Consolidated sales increased by $885.7 million, or 38.2%, to $3,201.6 million for the 2004 First Half from $2,315.9 million for the 2003 First Half. Organic sales growth for our defense businesses was 15.8%, or $320.2 million, driven by continued strong demand for L-3's secure communications and ISR systems
and products, aircraft modernization and maintenance, training and government services, training devices, guidance, navigation and imaging products and naval power equipment and services. Organic sales for our commercial and other non-military businesses increased by 0.9%, or $2.5 million, primarily due to increased volume for commercial aviation products partially offset by lower sales for explosives detection systems (EDS). The increase in consolidated sales from acquired businesses was $563.0 million, or 24.3%.
Sales from "Contracts, primarily U.S. Government" increased by $852.6 million, or 42.1%, to $2,876.0 million for the 2004 First Half from $2,023.4 million for the 2003 First Half. The increase in sales from acquired businesses was $535.6 million, or 26.5%. The acquired businesses include Aeromet, Avionics Systems, Klein, MAS, Vertex, and certain defense and aerospace assets of IPICOM, Inc., all of which were acquired in 2003, and AVYSIS, Bay Metals, Beamhit, Brashear and the GEDD business, all of which were acquired in the 2004 Second Quarter. Organic sales growth was $317.0 million, or 15.7%, primarily because of higher sales volume for our secure communications and ISR systems and products, aircraft modernization and maintenance, training and government services, training devices, guidance, navigation and imaging products and naval power equipment and services. Organic sales growth does not include the portion of the AMCOM contract sales of $43.8 million attributable to Vertex's pre-acquisition ownership interest of 40% in the contract, which are included in sales from acquired businesses.
Sales from "Commercial, primarily products" increased by $33.1 million, or 11.3%, to $325.6 million for the 2004 First Half from $292.5 million for the 2003 First Half. The increase in sales from the Avionics Systems and Flight Systems Engineering acquired businesses, both acquired in 2003, was $27.4 million. Organic sales increased by 1.9%, or $5.7 million, primarily due to the increased volume for commercial aviation products, partially offset by lower sales of EDS systems.
Consolidated costs and expenses increased by $793.6 million, or 38.2%, to $2,871.9 million for the 2004 First Half from $2,078.3 million for the 2003 First Half, primarily as a result of the increase in sales.
Costs and expenses for "Contracts, primarily U.S. Government" increased by $779.5 million, or 43.4%, to $2,575.9 million for the 2004 First Half from $1,796.4 million for the 2003 First Half. The increase in costs and expenses from acquired businesses was $494.4 million. The remaining increase is primarily attributed to organic sales growth from our defense businesses. SG&A, IRAD and B&P costs included in costs and expenses for "Contracts, primarily U.S. Government" were $279.4 million for the 2004 First Half and $237.4 million for the 2003 First Half. See Note 5 to our unaudited condensed consolidated financial statements.
Costs and expenses for "Commercial, primarily products" increased by $14.1 million, or 5.0%, to $296.0 million for the 2004 First Half from $281.9 million for the 2003 First Half. Cost of sales increased by $5.1 million to $193.1 million for the 2004 First Half from $188.0 million for the 2003 First Half. The increase in cost of sales was primarily due to increased costs attributable to the Avionics Systems acquired business and higher sales volume for our commercial aviation products, partially offset by reduced costs attributable to lower sales volume for EDS systems. SG&A expenses increased by $1.0 million to $70.4 million for the 2004 First Half from $69.4 million for the 2003 First Half, but declined as a percentage of sales to 21.6% from 23.7% due to cost and expense reductions and sales volume increases. R&D expenses increased by $8.0 million to $32.5 million for the 2004 First Half from $24.5 million for the 2003 First Half. The increase was primarily due to the Avionics Systems acquired business and its development expenditures for Smartdeck™.
Consolidated operating income increased by $92.1 million, or 38.8%, to $329.7 million for the 2004 First Half from $237.6 million for the 2003 First Half. The increase was primarily due to higher sales from all of our segments. Consolidated operating margin was unchanged at 10.3% for the 2004 First Half compared to the 2003 First Half. The changes in the operating margins for our segments are discussed below.
Operating income for "Contracts, primarily U.S. Government" increased by $73.1 million, or 32.2%, to $300.1 million for the 2004 First Half from $227.0 million for the 2003 First Half. Operating margin decreased by 0.8 percentage points to 10.4% for the 2004 First Half from 11.2% for the 2003 First Half.
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Operating margin decreased primarily because of lower operating margins, which we expected, from the Vertex acquired business and the AMCOM contract, which have lower margins than our other U.S. Government contractor businesses.
Operating income for "Commercial, primarily products" increased by $19.0 million, or 179.2%, to $29.6 million for the 2004 First Half from $10.6 million for the 2003 First Half. Operating margin increased by 5.5 percentage points to 9.1% for the 2004 First Half from 3.6% for the 2003 First Half. The increase is primarily because of higher margins from the Avionics Systems acquired business and cost and expense reductions at our PrimeWave Communications and commercial technical support services businesses, partially offset by development expenditures for Smartdeck™ and lower sales volume for EDS systems.
Interest expense increased by $6.0 million to $71.9 million for the 2004 First Half from $65.9 million for the 2003 First Half because of higher levels of outstanding debt during the 2004 First Half compared to the levels of outstanding debt during the 2003 First Half due to the sale of $400.0 million of 6 1/8% senior subordinated notes in December of 2003 and the sale of $400.0 million of 6 1/8% senior subordinated notes in May of 2003, which was partially offset by the early retirement of our $180.0 million of 8½% senior subordinated notes in June of 2003 and the conversions and redemptions of our $300.0 million of 5¼% convertible senior subordinated notes in January of 2004.
For the 2004 First Half, other expense (income), net, includes a $2.6 million loss for our pro rata share of the losses related to our investments accounted for using the equity method, and a $1.9 million loss related to an increase in the liability that represents the fair value assigned to the embedded derivatives related to the CODES.
The income tax provision for the 2004 First Half is based on the estimated effective income tax rate for 2004 of 36.5%, compared with the effective income tax rate of 36.0% for the 2003 Second Quarter. The 2004 effective income tax rate includes the current R&E Credit through its expiration date of June 30, 2004, whereas the 2003 effective income tax rate includes the R&E Credit for the entire year for 2003.
Basic EPS increased by $0.44 to $1.52 for the 2004 First Half from $1.08 for the 2003 First Half. Diluted EPS increased by $0.44 to $1.47 for the 2004 First Half from $1.03 for the 2003 First Half. Net income for the 2003 First Half includes an after-tax charge of $7.2 million, or $.07 per diluted share, for the early retirement of our $180.0 million of 8½% senior subordinated notes. Excluding this debt retirement charge, diluted EPS would have increased by $0.37 for the 2004 First Half compared to the 2003 First Half.
The diluted EPS computation for the 2004 and 2003 First Half did not include the effect of the 7.8 million shares of L-3 Holdings common stock that are issuable upon conversion of the CODES because the conditions required for them to become convertible were not satisfied. However, if the CODES had been convertible, diluted EPS would have been $0.05 lower than reported for the 2004 First Half and $0.02 lower than reported for the 2003 First Half.
Secure Communications & ISR
Sales within our Secure Communications & ISR segment increased by $117.6 million, or 17.3%, to $797.9 million for the 2004 First Half from $680.3 million for the 2003 First Half. Organic sales growth was $94.7 million, or 13.9%, reflecting continued strong demand from the DoD and other U.S. Government agencies for our secure communications and ISR systems and products. The increase in sales from acquired businesses was $22.9 million, or 3.4%. The acquired businesses include Aeromet and certain defense and aerospace assets of IPICOM, Inc., which were acquired in 2003.
Operating income increased by $28.1 million to $103.0 million for the 2004 First Half from $74.9 million for the 2003 First Half because of higher sales volume and operating margin. Operating margin increased by 1.9 percentage points to 12.9% for the 2004 First Half from 11.0% for the 2003 First Half, primarily because of organic sales growth, cost reductions and lower operating losses for the PrimeWave Communications business. These improvements to operating margin were partially offset by a loss related to the design, development and testing activities on a production contract for transportable tactical satellite communications terminals, which reduced operating margin by 0.8 percentage points.
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Training, Simulation & Government Services
Sales within our Training, Simulation & Government Services segment increased by $80.7 million, or 16.1%, to $582.0 million for the 2004 First Half from $501.3 million for the 2003 First Half. Organic sales growth was $76.7 million, or 15.3%, driven by increased sales of training and government services. The increase in sales from acquired businesses was $4.0 million. The acquired businesses include Beamhit and the GEDD business, which were both acquired during the 2004 Second Quarter.
Operating income increased by $6.8 million to $67.2 million for the 2004 First Half from $60.4 million for the 2003 First Half because of higher sales volume, partially offset by lower operating margin. Operating margin decreased by 0.5 percentage points to 11.5% for the 2004 First Half from 12.0% for the 2003 First Half. The decrease was primarily due to higher sales from cost-reimbursable type and time-and-material type contracts, which generally have lower profit margins than fixed-priced type contracts.
Aviation Products & Aircraft Modernization
Sales within our Aviation Products & Aircraft Modernization segment increased by $667.7 million, or 164.4%, to $1,073.8 million for the 2004 First Half from $406.1 million for the 2003 First Half. The increase in sales from acquired businesses was $526.1 million. The acquired businesses include Vertex, MAS, Avionics Systems and Flight Systems Engineering, which were acquired during 2003, and AVYSIS, which was acquired during the 2004 Second Quarter. Organic sales growth was $141.6 million, or 34.9%, driven by sales of $65.6 million from the AMCOM contract, $50.9 million for aircraft modernization due to strong DoD demand and an increase of $25.1 million primarily for commercial aviation products. Organic sales growth does not include the portion of the AMCOM contract sales of $43.8 million attributable to Vertex's pre-acquisition ownership interest of 40% in the contract, which are included in sales from acquired businesses above.
Operating income increased by $49.5 million to $104.0 million for the 2004 First Half from $54.5 million for the 2003 First Half because of higher sales volume partially offset by lower operating margin. Operating margin declined by 3.7 percentage points to 9.7% for the 2004 First Half from 13.4% for the 2003 First Half. Margins from acquired businesses, primarily Vertex, decreased operating margin by 1.7 percentage points. The AMCOM contract decreased operating margin by 0.9 percentage points. The remaining decrease is primarily due to higher sales volume for aircraft modernization and maintenance, which typically generate lower operating margins than sales of commercial aviation products.
Specialized Products
Sales within our Specialized Products segment increased by $19.7 million, or 2.7%, to $747.9 million for the 2004 First Half from $728.2 million for the 2003 First Half. Organic sales growth was $9.7 million, or 1.3%. The increase was driven by increased sales of $45.7 million primarily for training devices, guidance, navigation and imaging products, naval power equipment and services and $23.6 million for maintenance of security systems, primarily EDS. These increases were partially offset by volume declines of $18.4 million for ruggedized computers and displays and lower volume of $26.9 million for EDS systems during the 2004 First Half. Sales for undersea warfare products also declined by $14.3 million due to contracts nearing completion and reliability problems on an undersea dipping sonar product that are being remediated, which reduced production and sales. The increase in sales from acquired businesses was $10.0 million. The acquired businesses include Klein, which was acquired in September 2003, and Bay Metals and Brashear, which were both acquired during the 2004 Second Quarter.
Operating income increased by $7.7 million to $55.5 million for the 2004 First Half from $47.8 million for the 2003 First Half primarily because of cost reductions and volume increases for navigation and imaging products, naval power equipment and services and microwave components, which were partially offset by an increase in the estimated costs to remediate the product liability problems on an undersea dipping sonar product. Operating margin increased by 0.8 percentage points to 7.4% for the 2004 First Half from 6.6% for the 2003 First Half. Operating margin increased by 1.9 percentage points primarily due to volume increases and cost reductions for guidance, navigation and imaging products and naval power
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equipment and services. These increases were partially offset by decreases of 0.5 percentage points because of an increase in the estimated costs to remedy product reliability problems on an undersea dipping sonar product and 0.6 percentage points due to lower EDS volume.
LIQUIDITY AND CAPITAL RESOURCES
Balance Sheet
Contracts in process increased by $156.1 million to $1,771.4 million at June 30, 2004 from $1,615.3 million at December 31, 2003. See Note 5 to the unaudited condensed consolidated financial statements. The increase included $23.5 million related to acquired business and $132.6 million principally from:
 | |
| • | increases of $52.6 million in unbilled contract receivables, due to sales exceeding deliveries and billings for secure communications and ISR systems and products and training and government services. These increases were partially offset by a decrease in unbilled contract receivables for aircraft modernization due to milestone billings and lower EDS sales; |
| |
| • | increases of $32.5 million in billed receivables because of deliveries and billings for aircraft modernization and higher sales volume of secure communications systems and products and slower collections for certain secure communication contracts due to timing. These increases were partially offset by a reduction in billed receivables for EDS due to lower sales volumes and improved collections for government services; |
| |
| • | increases of $32.2 million in inventoried contract costs, primarily for secure communications and ISR systems and products due to the procurement of aircraft for proprietary programs, and ruggedized computers and displays. These increases were partially offset by a decrease for secure communications and ISR systems and products due to deliveries during the period; and |
| |
| • | increases of $15.3 million in inventories at lower of cost or market due to increases for security products, primarily EDS, partially offset by decreases for commercial aviation products due to higher sales volume. |
L-3's days receivable outstanding (DRO) was 70.3 at June 30, 2004, unchanged from our DRO at December 31, 2003. We calculate our DRO by dividing (i) our aggregate end of period billed receivables and net unbilled contract receivables, by (ii) our sales for the last twelve-month period adjusted on a pro forma basis to include sales from acquisitions that we completed as of the end of the period (which amounted to $6,361.5 million for the twelve-month period ended June 30, 2004), multiplied by 365.
L-3's days inventory held (DIH) was 35.3 at June 30, 2004, compared with 36.3 at December 31, 2003. We calculate DIH by dividing (i) our aggregate end of period net inventoried contract costs and inventories at lower of cost or market, by (ii) our cost of sales for the last twelve-month period adjusted on a pro forma basis to include cost of sales from acquisitions that we completed as of the end of the period (which amounted to $5,655.8 million for the twelve-month period ended June 30, 2004), multiplied by 365.
Included in contracts in process at June 30, 2004 are net billed receivables of $6.7 million and net inventories of $12.7 million related to our PrimeWave Communications business. At December 31, 2003, we had $6.7 million of net billed receivables and $11.4 million of net inventories related to our PrimeWave Communications business.
The decrease in property, plant and equipment (PP&E) during the 2004 First Half was principally related to depreciation expense and disposals, partially offset by capital expenditures. The percentage of depreciation expense to average gross PP&E increased to 6.3% for the 2004 First Half from 6.0% for the 2003 First Half. The increase was attributable to the impact of business acquisitions completed during 2003. We did not change any of the depreciation methods or assets estimated useful lives that L-3 uses to calculate its depreciation expense.
Goodwill increased by $96.7 million to $3,749.1 million at June 30, 2004 from $3,652.4 million at December 31, 2003. The increase was comprised of (i) $71.1 million for acquisitions completed during the
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2004 First Half, (ii) $22.8 million for increases to purchase price payments for certain acquisitions completed prior to January 1, 2004, related to final closing date net assets of the acquired businesses and contingent purchase price adjustments or earnouts, which were resolved during the period, and (iii) $2.8 million primarily related to final estimates of fair value for acquired assets and liabilities assumed on acquisitions completed prior to January 1, 2004.
The increase in accounts payable was due to increased purchases from third-party vendors and subcontractors as a result of higher volumes for contracts-in-process and the timing of payments for such purchases. The increase in accrued employment costs was due to the timing of payments of salaries and wages to employees. The increase in accrued interest was due to the timing of interest payments. The decrease in other current liabilities was primarily due to the payment of the remaining purchase price for the acquisition of certain aerospace and defense assets of IPICOM, Inc., and the payment upon settlement of a foreign currency hedging forward contract. The increase in pension and postretirement benefit liabilities was primarily due to pension expenses exceeding related cash contributions of $19.1 million. The increase in other liabilities was primarily due to the increase of the fair values of our outstanding interest rate swap agreements and the embedded derivatives related to the CODES.
Statement of Cash Flows
Six Months Ended June 30, 2004 Compared with Six Months Ended June 30, 2003
Cash increased to $228.0 million at June 30, 2004 from $134.9 million at December 31, 2003. The table below provides a summary of our cash flows for the periods indicated.
| | | | | | | | | | |
| | | Six Months Ended June 30, |
| | | 2004 | | 2003 |
| | | (in millions) |
| Net cash from operating activities | | $ | 244.0 | | | $ | 208.3 | |
| Net cash used in investing activities | | | (159.4 | ) | | | (257.1 | ) |
| Net cash from financing activities | | | 8.5 | | | | 220.7 | |
| Net increase in cash | | $ | 93.1 | | | $ | 171.9 | |
|
Operating Activities
We generated $244.0 million of cash from operating activities during the 2004 First Half, an increase of $35.7 million from the $208.3 million generated during the 2003 First Half. Net income adjusted for non-cash expenses and deferred income taxes increased by $79.3 million to $302.1 million for the 2004 First Half from $222.8 million for the 2003 First Half. Deferred income taxes increased primarily because of larger estimated tax deductions arising from our recent acquisitions. Non-cash expenses consist primarily of contributions of L-3 Holdings' common stock to employee savings plans of $24.3 million and depreciation and amortization of $58.8 million. During the 2004 First Half, the use of cash related to the change in operating assets and liabilities was $58.1 million, compared to $14.5 million for the 2003 First Half. The use of cash for contracts in process was primarily driven by increases in unbilled contract receivables, billed receivables and inventoried contract costs for our defense businesses, as discussed above under "Liquidity and Capital Resources — Balance Sheet." The use of cash for other current assets was primarily due to deposits paid to vendors and insurance premiums paid during the 2004 First Half. These prepaid insurance premiums will be expensed over the second half of 2004. The source of cash for accounts payable was due to increased purchases of materials, components and services and the timing of payments for such purchases. The timing of payments to employees for salaries and wages was a source of cash because costs and expenses for salaries and wages exceeded cash payments for them. The use of cash for other current liabilities was primarily due to the payment upon settlement of a foreign currency hedging forward contract and cash payments for costs incurred in excess of estimated contract value for certain contracts in a loss position. These uses of cash were partially offset by cash received from billings in excess of costs incurred for certain training and satellite communications contracts. The source of cash from the change in pension and postretirement benefit liabilities was due to expenses exceeding related cash contributions.
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We expect to generate net cash from operating activities of between $535 million and $545 million for the full year 2004, including a deferred income tax provision of approximately $100 million, and a use of cash of approximately $120 million for changes in operating assets and liabilities, including working capital. Additionally, we expect the use of cash for contracts in process, which amounted to $119.1 million for the first quarter of 2004 and $13.5 million for the 2004 Second Quarter, to decline significantly during the second half of 2004.
Our cash interest payments, which are based on the fixed rate coupons and the interest payment dates of our debt, were approximately $29 million for the first quarter of 2004 and $30 million for the 2004 Second Quarter. These cash interest payments, before any potential savings from our interest rate swap agreements, are expected to be approximately $44 million for the third quarter of 2004 and approximately $30 million for the fourth quarter of 2004. The interest payments for the third quarter of 2004 are expected to exceed those for each of the other three quarters of 2004 because of the timing of the interest coupon payments on the $400.0 million of 6 1/8% Senior Subordinated Notes we sold in December 2003, which are paid in January and July, commencing July 2004.
We expect to generate a deferred income tax provision of approximately $100 million for the full year 2004. This estimate of deferred income taxes for 2004 will probably increase, if we acquire additional businesses during 2004. L-3 receives substantial income tax deductions from its acquisitions of businesses that are structured as asset purchases for income tax purposes. The effect of these income tax deductions is that our cash payments for income taxes are less than our provision for income taxes reported on the statement of operations. This difference is presented in the deferred income tax provision on our statement of cash flows. The deferred income tax provision primarily results from deducting amortization of tax intangibles, including goodwill, from the acquisitions structured as asset purchases on L-3's income tax returns over 15 years, in accordance with income tax rules and regulations, while no goodwill amortization is recorded for financial reporting purposes, in accordance with SFAS No. 142. We expect our business acquisitions that have been structured as asset purchases for income tax purposes to continue to generate substantial annual deferred tax benefits through 2017. While these income tax deductions are reported as changes to deferred income tax liabilities and assets, they are not differences that are scheduled to reverse in future periods from normal operations. Rather, they will only reverse if L-3 sells its acquired businesses or incurs a goodwill impairment loss for them, because in either case, L-3's financial reporting amounts for goodwill would be greater than the income tax basis for goodwill.
Investing Activities
During the 2004 First Half, we used $131.3 million of cash for acquisitions of businesses. We paid $90.2 million to acquire Beamhit, Brashear, GEDD, AVISYS and Bay Metals. We paid $11.5 million for the final contractual purchase price adjustment for the Vertex acquired business. We also paid $29.6 million primarily for the remaining contractual purchase price for certain aerospace and defense assets of IPICOM, Inc., which is subject to adjustment based on net assets acquired, and for earnouts, most of which were accrued as other current liabilities at December 31, 2003. During the 2003 First Half, we used $219.9 million of cash to acquire businesses, primarily for our acquisition of Avionics Systems.
We make capital expenditures for the improvement of manufacturing facilities and equipment. We expect to use approximately $105 million of cash for capital expenditures, net of cash proceeds from dispositions of property, plant and equipment, for the full year of 2004.
Financing Activities
Debt
Senior Credit Facilities. At June 30, 2004, available borrowings under our senior credit facilities were $669.9 million, after reductions for outstanding letters of credit of $80.1 million. There were no outstanding borrowings under our senior credit facilities at June 30, 2004.
Redemptions. On December 22, 2003, L-3 Holdings announced a full redemption of $300.0 million of its 5.25% Convertible Senior Subordinated Notes due 2009 (Convertible Notes), which expired on
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January 9, 2004. At December 31, 2003, holders of approximately $1.6 million of the Convertible Notes had exercised their conversion rights and converted such notes into 40,000 shares of L-3 Holdings common stock. On January 9, 2004, holders of $298.2 million of the Convertible Notes exercised their conversion rights and converted such notes into 7,317,327 shares of L-3 Holdings common stock. The remaining $0.2 million of Convertible Notes were redeemed for cash on January 12, 2004.
Interest Rate Swap Agreements. Depending on interest rate levels, we may enter into interest rate swap agreements to convert certain of our fixed interest rate debt obligations to variable interest rates, or terminate any existing interest rate swap agreements. The variable interest rate that we pay under the swap agreements is equal to (i) the variable rate basis, plus (ii) the variable rate spread. The table below presents our interest rate swap agreements that are currently outstanding.
| | | | | | | | | | | | | | | | | | | | | | |
Inception
Date | | Fixed Rate Debt Obligation | | Notional
Amount | | Variable Rate
Basis | | Average
Variable
Rate Spread | | Interest
Settlement
Dates | | Break Even
USD LIBOR
Interest Rate(2) |
| | | | | | | (in millions) | | | | | | | | | | |
March
2004 | | $400.0 million of 6 1/8% Senior
Subordinated Notes due 2014 | | $200.0 | | Six-Month USD
LIBOR(1) | | 1.6% | | January 15
and
July 15 | | 4.53% |
| | | | | | | | | | | |
April
2004 | | $400.0 million of 6 1/8% Senior
Subordinated Notes due 2014 | | $100.0 | | Six-Month USD
LIBOR(1) | | 0.8% | | January 15
and
July 15 | | 5.33% |
|
| |
| (1) | The six-month USD LIBOR interest rate was 1.94% on June 30, 2004 and 1.16% on March 31, 2004. |
| |
| (2) | For every basis point (0.01%) that the six-month USD LIBOR Interest Rate is greater than the Break Even USD LIBOR Interest Rate indicated above, we will incur additional interest expense above the fixed interest rate. Conversely, for every basis point that the six-month USD LIBOR Interest Rate is less than the Break Even USD LIBOR Interest Rate indicated above, interest expense will be reduced from the fixed interest rate. Such additional interest expense or reduction, as the case may be, will equal $0.02 million for the interest rate swap agreements on the $200.0 million notional amount of senior subordinated notes, and $0.01 million for the interest rate swap agreements on the $100.0 million notional amount of senior subordinated notes. These amounts are calculated on a per annum basis until maturity. |
Outstanding interest rate swap agreements reduced interest expense by $1.8 million during the 2004 Second Quarter, compared to $1.3 million during the 2003 Second Quarter and by $2.1 million during the 2004 First Half, compared to $2.8 million during the 2003 First Half. Interest expense was reduced by $1.1 million for the 2004 Second Quarter, compared to $0.7 million for the 2003 Second Quarter and by $2.1 million for the 2004 First Half, compared to $1.2 million for the 2003 First Half for amortization of deferred gains on terminated interest rate swap agreements.
Debt Covenants. The senior credit facilities, senior subordinated notes and CODES agreements contain financial covenants and other restrictive covenants, which remain in effect so long as we owe any amount or any commitment to lend exists thereunder. We are in compliance with those covenants in all material respects. The borrowings under the senior credit facilities are guaranteed by L-3 Holdings and by substantially all of the material domestic subsidiaries of L-3 Communications on a senior basis. The payments of principal and premium, if any, and interest on the senior subordinated notes are unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally, by substantially all of L-3 Communications' restricted subsidiaries other than its foreign subsidiaries. The guarantees of the senior subordinated notes are junior to the guarantees of the senior credit facilities and rank pari passu with each other and the guarantees of the CODES. The CODES are unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally, by L-3 Communications and substantially all of its restricted subsidiaries other than its foreign subsidiaries. These guarantees rank junior to the guarantees of the senior credit facilities and rank pari passu with each other and the guarantees of the senior subordinated notes. See Note 8 to our consolidated financial statements for the fiscal year ended December 31, 2003, included in our Annual Report on Form 10-K filed on March 4, 2004, for a description of our debt and related financial covenants at December 31, 2003.
Equity
In January of 2004, we announced that our Board of Directors declared our first quarterly cash dividend of $0.10 per share. On March 15, 2004, we paid cash dividends of $10.5 million in aggregate to shareholders of record at the close of business on February 17, 2004.
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On April 27, 2004, we announced that our Board of Directors declared a regular quarterly dividend of $0.10 per share. On June 15, 2004, we paid cash dividends of $10.6 million in aggregate to shareholders of record at the close of business on May 17, 2004.
On July 14, 2004, we announced that our Board of Directors declared a regular quarterly dividend of $0.10 per share payable on September 15, 2004, to shareholders of record at the close of business on August 17, 2004.
Based upon our current level of operations, we believe that our cash from operating activities, together with available borrowings under the senior credit facilities, will be adequate to meet our anticipated requirements for working capital, capital expenditures, commitments, research and development expenditures, contingent purchase prices, program and other discretionary investments, dividends and interest payments for the foreseeable future. There can be no assurance, however, that our business will continue to generate cash flow at current levels, or that currently anticipated improvements will be achieved. If we are unable to generate sufficient cash flow from operations to service our debt, we may be required to sell assets, refrain from declaring quarterly dividends, reduce capital expenditures, refinance all or a portion of our existing debt or obtain additional financing. Our ability to make scheduled principal payments or to pay interest on or to refinance our indebtedness depends on our future performance and financial results, which, to a certain extent, are subject to general conditions in or affecting the defense industry and to general economic, political, financial, competitive, legislative and regulatory factors beyond our control. There can be no assurance that sufficient funds will be available to enable us to service our indebtedness, or make necessary capital expenditures and to make discretionary investments.
Contingencies
See Note 12 to the Unaudited Condensed Consolidated Financial Statements.
Recently Issued and Proposed Accounting Standards
In December of 2003, the Financial Accounting Standards Board (FASB) revised its FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46R). FIN 46R clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements. FIN 46R requires that a business enterprise review all of its legal structures used to conduct its business activities, including those to hold assets, and its majority-owned subsidiaries, to determine whether those legal structures are variable interest entities (VIEs) required to be consolidated for financial reporting purposes by the business enterprise. Generally, a VIE is a legal structure for which the holders of a majority voting equity (ownership) interest may not have a controlling financial interest in the legal structure. Variable interests in a VIE are the contractual, ownership, creditor or other pecuniary interests in the VIE that change with changes in the fair value of the net assets exclusive of variable interests. FIN 46R provides guidance for identifying legal structures which are VIEs and the variable interests in a VIE, and also provides guidance for determining whether a business enterprise shall consolidate a VIE. FIN 46R requires that a business enterprise that holds a significant variable interest in a VIE make new disclosures in its financial statements. We adopted the provisions of FIN 46R during the interim period ended March 31, 2004. We do not hold any significant interests in VIEs that require consolidation or additional disclosures.
On December 8, 2003, President Bush signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act"). This Act introduces a federal subsidy to employees who sponsor retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. In May of 2004, the FASB issued FASB Staff Position 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP 106-2). FSP 106-2 provides guidance on the accounting for the effects of the Act and requires certain disclosures regarding the effect of the federal subsidy provided by the Act. The guidance in FSP 106-2 applies only if (i) the prescription drug benefits under our defined benefit postretirement health care plan are considered actuarially equivalent to Medicare Part D and therefore qualify for the subsidy under the Act, and (ii) the expected subsidy will reduce our share of the cost of the underlying postretirement prescription drug coverage. FSP 106-2 is effective for the first interim period beginning after June 15, 2004.
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The amount of the accumulated postretirement benefit obligation or net periodic benefit cost recorded in the unaudited condensed consolidated financial statements and disclosed in the accompanying notes do not include the effects of the Act because we have not yet determined whether the benefits provided by our postretirement benefit plan are actuarially equivalent to Medicare Part D. We expect to make this determination by September 30, 2004.
On July 19, 2004, the Emerging Issues Task Force (EITF) of the FASB issued a draft abstract for EITF Issue No. 04-8, The Effect of Contingently Convertible Debt Effect on Diluted Earnings Per Share, which addresses when the dilutive effect of contingently convertible debt instruments should be included in diluted EPS. The draft abstract contains the EITF's tentative conclusion reached at their June 30 – July 1, 2004 meeting that contingently convertible debt instruments should be included in the computation of diluted EPS regardless of whether the market price trigger has been met, that such accounting treatment is effective for reporting periods ending after December 15, 2004, and prior period EPS amounts presented for comparative purposes should be restated. The EITF is scheduled to consider comments on their tentative conclusions in EITF Issue No. 04-8 at their September 29 – 30, 2004 meeting. The impact of including the dilution from the assumed conversion of L-3 Holdings' CODES on L-3 Holdings' diluted EPS for the 2004 Second Quarter and 2004 First Half and their comparative prior periods are discussed above under "Results of Operations".
Forward-Looking Statements
Certain of the matters discussed concerning our operations, cash flows, financial position, economic performance, and financial condition, including in particular, the likelihood of our success in developing and expanding our business and the realization of sales from backlog, include forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act.
Statements that are predictive in nature, that depend upon or refer to events or conditions or that include words such as "expects," "anticipates," "intends," "plans," "believes," "estimates" and similar expressions are forward-looking statements. Although we believe that these statements are based upon reasonable assumptions, including projections of orders, sales, operating margins, earnings, cash flow, research and development costs, working capital, capital expenditures and other projections, they are subject to several risks and uncertainties, and therefore, we can give no assurance that these statements will be achieved. Such statements will also be influenced by factors such as:
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| • | our dependence on the defense industry and the business risks peculiar to that industry, including changing priorities or reductions in the U.S. Government defense budget; |
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| • | our reliance on contracts with a limited number of agencies of, or contractors to, the U.S. Government and the possibility of termination of government contracts by unilateral government action or for failure to perform; |
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| • | our ability to obtain future government contracts on a timely basis; |
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| • | the availability of government funding and changes in customer requirements for our products and services; |
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| • | our significant amount of debt and the restrictions contained in our debt agreements; |
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| • | our ability to continue to retain and train our existing employees and to recruit and hire new qualified and skilled employees; |
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| • | our collective bargaining agreements and our ability to favorably resolve labor disputes should they arise; |
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| • | the business and economic conditions in the markets in which we operate, including those for the commercial aviation and communications markets; |
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| • | economic conditions, competitive environment, international business and political conditions and timing of international awards and contracts; |
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| • | our extensive use of fixed-price type contracts as compared to cost-reimbursable type and time-and-material type contracts; |
45
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| • | our ability to identify future acquisition candidates or to integrate acquired operations; |
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| • | the rapid change of technology and high level of competition in the communication equipment industry; |
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| • | our introduction of new products into commercial markets or our investments in commercial products or companies; |
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| • | pension, environmental or legal matters or proceedings and various other market, competition and industry factors, many of which are beyond our control; and |
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| • | the fair values of our assets including identifiable intangible assets and the estimated fair value of the goodwill balances for our reporting units which can be impaired or reduced by the other factors discussed above. |
Readers of this document are cautioned that our forward-looking statements are not guarantees of future performance and our actual results or developments may differ materially from the expectations expressed in the forward-looking statements.
As for the forward-looking statements that relate to future financial results and other projections, actual results will be different due to the inherent uncertainties of estimates, forecasts and projections and may be better or worse than projected and such differences could be material. Given these uncertainties, you should not place any reliance on these forward-looking statements. These forward-looking statements also represent our estimates and assumptions only as of the date that they were made. We expressly disclaim a duty to provide updates to these forward-looking statements, and the estimates and assumptions associated with them, after the date of this filing to reflect events or changes or circumstances or changes in expectations or the occurrence of anticipated events.
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ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See Part II, Item 7, "Management's Discussion and Analysis of Results of Operations and Financial Condition — Liquidity and Capital Resources — Derivative Financial Instruments," of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003 for a discussion of the Company's exposure to market risks. The only substantial change in those risks during the six months ended June 30, 2004 is discussed below.
Derivative Financial Instruments
Interest Rate Risk. Our financial instruments that are sensitive to changes in interest rates include borrowings under the senior credit facilities and interest rate swap agreements, all of which are denominated in U.S. dollars. The interest rates on the senior subordinated notes and CODES are fixed-rate and are not affected by changes in interest rates.
In March and April of 2004, we entered into new interest rate swap agreements on $300.0 million aggregate principal amount of our $400.0 million of 6 1/8% senior subordinated notes due 2014, to convert their fixed interest rates to variable rates. These new swap agreements are discussed above under "Management's Discussion and Analysis of Results of Operations and Financial Condition — Statement of Cash Flows — Financing Activities," of this report.
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ITEM 4.
CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to our management, including our Chairman and Chief Executive Officer and our President and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Our management, with the participation of our Chairman and Chief Executive Officer and our President and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2004. Based upon that evaluation and subject to the foregoing, our Chairman and Chief Executive Officer and our President and Chief Financial Officer concluded that the design and operation of our disclosure controls and procedures provided reasonable assurance that the disclosure controls and procedures are effective to accomplish their objectives.
In addition, there was no change in our internal control over financial reporting that occurred during the quarter ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II — OTHER INFORMATION
ITEM 1.
LEGAL PROCEEDINGS
From time to time we are involved in legal proceedings arising in the ordinary course of our business. We believe that we are adequately reserved for these liabilities and that there is no litigation that will have a material adverse effect on our consolidated results of operations, financial condition or cash flows. However, as discussed below, we are a party to a number of material litigations, for which an adverse determination could have a material adverse effect on our consolidated financial position, results of operations or cash flows.
On August 6, 2002, Aviation Communications & Surveillance Systems, LLC (ACSS), a subsidiary of L-3 Communications Corporation, was sued by Honeywell International Inc. and Honeywell Intellectual Properties, Inc. (collectively, "Honeywell") for alleged infringement of patents that relate to terrain awareness avionics. ACSS has been indemnified to a certain extent by Thales Avionics, which provided ACSS with the alleged infringing technology. Thales Avionics owns 30% of ACSS. Honeywell, Thales Avionics and ACSS have executed a settlement agreement resolving the matter with no liability to, and no restriction on, the operation of business by the Company or ACSS.
L-3 Integrated Systems and its predecessors have been involved in a litigation with Kalitta Air arising from a contract to convert Boeing 747 aircraft from passenger configuration to cargo freighters. The lawsuit was brought in the northern district of California on January 31, 1997. The aircraft were modified using Supplemental Type Certificates (STCs) issued in 1988 by the Federal Aviation Administration (FAA) to Hayes International, Inc. (Hayes/Pemco) as a subcontractor to GATX/Airlog Company (GATX). Between 1988 and 1990, Hayes/Pemco modified five aircraft as a subcontractor to GATX using the STCs. Between 1990 and 1994, Chrysler Technologies Airborne Systems, Inc. (CTAS), a predecessor to L-3 Integrated Systems, performed as a subcontractor to GATX and modified an additional five aircraft using the STCs. Two of the aircraft modified by CTAS were owned by American International Airways, the predecessor to Kalitta Air. In 1996, the FAA determined that the engineering data provided by Hayes/Pemco supporting the STCs was inadequate and issued an Airworthiness Directive that effectively grounded the ten modified aircraft. The Kalitta Air aircraft have not been in revenue service since that date. The matter was tried in January 2001 against GATX and CTAS with the jury finding fault on the part of GATX but rendering a unanimous defense verdict in favor of CTAS. Certain co-defendants had settled prior to trial. The U.S. Ninth Circuit Court of Appeals has reversed and remanded the trial court's summary judgment rulings in favor of CTAS regarding a negligence claim by Kalitta Air, which asserts that CTAS as an expert in aircraft modification should have known that the STCs were deficient, and excluding certain evidence at trial. Based on this ruling, a retrial has been scheduled for September 2004. In preparation of such retrial, Kalitta Air has submitted to us an expert report on damages that calculated Kalitta Air's damages at either $232 million or $602 million, depending on different factual assumptions. We have retained experts whose reports indicate that, even in the event of an adverse jury finding on the liability issues at trial, Kalitta Air has already recovered amounts from the other parties to the initial suit that more than fully compensated Kalitta Air for any damages it incurred. CTAS' insurance carrier has accepted defense of the matter with a reservation of its right to dispute its obligations under the applicable insurance policy in the event of an adverse jury finding. We have meritorious defenses and intend to continue to vigorously defend this matter. However, litigation is inherently uncertain and it is possible that an adverse decision could be rendered, which could have a material adverse effect on our consolidated financial position, results of operations or cash flows.
On November 18, 2002, we initiated a proceeding against OSI Systems, Inc. (OSI) in the United States District Court sitting in the Southern District of New York seeking, among other things, a declaratory judgment that we had fulfilled all of our obligations under a letter of intent with OSI (the "OSI Letter of Intent"). Under the OSI Letter of Intent, we were to negotiate definitive agreements with OSI for the sale of certain businesses we acquired from PerkinElmer, Inc. on June 14, 2002. On February 7, 2003, OSI filed an answer and counterclaims alleging, among other things, that we defrauded OSI,
49
breached obligations of fiduciary duty to OSI and breached our obligations under the OSI Letter of Intent. OSI seeks damages in excess of $100 million, not including punitive damages. Under the OSI Letter of Intent, we proposed selling to OSI the conventional detection business and the ARGUS business that we acquired from PerkinElmer, Inc. Negotiations with OSI lasted for almost one year and ultimately broke down over issues regarding, among other things, intellectual property, product-line definitions, allocation of employees and due diligence. Discovery on the matter is essentially complete. We believe that the claims asserted by OSI in its suit are without merit and intend to vigorously defend against the OSI claims.
L-3 Communications Vertex Aerospace LLC (formerly known as Vertex Aerospace LLC and acquired by L-3 Communications Corporation on December 1, 2003) (L-3 Vertex) is named as a defendant in three wrongful death lawsuits in the United States District Court, Western District of North Carolina arising from the crash of Air Midwest Flight 5481 at Charlotte-Douglas International Airport in Charlotte, North Carolina on January 8, 2003. The crash resulted in the deaths of nineteen passengers and two crewmembers. Each of the lawsuits alleges contributing factors, including that the accident was caused by the improper maintenance of the aircraft by L-3 Vertex, and seeks to recover compensatory and punitive damages. No discovery has taken place in the lawsuits at this time. Eighteen claims resulting from this incident have previously settled. The National Transportation Safety Board (NTSB) investigated the cause of the crash and has concluded that the crash was caused by the incorrect rigging of the elevator control system compounded by the airplane's center of gravity, which was substantially aft of the certified limit, with several other contributing factors. L-3 Vertex believes that it has meritorious defenses to the pending lawsuits, and intends to defend the cases vigorously. The actions have been tendered to L-3 Vertex's insurance carrier, who has accepted the defense of each action served upon L-3 Vertex to date. L-3 Vertex was also indemnified by Air Midwest for losses L-3 Vertex incurred arising out of its provision of maintenance services to Air Midwest. Based on the availability of insurance and the indemnification from Air Midwest, we do not believe we will have a material liability in this matter.
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ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On April 27, 2004, at the Company's annual meeting of Stockholders, the following proposals were acted:
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| (1) | Three nominees for the Board of Directors were elected to three-year terms expiring in 2007. The votes were as follows: |
| | | | | | | | | | |
| | | For | | Withheld |
| Thomas A. Corcoran | | | 91,558,914 | | | | 1,535,442 | |
| Claude R. Canizares | | | 91,741,840 | | | | 1,352,516 | |
| Alan H. Washkowitz | | | 90,626,052 | | | | 2,468,304 | |
|
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| (2) | The selection of PricewaterhouseCoopers LLP to serve as independent auditors for 2004 was ratified. The votes were as follows: |
| | | | | | |
| For | | | 90,812,817 | |
| Against | | | 2,216,079 | |
| Abstain | | | 65,460 | |
|
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| (3) | The Amendment of the 1999 Long-Term Performance Plan to increase the number of shares available for issuance was approved. The votes were as follows: |
| | | | | | |
| For | | | 64,755,817 | |
| Against | | | 8,550,965 | |
| Abstain | | | 481,510 | |
| Broker non-votes | | | 19,306,064 | |
|
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| (4) | The performance goals and other terms of performance-based awards under the 1999 Long-Term Performance plan were ratified. The votes were as follows: |
| | | | | | |
| For | | | 70,992,300 | |
| Against | | | 2,567,917 | |
| Abstain | | | 228,075 | |
| Broker non-votes | | | 19,306,064 | |
|
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ITEM 6.
EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
| | | | | | |
| Exhibit Number | | Description of Exhibit |
| | | |
| 3.1 | | Certificate of Incorporation of L-3 Communications Holdings, Inc. (incorporated by reference to Exhibit 3.1 to the Registrants' Quarterly Report on Form 10-Q for the period ended June 30, 2002). |
| | | |
| 3.2 | | By laws of L-3 Communications Holdings, Inc. (incorporated by reference to Exhibit 3.2 to the Registration Statement on Form S-1 (File No. 333-46975)). |
| | | |
| 3.3 | | Certificate of Incorporation of L-3 Communications Corporation (incorporated by reference to Exhibit 3.1 to L-3 Communications Corporation's Registration Statement on Form S-4 (File No. 333-31649)). |
| | | |
| 3.4 | | Bylaws of L-3 Communications Corporation (incorporated by reference to Exhibit 3.2 to L-3 Communications Corporation's Registration Statement on Form S-4 (File No. 333-31649)). |
| | | |
| *11 | | L-3 Communications Holdings, Inc. Computation of Basic Earnings Per Share and Diluted Earnings Per Share. |
| | | |
| **12.1 | | Ratio of Earnings to Fixed Charges. |
| | | |
| **31.1 | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d - 14(a) of the Securities Exchange Act, as amended. |
| | | |
| **31.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d - 14(a) of the Securities Exchange Act, as amended. |
| | | |
| **32 | | Section 1350 Certifications. |
|
| |
| * | The information required in this exhibit is presented in Note 10 to the Unaudited Condensed Consolidated Financial Statements as of June 30, 2004 in accordance with the provisions of SFAS No. 128, Earnings Per Share. |
| |
| ** | Filed herewith |
(b) Reports on Form 8-K
Current Report filed on April 27, 2004 announcing that L-3 Holdings' Board of Directors had declared L-3's regular quarterly dividend of $0.10 per share, payable on June 15, 2004, to shareholders of record at the close of business on May 17, 2004.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrants have duly caused this report to be signed on their behalf by the undersigned thereunto duly authorized.
| L-3 Communications Holdings, Inc. and
L-3 Communications Corporation
Registrants |
Date: August 9, 2004
/s/ Robert V. LaPenta
| Name: Robert V. LaPenta
Title: President and Chief Financial Officer
(Principal Financial Officer) |
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EXHIBIT INDEX
| | | | | | |
| Exhibit Number | | Description of Exhibit |
| 3.1 | | Certificate of Incorporation of L-3 Communications Holdings, Inc. (incorporated by reference to Exhibit 3.1 to the Registrants' Quarterly Report on Form 10-Q for the period ended June 30, 2002). |
| 3.2 | | By laws of L-3 Communications Holdings, Inc. (incorporated by reference to Exhibit 3.2 to the Registration Statement on Form S-1 (File No. 333-46975)). |
| 3.3 | | Certificate of Incorporation of L-3 Communications Corporation (incorporated by reference to Exhibit 3.1 to L-3 Communications Corporation's Registration Statement on Form S-4 (File No. 333-31649)). |
| 3.4 | | Bylaws of L-3 Communications Corporation (incorporated by reference to Exhibit 3.2 to L-3 Communications Corporation's Registration Statement on Form S-4 (File No. 333-31649)). |
| *11 | | L-3 Communications Holdings, Inc. Computation of Basic Earnings Per Share and Diluted Earnings Per Share. |
| **12.1 | | Ratio of Earnings to Fixed Charges. |
| **31.1 | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d- 14(a) of the Securities Exchange Act, as amended. |
| **31.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule15d- 14(a) of the Securities Exchange Act, as amended. |
| **32 | | Section 1350 Certifications. |
|
| |
| * | The information required in this exhibit is presented in Note 10 to the Unaudited Condensed Consolidated Financial Statements as of June 30, 2004 in accordance with the provisions of SFAS No. 128, Earnings Per Share. |
| |
| ** | Filed herewith |
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934![[ ]](https://capedge.com/proxy/10-Q/0000950136-04-002501/ebox.gif){kind=small}
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934![[X]](https://capedge.com/proxy/10-Q/0000950136-04-002501/cbox.gif){kind=small}
Yes