PART I. FINANCIAL INFORMATION
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read together with the consolidated financial statements and the notes to those statements that appear elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K filed with the Securities Exchange Commission on March 13, 2012.
Some of the statements in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations", and elsewhere in this Quarterly Report on Form 10-Q, contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, regarding future events and the future results of DRC that are based on our current expectations, estimates, forecasts, and projections about the industries in which DRC operates and the beliefs and assumptions of the management of DRC. Words such as "anticipates", "believes", "estimates", "expects", "intends", "plans", "projects", "may", "will", "should", and other similar expressions are intended to identify these forward-looking statements. Such statements are subject to factors that could cause actual results to differ materially from anticipated results. Such factors include, but are not limited to, the following:
·
|
Our dependency on the Federal government and changes in federal spending priorities;
|
·
|
A shift in pricing structure for government contracts;
|
·
|
Risks associated with actual and potential goodwill impairment;
|
·
|
An increased focus on the elimination of administrative costs within the Department of Defense;
|
·
|
Failure to obtain new government contracts or retain existing contracts;
|
·
|
The effect of Federal government in-sourcing on our business;
|
·
|
The loss of skilled personnel;
|
·
|
The risk of security breaches in systems we develop, install, or maintain;
|
·
|
Failure by Congress to timely approve budgets governing spending by Federal agencies;
|
·
|
Risks due to government contract provisions providing for rights unfavorable to us, including the ability to terminate contracts at any time for convenience;
|
·
|
Potential systems or service failures that could result in liability to our company;
|
·
|
Competition with competitors who may have advantages due to having greater resources or qualifying for special statuses;
|
·
|
Failure to obtain or maintain necessary security clearances;
|
·
|
Risks associated with various, complex Federal government procurement laws and regulations;
|
·
|
Adverse effects in the event of an unfavorable Federal audit of our contracts;
|
·
|
Failure to adequately safeguard confidential information;
|
·
|
An adverse outcome related to ongoing legal proceedings;
|
·
|
Incurrence of expenditures prior to final receipt of contracts;
|
·
|
Competitive conditions in current markets and difficulties in entering new markets; and
|
·
|
Our ability to maintain sufficient sources of financing and the risk that our financing requirements should increase.
|
These and other risk factors are more fully described in our Annual Report on Form 10-K for the year ended December 31, 2011 under the section entitled "Risk Factors", and from time to time, in other filings with the SEC. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document. Actual results may differ materially and adversely from those expressed in any forward-looking statements. Except to the extent required by applicable law or regulation, DRC undertakes no obligation to revise or update publicly any forward-looking statements for any reason.
Unless the context otherwise requires, references in this Form 10-Q to "DRC", "we", "us", or "our" refer to Dynamics Research Corporation and its subsidiaries.
Dynamics Research Corporation, headquartered in Andover, Massachusetts, is a leading provider of innovative management consulting, engineering, and information technology services and solutions to federal and state governments.
Our go-to-market strategy is sharply focused within each of four dimensions:
·
|
Solutions.
We deliver five high-value, differentiated solutions to our clients: business transformation, information technology, training and performance support, management services, and science and engineering services. We believe our solutions align well with the needs of our government customers today who require improved efficiencies and effectiveness, and face procurement reform, transformational and technology based changes, and ongoing, changing security threats.
|
·
|
Markets and Customers.
We target markets which are based on long-term market force drivers that have sustained demand for our services. We select specific customers from government agencies in our target growth markets with needs that well match the solutions we provide. Currently our target growth markets include homeland security, healthcare, cyber security, intelligence, and financial/regulatory reform.
|
·
|
Prime Government and Agency-Wide Contracts.
We hold a portfolio of government and agency-wide multiple award schedule ID/IQ task order contracts. Today, these types of contracts are the federal government's preferred means of procurement for services.
|
·
|
Acquisitions.
We use acquisitions, funded through both operationally generated cash and leverage, to strengthen our position in our target growth markets.
|
On September 30, 2011, we completed the merger of High Performance Technologies, Inc. ("HPTi") for $143 million in cash plus net working capital of $3.4 million. HPTi is a leading provider of high-end technology services to the federal healthcare and military technology markets. The merger strengthens and expands the Company's market presence as a provider of high-end services and solutions in the federal market.
In the first nine months of 2012 as well as in 2011, we generated 95% of our revenue from contracts with the United States government, either as a prime contractor or as a subcontractor. As a result, we are significantly impacted by trends and changes in federal expenditures and procurement policies. The U.S. government deficit, budgetary challenges, and efforts to curtail expenditures are ongoing and reflected in (i) the Budget Control Act of 2011, which increased the debt ceiling and enacted 10-year discretionary spending caps and automatic spending cuts, referred to as sequestration, which will require $1.2 trillion of spending cuts over 10 years, if not amended by Congress and the President, (ii) the Defense Strategic Guidance, issued on January 5, 2012, which outlines fundamental changes in the strategy of United States armed forces, which is smaller and leaner but agile, flexible, and technologically advanced, and (iii) the President's budget submission for the fiscal year beginning October 1, 2012. Additionally, sizeable mandatory outlays for social security and medical programs in the face of large budget deficits indicate that federal discretionary spending will remain under pressure.
Overall, the President's information technology budget request of $78.9 billion for fiscal year 2013 is down slightly from the fiscal year 2012 enacted budget, reflecting reductions in defense and intelligence budgets and increases in civilian agencies such as the Departments of Treasury, Veterans Affairs, and Education.
We have seen and anticipate continued impacts from government budget management initiatives, the specific timing and effects of which may not be predictable, such as:
·
|
Program delays, cuts, and terminations,
|
·
|
fewer new program starts,
|
·
|
intensified price competition for new business and re-competes of current business, and
|
·
|
pressure to reduce dependency on service contractors and set more work aside for small and socially disadvantaged businesses.
|
These events may result in (i) new business contract wins being lower than expected or needed to sustain growth, (ii) ending of or reductions to current programs and contracts, and (iii) lower profit margins as a result of pricing pressure and the need to invest in winning new and retaining existing business – all of which may adversely affect our results of operations and financial condition.
NON-GAAP FINANCIAL MEASURES
In evaluating our operating performance, management uses certain non-GAAP financial measures to supplement the consolidated financial statements prepared under generally accepted accounting principles in the United States ("GAAP").
Management believes these non-GAAP measures help indicate our operating performance before charges that are considered by management to be outside our ongoing operating results. Accordingly, management uses these non-GAAP measures to gain a better understanding of our comparative operating performance from period-to-period and as a basis for planning and forecasting future periods. Management believes these non-GAAP measures, when read in conjunction with our GAAP financials, provide useful information to investors by offering:
·
|
the ability to make more meaningful period-to-period comparisons of our ongoing operating results, net of the effect of goodwill impairment;
|
·
|
the ability to better identify trends in our underlying business and perform related trend analysis;
|
·
|
a higher degree of transparency for certain expenses (particularly when a specific charge impacts multiple line items);
|
·
|
a better understanding of how management plans and measures our underlying business; and
|
·
|
an easier way to compare our most recent results of operations against investor and analyst financial models.
|
The non-GAAP measures we use exclude the goodwill impairment charges incurred in the second and third quarters of 2012, the transaction-related costs related to the HPTi merger and its related tax effect that management believes is outside of our ongoing operations for the periods presented.
These non-GAAP measures have limitations; however, because they do not include all items of expense that impact our operations. Management compensates for these limitations by also considering our GAAP results. The non-GAAP financial measures we use are not prepared in accordance with, and should not be considered an alternative to, measurements required by GAAP, such as operating loss, net loss and loss per share, and should not be considered measures of our liquidity. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the most directly comparable GAAP measures. In addition, these non-GAAP financial measures may not be comparable to similar measures reported by other companies.
Non-GAAP financial measures, together with a reconciliation with the most direct comparable financial measures under GAAP for the three and nine months ended September 30, 2012 and 2011 were as follows:
|
|
Three Months Ended
|
|
|
Nine Months Ended
|
|
|
|
September 30,
|
|
|
September 30,
|
|
(in thousands)
|
|
2012
|
|
|
2011
|
|
|
2012
|
|
|
2011
|
|
Selling, general and administrative expenses
|
|
$
|
5,684
|
|
|
$
|
7,041
|
|
|
$
|
18,985
|
|
|
$
|
19,519
|
|
Operating transaction costs
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
(1,703
|
)
|
Non-GAAP selling, general and administrative
|
|
$
|
5,684
|
|
|
$
|
7,041
|
|
|
$
|
18,985
|
|
|
$
|
17,816
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating income (loss)
|
|
$
|
(32,092
|
)
|
|
$
|
8,844
|
|
|
$
|
(33,332
|
)
|
|
$
|
16,809
|
|
Impairment of goodwill
|
|
|
36,600
|
|
|
|
-
|
|
|
|
48,600
|
|
|
|
-
|
|
Operating transaction costs
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
1,703
|
|
Non-GAAP operating income
|
|
$
|
4,508
|
|
|
$
|
8,844
|
|
|
$
|
15,268
|
|
|
$
|
18,512
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest expense, net
|
|
$
|
(2,579
|
)
|
|
$
|
(3,027
|
)
|
|
$
|
(7,979
|
)
|
|
$
|
(4,047
|
)
|
Non operating transaction costs
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
533
|
|
Non-GAAP interest expense, net
|
|
$
|
(2,579
|
)
|
|
$
|
(3,027
|
)
|
|
$
|
(7,979
|
)
|
|
$
|
(3,514
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before provision (benefit) for income taxes
|
|
$
|
(32,257
|
)
|
|
$
|
5,660
|
|
|
$
|
(38,833
|
)
|
|
$
|
12,768
|
|
Impairment of goodwill
|
|
|
36,600
|
|
|
|
-
|
|
|
|
48,600
|
|
|
|
-
|
|
Total transaction costs
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
2,236
|
|
Non-GAAP income before provision for income taxes
|
|
$
|
4,343
|
|
|
$
|
5,660
|
|
|
$
|
9,767
|
|
|
$
|
15,004
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Provision (benefit) for income taxes
|
|
$
|
(11,663
|
)
|
|
$
|
2,382
|
|
|
$
|
(13,951
|
)
|
|
$
|
5,345
|
|
Tax benefit for impairment of goodwill
|
|
|
13,200
|
|
|
|
-
|
|
|
|
17,700
|
|
|
|
-
|
|
Tax benefit for transaction costs
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
940
|
|
Non-GAAP provision for income taxes
|
|
$
|
1,537
|
|
|
$
|
2,382
|
|
|
$
|
3,749
|
|
|
$
|
6,285
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss)
|
|
$
|
(20,594
|
)
|
|
$
|
3,278
|
|
|
$
|
(24,882
|
)
|
|
$
|
7,423
|
|
Impairment of goodwill, net of taxes
|
|
|
23,400
|
|
|
|
-
|
|
|
|
30,900
|
|
|
|
-
|
|
Total transaction costs, net of taxes
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
1,296
|
|
Non-GAAP net income
|
|
$
|
2,806
|
|
|
$
|
3,278
|
|
|
$
|
6,018
|
|
|
$
|
8,719
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings (loss) per share:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
GAAP Basic
|
|
$
|
(1.99
|
)
|
|
$
|
0.32
|
|
|
$
|
(2.40
|
)
|
|
$
|
0.74
|
|
Per share effect of goodwill impairment
|
|
|
2.26
|
|
|
|
-
|
|
|
|
2.98
|
|
|
|
-
|
|
Per share effect of transaction costs
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
0.13
|
|
Non-GAAP Basic
|
|
$
|
0.27
|
|
|
$
|
0.32
|
|
|
$
|
0.58
|
|
|
$
|
0.87
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
GAAP Diluted
|
|
$
|
(1.99
|
)
|
|
$
|
0.32
|
|
|
$
|
(2.40
|
)
|
|
$
|
0.73
|
|
Per share effect of goodwill impairment
|
|
|
2.25
|
|
|
|
-
|
|
|
|
2.97
|
|
|
|
-
|
|
Per share effect of transaction costs
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
0.13
|
|
Non-GAAP Diluted
(1)
|
|
$
|
0.27
|
|
|
$
|
0.32
|
|
|
$
|
0.58
|
|
|
$
|
0.85
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average shares outstanding:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
|
|
|
10,360,203
|
|
|
|
10,244,868
|
|
|
|
10,356,334
|
|
|
|
10,060,585
|
|
Diluted
|
|
|
10,384,518
|
|
|
|
10,314,413
|
|
|
|
10,394,775
|
|
|
|
10,205,603
|
|
(1)
|
May not add due to rounding.
|
RESULTS OF OPERATIONS
Operating results expressed as a percentage of total revenue are as follows:
|
|
Three Months Ended September 30,
|
|
(in millions)
|
|
2012
|
|
|
2011
|
|
Revenue
|
|
$
|
76.8
|
|
|
|
|
|
$
|
96.4
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross profit
|
|
$
|
11.2
|
|
|
|
14.6
|
%
|
|
$
|
17.4
|
|
|
|
18.1
|
%
|
Selling, general and administrative
|
|
|
5.7
|
|
|
|
7.4
|
%
|
|
|
7.0
|
|
|
|
7.3
|
%
|
Amortization of intangible assets
|
|
|
1.0
|
|
|
|
1.3
|
%
|
|
|
1.6
|
|
|
|
1.6
|
%
|
Impairment of goodwill
|
|
|
36.6
|
|
|
|
47.7
|
%
|
|
|
-
|
|
|
|
0.0
|
%
|
Operating income (loss)
|
|
|
(32.1
|
)
|
|
|
(41.8
|
)%
|
|
|
8.8
|
|
|
|
9.2
|
%
|
Interest expense, net
|
|
|
(2.6
|
)
|
|
|
(3.4
|
)%
|
|
|
(3.0
|
)
|
|
|
(3.1
|
)%
|
Other income (expense), net
|
|
|
2.4
|
|
|
|
3.1
|
%
|
|
|
(0.2
|
)
|
|
|
(0.2
|
)%
|
Provision (benefit) for income taxes(1)
|
|
|
(11.7
|
)
|
|
|
36.2
|
%
|
|
|
2.4
|
|
|
|
42.1
|
%
|
Net income (loss)(2)
|
|
$
|
(20.6
|
)
|
|
|
(26.8
|
)%
|
|
$
|
3.3
|
|
|
|
3.4
|
%
|
|
|
Nine Months Ended September 30,
|
|
(in millions)
|
|
2012
|
|
|
2011
|
|
Revenue
|
|
$
|
243.5
|
|
|
|
|
|
$
|
234.4
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross profit
|
|
$
|
37.3
|
|
|
|
15.3
|
%
|
|
$
|
38.6
|
|
|
|
16.5
|
%
|
Selling, general and administrative
|
|
|
19.0
|
|
|
|
7.8
|
%
|
|
|
19.5
|
|
|
|
8.3
|
%
|
Amortization of intangible assets
|
|
|
3.1
|
|
|
|
1.3
|
%
|
|
|
2.3
|
|
|
|
1.0
|
%
|
Impairment of goodwill
|
|
|
48.6
|
|
|
|
20.0
|
%
|
|
|
-
|
|
|
|
0.0
|
%
|
Operating income (loss)
|
|
|
(33.3
|
)
|
|
|
(13.7
|
)%
|
|
|
16.8
|
|
|
|
7.2
|
%
|
Interest expense, net
|
|
|
(8.0
|
)
|
|
|
(3.3
|
)%
|
|
|
(4.0
|
)
|
|
|
(1.7
|
)%
|
Other income, net
|
|
|
2.5
|
|
|
|
1.0
|
%
|
|
|
0.0
|
|
|
|
0.0
|
%
|
Provision (benefit) for income taxes(1)
|
|
|
(14.0
|
)
|
|
|
35.9
|
%
|
|
|
5.3
|
|
|
|
41.9
|
%
|
Net income (loss)(2)
|
|
$
|
(24.9
|
)
|
|
|
(10.2
|
)%
|
|
$
|
7.4
|
|
|
|
3.2
|
%
|
(1)
|
The percentage of provision for income taxes relates to a percentage of income (loss) before income taxes.
|
|
|
(2)
|
Net income (loss) may not add due to rounding.
|
Revenues
Revenues for the three and nine months ended September 30, 2012 were earned from the following sectors:
|
|
Three Months Ended September 30,
|
|
(in millions)
|
|
2012
|
|
|
2011
|
|
National defense and intelligence agencies
|
|
$
|
44.6
|
|
|
|
58.0
|
%
|
|
$
|
59.5
|
|
|
|
61.7
|
%
|
Homeland security
|
|
|
11.8
|
|
|
|
15.4
|
|
|
|
13.0
|
|
|
|
13.5
|
|
Federal civilian agencies
|
|
|
16.3
|
|
|
|
21.3
|
|
|
|
20.1
|
|
|
|
20.9
|
|
Total revenue from federal agencies
|
|
|
72.7
|
|
|
|
94.7
|
|
|
|
92.6
|
|
|
|
96.1
|
|
State and local government agencies and other
|
|
|
4.1
|
|
|
|
5.3
|
|
|
|
3.8
|
|
|
|
3.9
|
|
Total revenue
|
|
$
|
76.8
|
|
|
|
100.0
|
%
|
|
$
|
96.4
|
|
|
|
100.0
|
%
|
|
|
Nine Months Ended September 30,
|
|
(in millions)
|
|
2012
(2)
|
|
|
2011
|
|
National defense and intelligence agencies
|
|
$
|
142.0
|
|
|
|
58.3
|
%
|
|
$
|
154.8
|
|
|
|
66.0
|
%
|
Homeland security
|
|
|
36.2
|
|
|
|
14.9
|
|
|
|
36.6
|
|
|
|
15.6
|
|
Federal civilian agencies
|
|
|
53.3
|
|
|
|
21.9
|
|
|
|
31.7
|
|
|
|
13.5
|
|
Total revenue from federal agencies
(1)
|
|
|
231.4
|
|
|
|
95.1
|
|
|
|
223.1
|
|
|
|
95.2
|
|
State and local government agencies and other
|
|
|
12.0
|
|
|
|
4.9
|
|
|
|
11.3
|
|
|
|
4.8
|
|
Total revenue
(1)
|
|
$
|
243.5
|
|
|
|
100.0
|
%
|
|
$
|
234.4
|
|
|
|
100.0
|
%
|
(1)
|
Totals may not add due to rounding.
|
|
|
(2)
|
Revenues for the first and second quarter of 2012 have been reclassified to conform to current period and 2011 presentation as follows:
|
|
|
Three Months Ended
|
|
(in millions)
|
|
March 31, 2012
|
|
|
June 30, 2012
|
|
National defense and intelligence agencies
|
|
$
|
50.4
|
|
|
|
58.7
|
%
|
|
$
|
47.0
|
|
|
|
58.2
|
%
|
Homeland security
|
|
|
12.3
|
|
|
|
14.3
|
|
|
|
12.1
|
|
|
|
14.9
|
|
Federal civilian agencies
|
|
|
19.2
|
|
|
|
22.4
|
|
|
|
17.7
|
|
|
|
21.9
|
|
Total revenue from federal agencies
|
|
|
81.9
|
|
|
|
95.4
|
|
|
|
76.8
|
|
|
|
95.0
|
|
State and local government agencies and other
|
|
|
3.9
|
|
|
|
4.6
|
|
|
|
4.0
|
|
|
|
5.0
|
|
Total revenue
|
|
$
|
85.9
|
|
|
|
100.0
|
%
|
|
$
|
80.8
|
|
|
|
100.0
|
%
|
We reported total revenue of $76.8 million and $96.4 million in the third quarter of 2012 and 2011, respectively, and $243.5 million and $234.4 million in the first nine months of 2012 and 2011, respectively.
Total revenues represent a decrease of 20.3% in the third quarter of 2012 and an increase of 3.9% in the first nine months of 2012, from the comparable periods in 2011
. Several contracts ended in the fourth quarter of 2011, which represented more than half of the decline in revenue in the third quarter of 2012 compared with the same period in 2011. The increase for the first nine months of 2012 was due to HPTi results being included in all reporting periods during 2012.
During the fourth quarter of 2011, we saw evidence of aggressive government cost-cutting initiatives that impacted several successful programs, which were completed in the fourth quarter of 2011, where clients deferred or cancelled follow-on awards due to cost-cutting efforts. The reduction in annual revenue from these completed programs totaled approximately $30 million, which has impacted the first nine months of 2012 and our outlook for the remainder of 2012.
In the first six months of 2012, we continued to see a shortage of new business awards, but saw strong activity in third quarter contract actions. The total contract value of our new business wins in the first nine months of 2012 totaled $150.1 million. Regarding competitions to re-win existing business we won $158 million, or 85%, of the award decisions made in the first nine months of 2012, down from a re-win rate of 98% for the 2011 fiscal year.
In the second quarter of 2012, we were adversely impacted by two contracts which were subject to re-compete or extension. One of the contracts was not extended or re-competed due to a lack of funds, and the other, which was scheduled for a competitive procurement, was awarded on a sole source basis to a small, socially disadvantaged business. The contracts, which impacted the third quarter of 2012, generated approximately $11 million in annual revenue with 75 employees.
Revenues by contract type as a percentage of revenues were as follows:
|
|
Three Months Ended
|
|
|
Nine Months Ended
|
|
|
|
September 30,
|
|
|
September 30,
|
|
|
|
2012
|
|
|
2011
|
|
|
2012
|
|
|
2011
|
|
Fixed price, including service type contracts
|
|
|
45
|
%
|
|
|
46
|
%
|
|
|
46
|
%
|
|
|
48
|
%
|
Time and materials
|
|
|
37
|
|
|
|
33
|
|
|
|
34
|
|
|
|
31
|
|
Cost reimbursable
|
|
|
18
|
|
|
|
21
|
|
|
|
20
|
|
|
|
21
|
|
|
|
|
100
|
%
|
|
|
100
|
%
|
|
|
100
|
%
|
|
|
100
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Prime contract
|
|
|
83
|
%
|
|
|
82
|
%
|
|
|
84
|
%
|
|
|
78
|
%
|
Sub-contract
|
|
|
17
|
|
|
|
18
|
|
|
|
16
|
|
|
|
22
|
|
|
|
|
100
|
%
|
|
|
100
|
%
|
|
|
100
|
%
|
|
|
100
|
%
|
Backlog and Bookings
Our backlog position was as follows:
(in millions)
|
|
September 30, 2012
|
|
|
December 31, 2011
|
|
Backlog:
|
|
|
|
|
|
|
Funded
|
|
$
|
182.4
|
|
|
$
|
183.3
|
|
Unfunded
|
|
|
574.9
|
|
|
|
618.6
|
|
Total backlog
|
|
$
|
757.3
|
|
|
$
|
801.9
|
|
We expect that substantially all of our funded backlog at September 30, 2012 will generate revenue during the subsequent twelve month period. The funded backlog generally is subject to possible termination at the convenience of the contracting party. Contracts are typically funded on an annual basis or incrementally for shorter time periods. The funded backlog as of September 30, 2012 and December 31, 2011 covered approximately 7.1 months and 6.2 months of revenue, respectively. Funded bookings were $108.0 million and $61.5 million in the three months ended September 30, 2012 and December 31, 2011, respectively, and generated a book-to-bill ratio of approximately 1.4 to 1.0 and 1.0 to 1.0 for each respective period.
Gross profit was $11.2 million and $17.4 million for the third quarter of 2012 and 2011, respectively, resulting in a gross margin of 14.6% and 18.1%, respectively. For the first nine months of 2012 and 2011, gross profit was $37.3 million and $38.6 million, respectively, resulting in a gross margin of 15.3% and 16.5%, respectively.
In the third quarter of 2012, lower revenue represented about $6 million of the gross profit decline. Price erosion represented about $0.7 million, or 0.1 point of gross profit reduction. Indirect overhead costs were 2 points higher as a percent of revenue due in part to higher than normal severance costs.
Overhead costs included in gross profit totaled $17.8 million, or 23.2 percent of revenue, in the third quarter of 2012, compared with $20.3 million, 21.0 percent of revenue, for the third quarter of 2011.
Selling, general and administrative expenses
Selling, general and administrative expenses were $5.7 million and $7.0 million for the third quarter of 2012 and 2011, respectively, and $19.0 million and $19.5 million, respectively, in the first nine months of 2012 and 2011, respectively. Selling, general and administrative expenses as a percent of total revenue in the third quarter of 2012 and 2011 were 7.4% and 7.3%, respectively, and 7.8% and 8.3% in the first nine months of 2012 and 2011, respectively. The decrease in selling, general and administrative expenses in third quarter of 2012 was due to our indirect cost reduction initiatives. The decrease in selling, general and administrative expenses in the nine months of 2012 was due to transaction-related costs of $1.7 million recorded in the second quarter of 2011 and our indirect cost reduction initiatives partially offset by added costs for the merger of HPTi.
Intangible assets
Amortization expense was $1.0 million and $1.6 million in the third quarter of 2012 and 2011, respectively, and $3.1 million and $2.3 million in the first nine months of 2012 and 2011, respectively.
The increase in amortization expense for the first nine months of 2012 was due to a full year of amortization related to the $20 million of acquired intangible assets from the HPTi merger.
The remaining amortization expense for the current fiscal year is expected to be approximately $1.0 million.
Impairment of goodwill
During the second quarter of 2012, we recorded an estimated goodwill impairment charge of $12.0 million based on a step 1 analysis performed. We completed the step 2 analysis on October 31, 2012, and determined the total amount of the goodwill impairment to be $48.6 million, which resulted in an additional charge of $36.6 million in the quarter ending September 30, 2012.
The determination of valuation for goodwill impairment testing is sensitive to (i) changes in the market price of DRC's stock, (ii) changes in premiums paid in excess of market price for public companies in our industry sector which are acquired, (iii) estimated future cash flows, (iv) weighted average cost of capital, and (v) market multiples. A significant decrease in any of these assumptions would cause a decline in valuation and increase the risk of impairment. At September 28, 2012 and December 30, 2011, the price of our common stock was $6.85 per share and $11.34 per share, respectively.
Interest expense, net
Net interest expense was $2.6 million and $3.0 million in the third quarter of 2012 and 2011, respectively, and $8.0 million and $4.0 million in the first nine months of 2012 and 2011, respectively. The increase in interest expense for the nine months of 2012 was due to the higher outstanding debt borrowings incurred in connection with the HPTi merger and higher interest rates in 2012. Interest expense for the nine months of 2011 included a charge of $0.5 million due to the payoff of the interest rate swap and the write-off of deferred financing cost associated with our previous credit facility that occurred in the second quarter of 2011.
Other income (expense), net
Other income (expense) consists of our portion of earnings and losses in
HMR
Tech, gains and losses realized from our deferred compensation plan and results from other non-operating transactions, all of which were not material to our results. Other income for the third quarter of 2012 included a $2.4 million gain related to settlement of a contract claim by
HMR
Tech. This matter relates to the 2006 wrongful termination by the Air Force of the Consolidated Acquisition Professional Services, or CAPS, contract held by a joint venture in which DRC was a significant participant. The Air Force paid the joint venture $6.3 million in damages. Our share of the settlement of $2.4 million was calculated net of expenses.
Income tax provision (benefit)
We recorded income tax benefits of $11.7 million and $14.0 million for the three and nine months ended September 30, 2012, respectively, and recorded income tax provisions of $2.4 million and $5.3 million in the three and nine months ended September 30, 2011. During the three months ended September 30, 2012, we recognized a tax benefit of $0.2 million primarily related to a reversal of a previously recorded unrecognized tax benefit. The reduction in unrecognized tax benefit was due to a change in judgment during the quarter. Additionally, the tax benefit associated with the goodwill impairment charge of $36.6 million was applied at a rate of 36%. Absent these items the effective tax rate on operating results was 40.9% for the nine months ended September 30, 2012 compared to 41.9% for comparable prior year period.
Net Income (Loss)
The net loss for the three and nine months ended September 30, 2012 was $20.6 million and $24.9 million, respectively, compared to net income for the three and nine months ended September 30, 2011 of $3.3 million and $7.4 million, respectively. Results for the three and nine months ended September 30, 2012 included a goodwill impairment charge of $36.6 million, or $23.4 million net of income tax benefits, and $48.6 million, or $30.9 million net of income tax benefits, respectively. Excluding the goodwill impairment charge net income for the three and nine months ended September 30, 2012 was $2.8 million, or $0.27 per diluted share, and $6.0 million, or $0.58 per diluted share, respectively.
LIQUIDITY AND CAPITAL RESOURCES
The following discussion analyzes liquidity and capital resources by operating, investing, and financing activities as presented in our Consolidated Statements of Cash Flows. Our principal sources of liquidity are cash flows from operations and borrowings from our revolving credit agreement.
Our results of operations, cash flows, and financial condition are subject to trends, events, and uncertainties, including demands for capital to support growth, economic conditions, government payment practices, and contractual matters. Our need for access to funds is dependent on future operating results, our growth and acquisition activity, and external conditions.
We have evaluated our future liquidity needs, both from a short-term and long-term basis. Our cash flows in the past and for the remainder of 2012 are expected to exceed our fixed costs and debt service requirements. During the first nine months of 2012 we repaid a total of $9.9 million of our senior term loan, of which $1.0 million was prepaid. Additionally, we maintain a $20 million revolving credit facility, of which $19.3 million was available at September 30, 2012. Based on these circumstances, we believe we have sufficient funds to meet our working capital and capital expenditure needs for the short-term.
To provide for long-term liquidity, we believe we can generate substantial positive cash flow, as well as obtain additional capital, if necessary, from the use of debt or equity. In the event that our current capital resources are not sufficient to fund requirements, we believe our access to additional capital resources would be sufficient to meet our needs.
With the HPTi merger, we have utilized our access to capital resources to acquire a business that aligns with our growth strategy. In the long-term, we believe that selective acquisitions are an important component of our growth strategy and we may acquire, from time to time, businesses or contracts that are aligned with our core capabilities and which complement our customer base.
Operating activities
Net cash provided by contract receivables was $15.0 million in the first nine months of 2012 compared to net cash used of $4.5 million in the first nine months of 2011. The federal budget for the current fiscal year was finalized earlier than in the previous year. We believe this factor contributed to the improvement in collections in the first nine months of 2012. Overall, contract receivables days sales outstanding ("DSO") was 60 days at September 30, 2012 compared to 68 days at December 31, 2011. Federal business DSO, which excludes the effect of state contracts, was 52 days at September 30, 2012 compared to 60 days at December 31, 2011.
Our net deferred tax asset was $10.0 million at September 30, 2012 compared to a deferred tax liability of $2.9 million at December 31, 2011. The increase in deferred taxes was primarily due to $17.7 million of deferred taxes associated with the goodwill impairment charge partially offset by $3.4 million of deferred tax liabilities associated with amortization of certain intangible assets and goodwill balances as well as a deferred tax liability of $1.4 million for pension funding. During the first nine months of 2012 and 2011, we paid $0.9 million and $2.5 million, respectively, in income taxes, net of refunds, and currently anticipate net income tax payments of $0.1 million in the remaining quarter of 2012.
The IRS had challenged the deferral of income for tax reporting purposes related to unbilled receivables including the applicability of a Letter Ruling issued by the IRS to DRC in January 1976 which granted to us deferred tax treatment of the unbilled receivables. This issue was elevated to the IRS National Office for determination. On October 23, 2008, we received a notification of ruling from the IRS National Office. This ruling provided clarification regarding the IRS position relating to revenue recognition for tax purposes regarding our unbilled receivables. During September 2009, the IRS completed its examination of our tax returns for 2004 through 2007 and issued a Revenue Agent Report ("RAR"), which reduced the deferral of income for tax reporting purposes. As a result, we reclassified approximately $1.0 million from deferred to current taxes payable. The RAR also included an assessment of interest of $0.5 million. We filed a protest letter with the IRS to appeal the assessment. During the three months ended September 30, 2012, we executed closing agreements with the IRS on our tax audits through the year 2009. The closing agreements are subject to Joint Congressional Committee approval, primarily due to large tax deduction in 2009 related to a legal settlement reached in 2008. We do not have reason to believe approval by the Joint Congressional Committee will be withheld.
Share-based compensation was $0.5 million in the first nine months of 2012 and 2011. As of September 30, 2012 the total unrecognized compensation cost related to restricted stock awards was $1.3 million which is expected to be amortized over a weighted-average period of 2.3 years, and the unrecognized compensation cost related to stock option awards was $0.1 million which is expected to be amortized over a weighted-average period of 0.9 years.
Non-cash amortization expense of our acquired intangible assets was $3.1 million and $2.3 million in the first nine months of 2012 and 2011, respectively. This increase was as a result of a full year of amortization from the acquisition of HPTi, in which we acquired a significant amount of additional intangible assets. We anticipate that non-cash expense for the amortization of intangible assets will remain at a comparable quarterly level for the remainder of 2012.
Our defined benefit pension plan was underfunded by $23.3 million and $27.1 million at September 30, 2012 and December 31, 2011, respectively. We contributed $4.9 million and $3.9 million to fund the pension plan in the first nine months of 2012 and 2011, respectively, and recorded pension expense of $0.7 million and $0.2 million in the first nine months of 2012 and 2011, respectively. We expect to contribute an additional $0.7 million to fund the pension plan in the remaining quarter of 2012 and anticipate pension expense to be approximately $0.9 million in 2012.
Investing activities
Net cash used in investing activities in the first nine months of 2012 primarily consisted of the settlement of the HPTi merger working capital payment of $2.4 million and payments for capital expenditures of $0.8 million, partially offset by $2.5 million of dividends from
HMR
Tech. Net cash used in investing activities in the first nine months of 2011 was primarily for the merger of HPTi of $144.0 million and investing of capital expenditures of $1.5 million.
We expect discretionary capital expenditures in 2012 to be approximately $1 million.
Financing activities
During the first nine months of 2012, net cash used in financing activities was primarily due to repayments under our senior term loan of $9.9 million, partially offset by proceeds from the issuance of common stock through stock plan transactions of $0.3 million. Net cash provided by financing activities in the first nine months of 2011 consisted of net borrowings of $144.0 million and $1.7 million from the issuance of common stock through stock plan transactions, partially offset by repayments of $17.8 million on our senior term loan, $22.0 million on a previous term loan and $1.9 million in deferred financing costs associated with the HPTi merger.
Concurrent with the merger of HPTi, we replaced our then-existing credit facility with a new secured credit facility with a $110 million five-year senior term loan and a $20 million revolving credit facility, and entered into a $40 million unsecured subordinated facility with a six-year term.
We are considering the possibility of a partial or total pay off of the $40 million subordinated debt. If completed, the transaction would include a make-whole payment to the subordinated debt holder and would result in a reduction in interest expense going forward.
During the first nine months of 2012, we repaid $9.9 million of the senior term loan, of which $1.0 million was prepaid. For the remainder of 2012 our senior term loan requires quarterly repayments totaling $3.4 million. We expect operating cash flows will exceed these required repayments. At September 30, 2012, the borrowing capacity available under our revolver was $19.3 million.
Effective June 30, 2012, we amended our credit agreements to exclude non-cash expenses resulting from any impairment or write-off of goodwill during DRC's 2012 fiscal year from the definition of Consolidated Earnings Before Interest, Tax and Amortization ("EBITDA") as presented in our financial covenants.
At
September 30, 2012
, we were in compliance with our loan covenants. Our most stringent financial covenant is the fixed charge coverage ratio. This covenant requires us to maintain a ratio of adjusted consolidated EBITDA to adjusted consolidated interest expense of not less than 1.25 to 1.00. At
September 30,
2012, our fixed charge coverage ratio was 1.63 to 1.00. This fixed charge coverage ratio is tested on a quarterly basis and is measured on a trailing four fiscal quarter basis.
Effective September 30, 2011, we entered into an interest rate swap agreement with an initial notional amount of $40.0 million of the term loan to manage its exposure to interest rate changes. The swap effectively converts a portion of our variable rate debt under the term loan to a fixed rate, without exchanging the notional principal amounts.
Under this agreement, we receive a floating rate based on the 90-day LIBOR rate and pay a fixed rate of 4.18% (including the applicable margin of 3.50%) on the outstanding notional amount. The swap fixed rate was structured to mirror the payment terms of the term loan for the two-year period. The fair value of the swap at inception was zero. It is not expected that any gains or losses will be reported in the statement of operations during the term of the agreement as the swap is expected to be highly effective through its maturity based on the matching terms of the swap and facility agreements.
If, at any time, the swap is determined to be ineffective, in whole or in part, due to changes in the interest rate swap or underlying debt agreements, the fair value of the portion of the swap determined to be ineffective will be recognized as a gain or loss in the statement of operations for the applicable period. The swap agreement is scheduled to expire in September 2013.
Approximately 148,000 shares issued through DRC's employee stock purchase plan between July 2007 and May 2011, at purchase prices ranging from $6.63 to $14.12 per share, were not registered under the federal securities law. We intend to offer to rescind the sales of approximately 72,000 shares that retain rights of rescission pursuant to applicable statutes of limitations. The amount of cash expected to be paid to the original purchasers for the repurchase of these shares is approximately $0.7 million, plus interest. The cost to repurchase these shares, based on the September 28, 2012 stock price of $6.85, exceeded market value by $0.2 million. If the fair market value of our common stock decreases before such repurchase, it may materially increase the cost to us for such repurchase, impacting our financial condition and cash flows.
In December 2010, DRC's board of directors authorized a share repurchase program, which allowed us to buy back up to 700,000 shares of our common stock through June 6, 2011. During the first half of 2011, we repurchased 20,728 shares at a weighted average price of $14.97. The timing, price and amount of repurchases were determined by management based on its evaluation of market conditions and other factors. These repurchases were made through the open market, including block purchases, in private negotiated transactions, or otherwise. The buyback was funded through available cash balances or borrowings.
During the first nine months of 2012, the average outstanding balance of our senior term loan was $76.2 million at a weighted average interest rate of 4.15% compared to 4.62% in the first nine months of 2011. In addition, the interest rate of our $40.0 million subordinated loan was 13.0%.