EX-13 2 ex13.txt EXHIBIT 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CRITICAL ACCOUNTING POLICIES REVENUE RECOGNITION: Revenues on long-term contracts, substantially all of which are directly or indirectly 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. Actual results could differ from the Company's estimates and assumptions. RETIREMENT OBLIGATIONS: The determination of the Company's obligation and expense for pension and other postretirement benefits is dependent on certain assumptions developed by the Company and used by actuaries in calculating such amounts. Assumptions include, among others, the discount rate and the expected long-term rate of return on plan assets. Actual results that differ from assumptions made are accumulated and amortized over future periods and, therefore, generally affect the Company's recognized expense and recorded obligation in such future periods. Significant differences in actual experience or significant changes in assumptions may materially affect pension and other postretirement obligations. GOODWILL AND OTHER LONG-LIVED ASSETS: Management annually reviews goodwill and other long-lived assets with indefinite useful lives for impairment or whenever events or changes in circumstances indicate the carrying amount may not be recoverable. If the Company determines that the carrying value of the long-lived asset may not be recoverable, a permanent impairment charge is recorded for the amount by which the carrying value of the long-lived asset exceeds its fair value. Fair value is measured based on a discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in the Company's current business model. The estimates of cash flows and discount rate are subject to change due to the economic environment, including such factors as interest rates, expected market returns and volatility of markets served. Management believes that the estimates of future cash flows and fair value are reasonable; however, changes in estimates could result in an impairment charge. Intangible assets with estimated useful lives are amortized over these lives and reviewed for impairment on a periodic basis. The following analysis should be read in this context. RECENT DEVELOPMENTS Over the past three years, the Company's net revenues and net income have increased substantially as a result of both internal growth and several significant acquisitions. Effective December 5, 2003, the Company acquired all of the outstanding stock of Pivotal Power Inc. (Pivotal Power), a supplier of high performance static power conversion equipment primarily to military customers, for approximately $10.1 million, net of cash acquired. In conjunction with the Pivotal Power acquisition, the Company recorded $1.2 million in customer-related intangibles which are being amortized over an estimated useful life of 6 years. After allocating the purchase price to the fair value of all identifiable tangible and intangible assets, goodwill of $4.8 million was recorded. Pivotal Power is included within the Company's Support Systems business segment. During 2003, the Company acquired two companies operating in the defense industry. Effective May 1, 2003, the Company acquired all the capital stock of Technical and Management Services Corporation (TAMSCO), a provider of information technology logistics and digitization services, and a designer and integrator of telecommunications systems primarily for the U.S. Department of Defense (DoD), for approximately $71.1 million in cash plus the payoff of primarily working capital-related indebtedness. In conjunction with the TAMSCO acquisition, the Company recorded $29.9 million in customer-related intangibles, which are being amortized over the weighted average of the related customer contracts' estimated useful lives of 15.6 years. After allocating the purchase price to the fair value of all identifiable tangible and intangible assets, goodwill of $35.8 million was recorded. TAMSCO is included in the Company's Support Services business segment. Effective September 24, 2003, the Company acquired all of the capital stock of Engineered Environments, Inc. (EEi), a designer and manufacturer of specialized environmental control units and heat transfer systems for defense and industrial 2 markets, for approximately $15.6 million in cash plus the payoff of certain mortgages and working capital-related indebtedness. In conjunction with the EEi acquisition, the Company recorded $2.9 million in customer-related intangibles, which are being amortized over an estimated useful life of 6 years. After allocating the purchase price to the fair value of all identifiable tangible and intangible assets, goodwill of $11.6 million was recorded. EEi is included in the Company's Support Systems business segment. During 2002, the Company also acquired two companies operating in the defense industry. Effective May 10, 2002, the Company acquired all the capital stock of Radian, Inc. (Radian), a provider of engineering services, asset protection/security systems and power generation equipment to the DoD, for approximately $42.0 million in cash and Company common stock, plus the payoff of certain working capital-related indebtedness. In conjunction with the Radian acquisition, the Company recorded $15.3 million in customer-related intangibles, which are being amortized over the weighted average of the related customer contracts' estimated useful lives of 5.4 years. After allocating the purchase price to the fair value of all identifiable tangible and intangible assets, goodwill of $31.7 million was recorded. Radian is included within the Company's Support Services business segment. Effective June 27, 2002, the Company acquired all of the capital stock of Universal Power Systems, Inc. (UPSI), a provider of uninterruptible power supply systems to the DoD, intelligence agencies and commercial customers. The final purchase price, including contingent cash consideration paid based upon UPSI's net revenue levels through October 31, 2003, totaled approximately $12.5 million. After allocating the purchase price to the fair value of all identifiable tangible and intangible assets, goodwill of $12.5 million was recorded. UPSI is included within the Company's Support Systems business segment. RESULTS OF CONTINUING OPERATIONS The following discussion is with regard to the Company's results of continuing operations. The discontinued operations of the Company's Engineered Specialty Plastics, Inc. (ESP) subsidiary are discussed later. The following table provides a comparative margin analysis for continuing operations for the years ended October 31, 2004, 2003 and 2002. 3
YEAR ENDED OCTOBER 31 2004 2003 2002 ------------------------------------------------------------------------ Net revenues 100.0% 100.0% 100.0% Cost of revenues 74.8 75.9 76.7 ------------------------------------------------------------------------ Gross profit 25.2 24.1 23.3 Selling, general and administrative expense 11.1 11.1 11.1 Restructuring expense 0.3 0.3 Loss on sale of assets 0.1 ------------------------------------------------------------------------ Income from operations 14.0 12.7 11.9 Interest expense, net 0.1 0.3 0.8 ------------------------------------------------------------------------ Income before income taxes 13.9 12.4 11.1 Income tax provision 5.3 4.8 4.3 ------------------------------------------------------------------------ Net income 8.6% 7.6% 6.8% ------------------------------------------------------------------------
BUSINESS SEGMENTS WITHIN CONTINUING OPERATIONS The Company operates in two business segments: Support Systems and Support Services. The Support Systems segment engineers and manufactures integrated military electronics and other military support equipment primarily for the DoD, as well as related air handling and heat transfer equipment for commercial and industrial users, and material handling equipment for the U.S. Postal Service. Segment products include environmental control systems, power generation, distribution and conditioning systems, chemical and biological protection systems, petroleum and water distribution systems, load management and transport systems, airborne radar systems, reconnaissance, surveillance and target acquisition systems, avionics test equipment and other multipurpose military support equipment. The Support Services segment provides engineering, 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. The following table sets forth net revenues and income from operations, in millions, for the years ended October 31, 2004, 2003 and 2002 for each of the Company's business segments:
YEAR ENDED OCTOBER 31 2004 2003 2002 -------------------------------------------------------------------------------------------------------------------- Net Revenues Support Systems $514.7 58.3% $389.3 68.0% $374.4 91.8% Support Services 410.4 46.4 188.3 32.9 33.7 8.3 Intersegment Revenues (41.5) (4.7) (4.9) (0.9) (0.2) (0.1) -------------------------------------------------------------------------------------------------------------------- Total $883.6 100.0% $572.7 100.0% $407.9 100.0% -------------------------------------------------------------------------------------------------------------------- Income from Operations Support Systems $93.0 75.4% $ 54.2 74.6% $48.0 98.8% Support Services 30.3 24.6 18.4 25.4 0.6 1.2 -------------------------------------------------------------------------------------------------------------------- Total $123.3 100.0% $72.6 100.0% $48.6 100.0% --------------------------------------------------------------------------------------------------------------------
4 2004 COMPARED TO 2003 Consolidated net revenues increased $310.9 million, or 54.3%, in 2004 to $883.6 million from $572.7 million in 2003. $181.3 million of this increase represents an increase in net revenues contributed by TAMSCO, EEi and Pivotal Power, which were acquired May 1, September 24, and December 5, 2003, respectively. Of the $129.6 million of net revenue growth from all other operating subsidiaries, the Company's programs for Manportable Surveillance and Target Acquisition Radar (MSTAR), Field Deployable Environmental Control Units (FDECU), Deployable Power Generation and Distribution Systems (DPGDS) and vehicle uparmor kits provided the most significant revenue gains. Gross profit for 2004 increased $84.6 million, or 61.3%, to $222.7 million (25.2% of consolidated net revenues) from $138.1 million (24.1% of consolidated net revenues) in 2003. $23.1 million of this increase represents an increase in gross profit contributed by TAMSCO, EEi and Pivotal Power, which had gross profit for either a portion or none of 2003. Of the $61.5 million of gross profit growth from all other operating subsidiaries, the Company's programs for MSTAR, FDECU, DPGDS and vehicle uparmor kits provided the most significant increases. In addition, MSTAR, FDECU and DPGDS have significantly higher margins than most of the Company's programs, which contributed to a more favorable product mix and a higher overall gross margin in 2004. Selling, general and administrative expense increased $34.2 million, or 53.6%, in 2004 to $98.0 million (or 11.1% of consolidated net revenues) from $63.8 million (11.1% of consolidated net revenues) in 2003. $21.2 million of this increase was due to an increase in selling, general and administrative expenses from TAMSCO, EEi and Pivotal Power. In addition, the Company incurred a $5.0 million severance charge ($4.2 million of which represents a non-cash charge) in connection with the resignation of the Company's former Chief Executive Officer. Selling, general and administrative expense also included amortization expense related to acquired customer-related intangibles of $6.7 million and $2.8 million in 2004 and 2003, respectively. Under its facility rationalization plan, the Company incurred restructuring expense of $0.1 million and $1.8 million, respectively, in 2004 and 2003 related to the write-down of fixed assets at the affected facilities and to accrue for expected employee benefits costs. During 2004, the Company completed the sales of its Sanford, Florida and Blue Ash, Ohio facilities, which had been vacated in conjunction with facility rationalization initiatives. Primarily as a result of these disposals, the Company incurred a $1.3 million loss on sale of assets in 2004 compared to a $0.1 million gain on sale of assets in 2003. As a result of the above, operating income from continuing operations increased by $50.7 million, or 69.8%, in 2004 to $123.3 million from $72.6 million in 2003. 5 SUPPORT SYSTEMS: Net revenues (prior to the elimination of intersegment revenues) for the Support Systems segment increased by $125.4 million, or 32.2%, to $514.7 million in 2004 from $389.3 million in 2003. The current year increase was partially attributable to the incremental net revenues of EEi and Pivotal Power of $11.5 million and $7.9 million, respectively, during the current year. Excluding the impact of acquisitions, net revenues for the segment increased by a net of $106.0 million during 2004. Programs with the largest revenue gains during 2004 included the MSTAR, FDECU and intersegment work on the DPGDS and vehicle uparmor kits being performed for the Support Services segment. Segment net revenues were partially offset by reduced work on the 60-K Tunner Aircraft Cargo Loader (Tunner) as production work on that contract ends in mid-2005. Gross profit for the segment increased by $53.5 million, or 52.7%, to $155.0 million in 2004 (30.1% of segment net revenues) from $101.5 million (26.1% of segment net revenues) in 2003. The increase in gross profit was attributable to incremental gross profit from EEi and Pivotal Power of a combined $7.2 million coupled with higher profits on MSTAR, FDECU and intersegment work on the DPGDS and vehicle uparmor kits due to increased revenues and production levels as noted above. In addition, MSTAR, FDECU and DPGDS have significantly higher margins than most of the segment's programs, which contributed to a more favorable product mix and higher gross margins in 2004. Income from operations for the segment increased by $38.8 million, or 72.0%, in 2004 to $93.0 million from $54.2 million in 2003. The increase was the result of higher gross profit partially offset by additional selling, general and administrative expense in 2004. SUPPORT SERVICES: Net revenues (prior to the elimination of intersegment revenues) for the Support Services segment increased by $222.1 million, or 118.9%, in 2004 to $410.4 million from $188.3 million in 2003. The significant growth in net revenues was primarily attributable to the inclusion of TAMSCO for a full year in 2004 versus just six months post-acquisition in 2003. TAMSCO reported revenues of $232.0 million in 2004 and $70.1 million in 2003. Significant revenue increases were also generated by the DPGDS program and from vehicle uparmor kits. Gross profit for the segment increased by $31.1 million, or 85.1%, in 2004 to $67.7 million (16.5% of segment net revenues) from $36.6 million (19.4% of segment net revenues) in 2003. The increase in gross profit was attributable to the higher level of net revenues in 2004 as discussed above. The decrease in gross margin for the segment was primarily the result of a significant increase in revenues from pass-through contract vehicles, such as the Rapid Response and FAST programs, which provide much lower margins. This decrease was partially offset by the DPGDS and vehicle uparmor programs which provided higher margins. Income from operations for the segment increased by $11.9 million in 2004 to $30.3 million from $18.4 million in 2003 as a result of the significant increases in net revenues and gross profit as compared to the prior year. 6 Net interest expense decreased by $0.8 million to $0.9 million in 2004 compared to $1.7 million in 2003 primarily as a result of lower outstanding borrowings throughout 2004. As of October 31, 2004, the Company had completely paid off borrowings against its revolving credit facility and had cash and cash equivalents of $33.2 million. The Company's reported effective income tax rate for 2004 was 38.0% and for 2003 was 39.0% resulting in total income tax expense of $46.5 million in 2004 and $27.7 million in 2003. The reduction in the Company's effective income tax rate was primarily the result of the Company's state income tax reduction initiatives. As a result of the foregoing, net income from continuing operations increased 75.4% to $75.9 million (8.6% of consolidated net revenues) in 2004 compared to $43.3 million (7.6% of consolidated net revenues) in 2003. DISCONTINUED OPERATIONS: During 2002, the Company formally adopted a plan to dispose of ESP, a wholly-owned subsidiary. ESP was sold to a private equity group in 2003. As a result, ESP's financial results were reclassified as a discontinued operation in the Consolidated Financial Statements for all periods presented. Income from discontinued operations totaled $0.3 million, net of income tax, in 2003 and recorded after-tax losses of $0.2 million in 2003 to reduce the carrying value of ESP's assets to their estimated net realizable values less estimated selling costs. See Note E in the Consolidated Financial Statements. 2003 COMPARED TO 2002 Consolidated net revenues increased $164.8 million, or 40.4%, in 2003 to $572.7 million from $407.9 million in 2002. The increase was primarily attributable to the inclusion of $70.6 million in net revenues of TAMSCO since its acquisition date in 2003 combined with incremental revenues of $82.9 million and $9.3 million, respectively, generated by Radian and UPSI in 2003 over their levels for a partial year during 2002. Gross profit for 2003 increased $42.9 million, or 45.1%, to $138.1 million (24.1% of consolidated net revenue) from $95.2 million (23.3% of consolidated net revenues) in 2002. The increase was primarily due to the incremental contributions from TAMSCO, Radian and UPSI in 2003 of $9.9 million, $18.7 million and $3.5 million, respectively, combined with higher profit levels on certain existing programs for the current year as discussed below. Selling, general and administrative expense increased $18.7 million, or 41.4%, in 2003 to $63.8 million (or 11.1% of consolidated net revenues) from $45.1 million (11.1% of consolidated net revenues) in 2002. This increase was primarily the result of the recent acquisitions of TAMSCO, Radian and UPSI 7 which incurred incremental selling, general and administrative expense of a combined $13.5 million during 2003, including an additional $1.4 million in amortization of acquired customer-related intangibles. Under its facility rationalization plans, the Company incurred restructuring expense of $1.8 million and $1.4 million, respectively, in 2003 and 2002 related to the write-down of fixed assets at the affected facilities and to accrue for expected employee benefits costs. As a result of the above, operating income from continuing operations increased by $24.0 million, or 49.4%, in 2003 to $72.6 million from $48.6 million in 2002. SUPPORT SYSTEMS: Net revenues (prior to the elimination of intersegment revenues) for the Support Systems segment increased by $14.9 million, or 4.0%, to $389.3 million in 2003 from $374.4 million in 2002. The increase was primarily attributable to the incremental net revenues of UPSI and EEi of $9.3 million and $1.5 million, respectively, during the current year. Excluding the impact of acquisitions, net revenues for the segment increased by a net of $4.1 million during 2003. Higher production levels related to heightened military operations in Iraq and Afghanistan, principally for the FDECU, the Knight Precision Targeting System (Knight) and other support equipment, led to solid revenue gains on these defense programs during 2003. However, the completion of the M1000 Heavy Equipment Transport trailer (M1000) production program during mid-2003, and reduced contract work on the Tunner and High Power Offload to CASS (HPOC) program in 2003 largely offset these advances. Gross profit for the segment increased by $12.9 million, or 14.6%, to $101.5 million in 2003 (26.1% of segment net revenues) from $88.6 million (23.7% of segment net revenues) in 2002. The increase in gross profit was the result of the incremental contribution from UPSI and EEi in 2003 of a combined $3.9 million coupled with higher profits on FDECU, Knight and other support equipment programs due to increased revenues and production levels as noted above. Income from operations for the segment increased by $6.2 million, or 12.7%, in 2003 to $54.2 million from $48.0 million in 2002. The increase was the result of higher gross profit partially offset by additional selling, general and administrative expense in 2003. 8 SUPPORT SERVICES: Net revenues (prior to the elimination of intersegment revenues) for the Support Services segment increased by $154.6 million, or 458.8%, in 2003 to $188.3 million from $33.7 million in 2002. The significant growth in net revenues was attributable to the inclusion of TAMSCO which reported $70.6 million in net revenues since its 2003 acquisition date, combined with $82.9 million in incremental net revenues reported by Radian in 2003. Radian's rapid revenue growth resulted from the inclusion of its operations for a full year in 2003 as well as a significant year-over-year increase in revenues on the DPGDS program with the U.S. Air Force and Army. Gross profit for the segment increased by $30.0 million, or 463.1%, in 2003 to $36.6 million (19.4% of segment net revenues) from $6.5 million (19.3% of segment net revenues) in 2002. The increase in gross profit was attributable to the higher level of net revenues in 2003 as discussed above. Income from operations for the segment increased by $17.8 million in 2003 to $18.4 million from $0.6 million in 2002 as a result of the significant increases in net revenues and gross profit as compared to the prior year. Net interest expense decreased by $1.5 million to $1.7 million in 2003 compared to $3.2 million in 2002 as a result of lower interest rates on outstanding borrowings throughout 2003. The Company's effective borrowing rate decreased from 4.94% at October 31, 2002 to 2.34% at October 31, 2003. The Company's reported effective income tax rate for both 2003 and 2002 was 39% resulting in total income tax expense of $27.7 million in 2003 and $17.7 million in 2002. As a result of the foregoing, net income from continuing operations increased 56.4% to $43.3 million (7.6% of consolidated net revenues) in 2003 compared to $27.7 million (6.8% of consolidated net revenues) in 2002. DISCONTINUED OPERATIONS: As discussed above, in conjunction with the Company's 2002 decision to divest of ESP, its financial results have been reclassified as a discontinued operation in the Consolidated Financial Statements for all periods presented. Income from discontinued operations totaled $0.3 million, net of income tax, in 2003 compared to $49,000, net of income tax, in 2002. In conjunction with the planned disposition of ESP, the Company recorded after tax losses of $0.2 million and $4.2 million, respectively, during 2003 and 2002 to reduce the carrying value of ESP's assets to their estimated net realizable values less estimated selling costs. ESP was sold to a private equity group in 2003. See Note E in the Consolidated Financial Statements. 9 OUTLOOK FOR 2005 AND FUTURE YEARS Effective December 9, 2004, the Company entered into a definitive purchase agreement to acquire the membership interests of Spacelink International, LLC (Spacelink), which designs, integrates, operates and maintains deployed satellite and wireless networks for the DoD, the U.S. intelligence community and other federal agencies and multinational organizations worldwide. The pending transaction is subject to regulatory and other approvals, as well as the satisfaction of customary closing conditions. The Company expects to complete the transaction in February, 2005. The purchase price is $150.5 million, which includes $138.5 million in cash and $12.0 million in common stock. The purchase price is subject to certain adjustments to be finalized after closing, including contingent considerations based upon Spacelink's future financial performance. Effective January 7, 2005, the Company acquired all of the outstanding stock of Prospective Computer Analysts Incorporated (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 final working capital adjustment. The purchase price was financed with the Company's existing cash balances. Spacelink will be included in the Support Services segment and PCA will be included in the Support Systems segment. The Company is forecasting approximately a 10% to 12% increase in consolidated net revenues to between $975 and $985 million for 2005, which includes the impact of the Spacelink and PCA acquisitions. Reflecting the above forecasted assumptions, the Company expects diluted earnings per share to increase to between $3.10 and $3.15 in 2005. The Company anticipates that cash flows generated from operating earnings growth will be used to pay down borrowings against the Company's revolving credit facility generated as a result of the Spacelink and PCA acquisitions. The Company continues to believe that significant growth opportunities exist within the military support equipment, electronics and logistics support segments of the defense industry in response to (i) the current fragmentation within the industry; (ii) the DoD's emphasis on awarding contracts on the basis of "best value;" (iii) the DoD's increasing outsourcing of engineering, design and logistics services to contractors; (iv) heightened military operations around the globe; and, (v) overall increases in defense spending by the DoD. The Company's focus for 2005 includes the continued rationalization of its existing defense operations in order to leverage its infrastructure and achieve additional operational synergies, as well as the integration of Spacelink and PCA operations. The Company continues to review potential defense acquisitions in both the Support Systems and Support Services business areas. Any such transaction must be accretive to earnings, must bring significant increases in revenues and backlog, and must provide long-term value to the Company's shareholders. 10 LIQUIDITY AND CAPITAL RESOURCES Effective April 23, 2003, the Company retired all borrowings under its existing credit facility and entered into a new bank agreement which provided a $125 million unsecured, revolving credit facility. Borrowings under the new agreement, which expires April 23, 2007, are subject to interest, at the Company's option, at either the Eurodollar rate plus an applicable margin or at the prime rate plus an applicable margin. The margin applicable to the Eurodollar rate varies from 0.875% to 1.625% and the margin applicable to the prime rate varies from 0.0% to 0.25% depending upon the Company's ratio of total indebtedness to earnings before interest, taxes, depreciation and amortization (leverage ratio). As of October 31, 2004, the Company had no borrowings against the revolving credit facility, remaining availability under the facility of $121.4 million and a cash balance of $33.2 million. As previously indicated, the acquisitions of Spacelink and PCA will require borrowing against the revolving credit facility. The Company's working capital needs are generally funded through cash flow from operations and the revolving credit facility. At October 31, 2004, the Company's working capital and ratio of current assets to current liabilities (excluding its revolving credit facility) were $112.0 million and 1.85 to 1, respectively, compared with $43.8 million and 1.39 to 1 a year ago. During 2004, the Company generated operating cash flows from continuing operations of $66.6 million compared to $64.8 million in 2003. Operating cash flows for 2004 were constrained by a $30.2 million increase in working capital and net long-term operating assets, which was required as a result of the Company's growth. During 2004, the Company expended cash totaling $19.6 million in conjunction with the acquisitions of Pivotal Power, TAMSCO, EEi and UPSI, including the payoff of certain loans and contingent consideration associated therewith. The Company financed these transactions with cash and short-term borrowings under its revolving credit facility. 11 Investment in property, plant and equipment totaled $8.0 million and $9.7 million, respectively, in 2004 and 2003. The Company anticipates that capital expenditures in 2005 should not exceed $20 million. Management believes that cash flow generated from operations, together with its available revolving credit facility, will provide the necessary resources to meet the capital needs of the Company for the foreseeable future. COMMITTED AMOUNTS Total contractual and contingent obligations, in thousands, as of October 31, 2004 are as follows:
PAYMENTS / EXPIRATION YEAR ENDED OCTOBER 31 2005 2006 2007 2008 2009 TOTAL ------------------------------------------------------------------------------------------------------- Contractual Obligations: Long-term debt $ 340 $ 313 $ 119 $ 35 $ 314 $ 1,121 Operating leases 3,779 2,979 2,042 462 330 9,592 Unconditional purchase obligations 207,736 701 208,437 Contributions to pension and other postretirement benefit plans 7,889 6,997 6,757 6,650 6,461 34,754 ------------------------------------------------------------------------------------------------------- 219,744 10,990 8,918 7,147 7,105 253,904 Contingent Obligations: Letters of credit 3,617 3,617 ------------------------------------------------------------------------------------------------------- Total Obligations 223,361 $ 10,990 $ 8,918 $7,147 $7,105 $257,521 -------------------------------------------------------------------------------------------------------
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 $5.0 million, $4.2 million and $2.5 million for the years ended October 31, 2004, 2003 and 2002, respectively. As discussed in Note E of the Consolidated Financial Statements, the Company completed the sale of 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 are seeking $6.0 million in damages from the Company. Under the terms of the Agreement, this claim is subject to binding arbitration which the Company believes will be completed by April 30, 2005. The Company has denied liability and is defending the claim vigorously. The Company also believes that this claim is without merit and that awarded damages, if any, will not have a material effect on the consolidated financial position, results of operations or cash flows of the Company. 12 INFLATION Since a significant portion of the Company's contracts with the DoD are at fixed prices, inflation can affect the ultimate profit to be realized on them. Some contracts have price adjustment provisions that limit the impact of inflation on profits. In addition, the Company's volume purchasing and forward purchasing policies serve to limit the effects of inflation. The Company considers potential inflation in preparation of contract proposals and bids. In addition, the Company's commercial and industrial products are predominantly custom-made. Therefore, the impact of inflation on operating results is typically not significant. The Company attempts to alleviate inflationary pressures on commercial and industrial products by increasing selling prices to help offset rising costs (subject to competitive conditions), increasing productivity and improving manufacturing techniques. Because of these factors, management does not believe that inflation has had, or that anticipated inflation will have, a significant effect on the Company's operations. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In December 2003, the FASB issued a revision to Interpretation 46 (FIN 46R) to clarify some of the provisions of FASB Interpretation No. 46, "Consolidation of Variable Interest Entities," and to exempt certain entities from its requirements. The adoption of FIN 46R has not had a material impact on the Company's financial statements as it does not maintain any of the interests governed by this pronouncement. In December 2003, the FASB issued Statement of Financial Accounting Standards No. 132 (Revised 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits", (SFAS 132R). This statement requires more detailed disclosure information about pension plan assets, benefit obligations, cash flows, benefit costs and related information. Companies are required to segregate plan assets by category, such as debt, equity and real estate, and to provide certain expected rates of return and other informational disclosures. SFAS 132R is effective for interim periods beginning after December 15, 2003 and was adopted by the Company in the second quarter of 2004. In May 2004, the FASB issued FASB Staff Position No. FAS 106-2 (FSP 106- 2), "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" (the Medicare Act) which supersedes FSP 106-1 of the same title. FSP 106-2 clarifies the accounting for the benefits attributable to new government subsidies for companies that provide prescription drug benefits to retirees. FSP 106-2 is effective for interim periods beginning after June 15, 2004 and was adopted by the Company in the fourth quarter of 2004. The Company expects to be eligible for little, if any, subsidy based on the design of the retiree medical plan. Therefore, the effects of the Act will not have a material impact on the Company's estimated health care costs or participation rates. 13 In October 2004, 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. 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. In December 2004, the FASB issued two FASB Staff Positions (FSP) regarding the accounting implications of the Act related to (1) the deduction for qualified domestic productions 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 and related FASB pronouncements will have a material impact on the Company's Consolidated Financial Statements. In December 2004, the FASB issued SFAS 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 for public entities that do not file as small business issuers as of the first interim or annual reporting period that begins after June 15, 2005 and thus will be adopted by the Company for the quarter ending October 31, 2005. FORWARD-LOOKING STATEMENTS In addition to historical information, this Annual Report includes certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. The forward-looking statements involve certain risks and uncertainties, including but not limited to 2005 forecasted results, acquisitions, additional financing requirements, the decision of any of the Company's key customers (including the U.S. Government) to reduce or terminate orders with the Company, cutbacks in defense spending by the U.S. Government and increased competition in the Company's markets, which could cause the Company's actual results to differ materially from those projected in, or inferred by, the forward- looking statements. 14 ENGINEERED SUPPORT SYSTEMS, INC. -------------------------------- CONSOLIDATED BALANCE SHEETS
In thousands, except per share amounts October 31 2004 2003 ------------------------------------------------------------------------------------- ASSETS CURRENT ASSETS Cash and cash equivalents $ 33,153 $ 2,880 Accounts receivable, net 139,191 90,805 Contracts in process and inventories, net 61,009 50,959 Deferred income taxes 6,921 5,939 Prepaid expenses and other assets 2,846 4,668 ------------------------------------------------------------------------------------- Total Current Assets 243,120 155,251 PROPERTY, PLANT AND EQUIPMENT Land 4,387 5,541 Buildings and improvements 39,704 41,955 Machinery and equipment 26,567 26,672 Furniture and fixtures 5,465 4,998 ------------------------------------------------------------------------------------- 76,123 79,166 Accumulated depreciation (29,177) (28,800) ------------------------------------------------------------------------------------- 46,946 50,366 Goodwill 167,358 191,332 Acquired customer-related intangibles 38,314 11,049 Deferred income taxes 1,876 2,145 Other assets 13,520 11,303 ------------------------------------------------------------------------------------- TOTAL ASSETS $511,134 $421,446 ------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Notes payable $ $73,100 Current maturities of long-term debt 340 90 Accounts payable 71,796 48,609 Income taxes payable 10,067 2,493 Accrued employee compensation 27,806 27,933 Other liabilities 21,063 32,336 ------------------------------------------------------------------------------------- Total Current Liabilities 131,072 184,561 Long-term debt 781 Additional minimum pension liability 28,237 25,751 Other liabilities 14,088 13,967 Commitments and contingencies (Note M) SHAREHOLDERS' EQUITY Common stock, par value $.01 per share; 85,000 shares authorized; 26,642 and 25,263 shares issued 266 253 Additional paid-in capital 151,805 106,512 Retained earnings 202,730 127,753 Accumulated other comprehensive loss (17,845) (16,142) ------------------------------------------------------------------------------------- 336,956 218,376 Treasury stock at cost, 0 and 561 shares (21,209) ------------------------------------------------------------------------------------- Total Shareholders' Equity 336,956 197,167 ------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $511,134 $421,446 ------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements.
15 ENGINEERED SUPPORT SYSTEMS, INC. -------------------------------- CONSOLIDATED STATEMENTS OF INCOME
In thousands, except per share amounts Year Ended October 31 2004 2003 2002 ------------------------------------------------------------------------------------- Net revenues: Products $596,162 $461,490 $389,324 Services 287,468 111,211 18,621 ------------------------------------------------------------------------------------- 883,630 572,701 407,945 ------------------------------------------------------------------------------------- Cost of revenues: Products 408,282 340,380 297,286 Services 252,658 94,262 15,481 ------------------------------------------------------------------------------------- 660,940 434,642 312,767 ------------------------------------------------------------------------------------- Gross profit 222,690 138,059 95,178 Selling, general and administrative expense 98,042 63,832 45,145 Restructuring expense 62 1,758 1,441 Gain (loss) on sale of assets (1,290) 147 7 ------------------------------------------------------------------------------------- Operating income from continuing operations 123,296 72,616 48,599 Interest expense (1,215) (1,881) (3,367) Interest income 353 221 128 ------------------------------------------------------------------------------------- Income from continuing operations 122,434 70,956 45,360 Income tax provision 46,525 27,673 17,694 ------------------------------------------------------------------------------------- Net income from continuing operations 75,909 43,283 27,666 Discontinued operations: Income from discontinued operations, net of income tax 294 49 Loss on disposal, net of income tax (169) (4,182) ------------------------------------------------------------------------------------- Net income $ 75,909 $ 43,408 $ 23,533 ------------------------------------------------------------------------------------- Basic earnings per share: Continuing operations $ 2.92 $ 1.79 $ 1.18 Discontinued operations: Income 0.01 Loss on disposal (0.01) (0.17) ------------------------------------------------------------------------------------- Total $ 2.92 $ 1.79 $ 1.01 ------------------------------------------------------------------------------------- Diluted earnings per share: Continuing operations $ 2.72 $ 1.68 $ 1.14 Discontinued operations: Income 0.01 Loss on disposal (0.01) (0.17) ------------------------------------------------------------------------------------- Total $ 2.72 $ 1.68 $ 0.97 ------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements.
16 ENGINEERED SUPPORT SYSTEMS, INC. -------------------------------- CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
In thousands Accumulated Additional Other Common Paid-in Retained Comprehensive Treasury Stock Capital Earnings Loss Stock Total ------------------------------------------------------------------------------------------------------------- Balance at October 31, 2001 $117 $85,682 $61,823 $(5,554) $(32,676) $109,392 Comprehensive income: Net income 23,533 23,533 Other components of comprehensive income, net of tax: Minimum pension liability adjustment (9,428) (9,428) Adjustment to fair value of derivatives 707 707 ------- Total comprehensive income 14,812 ------- Cash dividends (395) (395) Issuance of common stock 1 1,354 1,355 Exercise of stock options 5,235 792 6,027 Issuance of treasury stock 3,350 316 3,666 Three-for-two stock split 52 (52) ------------------------------------------------------------------------------------------------------------- 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 adjustments 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) $ 0 $336,956 ------------------------------------------------------------------------------------------------------------- See notes to consolidated financial statements.
17 ENGINEERED SUPPORT SYSTEMS, INC. -------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS
In thousands Year Ended October 31 2004 2003 2002 ---------------------------------------------------------------------------------------------------------- CASH FLOW FROM OPERATING ACTIVITIES: Net income from continuing operations $ 75,909 $ 43,283 $ 27,666 Adjustments to reconcile net income from continuing operations to net cash provided by continuing operations: Depreciation and amortization 12,991 8,961 7,038 Deferred income taxes 2,423 5,768 (1,082) Loss (gain) on sale of assets 1,290 (147) (10) Stock option compensation expense 4,155 ---------------------------------------------------------------------------------------------------------- Cash provided by continuing operations before changes in operating assets and liabilities, excluding the effects of acquisitions 96,768 57,865 33,612 Changes in operating assets and liabilities: Accounts receivable (47,657) (13,639) (8,725) Contracts in process and inventories (7,520) 3,065 12,723 Accounts payable 22,455 5,539 4,911 Current income taxes 7,826 4,996 3,347 Net changes in other assets and liabilities (5,303) 7,017 9,343 ---------------------------------------------------------------------------------------------------------- Net cash provided by continuing operations 66,569 64,843 55,211 Net cash provided by (used in) discontinued operations 1,612 (670) ---------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 66,569 66,455 54,541 ---------------------------------------------------------------------------------------------------------- CASH FLOW FROM INVESTING ACTIVITIES: 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 Radian, net of cash acquired (39,997) Purchase of UPSI, net of cash acquired (2,026) (5,008) (5,500) Additions to property, plant and equipment (8,034) (9,681) (3,515) Proceeds from sale of property, plant and equipment 5,674 316 11 ---------------------------------------------------------------------------------------------------------- Net cash used in continuing operations (21,989) (108,418) (49,001) Net cash provided by (used in) discontinued operations 2,918 (11) ---------------------------------------------------------------------------------------------------------- Net cash used in investing activities (21,989) (105,500) (49,012) ---------------------------------------------------------------------------------------------------------- CASH FLOW FROM FINANCING ACTIVITIES: Net borrowings (payments) under line-of-credit agreement (73,100) 60,100 12,300 Payments of long-term debt (285) (41,910) (21,038) Proceeds of long-term debt 382 Exercise of stock options 56,526 18,387 6,027 Purchase of treasury stock (557) Cash dividends (932) (616) (395) Issuance of common stock to employee stock purchase plan 3,079 1,728 1,355 ---------------------------------------------------------------------------------------------------------- Net cash provided by (used in) continuing operations (14,330) 37,132 (1,751) Net cash provided by (used in) discontinued operations ---------------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities (14,330) 37,132 (1,751) ---------------------------------------------------------------------------------------------------------- Effective of exchange rate changes on cash 23 ---------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 30,273 (1,913) 3,778 Cash and cash equivalents at beginning of year 2,880 4,793 1,015 ---------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 33,153 $ 2,880 $ 4,793 ---------------------------------------------------------------------------------------------------------- See Notes to Consolidated Financial Statements.
18 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 the 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) and Pivotal Power Inc. (Pivotal Power). The Support Services segment includes the operations of Technical and Management Services Corporation (TAMSCO), Radian, Inc. (Radian) 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 DoD, as well as related heat transfer and air handling equipment for domestic commercial and industrial users, and material handling equipment primarily for the U.S. Postal Service. 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 19 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 K 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 from continuing operations 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. 20
Year Ended October 31 2004 2003 2002 --------------------- ---- ---- ---- Reported net income from continuing operations $75,909 $43,283 $27,666 Total stock-based employee compensation expense determined under the fair value method for all stock option awards, net of income tax 2,924 3,521 11,505 ------- ------- ------- Pro forma net income $72,985 $39,762 $16,561 ======= ======= ======= Earnings per share: Basic - as reported $ 2.92 $ 1.79 $ 1.18 ======= ======= ======= Basic - pro forma $ 2.81 $ 1.64 $ 0.71 ======= ======= ======= Diluted - as reported $ 2.72 $ 1.68 $ 1.14 ======= ======= ======= Diluted - pro forma $ 2.62 $ 1.54 $ 0.68 ======= ======= =======
The fair value of options at the grant date was estimated using the Black-Scholes model with the following weighted average assumptions for 2004, 2003 and 2002, respectively: an expected life of 1.5 years; volatility of 26%, 36%, and 51%; a dividend yield of 0.07%, 0.12% and 0.16%; and a risk-free interest rate of 3.52%, 3.25%, and 3.74%. The weighted average fair value of options granted in 2004, 2003 and 2002 was $8.06, $7.55 and $5.11, 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, 2004 and 2003, 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, 2004 and 2003, 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 21 79% and 72% of accounts receivable at October 31, 2004 and 2003, 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 $90 and $211 at October 31, 2004 and 2003, 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, 2004. 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 22 improvements, 5 to 15 years for machinery and equipment, and 3 to 10 years for furniture and fixtures. Depreciation expense totaled $5,627 in 2004, $5,387 in 2003 and $4,934 in 2002. 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 of 25,991 in 2004, 24,203 in 2003 and 23,373 in 2002. Diluted earnings per share is based on average diluted common shares outstanding of 27,866 in 2004, 25,838 in 2003 and 24,314 in 2002. 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 December 2003, the FASB issued a revision to Interpretation 46 (FIN 46R) to clarify some of the provisions of FASB Interpretation No. 46, "Consolidation of Variable Interest Entities," and to exempt certain entities from its requirements. The adoption of FIN 46R has not had a material impact on the Company's financial statements as it does not maintain any of the interests governed by this pronouncement. 23 In December 2003, the FASB issued Statement of Financial Accounting Standards No. 132 (Revised 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits", (SFAS 132R). This statement requires more detailed disclosure information about pension plan assets, benefit obligations, cash flows, benefit costs and related information. Companies are required to segregate plan assets by category, such as debt, equity and real estate, and to provide certain expected rates of return and other informational disclosures. SFAS 132R is effective for interim periods beginning after December 15, 2003 and was adopted by the Company in the second quarter of 2004. In May 2004, the FASB issued FASB Staff Position No. FAS 106-2 (FSP 106-2), "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" (the Medicare Act) which supersedes FSP 106-1 of the same title. FSP 106-2 clarifies the accounting for the benefits attributable to new government subsidies for companies that provide prescription drug benefits to retirees. FSP 106-2 is effective for interim periods beginning after June 15, 2004 and was adopted by the Company in the fourth quarter of 2004. The Company expects to be eligible for little, if any, subsidy based on the design of the retiree medical plan. Therefore, the effects of the Act will not have a material impact on the Company's estimated health care costs or participation rates. In October 2004, 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 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 Jobs Creation Act and related FASB pronouncements will have a material impact on the Company's Consolidated Financial Statements. In December 2004, the FASB issued SFAS 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 for public entities that do not file as small business issuers as of the first interim or annual reporting period that begins after June 15, 2005 and thus will be adopted by the Company for the quarter ending October 31, 2005. NOTE B >> ACQUISITIONS 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 U.S. Department of Defense (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 24 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 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 from continuing operations $ 46,144 ======== Basic earnings per share from continuing Operations $ 1.91 ======== Diluted earnings per share from continuing Operations $ 1.79 ======== 25 Certain information with respect to the assets and liabilities of TAMSCO as of acquisition date is summarized as follows: May 1, 2003 ----------- Accounts receivable $ 27,837 Contracts in process and inventories 6,832 Property, plant and equipment 2,906 Goodwill 35,847 Acquired customer-related intangibles 29,850 Other assets 676 -------- Total Assets $103,948 ======== Notes payable $ 14,038 Current maturities of long-term debt 813 Accounts payable 13,856 Accrued expenses and other liabilities 4,102 -------- $ 32,809 ======== 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 initial purchase price allocation for Pivotal Power 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 $1.2 million from goodwill, as recorded in the preliminary allocation, to acquired customer-related intangibles and recorded a $0.2 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 $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, totals $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 26 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-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 June 27, 2002, the Company acquired all of the outstanding common stock of UPSI, a provider of uninterruptible power supply systems for the DoD, intelligence agencies and commercial customers. The purchase price was approximately $5.5 million plus certain contingent cash consideration based upon UPSI's net revenue levels through two measurement dates, December 31, 2002 and October 31, 2003. Based upon UPSI's net revenue through the December 31, 2002 measurement date, $5.0 million of cash consideration was added to purchase price and paid during the year ended October 31, 2003. Based upon UPSI's net revenue through the October 31, 2003 measurement date, $2.0 million of cash consideration was added to purchase price and paid subsequent to and accrued as of October 31, 2003. The fair value of the assets acquired, including goodwill of $12.5 million, was $13.6 million and liabilities assumed totaled $1.1 million. The purchase price was financed with short-term borrowings under the Company's revolving credit facility. On May 10, 2002, the Company acquired all of the outstanding common stock of Radian, a supplier of engineering, logistics support and systems integration services to the DoD. The purchase price was approximately $42.0 million, which included consideration of $2.0 million in the common stock of the Company. The purchase price is net of $0.4 million of cash acquired. The fair value of the assets 27 acquired, including goodwill of $31.7 million and customer-related intangibles of $15.3 million, was $58.3 million and liabilities assumed totaled $16.3 million. The cash portion of the purchase price was financed with available cash resources and short-term borrowings under the Company's revolving credit facility. TAMSCO and Radian are included in the Support Services segment. Pivotal Power, EEI and UPSI 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 Company adopted SFAS 141, "Business Combinations," and SFAS 142, "Goodwill and Other Intangible Assets" effective November 1, 2001. The Company has identified its reporting units to be its operating subsidiaries. The carrying value of each reporting unit as of November 1, 2001 was determined by assigning assets and liabilities, including existing goodwill and acquired intangible assets, to the reporting units. Upon adoption of SFAS 142, amortization of goodwill ceased. The Company performed a transitional goodwill impairment assessment as of November 1, 2001 and goodwill impairment assessments as of October 31, 2002, 2003 and 2004. None of these assessments resulted in impairment of goodwill. 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, 2004: Support Support Systems Services Total ------- ------- -------- October 31, 2001 $71,427 $ $ 71,427 Acquisitions 5,406 26,611 32,017 ------- ------- -------- 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 ======= ======= ======== 28 The following disclosure presents certain information on the Company's acquired identifiable intangible assets as of October 31, 2004, 2003 and 2002. All acquired identifiable intangible assets are being amortized over their estimated useful lives, as indicated below, with no estimated residual values.
Weighted Average Amortization Gross Accumulated Net Period Amount Amortization Amount ---------------- ------- ------------ ------- Customer-related intangibles: October 31, 2004 11.6 years $49,263 $10,949 $38,314 October 31, 2003 5.4 years $15,300 $ 4,251 $11,049 October 31, 2002 5.4 years $15,300 $ 1,420 $13,880
The amortization expense related to acquired intangible assets was $6,698 for the year ended October 31, 2004 and $2,831 for the year ended October 31, 2003. Related estimated amortization expense is $5,505 annually through the year ending October 31, 2006, $5,137 for the year ending October 31, 2007, $2,550 for the year ending October 31, 2008 and $2,510 for the year ending October 31, 2009. 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 29 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. During the year ended October 31, 2004, the Company recorded the following costs in connection with this restructuring plan.
Accrued at Accrued at October 31, 2003 Expense Utilized October 31, 2004 ---------------- ------- -------- ---------------- Severance and related benefits $ 983 $ 62 $ 1,045 $ ====== ===== ======= =======
NOTE E >> DISCONTINUED OPERATIONS During the quarter ended April 30, 2002, the Company formally adopted a plan to dispose of Engineered Specialty Plastics, Inc. (ESP), a wholly-owned subsidiary. The Company completed the sale of ESP in the quarter ended April 30, 2003 to a private equity group. Consideration received by the Company included $4.1 million of cash, a $3.3 million two-year note from the buyers secured by the real property of ESP, and contingent consideration based upon ESP's future revenues, net of a $0.8 million working capital adjustment paid by the Company. In conjunction with the intended disposition of ESP, the Company recorded an estimated loss on disposal of discontinued operations of $4.2 million during the year ended October 31, 2002 to reduce the carrying value of ESP's net assets to their estimated fair value less estimated selling costs. The completion of the sale resulted in an additional $0.2 million loss 30 on disposal during the year ended October 31, 2003. The Company has reported the results of operations of ESP as discontinued operations in the Consolidated Statements of Income. Certain information with respect to the discontinued operations of ESP is as follows: Year Ended October 31 2003 2002 -------------------------------------------------------------------------- Net revenues $9,136 $17,619 -------------------------------------------------------------------------- Income from discontinued operations, net of income tax $ 294 $ 49 Loss on disposal, net of income tax (169) (4,182) -------------------------------------------------------------------------- Income (loss) on discontinued operations $ 125 $(4,133) ====== ======= NOTE F >> ACCOUNTS RECEIVABLE Accounts receivable includes amounts due from the U.S. government and its agencies of $109,991 and $65,441 at October 31, 2004 and 2003, respectively. NOTE G >> CONTRACTS IN PROCESS AND INVENTORIES Contracts in process and inventories are comprised of the following: October 31 2004 2003 -------------------------------------------------------------------------- Raw materials $ 1,874 $ 2,669 Work-in-process 5,246 2,332 Finished goods 493 185 Inventories substantially applicable to government contracts in process, reduced by progress payments of $54,629 and $55,010 53,396 45,773 -------------------------------------------------------------------------- $61,009 $50,959 -------------------------------------------------------------------------- 31 Contracts in process and inventories at October 31, 2004 and 2003 include estimated revenue of $82,763 and $91,568, respectively, representing accumulated contract costs and related estimated earnings on uncompleted government contracts. NOTE H >> NOTES PAYABLE AND LONG-TERM DEBT Effective April 23, 2003, the Company retired all borrowings under the existing credit facility and entered into a new bank agreement which provided a $125 million unsecured revolving credit facility. Borrowings under the new agreement, which expires April 23, 2007, are subject to interest, at the Company's option, at either the Eurodollar rate plus an applicable margin or at the prime rate plus an applicable margin. The margin applicable to the Eurodollar rate varies from 0.875% to 1.625% and the margin applicable to the prime rate varies from 0.0% to 0.25% depending upon the Company's ratio of total indebtedness to earnings before interest, taxes, depreciation and amortization (leverage ratio). At October 31, 2004, the Company had $121.4 million of availability under the revolving credit facility ($125.0 million total facility less $3.6 million of outstanding letters of credit), which carries an unused commitment fee of 0.2% to 0.35% depending on the Company's leverage ratio. The credit agreement contains certain covenants, including maintaining net worth of at least $135 million plus 50% of the sum, to extent positive, of net income and other comprehensive income (loss) after January 31, 2003 plus the net proceeds of all equity offerings. The Company must also maintain a leverage ratio no greater than 2.75 to 1 through October 31, 2004 and 2.50 to 1 subsequent to that date. Pursuant to the terms of the credit agreement, the Company is subject to various other financial and operating covenants and maintenance criteria, including restrictions on the Company's ability to incur additional indebtedness, make capital expenditures, create liens, dispose of material assets and enter into merger transactions and lease agreements. At October 31, 2004, the Company was in compliance with 32 all covenants of its credit agreement. No compensating balance is required or maintained related to the agreement. There were no borrowings under the revolving credit facility as of October 31, 2004 and borrowings under the revolving credit facility averaged $53.4 million for the year ended October 31, 2004. Borrowings under the revolving credit facility are unsecured and are guaranteed by the Company. Interest paid was $1,370 in 2004, $2,215 in 2003 and $3,124 in 2002. NOTE I >> INCOME TAXES The income tax provision is comprised of the following:
Year Ended October 31 2004 2003 2002 --------------------- ------- ------------------------ ----------------------- Continuing Continuing Operations Combined Operations Combined ---------- -------- ---------- -------- Current: Federal $40,338 $20,091 $20,187 $14,967 $14,117 State 4,153 1,798 1,798 2,017 2,017 Foreign (389) ------- ------- ------- ------- ------- 44,102 21,889 21,985 16,984 16,134 ------- ------- ------- ------- ------- Deferred: Federal 2,184 5,191 5,176 637 (974) State 187 593 592 73 (108) Foreign 52 ------- ------- ------- ------- ------- 2,423 5,784 5,768 710 (1,082) ------- ------- ------- ------- ------- $46,525 $27,673 $27,753 $17,694 $15,052 ======= ======= ======= ======= =======
The deferred income tax provision (benefit) results from the following temporary differences:
Year Ended October 31 2004 2003 2002 --------------------- ------- ------------------------ ----------------------- Continuing Continuing Operations Combined Operations Combined ---------- -------- ---------- -------- Uncompleted contracts $ (146) $ 541 $ 541 $ 143 $ 143 Depreciation 90 289 343 (504) (539) Goodwill and intangible amortization 2,035 3,589 3,589 1,485 1,485 Employee benefit plans 685 (57) (57) 348 354 Loss on disposal of discontinued operations (60) (1,823) Other, net (241) 1,422 1,412 (762) (702) ------- ------ ------ ------ ------- $ 2,423 $5,784 $5,768 $ 710 $(1,082) ======= ====== ====== ====== =======
33 Deferred income tax liabilities (assets) are comprised of the following: Year Ended October 31 2004 2003 -------------------------------------------------------------------------- Depreciation $ 2,398 $ 2,769 Uncompleted contracts (1,360) (1,212) Employee benefits (6,291) (4,124) Goodwill and intangibles 13,087 11,333 Asset reserves (1,160) (1,633) Capital loss carryforward (2,814) (2,814) Other comprehensive loss (11,299) (10,321) Other, net (4,475) (4,896) -------------------------------------------------------------------------- (11,914) (10,898) Valuation allowance 3,117 2,814 -------------------------------------------------------------------------- $ (8,797) $ (8,084) ========================================================================== Deferred income tax liabilities (assets) are presented on the Consolidated Balance Sheets as follows: Year Ended October 31 2004 2003 -------------------------------------------------------------------------- Current assets $(6,921) $(5,939) Non-current assets (1,876) (2,145) -------------------------------------------------------------------------- $(8,797) $(8,084) -------------------------------------------------------------------------- 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 2004 2003 2002 -------------------------------------------------------------------------- Income tax provision at statutory federal rate $42,852 $24,835 $15,876 State income taxes and other, net 3,673 2,838 1,818 -------------------------------------------------------------------------- $46,525 $27,673 $17,694 -------------------------------------------------------------------------- As of 2004 and 2003, the Company had a U.S. capital loss carryover of $7,402 which will expire in 2009. As of 2004, the Company had foreign investment tax credit carryovers of $1,007 which will begin to expire in 2006. The Company provided a valuation allowance of $3,117 in 2004 and $2,814 in 2003 on the capital loss carryforward and foreign tax credit carryovers, the recovery of which is uncertain. Income taxes paid were $12,479 in 2004, $13,923 in 2003 and $2,713 in 2002. 34 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. 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, 2004, 3,219 shares of unissued common stock were authorized and reserved for outstanding options, which had a weighted average remaining contractual life of 3.1 years at that date. Transactions involving the stock option plans are as follows: Shares Price per share -------------------------------------------------------------------------- Outstanding at October 31, 2001 1,418 $ 2.93 to $13.29 Options granted 3,564 $18.95 to $20.13 Options exercised (480) $ 2.93 to $13.29 -------------------------------------------------------------------------- Outstanding at October 31, 2002 4,502 $ 3.72 to $20.13 Options granted 765 $23.87 to $44.19 Options exercised (834) $ 3.72 to $24.92 Options forfeited (1) $20.13 -------------------------------------------------------------------------- Outstanding at October 31, 2003 4,432 $ 3.85 to $44.19 Options granted 586 $44.44 to $55.60 Options exercised (1,798) $ 3.89 to $44.19 Options forfeited (1) $20.13 to $55.25 -------------------------------------------------------------------------- Outstanding at October 31, 2004 3,219 $ 3.85 to $55.60 -------------------------------------------------------------------------- 35 The following table summarizes information for stock options outstanding at October 31, 2004:
Weighted Weighted Average Average Options Remaining Exercise Range of Exercise Prices Outstanding Life Price ----------------------------------------------------------------------------------------- $ 3.85 to $13.29 444 1.0 years $ 6.57 $18.95 to $26.10 1,701 2.8 years $19.97 $44.19 to $55.60 1,074 4.4 years $49.47
The following table provides information as of October 31, 2004 with respect to the shares of common stock that may be issued under the Company's existing equity compensation plans:
Number of shares Number of shares Weighted-average remaining available to be issued exercise price for future issuance upon exercise of of outstanding under equity outstanding options options compensation plans ------------------------------------------------------------------------------------------------------- Equity compensation approved by shareholders 2,982 $28.59 869 Equity compensation plans not approved by shareholders 237 $20.14 ------------------------------------------------------------------------------------------------------- Total 3,219 $27.97 869 =======================================================================================================
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 36 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 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 2004, 2003 and 2002: 2004 2003 2002 ----------------------------------------------------------------------------- PENSION BENEFITS Service cost $ 2,896 $ 2,859 $ 2,444 Interest cost 7,035 7,018 6,287 Expected return on plan assets (7,201) (6,994) (7,421) Amortization of prior service cost 536 556 126 Recognized actuarial loss (gain) 3,344 1,526 300 Other 36 ----------------------------------------------------------------------------- Net pension costs $ 6,610 $ 5,001 $ 1,736 ----------------------------------------------------------------------------- OTHER POSTRETIREMENT BENEFITS Service cost $ 236 $ 273 $ 199 Interest cost 593 713 651 Actuarial loss (gain) 339 343 123 ============================================================================= Net other benefit costs $ 1,168 $ 1,329 $ 973 ----------------------------------------------------------------------------- 37 A reconciliation of the changes in the plans' benefit obligations and fair values of assets over the two-year period ending October 31, 2004 and a statement of the funded status at October 31, 2004 and 2003 follows. 2004 2003 ------------------------------------------------------------------------------ PENSION BENEFITS RECONCILIATION OF BENEFIT OBLIGATION: Benefit obligation at beginning of year $115,842 $ 97,987 Service cost 2,896 2,859 Interest cost 7,035 7,018 Plan amendments 1,525 Actuarial loss 5,255 10,481 Benefit payments (4,124) (3,989) Other (100) (39) ------------------------------------------------------------------------------ Benefit obligation at October 31 $126,804 $115,842 ------------------------------------------------------------------------------ RECONCILIATION OF FAIR VALUE OF PLAN ASSETS: Fair value of plan assets at beginning of year $ 69,272 $ 58,742 Actual return on plan assets 6,276 9,411 Employer contributions 6,405 5,108 Benefit payments (4,124) (3,989) ------------------------------------------------------------------------------ Fair value of plan assets at October 31 $ 77,829 $ 69,272 ------------------------------------------------------------------------------ FUNDED STATUS: Funded status at October 31 $(48,975) $(46,570) Unrecognized prior service cost 2,750 3,358 Unrecognized actuarial loss 44,652 41,844 ------------------------------------------------------------------------------ Accrued benefit cost $ (1,573) $ (1,368) ------------------------------------------------------------------------------ OTHER POSTRETIREMENT BENEFITS RECONCILIATION OF BENEFIT OBLIGATION: Benefit obligation at beginning of year $ 11,384 $ 9,441 Service cost 236 273 Interest cost 593 713 Actuarial loss (1,069) 2,557 Benefit payments (1,398) (1,600) ------------------------------------------------------------------------------ Benefit obligation at October 31 $ 9,746 $ 11,384 ------------------------------------------------------------------------------ RECONCILIATION OF FAIR VALUE OF PLAN ASSETS: Fair value of plan assets at beginning of year $ $ Employer contributions 1,398 1,600 Benefit payments (1,398) (1,600) ------------------------------------------------------------------------------ Fair value of plan assets at October 31 $ $ ------------------------------------------------------------------------------ FUNDED STATUS: Funded status at October 31 $ (9,746) $(11,384) Unrecognized actuarial loss 3,270 4,680 ------------------------------------------------------------------------------ Accrued benefit cost $ (6,476) $ (6,704) ------------------------------------------------------------------------------ 38 The amounts recognized in the Company's Consolidated Balance Sheets as of October 31 are as follows: 2004 2003 ------------------------------------------------------------------------------ PENSION BENEFITS Prepaid benefit cost $4,006 $ 3,527 Accrued benefit cost (9,633) (8,832) Intangible asset 2,557 3,225 Additional minimum liability (28,237) (25,751) Other comprehensive loss 29,734 26,463 ------------------------------------------------------------------------------- Net amount recognized $ (1,573) $ (1,368) ------------------------------------------------------------------------------- OTHER POSTRETIREMENT BENEFITS Prepaid benefit cost $ 573 $ 516 Accrued benefit cost (7,049) (7,220) ------------------------------------------------------------------------------- Net amount recognized $ (6,476) $ 6,704 ------------------------------------------------------------------------------- Assumptions used in accounting for the defined benefit plans in 2004, 2003 and 2002 were a discount rate of 5.75%, 6.00% and 6.75%, respectively, and an expected long-term rate of return on assets of 8.75%, 8.75% and 9.5%, respectively. A 1% increase in the discount rate would decrease net pension costs for 2004 and the accrued benefit cost at October 31, 2004 by $2.0 million and a 1% decrease in the discount rate would increase net pension benefit costs for 2004 and the accrued benefit cost at October 31, 2004 by $2.2 million. A 1% increase in the expected long-term rate of return on assets would decrease net pension costs for 2004 and the accrued benefit cost at October 31, 2004 by $0.8 million and 39 a 1% decrease in the expected long-term rate of return on assets would increase net pension benefit costs for 2004 and the accrued benefit cost at October 31, 2004 by $0.8 million. Assumptions used in accounting for other postretirement benefits in 2004, 2003 and 2002 were a discount rate of 5.75%, 6.00% and 6.75%, respectively, and a health care cost trend of 9.5%, 10.0% and 10.5%, 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 2004 by $100 and a 1% decrease in the discount rate would increase net other benefit costs for 2004 by $100. A 1% increase in the health care cost trend rate for each year would increase the October 31, 2004 net benefit obligation by approximately $35, while a 1% decrease in the health care cost trend rate for each year would decrease the October 31, 2004 net benefit obligation by approximately $40. 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 ---------------------- ------------- 2004 2003 2004 ------ ------ ------ Equity securities 66.2% 69.0% 62.5% Debt securities 30.1% 29.9% 33.0% Real estate 2.7% 0.0% 2.5% Cash 1.0% 1.1% 2.0% ------ ------ ------ Total 100.0% 100.0% 100.0% ====== ====== ====== The Company expects to contribute $6,458 to its pension benefit plans and contribute $1,531 in expected benefit payments attributable to its other postretirement benefit plans during the year ending 40 October 31, 2005. 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 ---------- -------- ---------- 2005 $ 4,677 $1,531 2006 5,382 939 2007 5,759 799 2008 6,147 792 2009 6,558 803 2010 - 2014 39,885 4,434 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 has an Employee Stock Ownership Plan (ESOP) covering all employees of Engineered Air, Marlo Coil, Keco, Fermont, ESSIbuy, UPSI, Radian, TAMSCO and EEI, 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 and the Engineered Environments, 41 Inc. 401(k) Plan. The Company has recorded expense based on contributions to the ESOP, the TAMSCO plan and the EEI plan for the years ended October 31, 2004, 2003 and 2002 of $4,600, $1,989 and $1,895, respectively. The Company also has a qualified Employee Stock Purchase Plan (ESPP), the terms of which allow for qualified employees, as defined, to participate in the purchase 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. The Company issued 86, 54 and 46 shares of common stock during the years ended October 31, 2004, 2003 and 2002 pursuant to the ESPP at an average price per share of $34.18, $30.41 and $28.90, 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, and material handling equipment primarily for the U.S. Postal Service. 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. 42 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 2004, 2003 and 2002, approximately, 94%, 95% and 91% of consolidated net revenues were derived directly or indirectly from the U.S. government. 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 ---------- -------- --------- -------- 2004 $853,286 $30,344 $883,630 2003 556,809 15,892 572,701 2002 393,581 14,364 407,945 The Company attributes foreign net revenues based on the domicile of the purchaser of the product or service. Of the $511.1 million in total Company assets as of October 31, 2004, $15.1 million were located in countries other than the U.S. 43 Information by segment is summarized as follows:
Year Ended October 31 2004 2003 2002 -------------------------------------------------------------------------------------------- NET REVENUES: Support Systems: Products $514,702 $389,301 $374,428 Services -------------------------------------------------------------------------------------------- 514,702 389,301 374,428 -------------------------------------------------------------------------------------------- Support Services: Products 122,978 77,111 15,121 Services 287,468 111,211 18,621 -------------------------------------------------------------------------------------------- 410,446 188,322 33,742 -------------------------------------------------------------------------------------------- Intersegment Revenues (41,518) (4,922) (225) -------------------------------------------------------------------------------------------- $883,630 $572,701 $407,945 ============================================================================================ OPERATING INCOME FROM CONTINUING OPERATIONS: Support Systems $ 92,966 $ 54,200 $ 48,022 Support Services 30,330 18,416 577 -------------------------------------------------------------------------------------------- 123,296 72,616 48,599 Interest expense (1,215) (1,881) (3,367) Interest income 353 221 128 -------------------------------------------------------------------------------------------- Income from continuing operations before income tax $122,434 $ 70,956 $ 45,360 ============================================================================================ IDENTIFIABLE ASSETS: Support Systems $272,605 $224,599 $213,685 Support Services 238,529 194,702 65,075 -------------------------------------------------------------------------------------------- 511,134 419,301 278,760 Discontinued operations 11,387 -------------------------------------------------------------------------------------------- $511,134 $419,301 $290,147 -------------------------------------------------------------------------------------------- DEPRECIATION AND AMORTIZATION: Support Systems $ 6,113 $ 5,529 $ 5,467 Support Services 6,878 3,432 1,571 -------------------------------------------------------------------------------------------- $ 12,991 $ 8,961 $ 7,038 -------------------------------------------------------------------------------------------- CAPITAL EXPENDITURES: Support Systems $ 5,763 $ 8,782 $ 3,487 Support Services 2,271 899 28 -------------------------------------------------------------------------------------------- Total $ 8,034 $ 9,681 $ 3,515 --------------------------------------------------------------------------------------------
NOTE M >> COMMITMENTS AND CONTINGENCIES As discussed in Note E, the Company completed the sale of ESP, a wholly-owned subsidiary, in the quarter ended April 30, 2003 to a private equity group (the Buyers). The Buyers subsequently alleged 44 that the Company breached certain representations made under the related Stock Purchase Agreement (the Agreement) and are seeking $6.0 million in damages from the Company. Under the terms of the Agreement, this claim is subject to binding arbitration which the Company believes will be completed by April 30, 2005. The Company has denied liability and is defending the claim vigorously. The Company also believes that this claim is without merit and that awarded damages, if any, will not have a material effect on the consolidated financial position, results of operations or cash flows of the Company. 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, 2004 are as follows:
Payments / Expiration ---------------------------------------------------------------------- 2005 2006 2007 2008 2009 Total -------- ------- ------ ------ ------ -------- Contractual Obligations: Long-term debt $ 340 $ 313 $ 119 $ 35 $ 314 $ 1,121 Operating leases 3,779 2,979 2,042 462 330 9,592 Unconditional purchase obligations 207,736 701 208,437 Contributions to pension and other postretirement benefit plans 7,889 6,997 6,757 6,650 6,461 34,754 -------- ------- ------ ------ ------ -------- 219,744 10,990 8,918 7,147 7,105 253,904 Contingent Obligations: Letters of credit 3,617 3,617 -------- ------- ------ ------ ------ -------- Total Obligations $223,361 $10,990 $8,918 $7,147 $7,105 $257,521 ======== ======= ====== ====== ====== ========
45 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 $5.0 million, $4.2 million and $2.5 million for the years ended October 31, 2004, 2003 and 2002, respectively. NOTE N >> SUBSEQUENT EVENT Effective December 9, 2004, the Company entered into a definitive purchase agreement to acquire the membership interests of Spacelink International, LLC (Spacelink), which designs, integrates, operates and maintains deployed satellite and wireless networks for the DoD, the U.S. intelligence community and other federal agencies and multinational organizations worldwide. The pending transaction is subject to regulatory and other approvals, as well as the satisfaction of customary closing conditions. The Company expects to complete the transaction in February, 2005. The purchase price is $150.5 million, which includes $138.5 million in cash and $12.0 million in common stock. The purchase price is subject to certain adjustments to be finalized after closing, including contingent consideration based upon Spacelink's future financial performance. Effective January 7, 2004, the Company acquired all of the outstanding stock of Prospective Computer Analysts Incorporated (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 final working capital adjustment. The purchase price was financed with the Company's existing cash balances. Spacelink will be included in the Support Services segment and PCA will be included in the Support Systems segment. 46 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Engineered Support Systems, Inc.: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Engineered Support Systems, Inc. and its subsidiaries at October 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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 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. /s/ PricewaterhouseCoopers LLP -------------------------------- PricewaterhouseCoopers LLP St. Louis, Missouri December 14, 2004 47 SUPPLEMENTAL INFORMATION The table below presents unaudited quarterly financial information in thousands, except for per share data, for the years ended October 31, 2004 and 2003.
----------------------------------------------------------------------------------------------------------------------------------- Quarter Ended January 31 April 30 July 31 October 31 Fiscal Year ----------------------------------------------------------------------------------------------------------------------------------- 2004 2003 2004 2003 2004 2003 2004 2003 2004 2003 ----------------------------------------------------------------------------------------------------------------------------------- Net revenues $195,130 $121,663 $210,136 $125,057 $221,991 $155,669 $256,373 $170,312 $883,630 $572,701 Gross profit 46,271 27,146 53,425 29,783 56,816 38,161 66,178 42,969 222,690 138,059 Net income from continuing operations 15,743 8,441 18,323 8,479 20,506 12,416 21,337 13,947 75,909 43,283 Net income 15,743 8,578 18,323 8,636 20,506 12,416 21,337 13,778 75,909 43,408 Diluted earnings per share: Continuing operations $ 0.57 $ 0.33 $ 0.66 $ 0.33 $ 0.73 $ 0.48 $ 0.76 $ 0.52 $ 2.72 $ 1.68 Total $ 0.57 $ 0.34 $ 0.66 $ 0.34 $ 0.73 $ 0.48 $ 0.76 $ 0.51 $ 2.72 $ 1.68
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. Earnings per share calculations are based on diluted common shares outstanding for each quarter and, therefore, the sum of the quarters may not necessarily be equal to the full year diluted earnings per share amounts. 48