UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2012
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file numbers 001-14141 and 333-46983
L-3 COMMUNICATIONS HOLDINGS, INC.
L-3 COMMUNICATIONS CORPORATION
(Exact names of registrants as specified in their charters)
Delaware | 13-3937434 and 13-3937436 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification Nos.) | |
600 Third Avenue, New York, NY | 10016 | |
(Address of principal executive offices) | (Zip Code) |
(212) 697-1111
(Telephone number)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class | Name of each exchange on which registered: | |
L-3 Communications Holdings, Inc. |
New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check mark if the registrants are well-known seasoned issuers, as defined in Rule 405 of the Securities Act. | x Yes ¨ No | |
Indicate by check mark if the registrants are not required to file reports pursuant to Section 13 or Section 15(d) of the Act. | ¨ Yes x No |
Indicate by check mark whether the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrants have submitted electronically and posted on their corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrants were required to submit and post such files). x Yes ¨ No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant L-3 Communications Holdings, Inc. is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x |
Accelerated filer ¨ |
Non-accelerated filer ¨ |
Smaller reporting company ¨ | |||
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant L-3 Communications Corporation is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ |
Accelerated filer ¨ |
Non-accelerated filer x |
Smaller reporting company ¨ | |||
(Do not check if a smaller reporting company) |
Indicate by check mark whether the registrants are shell companies (as defined in Rule 12b-2 of the Act). ¨ Yes x No
The aggregate market value of the L-3 Communications Holdings, Inc. voting stock held by non-affiliates of the Registrants as of June 29, 2012 was approximately $7.1 billion. For purposes of this calculation, the Registrants have assumed that their directors and executive officers are affiliates.
There were 89,897,127 shares of L-3 Communications Holdings, Inc. common stock with a par value of $0.01 outstanding as of the close of business on February 21, 2013.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive proxy statement to be filed with the Securities and Exchange Commission (SEC) pursuant to Regulation 14A relating to the Registrants Annual Meeting of Shareholders, to be held on April 30, 2013, will be incorporated by reference in this Form 10-K in response to Items 10,11,12,13 and 14 of Part III. The definitive proxy statement will be filed with the SEC no later than 120 days after the registrants fiscal year ended December 31, 2012.
L-3 COMMUNICATIONS HOLDINGS, INC.
L-3 COMMUNICATIONS CORPORATION
INDEX TO ANNUAL REPORT ON FORM 10-K
For the Year Ended December 31, 2012
PART I
For convenience purposes in this filing on Form 10-K, L-3 Holdings refers to L-3 Communications Holdings, Inc., and L-3 Communications refers to L-3 Communications Corporation, a wholly-owned operating subsidiary of L-3 Holdings. L-3, we, us and our refer to L-3 Holdings and its subsidiaries, including L-3 Communications.
Overview
L-3 Holdings, a Delaware corporation organized in April 1997, derives all of its operating income and cash flows from its wholly-owned subsidiary, L-3 Communications. L-3 Communications, a Delaware corporation, is a prime contractor in Intelligence, Surveillance and Reconnaissance (ISR) systems, Command, Control, Communications (C3) systems, aircraft modernization and sustainment of aircraft, maritime vessels and ground vehicles, and national security solutions. L-3 is also a leading provider of a broad range of electronic systems used on military and commercial platforms. Our customers include the United States (U.S.) Department of Defense (DoD) and its prime contractors, U.S. Government intelligence agencies, the U.S. Department of Homeland Security (DHS), U.S. Department of State (DoS), allied foreign governments, and domestic and foreign commercial customers.
We have four reportable segments: (1) Electronic Systems, (2) C3ISR, (3) Aircraft Modernization and Maintenance (AM&M), and (4) National Security Solutions (NSS). Financial information for our segments, including sales by geographic area, is included in Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations and in Note 22 to our audited consolidated financial statements.
On July 17, 2012, L-3 completed the spin-off of its subsidiary, Engility Holdings, Inc. (Engility), to its shareholders. As a result of the spin-off, the assets, liabilities, non-controlling interest, results of operations and cash flows of the Engility businesses have been classified as discontinued operations for all periods presented. References to financial data are to L-3s continuing operations, unless specifically noted. Engility had sales of $911 million for the January 1 through July 17, 2012 period and $2,011 million and $2,290 million for the years ended December 31, 2011 and 2010, respectively. See Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Overview and Outlook 2012 Events for additional information.
For the year ended December 31, 2012, we generated sales of $13,146 million, operating income of $1,351 million and net cash from operating activities from continuing operations of $1,231 million. The table below presents a summary of our 2012 sales by major category of end customer. For a more detailed presentation of our sales by end customer, see Major Customers within this Business section.
2012 Sales | % of Total Sales |
|||||||
(in millions) | ||||||||
DoD |
$ | 9,376 | 71 | % | ||||
Other U.S. Government |
650 | 5 | ||||||
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|
|
|||||
Total U.S. Government |
$ | 10,026 | 76 | % | ||||
Foreign governments |
1,463 | 11 | ||||||
Commercial foreign |
985 | 8 | ||||||
Commercial domestic |
672 | 5 | ||||||
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|
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Total sales |
$ | 13,146 | 100 | % | ||||
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1
Business Strategy
Our business strategy is customer-focused and aims to increase shareholder value by expanding our strong positions in C3ISR, electronic systems and aircraft modernization and maintenance by leveraging our customer relationships and pursuing adjacent market opportunities. We intend to gain market share with innovative and affordable solutions, collaboration across L-3 and demonstrated past performance that address customer imperatives. We will continue shifting our business portfolio to emphasize products, systems and proprietary services. Our spin-off Engility and the acquisitions of the Kollmorgen Electro-Optical business (named L-3 KEO) and the commercial aircraft simulation business from Thales Group (named Link Simulation & Training U.K. Limited (Link U.K.)) completed in 2012 are examples of this element of our strategy. Financially, our emphasis is on growing earnings and cash flow per share. Our strategy involves a flexible and balanced combination of organic growth, cost reductions, and select business acquisitions and divestitures, enabling us to grow the company and also return cash to our shareholders in a balanced and disciplined manner. Our strategy includes the elements discussed below.
Maintain an Entrepreneurial, Accountable and Results-Driven Culture. A key part of L-3s strategy is our entrepreneurial, accountable, and results-driven culture that is focused on meeting our customers needs and on achieving L-3s strategic goals and growth objectives. L-3s culture is made up of diverse people providing creative solutions and ideas in an environment that fosters teamwork and collaboration across our business units. Operating with integrity and a commitment to the highest standards of ethical conduct is an important part of our strategy to build and maintain the trust of our customers, shareholders, employees, suppliers and communities where we live and work.
Strengthen and Expand Our Market Positions. We intend to use our existing prime contractor and supplier positions and internal investments to increase our market share and grow our sales organically. We intend to expand our prime contractor roles in select business areas where we have domain expertise, including C3ISR and aircraft modernization and maintenance. We expect to benefit from and expand our supplier positions to multiple bidders by leveraging our customer relationships and pursuing adjacent market opportunities. As an independent supplier of a broad range of products, subsystems and systems in several key business areas, our growth will partially be driven by expanding our share of existing programs and participating in new programs. Teaming arrangements with other prime contractors and platform original equipment manufacturers is one way we intend to pursue select new business opportunities. We plan to maintain our diversified and broad business mix with limited reliance on any single contract, follow-on or new business opportunity. While sales to the U.S. Government, especially the DoD, will remain an integral part of L-3s business, we also intend to continue to increase our sales from commercial and international businesses. We expect to continue to supplement our organic sales growth by acquiring, on a select basis, businesses that add new products, technologies, programs and contracts, or provide access to select DoD or non-DoD customers and provide attractive returns on investment.
Collaborate to Increase Growth Opportunities. We intend to deepen the collaboration among our diversified businesses to develop new business opportunities, combine our leading technologies and deliver the right solutions to our customers quickly. We expect that our core strengths of agility, responsiveness and cost-effectiveness will allow us to continue to provide exceptional performance to our customers. We intend to continue our shift from a black box provider to a complete solutions provider.
Leverage Our Excellent Customer Relationships. We will maintain, strengthen, and expand our customer relationships by identifying opportunities to use our customer relationships and leverage the capabilities of our various businesses, including proprietary technologies, to expand the scope of our products to existing and new customers. We will also continue to align our products, services, internal investments in research and development and business development activities to proactively address customer priorities and requirements and invest in growth areas such as C3ISR, sensor systems, special operations, cyber security and intelligence support.
2
Proactively Manage our Cost Structure and Optimize our Business Portfolio. We intend to continue to aggressively improve and reduce our direct contract costs and overhead costs, including general and administrative costs. Our effective management of labor, material, subcontractor and other direct costs is an important element of cost control and favorable contract performance. We believe that proactively re-sizing our businesses to their anticipated sales, combined with continuous cost improvement will enable us to increase our cost competitiveness, and to selectively invest in new product development, bids and proposals and other business development activities to increase our market share.
Achieve Outstanding Program Performance. We believe that outstanding performance on our existing programs and contracts in terms of on-budget, on-schedule and satisfying and exceeding technical and other contractual performance requirements, is the foundation for expanding L-3s prime contractor and supplier positions and growing market share. We believe that a prerequisite for growing and winning new business is to retain our existing business by successfully meeting the performance criteria included in our existing contracts. We will continue to focus on delivering superior contract performance with affordable prices to our customers in order to maintain our reputation as an agile and responsive contractor and to differentiate ourselves from our competitors.
Attract and Retain Skilled Personnel. The success of our businesses is, to a large extent, dependent upon the knowledge and skills of our employees. We intend to continue to attract and retain employees who have management, contracting, engineering and technical skills and who have U.S. Government security clearances, particularly those with clearances of top-secret and above.
Business Acquisitions and Divestitures
During the years ended December 31, 2012, 2011 and 2010, we used net cash of $348 million, $20 million and $756 million for business acquisitions, respectively. As discussed above, we completed the spin-off of our subsidiary, Engility, to our shareholders on July 17, 2012. See Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Business Acquisitions and Divestitures for additional information regarding our business acquisitions and divestitures, including the spin-off of Engility.
Products and Services
Our four reportable segments provide a wide range of products and services to various customers and are described below. See Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Reportable Segment Results of Operations and Note 22 to our audited consolidated financial statements for financial information about each segment.
3
Electronic Systems Reportable Segment
In 2012, Electronic Systems net sales of $5,677 million represented 43% of our total net sales. The businesses in this reportable segment provide a broad range of products and services, including components, products, subsystems, systems and related services to military and commercial customers in several niche markets. The table below provides a summary of the segments business areas and the percentage that each contributed to Electronic Systems net sales in 2012.
Business Area |
% of 2012 Segment Sales |
|||
Microwave |
19 | % | ||
Power & Control Systems |
15 | |||
Sensor Systems |
15 | |||
Simulation & Training |
11 | |||
Aviation Products |
9 | |||
Precision Engagement |
8 | |||
Warrior Systems |
7 | |||
Security & Detection |
6 | |||
Space & Propulsion |
5 | |||
Undersea Warfare |
3 | |||
Marine Services |
2 | |||
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|
|||
Total Electronic Systems |
100 | % | ||
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The table below provides additional information for the systems, products, and services selected applications and selected platforms or end users of our Electronic Systems reportable segment.
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
Microwave | ||||
Passive and active microwave components and subsystems and non-ionizing radiation monitoring equipment |
Radio transmission, switching and conditioning, transponder control, channel and frequency separation, ground vehicles, aircraft and satellites |
DoD and original equipment manufacturers (OEMs), Satellite Communications (SATCOM) for DoD and various government agencies | ||
Traveling wave tubes, power modules, klystrons and digital broadcast |
Microwave vacuum electron devices and power modules |
DoD and allied foreign military manned/unmanned platforms, various missile programs and commercial broadcast | ||
Quick-deploy flyaway very small aperture terminals (VSAT) and vehicular satellite systems |
Satellite communication systems |
U.S. Army, U.S Air Force (USAF) and various DoD agencies | ||
High dynamic small aperture Ku/Ka-band receive/transmit systems |
Off road use on military vehicles, watercraft, and airborne platforms to provide two-way broadband connectivity while on the move |
U.S. Army and various DoD agencies | ||
Tactical ground based signal intercept and direction finding systems |
Man portable and military vehicle mounted tactical signal intercept/exploitation and direction finding systems |
U.S. Army and other DoD/U.S. intelligence agencies |
4
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
Managed satellite networks and integrated remote VSAT satellite systems |
Deployment and support of global communication networks for tactical and enterprise applications |
U.S. Army, DoD/U.S. intelligence agencies, allied forces and commercial contractors | ||
Spread spectrum & time division multiple access modems that support ultra-high frequency (UHF) using Ka band operation |
On the move SATCOM and other tactical communications systems utilizing small aperture terminals |
U.S. military and various international allied military and special forces customers | ||
Ultra-wide frequency and advanced radar antennas and radomes |
Surveillance and radar detection |
Military fixed and rotary winged aircraft, SATCOM | ||
Telemetry and instrumentation systems |
Spacecraft telemetry tracking and control, encryption and high data rate transmitters, satellite command and control software, airborne and ground test telemetry systems, and tactical intelligence receivers |
Aircraft, missiles and satellites | ||
Power & Control Systems | ||||
Integrated electrical power and electric propulsion packages, integrated automation, navigation, communication, and dynamic positioning systems, and audio/visual solutions and safety systems |
Surface ships ranging from shipping vessels, container carriers, environmental, research and offshore construction ships, naval frigates, ferries, cruise liners and mega yachts |
Commercial shipbuilders and shipowners and allied foreign navies | ||
Naval power delivery, conversion and switching products, and hybrid electric drives |
Switching, distribution and protection, frequency and voltage conversion, propulsion motors and drive units |
Naval submarines, surface ships and aircraft carriers | ||
Automation, navigation, communications, and sensors and integrated Command, Control, Communications, Computers and Navigation (C4N) solutions |
Vessel bridge and machinery plant platform management systems, and C4N systems |
U.S. Navy (USN) and allied foreign navies and other government agencies | ||
Power plant simulation, modeling, computer systems, and training services |
Submarines, nuclear and other power plants |
Allied foreign navies, nuclear and other power plant companies |
5
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
Sensor Systems | ||||
Targeted stabilized camera systems with integrated sensors and wireless communication systems |
Intelligence data collection and surveillance and reconnaissance |
DoD, intelligence and security agencies, law enforcement, manned/unmanned platforms | ||
Submarine photonic systems and periscopes |
Virginia class submarines |
USN | ||
Airborne and ground based high energy laser beam directors, laser designators and high tracking rate telescopes |
Directed energy systems, space surveillance, satellite laser ranging and laser communications, airborne and ground target designation/illumination |
USAF and NASA | ||
Simulation & Training | ||||
Military and commercial aircraft flight simulators, reconfigurable training devices, distributed mission training suites |
Advanced simulation technologies and training for pilots, navigators, flight engineers, gunners and operators |
Fixed and rotary winged aircraft and ground vehicles for USAF, USN, U.S. Army, Canadian Department of National Defense (DND), allied foreign militaries, commercial airlines and aircraft OEMs | ||
Training services, courseware integrated logistics support and maintenance |
Systems management, operations, and maintenance |
Various DoD and allied foreign military customers | ||
Aviation Products | ||||
Solid state crash protected cockpit voice and flight data recorders |
Aircraft voice and flight data recorders that continuously record voice and sounds from cockpit and aircraft intercommunications |
Commercial transport, business, regional and military aircraft | ||
Airborne traffic and collision avoidance systems, terrain awareness warning systems |
Reduce the potential for midair aircraft collisions and crashes into terrain by providing visual and audible warnings and maneuvering instructions to pilots |
Commercial transport, business, regional and military aircraft | ||
Advanced cockpit avionics |
Pilot safety, navigation and situation awareness products |
Commercial transport, business, regional and military aircraft |
6
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
Cockpit and mission displays |
High performance, ruggedized flat panel and cathode ray tube displays and processors |
Various military aircraft | ||
Precision Engagement | ||||
Unmanned systems and components |
Tactical unmanned air systems (UAS), medium altitude long endurance (MALE) UAS, small expendable UAS, flight controls, sensors and remote viewing systems |
U.S. DoD and allied foreign ministries of defense | ||
Global Positioning System (GPS) receivers |
Location tracking |
Guided projectiles and precision munitions | ||
Fuzing and ordnance systems |
Precision munitions, fuzes, and electronic and electro safety arming devices (ESADs) |
Various DoD and allied foreign military customers | ||
Remote viewing video and exploitation systems |
Portable situational awareness and video exploitation software and hardware for soldiers, ships and vehicles |
U.S Marine Corps (USMC), USN and various DoD | ||
Lightweight man portable computer/displays for dismounted soldiers |
Situational awareness and connectivity for dismounted soldiers |
United Kingdom Ministry of Defense (U.K. MoD) | ||
Improvised Explosive Device (IED) Defense Systems |
Vehicle based and manpack IED detection and jamming systems |
U.K. MoD and international allies | ||
Force protection, electronic warfare and satellite monitoring |
Counter improvised explosive device (IED) systems, jamming and satellite monitoring |
U.K. MoD and other international security agencies and ministries of defense | ||
Warrior Systems | ||||
Enhanced vision and weapon sights products |
Image intensified night vision goggles/sights, holographic weapon sights, thermal sights and images, and driver viewers for special forces, pilots and aircrews, soldiers, marines, sailors and law enforcement personnel |
U.S. Army, USN, USMC, DHS, allied foreign militaries and law enforcement agencies | ||
Weapons Training Systems |
Laser marksmanship training systems and advanced integrated technologies for security products and services |
DoD and law enforcement agencies |
7
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
Laser designation and range finder systems |
Airborne and ground target designation/illumination |
DoD, law enforcement and allied foreign customers | ||
Security & Detection | ||||
Airport security systems, explosives detection systems and whole body imaging systems |
Rapid scanning of passenger checked baggage and carry-on luggage, scanning of large cargo containers |
DHS, including the U.S. Transportation and Security Administration (TSA), domestic and international airports and state and local governments | ||
Non-invasive security systems and portals, and sophisticated sensors with threat detection capabilities |
Aviation, rail and border crossing security |
TSA, U.S. Customs and Border Protection agency, various regulatory authorities and private security companies | ||
Space & Propulsion | ||||
Navigation systems and positioning navigation units |
Satellite launch and orbiting navigation and navigation for ground vehicles and fire control systems |
USAF, U.S. Army, USMC and NASA | ||
Ballistic missile targets |
Targets for ground based ballistic missile intercept systems |
U.S. Missile Defense Agency | ||
Heavy fuel engines, cross drive variable transmissions, turret drive systems, vehicle suspension, advanced drive systems and auxiliary power generators |
Power trains and suspension systems for military vehicles, power and energy management for military hybrid electric vehicles, non-portable and under armor auxiliary power units, and heavy fueled engines for unmanned systems |
U.S. Army, USMC and allied foreign ministries of defense, manned/unmanned military platforms | ||
High power microwave sources, systems & effects, pulse power systems and electromagnetics hardened construction |
Forensic analysis of weapons of mass destruction, active detection of special nuclear material and irradiation systems for decontamination and industrial applications |
U.K. MoD, U.S. Defense Threat Reduction Agency, U.S. Army and USAF | ||
Undersea Warfare | ||||
Airborne dipping sonars, submarine and surface ship towed arrays |
Submarine and surface ship detection and localization |
USN and allied foreign navies |
8
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
Underwater sensor ranges |
Monitor nuclear testing, track submarines and surface vessels |
U.S. and foreign military and commercial customers | ||
Marine Services | ||||
Service life extensions |
Landing craft air cushion amphibious vehicle |
USN | ||
In-service engineering, ship repair, overhaul, upgrades and maintenance, and battle force tactical training |
Embedded shipboard training systems, towed arrays, navigation systems, radar systems and electronic warfare systems |
USN, U.S. Coast Guard (USCG), U.S. Army and commercial shipowners |
C3ISR Reportable Segment
In 2012, C3ISR net sales of $3,601 million represented 27% of our total net sales. The businesses in this segment provide products and services for the global ISR market, specializing in signals intelligence (SIGINT) and communications intelligence (COMINT) systems. These products and services provide the warfighter the unique ability to collect and analyze data from command centers, communication nodes and air defense systems for real-time situational awareness and response. The businesses in this reportable segment also provide C3 systems, networked communications systems and secure communications products for military and other U.S. Government and allied foreign government intelligence, reconnaissance and surveillance applications. We believe that these products and services are critical elements for a substantial number of major command, control and communication, intelligence gathering and space systems. These products and services are used to connect a variety of airborne, space, ground and sea-based communication systems and are used in the transmission, processing, recording, monitoring, and dissemination functions of these communication systems. Major products and services for this reportable segment include:
| highly specialized fleet management sustainment and support services, including procurement, systems integration, sensor development, modifications and periodic depot maintenance for ISR and special mission aircraft and airborne systems; |
| strategic and tactical SIGINT systems that detect, collect, identify, analyze and disseminate information; |
| secure data links that enable real-time information collection and dissemination to users of networked communications for airborne, satellite, ground and sea-based remote platforms, both manned and unmanned; |
| secure terminal and communication network equipment and encryption management; and |
| communication systems for surface and undersea vessels and manned space flights. |
9
The table below provides additional information for the systems, products and services, selected applications and selected platforms or end users of our C3ISR reportable segment.
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
ISR Systems | ||||
Prime mission systems integration, sensor development and operations and support |
Signal processing, airborne (SIGINT) applications, antenna technology, real-time process control and software development |
USAF, U.K MoD, and other allied foreign military ISR aircraft platforms and ground systems | ||
Fleet management of special mission aircraft, including avionics and mission system upgrades and logistics support |
Measurement collection and signal intelligence, special missions |
DoD and classified customers within the U.S. Government | ||
ISR operations and support |
Data link support and services, special applications, classified projects, spares and repairs |
USAF and U.S. Army ISR aircraft platforms and ground systems | ||
Networked Communications | ||||
Airborne, space and surface data link terminals, ground stations, and transportable tactical SATCOM systems |
High performance, wideband secure communication links for relaying of intelligence and reconnaissance information |
Manned aircraft, unmanned aerial vehicles (UAVs), naval ships, ground vehicles and satellites for the DoD | ||
Multi-band Manpack Receivers |
Portable, ruggedized terminals used for receiving reconnaissance video and sensor data from multiple airborne platforms |
U.S. Special Operations Command (USSOCOM), USAF and other DoD customers | ||
Secure Communications Products | ||||
Secure communication terminals and equipment, and secure network encryption products |
Secure and non-secure voice, data and video communication for office, battlefield and secure internet protocol (IP) network applications |
DoD and U.S. Government intelligence agencies | ||
Ground-based satellite communication terminals and payloads |
Interoperable, transportable ground terminals |
DoD and U.S. Government intelligence agencies | ||
Shipboard communications systems |
Internal and external communications (radio rooms) |
USN, USCG and allied foreign navies |
10
Aircraft Modernization and Maintenance (AM&M) Reportable Segment
In 2012, AM&M net sales of $2,483 million represented 19% of our total net sales. The businesses in this segment provide modernization, upgrades and sustainment, maintenance and logistics support services for military and various government aircraft and other platforms, including ground vehicles. We sell these services primarily to the DoD, the Canadian DND and other allied foreign governments. Major products and services for this reportable segment include:
| engineering, modification, maintenance, logistics and upgrades for aircraft, ground vehicles and personnel equipment; |
| turnkey aviation life cycle management services that integrate custom developed and commercial off-the-shelf products for various military fixed and rotary wing aircraft, including heavy maintenance and structural modifications and interior modifications and construction; and |
| aerospace and other technical services related to large fleet support, such as aircraft and vehicle modernization, maintenance, repair and overhaul, logistics, support and supply chain management, primarily for military training, tactical, cargo and utility aircraft. |
The table below provides additional information for the systems, products and services, selected applications and selected platforms or end users of our AM&M reportable segment.
Systems/Products/Services |
Selected Applications |
Selected Platforms/End Users | ||
Aircraft and Base Support Services | ||||
Logistics support, maintenance and refurbishment |
Aircraft maintenance repair and overhaul, flight operations support for training, cargo and special mission aircraft |
U.S. Army, USAF, USN, Canadian DND and other allied foreign militaries | ||
Contract Field Teams (CFT) |
Deployment of highly mobile, quick response field teams to customer locations to supplement the customers resources for various ground vehicles and aircraft |
U.S. Army, USAF, USN and USMC | ||
Contractor Operated and Managed Base Supply (COMBS) |
Inventory management activities relating to flight support and maintenance, including procurement and field distribution |
Military training and cargo aircraft | ||
Aircraft Modernization | ||||
Modernization and life extension maintenance upgrades and support |
Aircraft structural modifications and inspections, installation of mission equipment, navigation and avionics products, interior modifications |
USN, USAF, Canadian DND, Royal Australian Air Force, other allied foreign governments, OEMs, very important person and head of state aircraft, and various military fixed and rotary wing aircraft | ||
Fabrication and assembly of fixed and rotary wing aeronautical structures |
Rotary wing cabin assemblies, new and modified wings and subassemblies, and parts fabrication for OEMs |
U.S. Army, USN, USMC, Canadian DND and OEMs |
11
National Security Solutions (NSS) Reportable Segment
In 2012, NSS net sales of $1,385 million represented 11% of our total net sales. The businesses in this segment provide full-spectrum cyber operations support, enterprise and mission IT solutions, intelligence operations support, and operational infrastructure solutions to the DoD, U.S. Government intelligence agencies, federal civilian agencies and allied foreign governments. Major services, solutions and systems for this reportable segment include:
| providing solutions and systems for secure communications, information systems networks and mobile devices and ensuring the integrity of information to enable trusted, interconnected, and resilient networks; |
| providing operational enterprise IT solutions that help keep our customers relevant in their dynamic mission environment; |
| developing solutions and systems for our customers that enable available data to be used more effectively to provide assessments, gain and maintain situation awareness, support decision-making, improve operations, and bring about customers desired effects; |
| supporting intelligence collection, tasking, exploitation, analysis, dissemination, training, situational awareness, visualization, normalization, minimization and outcome assurance; and |
| developing next-generation solutions and systems that help our customers solve operational, informational, and physical security challenges that can place facilities, infrastructure, installations, borders and perimeters, and transportation environments at risk. |
The table below provides additional information for the systems, products and services, selected applications and selected platforms or end users of our NSS reportable segment.
Solutions/Systems/Services |
Selected Applications/Capabilities |
Selected End Users | ||
Full-Spectrum Cyber Operations Support |
High-performance computing, dynamic network protection, advanced forensics and exploitation, modeling, simulation and wargaming, cloud and mobile security, and network virtualization |
USAF, U.S. Government intelligence agencies, US Combatant Commands and Defense Information Systems Agency | ||
Enterprise and Mission IT |
Enterprise architecture and systems engineering, systems integration and development, operations and maintenance (O&M) transformations for efficiencies and cost reductions, performance-based managed services, agile software engineering and development, space communications and launch support |
U.S. Army, USAF, U.S. Navy, USSOCOM, U.S. Government intelligence agencies, UK MoD, Department of the Interior, DoS, NASA, and state and local government agencies |
12
Solutions/Systems/Services |
Selected Applications/Capabilities |
Selected End Users | ||
Intelligence Operations Support |
Data fusion and analytics, visualization and decision-making, training and workforce development, mission engineering and operations support, mission-essential staffing and knowledge management |
U.S. Army, USAF, USN, U.S. Combatant Commands, DoS, U.S. Government intelligence agencies, and UK MoD | ||
Operational Infrastructure Support |
Risk, threat and vulnerability assessment, complex systems architecture, enterprise-level command and control systems, intelligent surveillance, logistics and integrated sustainment, and surveillance, detection and response systems |
USAF, USN, U.S. Missile Defense Agency, U.S. Strategic Command, DHS, National Oceanic and Atmospheric Administration (NOAA), and foreign governments |
Funded Backlog and Orders
We define funded backlog as the value of funded orders received from customers, less the cumulative amount of sales recognized on such orders. We define funded orders as the value of contract awards received from the U.S. Government, for which the U.S. Government has appropriated funds, plus the value of contract awards and orders received from customers other than the U.S. Government. The table below presents our funded backlog, percentage of funded backlog at December 31, 2012 expected to be recorded as sales in 2013 and funded orders for each of our reportable segments and on a consolidated basis.
Funded Backlog at December 31, |
Percentage of Funded Backlog at December 31, 2012 Expected to be Recorded as Sales in 2013 |
Funded Orders | ||||||||||||||||||
2012 | 2011 | 2012 | 2011 | |||||||||||||||||
(in millions) | (in millions) | |||||||||||||||||||
Reportable Segment: |
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Electronic Systems |
$ | 5,070 | $ | 4,672 | 63% | $ | 5,745 | $ | 5,326 | |||||||||||
C3ISR |
2,936 | 2,831 | 67% | 3,706 | 3,779 | |||||||||||||||
AM&M |
2,168 | 1,731 | 60% | 2,916 | 2,296 | |||||||||||||||
NSS |
710 | 665 | 82% | 1,431 | 1,490 | |||||||||||||||
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Consolidated |
$ | 10,884 | $ | 9,899 | 65% | $ | 13,798 | $ | 12,891 | |||||||||||
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Our funded backlog does not include the full potential value of our contract awards, including those pertaining to multi-year, cost-plus type contracts, which are generally funded on an annual basis. Funded backlog also excludes the potential future orders and related sales from unexercised priced contract options that may be exercised by customers under existing contracts and the potential future orders and related sales of purchase orders that we may receive in the future under indefinite quantity contracts or basic ordering agreements during the term of such agreements.
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Major Customers
The table below presents a summary of our 2012 sales by end customer and the percent contributed by each to our total 2012 sales. For additional information regarding domestic and foreign sales, see Note 22 to our audited consolidated financial statements.
2012 Sales | % of Total Sales |
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(in millions) | ||||||||
Air Force |
$ | 3,599 | 27 | % | ||||
Army |
2,824 | 22 | ||||||
Navy/Marines |
1,897 | 14 | ||||||
Other Defense |
1,056 | 8 | ||||||
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Total DoD |
$ | 9,376 | 71 | % | ||||
Other U.S. Government |
650 | 5 | ||||||
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Total U.S. Government |
$ | 10,026 | 76 | % | ||||
Foreign governments |
1,463 | 11 | ||||||
Commercial foreign |
985 | 8 | ||||||
Commercial domestic |
672 | 5 | ||||||
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Total sales |
$ | 13,146 | 100 | % | ||||
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Direct sales to the end customer represent approximately 67% of our consolidated sales, and we are a subcontractor or supplier for the remaining 33%. Additionally, approximately 69% of our DoD sales for 2012 were direct to the customer, and approximately 31% were indirect through other prime system contractors and subcontractors of the DoD.
Our sales are predominantly derived from contracts with agencies of, and prime system contractors to, the U.S. Government. Various U.S. Government agencies and contracting entities exercise independent and individual purchasing decisions, subject to annual appropriations by the U.S. Congress. For the year ended December 31, 2012, our five largest contracts generated 13% of our consolidated sales and our largest contract (revenue arrangement) in terms of annual sales was the Fort Rucker Maintenance Support contract with the U.S. Army Aviation and Missile Life Cycle Management Command (AMCOM), which is included in our AM&M segment. Under this contract, which generated approximately 4% of our 2012 sales, we provide maintenance, logistics and other related sustainment support services for rotary wing aircraft assigned to Fort Rucker and satellite units in Alabama. On July 24, 2012, we won the AMCOM contract re-competition, which includes a one-year base period through September 30, 2013, and four one-year options, with an estimated total contract value of $1.98 billion.
Research and Development
We conduct research and development activities that consist of projects involving applied research, new product and systems development and select concept studies. We employ scientific, engineering and other personnel to improve our existing product-lines and systems and develop new products, technologies, and systems. As of December 31, 2012, we employed approximately 12,000 engineers, a substantial portion of whom hold advanced degrees, and who work on company-sponsored research and development efforts and customer funded research and development contracts.
Company-sponsored (Independent) research and development costs for our businesses that are U.S. Government contractors are allocated to U.S. Government contracts and are charged to cost of sales when the related sales are recognized as revenue. Research and development costs for our commercial businesses are
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expensed as incurred and are also charged to cost of sales. The table below presents company-sponsored (Independent) research and development expenses incurred for the years ended December 31, 2012, 2011 and 2010 for our U.S. Government businesses and our commercial businesses.
Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
(in millions) | ||||||||||||
Company-Sponsored Research and Development Costs: |
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U.S. Government Contractor Businesses |
$ | 196 | $ | 194 | $ | 186 | ||||||
Commercial Businesses |
88 | 85 | 80 | |||||||||
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Total |
$ | 284 | $ | 279 | $ | 266 | ||||||
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Customer-funded research and development costs pursuant to contracts (revenue arrangements) are not included in the table above because they are direct contract costs and are charged to cost of sales when the corresponding revenue is recognized. See Note 2 to our audited consolidated financial statements for additional information regarding research and development.
Competition
Our businesses generally encounter significant competition. We believe that we are a major provider for many of the products and services we offer to our DoD, government and commercial customers.
Our ability to compete for existing and new business depends on a variety of factors, including:
| the effectiveness and innovation of our technologies, systems and research and development programs; |
| our ability to offer better program performance at an affordable and competitive cost; |
| historical technical, cost and schedule performance; |
| our ability to attain supplier positions on contracts; |
| our ability to maintain an effective supplier and vendor base; |
| our ability to retain our employees and hire new ones, particularly those who have U.S. Government security clearances; |
| the capabilities of our facilities, equipment and personnel to undertake the business for which we compete; and |
| our ability to quickly and flexibly meet customer requirements and priorities. |
L-3 is a defense supplier with a broad and diverse portfolio of products and services. We are primarily a non-platform prime contractor and have diverse subcontractor positions. We supply our products and services to other prime system contractors. However, we also compete directly with other large prime system contractors for: (1) certain products, subsystems and systems, where they have vertically integrated businesses and (2) niche areas where we are a prime contractor. We also compete with numerous other aerospace, defense and government technical services contractors, which generally provide similar products, subsystems, systems or services.
In addition, our ability to compete for select contracts may require us to team with one or more of the other prime system contractors that bid and compete for major platform programs, and our ability to team with them is often dependent upon the outcome of a competition for subcontracts they award.
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Patents and Licenses
Generally, we do not believe that our patents, trademarks and licenses are material to our operations. Furthermore, most of our U.S. Government contracts generally permit us to use patents owned by other U.S. Government contractors. Similar provisions in U.S. Government contracts awarded to other companies make it impossible for us to prevent the use of our patents in most DoD work performed by other companies for the U.S. Government.
Raw Materials
Generally, our businesses engage in limited manufacturing activities and have minimal exposure to fluctuations in the supply of raw materials. L-3s business mix is approximately 43% services work, and for those businesses that sell hardware and product, most of the value that we provide is labor oriented, such as design, engineering, assembly and test activities. In manufacturing our products, we use our own production capabilities as well as a diverse base of third party suppliers and subcontractors. Although certain aspects of our manufacturing activities require relatively scarce raw materials, we have not experienced difficulty in our ability to procure raw materials, components, sub-assemblies and other supplies required in our manufacturing processes.
Contracts
Generally, the sales price arrangements for our contracts are either fixed-price, cost-plus or time-and-material type. Generally, a fixed-price type contract offers higher profit margin potential than a cost-plus type or time-and-material type contract, which is commensurate with the greater levels of risk we assume on a fixed-price type contract.
On a fixed-price type contract (revenue arrangement), we agree to perform the contractual statement of work for a predetermined sales price. Although a fixed-price type contract generally permits us to retain profits if the total actual contract costs are less than the estimated contract costs, we bear the risk that increased or unexpected costs may reduce our profit or cause us to sustain losses on the contract. Accounting for the sales on a fixed-price type contract that is covered by contract accounting standards requires the preparation of estimates for: (1) the total contract revenue, (2) the total costs at completion, which is equal to the sum of the actual incurred costs to date on the contract and the estimated costs to complete the contracts statement of work, and (3) the measurement of progress towards completion. Adjustments to original estimates for a contracts revenue, estimated costs at completion and estimated total profit or loss are often required as work progresses under a contract, as experience is gained and as more information is obtained, even though the scope of work required under the contract may not change.
On a cost-plus type contract (revenue arrangement), we are paid our allowable incurred costs plus a profit which can be fixed or variable depending on the contracts fee arrangement up to predetermined funding levels determined by our customers. Cost-plus type contracts with award and incentive fee provisions are our primary variable contract fee arrangement. Award fees provide for a fee based on actual performance relative to contractually specified performance criteria. Incentive fees provide for a fee based on the relationship which total allowable costs bear to target cost. The tables below present our sales from cost-plus type contracts with award fees and incentive fees and the percentage of available performance-based award fees we achieved.
Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
Sales from Cost-Plus Contracts with: |
(in millions) | |||||||||||
Award fees |
$ | 624 | $ | 664 | $ | 678 | ||||||
Incentive fees |
711 | 842 | 941 | |||||||||
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Performance based fees |
$ | 1,335 | $ | 1,506 | $ | 1,619 | ||||||
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Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
(in millions) | ||||||||||||
Percentage of Available Performance Based Award Fees Achieved |
91 | % | 91 | % | $ | 90 | % |
On a time-and-material type contract (revenue arrangement), we are paid on the basis of direct labor hours expended at specified fixed-price hourly rates (that include wages, overhead, allowable general and administrative expenses and profit) and materials at cost. Therefore, on cost-plus type and time-and-material type contracts we do not bear the risks of unexpected cost overruns, provided that we do not incur costs that exceed the predetermined funded amounts.
Substantially all of our cost-plus type contracts and time-and-material type contracts are with U.S. Government customers while sales to commercial customers are transacted under fixed-price sales arrangements and are included in our fixed-price contract-type sales. The table below presents the percentage of our total sales generated from each contract-type for the years ended December 31, 2012, 2011, and 2010.
Contract-Type |
Year Ended December 31, | |||||||||||
2012 | 2011 | 2010 | ||||||||||
Fixed-price |
71% | 69% | 64% | |||||||||
Cost-plus |
24% | 23% | 26% | |||||||||
Time-and-material |
5% | 8% | 10% | |||||||||
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Total sales |
100% | 100% | 100% | |||||||||
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Regulatory Environment
Most of our revenue arrangements with agencies of the U.S. Government, including the DoD, are subject to unique procurement and administrative rules. These rules are based on both laws and regulations, including the U.S. Federal Acquisition Regulation, that: (1) impose various profit and cost controls, (2) regulate the allocations of costs, both direct and indirect, to contracts and (3) provide for the non-reimbursement of unallowable costs. Unallowable costs include, but are not limited to, lobbying expenses, interest expenses and certain costs related to business acquisitions, including, for example, the incremental depreciation and amortization expenses arising from fair value increases to the historical carrying values of acquired assets. Our contract administration and cost accounting policies and practices are also subject to oversight by government inspectors, technical specialists and auditors. See Part I Item 1A Risk Factors for a discussion of certain additional business risks specific to our government contracts.
Our U.S. Government contracts are subject to extensive legal and regulatory requirements and, from time to time, agencies of the U.S. Government investigate whether our operations are being conducted in accordance with these requirements. Investigations could result in administrative, civil, or criminal liabilities, including repayments, disallowance of certain costs, or fines and penalties. As is common in the U.S. defense industry, we are subject to business risks, including changes in the U.S. Governments procurement policies (such as greater emphasis on competitive procurement), governmental appropriations, national defense policies or regulations, service modernization plans, and availability of funds. A reduction in expenditures by the U.S. Government for products and services of the type we manufacture and provide, lower margins resulting from increasingly competitive procurement policies, a reduction in the volume of contracts or subcontracts awarded to us or the incurrence of substantial contract cost overruns could materially adversely affect our business.
Certain of our sales are under foreign military sales (FMS) agreements directly between the U.S. Government and allied foreign governments. In such cases, because we serve only as the supplier, we do not have unilateral control over the terms of the agreements. Certain of our sales are direct commercial sales to allied foreign governments. These sales are subject to U.S. Government approval and licensing under the Arms Export Control Act. Legal restrictions on sales of sensitive U.S. technology also limit the extent to which we can sell our products to allied foreign governments or private parties.
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All of our U.S. Government contracts can be terminated by the U.S. Government either for its convenience or if we default by failing to perform under the contract. Termination for convenience provisions provide only for our recovery of costs incurred or committed settlement expenses and profit on the work completed prior to termination. Termination for default provisions provide for the contractor to be liable for excess costs incurred by the U.S. Government in procuring undelivered items from another source. Our contracts with foreign governments generally contain similar provisions relating to termination at the convenience of the customer.
Environmental Matters
Our operations are subject to various environmental laws and regulations relating to the discharge, storage, treatment, handling, disposal and remediation of certain materials, substances and wastes used in our operations. We continually assess our obligations and compliance with respect to these requirements.
We have also assessed the risk of environmental contamination for our various manufacturing facilities, including our acquired businesses and, where appropriate, have obtained indemnification, either from the sellers of those acquired businesses or through pollution liability insurance. We believe that our current operations are in substantial compliance with all existing applicable environmental laws and permits. We believe our current expenditures will allow us to continue to be in compliance with applicable environmental laws and regulations. While it is difficult to determine the timing and ultimate cost to be incurred in order to comply with these laws, based upon available internal and external assessments, with respect to those environmental loss contingencies of which we are aware, we believe there are no environmental loss contingencies that, individually or in the aggregate, would be material to our consolidated results of operations, financial position or cash flows.
Employees
As of December 31, 2012, we employed approximately 51,000 full-time and part-time employees, 84% of whom were located in the United States. Of these employees, approximately 19% are covered by 177 separate collective bargaining agreements with various labor unions. The success of our business is, to a large extent, dependent upon the knowledge of our employees and on the management, contracting, engineering and technical skills of our employees. In addition, our ability to grow our businesses, obtain additional orders for our products and services and to satisfy contractual obligations under certain of our existing revenue arrangements is largely dependent upon our ability to attract and retain employees who have U.S. Government security clearances, particularly those with clearances of top-secret and above. We believe that relations with our employees are positive.
L-3 Holdings Obligations
The only obligations of L-3 Holdings at December 31, 2012 were: (1) its 3% Convertible Contingent Debt Securities (CODES) due 2035, which were issued by L-3 Holdings on July 29, 2005, (2) its guarantee of borrowings under the revolving credit facility of L-3 Communications and (3) its guarantee of other contractual obligations of L-3 Communications and its subsidiaries. L-3 Holdings obligations relating to the CODES have been jointly, severally, fully and unconditionally guaranteed by L-3 Communications and certain of its wholly-owned domestic subsidiaries. In order to generate the funds necessary to repurchase its common stock and pay dividends declared and principal and interest on its outstanding indebtedness, if any, L-3 Holdings relies on dividends and other payments from its subsidiaries.
Available Information
We are subject to the informational requirements of the Securities Exchange Act of 1934 and, in accordance therewith, file reports, including annual, quarterly and current reports, proxy statements and other information with the SEC. Such reports and other information can be inspected and copied at the Public Reference Room of the SEC located at 100 F Street, N.E., Washington, D.C. 20549. Copies of such material can be obtained from the Public Reference Room of the SEC at prescribed rates. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Such material may also be accessed electronically by means of the SECs home page on the Internet at http://www.sec.gov.
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You may also obtain a free copy of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statement for the annual shareholders meeting, as well as any amendments to those reports as soon as reasonably practicable after electronic filing with the SEC through our website on the Internet at http://www.L-3com.com.
We also have a Corporate Governance webpage. You can access our Corporate Governance Guidelines and charters for the audit, compensation and nominating/corporate governance committees of our Board of Directors through our website, http://www.L-3com.com, by clicking on the Corporate Governance link under the heading Investor Relations. We post our Code of Ethics and Business Conduct on our Code of Ethics webpage under the link Code of Ethics and Business Conduct. Our Code of Ethics and Business Conduct applies to all directors, officers and employees, including our chairman, president and chief executive officer, our senior vice president and chief financial officer, and our vice president, controller and principal accounting officer. We will post any amendments to the Code of Ethics and Business Conduct, and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange, Inc. (NYSE), on our website within the required periods. The information on our website is not incorporated by reference into this report.
To learn more about L-3, please visit our website at http://www.L-3com.com. From time to time we use our website as a channel of distribution of material company information. Financial and other material information regarding L-3 is routinely posted on our website and is readily accessible.
You should carefully consider the following risk factors and other information contained in this Form 10-K, including Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations. Any of these risks could materially affect our business and our financial condition, results of operations and cash flows, which could in turn materially affect the price of our common stock.
Our contracts (revenue arrangements) with U.S. Government customers entail certain risks.
A decline in or a redirection of the U.S. defense budget could result in a material decrease in our sales, results of operations and cash flows.
Our government contracts and sales are highly correlated and dependent upon the U.S. defense budget which is subject to the congressional budget authorization and appropriations process. Congress usually appropriates funds for a given program on a September 30 fiscal year basis, even though contract periods of performance may extend over many years. Consequently, at the beginning of a major program, the contract is usually partially funded, and additional monies are normally committed to the contract by the procuring agency only as appropriations are made by Congress in future fiscal years. DoD budgets are a function of factors beyond our control, including, but not limited to, changes in U.S. procurement policies, budget considerations, current and future economic conditions, presidential administration priorities, changing national security and defense requirements, geopolitical developments and actual fiscal year congressional appropriations for defense budgets. Any of these factors could result in a significant decline in, or redirection of, current and future DoD budgets and impact our future results of operations, including our sales and operating income growth rates.
In August 2011, Congress enacted the Budget Control Act of 2011 (BCA). The BCA imposed spending caps and discretionary spending cuts of approximately $487 billion to DoD base budgets for FY 2012 to FY 2021, compared to previously proposed DoD base budgets. The BCA also triggered an automatic sequestration process, which was originally scheduled to become effective on January 2, 2013, that imposes additional budget cuts to U.S. national security accounts of approximately $490 billion for FY 2013 to FY 2021 and other U.S. Government budget cuts of another $500 billion to discretionary non-national security accounts. The national security spending cuts from sequestration are expected to mostly reduce DoD budgets by equally cutting funding for all DoD budget line items. The American Taxpayer Relief Act, enacted on January 2, 2013, delayed the implementation of the BCA sequestration cuts to March 1, 2013, reduced the sequester cut to the FY 2013 DoD
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budget to approximately $46 billion and increased the sequester cut for FY 2014 to approximately $59 billion. If the sequestration cuts to the DoD budget occur, we expect that they will negatively impact our results of operations and cash flows, and could potentially trigger goodwill impairment charges.
On February 13, 2012, the Obama Administration (Administration) submitted its FY 2013 proposed budget (FY 2013 DoD Plan) to Congress which complies with the first phase of the BCA imposed spending cuts, but does not address the BCA sequestration cuts. The FY 2013 DoD Plan reduced DoD base budgets by $259 billion for FY 2013 to FY 2017, compared to the previously proposed budgets. Congress has not yet authorized or appropriated a FY 2013 DoD budget. Instead, Congress enacted a six-month Continuing Resolution Authority which funds the DoD until March 27, 2013, at levels similar to the DoD FY12 budget, however, the ultimate DoD FY 2013 budget must comply with the BCA sequestration provisions.
The Administrations proposed DoD FY 2014 budget or plan, which was scheduled for release in February 2013, has been delayed to March 2013 or later, due to the ongoing debate between the Administration and Congress about U.S Federal government deficit reduction, including spending and revenues, debt levels and the BCA sequestration cuts.
The declining DoD budgets will reduce funding for some of our revenue arrangements and generally will have a negative impact on our sales, results of operations and cash flows. Additionally, the in-process withdrawal of U.S. military forces from Afghanistan by the end of 2014 is expected to continue to negatively impact our results of operations and cash flows related to supporting U.S. military operations in Afghanistan.
In addition, if the existing statutory limit on the amount of permissible federal debt is not raised by May 19, 2013, we may be required to continue to perform for some period of time on certain of our U.S Government contracts even if the U.S Government is unable to make timely payments. Furthermore, such limits could also potentially delay program/contract start dates in an effort to curb obligations until all debt negotiations are complete or the U.S Government may issue a stop work order and later order the work to resume or may terminate the contract altogether. Any of these events would likely result in a material adverse effect on our financial position, results of operations and cash flows.
We rely predominantly on sales to U.S. Government entities, and the loss or delay of a significant number of our contracts would have a material adverse effect on our results of operations and cash flows.
Our sales are predominantly derived from contracts (revenue arrangements) with agencies of, and prime system contractors to, the U.S. Government. The loss or delay of all or a substantial portion of our sales to the U.S. Government would have a material adverse effect on our results of operations and cash flows. Approximately 76%, or $10.0 billion, of our sales for the year ended December 31, 2012 were made directly or indirectly to U.S. Government agencies, including 71% to the DoD. Aggregate sales for our five largest contracts (revenue arrangements) amounted to approximately $1.7 billion, or 13% of our sales for the year ended December 31, 2012. For the year ended December 31, 2012, our largest contract (revenue arrangement) in terms of annual sales was the Fort Rucker Maintenance Support contract with the U.S. Army Aviation and Missile Life Cycle Management Command (AMCOM), which is included in our AM&M segment. Under this contract, which generated approximately 4% of our 2012 sales, we provide maintenance, logistics, and other related sustainment support services for rotary wing aircraft assigned to Fort Rucker and satellite units in Alabama. On July 24, 2012, we won the AMCOM contract re-competition, which includes a one-year base period through September 30, 2013, and four one-year options, with an estimated total contract value of $1.98 billion.
A substantial majority of our total sales are for products and services under contracts with various agencies and procurement offices of the DoD or with prime contractors to the DoD. Although these various agencies, procurement offices and prime contractors are subject to common budgetary pressures and other factors, our customers exercise independent purchasing decisions. Because of this concentration of contracts, if a significant number of our DoD contracts and subcontracts are simultaneously delayed or cancelled for budgetary, performance or other reasons, it would have a material adverse effect on our results of operations and cash flows.
In addition to contract cancellations and declines in agency budgets, our backlog and future financial results may be adversely affected by:
| curtailment of the U.S. Governments use of technology or other services and product providers, including curtailment due to government budget reductions and related fiscal matters; |
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| developments in Afghanistan or other geopolitical developments that affect demand for our products and services; |
| our ability to hire and retain personnel to meet increasing demand for our services; and |
| technological developments that impact purchasing decisions or our competitive position. |
The DoDs wide-ranging efficiency and better buying power initiatives, which target affordability and cost growth, could have a material effect on the procurement process and may adversely affect our existing contracts and the award of new contracts.
The DoD has issued guidance regarding changes to the procurement process that is intended to control cost growth throughout the acquisition cycle by developing a competitive strategy for each program. As a result, the Company expects to engage in more frequent negotiations and re-competitions on a cost or price analysis basis with every competitive bid in which it participates. This initiative is organized into five major areas: affordability and cost growth; productivity and innovation; competition; services acquisition; and processes and bureaucracy. Because this initiative significantly changes the way the U.S. Government solicits, negotiates and manages its contracts, this initiative could result in a reduction in expenditures for the type of products we manufacture for, and services we provide to, the U.S. Government and could have a material negative impact on our future sales, earnings and cash flows.
In addition, the FY 2013 DoD Plan seeks reductions in contractor support services and consolidation of enterprise IT systems as part of an effort to achieve another $60 billion of efficiency savings over the five fiscal years FY 2013 through FY 2017. This initiative will primarily affect our businesses within the National Security Solutions reportable segment and could result in the loss of certain of our existing contracts (revenue arrangements) depending on how the DoD implements this initiative.
Our government contracts contain unfavorable termination provisions and are subject to audit and modification. If a termination right is exercised by the government, it could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Companies engaged primarily in supplying defense-related equipment and services to U.S. Government agencies are subject to certain business risks peculiar to the defense industry. These risks include the ability of the U.S. Government to unilaterally:
| suspend us from receiving new contracts pending resolution of alleged violations of procurement laws or regulations; |
| terminate existing contracts; |
| reduce the value of existing contracts; and |
| audit our contract-related costs and fees, including allocated indirect costs. |
All of our U.S. Government contracts can be terminated by the U.S. Government either for its convenience or if we default by failing to perform under the contract. Termination for convenience provisions provide only for our recovery of costs incurred or committed settlement expenses and profit on the work completed prior to termination. Termination for default provisions provide for the contractor to be liable for excess costs incurred by the U.S. Government in procuring undelivered items from another source. Our contracts with foreign governments generally contain similar provisions relating to termination at the convenience of the customer.
U.S. Government agencies, including the Defense Contract Audit Agency and various agency Inspectors General, routinely audit and investigate our costs and performance on contracts, as well as our accounting and general business practices. Based on the results of such audits, the U.S. Government may adjust our contract
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related costs and fees, including allocated indirect costs. In addition, under U.S. Government purchasing regulations, some of our costs, including certain business acquisition costs, most financing costs, portions of research and development costs, and certain marketing expenses may not be reimbursable under U.S. Government contracts.
We currently have a backlog of funded orders, primarily under contracts with the U.S. Government. Our total funded backlog was $10,884 million at December 31, 2012. As described above, the U.S. Government may unilaterally modify or terminate its contracts with us. Accordingly, most of our backlog could be modified or terminated by the U.S. Government, which would negatively impact our future sales, results of operations and cash flows.
We may not be able to win competitively awarded contracts or receive required licenses to export our products, which could have a material adverse effect on our business, financial condition, results of operations and future prospects.
Our government contracts are subject to competitive bidding. We obtain many of our U.S. Government contracts through a competitive bidding process. We may not be able to continue to win competitively awarded contracts. In addition, awarded contracts may not generate sales sufficient to result in our profitability. We are also subject to risks associated with the following:
| the frequent need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and/or cost overruns; |
| the substantial time, effort and experience required to prepare bids and proposals for competitively awarded contracts that may not be awarded to us; |
| design complexity and rapid technological obsolescence; and |
| the constant need for design improvement. |
In addition to these U.S. Government contract risks, we are not permitted to export some of our products and are also required to obtain licenses from U.S. Government agencies to export many of our products and systems. Failure to receive required licenses would eliminate our ability to sell our products and systems outside the United States.
Intense competition and bid protests may adversely effect our sales, results of operations and cash flows.
The defense and commercial industries in which our businesses operate are highly competitive. We expect that the DoDs increased use of commercial off-the-shelf products and components in military equipment will continue to encourage new competitors to enter the market. We also expect increased competition for our products and services from other providers due to the uncertainty of future U.S. defense budgets. Furthermore, the current competitive environment has resulted in an increase of bid protests from unsuccessful bidders, which typically extends the time until work on a contract can begin. Additionally, some of our competitors are larger than we are and have more financial and other resources than we have. For more information concerning the factors that affect our ability to compete, see Part I Item 1 Business Competition.
We are subject to government investigations, which could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.
U.S. Government contracts are subject to extensive legal and regulatory requirements, and from time to time agencies of the U.S. Government investigate whether such contracts were and are being conducted in accordance with these requirements. We are currently cooperating with the U.S. Government on several investigations, including those discussed in Note 19 to our audited consolidated financial statements. Under U.S. Government regulations, an indictment of the Company by a federal grand jury, or an administrative finding against us as to
22
our present responsibility to be a U.S. Government contractor or subcontractor, could result in us being suspended for a period of time from eligibility for awards of new government contracts or task orders or in a loss of export privileges. A conviction, or an administrative finding against us that satisfies the requisite level of seriousness, could result in debarment from contracting with the federal government for a specific term.
We are subject to the risks of current and future legal proceedings, which could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.
At any given time, we are a defendant in various material legal proceedings and litigation matters arising in the ordinary course of business, including litigation, claims and assessments that have been asserted against acquired businesses, which we have assumed. Although we maintain insurance policies, these policies may not be adequate to protect us from all material judgments and expenses related to current or future claims and may not cover the conduct that is the subject of the litigation. Desired levels of insurance may not be available in the future at economical prices or at all. In addition, we believe that while we have valid defenses with respect to legal matters pending against us, the results of litigation can be difficult to predict, including those involving jury trials. Accordingly, our current judgment as to the likelihood of our loss (or our current estimate as to the potential range of loss, if applicable) with respect to any particular litigation matter may turn out to be wrong. A significant judgment against us, arising out of any of our current or future legal proceedings and litigation, could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects. For a discussion of material litigation to which we are currently a party, see Note 19 to our audited consolidated financial statements.
If we are unable to keep pace with rapidly evolving products and service offerings and technological change, there could be a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.
The rapid change of technology is a key feature of most of the markets in which our products, services and systems oriented businesses operate. To succeed in the future, we will need to continue to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. Historically, our technology has been developed through customer-funded and internally funded research and development and through certain business acquisitions. We may not be able to continue to maintain comparable levels of research and development or successfully complete such acquisitions. In the past, we have allocated substantial funds to capital expenditures, programs and other investments. This practice will continue to be required in the future. Even so, we may not be able to successfully identify new opportunities and may not have the necessary financial resources to develop new products and systems in a timely or cost-effective manner. At the same time, products and technologies developed by others may render our products, services and systems obsolete or non-competitive.
Our business acquisition strategy involves risks, and we may not successfully implement our strategy.
We opportunistically seek to acquire businesses that enhance our capabilities and add new technologies, products, services, programs, contracts, and customers to our existing businesses. We may not be able to continue to identify acquisition candidates on commercially reasonable terms or at all. If we make additional business acquisitions, we may not realize the benefits anticipated from these acquisitions, including sales growth, cost synergies and improving margins. Furthermore, we may not be able to obtain additional financing for business acquisitions, since such additional financing could be restricted or limited by the terms of our debt agreements or due to unfavorable capital market conditions.
The process of integrating the operations of acquired businesses into our existing operations may result in unforeseen difficulties and may require significant financial and managerial resources that would otherwise be available for the ongoing development or expansion of our existing operations. Possible future business acquisitions could result in the incurrence of additional debt and related interest expense and contingent liabilities, each of which could result in an increase to our already significant level of outstanding debt, as well as more restrictive covenants.
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We consider and may enter into strategic business acquisitions on an ongoing basis and may be evaluating acquisitions or engaging in acquisition negotiations at any given time. We regularly evaluate potential acquisitions and joint venture transactions and have not entered into any agreements with respect to any material transactions at this time. Furthermore, in certain of our business acquisitions we have assumed all claims against and liabilities of the acquired business, including both asserted and unasserted claims and liabilities.
Goodwill represents a significant asset on our balance sheet and may become impaired.
Goodwill represents the largest asset on our balance sheet, with an aggregate balance of $7,744 million at December 31, 2012. We review goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also review goodwill annually in accordance with the accounting standards for goodwill and intangible assets. The annual impairment test requires us to determine the fair value of our reporting units in comparison to their carrying values. A decline in the estimated fair value of a reporting unit could result in a goodwill impairment, and a related non-cash impairment charge against earnings, if estimated fair value for the reporting unit is less than the carrying value of the net assets of the reporting unit, including its goodwill. The fair value of six of our reporting units exceeded the carrying value of the net assets of those reporting units by less than 20% at November 30, 2012, the date of our annual impairment assessment. The estimated fair values of our reporting units will be negatively impacted by reductions in the DoD budget that impact our programs, including the automatic sequestration process, should it occur. A decline in the estimated fair value of one or more of our reporting units could potentially trigger goodwill impairment charges and a material adverse effect on our results of operations. See Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies Goodwill and Identifiable Intangible Assets for further discussion.
Our results of operations and cash flows are substantially affected by our mix of fixed-price, cost-plus and time-and-material type contracts.
Our sales are transacted using written revenue arrangements, or contracts, which are generally fixed-price, cost-plus or time-and-material. For a description of our revenue recognition policies, see Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies. The table below presents the percentage of our total sales generated from each contract-type.
Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
Contract-Type |
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Fixed-price |
71 | % | 69 | % | 64 | % | ||||||
Cost-plus |
24 | % | 23 | % | 26 | % | ||||||
Time-and-material |
5 | % | 8 | % | 10 | % | ||||||
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Total sales |
100 | % | 100 | % | 100 | % | ||||||
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Substantially all of our cost-plus and time-and-material type contracts are with the U.S. Government, primarily the DoD. Substantially all of our sales to commercial customers are transacted under fixed-price sales arrangements, and are included in our fixed-price type contract sales.
On a fixed-price type contract (revenue arrangement), we agree to perform the contractual statement of work for a predetermined sales price. Although a fixed-price type contract generally permits us to retain profits if the total actual contract costs are less than the estimated contract costs, we bear the risk that increased or unexpected costs may reduce our profit or cause us to sustain losses on the contract.
On a cost-plus type contract (revenue arrangement), we are paid our allowable incurred costs plus a profit which can be fixed or variable depending on the contracts fee arrangement up to predetermined funding levels determined by our customers. On a time-and-material type contract (revenue arrangement), we are paid on the basis of direct labor hours expended at specified fixed-price hourly rates (that include wages, overhead,
24
allowable general and administrative expenses and profit) and materials at cost. Therefore, on cost-plus type and time-and-material type contracts, we do not bear the risks of unexpected cost overruns, provided that we do not incur costs that exceed the predetermined funded amounts.
Additionally, the impact of revisions in profit or loss estimates for all types of contracts subject to percentage of completion accounting are recognized on a cumulative catch-up basis in the period in which the revisions are made. Provisions for anticipated losses on contracts are recorded in the period in which they become evident. Amounts representing contract change orders or claims are included in sales only when they can be reliably estimated and their realization is reasonably assured. The revisions in contract estimates, if significant, can materially affect our results of operations and cash flows, as well as reduce the valuations of receivables and inventories; and in some cases, result in liabilities to complete contracts in a loss position.
Our significant level of debt and our ability to make payments on or service our indebtedness may adversely affect our financial and operating activities or our ability to incur additional debt.
At December 31, 2012, we had approximately $3,639 million in aggregate principal amount of outstanding debt. On February 3, 2012, we amended and restated our $1 billion Revolving Credit Facility (Amended and Restated Revolving Credit Facility), which also extended the expiration date to February 3, 2017. In addition, at December 31, 2012 we had the availability of substantially all of our Amended and Restated Revolving Credit Facility. In the future, we may increase our borrowings, subject to any limitations imposed on us by our debt agreements. The first scheduled maturity of our existing debt is our $500 million aggregate principal amount of our 3.95% Senior Notes maturing November 15, 2016. See Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Debt and Note 10 to our audited consolidated financial statements.
Our ability to make scheduled payments of principal and interest on our indebtedness and to refinance our existing debt depends on our future financial performance as well as our ability to access the capital markets, and the relative attractiveness of available financing terms. We do not have complete control over our future financial performance because it is subject to economic, political, financial (including credit market conditions), competitive, regulatory and other factors affecting the aerospace and defense industry, as well as commercial industries in which we operate. It is possible that in the future our businesses may not generate sufficient cash flow from operations to allow us to service our debt and make necessary capital expenditures. If this situation occurs, we may have to reduce costs and expenses, sell assets, restructure debt or obtain additional equity capital. We may not be able to do so in a timely manner or upon acceptable terms in accordance with the restrictions contained in our debt agreements. Our level of indebtedness has important consequences to us. These consequences may include:
| requiring a substantial portion of our net cash flow from operations to be used to pay interest and principal on our debt and therefore be unavailable for other purposes, including acquisitions, capital expenditures, paying dividends to our shareholders, repurchasing shares of our common stock, research and development and other investments; |
| limiting our ability to obtain additional financing for acquisitions, working capital, investments or other expenditures, which, in each case, may limit our ability to carry out our acquisition strategy; |
| increasing interest expense due to higher interest rates on our Amended and Restated Revolving Credit Facility as it has a variable interest rate; |
| heightening our vulnerability to downturns in our business or in the general economy and restricting us from making acquisitions, introducing new technologies and products or exploiting business opportunities; and |
| impacting debt covenants that limit our ability to borrow additional funds or dispose of assets. Failure to comply with such covenants could result in an event of default which, if not cured or waived, could result in the acceleration of our outstanding indebtedness. |
25
Additionally, on December 31, 2012, we had $8,810 million of contractual obligations (including outstanding indebtedness). For a detailed listing of the components of our contractual obligations, see Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Contractual Obligations.
Our Amended and Restated Revolving Credit Facility and Senior Notes restrict our ability to finance our future operations and, if we are unable to meet our financial ratios, could cause our existing debt to be accelerated.
Our Amended and Restated Revolving Credit Facility and Senior Notes contain certain significant covenants that, among other things, include, depending on the debt instrument, restrictions on our ability to:
| sell assets; |
| incur more indebtedness; |
| create liens; |
| make certain investments or business acquisitions; |
| engage in business mergers or consolidations; and |
| engage in certain transactions with subsidiaries and affiliates. |
These restrictions could impair our ability to finance our future operations or capital needs or engage in other business activities that may be in our interest. In addition, our Amended and Restated Revolving Credit Facility also requires us to maintain compliance with certain financial ratios, including (1) total consolidated earnings before interest, taxes, depreciation and amortization to total consolidated cash interest expense, (2) total consolidated funded indebtedness less designated cash balances to total consolidated earnings before interest, taxes, depreciation and amortization, and (3) consolidated senior indebtedness less designated cash balances to consolidated earnings before interest, taxes, depreciation and amortization. Our ability to comply with these ratios and covenants may be affected by events beyond our control. A breach of any of these agreements or our inability to comply with the required financial ratios or covenants could result in a default under those debt agreements. In the event of any such default, the lenders under those debt agreements could elect to declare all outstanding debt, accrued interest and fees to be due and immediately payable.
For further discussion of our financial ratios, debt agreements and other payment restrictions, see Note 10 to our audited consolidated financial statements.
If we are unable to attract and retain key management and personnel, we may become unable to operate our business effectively.
Our future success depends to a significant degree upon the continued contributions of our management, and our ability to attract and retain highly qualified management and technical personnel, including employees who have U.S. Government security clearances, particularly clearances of top-secret and above. We do not maintain any key person life insurance policies for members of our management. We face competition for management and technical personnel from other companies and organizations. Failure to attract and retain such personnel would damage our future prospects.
Environmental laws and regulations may subject us to significant liability.
Our operations are subject to various U.S. federal, state and local as well as certain foreign environmental laws and regulations within the countries in which we operate relating to the discharge, storage, treatment, handling, disposal and remediation of certain materials, substances and wastes used in our operations.
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New laws and regulations, stricter enforcement of existing laws and regulations, the discovery of previously unknown contamination or the imposition of new clean-up requirements may require us to incur a significant amount of additional costs in the future and could decrease the amount of cash flow available to us for other purposes, including capital expenditures, research and development and other investments and could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.
Our sales to certain foreign customers expose us to risks associated with operating internationally.
For the year ended December 31, 2012, sales to foreign customers, excluding our foreign sales made under FMS agreements directly between the U.S. Government and allied foreign governments, represented approximately 15% of our consolidated sales. Consequently, our businesses are subject to a variety of risks that are specific to international operations, including the following:
| export regulations that could erode profit margins or restrict exports; |
| compliance with the U.S. Foreign Corrupt Practices Act and similar non-U.S. regulations; |
| the burden and cost of compliance with foreign laws, treaties and technical standards and changes in those regulations; |
| contract award and funding delays; |
| potential restrictions on transfers of funds; |
| currency fluctuations; |
| import and export duties and value added taxes; |
| transportation delays and interruptions; |
| uncertainties arising from foreign local business practices and cultural considerations; and |
| potential military conflicts and political risks. |
While we have and will continue to adopt measures to reduce the potential impact of losses resulting from the risks of our foreign business, we cannot ensure that such measures will be adequate.
Our business could be negatively impacted by security threats and other disruptions.
As a U.S. defense contractor, we face various security threats, including cyber security attacks to our information technology infrastructure, attempts to gain access to our proprietary or classified information as well as threats to the physical security of our facilities and employees. Although we utilize various procedures and controls to monitor and mitigate these threats, there can be no assurance that these procedures and controls will be sufficient to prevent disruptions in mission critical systems, the unauthorized release of confidential information and corruption of data. Accordingly, any significant operational delays, or any destruction, manipulation or improper use of our data, information systems or networks could adversely affect our financial results and damage the reputation for our products and services.
The Companys spin-off of Engility could result in substantial tax liability to the Company and its shareholders.
We received an Internal Revenue Service (IRS) Ruling stating that L-3 and its shareholders would not recognize any taxable income, gain or loss for U.S. federal income tax purposes as a result of the spin-off of Engility. In addition, we received an opinion of counsel that the spin-off satisfies certain requirements for tax-free treatment that are not covered in the IRS Ruling; however, an opinion of counsel is not binding on the
27
IRS. Accordingly, the IRS or the courts may reach conclusions with respect to the spin-off that are different from the conclusions reached in the opinion of counsel. Moreover, both the IRS Ruling and the opinion of counsel are based on certain factual statements and representations made by us, which, if incomplete or untrue in any material respect, could invalidate the IRS Ruling or opinion of counsel.
If, notwithstanding receipt of the IRS Ruling and opinion of counsel, the spin-off and certain related transactions were determined to be taxable, then we would be subject to a substantial tax liability. In addition, if the spin-off were taxable, each holder of our common stock who receives shares of Engility would generally be treated as receiving a taxable distribution of property in an amount equal to the fair market value of the shares of Engility received.
Pension expense and funding may fluctuate significantly because of changes in key estimates and assumptions, including discount rates and assumed long-term rate of return on assets, as well as our actual investment returns and regulatory actions, which could negatively impact our results of operations, cash flows and financial condition.
Determining our pension expense requires significant judgment, particularly with respect to our discount rates, assumed long-term rate of return on assets and other actuarial assumptions. If our assumptions change significantly due to changes in economic, legislative, demographic experience and/or circumstances, our pension expense, the funded status of our plans and our cash contributions to such plans would be impacted, which could negatively affect our results of operations, cash flows and financial condition. In addition, differences between our actual investment returns and our assumed long-term rate of return on assets could also impact our pension expense, the funded status of our plans and our required cash contributions to the plans. Further, our pension expense and the funded status of our plans, including required cash contributions to the Plans, may be impacted by regulatory actions in any given year.
Additionally, due to government regulations, pension plan cost recoveries under Cost Accounting Standards (CAS), for our government contracts occur in different periods from when pension expense is recognized under Financial Accounting Standards (FAS) for financial statement purposes or when cash contributions are made. These timing differences could have a material adverse effect on our cash flow. In December 2011, cost accounting standards were revised in order to harmonize the measurement and period of assignment of defined benefit pension plan costs allocable to U.S. Government contracts with the minimum required contributions under the Employee Retirement Income Security Act of 1974 (ERISA), as amended by the Pension Protection Act of 2006. We anticipate the revised CAS will better align, but not eliminate, mismatches between ERISA funding requirements and pension plan cost recoveries under CAS.
Item 1B. Unresolved Staff Comments
None.
At December 31, 2012, we operated in 396 locations consisting of manufacturing facilities, administration, research and development and other properties throughout the United States and internationally. Of these, we owned 35 locations consisting of approximately 5.6 million square feet and leased space at 361 locations consisting of approximately 14.8 million square feet.
Our reportable segments have major operations at the following locations:
| Electronic Systems Phoenix and Tempe, Arizona; Anaheim, San Carlos, San Diego, San Leandro, Simi Valley, Sylmar and Torrance, California; Orlando, Sarasota and St. Petersburg, Florida; Ayer, Massachusetts; Grand Rapids and Muskegon, Michigan; Londonderry, New Hampshire; Budd Lake, New Jersey; Albuquerque, New Mexico; Binghamton and Hauppauge, New York; Cincinnati and Mason, Ohio; |
28
Tulsa, Oklahoma; Philadelphia, Pittsburgh and Williamsport, Pennsylvania; Arlington, Carrollton, and Garland, Texas; Ontario, Canada; Elmenhorst, and Hamburg, Germany; Bologna, Italy; and West Sussex, U.K. |
| C3ISR Camden, New Jersey; Greenville and Rockwall, Texas; and Salt Lake City, Utah. |
| AM&M Crestview, Florida; Madison, Mississippi; Waco, Texas; and Quebec, Canada. |
| NSS Annapolis, Maryland; and Chantilly and Reston, Virginia. |
| Corporate and other locations New York, New York and Arlington, Virginia. |
A summary of square footage by reportable segment as of December 31, 2012 is presented below.
Leased | Owned | Total | ||||||||||
(Square feet in millions) | ||||||||||||
Electronic Systems |
7.7 | 3.9 | 11.6 | |||||||||
C3ISR |
5.1 | | 5.1 | |||||||||
AM&M |
1.0 | 1.7 | 2.7 | |||||||||
NSS |
0.9 | | 0.9 | |||||||||
Corporate |
0.1 | | 0.1 | |||||||||
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Total |
14.8 | 5.6 | 20.4 | |||||||||
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Management believes all of our properties have been well maintained, are in good condition, and are adequate to meet our current contractual requirements.
The information required with respect to this item can be found in Note 19 to our audited consolidated financial statements and is incorporated by reference into this Item 3.
Item 4. Mine Safety Disclosures
None.
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PART II
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The common stock of L-3 Holdings is traded on the NYSE under the symbol LLL. On February 15, 2013, the number of holders of L-3 Holdings common stock was approximately 31,635. On February 21, 2013, the closing price of L-3 Holdings common stock, as reported by the NYSE, was $76.46 per share.
The table below sets forth the high and low closing price of L-3 Holdings common stock as reported on the NYSE composite transaction tape and the amount of dividends paid per share during the past two calendar years.
Dividends Paid | Closing Price (High-Low) |
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2012 | 2011 | 2012 | 2011 | |||||||||||||
Common Stock Dividends Paid and Market Prices(1) |
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First Quarter |
$ | 0.50 | $ | 0.45 | $ | 71.34 $66.91 | $ | 80.85 $70.84 | ||||||||
Second Quarter |
0.50 | 0.45 | 74.01 67.11 | 88.31 74.95 | ||||||||||||
Third Quarter |
0.50 | 0.45 | 74.45 68.27 | 86.77 58.94 | ||||||||||||
Fourth Quarter |
0.50 | 0.45 | 77.91 72.10 | 70.97 60.04 | ||||||||||||
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Year Ended December 31 |
$ | 2.00 | $ | 1.80 | 77.91 66.91 | 88.31 58.94 | ||||||||||
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(1) | The stock prices in the table above on or prior to July 17, 2012, the date of the Engility spin-off, have not been adjusted for the impact of the spin-off. |
On February 5, 2013, L-3 Holdings announced that its Board of Directors had increased L-3 Holdings regular quarterly cash dividend by 10% to $0.55 per share, payable on March 15, 2013, to shareholders of record at the close of business on March 1, 2013. L-3 Holdings relies on dividends received from L-3 Communications to generate the funds necessary to pay dividends on L-3 Holdings common stock.
Issuer Purchases of Equity Securities
The following table provides information about share repurchases made by L-3 Holdings of its common stock that are registered pursuant to Section 12 of the Exchange Act during the 2012 fourth quarter. Repurchases are made from time to time at managements discretion in accordance with applicable federal securities laws. All share repurchases of L-3 Holdings common stock have been recorded as treasury shares.
Total Number of Shares Purchased |
Average Price Paid Per Share |
Total Number of Shares Purchased As Part of Publicly Announced Plans or Programs |
Maximum Number (or Approximate Dollar Value) of Shares That May Yet Be Purchased Under The Plans or Programs(1) |
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(in millions) | ||||||||||||||||
October 1 October 31, 2012 |
1,019,790 | $ | 73.06 | 1,019,790 | $ | 555 | ||||||||||
November 1 30, 2012 |
1,717,947 | 74.88 | 1,717,947 | $ | 427 | |||||||||||
December 1 31, 2012 |
2,148,146 | 76.60 | 2,148,146 | $ | 262 | |||||||||||
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Total |
4,885,883 | $ | 75.26 | 4,885,883 | ||||||||||||
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(1) | The share repurchases described in the table above were made pursuant to the $1.5 billion share repurchase program authorized by L-3 Holdings Board of Directors on April 26, 2011, which has a stated termination date of April 30, 2013. On February 5, 2013, L-3 Holdings Board of Directors authorized a new share repurchase program that allows the Company to repurchase up to an additional $1.5 billion of its common stock through June 30, 2015. |
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From January 1, 2013 through February 26, 2013, L-3 Holdings repurchased 1.3 million shares of its common stock at an average price of $77.42 per share for an aggregate amount of approximately $104 million.
The graph below compares the cumulative total returns of our common stock with the cumulative total return of the Standard & Poors 500 Composite Stock Index and the Standard & Poors 1500 Aerospace & Defense Index, for the period from December 31, 2007 to December 31, 2012. These figures assume that all dividends paid over the performance period were reinvested. On July 17, 2012, we completed the Engility spin-off. Our shareholders received one share of Engility common stock for every six shares of our common stock held on the record date (July 16, 2012). The effect of the spin-off is reflected in the cumulative total return as a reinvested dividend. The figures also assume that the starting value of each index and the investment in our common stock was $100 on December 31, 2007.
We are one of the companies included in the Standard & Poors 1500 Aerospace & Defense Index and the Standard & Poors 500 Composite Stock Index. The starting point for the measurement of our common stock cumulative total return was our stock price of $105.94 per share on December 31, 2007. The graph is not, and is not intended to be, indicative of future performance of our common stock.
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Item 6. Selected Financial Data
The selected financial data presented below is derived from our audited consolidated financial statements and has been adjusted to reflect the spin-off of Engility and related classification of its assets, liabilities, results of operations and cash flows as discontinued operations.
Year Ended December 31, | ||||||||||||||||||||
2012 | 2011(1) | 2010 | 2009 | 2008(2) | ||||||||||||||||
(in millions, except per share data) | ||||||||||||||||||||
Statement of Operations Data: |
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Net sales |
$ | 13,146 | $ | 13,158 | $ | 13,390 | $ | 13,147 | $ | 12,202 | ||||||||||
Cost of sales |
11,795 | 11,716 | 11,905 | 11,780 | 10,944 | |||||||||||||||
Impairment charge |
| 43 | | | | |||||||||||||||
Litigation gain |
| | | | 126 | (3) | ||||||||||||||
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Operating income |
1,351 | 1,399 | 1,485 | 1,367 | 1,384 | |||||||||||||||
Interest and other income, net |
8 | | 21 | 19 | 24 | |||||||||||||||
Interest expense |
(184 | ) | (204 | ) | (236 | ) | (245 | ) | (248 | )(3) | ||||||||||
Debt retirement charge |
(13 | ) | (35 | ) | (18 | ) | (10 | ) | | |||||||||||
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Income from continuing operations before income taxes |
1,162 | 1,160 | 1,252 | 1,131 | 1,160 | |||||||||||||||
Provision for income taxes |
374 | 296 | 428 | 374 | 393 | |||||||||||||||
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Income from continuing operations |
788 | 864 | 824 | 757 | 767 | |||||||||||||||
Income from discontinued operations, net of tax |
32 | 104 | 142 | 154 | 182 | |||||||||||||||
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Net income |
820 | 968 | 966 | 911 | 949 | |||||||||||||||
Less: Noncontrolling interests |
10 | 12 | 11 | 10 | 11 | |||||||||||||||
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Net income attributable to L-3 |
$ | 810 | $ | 956 | $ | 955 | $ | 901 | $ | 938 | ||||||||||
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Earnings per share allocable to L-3 Holdings common shareholders: |
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Basic: |
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Continuing operations |
$ | 8.12 | $ | 8.17 | $ | 7.09 | $ | 6.34 | $ | 6.17 | ||||||||||
Discontinued operations |
0.29 | 0.97 | 1.22 | 1.31 | 1.50 | |||||||||||||||
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Basic earnings per share |
$ | 8.41 | $ | 9.14 | $ | 8.31 | $ | 7.65 | $ | 7.67 | ||||||||||
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Diluted: |
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Continuing operations |
$ | 8.01 | $ | 8.08 | $ | 7.04 | $ | 6.30 | $ | 6.10 | ||||||||||
Discontinued operations |
0.29 | 0.95 | 1.21 | 1.31 | 1.49 | |||||||||||||||
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Diluted earnings per share |
$ | 8.30 | $ | 9.03 | $ | 8.25 | $ | 7.61 | $ | 7.59 | ||||||||||
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L-3 Holdings weighted average common shares outstanding: |
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Basic |
96.3 | 104.4 | 114.3 | 116.8 | 121.2 | |||||||||||||||
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Diluted |
97.6 | 105.6 | 115.1 | 117.4 | 122.4 | |||||||||||||||
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Cash dividends paid per common share |
$ | 2.00 | $ | 1.80 | $ | 1.60 | $ | 1.40 | $ | 1.20 | ||||||||||
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(1) | The year ended December 31, 2011 includes: (1) a tax benefit of $78 million, or $0.74 per diluted share, for a net reversal of amounts previously accrued related to tax years for which the statutes of limitations had expired, (2) a non-cash goodwill impairment charge of $43 million ($42 million after income taxes, or $0.40 per diluted share), due to a decline in the estimated fair value of our Marine Services business and (3) $14 million ($8 million after income taxes, or $0.08 per diluted share), for our portion of an impairment charge for long-lived assets at an equity method investment. |
(2) | The year ended December 31, 2008 includes: (1) a gain of $12 million ($7 million after income taxes, or $0.06 per diluted share) related to the sale of a product line, (2) a non-cash impairment charge of $28 million ($17 million after income taxes, or $0.14 per diluted share) |
32
related to a write-down of capitalized software development costs associated with a general aviation product, and (3) an after-tax gain of $20 million, or $0.16 per diluted share, related to the sale of our 85% ownership interest in Medical Education Technologies, Inc. on October 8, 2008. (The gain is excluded from income from continuing operations for the year ended December 31, 2008.) |
(3) | The year ended December 31, 2008 includes a gain of $133 million ($81 million after income taxes, or $0.66 per diluted share) related to the reversal of a $126 million current liability for pending and threatened litigation and $7 million of related accrued interest as a result of a June 27, 2008 decision by the U.S. Court of Appeals which vacated an adverse 2006 jury verdict. |
Year Ended December 31, | ||||||||||||||||||||
2012 | 2011 | 2010 | 2009 | 2008 | ||||||||||||||||
(in millions) | ||||||||||||||||||||
Balance Sheet Data (at year end): |
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Working capital(1) |
$ | 1,974 | $ | 2,406 | $ | 2,163 | $ | 2,381 | $ | 1,993 | ||||||||||
Total assets |
13,826 | 15,508 | 15,451 | 14,875 | 14,484 | |||||||||||||||
Long-term debt |
3,629 | 4,125 | 4,126 | 4,112 | 4,493 | |||||||||||||||
Equity |
5,539 | 6,724 | 6,855 | 6,660 | 5,941 | |||||||||||||||
Cash Flow Data: |
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Net cash provided by operating activities from continuing operations |
$ | 1,231 | $ | 1,231 | $ | 1,270 | $ | 1,147 | $ | 1,115 | ||||||||||
Net cash used in investing activities from continuing operations |
(200 | ) | (199 | ) | (944 | ) | (262 | ) | (375 | ) | ||||||||||
Net cash used in financing activities from continuing operations |
(1,527 | ) | (1,119 | ) | (917 | ) | (1,004 | ) | (840 | ) |
(1) | Based on continuing operations. |
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
Overview and Outlook
L-3s Business
L-3 is a prime contractor in Intelligence, Surveillance and Reconnaissance (ISR) systems, Command, Control, Communications (C3) systems, aircraft modernization and sustainment of aircraft, maritime vessels and ground vehicles, and national security solutions. L-3 is also a leading provider of a broad range of electronic systems used on military and commercial platforms. Our customers include the DoD and its prime contractors, U.S. Government intelligence agencies, the U.S. Department of Homeland Security (DHS), U.S. Department of State (DoS), allied foreign governments, and domestic and foreign commercial customers.
We have the following four reportable segments: (1) Electronic Systems, (2) C3ISR, (3) Aircraft Modernization and Maintenance (AM&M), and (4) National Security Solutions (NSS). Financial information with respect to each of our segments is included in Note 22 to our audited consolidated financial statements. Electronic Systems provides a broad range of products and services, including components, products, subsystems, systems, and related services to military and commercial customers in several niche markets across several business areas, including microwave, power & control systems, sensor systems, simulation & training, aviation products, precision engagement, warrior systems, security & detection, space & propulsion, undersea warfare and marine services. C3ISR provides products and services for the global ISR (intelligence, surveillance and reconnaissance) market, C3 systems, networked communications systems and secure communications products. We believe that these products and services are critical elements for a substantial number of major command, control and communication, intelligence gathering and space systems. These products and services are used to connect a variety of airborne, space, ground and sea-based communication systems and are used in the transmission, processing, recording, monitoring, and dissemination functions of these communication systems. AM&M provides modernization, upgrades and sustainment, maintenance and logistics support services for military and various government aircraft and other platforms. We sell these services primarily to the DoD, the Canadian Department of Defense and other allied foreign governments. NSS provides a full range of cyber security, intelligence, enterprise IT and security solutions services to the DoD, U.S. Government intelligence agencies, federal civilian agencies and allied foreign governments.
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On July 17, 2012, L-3 completed the spin-off of its subsidiary, Engility Holdings, Inc. (Engility) to L-3s shareholders. As a result of the spin-off, the assets, liabilities, non-controlling interest, results of operations and cash flows of the Engility businesses have been classified as discontinued operations for all periods presented. References to financial data are to L-3s continuing operations, unless specifically noted. See 2012 Events within this section for additional information.
For the year ended December 31, 2012, we generated sales of $13,146 million. Our primary customer was the DoD. The table below presents a summary of our 2012 sales by end customer and the percent contributed by each to our total 2012 sales.
2012 Sales | % of Total Sales |
|||||||
(in millions) | ||||||||
Air Force |
$ | 3,599 | 27 | % | ||||
Army |
2,824 | 22 | ||||||
Navy/Marines |
1,897 | 14 | ||||||
Other Defense |
1,056 | 8 | ||||||
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Total DoD |
$ | 9,376 | 71 | % | ||||
Other U.S. Government |
650 | 5 | ||||||
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Total U.S. Government |
$ | 10,026 | 76 | % | ||||
Foreign governments |
1,463 | 11 | ||||||
Commercial foreign |
985 | 8 | ||||||
Commercial domestic |
672 | 5 | ||||||
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Total sales |
$ | 13,146 | 100 | % | ||||
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Most of our contracts (revenue arrangements) with the U.S. Government are subject to U.S. Defense Contract Audit Agency audits and various cost and pricing regulations, and include standard provisions for termination for the convenience of the U.S. Government. Multiyear U.S. Government contracts and related orders are subject to cancellation if funds for contract performance for any subsequent year become unavailable. Foreign government contracts generally include comparable provisions relating to termination for the convenience of the relevant foreign government.
Business Environment
U.S. Government Markets. Sales to U.S. Government customers represented 76% of our 2012 sales, and were primarily to DoD customers, which comprised of 71% of our sales. Therefore, our annual sales are generally highly correlated to changes in U.S. Government spending levels, and especially DoD budget levels. Recent DoD budgets are declining, compared to the DoD budget growth that occurred during the last decade. The total DoD budget (base and Overseas Contingency Operations (OCO)) for the fiscal year ended September 30, 2012 (FY 2012) declined 6% compared to FY 2011, and the total DoD budget for FY 2011 was approximately unchanged compared to FY 2010. From FY 2000 to FY 2010, the total DoD budget grew at a compound annual rate of approximately 9%.
In August 2011, Congress enacted the Budget Control Act of 2011 (BCA). The BCA imposed spending caps and discretionary spending cuts of approximately $487 billion to DoD base budgets for FY 2012 to FY 2021, compared to previously proposed DoD base budgets. The BCA also triggered an automatic sequestration process, which was originally scheduled to become effective on January 2, 2013, that imposes additional budget cuts to U.S. national security accounts of approximately $490 billion for FY 2013 to FY 2021 and other U.S. Government budget cuts of another $500 billion to discretionary non-national security accounts. The national security spending cuts from sequestration are expected to mostly reduce DoD budgets by equally cutting funding for all DoD budget line items. The American Taxpayer Relief Act, enacted on January 2, 2013, delayed the implementation of the BCA sequestration cuts to March 1, 2013, reduced the sequester cut to the FY 2013 DoD budget to approximately $46 billion and increased the sequester cut for FY 2014 to approximately $59 billion.
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On February 13, 2012, the Obama Administration (Administration) submitted its FY 2013 proposed budget (FY 2013 DoD Plan) to Congress which complies with the first phase of the BCA imposed spending cuts, but does not address the BCA sequestration cuts. The FY 2013 DoD Plan reduced DoD base budgets by $259 billion for FY 2013 to FY 2017, compared to the previously proposed budgets. Congress has not yet authorized or appropriated a FY 2013 DoD budget. Instead, Congress enacted a six-month Continuing Resolution Authority (CRA) which funds the DoD until March 27, 2013, at levels similar to the DoD FY12 budget, however the ultimate DoD FY 2013 budget must comply with the BCA sequestration provisions.
The FY 2013 DoD Plan revised national security strategy along five core tenets, to: (1) rebalance military posture towards the Asia-Pacific global region, while leveraging partners in other regions to preserve U.S. military presence, (2) resizing military forces to enable the defeat of one foe while imposing unacceptable costs on another foe, (3) protect key investments for next generation capabilities, particularly versus anti-access/area denial threats, (4) not sizing forces for sustained stabilization operations, but preserving such military expertise, and (5) structuring military budget cuts, if possible, to allow for the reversal or regeneration of military capabilities. The FY 2013 DoD Plan also contains funding priorities, trade-offs and risks for high-end strike and power projection; special operations, advanced ISR and cyber security; favoring multi-mission and common fleets across the DoD Armed Services; accepting risk inherent in smaller military forces; and shielding active military duty personnel from pay and healthcare cuts. The FY 2013 DoD Plan also includes more disciplined use of resources from efficiency initiatives in acquisition and management of equipment and services procured by the DoD from private industry, select program terminations, restructurings and deferrals; and, reprioritization of key missions. The table below presents the enacted DoD budget (base and OCO) for FY 2012 and the proposed DoD budgets for FY 2013 to FY 2017, as provided in the FY 2013 DoD Plan.
Fiscal Year |
Base | OCO | Total | Annual Total Budget Change |
||||||||||||
(in billions) | ||||||||||||||||
2012 |
$ | 530.6 | $ | 115.1 | $ | 645.7 | -6 | % | ||||||||
2013 |
$ | 525.4 | $ | 88.5 | $ | 613.9 | -5 | % | ||||||||
2014 |
$ | 533.6 | $ | 44.2 | $ | 577.8 | -6 | % | ||||||||
2015 |
$ | 545.9 | $ | 44.2 | $ | 590.1 | 2 | % | ||||||||
2016 |
$ | 555.9 | $ | 44.2 | $ | 600.1 | 2 | % | ||||||||
2017 |
$ | 567.3 | $ | 44.2 | $ | 611.5 | 2 | % |
We believe L-3 is well positioned to benefit from several of the DoDs focus areas. However, declining DoD budgets, will generally pressure and possibly reduce funding for some of our revenue arrangements, which can negatively impact our results of operations and cash flows. The in-process withdrawal of U.S. military forces from Afghanistan by the end of 2014 is expected to continue to negatively impact our sales related to supporting U.S. military operations in Afghanistan. Additionally, if the DoD budget sequestration cuts occur, we expect that they will negatively impact our results of operations and cash flows, and could potentially trigger goodwill impairment charges. See Critical Accounting Policies Goodwill and Identifiable Assets within this section.
The Administrations proposed DoD FY 2014 budget or plan, which was scheduled for release in February 2013, has been delayed to March 2013 or later, due to the ongoing debate between the Administration and Congress about U.S Federal government deficit reduction, including spending and revenues, debt levels and the BCA sequestration cuts.
Commercial and International Markets. Sales to end customers other than the U.S. Government represented 24% of our 2012 sales. These sales are generally affected by global economic conditions for our commercial end markets and foreign government security and military priorities, as well as the fiscal situations of our foreign government end customers.
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Key Performance Measures
The primary financial performance measures that we use to manage our businesses and monitor results of operations are sales trends and operating income trends. Management believes that these financial performance measures are the primary growth drivers for our earnings and cash flow per common share. One of our primary business objectives is to increase sales from organic growth and select business acquisitions. We define organic sales growth as the increase or decrease in sales for the current period compared to the prior period, excluding sales in the: (1) current period from business acquisitions that are included in our actual results of operations for less than twelve months, and (2) prior period from business and product line divestitures that are included in our actual results of operations for the twelve-month period prior to the divestiture date. We expect to supplement, strengthen and enhance our existing businesses by selectively acquiring new businesses that: (1) add important new technologies and products, (2) provide access to select customers, programs and contracts, and (3) provide attractive returns on investment. Another important financial performance measure that we use is operating margin, which we define as operating income as a percentage of sales, because sales growth combined with operating margin levels determine our operating income levels.
Sales Trends. For the year ended December 31, 2012, consolidated net sales of $13,146 million declined by 0.1%, comprised of an organic sales decline of 1.6%, partially offset by net sales from business acquisitions of 1.5%, compared to the year ended December 31, 2011. Our average annual sales growth for the five years ended December 31, 2012 was 3%, with average annual organic sales growth of approximately 2% and average annual sales growth from business acquisitions, net of divestitures, of approximately 1%. See Results of Operations, including segment results below for further discussion of sales.
For the years ended December 31, 2012, 2011, and 2010, our largest contract (revenue arrangement) in terms of annual sales was the Fort Rucker Maintenance Support contract with the U.S. Army Aviation and Missile Life Cycle Management Command (AMCOM), which is included in our AM&M segment. Under this contract, which generated approximately 4% of our 2012, 2011, and 2010 sales, we provide maintenance, logistics and other related sustainment support services for rotary wing aircraft assigned to Fort Rucker and satellite units in Alabama. On July 24, 2012, we won the AMCOM contract re-competition, which includes a one-year base period through September 30, 2013, and four one-year options, with an estimated total contract value of $1.98 billion.
Our sales trends are highly correlated to DoD budget levels because we derive approximately 71% of our annual sales from the DoD. DoD budgets are a function of several factors and uncertainties beyond our control, including, but not limited to, changes in U.S. procurement policies, budget considerations, current and future economic conditions, presidential administration priorities, U.S. military engagements, changing national security and defense requirements, geo-political developments, actual fiscal year congressional appropriations for defense budgets, and the outcome of the FY 2013 CRA and the BCA sequestration cuts. Any of these factors could result in a significant increase, decrease or redirection of DoD budgets and impact L-3s future results of operations, including our sales and operating income growth rates. Additionally, L-3s future results of operations will be affected by our ability to retain our existing business, including our revenue arrangements with DoD customers, and to successfully compete for new business, which largely depends on: (1) our successful performance on existing contracts, (2) the effectiveness and innovation of our technologies and research and development activities, (3) our ability to offer better program performance than our competitors at an affordable cost, and (4) our ability to retain our employees and hire new ones, particularly those employees who have U.S. Government security clearances.
Segment Operating Income Trends. For the year ended December 31, 2012, our segment operating income was $1,351 million, a decrease of 6% from $1,442 million for the year ended December 31, 2011. Our segment operating income as a percentage of sales (segment operating margin) was 10.3% for the year ended December 31, 2012, a decrease of 70 basis points from 11.0% for the year ended December 31, 2011. See Results of Operations, including segment results below for a discussion of operating margin.
We remain focused on increasing operating margin, to the extent possible, by reducing indirect costs, improving contract performance, and increasing sales. Our 2012 operating margin declined compared to 2011,
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and we expect our 2013 operating margin will also decline as compared to 2012. While we are taking action to maintain and increase operating margin, we may not be able to do so in the future. Furthermore, select business acquisitions and select new business, including contract renewals and new contracts, could have lower operating margins than L-3s operating margins on existing business and contracts. Changes in the competitive environment and DoD procurement practices, reductions to the DoD budget, changes in our annual pension expense and our consolidated sales levels could also result in lower operating margin.
2012 Events
Spin-off of Engility. On July 17, 2012, L-3 completed the spin-off of its subsidiary, Engility, to L-3s shareholders. The spin-off was a tax-free distribution to L-3 shareholders for U.S. federal tax purposes, except for cash received in lieu of fractional shares. L-3 shareholders of record on July 16, 2012 (the record date) received one share of Engility common stock for every six shares of L-3 common stock held on the record date. Engility began trading as an independent publicly traded company on the New York Stock Exchange on July 18, 2012.
In connection with the spin-off, Engility made a cash distribution of $335 million to L-3. We used a portion of the proceeds to redeem $250 million of our 6 3/8% Senior Subordinated Notes due 2015 (6 3/8% 2015 Notes) on July 26, 2012 and the remaining proceeds were used primarily to repurchase outstanding shares of our common stock. There was no gain or loss recognized by us as a result of the spin-off transaction.
Prior to the completion of the spin-off, L-3 and Engility entered into a Distribution Agreement dated July 16, 2012 and several other agreements that govern certain aspects of our relationship with Engility following the spin-off. These agreements generally provide that each party is responsible for its respective assets, liabilities and obligations, including employee benefits, insurance and tax-related assets and liabilities, following the spin-off, whether accrued or contingent. The agreements also describe our future commitments to provide Engility with certain services for a period of two to eighteen months in most circumstances.
As a result of the spin-off, the assets, liabilities, non-controlling interest, results of operations and cash flows of the Engility businesses have been classified as discontinued operations for all periods presented. We incurred transaction expenses in connection with the spin-off of $19 million ($14 million after income taxes) for the year ended December 31, 2012 and $9 million ($7 million after income taxes) for the year ended December 31, 2011, which have been included in discontinued operations. In addition, we allocated interest expense for debt not directly attributable or related to L-3s other operations of $14 million, $31 million, and $33 million to discontinued operations for the years ended December 31, 2012, 2011, and 2010, respectively. Interest expense was allocated in accordance with the accounting standards for discontinued operations and was based on the ratio of Engility net assets to the sum of: (1) total L-3 consolidated net assets and (2) L-3 consolidated total debt.
Engilitys statement of operations data, which has been classified as discontinued operations, is provided in the table below. See Note 4 to the audited consolidated financial statements for additional information.
January 1 to July 17, |
Year Ended December 31, | |||||||||||
2012 | 2011 | 2010 | ||||||||||
(in millions) | ||||||||||||
Product and service revenues |
$ | 911 | $ | 2,011 | $ | 2,290 | ||||||
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Operating income from discontinued operations before income taxes |
68 | 199 | 265 | |||||||||
Interest expense allocated to discontinued operations |
(14 | ) | (31 | ) | (33 | ) | ||||||
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Income from discontinued operations before income taxes |
$ | 54 | $ | 168 | $ | 232 | ||||||
Income tax expense |
22 | 64 | 90 | |||||||||
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Income from discontinued operations, net of income tax |
$ | 32 | $ | 104 | $ | 142 | ||||||
Less: Net income attributable to noncontrolling interests |
4 | 3 | 2 | |||||||||
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Net income from discontinued operations attributable to L-3 |
$ | 28 | $ | 101 | $ | 140 | ||||||
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2012 Amended and Restated Revolving Credit Facility. On February 3, 2012, we amended and restated our $1 billion Revolving Credit Facility, which extended the expiration date to February 3, 2017. The terms of the Amended and Restated Revolving Credit Facility are substantially consistent with the terms of this facility prior to its amendment and restatement except that: (1) provisions that previously limited the ability of L-3 Communications to pay dividends, repurchase L-3 Holdings common stock and make other distributions with respect to any capital stock were eliminated, (2) a provision that previously limited the ability of L-3 Communications to make investments in L-3 Holdings was made less restrictive and (3) the cost of borrowings, loan commitment fees and letter of credit fees were reduced. In addition, the Amended and Restated Revolving Credit Facility provides for uncommitted incremental revolving facilities and additional term loan facilities in an aggregate principal amount of up to $500 million. See Note 10 of our audited consolidated financial statements for additional information regarding the amendment of our $1 billion Amended and Restated Revolving Credit Facility.
Debt Redemptions. On July 26, 2012, (the redemption date), L-3 Communications used a portion of the proceeds from the spin-off of Engility to redeem $250 million of L-3 Communications 63/8% Senior Subordinated Notes due 2015 (63/8% 2015 Notes) at a redemption price of 102.125%, plus accrued and unpaid interest, up to but not including the redemption date. In connection with the redemption of the 63/8% 2015 Notes, the Company recorded a debt retirement charge of $8 million ($5 million after income tax, or $0.05 per diluted share).
On October 15, 2012 (the redemption date), L-3 Communications redeemed the remaining outstanding $250 million of its 63/8% 2015 Notes at a redemption price of 101.063%, plus accrued and unpaid interest, up to but not including the redemption date. In connection with the redemption, the Company recorded a debt retirement charge of approximately $5 million ($3 million after income tax, or $0.03 per diluted share).
2011 Events
Our 2011 results were impacted by the items discussed below, which increased net income attributable to L-3 by $28 million and diluted earnings per share by $0.26 (collectively referred to as the Q4 2011 Items):
| A tax benefit of $78 million, or $0.74 of diluted earnings per share, for a net reversal of amounts previously accrued related to tax years for which the statutes of limitations expired; and |
| Non-cash impairment charges of $57 million ($50 million after income taxes), or $0.48 of diluted earnings per share. The impairment charges include: (1) a goodwill impairment charge of $43 million, ($42 million after income taxes, or $0.40 per diluted share), which is included in operating income and (2) $14 million, ($8 million after income taxes, or $0.08 per diluted share), which is included in interest and other income, net, for our portion of an impairment charge for long-lived assets at an equity method investment. The goodwill impairment charge was due to a decline in the estimated fair value of the Marine Services business, which is part of the Electronic Systems segment, as a result of a decline in its projected future cash flows. |
Debt Repurchases, Issuances and Redemptions. On February 2, 2011, we repurchased approximately $11 million of our CODES as a result of the exercise by the holders of their contractual right to require us to repurchase their CODES.
On February 7, 2011, L-3 Communications issued $650 million in principal amount of 4.95% Senior Notes that mature on February 15, 2021 (2021 Senior Notes). The 2021 Senior Notes were issued at a discount of $4 million. On March 9, 2011, the net cash proceeds from this offering, together with cash on hand, were used to redeem L-3 Communications $650 million 5 7/8% Senior Subordinated Notes due January 15, 2015 (5 7/8% 2015 Notes). In connection with the redemption of the 5 7/8% 2015 Notes, we recorded a debt retirement charge of $18 million ($11 million after income taxes, or $0.10 per diluted share).
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On November 22, 2011, L-3 Communications issued $500 million in principal amount of 3.95% Senior Notes that mature on November 15, 2016 (2016 Senior Notes). The 2016 Senior Notes were issued at a discount of $4 million. On December 22, 2011, the net proceeds from this offering, together with cash on hand, were used to redeem $500 million of L-3 Communications 63/8% 2015 Notes. In connection with the redemption of the 6 3/8% 2015 Notes, we recorded a debt retirement charge of $17 million ($10 million after income tax, or $0.10 per diluted share).
Business Acquisitions and Divestitures
As discussed above, one aspect of our strategy is to selectively acquire businesses that add new products and technologies, or provide access to select customers, programs and contracts. We intend to continue acquiring select businesses for reasonable valuations that will provide attractive returns to L-3. Our business acquisitions, depending on their contract-type, sales mix or other factors, could reduce L-3s consolidated operating margin while still increasing L-3s operating income, earnings per share, and net cash from operating activities. In addition, we may also dispose of certain businesses if we determine that they no longer fit into L-3s overall business strategy and we are able to receive an attractive price.
Acquisitions. The table below summarizes the acquisitions that we have completed during the years ended December 31, 2010, 2011 and 2012, referred to herein as business acquisitions. See Note 4 to our audited consolidated financial statements for further information regarding our business acquisitions. During the year ended December 31, 2012, we used net cash of $348 million primarily for business acquisitions.
Business Acquisitions |
Date Acquired | Purchase Price(1) |
||||||
(in millions) | ||||||||
2010 |
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Insight Technology Incorporated |
April 14, 2010 | $ | 611 | |||||
Airborne Technologies, Inc. |
August 4, 2010 | 34 | ||||||
3Di Technologies (3Di) |
September 17, 2010 | 60 | (2) | |||||
FUNA International, GmbH |
December 22, 2010 | 50 | ||||||
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Total 2010 |
$ | 755 | ||||||
|
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2011 |
||||||||
Communications and engineering business of ComHouse Wireless L.P. |
July 1, 2011 | $ | 13 | |||||
Cargo radiation screening business of Detector Network International (DNI) |
October 28, 2011 | 5 | (3) | |||||
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|||||||
Total 2011 |
$ | 18 | ||||||
|
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2012 |
||||||||
L-3 KEO |
February 6, 2012 | $ | 205 | (4) | ||||
MAVCO, Inc. |
April 13, 2012 | 10 | ||||||
Link Simulation & Training U.K Limited |
August 6, 2012 | 134 | (4) | |||||
|
|
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Total 2012 |
$ | 349 | ||||||
|
|
(1) | The purchase price represents the contractual consideration for the acquired business, excluding adjustments for net cash acquired and acquisition transaction costs. |
(2) | Excludes additional purchase price, not to exceed $11 million, which is contingent upon the post acquisition financial performance of 3Di through December 31, 2012. See Note 4 to our audited consolidated financial statements for additional information on the additional purchase price for this acquisition. |
(3) | Excludes additional purchase price, not to exceed $10 million, which is contingent upon the post acquisition financial performance of DNI through December 31, 2014. See Note 4 to our audited consolidated financial statements for additional information on the additional purchase price for this acquisition. |
(4) | The final purchase price is subject to adjustment based on the closing date working capital. |
39
All of our business acquisitions are included in our consolidated results of operations from their dates of acquisition. We regularly evaluate potential business acquisitions.
Divestitures. On February 22, 2011, we divested Microdyne Corporation (Microdyne) and on December 17, 2010, we divested InfraredVision Technology Corporation (ITC), both of which were within the Electronic Systems segment. These divestiture transactions resulted in pre-tax losses of approximately $2 million for Microdyne and $1 million for ITC. Microdynes and ITCs annual revenues (approximately $8 million and $4 million, respectively), pre-tax income and net assets were not material for any period presented, and, therefore, these divestitures are not reported as discontinued operations.
Spin-off of Engility: On July 17, 2012, we completed the spin-off of our subsidiary, Engility Holdings, Inc. See 2012 Events within this section for further discussion of the spin-off, distribution of proceeds and impact on our financial results and financial position.
Critical Accounting Policies
Our significant accounting policies are described in Note 2 to our audited consolidated financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of sales and cost of sales during the reporting period. The most significant of these estimates and assumptions relate to contract revenue, profit and loss recognition, fair values of assets acquired and liabilities assumed in business combinations, market values for inventories reported at lower of cost or market, pension and post-retirement benefit obligations, stock-based employee compensation expense, income taxes, including the valuations of deferred tax assets, litigation reserves and environmental obligations, accrued product warranty costs and the recoverability, useful lives and valuation of recorded amounts of long-lived assets, identifiable intangible assets and goodwill. Changes in estimates are reflected in the period during which they become known. Actual amounts will differ from these estimates and could differ materially. We believe that our critical accounting estimates have the following attributes: (1) we are required to make assumptions about matters that are uncertain and require judgment at the time of the estimate; (2) use of reasonably different assumptions could have changed our estimates, particularly with respect to estimates of contract revenues and costs, and recoverability of assets, and (3) changes in the estimate could have a material effect on our financial condition or results of operations. We believe the following critical accounting policies contain the more significant judgments and estimates used in the preparation of our financial statements.
Contract Revenue Recognition and Contract Estimates. Approximately 48% of our consolidated net sales are generated from contracts (revenue arrangements) that require us to design, develop, manufacture, modify, upgrade, test and integrate complex aerospace and electronic equipment, and to provide related engineering and technical services according to the buyers specifications. These revenue arrangements or contracts are generally fixed-price, cost-plus, or time-and-material type and are covered by accounting standards for construction-type and production-type contracts and federal government contractors. Substantially all of our cost-plus type and time-and-material type contracts are with the U.S. Government, primarily the DoD. Certain of our contracts with the U.S. Government are multi-year contracts that are funded annually by the customer, and sales on these multi-year contracts are based on amounts appropriated (funded) by the U.S. Government. Our remaining sales are accounted for in accordance with accounting standards for revenue arrangements with commercial customers.
Sales and profits on fixed-price type contracts that are covered by accounting standards for construction-type and production-type contracts and federal government contractors are substantially recognized using percentage-of-completion (POC) methods of accounting. Sales on such contracts represent approximately 39% of our consolidated net sales. Sales and profits on fixed-price production contracts under which units are produced and delivered in a continuous or sequential process are recorded as units are delivered based on their contractual selling prices (the units-of-delivery method). Sales and profits on each fixed-price production contract under which units are not produced and delivered in a continuous or sequential process, or under which a relatively few
40
number of units are produced, are recorded based on the ratio of actual cumulative costs incurred to total estimated costs at completion of the contract multiplied by the total estimated contract revenue, less cumulative sales recognized in prior periods (the cost-to-cost method). Under both POC methods of accounting, a single estimated total profit margin is used to recognize profit for each contract over its entire period of performance, which can exceed one year.
Accounting for the sales on these fixed-price contracts requires the preparation of estimates of: (1) total contract revenue, (2) total costs at completion, which is equal to the sum of the actual incurred costs to date on the contract and the estimated costs to complete the contracts statement of work, and (3) measurement of progress towards completion. The estimated profit or loss at completion on a contract is equal to the difference between the total estimated contract revenue and the total estimated cost at completion. Under the units-of-delivery method, sales on a fixed-price type contract are recorded as the units are delivered during the period based on their contractual selling prices. Under the cost-to-cost method, sales on a fixed-price type contract are recorded at amounts equal to the ratio of actual cumulative costs incurred divided by total estimated costs at completion, multiplied by (i) the total estimated contract revenue, less (ii) the cumulative sales recognized in prior periods. The profit recorded on a contract in any period using either the units-of-delivery method or cost-to-cost method is equal to (i) the current estimated total profit margin multiplied by the cumulative sales recognized, less (ii) the amount of cumulative profit previously recorded for the contract. In the case of a contract for which the total estimated costs exceed the total estimated revenues, a loss arises, and a provision for the entire loss is recorded in the period that the loss becomes evident. The unrecoverable costs on a loss contract that are expected to be incurred in future periods are recorded as a component of other current liabilities entitled Estimated cost in excess of estimated contract value to complete contracts in process in a loss position.
Adjustments to estimates for a contracts revenue, estimated costs at completion and estimated profit or loss are often required as work progresses under a contract, as experience is gained and more information is obtained, even though the scope of work required under the contract may not change, or if contract modifications occur. The impact of revisions in profit (loss) estimates for all types of contracts subject to percentage-of-completion accounting are recognized on a cumulative catch-up basis in the period in which the revisions are made. Amounts representing contract change orders or claims are included in sales only when they can be reliably estimated and their realization is reasonably assured. The revisions in contract estimates, if significant, can materially affect our results of operations and cash flows, as well as reduce the valuations of receivables and inventories, and in some cases result in liabilities to complete contracts in a loss position. Aggregate net changes in contract estimates increased operating income by $78 million, or 6%, for the year ended December 31, 2012, $73 million, or 5%, for the year ended December 31, 2011, and $45 million, or 3%, for the year ended December 31, 2010.
Sales and profits on cost-plus type contracts that are covered by accounting standards for government contractors are recognized as allowable costs are incurred on the contract, at an amount equal to the allowable costs plus the estimated profit on those costs. Sales on such contracts represent approximately 9% of our consolidated net sales. The estimated profit on a cost-plus contract is fixed or variable based on the contractual fee arrangement. Incentive and award fees are our primary variable fee contractual arrangement. Incentive and award fees on cost-plus type contracts are included as an element of total estimated contract revenues and recorded to sales when a basis exists for the reasonable prediction of performance in relation to established contractual targets and we are able to make reasonably dependable estimates for them. Sales and profits on time-and-material type contracts are recognized on the basis of direct labor hours expended multiplied by the contractual fixed rate per hour, plus the actual costs of material and other direct non-labor costs. On a time-and-material type contract, the fixed hourly rates include amounts for the cost of direct labor, indirect contract costs and profit. Cost-plus type or time-and-material type contracts generally contain less estimation risks than fixed-price type contracts.
Sales on arrangements for (1) fixed-price type contracts that require us to perform services that are not related to production of tangible assets (Fixed-Price Service Contracts), and (2) certain commercial customers are recognized in accordance with accounting standards for revenue arrangements with commercial customers. Sales for our businesses whose customers are primarily commercial business enterprises are substantially generated
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from single element revenue arrangements. Sales are recognized when there is persuasive evidence of an arrangement, delivery has occurred or services have been performed, the selling price to the buyer is fixed or determinable and collectability is reasonably assured. Sales for Fixed-Price Service Contracts that do not contain measurable units of work performed are generally recognized on a straight-line basis over the contractual service period, unless evidence suggests that the revenue is earned, or obligations fulfilled, in a different manner. Sales for Fixed-Price Service Contracts that contain measurable units of work performed are generally recognized when the units of work are completed. Sales and profit on cost-plus and time-and-material type contracts within the scope of revenue recognition accounting standards for revenue arrangements with commercial customers are recognized in the same manner as those within the scope of contract accounting standards, except for incentive and award fees. Cost-based incentive fees are recognized when they are realizable in the amount that would be due under the contractual termination provisions as if the contract was terminated. Performance based incentive fees and award fees are recorded as sales when awarded by the customer.
For contracts with multiple deliverables, we apply the separation and allocation guidance under the accounting standard for revenue arrangements with multiple deliverables, unless all the deliverables are covered by contract accounting standards, in which case we apply the separation and allocation guidance under contract accounting standards. Revenue arrangements with multiple deliverables are evaluated to determine if the deliverables should be separated into more than one unit of accounting. We recognize revenue for each unit of accounting based on the revenue recognition policies discussed above.
Sales and profit in connection with contracts to provide services to the U.S. Government that contain collection risk because the contracts are incrementally funded and subject to the availability of funds appropriated, are deferred until the contract modification is obtained, indicating that adequate funds are available to the contract or task order.
Goodwill and Identifiable Intangible Assets. In accordance with the accounting standards for business combinations, we record the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition (commonly referred to as the purchase price allocation). Identifiable intangible assets are recognized as assets apart from goodwill if they arise from contractual or other legal rights, or if they are capable of being separated or divided from the acquired business and sold, transferred, licensed, rented or exchanged. However, we do not recognize separate intangible assets for the assembled workforces of our business acquisitions.
Generally, the largest separately identifiable intangible asset from the businesses that we acquire is the value of their assembled workforces, which includes the human capital of the management, administrative, marketing and business development, scientific, engineering and technical employees of the acquired businesses. The success of our businesses, including their ability to retain existing business (revenue arrangements) and to successfully compete for and win new business (revenue arrangements), is primarily dependent on the management, marketing and business development, contracting, engineering and technical skills and knowledge of our employees, rather than on productive capital (plant and equipment, and technology and intellectual property). Additionally, for a significant portion of our businesses, our ability to attract and retain employees who have U.S. Government security clearances, particularly those with top-secret and above clearances, is critical to our success, and is often a prerequisite for retaining existing revenue arrangements and pursuing new ones. Generally, patents, trademarks and licenses are not material for our acquired businesses. Furthermore, our U.S. Government contracts (revenue arrangements) generally permit other companies to use our patents in most domestic work performed by such other companies for the U.S. Government. Therefore, because intangible assets for assembled workforces are part of goodwill, the substantial majority of the intangible assets for our acquired business acquisitions are recognized as goodwill. Additionally, the value assigned to goodwill for our business acquisitions also includes the value that we expect to realize from cost reduction measures that we implement for our acquired businesses. Goodwill equals the amount of the purchase price of the business acquired in excess of the sum of the fair value of identifiable acquired assets, both tangible and intangible, less the fair value of liabilities assumed. At December 31, 2012, we had goodwill of $7,744 million and identifiable intangible assets of $314 million.
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The most significant identifiable intangible asset that is separately recognized in accordance with U.S. GAAP for our business acquisitions is customer contractual relationships. All of our customer relationships are established through written customer contracts (revenue arrangements). The fair value for customer contractual relationships is determined, as of the date of acquisition, based on estimates and judgments regarding expectations for the estimated future after-tax earnings and cash flows (including cash flows from working capital) arising from the follow-on sales on contract (revenue arrangement) renewals expected from customer contractual relationships over their estimated lives, including the probability of expected future contract renewals and sales, less a contributory asset charge, all of which is discounted to present value. All identifiable intangible assets are amortized over their estimated useful lives as the economic benefits are consumed. We review customer contractual relationships for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable in accordance with the accounting standards for long-lived assets. If any such event or change in circumstances occurs, and, if our revised estimates of future after-tax cash flows are significantly lower than our estimates at the date we acquired the customer contractual relationships, we may be required to record an impairment charge to write down these intangible assets to their realizable values. We also review and update our estimates of the duration of our customer contractual relationships, at least annually. If such estimates indicate that the duration of our customer contractual relationships has decreased compared to the estimates made as of the date we acquired these intangible assets, then we accelerate the amortization period for our customer contractual relationships over their remaining useful economic lives.
We review goodwill for impairment annually as of November 30 and, additionally on an interim basis, whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The accounting standards for goodwill allow for the assessment of qualitative factors, such as macroeconomic conditions, industry and market conditions and entity relevant events or circumstances to determine whether it is more likely or not that the fair value of a reporting unit is less than its carrying amount. L-3 did not utilize a qualitative assessment approach for the November 30, 2012 goodwill impairment test, as we chose instead to complete the quantitative two-step testing process for each reporting unit.
A reporting unit is an operating segment, as defined by the segment reporting accounting standards, or a component of an operating segment. A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and is reviewed by operating segment management. Two or more components of an operating segment may be aggregated and deemed a single reporting unit for goodwill impairment testing purposes if the components have similar economic characteristics.
L-3 had 15 reporting units at December 31, 2012 compared to 17 reporting units at December 31, 2011. The composition of our reporting units and associated goodwill balances changed in 2012 as compared to 2011 due to business realignments that resulted in the consolidation of two reporting units into other existing reporting units. The reporting units had fair values in excess of their carrying values at the time of the realignments and the related goodwill for each was included in the existing reporting units.
L-3s aggregate balance of goodwill increased by $272 million to $7,744 million at December 31, 2012 from $7,472 million at December 31, 2011 due to $250 million for business acquisitions and $22 million of foreign currency translation adjustments. The table below presents the number of reporting units and the associated goodwill at December 31, 2012 for each of our reportable segments.
Reportable Segment |
Number of Reporting Units |
Aggregate Goodwill |
||||||
(in millions) | ||||||||
Electronic Systems |
11 | $ | 4,804 | |||||
C3ISR |
2 | 797 | ||||||
AM&M |
1 | 1,175 | ||||||
NSS |
1 | 968 | ||||||
|
|
|
|
|||||
Total |
15 | $ | 7,744 | |||||
|
|
|
|
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The first step in the process of testing goodwill for potential impairment is to compare the carrying value of the reporting unit to its fair value. If a potential impairment is identified, the second step is to measure the impairment loss by comparing the implied fair value of goodwill with the carrying value of goodwill of the reporting unit. Our methodology for determining the fair value of a reporting unit is estimated using a discounted cash flow (DCF) valuation approach, and is dependent on estimates for future sales, operating income, depreciation and amortization, income tax payments, working capital changes, and capital expenditures, as well as expected long-term growth rates for cash flows. All of these factors are affected by economic conditions related to the industries in which we operate (predominantly the U.S. defense industry), as well as, conditions in the U.S. capital markets.
The more significant assumptions used in our DCF valuations to determine the fair values of our reporting units in connection with the goodwill valuation assessment at November 30, 2012 were: (1) detailed three-year cash flow projections for each of our reporting units, which are based primarily on our estimates of future sales, operating income, and cash flows, (2) the expected long-term growth rates for each of our reporting units, which approximate the expected long-term growth rate for the U.S. economy and the respective industries in which the reporting units operate, and (3) risk adjusted discount rates, which represent the weighted average cost of capital (WACC) for each reporting unit and include the estimated risk-free rate of return that is used to discount future cash flow projections to their present values. There were no significant changes to the underlying methods used in 2012 as compared to the prior year DCF valuations of our reporting units.
Each reporting unit WACC was comprised of: (1) an estimated required rate of return on equity, based on publicly traded companies with business and economic risk characteristics comparable to each of L-3s reporting units (Market Participants), including a risk free rate of return of 2.81% on the 30 year U.S. Treasury Bond as of November 30, 2012 (3.06% as of November 30, 2011) and an equity risk premium of 6% (same as 2011) and (2) an after-tax rate of return on Market Participants debt, each weighted by the relative market value percentages of Market Participants equity and debt. The WACC assumptions for each reporting unit are based on a number of market inputs that are outside of our control and are updated annually to reflect changes to such market inputs as of the date of our annual goodwill impairment assessments, including changes to: (1) the estimated required rate of return on equity based on historical returns on common stock securities of Market Participants and the Standard & Poors 500 Index over the prior two-year period, (2) the risk free rate of return based on the prevailing market yield on the 30 year U.S. Treasury Bond, (3) the rate of return of Market Participants publically traded debt securities, and (4) the relative market value percentages of Market Participants equity and debt.
The table below presents the weighted average risk adjusted discount rate assumptions used in our DCF valuation for each of our reportable segments for our goodwill impairment assessments at November 30, 2012.
Reportable Segment |
WACC | |||
Electronic Systems(1) |
6.77 | % | ||
C3ISR(2) |
6.56 | % | ||
AM&M |
6.56 | % | ||
NSS |
6.94 | % |
(1) | The weighted average risk adjusted discount rate for the Electronic Systems reportable segment is comprised of separate discount rates for each reporting unit within the segment that range from 6.56% to 7.33%. |
(2) | Both reporting units within the C3ISR reportable segment used the risk adjusted discount rate as presented in the table above. |
As presented in the table below, L-3s historical three-year average annual cash flow growth rates for 2012, 2011 and 2010 for our reportable segments ranged from a negative 4% to a positive 63%. The annual cash flows generated by each of our reporting units varies from year to year, and, therefore, the annual cash flow growth rates do not result in linear trends, due to a number of factors. The factors that affect the level of annual cash flows in each of our reporting units include, but are not limited to: (1) variability of annual sales volume and sales growth rates, (2) increases and decreases in working capital, including customer advance payments and billings on multi-year contracts (revenue arrangements) with long-term performance periods (exceeding one
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year), (3) the timing of invoicing and cash collections between fiscal years from receivables due from customers on multi-year contracts (revenue arrangements), (4) the timing of increases and decreases of select inventories procured and produced in anticipation of future product sales, which frequently overlap the ending and beginning of fiscal years, (5) the timing of the receipt of award fee and incentive fee payments from customers on contracts (revenue arrangements), (6) variability in annual cash outlays for research and development costs, (7) changes in cash outlays for capital expenditures for property, plant and equipment, and (8) increases in annual sales and costs and expense volumes of a reporting unit resulting from business acquisitions. As a result of the factors discussed above and the varying sizes of our reporting units, the annual cash flow levels and growth rates at the reporting unit level tend to fluctuate significantly from year to year.
The 2012 cash flow amount and the cash flow growth rate for each of the last three years for each of our segments are presented in the following table.
Reportable Segment |
Estimated 2012 Cash Flow(1) |
Estimated Average Annual Cash Flow Growth Rate(1) | ||||||||||||||||||
(in millions) | 2012 | 2011 | 2010 | 3 Yr. Average | ||||||||||||||||
Electronic Systems(2) |
$ | 501 | (5)% | (9)% | 1 % | (4)% | ||||||||||||||
C3ISR(3) |
$ | 250 | (3)% | 130% | (40)% | 29% | ||||||||||||||
AM&M(4) |
$ | 150 | (14)% | (24)% | 46 % | 3% | ||||||||||||||
NSS(5) |
$ | 147 | 20% | 214% | (44)% | 63% |
(1) | Reportable segment estimated cash flow excludes interest payments on debt and other corporate cash flows. |
(2) | The decrease in 2012 cash flows for Electronic Systems was primarily due to lower operating income compared to 2011 for Space & Propulsion and Power & Control Systems. The decrease in 2011 cash flows was primarily due to lower operating income compared to 2010 for Warrior Systems, Training & Simulation, Space & Propulsion and Microwave and liquidation of advance payments at Microwave, partially offset by lower working capital requirements at Warrior Systems. The increase in 2010 cash flow was primarily due to higher operating income compared to 2009 for Sensor Systems, Microwave, Aviation Products and Undersea Warfare, partially offset by lower operating income for force protection products and systems. |
(3) | The decrease in 2012 cash flow for C3ISR was due to higher capital expenditures and an increase in tax payments as a result of a higher effective tax rate, partially offset by the timing of billings and cash receipts on fixed-price contracts. The increase in 2011 cash flow was due to working capital improvements, timing of billings and cash receipts on fixed-price contracts, and growth in operating income. The decrease in 2010 cash flow was due to the timing of billings and cash receipts on certain fixed-price contracts for networked communications and higher working capital requirements, partially offset by growth in sales and operating income. |
(4) | The decrease in 2012 cash flow for AM&M was primarily due to higher working capital requirements, primarily for inventory on new contracts that began in 2012 and an increase in estimated tax payments, partially offset by higher operating income and an increase in advanced payments. The decrease in 2011 cash flow was primarily due to higher working capital, primarily for inventory on new contracts that began in 2011 and the timing of billings, partially offset by an increase in advanced payments. The increase in 2010 cash flow was primarily due to working capital reductions, primarily for the billed receivables on contracts nearing completion and the loss of the SOFSA contract, and lower capital expenditures. |
(5) | The increase in 2012 cash flow for NSS was primarily due to the timing of billings and cash receipt and an increase in advance payments. The increase in 2011 cash flow was primarily due to working capital reductions due to lower sales volume, a decrease in tax payments and lower operating income. The decrease in 2010 cash flow was primarily due to lower margins on select contract renewals and new contracts. |
We consistently consider several factors to determine expected future annual cash flows for our reporting units, including, historical multi-year average cash flow trends by reporting unit and the expected future cash flow growth rates for each of our reporting units primarily based on our estimates of future sales, operating income, and working capital changes. Furthermore, the substantial majority of our reporting units are primarily dependent upon the DoD budget and spending. Historically, over 70% of L-3s annual sales have been generated from DoD customers. Accordingly, to determine expected future annual cash flows for our reporting units we also consider: (1) the DoD budget and spending priorities, (2) expansion into new markets, (3) changing conditions in existing markets for our products, systems, and services, (4) possible termination of certain government contracts, (5) expected success in new business competitions and re-competitions on existing business, and (6) anticipated operating margins and working capital requirements, which vary significantly depending on the stage of completion (early, mature, ending) of contracts (revenue arrangements). We closely monitor changes in these factors and their impact on the expected cash flow of our reporting units.
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In addition to the factors noted in the previous paragraph that were relevant and specific to each of our reporting units, our goodwill impairment assessments as of November 30, 2012 assumed a declining DoD budget through 2014 with growth of 2% beginning with fiscal year 2015, consistent with our discussion of industry considerations. However, our current estimates and assumptions may not result in the projected cash flow outcomes due to a number of factors, including:
| The outcome of potential additional DoD budget reductions of approximately $490 billion for FY 2013 to FY 2021 due to BCA sequestration cuts, which become effective on March 1, 2013 unless modified by additional legislation, which could have a negative impact on the fair values of at least some of our reporting units, and potentially trigger significant goodwill impairment charges; |
| even if the BCA sequestration cuts are avoided, additional DoD budget reductions made as part of any broader budget deficit negotiations could have a negative impact on the fair values of at least some our reporting units, and potentially trigger significant goodwill impairments; and |
| resolution of the FY 2013 DoD Plan and related six-month CRA. |
Additionally, our actual cash flows may be higher than our projections and the DCF valuation does not reflect actions that we may take to increase the profitability and cash flows of our reporting units, including our six reporting units with fair value cushions of less than 20% in the second table below. Actions we may take include consolidating and streamlining select business operations, creating future synergies with other L-3 businesses, or pursuing incremental targeted growth opportunities. Additionally, the DCF valuations do not assume future business acquisitions or divestitures.
The table below presents the estimated (1) 2013 cash flow amount, (2) average annual cash flow growth rates for 2013 2015, and (3) weighted average annual cash flow growth rates for 2016 and 2017 and after 2017 for each of our reportable segments.
Reportable Segment |
Estimated Cash Flow |
Estimated Average Annual Cash Flow Growth Rates | ||||||||||||||
(in millions) 2013 |
3 Yr. Average 2013 2015 |
2016 2017 | After 2017 | |||||||||||||
Electronic Systems |
$ | 400 | (1) | 2% | 0% | 1% | ||||||||||
C3ISR |
$ | 252 | (2) | (7)% | 0% | 2% | ||||||||||
AM&M |
$ | 130 | (3) | (7)% | 0% | 1% | ||||||||||
NSS |
$ | 76 | (4) | (14)% | 0% | 1% |
(1) | Electronic Systems projected cash flow is expected to decrease by $101 million from $501 million in 2012 to $400 million in 2013. The decrease is mainly due to lower operating income and higher working capital requirements at Aviation Products and Microwave, higher capital expenditures at Simulation & Training, and liquidation of advance payments on a contract with a non-DoD customer at Precision Engagement. |
(2) | C3ISR projected cash flow is expected to remain flat from 2012 to 2013. |
(3) | AM&M projected cash flow is expected to decrease by $20 million from $150 million in 2012 to $130 million in 2013. The decrease is primarily due to lower expected operating income and higher capital expenditures due to IT systems and facility upgrades. |
(4) | NSS projected cash flow is expected to decrease by $71 million from $147 million in 2012 to $76 million in 2013. The expected decrease is primarily due to 2012 working capital improvements, primarily due to the collection of billed receivables and advance payments, not expected to recur in 2013. Projected 2013 sales and operating income are also expected to decline as compared to 2012, although at a slower rate, which will contribute to a decline in 2013 cash flow. |
A decline in the estimated fair value of a reporting unit could result in a goodwill impairment, and a related non-cash impairment charge against earnings, if the estimated fair value for the reporting unit is less than the carrying value of the net assets of the reporting unit, including its goodwill. A large decline in estimated fair value of a reporting unit could result in an adverse effect on our financial condition and results of operations.
In order to evaluate the sensitivity of the fair value calculations relating to our goodwill impairment assessment, we applied hypothetical decreases to the estimated fair values of each of our reporting units. We determined that a decrease in fair value of at least 20% would be required before any reporting unit, with the exception of six reporting units presented in the table below, would have a carrying value in excess of its fair
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value. The table below presents the: (1) risk adjusted discount rates, (2) annual cash flow and three-year average growth rate, (3) 2012 cash flow, (4) goodwill balance, and (5) excess fair value percentage and dollar amount, for each of these six reporting units.
Risk
Adjusted Discount Rates |
Estimated Annual Cash Flow Growth Rate(1) |
Estimated 2012 Cash Flows(1) |
Goodwill Balance(2) |
Excess Fair Value(3) |
||||||||||||||||||||||||||||||||
Reporting Unit |
2012 | 2011 | 2010 | 3 Year Average |
||||||||||||||||||||||||||||||||
Marine Services(4) |
6.56% | (171)% | (66)% | (66)% | (101)% | $ | (2 | ) | $ | 63 | 14% | $ | 13 | |||||||||||||||||||||||
Undersea Warfare(5) |
6.56% | (73)% | (33)% | 24% | (27)% | $ | 9 | $ | 206 | 14% | $ | 23 | ||||||||||||||||||||||||
NSS(6) |
6.94% | 20% | 214% | (44)% | 63% | $ | 147 | $ | 968 | 13% | $ | 147 | ||||||||||||||||||||||||
Space & Propulsion Systems(7) |
6.56% | (111)% | (46)% | (19)% | (59)% | $ | (3 | ) | $ | 242 | 9% | $ | 24 | |||||||||||||||||||||||
Warrior Systems(8) |
6.63% | 84% | (40)% | (24)% | 9% | $ | 42 | $ | 605 | 9% | $ | 96 | ||||||||||||||||||||||||
Power & Control Systems(9) |
6.56% | (57)% | 21% | (34)% | (24)% | $ | 35 | $ | 781 | 7% | $ | 57 |
(1) | Reporting unit cash flow excludes interest payments on debt and other corporate cash flows. |
(2) | The goodwill balance is as of November 30, 2012, our goodwill impairment testing date. |
(3) | The excess fair value represents the percentage and dollar amount by which the fair value of a reporting unit must decline before a potential impairment is identified and would require the second step of the goodwill impairment assessment to be performed. |
(4) | Our DCF valuation for this reporting unit assumed higher projected cash flow of approximately $5 million in 2013 compared to 2012 due to planned working capital improvements and higher operating income. This will result in projected 2013 cash flow of $3 million, which would be equal to 2011 actual cash flow. In addition, our DCF valuation assumed that projected cash flows will grow approximately $2 million in 2014, remain flat to 2017 and then grow 1% annually after 2017. |
(5) | Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 32% in 2013 compared to 2012 levels due to liquidations of advance payments on contracts with non-DoD customers and contracts nearing completion. In addition, our DCF valuation assumed that projected cash flow will increase $13 million in 2014 from 2013 due to expected customer advance payments on new and follow-on contracts with foreign navies. Cash flow is projected to decline to 2012 levels in 2015 due to lower demand from foreign navies and liquidations of customer advance payments. Projected cash flows are expected to remain flat in 2016 and 2017 and then grow 1% annually after 2017. |
(6) | Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 48% in 2013 compared to 2012 due to lower expected sales and operating income, as well as 2012 cash inflows that are not expected to recur, including collections of billed receivables and customer advance payments. In addition, our DCF valuation assumed that projected cash flow will remain approximately 45% below 2012 levels in 2014 and 2015 due to lower DoD budgets. Projected cash flows are expected to remain flat from 2016 to 2017 and then grow 0.5% annually after 2017. |
(7) | Our DCF valuation for this reporting unit assumed positive cash flow of $1 million in 2013 compared to 2012 levels due to expected working capital improvements and higher operating income, partially offset by capital expenditures for a production facility and liquidation of customer advance payments on a large international contract. In addition, our DCF valuation assumed cash flow would increase by approximately $20 million in 2014 and remain flat in 2015, which would be approximately the same as actual cash flow levels in 2011. This increase reflects growth in M-60 tank refurbishments for foreign militaries and a ramp up in Bradley fighting vehicle production. Projected cash flows are expected to remain flat in 2016 compared to 2015 and then grow 0.4% after 2017. |
(8) | Our DCF valuation for this reporting unit assumed higher projected cash flow of approximately 22% in 2013 compared to 2012 levels due increased sales and lower working capital needs, primarily for inventory. In addition, our DCF valuation assumed that projected cash flow will grow 19% and 33% above 2013 levels in 2014 and 2015, respectively, primarily due to increased international sales at higher margins and associated customer advance payments and higher margins on domestic programs due to improved performance. Projected cash flows are expected to remain flat in 2016 as compared to 2015 and then grow 1% annually after 2017. |
(9) | Our DCF valuation for this reporting unit assumed higher projected cash flow of approximately 2% in 2013 compared to 2012 and remains flat in 2014 as compared to 2013. The DCF valuation assumed an increase of 26% in 2015 cash flow due to customer advance payments on new and follow-on contracts with foreign governments. Projected cash flows are expected grow 0.8% from 2016 to 2017 and then grow 1.4% annually after 2017. |
Pension Plan and Postretirement Benefit Plan Obligations. The obligations for our pension plans and postretirement benefit plans and the related annual costs of employee benefits are calculated based on several long-term assumptions, including discount rates and expected mortality for employee benefit liabilities, and rates of return on plan assets, and expected annual rates for salary increases for employee participants in the case of pension plans, and expected annual increases in the costs of medical and other health care benefits in the case of postretirement benefit obligations. These long-term assumptions are subject to revision based on changes in interest rates, financial market conditions, expected versus actual returns on plan assets, expected participant mortality and other actuarial assumptions, including future rates of salary increases, benefit formulas and levels, and rates of increase in the costs of benefits. Changes in the assumptions, if significant, could materially affect the amount of annual net periodic benefit costs recognized in our results of operations from one year to the next,
47
the liabilities for the pension plans and postretirement benefit plans, and our annual cash requirements to fund these plans. Our pension expense for 2013 is expected to increase by $3 million to $182 million from $179 million in 2012. Our discount rate assumption decreased from a weighted average rate of 5.02% in 2011 to 4.15% in 2012. The expected increase in our 2013 pension expense is primarily due to the decrease in discount rate, partially offset by decrease in salary scale assumptions. See Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Pension Plans for a further discussion of our estimated 2013 pension expense.
Discount rates are used to determine the present value of our pension obligations and also affect the amount of pension expense in any given period. The discount rate assumptions used to determine our pension and postretirement benefit obligations at December 31, 2012 and 2011 were based on a hypothetical AA yield curve represented by a series of annualized individual discount rates. Each bond issue underlying the yield curve is required to have a rating of AA or better by Moodys Investors Service, Inc. and/or Standard & Poors. The resulting discount rate reflects the matching of plan liability cash flows to the yield curve. For a sensitivity analysis projecting the impact of a change in the discount rate on our projected benefit obligation and pension expense, see Part II Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Pension Plans.
Valuation of Deferred Income Tax Assets and Liabilities. At December 31, 2012, we had deferred tax assets of $666 million, deferred tax liabilities of $880 million and a valuation allowance of $19 million. The deferred tax assets include $20 million for loss carryforwards and $9 million for tax credit carryforwards which are subject to various limitations and will expire if unused within their respective carryforward periods. Deferred income taxes are determined separately for each of our tax-paying entities in each tax jurisdiction. The future realization of our deferred income tax assets ultimately depends on our ability to generate sufficient taxable income of the appropriate character (for example, ordinary income or capital gains) within the carryback and carryforward periods available under the tax law and, to a lesser extent, our ability to execute successful tax planning strategies. Based on our estimates of the amounts and timing of future taxable income and tax planning strategies, we believe that we will be able to realize our deferred tax assets, except for capital losses and certain U.S. Federal, foreign and state net operating losses. A change in the ability of our operations to continue to generate future taxable income, or our ability to implement desired tax planning strategies, could affect our ability to realize the future tax deductions underlying our deferred tax assets, and require us to provide a valuation allowance against our deferred tax assets. The recognition of a valuation allowance would result in a reduction to net income and, if significant, could have a material impact on our effective tax rate, results of operations and financial position in any given period.
Liabilities for Pending and Threatened Litigation. We are subject to litigation, government investigations, proceedings, claims or assessments and various contingent liabilities incidental to our business or assumed in connection with certain business acquisitions. In accordance with the accounting standards for contingencies, we accrue a charge for a loss contingency when we believe it is both probable that a liability has been incurred, and the amount of the loss can be reasonably estimated. If the loss is within a range of specified amounts, the most likely amount is accrued, and if no amount within the range represents a better estimate we accrue the minimum amount in the range. Generally, we record the loss contingency at the amount we expect to pay to resolve the contingency and the amount is generally not discounted to the present value. Amounts recoverable under insurance contracts are recorded as assets when recovery is deemed probable. Contingencies that might result in a gain are not recognized until realizable. Changes to the amount of the estimated loss, or resolution of one or more contingencies could have a material impact on our results of operations, financial position and cash flows. See Note 19 to our audited consolidated financial statements for further discussion of our litigation matters.
Valuation of Long-Lived Assets. In addition to goodwill and identifiable intangible assets recognized in connection with our business acquisitions, our long-lived assets also include property, plant and equipment, capitalized software development costs for software to be sold, leased or otherwise marketed, and certain long-term investments. As of December 31, 2012, the consolidated carrying values of our property, plant and equipment were $1,017 million, certain long-term investments were $9 million, and capitalized software development costs were $36 million. As of December 31, 2012, the carrying value of our property, plant and
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equipment represented 7% of total assets and the carrying value of our capitalized software development costs and certain long-term investments each represented less than 1% of total assets. We review the valuation of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. An impairment loss is recognized when the carrying amount of a long-lived asset exceeds its fair value or net realizable value expected to result from the assets use and eventual disposition. We use a variety of factors to assess valuation, depending upon the asset. Long-lived assets are evaluated based upon the expected period the asset will be utilized, and other factors depending on the asset, including estimated future sales, profits and related cash flows, estimated product acceptance and product life cycles, changes in technology and customer demand, and the performance of invested companies and joint ventures. Changes in estimates and judgments on any of these factors could have a material impact on our results of operations and financial position.
Results of Operations
The following information should be read in conjunction with our audited consolidated financial statements. The following information has been adjusted to reflect the spin-off of Engility and related classification of assets, liabilities, non-controlling interests, results of operations and cash flows as discontinued operations. Also, our results of operations for the periods presented are affected by our business acquisitions. See Note 4 to our audited consolidated financial statements for a discussion of our business acquisitions.
Consolidated Results of Operations
The table below provides selected financial data, excluding discontinued operations, for the years ended December 31, 2012, 2011 and 2010.
Year
Ended December 31, |
Increase/ (decrease) |
Year
Ended December 31, |
Increase/ (decrease) |
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(in millions, except per share data) | 2012 | 2011(1) | 2011(1) | 2010 | ||||||||||||||||||||
Net sales |
$ | 13,146 | $ | 13,158 | $ | (12 | ) | $ | 13,158 | $ | 13,390 | $ | (232 | ) | ||||||||||
Operating income |
$ | 1,351 | $ | 1,399 | $ | (48 | ) | $ | 1,399 | $ | 1,485 | $ | (86 | ) | ||||||||||
Goodwill impairment charge |
| 43 | (43 | ) | 43 | | 43 | |||||||||||||||||
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Segment operating income |
$ | 1,351 | $ | 1,442 | $ | (91 | ) | $ | 1,442 | $ | 1,485 | $ | (43 | ) | ||||||||||
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Operating margin |
10.3 | % | 10.6 | % | (30 | ) bpts | 10.6 | % | 11.1 | % | (50 | )bpts | ||||||||||||
Goodwill impairment charge |
| % | 0.4 | % | (40 | ) bpts | 0.4 | % | | 40 | bpts | |||||||||||||
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Segment operating margin |
10.3 | % | 11.0 | % | (70 | ) bpts | 11.0 | % | 11.1 | % | (10 | )bpts | ||||||||||||
Interest expense |
$ | 184 | $ | 204 | $ | (20 | ) | $ | 204 | $ | 236 | $ | (32 | ) | ||||||||||
Interest and other income |
$ | 8 | $ | | $ | 8 | $ | | $ | 21 | $ | (21 | ) | |||||||||||
Debt retirement charge |
$ | 13 | $ | 35 | $ | (22 | ) | $ | 35 | $ | 18 | $ | 17 | |||||||||||
Effective income tax rate |
32.2 | % | 25.5 | % | 670 | bpts | 25.5 | % | 34.2 | % | (870 | ) bpts | ||||||||||||
Net income from continuing operations attributable to L-3 |
$ | 782 | $ | 855 | $ | (73 | ) | $ | 855 | $ | 815 | $ | 40 | |||||||||||
Q4 2011 items |
| (28 | ) | 28 | (28 | ) | | (28 | ) | |||||||||||||||
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Net income from continuing operations attributable to L-3, excluding Q4 2011 Items |
$ | 782 | $ | 827 | $ | (45 | ) | $ | 827 | $ | 815 | $ | 12 | |||||||||||
Diluted earnings per share from continuing operations |
$ | 8.01 | $ | 8.08 | $ | (0.07 | ) | $ | 8.08 | $ | 7.04 | $ | 1.04 | |||||||||||
Q4 2011 Items |
| (0.26 | ) | 0.26 | (0.26 | ) | | (0.26 | ) | |||||||||||||||
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Diluted earnings per share from continuing operations, excluding Q4 2011 items |
$ | 8.01 | $ | 7.82 | $ | 0.19 | $ | 7.82 | $ | 7.04 | $ | 0.78 | ||||||||||||
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Diluted weighted average common shares outstanding |
97.6 | 105.6 | (8.0 | ) | 105.6 | 115.1 | (9.5 | ) |
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(1) | The year ended December 31, 2011 includes: (1) a tax benefit of $78 million, or $0.74 of diluted earnings per share, for a net reversal of amounts previously accrued related to tax years for which the statute of limitations has expired, (2) a non-cash goodwill impairment charge of $43 million ($42 million after income taxes), or $0.40 per diluted share due to a decline in the estimated fair value of our Marine Services business and (3) $14 million ($8 million after income taxes), or $0.08 per diluted share for our share of an impairment charge for long-lived assets at an equity method investment. These items are collectively referred to as the Q4 2011 Items. |
The company believes that the Q4 2011 Items affect the comparability of the results of operations of the 2012 full year to the results of operations for the 2011 full year. The company also believes that disclosing net income and diluted EPS excluding the Q4 2011 Items will allow financial statement users to more easily compare the 2012 full year results to the 2011 full year results. Further, the goodwill impairment charge is included in consolidated operating income, but excluded from segment operating income because the charge is excluded by management for purposes of assessing segment operating performance. |
2012 Compared with 2011
Net Sales: For the year ended December 31, 2012, consolidated net sales of $13,146 million decreased by $12 million, or 0.1%, compared to the year ended December 31, 2011. Higher sales from the C3ISR, Electronic Systems and AM&M segments were offset by lower sales from the NSS segment. Acquired businesses, which are all included in the Electronic Systems segment, added $196 million to net sales in the year ended December 31, 2012. Net sales to commercial and foreign government end customers grew 15% to $3,120 million for the year ended December 31, 2012 compared to $2,719 million for the year ended December 31, 2011.
Sales from products, which primarily include products from our C3ISR and Electronic Systems segments, decreased by $17 million to $7,535 million compared to $7,552 million for the year ended December 31, 2012, representing 57% of consolidated net sales, for both years ended December 31, 2012 and 2011. The decrease in product sales was due to sales volume declines primarily for Power & Control Systems, Warrior Systems, network communication systems, and Precision Engagement. These decreases were partially offset by sales from the L-3 KEO and Link U.K. business acquisitions and organic sales growth primarily for: (1) Platform systems for new contracts, (2) airborne ISR systems and (3) Microwave Products.
Sales from services, primarily from our NSS, AM&M and C3ISR segments, increased by $5 million to $5,611 million compared to $5,606 million for the year ended December 31, 2012, representing 43% of consolidated net sales, for both years ended December 31, 2012 and 2011. Sales from services increased primarily due to sales growth primarily from airborne ISR logistics support and fleet management services, networked communications systems and Sensor Systems. These increases were partially offset by lower sales primarily due to: (1) less demand from the U.S. Special Operations Command (SOCOM) information technology (IT) support services due to our previous single-award contract converting to several multiple-award contracts, (2) a decline in IT support services for select non-DoD U.S. Government agencies and (3) lower demand for intelligence support services due to the drawdown of U.S. military forces from Iraq. See the reportable segment results for additional discussion of our segment sales.
Segment operating income and operating margin: Segment operating income for the year ended December 31, 2012 decreased by $91 million, or 6%, compared to the year ended December 31, 2011. Segment operating margin decreased by 70 basis points to 10.3% for the year ended December 31, 2012 compared to 11.0% for the year ended December 31, 2011. Higher pension expense of $38 million ($24 million after income tax, or $0.25 per diluted share) reduced segment operating margin by 30 basis points. The remaining decrease in segment operating margin was primarily due to sales mix changes in the Electronic Systems and C3ISR segments and $9 million of legal fees and inventory write-downs related to security and safety equipment in the NSS segment. See segment results below for additional discussion of sales and operating margin.
Interest expense: Interest expense declined by $20 million due to lower interest rates on outstanding fixed rate debt, partially offset by higher interest expense allocated to discontinued operations in 2011.
Interest and other income: Interest and other income increased by $8 million for the year ended December 31, 2012, compared to the year ended December 31, 2011 primarily due to a 2011 fourth quarter impairment charge of $14 million for long-lived assets at an equity method investment.
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Debt retirement charge: During 2012, we redeemed $500 million of our 6 3/8% 2015 Notes and recorded related debt retirement charges of $13 million. During 2011, we redeemed $650 million of our 5 7/8% 2015 Notes and $500 million of our 6 3/8% 2015 Notes and recorded related debt retirement charges of $35 million.
Effective income tax rate: The effective tax rate for the year ended December 31, 2012 increased to 32.2% from 25.5% for the year ended December 31, 2011. Excluding the Q4 2011 Items, the effective tax rate for the year ended December 31, 2011 would have been 31.2%. The increase in the effective tax rate was primarily due to the expiration of the U.S. Federal research and experimentation tax credit (R&E Credit) on December 31, 2011. The American Taxpayer Relief Act of 2012, which was enacted on January 2, 2013, retroactively reinstated and extended the R&E Credit for all of 2012 and 2013. As a result, the 2012 impact will be recorded in the 2013 first quarter.
Net income from continuing operations attributable to L-3 and diluted earnings per share from continuing operations: Net income from continuing operations attributable to L-3 in the year ended December 31, 2012 decreased 9% to $782 million compared to the year ended December 31, 2011, and diluted EPS from continuing operations decreased to $8.01 from $8.08. Excluding the Q4 2011 Items, net income from continuing operations attributable to L-3 decreased 5% and diluted EPS increased 2%.
Diluted weighted average common shares outstanding: Diluted weighted average common shares outstanding for the year ended December 31, 2012 declined by 8% compared to the year ended December 31, 2011 due to repurchases of L-3 common stock in connection with our share repurchase programs authorized by our Board of Directors, partially offset by additional shares issued in connection with various employee stock-based compensation programs and contributions to employee savings plans made in common stock.
2011 Compared with 2010
Net Sales: For the year ended December 31, 2011, consolidated net sales of $13,158 million decreased by $232 million, or 1.7%, compared to the year ended December 31, 2010. Lower sales primarily from the AM&M and Electronic Systems segments were partially offset by sales growth from the C3ISR segment. Acquired businesses, which are all included in the Electronics Systems segment, contributed $160 million to net sales for the year ended December 31, 2011.
Sales from products, which primarily include products from our C3ISR and Electronic Systems segments, decreased by $28 million to $7,552 million compared to $7,580 million, representing 57% of consolidated net sales, for both years ended December 31, 2011 and 2010. The decrease in product sales was due to sales volume declines primarily for Joint Cargo Aircraft (JCA), night vision products, combat propulsion systems, mobile satellite communication systems and simulation & training devices. These decreases were partially offset by sales from acquired businesses and organic sales growth primarily for networked communications and Sensor Systems. See the reportable segment results below for additional discussion of our segment sales.
Sales from services, primarily from our NSS, AM&M and C3ISR segments, decreased by $204 million to $5,606 million compared to $5,810 million, representing 43% of consolidated net sales, for both years ended December 31, 2011 and 2010. Sales from services decreased primarily due to the loss of the Special Operations Forces Support Activity (SOFSA) and Federal Aviation Administration (FAA) IT support services contracts, fewer task orders received for IT support services for the SOCOM and intelligence support services for the U.S. Army due to the drawdown of U.S. military forces from Iraq. These decreases were partially offset by increased contractor logistics support (CLS) services for U.S. Army C-12 aircraft, and increased intelligence and IT support services for U.S. Government agencies.
Operating income and operating margin: Consolidated operating income for the year ended December 31, 2011 decreased by $86 million, or 6%, compared to the year ended December 31, 2010. Segment operating income for the year ended December 31, 2011 decreased by $43 million, or 2.9%, compared to the year ended December 31, 2010. Segment operating margin decreased by 10 basis points to 11.0% for the year ended
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December 31, 2011 compared to 11.1% for the year ended December 31, 2010. Lower operating margins in the C3ISR and Electronic Systems segments were partially offset by higher operating margins for the AM&M segment. See the reportable segment results below for additional discussion of operating margin.
Interest expense: Interest expense decreased by $32 million for the year ended December 31, 2011 compared to the prior year. The decrease was primarily due to lower amortization of bond discounts and lower interest expense as a result of debt refinancings.
Interest and other income: Interest and other income declined by $21 million primarily due to a 2011 fourth quarter impairment charge of $14 million for long-lived assets at an equity method investment.
Debt retirement charge: During 2011, we redeemed $650 million of our 5 7/8% 2015 Notes and $500 million of our 6 3/8% 2015 Notes and recorded related debt retirement charges of $35 million. During 2010, we redeemed our 6 1/8% Senior Subordinated Notes due 2013 and 2014 and recorded related debt retirement charges of $18 million.
Effective income tax rate: The effective tax rate for the year ended December 31, 2011 decreased to 25.5% from 34.2% for the year ended December 31, 2010. Excluding the Q4 2011 Items, the effective tax rate would have decreased to 31.2% for 2011. This decrease was primarily due to: (1) $12 million for the reversal of previously accrued amounts in the second quarter of 2011, (2) additional federal tax benefits on the repatriation of foreign earnings, and (3) a 2010 tax provision of $5 million, or $0.04 per diluted share, related to the unfavorable tax treatment of the U.S. Federal Patient Protection and Affordable Care Act that did not recur in 2011.
Net income from continuing operations attributable to L-3 and diluted earnings per share from continuing operations: Net income from continuing operations attributable to L-3 increased by $40 million to $855 million for the year ended December 31, 2011, compared to the year ended December 31, 2010 and diluted EPS from continuing operations increased 15% to $8.08 from $7.04. Excluding the Q4 2011 Items of $28 million, or $0.26 per share, income from continuing operations increased $12 million to $827 million and diluted EPS increased $0.78, or 11%, to $7.82.
Diluted weighted average common shares outstanding: Diluted weighted average common shares outstanding for the year ended December 31, 2011 decreased by 9.5 million shares, or 8%, compared to the year ended December 31, 2010. The decrease was due to repurchases of our common stock in connection with our share repurchase programs authorized by our Board of Directors, partially offset by additional shares issued in connection with various employee stock-based compensation programs and contributions to employee savings plans made in common stock.
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Reportable Segment Results of Operations. The table below presents selected data by reportable segment reconciled to consolidated totals. See Note 22 to our audited consolidated financial statements for additional reportable segment data.
Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
(dollars in millions) | ||||||||||||
Net sales:(1) |
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Electronic Systems |
$ | 5,676.8 | $ | 5,627.9 | $ | 5,760.5 | ||||||
C3ISR |
3,601.2 | 3,479.9 | 3,211.9 | |||||||||
AM&M |
2,483.3 | 2,439.5 | 2,780.9 | |||||||||
NSS |
1,385.0 | 1,610.3 | 1,635.6 | |||||||||
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Consolidated net sales |
$ | 13,146.3 | $ | 13,157.6 | $ | 13,388.9 | ||||||
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Operating income: |
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Electronic Systems |
$ | 672.5 | $ | 718.9 | $ | 793.9 | ||||||
C3ISR |
363.7 | 394.4 | 365.3 | |||||||||
AM&M |
236.2 | 228.1 | 224.7 | |||||||||
NSS |
79.0 | 100.4 | 101.2 | |||||||||
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Total segment operating income |
$ | 1,351.4 | $ | 1,441.8 | $ | 1,485.1 | ||||||
Goodwill impairment charge |
| (42.6 | ) | | ||||||||
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Consolidated operating income |
1,351.4 | 1,399.2 | 1,485.1 | |||||||||
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Operating margin: |
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Electronic Systems |
11.8 | % | 12.8 | % | 13.8 | % | ||||||
C3ISR |
10.1 | % | 11.3 | % | 11.4 | % | ||||||
AM&M |
9.5 | % | 9.4 | % | 8.1 | % | ||||||
NSS |
5.7 | % | 6.2 | % | 6.2 | % | ||||||
Total segment operating margin |
10.3 | % | 11.0 | % | 11.1 | % | ||||||
Goodwill impairment charge |
| % | (0.4 | )% | | |||||||
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Consolidated operating margin |
10.3 | % | 10.6 | % | 11.1 | % | ||||||
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(1) | Net sales are after intercompany eliminations. |
Electronic Systems
Year Ended December 31, | Increase/ (decrease) |
Year Ended December 31, | Decrease | |||||||||||||||||||||
2012 | 2011 | 2011 | 2010 | |||||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Net sales |
$ | 5,676.8 | $ | 5,627.9 | $ | 48.9 | $ | 5,627.9 | $ | 5,760.5 | $ (132.6) | |||||||||||||
Operating income |
672.5 | 718.9 | (46.4) | 718.9 | 793.9 | (75.0) | ||||||||||||||||||
Operating margin |
11.8 | % | 12.8 | % | (100) bpts | 12.8 | % | 13.8 | % | (100) bpts |
2012 Compared with 2011
Electronic Systems net sales for the year ended December 31, 2012 increased by $49 million, or 1%, compared to the year ended December 31, 2011. Sales increased: (1) $149 million for Sensor Systems primarily for the L-3 KEO acquisition, (2) $85 million for Microwave Products primarily due to increased deliveries of mobile and ground-based satellite communication systems for the U.S. military and power devices for commercial satellite communication systems, (3) $72 million for Simulation & Training of which $49 million was from the Link U.K. acquisition and $23 million was primarily due to increased deliveries of U.S. Army rotary wing training systems for the Flight School XXI program, and (4) $30 million for Marine Services
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primarily due to the landing craft air cushion vehicle service life extension program. These increases were partially offset by sales declines of: (1) $157 million for Power & Control Systems due to reduced shipments of tactical quiet generators for the U.S. Army, which reduced sales by $92 million, and by $65 million due to negative foreign currency translation of $41 million and lower demand for commercial shipbuilding, (2) $82 million for Warrior Systems due to reduced U.S Army requirements for night vision and illumination products, and (3) $48 million for Precision Engagement due to lower volume from completed contracts.
Electronic Systems operating income for the year ended December 31, 2012 decreased by $46 million, or 6%, compared to the year ended December 31, 2011. Operating margin decreased by 100 basis points to 11.8%. Operating margin declined by 90 basis points primarily due to lower sales for Power & Control Systems and higher pension expense of $5 million, which reduced operating margin by 10 basis points.
2011 Compared with 2010
Electronic Systems net sales for the year ended December 31, 2011 decreased by $133 million, or 2%, compared to the year ended December 31, 2010, reflecting lower sales of: (1) $376 million due to declining DoD demand for night vision products, combat propulsion systems, mobile satellite communication systems and simulation & training devices, (2) $40 million due to lower manufacturing yields for power devices for satellite communications systems, (3) $23 million primarily due to reduced demand for force protection products to foreign ministries of defense and (4) $9 million from the sale of a general aviation product technology license in the 2010 fourth quarter that did not recur in the 2011 fourth quarter. These decreases were partially offset by sales from acquired businesses of $160 million, sales volume increases of $122 million for Sensor Systems to the U.S. Army and U.S. Air Force, and higher sales for commercial shipbuilding products of $33 million, with a majority of the increase from commercial shipbuilding products due to the strengthening of the U.S. dollar against the Euro.
Electronic Systems operating income for the year ended December 31, 2011 decreased by $75 million, or 9%, compared to the year ended December 31, 2010. Operating margin decreased by 100 basis points. Unfavorable contract performance and lower sales primarily for Warrior Systems and Simulation & Training reduced operating margin by 150 basis points, lower manufacturing yields for power devices for satellite communication systems reduced operating margin by 20 basis points and a $6 million loss on a contract termination recorded in 2011 reduced operating margin by 10 basis points. These decreases in operating margin were partially offset by 80 basis points due primarily to higher sales volume for Sensor Systems.
C3ISR
Year Ended December 31, | Increase/ (decrease) |
Year Ended December 31, | Increase/ (decrease) |
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2012 | 2011 | 2011 | 2010 | |||||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Net sales |
$ | 3,601.2 | $ | 3,479.9 | $ | 121.3 | $ | 3,479.9 | $ | 3,211.9 | $ | 268.0 | ||||||||||||
Operating income |
363.7 | 394.4 | (30.7) | 394.4 | 365.3 | 29.1 | ||||||||||||||||||
Operating margin |
10.1 | % | 11.3 | % | (120) bpts | 11.3 | % | 11.4 | % | (10) bpts |
2012 Compared with 2011
C3ISR net sales for the year ended December 31, 2012 increased by $121 million, or 3%, compared to the year ended December 31, 2011. The increase in sales was primarily due to higher demand for airborne ISR systems for U.S. government and foreign military customers.
C3ISR operating income for the year ended December 31, 2012 decreased by $31 million, or 8%, compared to the year ended December 31, 2011. Operating margin decreased by 120 basis points to 10.1%. Higher pension expense of $24 million reduced operating margin by 70 basis points and sales mix changes reduced operating margin by 50 basis points.
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2011 Compared with 2010
C3ISR net sales for the year ended December 31, 2011 increased by $268 million, or 8%, compared to the year ended December 31, 2010. This increase was primarily due to increased volume and new business for networked communication systems for manned and unmanned platforms, airborne ISR logistics support and fleet management services to the DoD, and international airborne ISR platforms. These increases were partially offset primarily by lower sales for airborne ISR platforms to the DoD.
C3ISR operating income for the year ended December 31, 2011 increased by $29 million, or 8%, compared to the year ended December 31, 2010. Operating margin decreased by 10 basis points primarily due to lower margin sales mix for networked communication systems.
Aircraft Modernization and Maintenance (AM&M)
Year Ended December 31, | Increase | Year Ended December 31, | Increase/ (decrease) |
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2012 | 2011 | 2011 | 2010 | |||||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Net sales |
$ | 2,483.3 | $ | 2,439.5 | $ | 43.8 | $ | 2,439.5 | $ | 2,780.9 | $ | (341.4) | ||||||||||||
Operating income |
236.2 | 228.1 | 8.1 | 228.1 | 224.7 | 3.4 | ||||||||||||||||||
Operating margin |
9.5 | % | 9.4 | % | 10 bpts | 9.4 | % | 8.1 | % | 130 bpts |
2012 Compared with 2011
AM&M net sales for the year ended December 31, 2012 increased by $44 million, or 2%, compared to the year ended December 31, 2011. Platform systems sales increased by $130 million, which was partially offset by a sales decline of $86 million for logistic support services. The platform systems increase was due primarily to volume on new contracts, including the Australia C-27J and international head-of-state aircraft modification contracts and increased scope on the EC-130 aircraft for the U.S. Air Force (USAF). These increases were partially offset by lower JCA volume for the USAF. Logistics support services decreased due primarily to the loss of a task order for U.S. Army contract field team support services in Southwest Asia, partially offset by increased demand for field maintenance and sustainment services on a U.S. Army rotary wing aircraft contract that was competitively won in September 2011, and for U.S. Army C-12 aircraft.
AM&M operating income for the year ended December 31, 2012 increased by $8 million, or 4%, compared to the year ended December 31, 2011. Operating margin increased by 10 basis points to 9.5%. Unfavorable contract performance in 2011 primarily for JCA increased operating margin by 110 basis points. This increase was partially offset by sales mix changes, which reduced operating margin by 60 basis points, and an increase in pension expense of $9 million, which reduced operating margin by 40 basis points.
2011 Compared with 2010
AM&M net sales for the year ended December 31, 2011 decreased by $341 million, or 12%, compared to the year ended December 31, 2010. The decrease was primarily the result of $332 million from the SOFSA contract loss, $75 million from lower JCA volume, and $35 million due to lower sales for MHP, partially offset by increased CLS services for U.S. Army C-12 aircraft.
AM&M operating income for the year ended December 31, 2011 increased by $3 million, or 2%, compared to the year ended December 31, 2010. Operating margin increased by 130 basis points. The increase in operating margin was due to: (1) improved contract performance for rotary wing cabin assemblies and special mission aircraft, which increased operating margin by 100 basis points, (2) the sales decline on the lower margin SOFSA contract, which increased operating margin by 60 basis points, and (3) a 2011 first quarter favorable price adjustment of $10 million for an international aircraft modernization contract, which increased operating margin by 40 basis points. These margin increases were partially offset by a 70 basis point decrease in operating margin primarily due to JCA for higher costs and reduced aircraft order quantities.
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National Security Solutions (NSS)
Year Ended December 31, | Decrease | Year Ended December 31, | Decrease |
|||||||||||||||||||||
2012 | 2011 | 2011 | 2010 | |||||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Net sales |
$ | 1,385.0 | $ | 1,610.3 | $ | (225.3) | $ | 1,610.3 | $ | 1,635.6 | $ | (25.3) | ||||||||||||
Operating income |
79.0 | 100.4 | (21.4) | 100.4 | 101.2 | (0.8) | ||||||||||||||||||
Operating margin |
5.7 | % | 6.2 | % | (50) bpts | 6.2 | % | 6.2 | % | bpts |
2012 Compared with 2011
NSS net sales for the year ended December 31, 2012 decreased by $225 million, or 14%, compared to the year ended December 31, 2011. Less demand for SOCOM IT support services, due to our previous single-award contract converting to several multiple-award contracts, which reduced our work share, lowered sales by $82 million. A decline in IT support services for select non-DoD U.S. Government agencies lowered sales by $93 million comprised of: (1) $38 million due to customer IT spending reductions, and (2) $55 million due to contract losses in 2011 and 2012. Sales also declined by $50 million for intelligence support services due to the drawdown of U.S. military forces in Iraq.
NSS operating income for the year ended December 31, 2012 decreased by $21 million, or 21%, compared to the year ended December 31, 2011. Operating margin decreased by 50 basis points to 5.7%. The decrease in operating margin was due primarily to legal fees of $5 million related to a supplier dispute, which reduced operating margin by 40 basis points, and a $4 million inventory write-down for security and safety equipment, which reduced operating margin by 30 basis points. These decreases were partially offset by reduced overhead costs, which increased operating margin by 20 basis points.
2011 Compared with 2010
NSS net sales for the year ended December 31, 2011 decreased by $25 million, or 2%, compared to the year ended December 31, 2010. The decrease in sales was due to: (1) $42 million for IT support services for SOCOM due to fewer task orders received because of more competitors on the current contract, (2) $37 million related to the loss of the FAA IT support services contract, (3) $28 million in lower intelligence support services for the U.S. Army due to the drawdown of U.S. military forces from Iraq, and (4) $26 million of lower sales related to the SBInet program for the DHS. These decreases were partially offset by $108 million in higher sales primarily due to increased demand for intelligence and IT support services for U.S. Government agencies.
NSS operating income for the year ended December 31, 2011 decreased by $1 million, or 1%, compared to the year ended December 31, 2010. Operating margin was unchanged. Higher business development costs for cyber security initiatives were offset by the higher margin sales mix for intelligence and IT support services and the timing of award fees.
Liquidity and Capital Resources
Anticipated Sources and Uses of Cash Flow
At December 31, 2012, we had total cash and cash equivalents of $349 million. While no amounts of the cash and cash equivalents are considered restricted, $230 million was held by the Companys foreign subsidiaries. The repatriation of cash held in non-U.S. jurisdictions is subject to local capital requirements, as well as income tax considerations. Our primary source of liquidity is cash flow generated from operations. We generated $1,231 million of cash from operating activities from continuing operations during the year ended December 31, 2012. Significant cash uses during the year ended December 31, 2012 included $872 million to repurchase shares of our common stock, $348 million for business acquisitions, and $195 million for dividends.
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As discussed in 2012 Events within this section, Engility made a cash distribution of $335 million to L-3 in connection with the spin-off on July 17, 2012. We used a portion of the proceeds to redeem $250 million of our 6 3/8% 2015 Notes on July 26, 2012.
On February 3, 2012, we amended and restated our $1 billion Revolving Credit Facility (Amended and Restated Revolving Credit Facility), which also extended the expiration date to February 3, 2017. As of December 31, 2012, we had the availability of substantially all of our Amended and Restated Revolving Credit Facility. We currently believe that our cash from operating activities together with our cash on hand, and available borrowings under our Amended and Restated Revolving Credit Facility will be adequate for the foreseeable future to meet our anticipated requirements for working capital, capital expenditures, defined benefit plan contributions, commitments, contingencies, research and development expenditures, business acquisitions (depending on the size), contingent purchase price payments on previous business acquisitions, program and other discretionary investments, interest payments, income tax payments, L-3 Holdings dividends and share repurchases.
Our business may not continue to generate cash flow at current levels, and it is possible that currently anticipated improvements may not be achieved. If we are unable to generate sufficient cash flow from operations to service our debt, we may be required to reduce costs and expenses, sell assets, reduce capital expenditures, reduce dividend payments, refinance all or a portion of our existing debt or obtain additional financing, which we may not be able to do on a timely basis, on satisfactory terms, or at all. Our ability to make scheduled principal payments or to pay interest on or to refinance our indebtedness depends on our future performance and financial results, which, to a certain extent, are subject to general conditions in or affecting the U.S. defense industry and to general economic, political, financial, competitive, legislative and regulatory factors beyond our control.
For a discussion of our debt refinancing activities during 2012, which improved our debt maturity profile and reduced ongoing interest expense, see Financing Activities Continuing Operations Debt.
Balance Sheet
Billed receivables decreased by $125 million to $968 million at December 31, 2012 from $1,093 million at December 31, 2011 due to: (1) the timing of billings and collections primarily for airborne ISR logistic services and AM&M, and (2) lower organic sales primarily for Sensor Systems, NSS and Warrior Systems. These decreases were partially offset by $37 million from business acquisitions and $5 million for foreign currency translation adjustments.
Contracts in process increased by $266 million to $2,652 million at December 31, 2012 from $2,386 million at December 31, 2011 The increase included: (1) $84 million of acquired contracts from business acquisitions, (2) $11 million from inventory received as part of the dissolution of an equity method investment, (3) $6 million of foreign currency translation adjustments and (4) $165 million from:
| Increases of $39 million in unbilled contract receivables primarily due to liquidation of progress payments for delivery of Simulation & Training devices and sales exceeding billings for Sensor Systems and Networked Communications, partially offset by a decrease for NSS due to lower sales and billings; and |
| Increases of $126 million in inventoried contract costs primarily due to Australian C-27J aircraft and a related training device for AM&M and spare parts for logistics support services. |
L-3s receivables days sales outstanding (DSO) was 71 at December 31, 2012, compared with 73 at December 31, 2011. We calculate our DSO by dividing: (1) our aggregate end of period billed receivables and net unbilled contract receivables, by (2) our trailing 12 month sales adjusted, on a pro forma basis, to include sales from business acquisitions and exclude sales from business divestitures that we completed as of the end of the period, multiplied by the number of calendar days in the trailing 12 month period (366 days at December 31, 2012 and 365 days at December 31, 2011). Our trailing 12 month pro forma sales were $13,240 million at December 31, 2012 and $13,169 million at December 31, 2011.
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The increase in inventories was primarily due to higher inventory for Microwave Products and Security & Detection Systems to support customer demand.
The decrease in current deferred income tax assets was primarily due to the difference in the recognition of income for contracts in process for purposes of income taxes as compared to financial reporting. The decrease in other current assets was primarily due to applying expected tax refunds, primarily for U.S. federal and state income taxes, to current year estimated tax payments.
The increase in net property, plant and equipment (PP&E) was principally due to capital expenditures, partially offset by depreciation expense.
Goodwill increased by $272 million to $7,744 million at December 31, 2012 from $7,472 million at December 31, 2011. The table below presents the changes in goodwill by segment.
Electronic Systems |
C 3ISR | AM&M | NSS | Consolidated Total |
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(in millions) | ||||||||||||||||||||
Balance at December 31, 2011 |
$ | 4,540 | $ | 797 | $ | 1,169 | $ | 966 | $ | 7,472 | ||||||||||
Business acquisitions(1) |
250 | | | | 250 | |||||||||||||||
Foreign currency translation(2) |
14 | | 6 | 2 | 22 | |||||||||||||||
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Balance at December 31, 2012 |
$ | 4,804 | $ | 797 | $ | 1,175 | $ | 968 | $ | 7,744 | ||||||||||
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(1) | The increase in goodwill for the Electronic Systems segment is due to the L-3 KEO, MAVCO and Link U.K. business acquisitions. See Note 4 to our audited consolidated financial statements for further discussion regarding these acquisitions. |
(2) | The changes in goodwill from foreign currency translation adjustments are due to fluctuations in the U.S. dollar and foreign currency exchange rates. The increases in goodwill presented in the Electronic Systems, AM&M and NSS segments during 2012 was primarily due to the weakening of the U.S. dollar against the Euro, Canadian dollar and the British Pound. |
The increase in identifiable intangible assets was primarily due to the recognition of $53 million of customer contractual relationships and technology intangibles due primarily to the L-3 KEO and Link U.K business acquisitions, partially offset by amortization expense. The decrease in other assets was primarily due to the dissolution of an equity method investment.
The fluctuation in accounts payable and accrued expenses were primarily due to the timing of when invoices for purchases from third-party vendors and subcontractors were received and payments were made. Business acquisitions increased accounts payable by $18 million and accrued expenses by $5 million.
The decrease in accrued employment costs was primarily due to a reduction in accrued payroll taxes due to headcount reductions and the timing of payments, partially offset by $7 million of acquired balances from theL-3 KEO business acquisition.
The increase in advance payments and billings in excess of costs incurred was primarily due to cash collections on performance based billings related to contracts with foreign customers for platform systems and milestone payments for Networked Communications and $60 million from business acquisitions. These increases were partially offset by primary liquidations on contracts for Undersea Warfare and space and propulsion, and lower advanced payments on new contracts for Sensor Systems.
Pension Plans
L-3 maintains defined benefit pension plans covering employees at certain of its businesses and approximately 25% of its employees. At December 31, 2012, L-3s projected benefit obligation, which includes accumulated benefits plus the incremental benefits attributable to projected future salary increases for covered employees, was $3,222 million and exceeded the fair value of L-3s pension plan assets of $2,026 million by $1,196 million. At December 31, 2011, L-3s projected benefit obligation was $2,679 million and exceeded the fair value of L-3s pension plan assets of $1,712 million by $967 million. The $229 million increase in our unfunded status was
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primarily due to the reduction in our weighted average discount rate from 5.02% at December 31, 2011 to 4.15% at December 31, 2012 and 2012 pension expense, partially offset by our 2012 actual pension plan asset return of approximately 13.0%, which was higher than our weighted average expected long-term rate of return assumption of 8.15%, and 2012 employer pension contributions.
We recorded net actuarial losses of $286 million in the year ended December 31, 2012 primarily due to the reduction in our weighted average discount rate as noted above, which is reflected in accumulated other comprehensive loss. Actuarial gains and losses that our pension plans experience are not recognized in pension expense in the year incurred, but rather are recorded as a component of accumulated other comprehensive income (loss) and amortized to pension expense in future periods over the estimated average remaining service periods of the covered employees. See Note 20 to our audited consolidated financial statements.
Our pension expense for 2012 was $179 million. We currently expect pension expense for 2013 to increase $3 million to approximately $182 million primarily due to the reduction in our weighted average discount rate as noted above, partially offset by: (1) expected asset returns on higher plan assets following our 2012 contributions and actual returns and (2) the decrease in the weighted average salary scale assumptions from 4.06% at December 31, 2011 to 3.56% at December 31, 2012.
Our pension expense for 2013 may be different from our current expectations when finalized due to a number of factors, including the effect of any future business acquisitions for which we assume liabilities for pension benefits, changes in headcount at our businesses that sponsor pension plans, actual pension plan contributions and changes (if any) to our pension assumptions for 2013, including the discount rate, expected long-term return on plan assets and salary increases.
Our contributions for 2012 were $173 million and we currently expect to contribute approximately $165 million to our pension plans in 2013, including $95 million of voluntary contributions. Actual 2013 pension contributions could be affected by changes in the funded status of our pension plans during 2012. A substantial portion of our pension plan contributions for L-3s businesses that are U.S. Government contractors are recoverable as allowable indirect contract costs at amounts generally equal to the annual pension contributions.
Our projected benefit obligation and annual pension expense are significantly affected by our discount rate assumption. For example, a reduction to the discount rate of 25 basis points would increase our projected benefit obligation at December 31, 2012 by approximately $124 million and our estimated pension expense for 2013 by approximately $15 million. Conversely, an increase to the discount rate of 25 basis points would have decreased our projected benefit obligation at December 31, 2012 by approximately $117 million, and our estimated pension expense for 2013 by approximately $14 million.
Statement of Cash Flows
The table below provides a summary of our cash flows from operating, investing, and financing activities for the periods indicated.
Year Ended December 31, | ||||||||||||
2012 | 2011 | 2010 | ||||||||||
(in millions) | ||||||||||||
Net cash from operating activities from continuing operations |
$ | 1,231 | $ | 1,231 | $ | 1,270 | ||||||
Net cash used in investing activities from continuing operations |
(200 | ) | (199 | ) | (944 | ) | ||||||
Net cash used in financing activities from continuing operations |
(1,527 | ) | (1,119 | ) | (917 | ) |
Operating Activities Continuing Operations
2012 Compared with 2011. We generated $1,231 million of cash from operating activities during the year ended December 31, 2012, which was unchanged when compared with $1,231 million generated during the year ended December 31, 2011. Operating cash flow increased $116 million due to more cash generated from changes
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in operating assets and liabilities primarily for collections of billed receivables and advance payments and billings in excess of costs incurred, partially offset by higher tax payments. This increase was offset by $76 million of lower net income and $40 million of lower non-cash expenses primarily for a 2011 non-cash goodwill impairment charge of $43 million that did not recur in 2012.
2011 Compared with 2010. We generated $1,231 million of cash from operating activities during the year ended December 31, 2011, a decrease of $39 million compared with $1,270 million generated during the year ended December 31, 2010. The decrease was due to $147 million of more cash used for changes in operating assets and liabilities primarily for advanced payments and billings in excess of costs incurred and accrued income taxes, partially offset by lower tax payments. This decrease was partially offset by $68 million of higher non cash expenses, primarily due to a non-cash goodwill impairment charge of $43 million and higher deferred income taxes, and higher income from continuing operations of $40 million. The net cash from changes in operating assets and liabilities is further discussed above under Liquidity and Capital Resources Balance Sheet.
Interest Payments. Our cash from operating activities included interest payments on debt of $198 million for the year ended December 31, 2012, $238 million for the year ended December 31, 2011, and $233 million for the year ended December 31, 2010. Our interest expense also included amortization of deferred debt issuance costs and bond discounts, which are non-cash items.
Investing Activities Continuing Operations
During 2012, we used $200 million of cash primarily to: (1) acquire three businesses discussed under Business Acquisitions and Divestitures and (2) pay $210 million for capital expenditures. These cash out flows were partially offset by $335 million of cash received from the spin-off of Engility and $20 million of cash received from the dissolution of an unconsolidated joint venture.
During 2011, we used $199 million of cash primarily to: (1) acquire two businesses discussed under Business Acquisitions and Divestitures and (2) pay $187 million for capital expenditures.
During 2010, we used $944 million of cash primarily to: (1) acquire four businesses discussed under Business Acquisitions and Divestitures, (2) pay $178 million for capital expenditures, and (3) invest $23 million in an unconsolidated subsidiary accounted for using the equity method.
Financing Activities Continuing Operations
Debt
At December 31, 2012, total outstanding debt was $3,629 million, comprised of $2,940 million of senior debt and $689 million of CODES, compared to $4,125 million at December 31, 2011, of which $2,938 million was senior debt and $1,187 million was subordinated debt and CODES. At December 31, 2012, we had the availability of substantially all of our $1 billion Amended and Restated Revolving Credit Facility. We also had $504 million of other standby letters of credit at December 31, 2012, that may have been drawn upon in the event that we did not perform on certain of our contractual requirements. There were no borrowings outstanding under our Amended and Restated Revolving Credit Facility at December 31, 2012. At December 31, 2012, our outstanding debt matures between November 15, 2016 and August 1, 2035. See Note 10 to our audited consolidated financial statements for the components of our debt at December 31, 2012.
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Debt Issuances
The terms of each of the outstanding Senior Notes issued by L-3 Communications during the years ended December 31, 2011 and 2010 are presented in the table below. There were no debt issuances during the year ended December 31, 2012.
Note |
Date of Issuance | Amount Issued |
Discount | Net Cash Proceeds |
Effective Interest Rate |
Redemption at Treasury Rate+ |
||||||||||||||||||
(in millions) | ||||||||||||||||||||||||
3.95% Senior Notes due November 15, 2016 |
November 22, 2011 | $ | 500 | $ | 4 | $ | 491 | 4.11 | % | 50 bps | ||||||||||||||
5.20% Senior Notes due October 15, 2019 |
October 2, 2009 | $ | 1,000 | $ | 4 | $ | 987 | 5.25 | % | 30 bps | ||||||||||||||
4.75% Senior Notes due July 15, 2020 |
May 21, 2010 | $ | 800 | $ | 3 | $ | 790 | 4.79 | % | 25 bps | ||||||||||||||
4.95% Senior Notes due February 15, 2021 |
February 7, 2011 | $ | 650 | $ | 4 | $ | 639 | 5.02 | % | 25 bps |
Debt Repayments
In connection with the spin-off, Engility made a cash distribution of $335 million to L-3. L-3 Communications used a portion of the proceeds to redeem $250 million of the 6 3/8% 2015 Notes on July 26, 2012. Also, on October 15, 2012, L-3 Communications redeemed the remaining outstanding $250 million of its 6 3/8% 2015 Notes. Information on the Senior Subordinated Notes we redeemed during the years ended December 31, 2012, 2011 and 2010 is presented in the table below.
Note |
Redemption Date | Principal Amount Redeemed |
Debt Retirement Charge |
Redemption Price % of Principal |
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(in millions) | ||||||||||||||||
6 3/8% Senior Subordinated Notes due October 15, 2015 |
October 15, 2012 | $ | 250 | $ | 5 | 101.063 | % | |||||||||
6 3/8% Senior Subordinated Notes due October 15, 2015 |
July 26, 2012 | $ | 250 | $ | 8 | 102.125 | % | |||||||||
6 3/8% Senior Subordinated Notes due October 15, 2015 |
December 22, 2011 | $ | 500 | $ | 17 | 102.125 | % | |||||||||
5 7/8% Senior Subordinated Notes due January 15, 2015 |
March 9, 2011 | $ | 650 | $ | 18 | 101.958 | % | |||||||||
6 1/8% Senior Subordinated Notes due January 15, 2014 |
June 21, 2010 | $ | 400 | $ | 13 | 102.042 | % | |||||||||
6 1/8% Senior Subordinated Notes due July 15, 2013 |
July 15, 2010 | $ | 400 | $ | 5 | 101.021 | % |
On February 2, 2011, we repurchased approximately $11 million of our CODES as a result of the exercise by the holders of their contractual right to require us to repurchase their CODES. The CODES are subject to redemption at the option of L-3 Holdings, in whole or in part, at a cash redemption price (plus accrued and unpaid interest, including contingent interest and additional interest, if any) equal to 100% of the principal amount of CODES. We may, from time to time, make open market purchases of our outstanding debt securities, including the CODES. Whether or not we repurchase any of our outstanding debt securities, including the CODES, the amount of any such repurchases will vary depending on numerous factors, including, without limitation, the trading price of our debt, other market conditions, our ongoing capital allocation planning, the levels of our cash and debt balances, other demands for cash, such as acquisition activity, and general economic conditions.
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Debt Covenants and Other Provisions. The Amended and Restated Revolving Credit Facility and Senior Notes contain financial and/or other restrictive covenants. See Note 10 to our audited consolidated financial statements for a description of our debt and related financial covenants, including dividend payment and share repurchase restrictions and cross default provisions. We were in compliance with our financial and other restrictive covenants at December 31, 2012 and 2011.
Under select conditions, including if L-3 Holdings common stock price is more than 120% (currently $109.45) of the then current conversion price (currently $91.21) for a specified period, the conversion feature of the CODES will require L-3 Holdings, upon conversion, to pay the holders of the CODES the principal amount in cash, and if the settlement amount exceeds the principal amount, the excess will be settled in cash or stock or a combination thereof, at our option. See Note 10 to our audited consolidated financial statements for additional information regarding the CODES, including conditions for conversion. L-3 Holdings closing stock price of February 21, 2013 was $76.46 per share.
Guarantees. The borrowings under the Amended and Restated Revolving Credit Facility are fully and unconditionally guaranteed by L-3 Holdings and by substantially all of the material wholly-owned domestic subsidiaries of L-3 Communications on an unsecured senior basis. The payment of principal and premium, if any, and interest on the Senior Notes are fully and unconditionally guaranteed, on an unsecured senior basis, jointly and severally, by L-3 Communications material wholly-owned domestic subsidiaries that guarantee any of its other indebtedness. The payment of principal and premium, if any, and interest on the CODES are fully and unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally, by L-3 Communications and its wholly-owned domestic subsidiaries that guarantee any of its other liabilities.
Prior to the spin-off of Engility, which was completed on July 17, 2012, Engility Holdings, Inc., Engility Corporation, International Resources Group Ltd. and LinCom Wireless, Inc. were guarantor subsidiaries. As a result of the spin-off, these entities no longer guarantee the debt of L-3 Communications or L-3 Holdings.
Subordination. The guarantees of the Amended and Restated Revolving Credit Facility and the Senior Notes rank senior to the guarantees of the CODES and rank pari passu with each other. The guarantees of the CODES are junior to the guarantees of the Amended and Restated Revolving Credit Facility and Senior Notes.
Equity
During 2012 and 2011, L-3 Holdings Board of Directors authorized the following quarterly cash dividends:
Date Declared |
Record Date | Cash Dividends Per Share |
Date Paid | Total Dividends Paid |
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(in millions) | ||||||||||||
2012 |
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February 7 |
March 1 | $ | 0.50 | March 15 | $ | 49 | ||||||
April 24 |
May 17 | $ | 0.50 | June 15 | $ | 49 | ||||||
June 26 |
August 17 | $ | 0.50 | September 17 | $ | 48 | ||||||
October 24 |
November 19 | $ | 0.50 | December 17 | $ | 46 | ||||||
2011 |
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February 8 |
March 1 | $ | 0.45 | March 15 | $ | 49 | ||||||
April 26 |
May 17 | $ | 0.45 | June 15 | $ | 48 | ||||||
July 12 |
August 18 | $ | 0.45 | September 15 | $ | 46 | ||||||
October 11 |
November 17 | $ | 0.45 | December 15 | $ | 45 |
In addition to the dividends paid as shown in the table above, the Company also paid $3 million of previously accrued dividends related to the vested employee stock-based awards in 2012.
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On February 5, 2013, L-3 Holdings announced that its Board of Directors had increased L-3 Holdings regular quarterly cash dividend by 10% to $0.55 per share, payable on March 15, 2013, to shareholders of record at the close of business on March 1, 2013.
On February 15, 2013, the number of holders of L-3 Holdings common stock was approximately 31,635. On February 21, 2013, the closing price of L-3 Holdings common stock, as reported by the NYSE, was $76.46 per share.
For the year ended December 31, 2012, L-3 Holdings repurchased $872 million, or 12.1 million shares, of its common stock compared to $958 million, or 13.3 million shares, of its common stock for the year ended December 31, 2011.
Contractual Obligations
The table below presents our estimated total contractual obligations from our continuing operations at December 31, 2012, including the amounts expected to be paid or settled for each of the periods indicated below.
Payments due by period | ||||||||||||||||||||
Total | Less than 1 year |
1 3 years | 3 5 years | More than 5 years |
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(in millions) | ||||||||||||||||||||
Contractual Obligations |
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L-3 Communications long-term debt(1) |
$ | 2,950 | $ | | $ | | $ | 500 | $ | 2,450 | ||||||||||
L-3 Holdings long-term debt(1)(2) |
689 | | | | 689 | |||||||||||||||
Interest payments(3) |
1,497 | 163 | 325 | 306 | 703 | |||||||||||||||
Non-cancelable operating leases(4) |
513 | 153 | 182 | (5) | 93 | 85 | ||||||||||||||
Notes payable and capital lease obligations |
34 | 9 | 23 | 1 | 1 | |||||||||||||||
Purchase obligations(6) |
2,804 | 2,206 | 568 | 29 | 1 | |||||||||||||||
Other long-term liabilities(7) |
323 | 176 | (8) | 93 | 12 | 42 | ||||||||||||||
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Total(9) |
$ | 8,810 | $ | 2,707 | $ | 1,191 | $ | 941 | $ | 3,971 | ||||||||||
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(1) | Represents principal amount of long-term debt and only includes scheduled principal payments. |
(2) | The CODES are convertible into cash and shares of L-3 Holdings common stock based on a conversion rate of 10.9640 shares of L-3 Holdings common stock per one thousand dollars in principal amount of the CODES (equivalent to a current conversion price of $91.21 per share). The conversion feature of the CODES may require L-3 Holdings to settle the principal amount with the holders of the CODES if L-3 Holdings common stock price is more than 120% of the then current conversion price (currently $109.45) for a specified period, and if the settlement amount exceeds the principal amount, the excess will be settled in cash or stock or a combination thereof, at our option. Additionally, holders of the CODES may require L-3 Holdings to repurchase the CODES, in whole or in part, on February 1, 2016, February 1, 2021, February 1, 2026 and February 1, 2031 at a cash repurchase price equal to 100% of the principal amount of the CODES (plus accrued and unpaid interest, if any). See Note 10 to our audited consolidated financial statements for additional information regarding the CODES, including conditions for conversion and contingent interest features. L-3 Holdings stock price on February 21, 2013 was $76.46. |
(3) | Represents expected interest payments on L-3s long-term debt balance as of December 31, 2012 using the stated interest rate on our fixed rate debt, assuming that current borrowings remain outstanding to the contractual maturity date. |
(4) | Non-cancelable operating leases are presented net of estimated sublease rental income. |
(5) | Represents the residual value guarantee for two real estate lease agreements, expiring on August 31, 2015, that are accounted for as operating leases. We have the right to exercise options under the lease agreements to renew the leases, to purchase both properties for $28 million or sell both properties on behalf of the lessor. If we elect to sell the properties, we must pay the lessor a residual value guarantee of $23 million. See Note 19 to our audited consolidated financial statements for a further description of these leases. |
(6) | Represents open purchase orders at December 31, 2012 for amounts expected to be paid for goods or services that are legally binding. |
(7) | Other long-term liabilities primarily consist of workers compensation and deferred compensation for the years ending December 31, 2014 and thereafter and also include pension and postretirement benefit plan contributions that we expect to pay in 2013. |
(8) | Our pension and postretirement benefit plan funding policy is generally to contribute in accordance with cost accounting standards that affect government contractors, subject to the Internal Revenue Code and regulations thereon. For 2013, we expect to contribute approximately $165 million to our pension plans and approximately $11 million to our postretirement benefit plans. Due to the current uncertainty of the amounts used to compute our expected pension and postretirement benefit plan funding, we believe it is not practicable to reasonably estimate such future funding for periods in excess of one year and we may decide or be required to contribute more than we expect to our pension and postretirement plans. |
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(9) | Excludes all income tax obligations, a portion of which represents unrecognized tax benefits in connection with uncertain tax positions taken, or expected to be taken on our income tax returns as of December 31, 2012 since we cannot determine the time period of future tax consequences. For additional information regarding income taxes, see Note 17 to our audited consolidated financial statements. |
Off Balance Sheet Arrangements
The table below presents our estimated total contingent commitments and other guarantees at December 31, 2012, including the amounts expected to be paid or settled for each of the periods indicated below.
Payments due by period | ||||||||||||||||||||
Total | 2013 | 2014-2015 | 2016-2017 | 2018 and thereafter |
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(in millions) | ||||||||||||||||||||
Contingent Commitments |
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Other standby letters of credit(1) |
504 | 410 | 53 | 21 | 20 | |||||||||||||||
Other guarantees(2) |
3 | | | 3 | | |||||||||||||||
Contingent commitments for earnout payments on business acquisitions(3) |
21 | 11 | 10 | | | |||||||||||||||
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Total(4) |
$ | 528 | $ | 421 | $ | 63 | $ | 24 | $ | 20 | ||||||||||
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(1) | Represents outstanding letters of credit with financial institutions covering performance and financial guarantees per contractual requirements with certain customers. These letters of credit may be drawn upon in the event of L-3s nonperformance. |
(2) | Represents the minimum guarantees made by L-3 or the lessee under the purchase option for certain operating leases in which the lease renewal is not exercised (see Note 19 to our audited consolidated financial statements for a description of these guarantees). |
(3) | Represents potential additional contingent purchase payments for business acquisitions that are contingent upon the post-acquisition financial performance or certain other performance conditions of the acquired businesses in accordance with the contractual purchase agreement. At December 31, 2012, our consolidated balance sheet includes $9 million within the other liabilities caption for the fair value of these contingent purchase payments. |
(4) | The total amount does not include residual value guarantees for two real estate lease agreements that are accounted for as operating leases. We have the right to exercise options under the lease agreements to purchase both properties for $28 million on or before August 31, 2015. See Note 19 to our audited consolidated financial statements for a further description of these leases. |
Legal Proceedings and Contingencies
We are engaged in providing products and services under contracts with the U.S. Government and, to a lesser degree, under foreign government contracts, some of which are funded by the U.S. Government. All such contracts are subject to extensive legal and regulatory requirements, and, periodically, agencies of the U.S. Government investigate whether such contracts were and are being conducted in accordance with these requirements. Under U.S. Government procurement regulations, an indictment by a federal grand jury, or an administrative finding against us as to our present responsibility to be a U.S. Government contractor or subcontractor, could result in the suspension for a period of time from eligibility for awards of new government contracts or task orders or in a loss of export privileges. A conviction, or an administrative finding that satisfies the requisite level of seriousness, could result in debarment from contracting with the federal government for a specified term. We are currently cooperating with the U.S. Government on several investigations, none of which we anticipate will have a material adverse effect on our consolidated financial position, results of operations or cash flows.
We continually assess our obligations with respect to applicable environmental protection laws. While it is difficult to determine the timing and ultimate cost that we will incur to comply with these laws, based upon available internal and external assessments, with respect to those environmental loss contingencies of which we are aware, we believe that even without considering potential insurance recoveries, if any, there are no environmental loss contingencies that, in the aggregate, would be material to our consolidated financial position, results of operations or cash flows. Also, we have been periodically subject to litigation, government investigations, proceedings, claims or assessments and various contingent liabilities incidental to our business. We accrue for these contingencies when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. For a description of our legal proceedings and contingencies, see Note 19 to our audited consolidated financial statements.
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Derivative Financial Instruments and Other Market Risk
Included in our derivative financial instruments are foreign currency forward contracts. All of our derivative financial instruments that are sensitive to market risk are entered into for purposes other than trading.
Interest Rate Risk. Our Amended and Restated Revolving Credit Facility is subject to variable interest and is therefore sensitive to changes in interest rates. The interest rates on the Senior Notes and CODES are fixed-rate and are not affected by changes in interest rates. Additional data on our debt obligations and our applicable borrowing spreads included in the interest rates we would pay on borrowings under the Amended and Restated Revolving Credit Facility, if any, are provided in Note 10 to our audited consolidated financial statements.
Foreign Currency Exchange Risk. Our U.S. and foreign businesses enter into contracts with customers, subcontractors or vendors that are denominated in currencies other than their functional currencies. To protect the functional currency equivalent cash flows associated with certain of these contracts, we enter into foreign currency forward contracts, which are generally designated and accounted for as cash flow hedges. At December 31, 2012, the notional value of foreign currency forward contracts was $221 million and the net fair value of these contracts was an asset of $5 million. The notional values of our foreign currency forward contracts with maturities ranging through 2017 and thereafter are presented in the table below.
Year of Maturity | ||||||||||||||||||||
2013 | 2014 | 2015 | 2016 | 2017 and thereafter | ||||||||||||||||
(in millions) | ||||||||||||||||||||
Notional value |
$ | 147 | $ | 52 | $ | 15 | $ | 4 | $ | 3 |
Accounting Standards Issued and Not Yet Implemented
For a discussion of accounting standards issued and not yet implemented, see Note 2 to our audited consolidated financial statements.
Inflation
The effect of inflation on our sales and earnings has not been significant. Although a majority of our sales are made under long-term contracts (revenue arrangements), the selling prices of such contracts, established for deliveries in the future, generally reflect estimated costs to be incurred in these future periods. In addition, some of our contracts provide for price adjustments through cost escalation clauses.
Forward-Looking Statements
Certain of the matters discussed concerning our operations, cash flows, financial position, economic performance and financial condition, including in particular, the likelihood of our success in developing and expanding our business and the realization of sales from backlog, include forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act.
Statements that are predictive in nature, that depend upon or refer to events or conditions or that include words such as expects, anticipates, intends, plans, believes, estimates and similar expressions are forward-looking statements. Although we believe that these statements are based upon reasonable assumptions, including projections of total sales growth, sales growth from business acquisitions, organic sales growth, consolidated operating margins, total segment operating margins, interest expense, earnings, cash flow, research and development costs, working capital, capital expenditures and other projections, they are subject to several risks and uncertainties, and therefore, it is possible that these statements may not be achieved. Such statements will also be influenced by factors which include, among other things:
| our dependence on the defense industry and the business risks peculiar to that industry, including changing priorities or reductions in annual DoD budgets and the outcome of potential additional reductions due to the sequestration process; |
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| backlog processing and program slips resulting from delayed funding of the DoD budget; |
| our reliance on contracts with a limited number of agencies of, or contractors to, the U.S. Government and the possibility of termination of government contracts by unilateral government action or for failure to perform; |
| the extensive legal and regulatory requirements surrounding our contracts with the U.S. or foreign governments and the results of any investigation of our contracts undertaken by the U.S. or foreign governments, including potential suspensions or debarments; |
| our ability to retain our existing business and related contracts (revenue arrangements); |
| our ability to successfully compete for and win new business and related contracts (revenue arrangements) and to win re-competitions of our existing contracts; |
| our ability to identify and acquire additional businesses in the future with terms, including the purchase price, that are attractive to L-3 and to integrate acquired business operations; |
| our ability to maintain and improve our consolidated operating margin and total segment operating margin in future periods; |
| our ability to obtain future government contracts (revenue arrangements) on a timely basis; |
| the availability of government funding and changes in customer requirements for our products and services; |
| our significant amount of debt and the restrictions contained in our debt agreements; |
| our ability to continue to retain and train our existing employees and to recruit and hire new qualified and skilled employees, as well as our ability to retain and hire employees with U.S. Government security clearances that are a prerequisite to compete for and to perform work on classified contracts for the U.S. Government; |
| actual future interest rates, volatility and other assumptions used in the determination of pension benefits and equity-based compensation, as well as the market performance of benefit plan assets; |
| our collective bargaining agreements, our ability to successfully negotiate contracts with labor unions and our ability to favorably resolve labor disputes should they arise; |
| the business, economic and political conditions in the markets in which we operate, including those for the commercial aviation, shipbuilding and communications markets; |
| global economic uncertainty; |
| the DoDs wide-ranging efficiency and better buying power initiatives; |
| events beyond our control such as acts of terrorism; |
| our ability to perform contracts (revenue arrangements) on schedule; |
| our international operations, including sales to foreign customers; |
| our extensive use of fixed-price type contracts as compared to cost-plus type and time-and-material type contracts; |