commercial health area.

Those changes adversely impact our EPS from continuing operations estimate by about $0.20.

Accordingly, our guidance estimate for fiscal 2014 is reduced to a range of $0.95 to $1.03 per share.

Operating margins, excluding separation and transition costs, are expected to run in the 7% to 8% range in aggregate in the second half of fiscal 2014, barring any unforeseen items.

And finally, as earlier stated, our cash flow guidance remains unchanged at $450 million-plus.

Wrapping up, we did have some select performance issues in Q2, which we are indeed addressing, but the vast majority of the business executed reasonably well given the headwinds we had entering the year, and the overall challenging market conditions.

We have made good progress on cost reduction efforts in core operations, and are now seeing margin benefits which will be amplified when we complete the separation, and put the transition costs we are incurring today behind us.

There are a number of actions you'll hear about in next week's Investor Day that will better clarify how both companies will exit this transition period and embark on a focused path for predictable profits, cash generation, and cash deployment.

With that, I'll turn it back over to John.

Thanks, Mark.

Looking forward, the entire SAIC leadership team, our Board of Directors and the 37,000 employees remain extremely optimistic about the future of these two great companies we are creating, Leidos and new SAIC.

We believe we're in the final stages of preparation to complete that separation in the near future, and with that, I'll open the floor up to your questions.

(Operator Instructions)

Our first question is from the line of Cai von Rumohr with Cowen and Company.

Could you give us a little more color on the specific problems before problem programs, and secondly, you mentioned you're going to be a little pickier, but price development with new customers, particularly foreign and state and local are kind of like for many analysts a red flag.

How many other contracts of that sort still are in your backlog?

Thanks so much.

Cai, this is Stu, good morning.

We have a very rigorous process of review of all of our programs, and we have a watch list that we pay particular attention to.

Of the 9,000 contracts we have within the Company today, we have about 25 programs that are on that watch list, and all four of the contracts that we noted in our call just a moment ago were on that watch list.

But based upon our Q2 testing, our customer interaction and schedule requirements, we really determined that our two foreign contracts needed to be redesigned, and we had to increase our cost and resourcing to meet schedules for the other two contracts, so we adjusted the EACs accordingly.

These types of estimates at completion or estimates to complete are standard process in any quarter, and there's lots of ups and downs.

They just all happened at the same time because of technical or customer milestones in Q2, which bore out new information.

So we feel pretty confident in the overall process of review, but we did use the opportunity to do a deep dive on much of our contract baseline this quarter, to take a look and see whether or not we had any other issues, and right now we don't see any that confront us with the same level of concern that we had in the other ones.

Okay, and then you'd mentioned that going forward, you're going to be a little bit more, I guess, picky about what you do.

Are you going to continue to take fixed price development contracts with state and local and foreign customers, or are you going to basically have a policy where you stick to customers you know a little better?

The first answer is, we do a lot of fixed price work and we do a lot of fixed price development and solutions work, so we're going to continue that, and we'll continue with the customer sets.

But I think when you cross the particular type of contract and the particular customer, this was a little bit out of the ordinary, and we also had folks that were working on these contracts that weren't necessarily the best in the Company to focus on them.

So it was kind of the perfect storm of the contract, the nature of the customer, the nature of deliverable, the timing of it, and we had on opportunity to fix it, so we did.

So we're going to keep focusing on many of the same customers.

We'll do a lot of business in future SAIC and state and local business, we'll continue to pursue foreign customers in Leidos and in new SAIC, and we're just going to be a lot more attentive to the nature of the delivery, the nature of the requirements and how we go about staffing the programs.

Just one last one.

You had a cost target of $350 million.

What is your cost target, saving target today?

How much more do you have to go to get there, and how does that split between the two new businesses?

Yes, again, Cai, we completed our cost cuts of $350 million, split approximately $200 million for Leidos and $150 million for new SAIC, and I think we're on track for that full $350 million program cut, and those cuts far exceed any dissynergy costs that we have related to splitting the two companies, which is nominally $50 million to $60 million on a full-year basis.

What our plan going forward is to really have, and we've already started this, a continuing improvement process.

We expect there will be more cost changes to come, post-separation both Leidos and new SAIC will have active programs, and be a little bit different between the two companies to address this, and the cost reductions that we've seen in fiscal year 2014 have considerably lowered our fiscal year 2014 wrap rates, and they will have greater impact in fiscal year 2015 and beyond on a full year basis.

So as you know, fiscal year 2014 is kind of a transitional year, and you'll see more evidence of the impact in fiscal year 2015 and beyond.

And we'll talk more about that at the investor conference on the 11th.

Thank you very much.

Our next question is from Edward Caso with Wells Fargo.

You mentioned the potential for ongoing divestitures.

I was curious if you could also talk about your intent on the acquisition side of the equation, as many believe that we're going to be consolidating here the next few years?

And within that context, can you offer any sense of what leverage limits you'd be happy with, with the two companies?

Thank you.

This is John Jumper.

Let me address the M&A plans.

You'll be hearing more about this at the investor conference, M&A and capital deployment, as we come up to the 11th.

But I think broadly speaking on M&A, we can say that we'll be much more focused on predictable profit streams and returning capital to our shareholders with M&A, and as always, we're going to try and maintain a balance.

I think the balance is going to favor taking better advantage of not building up a bunch of cash on the balance sheet and returning that to the shareholder.

These are decisions that the Board of Directors make every quarter, and I think we'll continue to look at it that way.

And this is Mark.

I'll comment on the leverage ratios going forward.

As the two companies exit this transition period and embark on a separate track, they will have leverage ratios on the 1.5 to 2x range, each of them, as previously stated, and as originally designed.

That would generally be where we would intend to operate for the most part going forward.

We would be willing to lever up to closer towards 3 in both companies, should the right compelling opportunities arise, but it's very important on the Leidos side we maintain an investment grade rating, to make sure the credit markets are available to us.

As we said, that's less important on the new SAIC side, but we still want to operate the capital structures, as John said, with less excess cash number one, but a fairly conservative leverage ratio in the 1.5 to 2.5 sort of arena.

Great.

Could you talk a little bit about where you think the September, the government's fourth quarter will come in as far as award activity is concerned, relative to the fourth quarter a year ago?

Thank you.

Let me start off, this is John.

I think that if there's one word to describe the situation we're in right now, it's confused.

I have a hard time, and I think my colleagues in the industry have a hard time even defining what the baseline is right now.

The spending patterns are erratic.

I think there's great caution among the contracting officers out there that we do business with day in and day out, which is our best indication of volatility.

So I think to try and be predictive about a fourth quarter or an end of year, even, for the government where you normally see a flush, trying to be predictive about that is extremely difficult, and I think it would be dangerous for anyone to try and define in any way what's going to happen.

My last question, Mr. Kendall came out in the last few days and mentioned that they had done things to sort of get through government 2013 and that there are harder decisions to come.

How would you interpret that, as far as the flow of funding to the government services sector in general?

Thank you.

Well Frank Kendall, I think, has been an outstanding spokesman for not only the Pentagon and for government spending, but for the rest of us in industry, and what Frank's referring to are some of the things we talked about earlier.

We've seen a pronounced 10% reduction in the intelligence budgets.

You've heard some of the agency leadership talking about that here in just recent weeks, yet the level of activity out there in the big world is anything but a level that would indicate a reduction in intelligence activity.

So I think there's some conflict here between what we're seeing out there in the world and the demands that we see being fairly well sustained on things like intelligence.

Having said that, I do believe that the government is looking for continued efficiencies, and I think that we will see, as Frank said, a decrease in spending, delayed decisions, and I think this all adds to the confusion I was talking about earlier.

Thank you.

Next is Ben Owens with Stifel Nicolaus.

First off, on the construction project write down you had talked about, can you go into more detail there and talk about what the size was and the reason for the write down?

This is Mark.

The construction project predominantly refers to our playing field renewable plant under construction in the State of Connecticut, and it was by itself in the low teens, in terms of the EAC adjustment for added cost, to make sure we could reach our very important deliverable in the Fall time frame.

And so we invested more, if you will, to make sure we hit schedule which is very important on that program.

Okay thanks and then I know you talked about the reasons for the Reveal acquisition write down, but can you maybe go into more detail there?

And talk about the trends you're seeing in the baggage and scanner space and are you seeing award slowdown or are you losing market share?

Could you go into more detail there?

Ben this is Stu.

First, I think we have a very strong safety and security business which includes the Reveal product line, and we are seeing a lack of orders across the entire industry from TSA for the checked baggage scanning systems.

TSA has 2,000 explosive detection systems that have been installed since 2002, with a useful life of around 7 to 10 years.

And they are hoping to extend that to 15 years and incorporate newer technologies to include addressing homemade explosives and the 75% threat mass.

So although TSA has the funding at this time, they are not purchasing any units until they reduce their inventory in the warehouse, and then they will have to if you look at the mathematics of the number of units deployed, how old they are, they're going to have to incorporate additional units over time.

So we look at the Reveal product line as a very solid product line, very capable, industry leading and it really is about the slowness in the awards across the industry and not for our particular product line itself.

Just to add to Stu's remarks, that business has been very successfully integrated with the rest of the security products business run by Alex Preston, and that business, Reveal by itself, is profitable today, in large part due to those efforts.

The impairment was $30 million, that's about 50% of the intangible value for that acquisition to put that into context, and entirely due to not necessarily the long term prospects we see there, but the slide to the right due to the procurement pause we see that Stu mentioned, and because of that, appropriate to remove some of the valuation originally ascribed in the acquisition.

Thank you.

Our next question is from George Price with BB&T Capital Markets.

I guess first thing, on the environment, obviously there's a lot of uncertainty, but if I just -- my feel of your comments just now, it seems that some of your peers may be discussing or suggesting more modest impact from the budget environment and the sequester, almost like we've seen the worst of it.

And that's not my perception of what I'm hearing from you, and so I was wondering if you could maybe comment on that a little bit further, in terms of how do you see this playing out over the next couple quarters?

When do you think the full impact of the sequester and the current environment is really going to be felt?

Let me start.

This is John.

I think Frank Kendall's words are exactly right, and I think his caution is that we probably have not seen the full impact of sequestration yet, and I think that we need to take that into consideration.

As I said this adds to the confusion, so I think there's probably more to come.

How much is hard to say, but I think Frank was being open and honest when he said that there's more to come.

I'll just add the trailing outlays from either prior years or otherwise probably buffered some of the reduction in the recent few months across the industry.

That will strip away, and as John said, the full impact of sequestration is most likely ahead of us and for that reason, we are more cautious in our guidance in the second half and taking it down accordingly.

Got you and then just you talked about JLI and DGS taking revenue down by about $150 million year over year, and attributing much of the rest due to sequester and draw down.

I was wondering, in the press release you threw out a couple other intel programs and a network operations management program that were also impacting revenue when you discussed the segments.

Are those in that $150 million, or can you quantify them at all either as actual revenue or as a percent?

And what I'm trying to circle around in as much detail as possible is what can we attribute to the broader cuts and what can we attribute to things that have rolled off?

I'll give that a shot, George, this is Mark.

First there are no programs that approach the size of JLI and DGS in terms of magnitude and impact on our year over year results, so those really dominate the landscape as individual programs.

As you know, those two programs were two of our four largest programs in the Company, that for two different reasons came to an end last year, and we're seeing effects of that in the year over year numbers this year.

I'd say there is a collection of airborne ISR programs that came to natural end, associated with troop reductions and so forth in the Middle East, those probably accounted for 3 to 4 percentage points of reduction in the national security sector.

But outside of that you really have a lot of smaller contracts, some coming into the mix providing growth and others moving away through the overall reductions we're seeing, so it's really a mixed bag after those two primarily.

Okay and last one real quick, on the EPS guidance, you talked through the write downs, the incremental costs, volume in commercial health.

I think you called that out Mark, as $0.20 of impact to guidance.

The upper end was taken down by $0.30.

What are the additional factors there?

Is that just uncertainty with respect to the environment, if you can just maybe call that out in a little more detail?

Thank you.

Yes, the $0.20 George is directly attributable to what I said in my earlier remarks.

The charges we took in Q2 primarily and the reduction in the revenue guidance for the rest of the year.

So with respect to stripping off the top end we no longer see the magnitude of possible upside that we had in our earlier guidance, if you'll remember that was $10.7 billion, so we've taken that down pretty dramatically and narrowed the range on revenue and therefore narrowed the range on EPS.

Okay, great.

Thank you very much.

Our next question is from Joe Nadol with JPMorgan.

I'd like to focus in on commercial healthcare a little bit.

Seems like relative to last quarter, your expectations have changed quite a bit and I know you gave some comments on it in your prepared remarks, just how it's a little hazier, but you still have good long term expectations.

But I was wondering if you could delve into that in a little bit more detail?

Sure, Joe, it's Mark.

Both the Vitalize and maxIT acquisitions came out of the gates very strong post acquisition, and we were speaking about those growth numbers over the past few quarters.

As mentioned, we are now seeing the spillover effects from the surprise, if you will, that came with sequestration, where the Medicare cuts that apply to hospitals are taking billions of dollars of reimbursements out of the system pretty suddenly, and by surprise, and it's understandably the administrations of those hospitals have cut back their discretionary spending.

That said, the same Federal Government has mandated the ICD-10 requirements, and the meaningful use requirements, and further stages after that, coupled with the ongoing development, proving that there can be better clinical outcomes by use of EHR systems and the data exploitation opportunities that come with that.

So we're very bullish on the long term outlook for our commercial health business.

We are even more bullish as we combine the technologies of the government business with the commercial group, to see how they can benefit each other, and so with that, sheer numbers speaking, the commercial health business starting off growing and then recent contraction will be about flat this year.

We're optimistic that we'll return to growth next year as those deadlines approach for meaningful use in ICD-10, and for all of the opportunities to improve clinical outcomes and administrative outcomes for hospitals in future years.

Mark, were those businesses evaluated for impairment as Reveal was, and can you just comment on how we should think about that going forward?

Sure.

All businesses are evaluated for impairment on a quarterly basis, and there's about, for your records about $60 million of purchased intangibles related to our commercial health businesses that we acquired over the past couple of years, and then there's a larger goodwill number after that, but based on our projections, we are comfortable that those long lived assets are not impaired.

Okay, and then just finally on the strategy, I know we're going to learn much more next week in a lot more detail, but just on the strategy that I think the premise -- part of the premise, as I understood it, of the separation here, was to create a stable Company that was pretty much all government and that --- and then another one that was more growth oriented with a mix of commercial and government businesses that was more acquisitive.

It seems like, and I know there's uncertainty in scanners and I know there's uncertainty but you're still bullish in commercial healthcare, but is there, are we pulling in the horns a little bit on the growth ambitions for Leidos, or am I not hearing that right?

I guess John, that question is to you.

Joe, I think it's safe to say that we are still very bullish on expanding our commercial presence and for that to be a larger percentage of our business.

As we go forward and we look at Leidos individually, our health and engineering will be about a third of our Company, and we do want to see that expand.

And when you balance that with the current dynamics of government budgets and what we're seeing, I must say it does introduce a certain amount of caution into how we move forward, but we want to get to a place where we're focused on profitability and running the businesses well.

It's, I think, safe to say we'd like to really exploit our internal capacity to grow to begin with.

We don't see any large M&A's on the horizon.

We want to focus on that internal growth potential, but we do want to grow those commercial markets to take advantage of their growth potential, and I think that's what we're going to see.

And then just one quick final one, a numbers question, Mark, back to you.

Can you give us on a combined basis, on a normalized basis, ex all of the items that of course are coming through the system now, what you expect corporate costs to be for the two companies combined?

Maybe broken up by Company.

Joe, we have not publicly provided a separate view of corporate costs before.

If you're referring to dissynergies perhaps, is that the nature of your question or can you be more specific?

Well, you're reporting the segments as I believe they are going to be in the new companies, two in Leidos and then the one in new SAIC, and corporate costs, this is so many items in corporate costs, as of course you're going through all of these efforts, the reorganization, everything else you're doing.

But to arrive at a normalized profitability estimate looking forward I think corporate costs are a critical component, unless I'm not thinking about the model the right way.

So you've taken so much cost out, you've provided the $350 million, provided the offsets, the dissynergy offsets, but when you net all that out so we can come up with earnings estimates for a couple years out, how do we think about the corporate cost?

Let me try to answer that and I'll provide more color next week as well, but with respect to the corporate segment that we report which does include some non-recurring and special charges from time to time particularly this year, but when you extract that out they typically have run between $5 million and $10 million per quarter, which reflects stock option expense and other expenses not allocable to the sectors.

With the going forward model, I would say the combination of dissynergies on one hand offset by cuts on the other, I wouldn't expect a major change from that run rate on a consolidated basis across the two companies.

And another way to think about that is the same cost categories dilute the segment margins by 10 to 20 basis points on an annual basis.

Okay, thank you.

See you next week.

Our next question is from Jason Kupferberg with Jefferies.

I just wanted to revisit some of the revenue synergy assumptions that you have been talking about for awhile post split, the $1 billion or so over the subsequent two to three years.

Is there any change at all in that thinking, just given the fact that as you guys alluded to, the end markets actually seem to be worsening rather than stabilizing?

Well let me give a try at that, Jason.

I think that you balance the uncertainty of the revenue stream going forward with the situation of the world, and somehow those don't comport very well right now.

So we continue to believe that given the situation we're in globally, opportunities will continue to arise.

You've heard me say it before in these earnings calls, that we seem to be as a nation, lousy predictors of what's going to happen next.

We don't ever seem to be able to get it right, and then something always happens.

So I think given that you balance the uncertainties of the world with actions that you see underway right now, even with the decision about Syria, all of these things lead me to believe that the revenue opportunities will continue to be there, given the world we live in.

This is Stu.

Just to add to that comment, one of the things we've talked about is the potential up lift from OCI reduction, and we've spent a lot of time evaluating the capability footholds that we do have relevant to all these new markets.

We're making some key strategic hires to gain some customer intimacy into the markets, we're building the opportunity funnels and strategies that allow us to address the markets, and we're also preparing a plan with investments and capture strategies, and that's happening on both the Leidos and the new SAIC side.

Obviously at this point of purgatory that we're in, where we can't really fully explore that because we're still one Company today.

Until we're two companies we can't really see the benefits of that, so we're doing a lot of pre-positioning but expect to see some different outcomes in the future.

Okay, is there any reason to believe that the $1 billion estimate is too aggressive, or is it simply too soon to say?

There's still a 10% growth in our addressable market.

That has not changed, so those revenue opportunities are still the same, as we see it.

The time frame, given the environment we're in, could change, since the procurement cycle as we see today is lengthening.

And I'll just further add to the remarks of John and Stu, as we evaluate those opportunities, we're going to be very profit-focused.

So chasing top line is nice, but they have to represent to us high confidence, profitable growth year over year in order to go after those, and that will be the lens through which we evaluate them.

And just timing on when you now think the breakup will be consummated, when the split will be consummated.

Do you think it will end up falling in your fiscal Q3 or is it more likely in the January quarter?

Jason, you know we can't be specific on that, but let me just say the plans are on track with the transactional part of this stuff is largely done.

We are going to have a Board vote and we are on track to complete it by the end of the fiscal year, which is what our publicly-announced schedule is.

And just last one for Mark on the separation-related costs.

I know you mentioned that they are going to peak in Q3.

Can you give us a general range just to get everyone on the same page, as far as what people will be modeling for the quarter?

Yes, so if you take the $158 million estimate for the year, we're about $100 million plus through that, through Q2.

I would expect a peak of much of the remaining $50 million ballpark in Q3 and the trail-off in Q4, and be done as we enter fiscal 2015.

Okay, thanks for the comments.

Next is James Friedman with SIG.

One question and one housekeeping in nature, Mark.

Your 10-Q had referenced some of the changes to the Fairfax County, Virginia facilities and the lease buyback there.

I was trying to estimate the potential savings from those assumptions.

I think it references $70 million.

Could you walk us through some of the timing of that and if that estimate is about right?

Thanks, Mark.

I'll provide this color to see if it addresses this question.

So the Fairfax reference is the McLean headquarters property that we announced in July, a sale transaction in which is a bundled sale, and we recognize cash proceeds and a minor P&L consequence in Q2 cash proceeds being $85 million and about a $2 million loss on that transaction at the end of the day.

I think the -- and just importantly, that's just part of an overall real estate monetization plan to take cash out of the real estate holdings and put it back into either our business or our shareholders' pockets.

The $70 million reference I have to believe relates to our estimate of leased exit costs that we would incur and report this fiscal year as part of our overall separation activity, and so we are well on our way toward achieving that, that's still our estimate for the year roughly.

And so that contemplates shrinking our footprint significantly by 20% to 25% across both companies to become more efficient and more profitable, and the $70 million is the future lease expenses for those properties we will exit deliberately this fiscal year, the payback of which will be within one year, and so that's a significant margin enhancement opportunity particularly visible in fiscal 2015 and beyond.

Excellent.

Good answer, thank you.

Next is Robert Spingarn with Credit Suisse.

Mark, you just noted the profit focus for your growth lanes, but the impairments on the fixed price development contracts suggest that perhaps pricing and competition may be partially at work here.

So while you say your revenue opportunity remains intact for the commercial businesses, should competition ultimately change the margin or the net profit growth there, or are you seeing greater competitive forces on pricing than maybe you expected at first?

Either Mark or Stu on that one?

Rob, Mark here.

I think I would say that the contracts mentioned were bid some time ago, and reflect the then thinking in terms of priorities.

What we are saying going forward is we will be very profit focused for things we bid going forward, and very selective on that premise.

There are, of course, pricing pressures today and there will be cases where the given margin on a program may not be equivalent to the overall Company margin.

But if it produces or contributes to year over year profit dollar growth and has a favorable ROI and has low capital intensity we'll probably do it, because as Stu mentioned in his remarks, we're focused on economic profit, and so year over year growth and capital efficiency is the name going forward.

That is the lens that we'll be focusing on as we conduct future bids.

Stu, is it fair to say that today, given what's going on in the environment though, that there are more people entering these growth lanes, and therefore the competition in pricing is getting even more aggressive than what you might have bid a couple of years ago?

Let me add a couple comments, I think John wants to jump on this also, but if you look at the markets people are entering, let's talk about health and engineering, we've been in those businesses for 25 years.

So there's a lot of people that are doing an attachment to their business, more of an applique, an add-on, whereas we really have it as a core fundamental part of our strategy and part of our business, and has been for several years, and you'll certainly see a good part of that in Leidos going forward with the health and engineering focus.

I think that there is a continued sense of concern on the part of small businesses.

It's their livelihood to try to continue to keep their business, so they are being very aggressive in the pricing.

I think some of the big guys that are platform builders are also being very aggressive.

So what Mark said, we look at pricing pressures all the time.

We think part of that has been offset by our reduction in our wrap rate.

I think part of our solutions focus at least in a good part of the Company will offset that.

We're very agile in our developments, we think we have the right solutions and we can build them generally faster than many others, and so a lot of our focus is on differentiating ourselves through our history, our legacy in the businesses, the unique intimacy we have with our customers, and our ability to develop solutions in a more rapid solution approach.

So you're saying that what affected the contracts for which you wrote down in the quarter, you took write downs in the quarter, that those things are not happening going forward?

You are not seeing whatever pressures you saw when you priced those?

Or you aren't reacting to them?

Well I think it's a mixed bag.

I think some of them we price very aggressively, and I think some were priced appropriately but we didn't necessarily have the right solution path going forward.

So it depends which program that we're referring to in the write down, but it's a little bit of each is right.

There are some that are more technical oriented, and there are some that are just resource constrained so we had to do a write down on both.

But Robert, you're right when you say there was a much different environment when those programs were bid several years ago.

And then Stu, you mentioned the 25 watch list programs and you talked about the four focus program for this quarter came from that group.

Yes.

How, in aggregate, how large are those 25 as a percentage perhaps of sales or margin?

Rob, this is Mark.

I'd say our top 25 represents maybe 20% of our total revenues maybe 25%, and I think the 25 on the watch list are a subset not necessarily the largest, so I think it's within that range.

And then just last thing.

General Jumper, you talked about some awards post quarter.

It sounds like you've been fairly active.

Should we be looking for -- what type of book-to-bill to you see here in the current quarter?

Sounds like it will be better than the first two?

If I could jump on that one, first of all I think our book-to-bill was low by historical standards as we mentioned before.

I think we have a pretty strong pipeline.

We currently have $27 billion in submits that outstanding awaiting award so if you assume a normative state, in the last couple years, you would expect the book-to-bill to rise, but once you add in the slowness in the award decisions, the doubling or 2.5 times in terms of that timing for the award decisions, and then the protests that are happening, I think we may have hit a new normative level in the 0.7 range for at least a period of time.

What's happened I think it's fair to say is all of our normal ways we calibrate turning award wins into revenue have been delayed, so the predictability is much more difficult than it's been in the past.

One of the things that's happening now is the customers are doling out much smaller increments on funding on a much shorter period of performance, so as opposed to getting a large booking for a multi-year program, you're getting things by the drink.

Would you say that a 0.7 normative rate, though, might suggest the revenue guidance is a bit optimistic?

No, I think if you look at what we said before about the potential inclusion of our large $500 million win, we would have been at 0.95 if that was included, so we are getting some wins.

We are getting the core business, but we would like to be above 1 all the time, but we just aren't there this time, and very few people are.

Okay, thank you for the help.

Thank you.

I'm showing no further questions.

I'll turn the call back to John Jumper for closing comments.

Thank you very much and let me just say that I'd like to take a moment to congratulate two members of our team.

First, Debbie James is one of our Sector Presidents, whose been leading our Technical and Engineering business, and has been nominated by President Obama to become Secretary of the Air Force.

If confirmed, this will continue Debbie's selfless commitment to answering the call of government service when asked.

We also extend our congratulations to a member of our Board of Directors, France Cordova.

France recently stepped down from her position as President of Purdue University, and has been nominated by President Obama to become Director of the National Science Foundation.

All of us at SAIC are proud to embrace the caliber of people nominated to these positions of national importance, and we wish Debbie and France all the best going through their confirmation process.

Thank you all very much.

Ladies and gentlemen, this concludes the SAIC conference call.

We thank you for your participation.

You may now disconnect.