EX-99.1 3 a2166579zex-99_1.txt EXHIBIT 99.1 The Financial Statements and Financial Statement Schedule listed below are included in this Report: o Consolidated Balance Sheets at October 31, 2005 and 2004 o Consolidated Statements of Income for the years ended October 31, 2005, 2004 and 2003 o Consolidated Statements of Shareholders' Equity for the years ended October 31, 2005, 2004 and 2003 o Consolidated Statements of Cash Flows for the years ended October 31, 2005, 2004 and 2003 o Notes to Consolidated Financial Statements o Schedule II - Valuation and Qualifying Accounts FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- ENGINEERED SUPPORT SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS In thousands, except per share amounts
October 31 2005 2004 --------------------------------------------------------------------------------------------------------------------------- ASSETS CURRENT ASSETS Cash and cash equivalents $ 13,064 $ 33,153 Accounts receivable, net 151,210 139,191 Contracts in process and inventories, net 77,193 61,009 Income taxes receivable 1,046 Deferred income taxes 6,284 6,921 Prepaid expenses and other assets 3,568 2,846 --------------------------------------------------------------------------------------------------------------------------- Total Current Assets 252,365 243,120 PROPERTY, PLANT AND EQUIPMENT Land 4,390 4,387 Buildings and improvements 46,385 39,704 Machinery and equipment 32,753 26,567 Furniture and fixtures 7,303 5,465 --------------------------------------------------------------------------------------------------------------------------- 90,831 76,123 Accumulated depreciation (36,281) (29,177) --------------------------------------------------------------------------------------------------------------------------- 54,550 46,946 Goodwill 332,109 167,358 Acquired customer-related intangibles 51,868 38,314 Deferred income taxes 1,876 Other assets 11,265 13,520 --------------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $702,157 $511,134 --------------------------------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Notes payable $ 45,000 $ Current maturities of long-term debt 187 340 Accounts payable 79,705 71,796 Income taxes payable 10,067 Accrued employee compensation 33,534 27,806 Other liabilities 22,007 21,063 --------------------------------------------------------------------------------------------------------------------------- Total Current Liabilities 180,433 131,072 Long-term debt 1,952 781 Deferred income taxes 1,873 Minimum pension liability 31,141 28,237 Other liabilities 13,449 14,088 Commitments and contingencies (Note M) SHAREHOLDERS' EQUITY Common stock, par value $.01 per share; 85,000 shares authorized; 41,912 and 26,642 shares issued 419 266 Additional paid-in capital 205,998 151,805 Retained earnings 286,559 202,730 Accumulated other comprehensive loss (19,667) (17,845) --------------------------------------------------------------------------------------------------------------------------- Total Shareholders' Equity 473,309 336,956 --------------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $702,157 $511,134 --------------------------------------------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements.
1 ENGINEERED SUPPORT SYSTEMS, INC. CONSOLIDATED STATEMENTS OF INCOME In thousands, except per share amounts
Year Ended October 31 2005 2004 2003 --------------------------------------------------------------------------------------------------------------------------- Net revenues: Products $ 560,929 $596,162 $461,490 Services 457,444 287,468 111,211 --------------------------------------------------------------------------------------------------------------------------- 1,018,373 883,630 572,701 --------------------------------------------------------------------------------------------------------------------------- Cost of revenues: Products 378,162 408,282 340,380 Services 395,175 252,658 94,262 --------------------------------------------------------------------------------------------------------------------------- 773,337 660,940 434,642 --------------------------------------------------------------------------------------------------------------------------- Gross profit 245,036 222,690 138,059 Selling, general and administrative expense 103,590 98,042 63,832 Restructuring expense 62 1,758 Gain (loss) on sale of assets (24) (1,290) 147 --------------------------------------------------------------------------------------------------------------------------- Operating income from continuing operations 141,422 123,296 72,616 Interest expense (2,651) (1,215) (1,881) Interest income 828 353 221 --------------------------------------------------------------------------------------------------------------------------- Income from continuing operations 139,599 122,434 70,956 Income tax provision 52,350 46,525 27,673 --------------------------------------------------------------------------------------------------------------------------- Net income from continuing operations 87,249 75,909 43,283 Discontinued operations: Income from discontinued operations, net of income tax 294 Loss on disposal, net of income tax (2,073) (169) --------------------------------------------------------------------------------------------------------------------------- Net income $ 85,176 $ 75,909 $ 43,408 =========================================================================================================================== Basic earnings per share: Continuing operations $ 2.11 $ 1.95 $ 1.19 Discontinued operations (0.05) --------------------------------------------------------------------------------------------------------------------------- Total $ 2.06 $ 1.95 $ 1.19 =========================================================================================================================== Diluted earnings per share: Continuing operations $ 2.02 $ 1.82 $ 1.12 Discontinued operations (0.05) --------------------------------------------------------------------------------------------------------------------------- Total $ 1.97 $ 1.82 $ 1.12 =========================================================================================================================== See Notes to Consolidated Financial Statements.
2 ENGINEERED SUPPORT SYSTEMS, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated In thousands Additional Other Common Paid-in Retained Comprehensive Treasury Stock Capital Earnings Loss Stock Total --------------------------------------------------------------------------------------------------------------------------- Balance at October 31, 2002 $170 $ 95,569 $84,961 $(14,275) $(31,568) $134,857 Comprehensive income: Net income 43,408 43,408 Other components of comprehensive income, net of tax: Minimum pension liability adjustment (2,044) (2,044) Adjustment to fair value of derivatives 177 177 -------- Total comprehensive income 41,541 -------- Cash dividends (616) (616) Issuance of common stock 1 1,727 1,728 Exercise of stock options 8,682 9,705 18,387 Purchase of treasury stock (557) (557) Issuance of treasury stock 983 844 1,827 Three-for-two stock split 82 (449) 367 --------------------------------------------------------------------------------------------------------------------------- Balance at October 31, 2003 253 106,512 127,753 (16,142) (21,209) 197,167 Comprehensive income: Net income 75,909 75,909 Other components of comprehensive income, net of tax: Minimum pension liability adjustment (2,293) (2,293) Currency translation adjustment 590 590 -------- Total comprehensive income 74,206 -------- Cash dividends (932) (932) Issuance of common stock 1 4,135 4,136 Exercise of stock options 12 36,594 19,920 56,526 Issuance of treasury stock 409 1,289 1,698 Stock option compensation 4,155 4,155 --------------------------------------------------------------------------------------------------------------------------- Balance at October 31, 2004 266 151,805 202,730 (17,845) 336,956 Comprehensive income: Net income 85,176 85,176 Other components of comprehensive income, net of tax: Minimum pension liability adjustment (2,014) (2,014) Currency translation adjustment 192 192 -------- Total comprehensive income 83,354 -------- Cash dividends (1,347) (1,347) Issuance of common stock related to Spacelink acquisition 2 13,241 13,243 Issuance of common stock 2 9,342 9,344 Exercise of stock options 10 31,749 31,759 Three-for-two stock split 139 (139) --------------------------------------------------------------------------------------------------------------------------- Balance at October 31, 2005 $419 $205,998 $286,559 $(19,667) $ $473,309 =========================================================================================================================== See Notes to Consolidated Financial Statements.
3 ENGINEERED SUPPORT SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
In thousands Year Ended October 31 2005 2004 2003 ---------------------------------------------------------------------------------------------------------------------- CASH FLOW FROM OPERATING ACTIVITIES: Net income $ 85,176 $ 75,909 $ 43,408 Adjustments to reconcile net income from continuing operations to net cash provided by continuing operations: Loss (gain) from discontinued operations 2,073 (125) Depreciation and amortization 18,286 12,991 8,961 Deferred income taxes 5,918 2,423 5,768 Loss (gain) on sale of assets 24 1,290 (147) Stock option compensation expense 4,155 ---------------------------------------------------------------------------------------------------------------------- Cash provided by continuing operations before changes in operating assets and liabilities, excluding the effects of acquisitions 111,477 96,768 57,865 Changes in operating assets and liabilities: Accounts receivable 13,801 (47,657) (13,639) Contracts in process and inventories (11,501) (7,520) 3,065 Accounts payable 6,895 22,455 5,539 Current income taxes (11,113) 7,826 4,996 Net changes in other assets and liabilities (7,708) (5,303) 7,017 ---------------------------------------------------------------------------------------------------------------------- Net cash provided by continuing operations 101,851 66,569 64,843 Net cash provided by discontinued operations 1,612 ---------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 101,851 66,569 66,455 ---------------------------------------------------------------------------------------------------------------------- CASH FLOW FROM INVESTING ACTIVITIES: Purchase of PCA, net of cash acquired (37,648) Purchase of Spacelink, net of cash acquired (136,149) Purchase of Mobilized Systems, net of cash acquired (16,744) Purchase of Pivotal Power, net of cash acquired (10,064) Purchase of TAMSCO, net of cash acquired (7,440) (77,415) Purchase of EEI, net of cash acquired (99) (16,630) Purchase of UPSI, net of cash acquired (2,026) (5,008) Additions to property, plant and equipment (12,066) (8,034) (9,681) Proceeds from sale of property, plant and equipment 59 5,674 316 ---------------------------------------------------------------------------------------------------------------------- Net cash used in continuing operations (202,548) (21,989) (108,418) Net cash provided by discontinued operations 2,918 ---------------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (202,548) (21,989) (105,500) ---------------------------------------------------------------------------------------------------------------------- CASH FLOW FROM FINANCING ACTIVITIES: Net borrowings (payments) under line-of-credit agreement 45,000 (73,100) 60,100 Payments of long-term debt (431) (285) (41,910) Proceeds of long-term debt 1,409 382 Exercise of stock options, including related income tax benefit 31,759 56,526 18,387 Purchase of treasury stock (557) Cash dividends (1,347) (932) (616) Issuance of common stock to employee stock purchase plan 4,268 3,079 1,728 ---------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) continuing operations 80,658 (14,330) 37,132 Net cash provided by (used in) discontinued operations ---------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities 80,658 (14,330) 37,132 ---------------------------------------------------------------------------------------------------------------------- Effect of exchange rate changes on cash (50) 23 ---------------------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents (20,089) 30,273 (1,913) Cash and cash equivalents at beginning of year 33,153 2,880 4,793 ---------------------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 13,064 $ 33,153 $ 2,880 ====================================================================================================================== See Notes to Consolidated Financial Statements.
4 ENGINEERED SUPPORT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (in thousands, except per share amounts) NOTE A -- SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Principles of Consolidation: The Consolidated Financial Statements include the accounts of Engineered Support Systems, Inc. (Company) and its wholly-owned subsidiaries. These subsidiaries are organized within the Company's two business segments: Support Systems and Support Services. The Support Systems segment includes the operations of Systems & Electronics Inc. (SEI), Keco Industries, Inc. (Keco), Engineered Air Systems, Inc. (Engineered Air), Engineered Coil Company, d/b/a Marlo Coil (Marlo Coil), Engineered Electric Company, d/b/a Fermont (Fermont), Universal Power Systems, Inc. (UPSI), Engineered Environments, Inc. (EEI), Pivotal Power Inc. (Pivotal Power), Prospective Computer Analysts, Inc. (PCA) and Mobilized Systems, Inc. (Mobilized Systems). The Support Services segment includes the operations of Technical and Management Services Corporation (TAMSCO), Radian, Inc. (Radian), Spacelink International, LLC (Spacelink) and ESSIbuy.com, Inc. (ESSIbuy). All material intercompany accounts and transactions have been eliminated in consolidation. Industry Information: The Company's Support Systems segment designs, engineers and manufactures integrated military electronics and other military support equipment primarily for the U.S. Department of Defense (DoD), as well as related heat transfer and air handling equipment for domestic commercial and industrial users. Segment products include environmental control systems, load management and transport systems, power generation, distribution and conditioning systems, airborne radar systems, reconnaissance, surveillance and target acquisition systems, chemical and biological protection systems, petroleum and water distribution systems and other multipurpose military support equipment. The Company's Support Services segment provides engineering services, logistics and training services, advanced technology services, asset protection systems and services, telecommunication systems integration and information technology services primarily for the DoD. The Support Services segment also provides certain power generation and distribution equipment and vehicle armor installation to the DoD. Substantially all revenues are directly or indirectly derived from contracts with the U.S. Government. Use of Estimates: In preparing these financial statements, management makes estimates and uses assumptions that affect some of the reported amounts and disclosures. Actual results could differ from these estimates and assumptions. Cash and Cash Equivalents: Cash equivalents include temporary investments with original maturities of three months or less. Revenue Recognition: Revenues on long-term contracts, substantially all of which are with the U.S. government, are recognized under the percentage of completion method and include a proportion of the earnings that are expected to be realized on the contract in the ratio that production measures, primarily labor, incurred bear to the total estimated production measures for the contract. Earnings expectations are based upon estimates of contract values and costs at completion. Contracts in process are reviewed on a periodic basis. Adjustments to revenues and earnings are made in the current accounting period based upon revisions in contract values and estimated costs at completion. Amounts representing contract change orders, claims and other items are included in revenues, as recognized under the percentage of completion method, only when these amounts can be reliably estimated and realization is probable. Provisions for estimated losses on contracts are recorded when identified. Substantially all other revenues are recognized when title passes to the customer. Stock-Based Compensation: The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for all stock option plans. (See Note J for a further description of these plans.) Accordingly, no compensation expense has been recognized for stock option awards. The following table illustrates the effect on net income and earnings per share had the Company applied the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) 123, "Accounting for Stock-Based Compensation," to stock option awards. 5
Year Ended October 31 2005 2004 2003 --------------------- ---- ---- ---- Reported net income $85,176 $75,909 $43,408 Total stock-based employee compensation expense determined under the fair value method for all stock option awards, net of income tax 7,265 2,924 3,521 ------- ------- ------- Pro forma net income $77,911 $72,985 $39,887 ======= ======= ======= Earnings per share: Basic - as reported $ 2.06 $ 1.95 $ 1.19 ======= ======= ======= Basic - pro forma $ 1.89 $ 1.87 $ 1.10 ======= ======= ======= Diluted - as reported $ 1.97 $ 1.82 $ 1.12 ======= ======= ======= Diluted - pro forma $ 1.80 $ 1.75 $ 1.03 ======= ======= =======
The fair value of options at the grant date was estimated using the Black-Scholes model with the following weighted average assumptions for 2005, 2004 and 2003, respectively: an expected life of 2.5, 1.5 and 1.5 years; volatility of 35%, 26%, and 36%; a dividend yield of 0.08%, 0.11% and 0.18%; and a risk-free interest rate of 3.59%, 3.52%, and 3.25%. The weighted average fair value of options granted in 2005, 2004 and 2003 was $9.03, $5.37 and $5.03, respectively. Fair Value of Financial Instruments: For purposes of financial reporting, the Company has determined that the fair value of the Company's financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and long-term debt, approximates book value at October 31, 2005 and 2004, based on either their short-term nature or on terms currently available to the Company in financial markets. Credit Risk: Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, and accounts receivable. At October 31, 2005 and 2004, the Company's cash and cash equivalents were primarily invested in money market accounts at a financial institution. Management believes the credit risk is limited due to the short-term nature of these funds. Management believes the credit risk related to accounts receivable is limited due to the fact that 76% and 79% of accounts receivable at October 31, 2005 and 2004, respectively, are due from the U.S. government and its agencies. Allowances for anticipated doubtful accounts are provided based on historical experience and evaluation of specific accounts. The allowance for doubtful accounts was $1,060 and $90 at October 31, 2005 and 2004, respectively. Interest Rate Risk: Interest rate risk is managed through a portfolio of variable- and fixed-rate debt that management deems appropriate. Furthermore, the Company will periodically convert its variable-rate debt to fixed rates via interest rate swaps. Given the Company's outstanding debt position and anticipated cash flows, management does not believe its exposure to interest rate fluctuations has had, or will have, a significant impact on the Company's operations. The Company, therefore, had no interest rate swaps as of October 31, 2005. Contracts in Process and Inventories: Contracts in process and inventories represent accumulated contract costs, estimated earnings thereon based upon the percentage of completion method and contract inventories reduced by the contract value of delivered items. Accumulated contract costs and inventories are stated at actual costs incurred and consist of direct engineering, production, tooling, applicable overhead and other costs (excluding selling, general and administrative costs which are charged against income as incurred). Title to or a security interest in certain items included in contracts in process and inventories is vested in the U.S. government by reason of the progress payment provisions of related contracts. In accordance with industry standards, contracts in process and inventories related to long-term contracts are classified as current assets although a portion may not be realized within one year. Substantially all inventories related to contracts not accounted for under the percentage of completion method are valued at the lower of cost or market using the first-in, first-out method. Property, Plant and Equipment: Property, plant and equipment are stated at cost and are depreciated using the straight-line method over their estimated useful lives of 15 to 40 years for buildings and improvements, 5 to 15 years for machinery and equipment, and 3 to 10 years for furniture and fixtures. Depreciation expense totaled $7,752 in 2005, $5,627 in 2004 and $5,387 in 2003. 6 Income Taxes: The income tax provision is based on earnings reported in the financial statements. Deferred income taxes are provided for the tax effects of temporary differences between financial and income tax reporting using current statutory tax rates. Impairment of Long-lived Assets: Long-lived assets, including goodwill, are reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If the sum of the expected future undiscounted cash flows is less than the carrying amount of the asset, a loss is recognized for the difference between the fair value and the carrying value of the asset. Earnings Per Share: Basic earnings per share is based on average basic common shares outstanding, after the effect to the stock split described in Note O, of 41,329 in 2005, 38,987 in 2004 and 36,305 in 2003. Diluted earnings per share is based on average diluted common shares outstanding, after giving effect to the stock split described in Note O, of 43,232 in 2005, 41,799 in 2004 and 38,757 in 2003. Average diluted common shares outstanding include common stock equivalents, which represent common stock options as computed using the treasury stock method. Treasury Stock: Shares of treasury stock are valued at cost using the first-in, first-out method. Recently Issued Accounting Pronouncements: In October 2004, the U.S. Congress passed the American Jobs Creation Act of 2004 (the Jobs Creation Act). The Jobs Creation Act includes numerous provisions that may materially affect business practices and accounting for income taxes. For companies that pay U.S. income taxes on manufacturing activities in the U.S., the Jobs Creation Act provides a phased-in deduction from taxable income equal to a stipulated percentage of qualified income from domestic production activities. In December 2004, the Financial Accounting Standards Board (FASB) issued two FASB Staff Positions (FSP) regarding the accounting implications of the Act related to (1) the deduction for qualified domestic production activities (FSP 109-1) and (2) the one-time tax benefit for the repatriation of foreign earnings (FSP 109-2). This guidance applies to financial statements for periods ending after the date the Act was enacted. The Jobs Creation Act also provides for a change in the period of application for foreign tax credits, elimination of the 90-percent limitation of foreign tax credits against Alternative Minimum Tax, expanded disallowance of interest on convertible debt, and tax shelter disclosure penalties. The Company adopted FSP 109-1 and FSP 109-2 in the first quarter of 2005. The one-time tax benefit for the repatriation of foreign earnings does not apply to the Company. The Company anticipates that the Jobs Creation Act and related FASB pronouncements will have a material impact on the Company's consolidated financial statements in future periods. However, this impact was not material for the year ended October 31, 2005. In November 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) 151, "Inventory Costs - an amendment of ARB No. 43, Chapter 4." SFAS 151 seeks to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage) in the determination of inventory carrying costs. The statement requires such costs to be treated as a current period expense. This statement is effective November 1, 2005 for the Company. The Company does not believe that the adoption of SFAS 151 will have a significant impact on its consolidated financial statements. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment," (SFAS 123R). SFAS 123R requires companies to expense the value of employee stock options and similar awards. SFAS 123R is effective November 1, 2005 for the Company. The Company is currently evaluating its compensation policies and practices, along with the impact of SFAS 123R on its consolidated results of operations. In May 2005, the FASB issued SFAS 154, "Accounting Changes and Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement No. 3." SFAS 154 requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 also redefines "restatement" as the revising of previously issued financial statements to reflect the correction of an error. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 (or fiscal 2007 for the Company). The Company does not believe that the adoption of SFAS 154 will have a significant impact on its consolidated financial statements. 7 NOTE B -- ACQUISITIONS On January 7, 2005, the Company acquired all of the outstanding stock of PCA, which develops and manufactures electronic test and measurement equipment provided for electronic warfare and avionics systems primarily to military customers. The purchase price was $37.6 million and is subject to a working capital adjustment. The purchase price was financed with the Company's existing cash balances. The fair value of assets acquired, including goodwill of $24.1 million and acquired customer-related intangibles of $6.4 million, was $38.1 million and liabilities assumed totaled $0.5 million. Effective February 1, 2005, the Company acquired all of the outstanding stock of Spacelink, which designs, integrates, operates and maintains deployed satellite and wireless networks for the DoD, the U.S. intelligence community and other forward deployed federal agencies and multinational organizations worldwide. The purchase price, including transaction costs, was $154.6 million, which included common stock of the Company with a value of $13.2 million. The cash consideration was financed with short-term borrowings under the Company's revolving credit facility. The purchase price was net of $2.2 million of cash acquired. The purchase price is also subject to a working capital adjustment of approximately $2.9 million, tax adjustments pursuant to Section 338(h)(10) of the Internal Revenue Code of approximately $2.3 million and to certain contingent cash consideration based upon Spacelink's earnings before interest, taxes, depreciation and amortization, as defined, for each of the twelve month periods ending January 31, 2006 and 2007. The fair value of assets acquired, including goodwill of $128.0 million and acquired customer-related intangibles of $13.8 million, was $165.7 million and liabilities assumed totaled $11.1 million. The following unaudited pro forma summary presents the combined results for the years ended October 31, 2005 and 2004, respectively, as adjusted to reflect the Spacelink purchase transaction assuming the acquisition had occurred at November 1, 2003. These pro forma results are not necessarily indicative of the combined results that would have occurred had the acquisition actually taken place on November 1, 2003, nor are they necessarily indicative of the combined results that may occur in the future.
Year Ended October 31 --------------------- 2005 2004 ---- ---- Net revenues $1,040,087 $979,790 ========== ======== Net income $85,181 $76,415 ======= ======= Basic earnings per share $2.06 $1.94 ===== ===== Diluted earnings per share $1.97 $1.81 ===== =====
8 Pro forma net income from operations for the year ended October 31, 2005 includes $1,249, or $0.03 per basic and diluted earnings per share from continuing operations, related to the combined after-tax impact of one-time bonus expenses and transaction costs incurred by Spacelink. Certain information with respect to the assets and liabilities of Spacelink as of the acquisition date is summarized below: February 1, 2005 ---------------- Accounts receivable $ 19,930 Other current assets 910 Property, plant and equipment 3,021 Goodwill 127,955 Acquired customer-related intangibles 13,810 -------- Total assets $165,626 ======== Accounts payable $ 398 Accrued liabilities 10,675 -------- Total liabilities $ 11,073 ======== Effective May 1, 2005, the Company acquired all of the outstanding stock of Mobilized Systems, which designs, manufacturers and tests highly specialized trailers, shelters and environmental control systems, primarily for the defense industry. The purchase price was $17.5 million, net of cash acquired, of which $16.7 million has been paid as of October 31, 2005 as reflected in the Consolidated Statement of Cash Flows. The remaining $0.8 million of consideration is in the form of long-term promissory notes payable to the sellers. The cash portion of the purchase price was financed with short-term borrowings under the Company's revolving credit facility. The fair value of assets acquired, including goodwill of $12.7 million and customer-related intangibles of $3.2 million, was $19.1 million and liabilities assumed totaled $1.6 million. On December 5, 2003, the Company acquired all of the outstanding stock of Pivotal Power, a supplier of high-performance static power conversion equipment primarily to military customers. The purchase price was approximately $10.1 million, net of cash acquired. The fair value of assets acquired, including goodwill of $4.8 million and acquired customer-related intangibles of $1.2 million, was $11.6 million and liabilities assumed totaled $1.5 million. The purchase price was financed with short-term borrowings under the Company's revolving credit facility. On September 24, 2003, the Company acquired all of the outstanding common stock of EEI, a designer and manufacturer of specialized environmental control units and heat transfer systems for defense and industrial markets. The purchase price was approximately $15.6 million. The purchase of EEI, net of cash acquired, totaled $16.7 million in the Consolidated Statements of Cash Flows, which represents the $15.6 million purchase price plus assumed indebtedness of $1.1 million. The initial purchase price allocation for EEI was based on preliminary information, which was subject to adjustment upon obtaining complete valuation information. During the fourth quarter of 2004, the Company completed its valuation and reclassified $2.9 million from goodwill, as recorded in the preliminary allocation, to acquired customer-related intangibles and recorded a $0.5 million non-cash charge in the quarter ended October 31, 2004 to reflect the related amortization expense from acquisition date. The fair value of assets acquired, including goodwill of $11.6 million and acquired customer- 9 related intangibles of $2.9 million, was $19.9 million and liabilities assumed totaled $4.3 million. The purchase price was financed with short-term borrowings under the Company's revolving credit facility. On May 1, 2003, the Company acquired all of the outstanding common stock of TAMSCO, a provider of information technology logistics and digitization services and a designer and integrator of telecommunication systems primarily for the DoD. The purchase price was approximately $71.1 million, which is net of $0.1 million of cash acquired. Approximately $1.1 million of the purchase price has not been paid subject to final collection of accounts receivable. In connection with this transaction, the Company also assumed and paid $14.9 million of TAMSCO indebtedness. The purchase of TAMSCO, net of cash acquired, totals $84.9 million in the Consolidated Statements of Cash Flows, which represents the $71.1 million purchase price plus assumed indebtedness of $14.9 million less $1.1 million of purchase price not yet paid. The initial purchase price allocation for TAMSCO was based on preliminary information, which was subject to adjustment upon obtaining complete valuation information. During the second quarter of 2004, the Company completed its valuation of the assets acquired and liabilities assumed. As a result, the Company reclassified $29.9 million from goodwill, as recorded in the preliminary allocation, to acquired customer-related intangibles and recorded a $2.2 million non-cash charge in the quarter ended April 30, 2004 to reflect the related amortization expense from acquisition date. The fair value of assets acquired, including goodwill of $35.9 million and acquired customer-related intangibles of $29.9 million, was $103.9 million and liabilities assumed totaled $32.8 million. The purchase price was financed with short-term borrowings under the Company's revolving credit facility. The following unaudited pro forma summary presents the combined historical results of operations, after giving effect to the stock split described in Note O, for the year ended October 31, 2003 as adjusted to reflect the TAMSCO purchase transaction assuming the acquisition had occurred at November 1, 2002. These pro forma results are not necessarily indicative of the combined results that would have occurred had the acquisition actually taken place on November 1, 2002, nor are they necessarily indicative of the combined results that may occur in the future. Year Ended October 31 2003 ---------- Net revenues $ 652,655 ========== Net income $ 46,269 ========== Basic earnings per share $ 1.27 ========== Diluted earnings per share $ 1.19 ========== 10 Spacelink and TAMSCO are included in the Support Services segment. PCA, Mobilized Systems, Pivotal Power and EEI are included in the Support Systems segment. The operating results of each are included in consolidated operations since their respective dates of acquisition. NOTE C -- GOODWILL AND INTANGIBLE ASSETS The following table presents changes in the Company's goodwill for the Support Systems segment and for the Support Services segment for the three years ended October 31, 2005: Support Support Systems Services Total ------- -------- ----- October 31, 2002 $ 76,833 $ 26,611 $103,444 Acquisitions 18,886 69,002 87,888 -------- -------- -------- October 31, 2003 95,719 95,613 191,332 Acquisitions 6,935 1,821 8,756 Reclassification to acquired customer-related intangibles (2,880) (29,850) (32,730) -------- -------- -------- October 31, 2004 99,774 67,584 167,358 Acquisitions 36,796 127,955 164,751 -------- -------- -------- October 31, 2005 $136,570 $195,539 $332,109 ======== ======== ======== As of October 31, 2005, the Company had $271.3 million of remaining tax deductible goodwill. The following disclosure presents certain information on the Company's acquired identifiable intangible assets as of October 31, 2005, 2004 and 2003. All acquired identifiable intangible assets are being amortized over their estimated useful lives, as indicated below, with no estimated residual values. 11
Weighted Average Amortization Gross Accumulated Net Period Amount Amortization Amount ---------------- ------- ------------ ------- Customer-related intangibles: October 31, 2005 9.3 years $72,660 $20,792 $51,868 October 31, 2004 11.6 years 49,263 10,949 38,314 October 31, 2003 5.4 years 15,300 4,251 11,049
The amortization expense related to acquired intangible assets was $9,843, $6,698 and $2,831, respectively, for the years ended October 31, 2005, 2004 and 2003. (Amoritization expense related to acquired intangible assets for the year ended October 31, 2004 includes $2,151 related to finalization of the TAMSCO intangible asset valuation. Total related TAMSCO amoritization expense was $1,981 and $3,142, respectively, for the years ended October 31, 2005 and 2004.) Related estimated amortization expense is $10,953 for the year ending October 31, 2006, $10,204 for the year ending October 31, 2007, $7,001 for the year ending October 31, 2008, $4,879 for the year ending October 31, 2009 and $3,222 for the year ending October 31, 2010. NOTE D -- OPERATIONAL RESTRUCTURING During the quarter ended April 30, 2003, the Company announced a restructuring plan under which electronics assembly work performed at the Sanford, Florida facility of the Company's SEI subsidiary would be relocated to alternate SEI facilities. Statement of Financial Accounting Standards No. 146 (SFAS 146), "Accounting for Costs Associated with Exit or Disposal Activities," applies to all disposal activities initiated after December 31, 2002. SFAS 146 requires that a liability for employee termination costs associated with an exit or disposal activity be recognized when the liability is incurred. In accordance with SFAS 146, the Company recorded restructuring expense of $2.1 million in the year ended October 31, 2003 and $0.1 million in the year ended October 31, 2004, consisting of $1.3 million for severance and related benefits and $0.9 million for non-cash costs associated with the write-down of the Sanford, Florida facility to its fair market value. The Company anticipates that it will record no additional restructuring expense related to this plan. The plan involved the termination of 107 employees, all of which had been terminated as of October 31, 2004. All related severance costs had been paid as of October 31, 2004. NOTE E -- DISCONTINUED OPERATIONS The Company completed the sale of Engineered Specialty Plastics, Inc. (ESP), a wholly-owned subsidiary, in the quarter ended April 30, 2003 to a private equity group (the Buyers). The Buyers subsequently alleged that the Company breached certain representations made under the related Stock Purchase Agreement (the Agreement) and sought a claim for associated damages under the binding arbitration provisions of the Agreement. During the quarter ended April 30, 2005, the Company and the Buyers reached a settlement on this claim, which included modification of the Company's $3.2 million note receivable from the Buyers to provide for suspension of interest charges and payments through July 31, 2006, extension of the note's repayment term to a balloon payment due in April 2009, and the release of the underlying real estate collateral securing the note. Because of this settlement, the Company recorded a charge for the impairment of the note during the quarter ended April 30, 2005 equal to $1.7 million, or $1.1 million net of income tax. During the quarter ended October 31, 2005, the Company was informed that the Buyers had liquidated all ESP assets, and the Company reserved an additional $1.6 million, or $1.0 million net of income tax, for the impairment of the remainder of the note. These amounts are reflected in discontinued operations on the Consolidated Statements of Income for the year ended October 31, 2005. Certain information with respect to the discontinued operations of ESP is as follows: Year Ended October 31 2005 2003 -------------------------------------------------------------------------- Net revenues $ $9,136 -------------------------------------------------------------------------- Income from discontinued operations, net of income tax of $188 in 2003 $ $ 294 Loss on disposal, net of income tax of $(1,244) in 2005 and $(108) in 2003 (2,073) (169) -------------------------------------------------------------------------- Income (loss) on discontinued operations $(2,073) $ 125 ======= ====== 12 NOTE F -- ACCOUNTS RECEIVABLE Accounts receivable includes amounts due from the U.S. government and its agencies of $115,561 and $109,991 at October 31, 2005 and 2004, respectively. NOTE G -- CONTRACTS IN PROCESS AND INVENTORIES Contracts in process and inventories are comprised of the following: October 31 2005 2004 ---------------------------------------------------------------------------- Raw materials $ 1,638 $ 1,874 Work-in-process 5,345 5,246 Finished goods 454 493 Inventories substantially applicable to government contracts in process, reduced by progress payments of $54,039 and $54,629 69,756 53,396 ---------------------------------------------------------------------------- $77,193 $61,009 ============================================================================ Contracts in process and inventories at October 31, 2005 and 2004 include estimated revenue of $95,610 and $82,763, respectively, representing accumulated contract costs and related estimated earnings on uncompleted government contracts. NOTE H -- NOTES PAYABLE On January 27, 2005, the Company entered into an Amended and Restated Credit Agreement (Amended Credit Agreement) with its banks. The Amended Credit Agreement replaced the Company's previous credit agreement dated April 23, 2003. The Amended Credit Agreement, which expires January 27, 2010, provides for a $200 million unsecured revolving credit facility. The Company may request, subject to certain conditions, an increase of up to $100 million in the amount of the aggregate commitment under the Amended Credit Agreement. Borrowings under the Amended Credit Agreement bear interest, at the Company's option, at either the Eurodollar rate plus an applicable margin, or at the higher of the prime rate or the federal funds rate plus one-half of one percent. The margin applicable to the Eurodollar rate varies from 0.625% to 1.375% depending upon the Company's ratio of total indebtedness to earnings before interest, taxes, depreciation and amortization (leverage ratio). The Amended Credit Agreement contains certain covenants, including maintaining net worth of at least $265 million, plus 50% of the sum, to the extent positive, of the Company's consolidated net income and other comprehensive income (loss) reported after October 31, 2004, plus the net proceeds of all subsequent equity offerings. The Company must also comply with certain financial covenants, including maintenance of a leverage ratio of no greater than 2.75 to 1. The Company is also subject to various other financial and operating covenants and maintenance criteria, including restrictions on the Company's ability to incur additional indebtedness, make investments, create liens, dispose of material assets and enter into merger transactions and acquisitions. As of October 31, 2005, the Company was in compliance with all applicable covenants of the Amended Credit Agreement. No compensating balance is required or maintained related to the Amended Credit Agreement. As of October 31, 2005, the Company had $45.0 million in borrowings under the Amended Credit Agreement. Borrowings under the Amended Credit Facility and the Company's previous revolving credit facility averaged $26.5 million for the year ended October 31, 2005. Borrowings under the Amended Credit Agreement are unsecured and are guaranteed by the Company. Interest paid was $2,460 in 2005, $1,370 in 2004 and $2,215 in 2003. 13 NOTE I -- INCOME TAXES The income tax provision is comprised of the following:
Year Ended October 31 2005 2004 2003 --------------------- -------------------------- ----------- ------------------------------- Continuing Continuing Operations Combined Operations Combined ---------- -------- ---------- -------- Current: Federal $42,840 $42,840 $40,338 $20,091 $20,187 State 3,896 3,896 4,153 1,798 1,798 Foreign (304) (304) (389) ------- ------- ------- ------- ------- 46,432 46,432 44,102 21,889 21,985 ------- ------- ------- ------- ------- Deferred: Federal 5,250 4,089 2,184 5,191 5,176 State 375 292 187 593 592 Foreign 293 293 52 ------- ------- ------- ------- ------- 5,918 4,674 2,423 5,784 5,768 ------- ------- ------- ------- ------- $52,350 $51,106 $46,525 $27,673 $27,753 ======= ======= ======= ======= =======
The deferred income tax provision (benefit) results from the following temporary differences:
Year Ended October 31 2005 2004 2003 --------------------- -------------------------- ----------- ------------------------------- Continuing Continuing Operations Combined Operations Combined ---------- -------- ---------- -------- Uncompleted contracts $ 771 $ 771 $ (146) $ 541 $ 541 Depreciation 75 75 90 289 343 Goodwill and intangible amortization 3,224 3,224 2,035 3,589 3,589 Employee benefit plans 882 882 685 (57) (57) Loss on disposal of discontinued operations (1,244) (60) Other, net 966 966 (241) 1,422 1,412 ------ ------ ------- ------- ------- $5,918 $4,674 $ 2,423 $ 5,784 $ 5,768 ====== ====== ======= ======= =======
Deferred income tax liabilities (assets) are comprised of the following: Year Ended October 31 2005 2004 ---------------------------------------------------------------------------- Depreciation $ 2,441 $ 2,398 Uncompleted contracts (571) (1,360) Employee benefits (5,527) (6,291) Goodwill and intangibles 16,139 13,087 Asset reserves (1,211) (1,160) Capital loss carryforward (3,994) (2,814) Other comprehensive loss (12,270) (11,299) Other, net (3,742) (4,475) ---------------------------------------------------------------------------- (8,735) (11,914) Valuation allowance 4,324 3,117 ---------------------------------------------------------------------------- $ (4,411) $ (8,797) ============================================================================ 14 Deferred income tax liabilities (assets) are presented on the Consolidated Balance Sheets as follows: Year Ended October 31 2005 2004 -------------------------------------------------------------------------- Current assets $(6,284) $(6,921) Non-current assets (1,876) Non-current liabilities 1,873 -------------------------------------------------------------------------- $(4,411) $(8,797) ========================================================================== A reconciliation between the income tax provision and the annual amount computed by applying the statutory federal income tax rate to income before income taxes is as follows:
Year Ended October 31 2005 2004 2003 ------------------------------------------------------------------------------------------ Income tax provision at statutory federal rate $48,860 $42,852 $24,835 State income taxes and other, net 3,490 3,673 2,838 ------------------------------------------------------------------------------------------ $52,350 $46,525 $27,673 ==========================================================================================
As of October 31, 2005, the Company had U.S. capital loss carryovers of $10,652, which expire in 2009. As of October 31, 2005, the Company had foreign investment tax credit carryovers of $1,405 which will begin to expire in 2006. The Company provided a valuation allowance of $4,324 in 2005 and $3,117 in 2004 on the capital loss and foreign investment tax credit carryovers, the recovery of which is uncertain. Income taxes paid were $40,059 in 2005, $12,479 in 2004 and $13,923 in 2003. NOTE J -- STOCK OPTIONS The Company has established plans whereby options may be granted to employees and directors of the Company to purchase shares of the Company's common stock. Options granted are at an option price equal to the market value on the date the option is granted and vest immediately. Subject to continuation of employment, all options must be exercised within five years from the date of grant and are exercisable at any time during this period. As of October 31, 2005, 4,711 shares of unissued common stock were authorized and reserved for outstanding options, which had a weighted average remaining contractual life of 2.9 years at that date. Transactions involving the stock option plans are as follows: Shares Price per share ------------------------------------------------------------------------------ Outstanding at October 31, 2002 6,753 $ 2.48 to $13.42 Options granted 1,148 $15.91 to $29.46 Options exercised (1,251) $ 2.48 to $16.61 ------------------------------------------------------------------------------ Options forfeited (2) $13.42 ------------------------------------------------------------------------------ Outstanding at October 31, 2003 6,648 $ 2.56 to $29.46 Options granted 879 $29.63 to $37.07 Options exercised (2,697) $ 2.56 to $29.46 Options forfeited (2) $13.42 to $36.83 ------------------------------------------------------------------------------ Outstanding at October 31, 2004 4,828 $ 2.56 to $37.07 Options granted 1,288 $34.93 to $41.11 Options exercised (1,345) $ 2.56 to $36.83 Options forfeited (60) $29.46 to $36.83 ------------------------------------------------------------------------------ Outstanding at October 31, 2005 4,711 $ 5.19 to $41.11 ============================================================================== 15 The following table summarizes information for stock options outstanding at October 31, 2005: Weighted Weighted Average Average Options Remaining Exercise Range of Exercise Prices Outstanding Life Price ----------------------------------------------------------------------------- $ 5.19 to $ 8.86 377 0.4 years $ 5.38 $12.63 to $16.61 1,885 1.9 years $12.91 $29.46 to $37.07 1,212 3.4 years $33.20 $34.93 to $41.11 1,237 4.6 years $35.75 During the quarter ended October 31, 2004, the Company recorded a charge of $5.0 million ($3.1 million on an after-tax basis) for severance and related benefit costs incurred in connection with the resignation of the Company's former Chief Executive Officer. Of this amount, $4.2 million ($2.6 million on an after-tax basis) represents a non-cash charge associated with the extension of the exercise period of vested non-qualified stock options in accordance with FASB Interpretation No. 44 (FIN44), "Accounting for Certain Transactions Involving Stock Compensation." NOTE K -- PENSION AND OTHER POSTRETIREMENT BENEFITS Effective September 30, 1999, the Company acquired SEI and assumed the pension and other postretirement benefit plans related to SEI's employees and non-employee participants. Substantially all employees of SEI are covered by defined benefit or defined contribution pension plans. In addition, certain retirees of SEI are eligible for postretirement health and life insurance benefits. To qualify for postretirement health and life insurance benefits, an SEI employee must retire at age 55 or later and the employee's age plus service must equal or exceed 75. Retiree contributions are defined as a percentage of medical premiums. Consequently, retiree contributions increase with increases in the medical premiums. The life insurance plans are noncontributory and provide coverage of a flat dollar amount for qualifying retired SEI employees. All former full-time employees of Engineered Air who were covered by a collective bargaining agreement are also covered by a defined benefit pension plan. These SEI and Engineered Air benefits are provided under defined benefit pay-related and flat-dollar plans, which are primarily non-contributory. Annual Company 16 contributions to retirement plans equal or exceed the minimum funding requirements of the Employee Retirement Income Security Act or other applicable regulations. The components of pension and other postretirement benefit costs are presented below for 2005, 2004 and 2003: 2005 2004 2003 ------------------------------------------------------------------------ PENSION BENEFITS Service cost $ 3,191 $ 2,896 $ 2,859 Interest cost 7,383 7,035 7,018 Expected return on plan assets (7,505) (7,201) (6,994) Amortization of prior service cost 536 536 556 Recognized actuarial loss 3,764 3,344 1,526 Other 36 ------------------------------------------------------------------------ Net pension costs $ 7,369 $ 6,610 $ 5,001 ======================================================================== OTHER POSTRETIREMENT BENEFITS Service cost $216 $ 236 $ 273 Interest cost 620 593 713 Actuarial loss 455 339 343 ------------------------------------------------------------------------ Net other benefit costs $ 1,291 $ 1,168 $ 1,329 ======================================================================== A reconciliation of the changes in the plans' benefit obligations and fair values of assets over the two-year period ending October 31, 2005 and a statement of the funded status at October 31, 2005 and 2004 follows. 2005 2004 ------------------------------------------------------------------------------- PENSION BENEFITS RECONCILIATION OF BENEFIT OBLIGATION: Benefit obligation at beginning of year $126,804 $115,842 Service cost 3,191 2,896 Interest cost 7,383 7,035 Actuarial loss 5,758 5,255 Benefit payments (4,291) (4,124) Other (100) (100) ------------------------------------------------------------------------------- Benefit obligation at October 31 $138,745 $126,804 =============================================================================== RECONCILIATION OF FAIR VALUE OF PLAN ASSETS: Fair value of plan assets at beginning of year $ 77,829 $ 69,272 Actual return on plan assets 6,521 6,276 Employer contributions 6,326 6,405 Benefit payments (4,291) (4,124) Other (129) ------------------------------------------------------------------------------- Fair value of plan assets at October 31 $ 86,256 $ 77,829 =============================================================================== 17 FUNDED STATUS: Funded status at October 31 $(52,489) $(48,975) Unrecognized prior service cost 2,214 2,750 Unrecognized actuarial loss 47,661 44,652 ------------------------------------------------------------------------------- Accrued benefit cost $ (2,614) $ (1,573) =============================================================================== OTHER POSTRETIREMENT BENEFITS RECONCILIATION OF BENEFIT OBLIGATION: Benefit obligation at beginning of year $ 9,746 $ 11,384 Service cost 216 236 Interest cost 620 593 Plan amendments (4,670) Actuarial loss (gain) 1,724 (1,069) Benefit payments (1,596) (1,398) ------------------------------------------------------------------------------- Benefit obligation at October 31 $ 6,040 $ 9,746 =============================================================================== RECONCILIATION OF FAIR VALUE OF PLAN ASSETS: Fair value of plan assets at beginning of year $ $ Employer contributions 1,596 1,398 Benefit payments (1,596) (1,398) ------------------------------------------------------------------------------- Fair value of plan assets at October 31 $ $ =============================================================================== FUNDED STATUS: Funded status at October 31 $ (6,040) $ (9,746) Unrecognized prior service cost (4,670) Unrecognized actuarial loss 4,531 3,270 ------------------------------------------------------------------------------- Accrued benefit cost $ (6,179) $ (6,476) =============================================================================== The amounts recognized in the Company's Consolidated Balance Sheets as of October 31 are as follows: 2005 2004 ------------------------------------------------------------------------------- PENSION BENEFITS Accrued benefit cost $ (6,407) $ (5,627) Intangible asset 2,214 2,557 Additional minimum liability (31,141) (28,237) Other comprehensive loss 32,720 29,734 ------------------------------------------------------------------------------- Net amount recognized $ (2,614) $ (1,573) =============================================================================== OTHER POSTRETIREMENT BENEFITS Accrued benefit cost $ (6,179) $ (6,476) ------------------------------------------------------------------------------- Net amount recognized $ (6,179) $ (6,476) =============================================================================== The postretirement plan amendment is that prescription drug coverage will no longer be offered to participants after the age of 65. This change is being made concurrently with the new Medicare Part D coverage for prescription drugs effective in 2006. Under the new arrangement, retiree contributions provide for 100% of the cost for post-65 coverage. 18 Assumptions used in accounting for the defined benefit plans in 2005, 2004 and 2003 were a discount rate of 5.50%, 5.75% and 6.00%, respectively, a rate of compensation increase of 3.75% in each year, and an expected long-term rate of return on assets of 8.75% in each year. A 1% increase in the discount rate would decrease net pension costs for 2005 and the accrued benefit cost at October 31, 2005 by $1.8 million and a 1% decrease in the discount rate would increase net pension benefit costs for 2005 and the accrued benefit cost at October 31, 2005 by $1.9 million. A 1% increase in the expected long-term rate of return on assets would decrease net pension costs for 2005 and the accrued benefit cost at October 31, 2005 by $0.8 million and a 1% decrease in the expected long-term rate of return on assets would increase net pension benefit costs for 2005 and the accrued benefit cost at October 31, 2005 by $0.8 million. Assumptions used in accounting for other postretirement benefits in 2005, 2004 and 2003 were a discount rate 5.50% 5.75% and 6.00%, respectively, and a health care cost trend of 9.5%, 9.5% and 10.0%, respectively, decreasing 0.5% annually to an ultimate rate of 5.5%. A 1% increase in the discount rate would decrease net other benefit costs for 2005 by $0.1 million and a 1% decrease in the discount rate would increase net other benefit costs for 2005 by $0.1 million. A 1% increase in the health care cost trend rate for each year would increase the October 31, 2005 net benefit obligation by approximately $12, while a 1% decrease in the health care cost trend rate for each year would decrease the October 31, 2005 net benefit obligation by approximately $14. The accumulated benefit obligation for defined benefit pension plans was $123.8 million and $111.7 million at October 31, 2005 and 2004, respectively. The weighted average asset allocation and the target allocation for the Company's pension benefit plans, by asset category, is as follows: Asset Target Allocation Allocation at October 31 at October 31 -------------------- ------------- 2005 2004 2005 ------ ------ ------ Equity securities 63.7% 66.2% 62.5% Debt securities 32.0% 30.1% 33.0% Real estate 2.9% 2.7% 2.5% Cash 1.4% 1.0% 2.0% ----- ----- ----- Total 100.0% 100.0% 100.0% ===== ===== ===== The Company expects to contribute $6,771 to its pension benefit plans and contribute $700 in expected benefit payments attributable to its other postretirement benefit plans during the year ending October 31, 2006. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid: Year Other Post Ending Pension Retirement October 31 Benefits Benefits ---------- -------- ---------- 2006 $ 5,379 $ 558 2007 5,892 552 2008 6,258 548 2009 6,709 530 2010 7,115 504 2011 - 2015 43,391 2,721 19 The Company's pension plan assets are managed by outside investment managers and assets are rebalanced when the target ranges are exceeded. Pension plan assets consist of marketable securities including common stocks, bonds, real estate and interest-bearing deposits. The Company's investment strategy with respect to pension assets is to achieve a total rate of return (income and capital appreciation) that is sufficient to provide retirement benefits to all eligible and future retirees of the pension plans. The Company regularly monitors performance and compliance with investment guidelines. The Company sponsors the Engineered Support Systems, Inc. 401(k) and Employee Stock Ownership Plan (ESOP), which covers all employees of Engineered Air, Marlo Coil, Keco, Fermont, ESSIbuy, UPSI, Radian, TAMSCO, EEI, PCA, Spacelink and Mobilized Systems and all employees of SEI with an employment starting date after December 31, 2004. The ESOP provides for a matching contribution by the Company of no less than 25% of each employee's contributions up to a maximum of 6% of the employee's earnings. The Company also makes discretionary annual contributions. All employee and employer contributions to the ESOP are 100% vested. In addition, the Company previously sponsored the TAMSCO Tax Deferred Retirement Plan, the Engineered Environments, Inc. 401(k) Plan, the Prospective Computer Analysts, Inc. Employee Savings and Retirement Plan, the Spacelink International, LLC 401(k) Plan, and Mobilized Systems, Inc. 401(k) Incentive Savings Plan. The Company has recorded expense based on contributions to the ESOP, the TAMSCO plan, the EEI plan, the PCA plan, the Spacelink plan, and the MSI plan for the years ended October 31, 2005, 2004 and 2003 of $7,173, $4,600 and $1,989, respectively. The Company also has a qualified Employee Stock Purchase Plan (ESPP), the terms of which allow for qualified employees, as defined, to purchase the Company's common stock at a price equal to 95% of the closing price at the beginning of each semi-annual stock purchase period. Prior to July 1, 2005, the plan allowed plan participants to purchase shares of the Company's common stock at a price equal to 85% of the lower of the closing price at the beginning or end of each semi-annual stock purchase period, but was amended to comply with recently enacted income tax law changes concerning employer-sponsored stock purchase plans. The Company issued 128, 129 and 81 shares of common stock during the years ended October 31, 2005, 2004 and 2003 pursuant to the ESPP at an average price per share of $31.69, $22.79 and $20.27, respectively. NOTE L -- BUSINESS SEGMENT INFORMATION Based on its organizational structure, the Company operates in two business segments: Support Systems and Support Services. The Support Systems segment designs, engineers and manufactures integrated military electronics and other military support equipment primarily for the DoD, as well as related heat transfer and air handling equipment for domestic commercial and industrial users. Segment products include environmental control systems, load management and transport systems, power generation, distribution and conditioning systems, airborne radar systems, reconnaissance, surveillance and target acquisition systems, chemical and biological protection systems, petroleum and water distribution systems and other multipurpose military support equipment. The Support Services segment provides engineering services, logistics and training services, advanced technology services, asset protection systems and services, telecommunication systems integration and information technology services primarily for the DoD. The Support Services segment also provides certain power generation and distribution equipment and vehicle armor installation to the DoD. Management utilizes more than one measurement and multiple views of data to measure business segment performance and to allocate resources to the segments. However, the dominant measurements are consistent with the Company's Consolidated Financial Statements and, accordingly, are reported on the same basis herein. Management evaluates the performance of its business segments and allocates resources to them primarily based on income from operations, along with cash flows and overall economic returns. The Company's export net revenues are not significant. All corporate expenses and assets have been allocated to the segments. In 2005, 2004 and 2003, approximately, 96%, 94% and 95% of consolidated net revenues were derived directly or indirectly from the U.S. government. 20 The following table summarizes the Company's net revenues attributed to the United States and to foreign countries: United Foreign Total October 31 States Countries Revenues ---------- -------- --------- -------- 2005 $993,288 $25,085 $1,018,373 2004 853,286 30,344 883,630 2003 556,809 15,892 572,701 The Company attributes foreign net revenues based on the domicile of the purchaser of the product or service. Of the $702.2 million in total Company assets as of October 31, 2005, $13.9 million were located in countries other than the U.S. Information by segment is summarized as follows:
------------------------------------------------------------------------------------------ Year Ended October 31 2005 2004 2003 ------------------------------------------------------------------------------------------ NET REVENUES: Support Systems: Products $ 501,013 $514,702 $389,301 Services ------------------------------------------------------------------------------------------ 501,013 514,702 389,301 ------------------------------------------------------------------------------------------ Support Services: Products 135,247 155,353 99,534 Services 457,444 287,468 111,211 ------------------------------------------------------------------------------------------ 592,691 442,821 210,745 ------------------------------------------------------------------------------------------ Intersegment Revenues (75,331) (73,893) (27,345) ------------------------------------------------------------------------------------------ $1,018,373 $883,630 $572,701 ==========================================================================================
21
OPERATING INCOME FROM CONTINUING OPERATIONS: Support Systems $ 87,490 $ 92,966 $ 54,200 Support Services 53,932 30,330 18,416 ------------------------------------------------------------------------------------------ 141,422 123,296 72,616 Interest expense (2,651) (1,215) (1,881) Interest income 828 353 221 ------------------------------------------------------------------------------------------ Income from continuing operations before income tax $139,599 $122,434 $ 70,956 ========================================================================================== IDENTIFIABLE ASSETS: Support Systems $319,180 $272,605 $224,599 Support Services 382,977 238,529 194,702 ------------------------------------------------------------------------------------------ $702,157 $511,134 $419,301 ========================================================================================== DEPRECIATION AND AMORTIZATION: ------------------------------------------------------------------------------------------ Support Systems $ 7,221 $ 6,113 $ 5,529 Support Services 11,065 6,878 3,432 ------------------------------------------------------------------------------------------ $18,286 $ 12,991 $ 8,961 ========================================================================================== CAPITAL EXPENDITURES: Support Systems $ 2,420 $ 5,763 $ 8,782 Support Services 9,646 2,271 899 ------------------------------------------------------------------------------------------ $ 12,066 $ 8,034 $ 9,681 ==========================================================================================
NOTE M -- COMMITMENTS AND CONTINGENCIES As a government contractor, the Company is continually subject to audit by various agencies of the U.S. government to determine compliance with various procurement laws and regulations. As a result of such audits and as part of normal business operations of the Company, various claims and charges are asserted against the Company. It is not possible at this time to predict the outcome of all such actions. However, management is of the opinion that it has good defenses against such actions and believes that none of these matters will have a material effect on the consolidated financial position or the results of operations of the Company. Total contractual and contingent obligations as of October 31, 2005 are as follows:
Payments / Expiration -------------------------------------------------------------- 2006 2007 2008 2009 2010 Total -------- ------- ------- ------ ------ -------- Contractual Obligations: Long-term debt $ 187 $ 198 $ 391 $ 533 $ $ 1,309 Operating leases 5,347 4,087 2,384 1,495 573 13,886 Unconditional purchase obligations 202,834 8,912 211,746 Contributions to pension and other postretirement benefit plans 7,471 7,471 7,371 7,371 3,871 33,555 -------- ------- ------- ------ ------ -------- 215,839 20,668 10,146 9,399 4,444 260,496 Contingent Obligations: Letters of credit 1,840 1,840 -------- ------- ------- ------ ------ -------- Total Obligations $217,679 $20,668 $10,146 $9,399 $4,444 $262,336 ======== ======= ======= ====== ====== ========
While contingent obligations are included in the table above, the Company does not expect to fund the full amounts indicated for letters of credit. Lease expense totaled $5.9 million, $5.0 million and $4.2 million for the years ended October 31, 2005, 2004 and 2003, respectively. NOTE N -- SEC INVESTIGATION In December 2004, the Company was notified by the Enforcement Division of the SEC of the issuance of a formal order directing a private investigation captioned In the Matter of Engineered 22 Support Systems, Inc. and that the SEC had issued subpoenas to various individuals associated with the Company to produce certain documents. The SEC staff also requested that the Company voluntarily produce certain documents in connection with the investigation. The subpoenas related to trading in the Company's stock around the Company's earnings releases in 2003 and the adequacy of certain disclosures made by the Company regarding related-party transactions in 2002 and 2003 involving insurance policies placed by the Company through an insurance brokerage firm in which a director of the Company was a principal at the time of the transactions. On or about September 23, 2005, the SEC staff contacted the Company's counsel and advised that it had issued a subpoena directed to the Company and expanded its investigation to include the Company's disclosure of a November 2004 stop-work order relating to the Company's Deployable Power Generation and Distribution System program for the U.S. Air Force, and trading in the Company's stock by certain individuals associated with the Company. In connection with the foregoing SEC investigation, the Company and certain of its directors and officers have provided information and testimony to the SEC. The Company continues to furnish information requested by the SEC. The Company is unable to determine at this time either the timing of the investigation or the impact, if any, which the investigation could have on the Company or the combined company following the Company's proposed merger with DRS as explained in Note P. NOTE O -- STOCK SPLIT On April 15, 2005, the Company effected a three-for-two stock split in the form of a 50% stock dividend. All per share amounts, as well as all share amounts related to the Company's stock option and stock purchase plans, have been restated to reflect this stock split. NOTE P -- MERGER AGREEMENT WITH DRS TECHNOLOGIES, INC. On September 21, 2005, the Company and DRS Technologies, Inc. (DRS) entered into a definitive agreement which provides for the acquisition by DRS of all of the outstanding common stock of the Company for approximately $1.9 billion, or $43.00 per share (subject to possible adjustment), through a combination of cash and DRS common stock. Pending customary regulatory approvals and other closing conditions, including approval by DRS and Company shareholders, the transaction is anticipated to close before March 31, 2006. 23 SUPPLEMENTAL INFORMATION The table below presents unaudited quarterly financial information for the years ended October 31, 2005 and 2004 (in thousands, except for per share amounts):
Quarter Ended January 31 April 30 July 31 October 31 Fiscal Year ----------------------------------------------------------------------------------------------------------------------------------- 2005 2004 2005 2004 2005 2004 2005 2004 2005 2004 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- Net revenues $233,533 $195,130 $263,768 $210,136 $258,735 $221,991 $262,337 $256,373 $1,018,373 $883,630 Gross profit 57,544 46,271 60,324 53,425 63,450 56,816 63,718 66,178 245,036 222,690 Net income from continuing operations 20,611 15,743 20,093 18,323 22,564 20,506 23,981 21,337 87,249 75,909 Net income 20,611 15,743 19,045 18,323 22,564 20,506 22,956 21,337 85,176 75,909 Diluted earnings per share; Continuing operations $0.48 $0.38 $0.46 $0.44 $0.52 $0.49 $0.55 $0.51 $2.02 $1.82 Total $0.48 $0.38 $0.44 $0.44 $0.52 $0.49 $0.53 $0.51 $1.97 $1.82
Earnings per share calculations are based on the average basic and diluted common shares outstanding for each quarter and, therefore, the sum of the quarters may not necessarily be equal to the full year basic and diluted earnings per share amounts. The results for the quarter ended October 31, 2004 include $1.7 million of net income resulting from revisions, adjustments and changes in estimates for certain long-term contracts, primarily at the Company's Keco subsidiary. 24 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Engineered Support Systems, Inc.: We have completed an integrated audit of Engineered Support Systems, Inc.'s 2005 consolidated financial statements and of its internal control over financial reporting as of October 31, 2005 and audits of its 2004 and 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated financial statements and financial statement schedule ------------------------------------------------------------------ In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Engineered Support Systems, Inc. and its subsidiaries at October 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Internal control over financial reporting ----------------------------------------- Also, in our opinion, management's assessment, included in the accompanying Report of Management on Internal Control over Financial Reporting, that the Company maintained effective internal control over financial reporting as of October 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of October 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding 25 of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. As described in the accompanying Report of Management on Internal Control over Financial Reporting, management has excluded certain elements of the internal control over financial reporting of Spacelink, LLC, Prospective Computer Analysts Incorporated, and Mobilized Systems, Inc. from its assessment of the Company's internal control over financial reporting as of October 31, 2005 because each was acquired by the Company in a purchase business combination during 2005. Subsequent to the acquisition, certain elements of the acquired businesses' internal control over financial reporting and related processes were integrated into the Company's existing systems and internal control over financial reporting. Those controls that were not integrated have been excluded from management's assessment of the effectiveness of internal control of financial reporting as of October 31, 2005. We have also excluded those elements from our audit of internal control over financial reporting. The combined excluded elements of Spacelink, LLC, Prospective Computer Analysts Incorporated, and Mobilized Systems, Inc. represent controls over accounts of approximately 4% of total assets and 8% of total revenues of the related consolidated financial statement amounts as of and for the year ended October 31, 2005. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP St. Louis, Missouri January 9, 2006 26 REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of ESSI is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of ESSI's financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect ESSI's transactions and dispositions of assets of the Company; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements in accordance with generally accepted accounting principles; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Management conducted an evaluation of the effectiveness of ESSI's internal control over financial reporting based on the framework and criteria established in Internal Control -- Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. This evaluation included review of the documentation of controls, evaluation of the design effectiveness of controls, testing of the operating effectiveness of controls and a conclusion on this evaluation. Based on this evaluation, management concluded that ESSI's internal control over financial reporting was effective as of October 31, 2005. Management's assessment of the effectiveness of ESSI's internal control over financial reporting as of October 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein. Management has excluded certain elements of the internal control over financial reporting of Spacelink, LLC, Prospective Computer Analysts Incorporated, and Mobilized Systems, Inc. from its assessment of the Company's internal control over financial reporting as of October 31, 2005 because each was acquired by the Company in a purchase business combination during 2005. Subsequent to the acquisition, certain elements of the acquired businesses' internal control over financial reporting and related processes were integrated into the Company's existing systems and internal control over financial reporting. Those controls that were not integrated have been excluded from management's assessment of the effectiveness of internal control of financial reporting as of October 31, 2005. The combined excluded elements of Spacelink, LLC, Prospective Computer Analysts Incorporated, and Mobilized Systems, Inc. represent controls over accounts of approximately 4% of total assets and 8% of total revenues of the related consolidated financial statement amounts as of and for the year ended October 31, 2005. 27