L3Harris Technologies Inc (LHX) 2006 Q1 法說會逐字稿

Good day and welcome to the Harris Corporation's first quarter fiscal year 2006 earnings release conference. As a reminder, today's call is being recorded. Beginning today's meeting is Pamela Padgett, Vice President of Investor Relations. Please go ahead, ma'am.

Good afternoon, everyone, and welcome to Harris Corporation's first quarter fiscal 2006 conference call. I'm Pamela Padgett, Vice President of Investor Relations. On the call with me today is Howard Lance, Chairman and CEO, Bryan Roub, Senior Vice President and Chief Financial President, and Bob Henry, Senior Vice President and President of the Government Communications Systems division. Before we get started let me say a few words about forward-looking statements. In the course of the teleconference, Howard, Bryan, or other management may make forward-looking statements.

Forward-looking statements involve assumptions, risks, and uncertainties that could cause rules to differ materially from those statements. For more information, a discussion of such assumptions, risks, and uncertainties, please see the press release and filings made by the Company with the SEC. In addition, in the tables of our release and on this teleconference we will discuss certain ratios and information that are non-GAAP financial measures. The reconciliation to the comparable GAAP measures is included in the tables of our release and on the Investor Relations section of our website, which is www. harris.com.

A replay of this call will also be available on the Investor Relations section of the website. Okay, Howard, I'll turn the call to you.

Thank you, Pam, and thanks to all of you once again for joining us today for our quarterly earnings call. Harris had another very strong quarter with double-digit revenue and earnings growth and strong cash flow. Revenue in the first quarter increased 13% to $760 million. Non-GAAP net income increased 63% to the prior year first quarter to $65 million.

This includes charges -- excludes, excuse me, this excludes charges taken in the quarter related to cost reduction actions in the broadcast communication segment. Non-GAAP earnings per diluted share increased 62% compared to last year, to $0.47. Cash flow from operations in the first quarter was $83 million compared to $9 million in the prior year quarter. Better than expected financial performance in the quarter coupled with momentum in orders and profitability, led us to once again increase fiscal year 2006 earnings guidance.

Now for the segment results. Government Communication Systems revenue in the first quarter was $433 million, about flat with last year. Operating income, however, increased 18% from the prior year to $53 million, exceeding our previous expectations. Operating margins expanded to slightly above 12% of sales in the quarter as a result of excellent program execution and continued attention to controlling costs. Higher award fees were achieved on several avionics programs, and in addition, we improved margins on fixed price, satcom, and weapons data link production programs. Higher margin wireless product shipments to our intelligence customers also contributed in the quarter.

We believe that our base of excellent performing programs, along with a positive mix of fixed-price production programs, will continue to sustain operating margins at these levels throughout fiscal 2006. Revenue in the quarter was negatively impacted by the completion last year of the Iraqi Media Network, or IMN program, which contributed $31 million in the first quarter of fiscal 2005. And it was also affected by the completion of a major classified program. Putting IMN aside, we were pleased that the underlying business grew 8% in the quarter, versus last year.

Several key programs continued to grow in the quarter, contributing to expanded revenue. These included the $1 billion, 10-year Patriot operations and maintenance program for the National Reconnaissance Office; the $2.2 billion, 15-year telecommunications infrastructure program for the Federal Aviation Administration; the improved fire control system for the U.S. Army Multiple Launch Rocket System; the potential $500 million U.S. Army aerial common sensor program; the $250 million FAB-T satcom program for the Air Force; the $77 million RADIC program for the National Security Agency, and several other new classified programs.

While the underlying business is solid and growing, top line year-over-year growth has become a bit more challenging. IMN contributed nearly $80 million in revenue during fiscal year 2005, and that revenue has become more difficult to replace than expected. I am pleased that both our Department of Defense and technical services business units increased revenue in the first quarter, and they are both expected to grow in the 12% to 15% range for fiscal 2006. In our national business unit, we continue to execute well and win programs. However, we have not seen the pick-up in intelligence spending that we had anticipated from the recent supplemental budget, and this business is our challenge for the year.

We believe this problem is due in large part to the diversion of funding to cover several well-publicized cost overruns on large intelligence programs. We anticipate this situation is a temporary one for our national business unit. Harris performance has not been the issue. We like our position in the long run in terms of maintaining our excellent performance track record and reputation, which, as you know, are absolutely critical for success in the intelligence area since many of these programs are never put up for competitive bid. In the civil business unit during the quarter, revenue was down due to the IMN program ending.

Excluding IMN, revenue increased during the quarter, and we expect to grow civil revenue about 20% in fiscal 2006 thanks to continued, successful work-scope expansion in the FTI program. I think you have to keep in perspective e that our civil business revenue was only about $120 million in fiscal 2003 and it grew to $300 million by last year. While we were disappointed by the losses in the quarter on the ERA and [A- whips] pursuits, we have grown this business unit significantly and consistently, and our expansion at the FAA and into additional federal agencies clearly remains on track.

Let me now turn your attention to some new wins in the quarter and several additional opportunities on the horizon. We have been awarded three contracts from Space Systems Loral to design and deliver four unfurlable mesh reflector antenna systems for their commercial satellites. Each one of these systems is valued in a range of 5- to $15 million. The commercial satellite market is expanding rapidly to meet the needs for more transmission bandwidth. We have several additional pursuits underway, and I believe Harris is ideally positioned to continue to leverage its leadership in government satellites across to address this commercial growth market.

Our Department of Defense business unit was awarded an $18 million production contract to provide anti-jam GPS technology for the U.S. Air Force Joint Direct Attack Munitions program, or JDAM. They also want a four-year, potential $100 million program for production of our large aperture, multi-band deployable antenna satcom terminal used by both the Air Force and Marine Corps. In addition, we had some good news in the quarter on the War Fighter Information Network Tactical, or WIN-T program, for the U.S. Army. First our potential program value has increased from $500 million to a new range of $850 million to $1 billion on this next generation military communications network that will provide on-the-move Army war fighters with increased battlefield awareness and communications capability.

Harris and BAE systems are developing the WIN-T transmission subsystem, with Harris providing the high bandwidth network radio, network wave forms, ground and airborne antenna subsystems. and SecNet 54 secure wireless LAN technology. WIN-T development work over the last 36 months culminated in a successful demonstration of key system technologies in September. Successful completion of a program review in November is expected to result in a low rate, initial production award for Harris during our fiscal third quarter. Several large program opportunities are still in the pipeline with about $3 billion in combined contract value, and we expect awards to be made during the next 12 months.

Our first pursuit should turn into a new win this week, and this is the ground segment for the GOES-R satellite program for the National Oceanographic and Atmospheric Administration. We are part of the Boeing team on this program, and our potential program value has increased from about $500 million to a new range from $750 million to $1 billion. Following the initial design phase, there will be a down select among the prime contractors in 18 to 24 months time.

Our next pursuit is the $600 million opportunity for the ground segment of the Transformational Communications Satellite, or T-SAT for the Department of Defense. We expect this award in December. Also, there's the design phase of a potential $250 million contract for the Department of Homeland Security called Integrated Wireless Network, or I-WIN program, expected in January. The $300 million cryptologic management system for the National Security Agency is expected to be awarded in December. The $800 million U.S. census bureau field data collection automation program is expected in April of next year. And finally, we expect an award of a 10 year information services contract under the General Service Administration's Alliance program. Now, this will be a very large, $50 billion, ID/IQ contract that will be spread across twenty different contractors, and we're expecting that to be awarded at the end of the fiscal year in June 2006.

Let me turn now to RF communications. Rf had another outstanding quarter in all respects; orders, revenue and profitability. Revenue in the first quarter was $171 million. This represents an increase of 51% over the prior year quarter. Strong revenue and order growth came from both domestic and international customers. Our outlook for fiscal year 2006 in RF revenue has once again increased. Orders at RF were greater than sales during the first quarter. We now expect fiscal 2006 orders at RF to be $800 million or higher, and that will further increase our order backlog between now and year end. As a result, we expect year-over-year revenue growth will now continue in fiscal 2007.

Operating income in the first quarter increased 84% to $58 million. Operating margins were 34% of sales, driven by the higher sales volume. I'm pleased to report that we have successfully increased manufacturing capacity during the past several quarters to keep pace with the increasing order volume, while at the same time maintaining our high standards for quality and very responsive customer lead times. Further capacity increases are planned for the second half of fiscal 2006 in anticipation of the higher order volume. Our higher gross margins are affording us the opportunity to further increase R&D spending on the development of the Falcon III product family as well as on the development of other new products for adjacent markets.

Our goal continues to be to fully utilize the RF segment's domestic and international sales channels to get new defense communications products to market around the world. In the first quarter, domestic revenue and orders continued to be driven by strong demand in support of force modernization and force restructuring efforts across the U.S. Department of Defense including the Army, Air Force and Marine Corps, as well as the reserves and National Guard. It's a very similar story in the international marketplace. Modernization programs and the need for interoperable communications systems among coalition forces continue to drive new demand.

Major international orders during the quarter included a $14 million order from the government of Chile for an integrated tactical area communications system. This system will interconnect tactical and high capacity data radios into an effective battlefield communications network. We also received an $8 million order from the Royal Netherlands Marine Corps for our Bowman HF tactical radio systems, thus leveraging our development from the UK Ministry of Defense program into additional countries. We received an order from the UK government for $7 million to support their [CHIMP] program, whose focus is creation of high grade, software programmable encryption modules.

It's clear that the U.S. tactical radio market remains very robust. U.S. forces are not only modernizing and replacing aging tactical communications equipment, but they're fielding requirements have changed dramatically and this is increasing the number of radios needed. Program funding from both supplemental and core DOD budgets continues to place a high priority on tactical communication investments. The uncertain future availability of radios under the Joint Tactical Radio System, or JTRS program, has really accentuated the need to field significant quantities of radio systems using technology available today.

To that end, the following the close of the quarter, we were awarded a potential $205 million contract with the U.S. marine corp for our Falcon II 117-F multi-band radios. We received an initial $67 million order against this contract and will begin shipping radios this quarter. Now, even with the delays and JTRS program that I have mentioned, the Department of Defense still has a desire to field JTRS capable radios that utilize the new Software Communications Architecture, or SCA, and we have the first one: the Harris Falcon III, multi-band hand-held with programmable, Type-1 encryption.

In August, we announced that the Falcon III had received its certification from the national security agency along with its official U.S. government designation: the AN/PRC-152(C). Almost immediately, we received our first order from the Army. This initial $38 million contract was for 1,300 dual radio vehicular systems using the 152 handheld. Initial deliveries in this order will commence in January, but we believe this is just the beginning.

You see, the beauty of the Falcon III is that it provides interoperability with the legacy, single band VHF SINCGARS radio systems while also offering added features of multi-band capability and portability. So the Army can field an advance technology radio today that can adapt to the future JTRS/SCA requirements tomorrow. We believe the Army has requirements for up to 200,000 additional SINCGARS radios, with as many as 64,000 of these in the multi-band, hand-held, dual radio vehicular configuration served by our Falcon III. This represents a $1.7 billion market opportunity for Harris over the next three to five years.

Let me turn now to the microwave division. Revenue in the microwave communication segment increased 9% from the prior year quarter to $75 million. Sales growth was driven by the North America region. Operating income improved to $3 million, about 4% operating margin as a percent of sales. Improving operating income resulted primarily from increased shipments of higher margin, TRuepoint and constellation radios and from continuing cost control. Orders in the quarter increased 18% and were greater than sales. It's important to note that order growth was strong in both North America and international markets.

Reflected in the strong sales and orders in North America is what we believe are the first signs of increased spending by mobile carriers to expand their network capacity now that their recent mergers are behind them. Activity and private networks remains strong in North America as well, with current emphasis on the creation of survivable networks that can withstand both natural disasters and acts of terrorism. These sophisticated networks require strong engineering design and technical execution, two clear Harris strengths. The strong order rates also reflect our continuing progress in moving into the federal government private network's market opportunities.

International orders continued strong in the Middle East and Africa, and orders improved in the quarter in Latin America and Asia. Major TRuepoint orders in the first quarter came from Malaysia, Nextel International Mexico, ZTE China, Nortel, and Rogers in Canada, Bell Canada and Telus Mobility in Canada, as well as Sprint Nextel. TRuepoint radios are already in service in more than 46 countries around the world and customer feed back continues to be very positive. Customers particularly like TRuepoint's flexibility to deal with changing traffic requirements, simultaneous voice and data capabilities, and its overall ease of operation. TRuepoint model configurations in all major frequencies and capacities have now been released to production. Our efforts are now focused on increasing production, cost reductions, and feature enhancements.

Given the rapid success and market acceptance of the TRuepoint radio family, we are developing a formal, end-of-life plan for our legacy international product lines; these would include the MICROSTAR MH, the MICROSTAR L, the Galaxy, and the ClearBurst. We're also working along with the final phase of shutting down manufacturing operations at our Montreal, Canada facility. We anticipate there will be significant charges associated with these actions when they occur, including severance, writedown of inventories, asset impairment and facility closure.

These actions could begin as soon as this quarter and would then be included in our fiscal second quarter financial results. Any potential charges have, of course, been excluded from our non-GAAP earnings guidance provided. With a strong North America market and TRuepoint success in driving higher gross margins and expanded revenue opportunities in our international markets, our confidence in reaching our fiscal 2006 microwave segment revenue growth and profitability guidance has increased.

And now turning to broadcast revenue and our broadcast communication segment was $88 million in the first quarter. That's an increase of 30% compared to last year's first quarter. Non-GAAP operating income for this segment was $6 million, excluding the previously discussed charges for cost reduction actions. The prior-year quarter benefited from about $10 million in revenue from the same IMN program I discussed for GCSD, and certainly that created difficult comparisons for the core business. Revenue in the first quarter for the segment did include the consolidated results from our Encoda Systems acquisition that occurred in November 2004 and is now part of the broadcast software systems business unit.

Revenue increased from U.S. shipments of both digital radio and digital television transmission equipment. However, weak international market conditions persisted, and shipments of both analog radio and analog television transmission equipment declined. Several large international projects were also delayed, and we have now discounted any contribution from them in fiscal 2006. International order highlights in the quarter were first from our Software Systems business unit included high definition systems for SkyPerfect, a multichannel digital network in Japan that offers broadcast and data services to customers via satellite. Also, we received an important order for automation systems from Antena 3, a national television and radio network in Spain.

In the U.S., broadband, cable, and content provider Comcast placed a large order from our traffic, management, and billing systems software. Major television orders in the quarter included digital TV transmission and high definition encoding equipment for one of the world's largest providers of Spanish language TV programming and that's TV Azteca, who is rolling out HDTV to nine cities in Mexico. A large order for our European standard digital TV equipment was placed by Swisscomm broadcast. They are a leading provider of broadcast infrastructure in Switzerland.

And in the U.S., we received a large order for DTV transmitters for multiple stations from a good customer, Media General. Orders for digital radio transmission systems continued to expand in the quarter, driven by the rollout of HD radio across the U.S. More than 500 AM and FM radio stations are now broadcasting in the HD radio format. In fact, there's at least one station in each of the top fifty markets. A total of 2,500 stations have committed to converting to HD radio technology during the next four years.

As expected, we recorded an $18 million initial charge during the first quarter as part of our broadcast segment facility consolidation and head count reduction action. Charges are expected to be $30 million in fiscal 2006 in aggregate, with most of the cost to be booked in the second quarter. We expect these actions will provide $15 million in fiscal 2006 cost savings, and these are reflected in our guidance. In fact, we are ahead of schedule in implementing our cost reduction actions as we exit the first quarter.

Yesterday we announced the completion of our acquisition of Leitch Technology Corporation, a global leader in high performance video hardware and software systems for broadcasters. This is a very exciting merger of two very complementary companies. The addition of Leitch this significantly expanding our position to serve this fast-growing market as broadcasters invest in high definition digital master control and HD production capability. No other company offers the breadth of products that now span the entire digital media content delivery chain.

I look forward to working with Leitch CEO Tim Thorsteinson and his team to continue to build on their recent success. Tim will continue to lead Leitch as a business unit within our Broadcast Communications division. The Leitch management team is excited about our opportunities as a combined company. They've done a superb job in focusing on the successful rollout of new HD products, expanding revenue and gross margins, and reducing their costs.

As we've said previously, we expect the Leitch transaction to be neutral to fiscal 2006 earnings, excluding the impact of in-process R&D writeoffs and one-time integration costs that are now estimated to be in range from $8 to $10 million. However, for fiscal year 2007 the transaction is expected to be accretive by $0.06 per share, with Leitch operating income margins expected in the 14 to 15% of sales, consistent with what we've previously communicated. The acquisition of Encoda Systems last year followed now by the acquisition of Leitch Technology this year has transformed our broadcast business. Harris is clearly positioned as a supplier of choice with the broadest array of digital hardware and software solutions anywhere in the industry and with a truly global sales presence.

With that, let me turn the call over to our Chief Financial Officer, Bryan Roub.

Thank you, Howard. Our financial position strengthened again this quarter with cash and cash equivalents at $730 million at the end of the quarter. Our cash flow from operations was excellent; it came in at $83 million, which compares to $9 million in the first quarter last year. All four segments generated positive cash flow in the quarter and even more important, all four improved when compared to the prior year. The increase was led by a better accounts receivable collections in our Government Communications System segment and the increased profitability in our RF communications segment. The remainder of the increase in cash is primarily due to the issuance of $300 million of our 5%, 10-year notes.

The cash raised from this financing, along with some of our excess cash, was used to finance our acquisition of Leitch. The total of net cash paid for Leitch was $451 million. Even within the $300 million debt issuance, our total debt to total capital ratio is well below our targeted total debt to total capital ratio of 35% to 40%. Importantly, our debt ratings with Standard & Poor's and Moody's were affirmed after the debt issuance. All of the asset management reports to you showed improvement over the same quarter of last year. Inventory turns were 8.9, up slightly from the same quarter last year of 8.7. Day sales outstanding were at 55 days, substantially better than 64 days in the same quarter last year.

Net operating working capital at the end of the quarter was $290 million, or 10% of annualized sales, down from 12% of last year. Return on invested capital in the first quarter this year was 19%, up from 15% in the prior-year quarter. In the quarter we bought back 150,000 shares of our common stock at an average price of $39.98. Under our existing repurchase program, we have authorization to buy back 4.4 million more shares, and we will continue to repurchase shares of our stock to offset the diluted effect of shares issued under our stock incentive plans as we go forward.

I want to mention that we made a slight change in our cash flow reporting format this quarter. The amortization of capitalized softwares now included in the depreciation on amortization line item, and the amount of capitalized software addition is now shown as a separate item in the investing activities category. We thought it was important to make this change in reporting now as software development is becoming a larger factor in our business. Another change we are making for similar reasons is to begin communicating our progress in terms of earnings before interest, taxes, depreciation and amortization, EBITDA.

After excluding the impact of the cost reduction actions and inventory writedowns in our broadcast communication segment, our EBITDA increased from $77 million in the first quarter of fiscal 2005, to $121 million in the first quarter of fiscal 2006, an increase of 57%. This large increase was led by the growth in RF earnings, but each segment showed good increases. EBITDA, as a percentage of revenue, also increased from 12% in the prior-year quarter to 16% in the current quarter.

Capital expenditures, including capitalized software, were $24 million in the first quarter. In fiscal 2006, we expect to spend between $105 and $115 million on capital expenditures, also including capitalized software. The bulk of the capital spending is concentrated in our government segment and is tied to the ramp-up of fixed-price production jobs and new product development and increase production related to our Falcon family of radios. Depreciation amortization, including the amortization of software and intangibles, is expected to be between $90 and $100 million for the year.

Finally, we are raising our estimate of cash flows from operations to be between $300 to $350 million from our previous guidance of $250 to $300 million. The increase reflects both the $25 million impact from changing the cash flow reporting format noted above earlier, as well as the fact that we are encouraged by the excellent start we had -- have had in the first quarter of this fiscal year. Back to you, Howard.

Thank you, Bryan. Let me conclude my remarks by discussing our revised earnings guidance for fiscal year 2006. We increased our non-GAAP earnings guidance from a previous range of $1.80 to $1.90 to a new range of $2.00 to $2.10 per diluted share. This guidance excludes charges associated with the broadcast segment cost reduction actions, charges associated with the Leitch acquisition, and any potential charges related to product end-of-life programs and the manufacturing shutdown in the microwave segment.

The midpoint of our new guidance represents a 36% increase in earnings over fiscal year 2005 non-GAAP earnings per share. The range of expected revenue growth is now 13% to 15% with healthy, organic growth of 8% to 10%. For Government Communication Systems, we're now expecting more modest revenue growth for the year in the range of 2% to 4%, with stronger year-over-year momentum expected by the fourth quarter. We're all weighing the federal budget unknowns. When the government fiscal year 2006 budget is finally approved, our customers will have a much better handle on their spending priorities, which will then give us better direction on some of our program pursuits.

New projects on the radar screen should also begin to firm up and become part of the opportunity funnel that will drive future growth. I think you'd agree that our track record for winning and growing above the market has been excellent, and there will be ample opportunities for us to pursue. We see this pause in growth as only temporary. The profit picture for our Government Communications System business, on the other hand, has improved as we saw in the first quarter results. We are now expecting operating margins in the range of 11.5% to 12.5% of sales for the fiscal year.

At RF Communications growing order rates, expanding market opportunities, and an increasing backlog give us confidence in raising expectations for fiscal 2006. We now expect revenue growth at RF in the range from 35% to 45% above last year with operating margins of 32% to 33% of revenue. Again, based on what our customers are telling us, the expectation of continued funding and the $800 million or higher order level for this year, we expect continued growth in fiscal year 2007 at RF.

Guidance for the Microwave segment is unchanged, but as I have already said, our confidence is a bit higher. We finished fiscal 2005 with increased momentum thanks to the success of TRuepoint and the North America sales team. That momentum has now continued into the first quarter with strong orders in both domestic and international markets. We expect revenue growth of 8% or maybe 9%, with operating margins above 5% for the fiscal year.

In Broadcast we now expect revenue, which includes the Leitch Technology acquisition, to be in a range of $530 to $540 million. Now, the core business revenue outlook has been slightly reduced from previous guidance due to the much slower than expected recovery in the international analog transmission markets, as I mentioned. On the positive side, however, Broadcast is increasing its earnings power in the core business faster than we previously expected. So we now expect 12% to 13% operating margins for the core business, which is about 100 basis points higher than our previous guidance. Combined with 9% to 10% margins on Leitch sales during fiscal year 2006, the total segment should achieve an 11% to 12% operating margin in total, or about the same level of operating income as our previous guidance.

In summary, we are clearly off to an excellent start after this great first quarter. Fiscal year 2006 should prove to be another solid year of revenue and earnings growth for the Company. At this time I'll ask the Operator to open the line and we'll take some of your questions.

[OPERATOR INSTRUCTIONS]. And our first question comes from Chris Donaghey with SunTrust Robinson Humphrey.

Hi, Good evening, guys.

Hi, Chris.

Howard, first of all, can you talk a little bit about how the ACF stop work order is going to impact the business?

We've had a little bit of an impact from that stop work order, as you know, in the first quarter. We see this air frame issue getting resolved and at this point I'm not sure how it will be resolved, but we don't expect this to be a big deal going forward one way or another. We have made some allowance for that in the growth rates that we have reduced at GCSD.

Okay, great. And just as you look at that 800 -- did you say you had an $800 million backlog in the RF business or was it $800 million in orders?

What I indicated, what we now expect in fiscal year '06 to be able to have new orders of $800 million or more. The backlog in the 10-K at the end of July was around $430 million, approximately. And based on the revenue guidance we've given for '06, Chris, that $800 million in orders would be more than sales, so we'll build even more backlog throughout the year and that gives us a very solid feeling about continuing to deliver growth in RF in '07.

Okay. And just on that $800 million in expected orders, how should we think about the mix of Falcon II versus Falcon III? Should that mix ramp towards Falcon III over the course of the year?

We don't have a lot of Falcon III expected orders in that $800 million. We got the initial order; we'll start shipping product in January. It's possible we might get Falcon III orders in the fourth quarter, but at this point the Falcon II is still the predominant product that we're shipping, and we're still at around a 70% U.S., 30% international view for the year. Of course that's a much heavier weighted view toward the U.S. than in some previous years. I think the important point I tried to note was the Falcon III has opened a number of new market tunes for us, least not of which, one, is the SINCGARS opportunity which we think is real at $1.7 billion over the next three to five years.

Okay. And one last question on the broadcast segment. If you excluded Encoda, which my estimate was about $30 million in the quarter, obviously organic growth would have been a negative value on that core business. Is that substantially all the international market? And also, it looks like that it would have been just barely profitable if you would have backed out the Encoda acquisition. Am I correct on that?

Yes I think directionally you're correct, Chris. The last year's number did not have Encoda so we got that increase year over year, but it did have $10 million for IMN, which is a pretty big one-time program. And the international demands, certainly as we rolled off the Romania project, the other projects are just not lining up in terms of size to fill that volume. So the core business was down; Encoda obviously allowed us to be up in total, and profitability-wise, I think you're right, the core business wouldn't have made a lot of money. That's why we're taking these steps in cost reduction. Clearly, that's going to be a different story as we proceed through the rest of the quarters this year and going forward.

Okay great. Thanks, and good quarter.

Thank you. We'll take our next question from Mark Jordan, A.G. Edwards.

Good afternoon.

Hi, Mark.

Question on the RF. You mentioned that obviously you have a very favorable expectation for incoming orders. It's my assumption about $170 million that roughly reflects current capacity at Rochester. You said you're going to increase your capacity there, and if you take the midpoint of your range you would be -- have a revenue assumption of, say, $750 million this year. To get there, that would mean you'd have to step up about $25 million per quarter in the third and fourth fiscal quarters. Is that the rough magnitude of the capacity addition you're planning in Rochester?

Yes. At this point, Mark, I don't think that we're going to have any capacity limitations. We've already increased capacity in our facility in the UK and have off-loaded some of the international products that can be made there to that location. We've added capacity over the last 12 months and already have in place a plan to increase capacity, not just to allow as they get up to that $750 million revenue number that you mentioned, but to go beyond that in '07 because we certainly expect to be at a run rate that's above this quarter by the time we get to Q3 and Q4 this year.

Okay. What has been the impact of FAS123R option expenses in the reported results?

About $0.01 a share.

Okay. If memory serves, you also had a significant amount of cash overseas. Have you planned to bring that back domestically under the current tax treaties?

No, no, we don't think we need to for the simple reason we just bought Leitch. We've been able to use our offshore cash to make that acquisition happen. We really don't have any offshore now.

Okay. Thank you very much.

Thank you, Mark.

We'll take our next question from John Bucher, Harris Nesbitt.

Thank you. Once again, I'm going to explore the RF communications area and the apparent, insatiable appetite for your tactical radios. You mentioned that you don't really have a lot of Falcon III programmed into your new order expectation of $800 million for fiscal '06. I'm wondering with agreements like the recent one you got, the new contract with MARCOR SYSCOM, it looks like the 117 is still selling strongly.

At what point do you think some of the program offices are going to take a harder look at that and maybe say, well, maybe we should substitute that with Falcon III to the extent that that form factor will suit the mission? And then secondly, are there other versions of the Falcon III that you're anticipating to launch and with what sort of timing do you have on that?

Well, certainly for the core of our Falcon II radios, which are in the manpack, or vehicular configuration, as we release a manpack version of the Falcon III, which is -- John, I just don't recall the specific timetable -- but it is certainly in next calendar year. I think that's when you'll start seeing a lot of the bulk volume start shipping over -- shifting over to the Falcon III. It will also have a lot to do with adding weight forms to the new radio so that we have more compatibility.

What we've got with the Falcon III we released right now is this handheld version multiband, with [high point] encryption, which is not a product that we've had to offer. So this is true incremental business. And our design team came up with a very creative way of taking two of those hand-held radios and fitting it into a vehicular amplifier adapter which fits in exactly the same place as the legacy SINCGARS radios. So you have the VHF capability but you have multiband and you have either one of these two handhelds that you can strip and use for portability.

So that's why we think they will shift a significant amount of their orders for SINCGARS replacements into this kind of configuration, and with that we'll be competing with the [Talus], the TCI, although their radio does not have the JTRS/SCA compatibility that ours does, nor the multiband capabilities. So we'd like to think that we'll win more than our fair share of that competition because we have a more versatile radio.

Yet some of this opportunity, or it sounds like the majority of this opportunity is not being factored into your outlook for new orders of around $800 million in '06?

Again, we don't have a lot factored in. We receive the initial order of $38 million. We don't start shipping that new configuration until January. And, as you know, John, they're going to want to get these in the field and validate their performance before we're likely to get a lot of follow-up orders. So if they do happen this year I think it will be very late in the fiscal year but, again, that $1.7 billion dollar opportunity over the next three to five years we think is quite real.

Okay. And that just sort of gives you -- your comment before about continued optimism into fiscal '07, obviously, that would be a point underpinning that?

That, plus we'll be shipping a lot of backlog of Falcon II radios that we get this year, yes.

Okay. Thank you very much.

Thank you.

From Citigroup, [Frah Angorin].

Good evening.

Hi, Frah.

Hi. The first question on the government business. I mean, I thought your classified revenues set pretty decent margins, and yet you basically think that classified revenue growth is not going to be very impressive this year but you have higher margin expectations, although you will have higher service revenues in the mix which have lower revenues -- which have lower margins. Why do you think that margins will be higher?

Well, it's really several factors. It's higher award fees on some of the cost-plus programs. Specifically this quarter, we called out some avionics programs where we got very high award fees based on our performance. Second, we're having a higher mix of fixed-production work. And on the fixed-production work, Bob an his team do a great job of driving costs down and that's allowing us to enhance margins. We also shipped -- and are shipping -- higher quantities of our new wireless product to our intel customers, which is on a fixed-price basis and we make very good margin on that product.

And then the last thing that's influencing the mix is in this quarter, we didn't have a lot of big, new programs starting up; typically, cost-plus programs that start up start, as you know, at a lower margin level. So we see this mix factor very favorable throughout this year allowing us to generate higher operating income contribution to our earnings, while falling a little bit short of our original hopes and expectations for revenue growth.

I see. And what were the work fees this quarter in the division?

I don't have a specific number, but Bob, the percent award fees in the quarter, do you know, off the top of your head, the number?

No.

I mean, we have said, externally, we run typically at the 90%level or above, and I think it's fair to say we're doing little better than historically and that's contributing to a bit of this positive mix.

Okay. And on the other side, incremental margins have been about 50% in the past three quarters and you had 34% margin this quarter and you're guiding for a 32%to 33% margin for the year. Is there a mix shift or -- I mean, what's driving the margin down?

Well, number one, we're investing -- reinvesting at a higher rate to get the rest of the Falcon III product line to market sooner, as well as we are investing with some programs looking at adjacent market opportunities to introduce new products and drive new, organic growth. So that's the primary factor is the investment side. There's really nothing substantial going on with mix. Margin can move a little bit from quarter to quarter, but we think 32, 33% is a good, safe number to use for this year.

I see. And one final, quick question. It seems cash flow was very strong and you could have funded the acquisition just with a bank revolver and you chose to issue the note. Did you want to keep the [inner flexibles] on the acquisition side?

Yes. Yes. And we needed -- we had not that much long term debt and thought that in this rate environment, a 10-year maturity at 5% looked pretty good to us, so we're just really keeping our flexibility.

Okay. Thank you very much.

Thank you.

Thank you, Frah.

Next we'll hear from Ted Wheeler, Buckingham Research.

Good evening, all.

Hi, Ted.

Great quarter. Two questions, kind of longer term. You mentioned in RF Com R&D expenditures are migrating higher with the good gross profits that you're looking at some adjacent markets. Do you have some specifics on size of markets and maybe when you might have product to test your concept there? I'm going to punt this one over to Bob. I think it's fair to say, Ted, though that we will try and spend some time at our spring analyst meeting on this subject. But Bob, do you want to comment on what we're working on?

I think we're going to wait until the spring analyst meeting to talk about the size of the markets, but let me tell you things we're looking at. We're looking at the RF weapon data links and putting them into some of the work that we're doing with some of the large primes. We're also looking at sensor systems and putting in RF technology and tying them in with sensors to be used in either homeland security or in DOD applications and used in the international marketplace. Those are two of the big areas that I like to talk about, and we might have a third one that we might want to talk about in the springtime when we get together that we're looking at.

And if you're successful with this result in some products for -- in a year's time or is it like a three year kind of roadmap?

On the sensor side it will probably be products within a year's time so it will be in our next fiscal year that we would have those. And on the weapon data link stuff, we already have some stuff that we're working on so they would also be available probably at the end of the '07 time frame.

Great. Thank for the color. One other. You mentioned the government private network market. Kind of the same question, is that something you would care to elaborate on in terms of the opportunity you see here and when products might be available?

Well, this is a market that I think we've talked about little bit in the past that we hadn't had enough focus on, even though we have great contacts through the government. For many years we didn't have a microwave radio, Ted, that was GSA listed for example. So we got that work done and [Jane Laden] and her team have really been focusing on this.

We won a couple of major projects; one for the FBI and one with Northrop Grumman for a project that they are doing internationally. So I still think we're just getting started there and that there's upside opportunity. I don't have a sense off the top of my head what the market size is, but I think we've -- clearly we are on to something here and I think we do have opportunity to continue to drive incremental growth.

Great. I guess one more, if I may. The end-of-life plan that you discussed, how long would it take to execute that program?

Probably about one year from the time that we announce it. Most of our contracts with customers provide a one-year notice period before we would cease production. So you would go out, announce an end-of-life date and solicit immediately final orders and then deliver those, hopefully, in no more than a one-year time frame.

Thanks again for your help.

Next we'll hear from Larry Harris, Oppenheimer.

Yes. Thank you and congratulations on the results. In the SINCGARS replacement area you mentioned, I believe, $1.7 billion over the next three to five years. Would that equate to the 64,000 multiband type radios?

Yes. So that is the map that we're doing, Larry. We're saying we believe that there is about 200,000 radios they would like to replace. We think that they will -- would like to put about 64,000 of those in vehicles and would be disposed to utilize this handheld concept where you have two handheld radios in this vehicular adapter.

And, again, basically, there will be two contractors competing for that business, and that's exactly the configuration that our initial order for the Falcon III handheld of 1,300 radios, $38 million. So if you basically scale that up, you get to $1.7 billion in opportunity if you have 64,000 of those systems.

Understood. And with respect to -- and maybe you've included this in your forecast but with respect to adjacent opportunities in the RF com area, what about in the wake of Katrina, additional needs, say, on the part of National Guard or radios that are compatible with the public safety radios produced by Motorola? Is there an opportunity there for you?

Potentially. We haven't sized that and don't have any appreciable volume for that kind of an application in our outlook.

Understood. And with respect to the broadcast area, there are various bills working their way through the House, through the Senate; they're looking at maybe end of 2008 or April 2009 for moving from analog to digital broadcast, finally. What are your thinking right now in terms of the number of stations that still are at low power? And could this provide a stimulus, maybe, over the next couple of years to the broadcast [inaudible]?

Well, first of all, this has been the ever-receding bonanza in terms of trying to call when that date is going to be. We still think there's $300 million or so to be spent, whenever that date is, between now and then to upgrade systems, primarily to full power. As you know, most stations are now on the air broadcasting something. They are doing their final channel selections and then they've got to get up to full power to cover their whole licensed area.

It's really just a question of number one, what will the date be; and number two, even if they say a date, do we really believe it, given the amount of waivers that they've offered in the past. So as I've said before, we're going to get our fair share of this business as it comes along, but we can't count on it to drive growth. And that's really -- it's that realization that has led to lots of other things that's happened in the last two years in our broadcast business. We're becoming cautiously optimistic about mobile video becoming a reality, and I think we're well-positioned there.

We've had some good test results. HD radio is clearly happening at a pace pretty consistent with what we expected, and we're very excited about Encoda and Leitch. Encoda is basically delivering consistent with the plan when we bought the company, and I'm very excited about what Leitch is going to do. Again, it's really helping us to reshape. We're not abandoning the transmission business, but as you've heard us discuss, the faster growth is another areas and we wanted to move there.

Understood.

All right. Thank you.

Operator, we'll take one more quick question.

And we'll take our final question from Jim McIlree, Unterberg Towbin.

Yes. Can you talk about the level of charges you expect in the microwave business? And secondly, what type of margin impact that has, ex the charges, both in the short term and the long term?

I can't really talk about the size of the charges other than to say they will be significant. We are working on this plan. Once that is in focus and we have communicated to customers, we will have a better sense as to exactly the size. We can shape some pieces of it, but certainly not all of it, especially the inventory piece, until we would get some idea of what the last orders are. There will be some cost reduction and margin improvement associated with shutting down Montreal manufacturing.

Today, we have more capacity there than we're using, so that will help, I hope, to move beyond this first milestone. We've always talked about 5% as a stopping point in terms of return on sales, but the bridge to get us then up to 10%. So certainly that will help, as well as will continued emphasis and focus on cost reductions. We talked at our last call about moving the TRuepoint 4000 model, which is the more basic PDH access radio, moving that off to Asia production during this year and that is still absolutely on track.

And by the end of our fiscal year we should be in a position where we are receiving both the outdoor unit, which goes there first, and then the indoor unit, which goes there second. Both of those should be done by that time. So I clearly see a path to continued margin expansion in FY '07 in microwave, and this shutting down our manufacturing and getting rid of any legacy costs with those older products will be helpful in that quest, Jim.

Is there a shot that as you go end of life you get a bulge of orders that possibly would be lower margin than the TRuepoints and so you get a negative margin impact?

I suppose it's possible. I don't think it's practical. In fact, I think our last time build -- we will try and do that because we won't be talking about large quantities at probably higher prices than normal. Obviously, we've got customers we have relationships with; we have to manage through that. But those are the unknowns until we make this announcement. I don't think it will have a negative impact on margin, though, other than the one-time costs associated with the action.

Thank you.

Thank you.

Well, thank you everyone for joining us, and we'll have the 10-Q out sometime tomorrow morning. Thank you.

And this concludes today's conference. We thank you all for joining us.