ManTech International Corp (MANT) 2004 Q2 法說會逐字稿

Good afternoon. My name is Marvin and I will be your conference facilitator today. At this time, I would like to welcome everyone to the ManTech International Corporation's conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number 1, on your telephone keypad. If you would like to withdraw your question, press star, then the number 2, on your telephone keypad. Thank you. Miss Crystal, you may begin your conference.

Welcome to ManTech International Corporation's second quarter 2004 earnings conference call. My name is Maureen Crystal, and I'm Executive Director of Investor Relations. Leading today's call for ManTech are George J. Pedersen, Chairman of the Board, CEO, and President, and Ronald R. Spoehel, our Executive Vice President and CFO.

Before we begin our discussion, it is important that we provide you with the required statements relating to our written and verbal disclosures and commentary regarding ManTech, and our results and operations. Statements made in ManTech's written and verbal disclosures and commentaries which do not address historical facts, could be interpreted to be forward-looking statements. These statements are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995, and are subject to factors that could cause actual results to differ materially from those statements. For example, we note the risks and uncertainties of retaining existing contracts and winning new ones, and of contract performance, and legal and regulatory compliance. For a discussion of these, and other risks and uncertainties, please refer to the section titled "Risks Related to the Company's Business" in ManTech's annual report on Form 10-K filed with the Securities and Exchange Commission on March 15th, 2004, and from time to time in ManTech's other filings with the Securities and Exchange Commission including among others its reports on Form 8-K and Form 10-Q. The Company's statements are made as of August 16th, 2004, and ManTech assumes no obligation to update any such forward-looking information.

Also, the entire content of today's call, which is being recorded and webcasted, is a copyright of ManTech International Corporation, and may not be reproduced in any form without written -- without prior written consent. Now, I would like to turn the call over to George Pedersen.

Good afternoon, and thank you for participating in today's call. For this afternoon's call, I will start with a discussion of our Personnel Security Investigations business, and review our recent announcements, as well as commenting on our other operations. I will then turn the call over to Ron for a financial review, and presentation of guidance. After Ron's remarks, we will go straight to answering your questions.

As you read in our press release today, ManTech International incurred a significant additional loss in our Personnel Security Investigation business in the second quarter. Ron and I will discuss the reason for this loss, and the PSI situation in detail. We will also address what we are doing to bring this business back toward profitability and mitigate the risk going forward. Our objective is to help you better understand the very complicated situation which produced these results. The senior management team is all very focused on the PSI business at this time. But I want you to understand that ManTech's core National Security Technology business continues to be healthy and growing. Revenues for these businesses in the second quarter were 205 million, up 21% over the same period in 2003. Our operating margins remained healthy. We will provide more details about our core business after we discuss our MSM subsidiary.

In the second quarter of 2004, we incurred a net loss of 5.2 million, which was caused by the poor performance of our ManTech MSM Security Services subsidiary. This subsidiary is totally focused on providing PSI support services to the Federal Government customers, the largest of which is is the Defence Security Service, or DSS. This contract is also the primary source of the problems we are experiencing. From a historical point of view, in January 2003, DSS awarded a PSI contract to a joint venture that ManTech had formed with a small firm called MSM, which had been in the PSI business for 25 years. It was one of 3 contracts awarded under this multiple award DPA solicitation. The estimated value for us over 3 years for the contract ceiling, was 50 million. We believe that this contract award would form the basis for significant growth and profitability of our PSI business.

It was well known that the Nation's backlog of security clearances was approaching 500,000, as reported by GAO, other government agencies, and various Congressional committees that have studied this critical issue. We began performance under this contract in a modest manner. We were tasked initially by DSS to process approximately 35 PSIs per day. Not long after this initial tasking, in the late spring of 2003, the DSS client approached us and asked if we would consider accepting and processing a very significant increase in case load, that would bring us up to processing 625 PSIs per day, up from the 35. There were extensive discussions with DSS, resulting in our agreeing to attempt to process more than 425 PSI cases per day. Tasking at this higher level was issued by the government and we began to implement a plan to respond to this need.

We took the following actions. Having acquired MSS earlier in the year, we made a decision to move our facility from the original MSM office space, that contained approximately 10,000 square feet, to a new 40,000 square foot modern facility. We began the process of increasing the staff by intensive recruiting and training that would result in our increasing our employment in this area, from 91 people to approximately 330 people over 9 months. We initiated an investment in significant new management control systems, including a case management system. We developed a training academy on-site.

At this time of increased investment, we were motivated by the fact that in addition to the DSS contract, we had begun to win additional contractual assignments from other customers, thus broadening our base. The DSS contract was originally expected to generate revenues of 16 million per year. That's 50 million divided by 3 years. With the additional tasking, we were now on a run rate on the DSS contract alone, that would produce revenues in the first year of approximately 37 million. The base business of MSM that we acquired was operating at 19 million. Thus, we saw projected revenues well over 50 million per year, not including additional contract awards, and potential future contracts that we were pursuing, such as at OPM. Given the high priority assigned to completing and issuing security clearances and the national backlog, which was increasing every day, we saw very little downside risk in this market.

Several major government policy changes resulted in operating issues within a number of government agencies, that fundamentally changed all of that, and changed our PSI business environment. First, the government made a decision to merge DSS into OPM. This had a significant impact on our MSM's operation in a number of ways. Our contract required access to the DSS case-management system, on which our employees had been trained to input the necessary clearance information. The government decided to shut this system down by 30 September 2004, which meant all the cases had to be completed by this date. DSS personnel were trained on the OPM system, and they are using it today. Our personnel were not. Therefore, we may have to have -- we may not have access to a case-management system after 30 September. And all parties realize that the case load assigned could not be completed by this day.

Second, the decision on the case-management system, along with some other policy decisions resulted in a request from DSS that we return as many DSS -- as many cases to DSS for their completion as possible, in order to assure that all of these cases could be completed by 30 September, this magic computer shutdown date. Extensive negotiations were carried on with senior DSS executives, the contracting officer, and others, resulting in agreement and a preparation of a draft modification to our contract. Draft modification dated June 29th, 2004, was provided to us. 2 days later, in an unprecedented action, the contracting officer informed us that a higher authority had changed the decision, which negated our agreement. Weeks of operational actions, planning, negotiations, were wiped out instantly.

When the expected October 1st, 2003, merger between DSS and OPM did not take place, the government made another decision, to slow down tasking and stop issuing new cases to contractors for the calendar year 2004. These 2004 cases were cases that DSS had received for processing after 1 October 2003. This also had an enormous impact on us, because our case line of new work began to slow down immediately. It is only in the past few months that DSS, the agency itself, has begun to process the '04 cases in-house with our contractor support, and using OPM's case management system now, not their own, as we understand it. We cannot overemphasize the impact that this had on our business.

We competed for the OPM contract that you all know about, along with 5 or 6 other bidders, expecting award to be made, initially we believed, in March 2004. The award was then delayed until the May, June time period. It was finally awarded at the end of July. But more importantly, we had just learned, at the contract award, when we attended the appropriate meeting, that we would not be trained on the OPM computer system until November this year. This delay, combined with the plan to shut down the DSS system, has produced a gap in the supply of new cases, that made at least 1/3 of our newly hired and trained staff redundant.

These individual changes, in themselves, contributed to our financial problem. Combined, they produced an environment that made financial forecasting extremely difficult. Our DSS customer is supposed to merge with OPM in the near future. Yet, we are told to plan to continue to process clearances after 30 September, relying on a case management system that is supposed to be turned off. We have not received any of the '04 cases, and the supply of '03 cases to us ended in September '03. As noted earlier, we also have a gap in the supply we expected under the OPM contract.

One of the critical impacts that occurred as a result of these policy changes, is that we no longer have a blended flow of cases that produced a combination of easy and complex cases. This blend, normal in the business, formed the basis of all our pricing algorithm. The number of leads necessary to close a case has risen dramatically as we get the complex cases. The facility we created is too large for the workload we now have, and we are now forecasting. Moreover, the work force was underutilized, and as a result, we had to terminate 1/3 of our employees 1 month ago -- 1/3 of our MSM employees a month ago. These employees specialized that were -- these employees that were terminated, specialized in the front-end activities of case processing. The operating costs at MSM exceeds our cost estimate because the case mix and a number of cases don't support the size of our current operation, among other factors.

To address these issues, we have developed a plan to scale back our MSM business to an operating level that can be supported by our current contract. The purpose of this plan is to make this business unit profitable as quickly as possible, including completion of the DSS contract. Negotiations with the DSS customer, and the contracting officer, is going on as we speak. Personnel with the DSS that we are dealing with are at the highest level, as is the contracting officer. We will deal with the needs of the OPM contract in November, when we should know the level of PSIs that they will assign to us. They continue to have extremely high backlog, but we will not know until that time period if everything will be assigned to MSM. We will not implement any business plan that anticipates award of future business, until such business has been negotiated and the contract formally issued.

As we said in the beginning of our conference call, it is important to emphasize our core business in ManTech, basic national security defense, intelligence marketplace has continued to grow. Revenues for these businesses in the second quarter were 205 million, up 21% over the same period in 2003. 17% of that amount comes from organic growth. Continued growth in our operations is supported by continued efforts to boost -- bolster the national security. Defense appropriation bill has been signed by the Congress, signed by the President, and will be effective 1 October. That's good news for us. It provides funding of 416 billion in new discretionary spending. We believe as others in the industry do, that there will be several supplemental appropriations during the year, and that expenditures will reach 500 billion in '05.

You may recall, that most of our revenue comes from the Department of Defense and the intelligence community. Although our work for the Department of State is funded by a separate committee, the areas in which we focus are well funded. All of the other appropriation bills will be dealt with when Congress returns, and the current thinking is that there will be an Omnibus appropriation bill. If that is correct, all of the other agencies that we support will be properly funded. Looking forward as we have told you over these past several years, we expect the growth of our core business to stay on track, exactly as we have indicated previously. We believe that we will continue to grow at 15% into 2000 -- 12 to 15% into 2005. And that does not include any negotiations for acquisitions, or even divestitures.

Ron will complete the financial picture and the guidance for our third quarter ended for the year shortly. In summary, please be assured that we are making the necessary changes in the MSM business, and we continue to grow our core business. I think it is also important to know that we continue to have approximately $300 million in equity. Our borrowing is minimal, we have available the necessary lines of credit to grow our business through organic growth and acquisition. We are in strong financial shape. Ron, would you continue with more detail?

Thank you, George, and good afternoon, everyone. Needless to say, this past quarter has been a challenging period for ManTech and its shareholders. While the performance of our core operations is gratifying, we have continued to experience disappointment and frustration, due to the complexities and dislocations associated with the PSI business and our MSM subsidiary. As evidenced by the delay in reporting our second-quarter results, MSM's determination of a contract loss accrual for one of its key contracts, proved particularly challenging in the face of a continually shifting environment. To highlight the continued performance of ManTech, and to give you more visibility in this quarter, we are providing specific information on the PSI business at MSM, as well as on our other activities which are focused on high-end intelligence and defense segments, that support mission-critical national security initiatives.

On a consolidated basis for the quarter, revenues were 198.6 million, an increase of 12% from the comparable period last year. Although reported revenues were lower than originally anticipated heading into the quarter, due to the 11.3 million impact from the previously announced change in estimate at MSM, revenue expansion also benefited from a full quarter of results from a recent acquisition of the ACS operations, which added 7.3 million in revenue to the quarter. Our operations, other than MSM, reported revenues for the quarter of 205.1 million, an increase of 21% year-over-year, and 8% sequentially. Our organic revenue growth from these operations of 17%, is reflective of the expanding work we are seeing across our Department of Defense and intelligence community customers. Our DOD and intel customers account for over 92% of our revenues, and we continued to derive 85% of our revenue from Secure Systems, and Information Technology Solutions. In total, our revenues are 99% from the Federal Government, over 43% through GSA contract vehicles, 71% from time and material and fixed-price contracts, and 87% in our capacity as prime contractor during this past quarter.

Now, turning to MSM. Second quarter was impacted by the previously reported 11.3 million downward adjustment to revenue, when the change in estimate on the fixed-price contract with DSS, based on the increased level of work remaining to be completed under the contract, as the cases were more complex and were requiring more time to complete than had originally been contemplated, based on previous case history. The second quarter at MSM was also impacted by the confluence of shifting customer priorities and policies, resulting in disruptions and inefficiencies at MSM, which led to a further change in estimate to the DSS contract of approximately 1.9 million, and caused case-volume processing to drop across the MSM contract space, and work load requirements to increase significantly in the quarter. These factors combined to cause MSM to end the quarter with revenue reductions netting to a negative 6.5 million.

Cost of services and operating expenses at MSM increased 6.1 million, from the first quarter's 11.7 million, to 17.8 million in the second quarter, as sequentially staff costs increased by half a million, [inaudible] personnel expanded by about a million, and an estimated feature contract loss of 4.7 million was accrued for contract costs necessary to complete the DSS contract. In total, therefore, including the original 11.3 million mentioned already, the resulting operating loss at MSM for the second quarter was 24.3 million. On a consolidated basis, MSM had an operating loss of 8.2 million for the second quarter, reflecting the consolidation of that MSM operating loss, with an operating profit of 16.1 million in our other operations. The operating margin for these other operations was 7.8%, which included the one-time impact of an $850,000 expense to terminate a real estate lease, .4% margin impact in the second quarter this year. Margin decrease in these other operations from an 8.5% operating margin in the comparable period in 2003, was also caused by a higher level of lower margin ODCs, or pass-through costs, in the second quarter of this year. As a percent of revenues, ODCs were 33.8% in these operations, as compared to 32.4% in the period last year for these operations.

On a consolidated basis, net loss for the quarter was 5.2 million, as compared to net income of 8.9 million in the year-earlier period. And diluted loss per share in the second quarter was 16 cents, using 32.3 million shares. For the 6 months ended June 30, revenue was 401.4 million, up 23% from the 325.2 million in the same period last year, as the full quarter impact of the acquisition of IDS and ACS operations were included. Organic revenue growth on a consolidated basis was 16%. In the first half of the year, for these operations other than MSM, organic revenue growth was 18%, as revenues grew to 395 million, from a comparable pro forma amount of approximately 335 million for the same period in 2003. Consolidated operating income was 11.1 million for the first 6 months of 2004, down from 28 million in the comparable period of 2003, reflecting the impact of the MSM loss.

For the first half of 2004, exclusive of the MSM operation, the Company's operating income was 34 million, growing from 27.1 million for the first half of last year. Operating margins in these operations were consistent in each year at 8.6%. Consolidated net income for the first 6 months of this year was 6.2 million, and diluted earnings per share was 19 cents, with 32.2 million diluted shares. Net cash flow from operations for the first 6 months was about break-even, as second quarter net cash outflows offset the cash in-flows in the first quarter of about 2.1 million. Second-quarter cash flow was impacted by the seasonality of certain items, and particularly -- in particular, taxes of over 10 million were paid in the quarter. Capital expenditures remained in an approximate level of 1% of sales. Impacted by the losses from MSM, free cash flow for the quarter was a negative 3.3 million, and for the 6 months was negative 1.6 million. Net debt as of June 30, 2004 was 26.4 million.

Our receivables overall, declined by just under 2 million, to 211.2 million as of June 30, which calculates to 96 days outstanding, of 3 days from 93 at the end of the first quarter. Billed receivables were 138.2 million, with a balance of 75.3 million in unbilled receivables. However, separating out receivables to reflect the impact of MSM, as we have done in the past, highlights the fundamentally different contract completion profile, billing, and cash collection cycle of our businesses. At the end of the second quarter, MSM's receivables totalled 24.7 million, comprised of billed receivables of 4.1 million, and unbilled of 20.6 million, in cash collections in the quarter of about 6 million.

For the DSS contract, with the previously mentioned changes in estimates for revenue, and the associated reduction in receivables, 13.2 million. Combined with the progress made and the revenues recorded on this contract in the second quarter, about 6 million. And the revenue -- and the receivable collections in the quarter over -- about 3 million. The MSM DSS receivable was reduced from 28.1 million at the end of the first quarter, to 17.6 million at the end of the second quarter. The receivable position going forward in MSM, and the associated cash collections, will depend in large measure on the timing of a resolution to the DSS contract, as covered by George earlier.

In our non-MSM operations, DSOs were 82 days at the end of the second quarter, about the same as at the end of the first quarter. And we continue to move forward, toward our stated target of bringing DSOs under 80 for these operations. Looking ahead, DSO progress would also drive an improvement in free cash flow, as we move forward through the year. And although cash flow forecasts are inherently uncertain, this could result in free cash flow which could be in excess of 25 million for the remainder of the year. Our forward outlook is also supported by our backlog, which remains in excess of 1.5 billion, funded to 401 million as of the end of June. This is up from a funded level of 342 million, at the same date last year. In addition, contract awards through the first half of the year, of about 750 million and a proposal pipeline of over 5 billion in opportunities in process, continue to provide forward visibility.

Our guidance for the third quarter and the full year, anticipates the continuation of strong underlying trends in our National Security business. However, our guidance also reflects some of the difficulties and expectations of continuing losses in the MSM operations. Also included, is consideration of the estimated future contract loss on the DSS contract and the associated reserve, which is -- the range of the loss is estimated to be in the 4 to $7 million area. And initial costs of transitioning activities to the OPM contract are included. The guidance does not include any impact of future acquisitions or divestitures.

As such, ManTech's guidance for the third quarter, is for revenues in the range of 208 to 218 million, up 15 to 20% from the third quarter of last year. Factoring in slight operating margin improvement in non-MSM operations, to about the 8.5% range, results in diluted EPS guidance in the range of 24 to 29 cents per share for the third quarter, based on 32.4 million diluted share equivalents. For the full year 2004, guidance for revenues is in the range of 835 to 850 million, with a growth rate of 19 to 21%. With operating margin expectations continuing in the 8.5% range for the non-MSM operation, diluted EPS guidance is in the range of 75 to 81 cents per share, based on 32.5 million diluted shares.

Now, we will be pleased to take any questions you may have.

The question and answer session will begin at this time. If you are using a speakerphone, please pick up the handset before pressing any numbers. At this time, I would like to remind everyone, in order to ask a question, please press star, then the number 1, on your telephone keypad. We'll pause for a moment to compile the Q & A roster. Your first question comes from Mark Jordan with A.G. Edwards. Please go ahead with your question.

Good afternoon. Ron and George, with -- in light of your guidance, would you clarify in the third quarter, you know, you stated 24 to 29, it looks like you did 29 in the base company in the second quarter. In that lower sequential number, or range, that implies, therefore, that there is -- there is a transition expense and/or windup cost of the DSS contract that is part of your guidance, is that correct? And could you clarify specifically what that drag is?

Yes, Mark. You're correct in that, -- there's approximately a $2 million risk range in there, and if -- you may recall from accounting guidelines, the 4.7 million that we've accrued as a contract loss, is only accruable for certain costs under the contract. So some of the ongoing costs of the operation, as George mentioned, as we continue to right-size the business, will be period cost in the third quarter and that's what's reflected.

Okay. Secondly, with -- could you give more color on the OPM contract? And, specifically, address the change in the risk profile that won't -- hopefully won't allow this event to reoccur?

There are several things that are a bit different in the OPM contract. One, there is a different set of cash-payment terms. In the DSS contract, there were no up-front cash payments. You got paid upon completion of the cash -- of the task. In OPM, the payment provides for 50% up-front. We have also been a bit more careful, we hope, in pricing our OPM contract as we go forward. So, it is better cash flow and, we think, more properly priced.

And by properly priced, you have escalators if the scope of work that needs to be done on a case is different from what your standard is, you have the ability to protect your yourself?

There is language in that contract that's a little bit different in that they prescreen these cases. And what we basically do is they -- by virtue of prescreening, which was not in the first contract, they will come in and tell you that approximately, there may be 30 leads on this case, or 40 leads, and that gives you an opportunity to look at it. We didn't have that kind of factor in the first contract.

Okay. A final question relative to the wind-down of the DSS. Do you believe that there's any accounts receivable credit exposure there, as this contract winds down? And, again, how much do you believe that you'll be able to generate, you know, from that subsidiary, as the DSS contract terminates and winds down and comes to completion?

We expect to collect all receivables that are due to us. The contract receivable level there reflects the revenues generated and the billings that are capable under the contract.

Okay. A final question, if I may. Looking out into '05, is it reasonable to assume that, you know, you talked about, in the second half of this year, moving towards sort of middle 8% operating margins for the base business. Is there any reason -- is there -- should we believe that that is at least a reasonable expectation for general operating margin potential for this Company in '05?

Yes, we do. We think it -- we continue to believe on a longer term basis that a target we have of the 10% operating margins is achievable, and we continue to move toward those goals.

Thank you.

Thank you, sir.

Your next question comes from Tom Maher with BB&T Capital Markets. Please go ahead with your question.

Thanks very much. George and Ron, just to make sure I understand it. The actual contract terms under the new contract have not changed, but you're saying there might be a higher risk profile there, in that they're not letting you have access to the -- at least the training on the OPM case-management system until November, did I hear that correctly?

It's not a higher risk-type thing. You cannot begin until you're trained on that computer system.

Okay. But they're not letting you get onto it until November, is that what you're saying?

That's correct.

Okay.

They have awarded, I believe it is 5 contracts.

Uh-huh.

And what they are doing is, they are ramping up the -- there is only so much time they can make that computer available for training, and some of it I believe has to be done on-site. And they have informed us that our training time period will begin in November.

November. Okay. And then just in terms of some of the issues you ran into in the client, and things being pulled back and what not, did any of that have to do with the union citing outsourcing, or anything like that? What's your sense on what drove the turnover, the decision to move forward, and some of the other things you were looking at?

I have not heard at any point in all these conversations any reference to union or outsourcing versus in-sourcing. That's not been an issue. And as you know, there have been GAO reports and various congressional committees. I think the issue is purely the idea of the merger of DSS and OPM. I think the complexity of it is such that it got beyond what they expected when they first started this process.

Okay. And then just one final question. When you talk about that merger, I know it had been uncertain before in the past about what would happen with the DSS people versus OPM, which I believe had been a 100% outsourcing shop. Have they come to any resolution on how those folks are going to be treated?

Sir, I don't know. Like you, I've heard versions that they go to OPM, I've heard versions that they have different plans. I don't think that anyone knows at this point in time. And that has been the difficulty in that, I think, certainly we have listened too closely to all of these reviews of what might happen, and at this point in time I think we just have to await the outcome.

Okay. Thank you very much. I appreciate it.

Your next question comes from Joseph Vafi with Jefferies. Please go ahead with your question.

Hi, guys, and good afternoon. Ron, I was wondering if you could walk us through that chart one more time, that's in the press release on the MSM charge, or I guess they're not charges, they are losses. You know, starting with that revenue line and going through the gross profit loss just so we have a clear understanding of where all those numbers are coming from.

Sure. On the revenue side, we start with the 11.3 million reduction from the change in estimate in May, an additional 1.9 change in estimate. And then net on the other items and revenue for the quarter, 6.7, comes out to the 6.5 negative. Okay?

Okay. So --

The contract loss accrual 4.7. And 13.1 of operating costs, which are a combination of the personnel and contractors. That's the 17.8 million. 1.9 of that, would be from the, if you will, G&A part of the operating expense part of the line item. So lumping those together you could separate that out and have 15.9 and 1.9, but that's what it comes to.

Okay. And so if we look at that loss in MSM in the quarter, can you give us a feel for the effects on cash -- cash versus non-cash in all of those -- in those numbers and MSM, and what we might have already seen come through your cash flow statement, and what we might expect to see on that MSM business. If there's going to be any more negative effects on the cash flow moving forward?

Well, there will be a negative effect on cash flow going forward, because although we have the contract loss accrual of 4.7 from an accounting GAAP standpoint in this quarter, you have the 4.7 million on -- that will be cash outflows in the third and fourth quarter going forward. The other cash outflows for the quarter -- there might be slight timing differences on accruals, but the 13.1 million of various operating costs are quarterly costs in the second period. The revenue items run through the change in receivables that I talked about in the remarks already.

Okay. So, sounds like a lot of those cash -- the cash effects have taken place, some will still continue to take place, and it sounds like there was one other additional -- it sounds like a contract accrual, or a true-up that's going to occur in the third quarter and would that also have an effect on the cash then, too, or is that a receivables situation there?

No. The contract accrual is a second-quarter item, and the other adjustment mentioned is also a second quarter item. So we expect to just continue to operate the business, and the revenues will just flow from direct operations in the third quarter, to the best we know at this time.

Okay.

I am not sure if I answered that directly, Joe, but --

I think so. It sounded like there was -- I mean looking at the delta on the third quarter guidance versus second quarter excluding MSM, there was -- there was a small -- depending on the business operation at MSM, is that the kind of delta between the lower end and the higher end, had something to do with MSM, and I was just wondering if that was cash related to the -- to something that had occurred previously or are you just operating a slight loss there until that thing gets going again?

We'll still be operating at a slight loss in the MSM subsidiary, and exactly how much it counts for the variability in the guidance for earnings in the quarter.

Okay. And then do you have a feel yet on the business as it moves over to OPM, what you think the kind of run-rate level that could get to, say a year out from now, maybe George, if you could maybe provide some color on that. Because we know the DSS contract was quite big.

Well, in the current business, we have -- if you get beyond the DSS, we are probably in the band of, I don't know, let let's say $25 million. The OPM contract, as you know, has a huge range of cases that they are making available to industry. And I think in our press release we basically said this could be 50 to $100 million a year. In total, they're talking about 400 to 800,000 cases being given to contractors under this contract. And that's a huge amount of money. But at this point in time, we have stopped trying to forecast until we actually get to the training phase, how many of our people do they train, then they will do the appropriate calculation. We don't want to fall into the trap of looking at this thing until I actually see the piece of paper, sir.

And then just one more question there. I know that business uses a -- you know, a fair number of subcontractors and the like. If you could kind of talk about, you know, maybe the ability to kind of hire these people or get them to work on some of your cases, and the competitive landscape there?

We do all of that. We look at the situation where we use them as consultants. We look at it where we have them as full-time employees. We've got about 2,400 contractor investigators at this point in time. What you really do, is you need to see a map of the United States. And you need to see where these cases are concentrated. If you take an area like Washington, D.C., there's a heavy concentration, so you will see us attempt to make those people full-time employees. If you get to Utah or an area like that, the number of cases out there are not as large, so in that area we may make those individuals consultants. It 's that approach, we look at the entire 50 states, and we determine where the cases are, and that's how we look at it.

We also -- we control this from a number of different ways. If we have particularly good investigators, obviously we try to make them full-time employees. But, again, we have available about 2,400 people in this category with the clearances, and that's a significant number, and whether they are full-time employees or consultants will determine what we see when this -- what share of this 400 to 800,000 cases a year flow to us.

Okay. Thank you very much.

Your next question comes from Bill Loomis with Legg Mason. Please go ahead with your question.

Hi. Thanks. On the -- Ron, on the receivables for the DSS contract, I think you said it went from 28 million, 17.6. Can you say again how many new receivables were added on the quarter, what the collections were, and how much was written off to get -- just walk us from that 28 to 17.6 million?

Okay. At the end, the receivable balance was reduced from the 28.1 million at the end of the first quarter, to 17.6 million at the end of the second quarter. And that has the 13.2 million in adjustments, revenue recorded in the quarter of about 6 million, and the collections of about 3.

Okay. So now, the 17.6 million is still a pretty big number, what gives you the confidence that you can get that collected? What do you and the auditors look at to give you confidence there?

A review of the contract terms. There's a -- negotiations will be continued, and the case-completion rates and prices under the contract.

There's a matrix in the contract that allows for completion at 4 different steps. And what we measure against is where we are in terms of that algorithm of 4 different cases. That's how we get there. As an example, if the government cancels a case, you don't wind up with zero, it depends on where you are. You may collect up to 90% of it, even though they don't complete the whole case, and there are 4 steps in that process. And what we do, is we run the cases that are in our case management system against that algorithm that tells us what the revenue is that we have earned at that point.

And these, the 17.6 million receivables still outstanding, these are from cases that were given to you last year, right?

Yes, sir. We've gotten no '04 cases under -- under that contract. We basically, as I think we said in the beginning, initially we were tasked to do 35 cases a day. They came in to us and asked if we could go to 600 cases a day. We finally concluded we would try to do 400 cases a day, and that's what they gave us, and that's the backlog that we're working on at this point in time.

And how much do you expect that 17 million to go down in the -- in this September quarter, in the third quarter?

That depends on -- it's so much -- I hate to say it the way I'm going to say it. It depends on a conclusion of these negotiations, and those negotiations are ongoing right now.

Uh-huh.

We've had a series of meetings in the past 3 weeks and once again, at the very highest level of this agency, and with the contracting officer, and we are awaiting their decision, as unfortunately we have been on a couple of occasions in this contract.

When you said earlier about the -- under the OPM contract, that they'll give you an estimate, a number of leads required to complete a case. Are you bidding on a per-case basis, so if it's 40 leads or whatever, that you can adjust your bidding on a per-case with the OPM contract --

There are a series of different types of investigations. That's where it starts, they're not all the same. And then we put a price together for these different case types. And -- and that's how -- that's how we price it.

Okay. And if they're wrong, if it takes say 3 times as many leads, or work hours to complete a case, what happens then?

The -- we will -- what we basically do, is we look at it and they prescope these cases and then that becomes a discussion item. I won't tell you that in all cases we have an automatic increase, but we will -- if we get a case that's been scoped at doing 30 or 40 leads, and then it comes in, and it turns out to be more than that, we will go back to them in this case, which we didn't have that option in the previous contract.

Okay. But is their language to get released if you do that, or is it still up for negotiations at that point?

There is some of each and I don't want to get into the details. It is -- it is not -- you know, if you get 31 versus 30, you get an automatic increase. But there is more flexibility than existed in the DSS contract.

Okay. Thank you.

And again the key issue, they pay you 50% cash up-front. A world of difference.

Uh-huh.

We're going to be -- as we said before, we're going to see how many cases they really wish to assign to us, how many investigators we will need, how many support personnel. We do nothing, -- we have a staff, but we don't do the kind of mission-oriented support to mission as we did before in this case. We will do what we have to, to properly support OPM, we just don't do it all up-front as we did with DSS.

Your next question comes from Chris Penny with Friedman, Billings and Ramsey. Please go ahead with your question.

Hi, thank you. Good afternoon. Ron, just looking at where you guys did other -- outside of MSM in the quarter, the -- kind of the operating margins there about 4.5%, I guess it kind of goes back to like let's say fiscal year '02, where you did 4.5% on an operating basis.

Chris, could you speak up a little bit? And did you say a 4.5% operating margin?

Correct. Is that -- am I calculating that right?

No. We did an operating margin of 7.8% in the businesses outside of MSM.

Okay. I'm looking I guess at your -- I'm looking at your after-tax then.

Oh, I'm -- okay, yes, on an after-tax basis.

Going back on a year-over-year -- or going back to '02, it's kind of the same -- right around the same margins. Other than MSM, can you give us how your operating margins are tracking? I mean it looks, based on what you did in the quarter, that they're kind of relative to where they had been 2 years ago. Can you give us a little sense outside of that where -- out outside of MSM, where those margins --

Right.

--have been tracking for the last couple years.

Chris, on 2 points there. Our margins have increased, and they're actually -- they might have been at those levels -- we had different debt levels. So if we stick at the operating side, we brought our operating margin from 7 to 8, which was posted in the quarter, said it would have actually have been in the low 8s, if you include the impact or disclude the impact of an $850,000 charge we had in the quarter for the termination of a real estate lease. So we're tracking in the -- this quarter was the low 8s, as a variety of factors came through, but we believe the 8.5% range is where you'd expect us to be tracking, and as we said both last year and this year in the first half of the year, we are tracking at 8.6% operating margins for the first halves of both years.

I don't know how this answers your question, but we have also presented information to the Street, that since going public, our revenues have increased 88%, but our operating income has increased 155%.

No, I understand. I appreciate that. I'm just trying to get a little more clarification as to why -- you know, what happened in the quarter I think, Ron, your explanation helped that.

Okay, I'm sorry.

And then just -- so just the question kind of looking into next year and I know you don't want to look too much forward into the OPM type of contract, but when we -- when you start adding on that business again at some point next year, at what do you think that you could start adding that on, at margins that are slightly higher than where you are given what you see as how these contracts are going to come out.

If the contracts are not profitable, we will not take the task.

All right. Do you see them as being more profitable than the other businesses outside of MSM right now?

I think learning the lesson that I learned last year, believing that the margins were at a certain level, I'm not going to answer that until I see what OPM puts in front of us, sir.

Okay, thank you.

I learned that lesson, if I learned nothing else.

Thank you.

Your next question comes from Tim Quillin with Stephens Incorporated. Please go ahead with your question.

Good afternoon. Just looking at the revenue in the core business in the second quarter, about 205 million and then looking at your guidance, for third quarter of 208 to 218.

Uh-huh.

You know, I guess the -- especially on the low end of the range, just the $3 million incremental increase would -- you know, what is the assumptions on MSM revenue that goes into that 3Q guidance?

It's a blend as we go into the 3Q guidance. The low end of the range would include something under 5 million for MSM, and the fact that in the second quarter, we had some good -- we had solid performance out of our business and some -- as we said in the first quarter, some one-time events. We believe we can continue those, and that's obviously why we have the range that we have. That gives us a low end of the range. So we have 15 to 20% growth built into our range from last year.

Okay. And excluding DSS, MSM is doing about 25 million in revenue, so I guess my expectation would be that you would book revenue closer to $6 million, maybe on the low end of the range. You know, what are you going to book from the DSS contract over the next couple quarters?

Right. Tim, it will be lower than that going to the next couple quarters because it's the -- as we complete the cases, we don't have the average case load that we had before, as we were rolling forward.

Right. Right. I'm just -- I'm just trying to get -- it just seems like maybe the revenue would be a little bit -- a little bit higher than the low end of your guidance range. But, -- and on DSS, then is this going to be fully ramped down, don't have to worry about it after 2004, or do you have to complete all the cases that are, you know, currently on your plate, and how long are you going to work out of that situation?

The cases, you know, depending on the negotiations with DSS on -- you know, could be completed on -- in the next quarter, or it could take a longer period of time. We haven't provided a specific time period for that.

As we tried to indicate in the opening remarks, it's difficult for us to assess what will really happen. They have come to us on 2 occasions and asked that we complete all cases by September 30th, and if we cannot complete them, would we cancel them and give them back so they can complete them. The purpose being, that they are going to turn their computer off on September 30th. Then they come to us and they say, well, that may not be the case, we may keep the computer open, so we may ask you to continue. So it's a difficult question for us to answer at this point in time, and we have taken, I will call it the pessimistic side, that they won't turn the computer off on September 30th and some other mechanism.

But there are 2 different approaches, and it is our obvious hope, because it's best for the mission, best for them and for us, if on September 30th, they take the cases back. They have more flexibility in doing a final close-out than a contractor does, and that's the negotiations that are ongoing essentially, for the second time. I think we pointed out in our statement, in an earlier time there were very detailed discussions about completing all cases, surrendering all cases, by the 30th of September. The government actually wrote a modification to the contract, which they sent to us to sign, and then at some policy level, that was changed. And we don't know what causes those changes, sir.

Right. And then the $4.7 million of accrual for losses, is that based on the caseload, as opposed to the time frame. So in other words, if this runs into '05, is $4.7 million going to be enough of an accrual?

That accrual accounts for completion of the cases, and it's both a question of time, as well as the costs of the specific items within the cases; i.e., the number of leads and the costs of the specific leads that need to be undertaken.

And then you expect an additional $2 million of period costs over a certain amount of time? And I guess you don't really know when those might actually be recognized?

Well, 2 million of period costs is more of a range talking about the third quarter that was built into the estimates.

Okay. But you're assuming a loss, and so there's a 2 million range in the second half around the losses you expect?

It's a rough approximation, yes.

Once again, I have to tell you that DSS, as a customer, is also in a difficult situation. As best we know, they do not know, sir, what their position is. Whether they continue as a stand-alone organization, whether they can merge, whether their computer gets turned off. So it's not that we're not try trying to tell you what we know, that's been the complexity of this whole issue. It's a very high-level policy issue and we have now looked at it, that we obviously hope for all concerned, including the fact you get these '03 cases completed, which is crucial, the '03 cases, that this thing be turned off by 30 September. But we just don't know.

Let me ask you this. What are the operating margins in MSM's current business excluding DSS?

That is impossible to calculate, and the reason for that is we created an entirely new cost environment, 40,000 square feet, 330 people, versus what we had before. And as we ramped down -- as you know on a fixed-price environment like that, it's volume dependent, and I cannot run an algorithm or develop an algorithm until I know that volume dependent.

Great. And --

We expected this business to be profitable, so believe me, we did.

In your press release, you mentioned potential divestiture of some business, but I guess it's -- if this business and this new OPM contract does not meet your profitability target, presumably close to your overall operating margins, then I guess you will take appropriate actions at some point, is that correct?

I think it's our policy not to comment on any specific M&A activity.

Okay. Thanks gentlemen. This, too, shall pass.

Thank you.

Thank you.

Once again, if you would like to ask a question, please press star, then the number 1, on your telephone keypad. Your next question comes from Cynthia Houlton with RBC Capital Markets. Please go ahead with your question.

You mentioned that you've been notified by OPM on the new contract, that you're going to start training in November. So are we to assume that there is no revenue for the new OPM contract for this calendar year, and that this is something we will probably get more visibility on what the revenue contribution will be for '05 during the next conference call?

We took a conservative approach and said no revenue in this year.

So the press release I guess, on the potential revenue contribution is just that, right, that at this point there's no guarantee that those revenues will be even a contribution for '05.

I think if you look at that, that's a -- that's a potential of where the contract could be on a longer term basis, as a run rate. It's not a specific time period.

And please remember, when the contract was first issued, we did not know when they would train us. It wasn't until there was a series of meetings after the contract award, once there was one meeting here in Washington that I attended, and then a meeting up in the Cave where we learned -- I don't know what that was, 10 days later, or whenever it was, that our position would be -- we would be available for training in November.

And then just on managing the costs, you had mentioned that there's some high fixed costs that you're trying to, you know, that you want to work with this contract to make it profitable regardless of what happens with OPM. Could you just walk through specifically what you have done already, and what you still need to do in terms of other further work force reductions. Actually getting rid of lease space, kind of what more is left to do on kind of some of the fixed costs.

One of the things we did is as we told you before, we had ramped up to about 330 people from 91. We terminated approximately 100 of those employees that had been hired and trained. Because they were focused on the front-end cases, and since we had no front-end cases coming in, they were made redundant. We made management changes up there, we made cost profile changes. We are looking at all elements of cost and bringing this back to a level of operation that is consistent with the contract business we have. Now, we have a 40,000 square foot facility, and some of that will be excessive. I don't know that exact amount yet. But at that point in time, we will deal with that as we do with any excess space, either sublease it, or move it again to a smaller facility, or something that is appropriate. We will profile the operation, management, support, and space.

Great. Thank you.

You have a follow-up question from Bill Loomis. Please go ahead.

Hi. Just going to another part of the business, on your State Department Embassy contract. Can you just talk about that, and a couple of your other larger programs, as far as what the funding outlook, what the general business level has been, and the outlook you expect over the next year and some of your larger programs, including the State Department contract.

Well, as you know, over the past -- I guess it's 4 years since they blew up the 2 embassies in Africa. Our revenues have grown from 10 million to 100 million, in round numbers, in the State Department. We are not involved in the construction, but we are involved in the security aspects of all of that. As you know, they'll spend a billion dollars on that new embassy in Baghdad. It is my understanding, that there is funding in the Defense Appropriation Bill for that. State Commerce Justice has yet to come through, as you know. I don't know the exact amount, other than there's funding in there. All indications are is that the State Department will have the funding they need, we believe, that the services and particularly the technology that we have developed for them will be in demand. I just can't tell you how quickly we will ramp up, or we will continue to ramp up the same way. They are a viable customer that's likely to grow.

Are you seeing growth for example, in the second quarter, were you seeing growth in your State Department work, and do you expect it in the second half versus a year ago?

A year ago, a year ago. I can't put myself into that particular quarter. I will tell you, I have openings to fill in that space. It's -- it's -- I can't answer that. I'll have to go back and look so I don't mislead you. But we have openings in that space, and obviously we think once the appropriation process is finished, and they get what is now thought to be an Omnibus bill, which will do a roll-up of State Commerce Justice, that they will get significant additional monies to spend in that fourth quarter, beginning 1 October.

And how about some of your other larger contracts, can you talk about the level of activity, the growth that you expect from those, or --

Well, I think anything in the defense and the intel side, as you know well, is going to be funded. The President signed a bill for 414 billion, and that's good news because that money's locked in for 1 October. That money will increase to 500 billion, or somewhere in that band. And I just see this year continuing the growth that we've had. There have been some recent articles, as you know in the newspapers, about the amount of growth in the Greater Washington area for defense and all the rest of it, and we are the same part of that team. We're seeing the same thing everyone else is seeing. There's a huge amount of money, there's a huge mission out there. We are being asked every day to put additional systems in place, we are talking about additional people in our intel business and some of the other areas, the demand is very high, sir, very high.

And what would you say based on your bid pipeline and opportunities, what would you say the level of business is?

Well we're still looking at growth in '05 of 12 to 15% over what we will do this year.

Uh-huh.

And realize that's a blended number. We continue to have business as you know, with EPA, NASA, and others that don't have growth, so the actual growth in the defense and the intelligence business is greater than that 12 to 15%. And ironically, Hubble may come alive again and all of a sudden we may have a new growth business.

Okay. Thank you.

You have a follow-up question from Chris Penny. Please go ahead.

Yes, thank you. You've stated that your guidance doesn't assume any acquisitions, and I was just looking for a comment regarding kind of your appetite for acquisitions given that maybe prices have come in a little bit, and then in light of what's happened with MSM. Can you talk a little bit about your appetite for acquisitions over the next 6 months to let's say a year or so?

We are not looking for acquisitions in the PSI business, sir.

Okay.

We are looking for acquisitions and continue to search in our base of security and intel business. As you know, we did complete one earlier in the year when we acquired a group in Boston from ACS, which has since been expanded to include work with NATO. As always, we are reviewing candidates continuously. We have 1 or 2 that look attractive, but until they close, we don't put them down. But we are still in the marketplace. We continue to have very strong equity. We have available cash borrowing at this point in time, to do acquisitions anywhere between 125 to $200 dollars if necessary. We'll have positive cash for the rest of the year. So we have money to do acquisitions, but not in the PSI space.

I guess the question --

Clearly -- and clearly from a financial perspective, we we'll continue to be very selective and focus on acquisitions that are accretive and meet the other requirements that we've stated consistently in the past.

We're happy with the ones that we have acquired in the other areas. We are happy with IDS, CTX, Aegis, ACS, in those areas and particularly, again particularly the areas where the very high clearances are involved. That's our focus.

So looking forward, I mean I guess applying a lessons learned from maybe the MSM, is there anything differently you are doing in the diligence process or anything that may significantly change how you look at some companies, or is it just strictly an isolated event that, you know --

MSM was not a due diligence issue. MSM was an assessment of what the marketplace would be. We scaled up to a national need. And if you look back on this, and I've asked myself a dozen times, what could I have seen? There were GAO reports, Congressional hearings, reported all over the place about this tremendous demand. And that had nothing to do with a due diligence on a company doing 19 million. It had to do with our belief that the government would continue to require those services, those clearances, and for a variety of reasons that turned out to not be true. That was not a due diligence issue, sir.

Well, thank you very much for your comments.

You have a follow-up from Joseph Vafi. Please go a head with your question.

Hi, guys. Just 1 quick follow-up on the second half and your cash flow outlook there. It sounds like you might be looking for a better free cash flow number. Obviously, a deferred tax change in Q2 was a big -- it was probably one of the biggest items affecting operating cash. Kind of -- or just go over some of the assumptions you see in some of the major lines that affect the cash flow, and how we might get to a much more positive number in H2. Thanks.

Yes. The [inaudible] is a continuing -- bring down our receivables by a couple of days. DSOs. And the profitability going forward. So as our tax position stabilizes, and the DSOs go down, we throw off some good cash.

And just to remind us on the unbilled, it was 75.3 million in second quarter, do you have their -- I just don't have it in front of me, Ron, what it was in the first quarter?

Um, I don't have that in front of me, but we can get that for you.

Okay. Thanks.

You have a follow-up from Mark Jordan. Please go a ahead with your question.

Good afternoon, again. George, I'd like to ask you what your feeling would be over the nearer term here with you know, potential taking some of the free cash flow that you should be throwing off over the next 6 to 12 months and in lieu of say, making acquisitions, looking at some form of, you know, a share buyback as long as the stock is valued where it is. Right now you're -- you know, you're valued at about .5 times enterprise value to sales, when the industry's at .9 to 1.0, and what is your view of making acquisitions at one-times revenue if you're selling at .5?

I have to find out if I'm allowed to answer that. I have a point of view, but I don't know if I'm allowed to answer that. And that is obviously an option for us. In fact, we talked about that at our -- at the board of directors level. But please excuse me, I don't know if I'm allowed to respond to you, other than that's something we have actively considered, too.

We look forward to whatever you can share in the future on that topic.

If I may, sir, can I talk to our lawyers and may I call you back?

Sure.

Okay. Other people might want to know the answer, too. Well, sir, let me find out from -- if I can talk to you first, and then I'll get the information out to everyone.

Thank you.

But it's obviously -- it's obviously a good idea.

Yeah.

From my point of view it sure is.

Yeah.

There are no further questions at this time. Thank you for participating in today's conference call. This call will be available for replay beginning around 9 o'clock p.m. this evening, and will remain available throughout midnight, August 31st. To access the replay, call 1-800-642-1687 or 706-645-9291. Confirmation code for the replay is 8498430. The replay will also be available on ManTech's website approximately 2 hours after the conclusion of the call. This concludes our conference call for today. Thank you for participating.