Nine Months Ended September 30, 2005 Compared with Nine Months Ended September 30, 2004
The tables below provide two presentations of sales, operating income and operating margin data for L-3 for the nine months ended September 30, 2005 (2005 Nine Month Period) and September 30, 2004 (2004 Nine Month Period). The first table presents the selected data segregated between L-3's U.S. Government contractor businesses and L-3's commercial businesses. The second table presents the selected data by reportable segment. See Note 15 to the unaudited condensed consolidated financial statements.
Consolidated sales increased by $1,558.7 million, or 31.3%, to $6,544.5 million for the 2005 Nine Months Period from $4,985.8 million for the 2004 Nine Month Period. Consolidated organic sales growth was 12.0%, or $598.7 million. Organic sales growth for our defense businesses was 12.0%, or $535.9 million, driven primarily by continued strong demand for secure networked communications and intelligence, surveillance and reconnaissance (ISR) systems and products, aircraft modernization and maintenance, government services, simulation devices, and naval power equipment products. Organic sales growth for our commercial businesses was 12.0%, or $62.8 million, primarily due to volume increases for security products and commercial aviation products. The increase in consolidated sales from acquired businesses was $960.0 million, or 19.3%, including $443.7 million due to the acquisition of Titan.
Sales from our Government Businesses increased by $1,438.2 million, or 32.2%, to $5,900.2 million for the 2005 Nine Month Period from $4,462.0 million for the 2004 Nine Month Period. The increase in sales from acquired businesses was $902.3 million, or 20.2%, including $443.7 million due to the acquisition of Titan. In addition to Titan, the acquired businesses also included Combat Propulsion Systems, Electron Technologies, Joseph Sheairs Associates, MAPPS, and SDG, Inc., which were acquired in 2005, and AVISYS, BAI Aerosystems, Bay Metals, Beamhit, Brashear, Cincinnati Electronics, D.P. Associates, Inc., Electronic Systems, the GEDD business and Sarnoff Video Security Systems, all of which were acquired in 2004. Sales from our Commercial Businesses increased by $120.5 million, or 23.0%, to $644.3 million for the 2005 Nine Month Period from $523.8 million for the 2004 Nine Month Period. The increase in sales from acquired businesses was $57.7 million, or 11.0%. The acquired businesses included ITC, Mobile-Vision and ALST, all of which were acquired in 2005 and Infrared Products, which was acquired in 2004.
Consolidated costs and expenses increased by $1,397.2 million, or 31.4%, to $5,853.9 million for the 2005 Nine Month Period from $4,456.7 million for the 2004 Nine Month Period. Costs and expenses for our Government Businesses increased by $1,283.0 million, or 32.3%, to $5,260.8 million for the 2005 Nine Month Period from $3,977.8 million for the 2004 Nine Month Period. Costs and expenses for our Commercial Businesses increased by $114.2 million, or 23.8%, to $593.1 million for the 2005 Nine Month Period from $478.9 million for the 2004 Nine Month Period.
The increase to costs and expenses for our Government Businesses due to acquired businesses was $789.5 million. The remaining increase is primarily attributable to organic sales growth. SG&A, IRAD and B&P costs included in cost of sales for our Government Businesses were $541.3 million for the 2005 Nine Month Period, compared to $436.7 million for the 2004 Nine Month Period. The increase of $104.6 million was primarily attributable to the acquired businesses and organic sales growth.
Cost of sales for our Commercial Businesses increased by $97.6 million to $418.5 million for the 2005 Nine Month Period from $320.9 million for the 2004 Nine Month Period. The increase in cost of sales was primarily due to increased costs attributable to higher sales volume for our security products and to the Infrared Products and Mobile-Vision acquired businesses. SG&A expenses increased by $17.3 million to $124.8 million for the 2005 Nine Month Period from $107.5 million for the 2004 Nine Month Period, and declined as a percentage of sales to 19.4% from 20.5% due primarily to higher sales volume. R&D expenses decreased by $0.7 million to $49.8 million for the 2005 Nine Month Period from $50.5 million for the 2004 Nine Month Period, primarily due to lower R&D expenses for our SmartdeckTM product partially offset by R&D at our Infrared Products business, which we acquired on November 9, 2004.
Consolidated operating income increased by $161.5 million, or 30.5%, to $690.6 million for the 2005 Nine Month Period from $529.1 million for the 2004 Nine Month Period. Consolidated operating margin was unchanged at 10.6% for both the 2005 and 2004 Nine Month Periods. The changes in the operating margins for our segments are discussed below. Operating income for our Government Businesses increased by $155.2 million, or 32.1%, to $639.4 million for the 2005 Nine Month Period from $484.2 million for the 2004 Nine Month Period. Operating margin decreased by 10 basis points to 10.8% for the 2005 Nine Month Period from 10.9% for the 2004 Nine Month Period. Operating income for our Commercial Businesses increased by $6.3 million, or 14%, to $51.2 million for the 2005
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Nine Month Period from $44.9 for the 2004 Nine Month Period. Operating margin decreased by 70 basis points to 7.9% for the 2005 Nine Month Period from 8.6% for the 2004 Nine Month Period, primarily due to lower margins on conventional airport security systems, partially offset by higher margins for commercial aviation products.
Interest expense increased by $29.7 million to $136.5 million for the 2005 Nine Month Period from $106.8 million for the 2004 Nine Month Period, primarily due to interest incurred on debt issued to finance the Titan acquisition.
Other (income) expense for the 2005 Nine Month Period was $6.4 million of income and was primarily comprised of interest income on our cash and cash equivalents, partially offset by a $3.0 million write-down of the carrying value of an equity investment. Other (income) expense for the 2004 Nine Month Period was $1.7 million of expense and was primarily comprised of an increase in the fair value of the embedded derivatives related to L-3's 2001 contingent convertible debt, which was converted into shares of L-3 Holdings' common stock in the fourth quarter of 2004, and losses on investments accounted for using the equity method.
Minority interests in net income of consolidated subsidiaries increased by $0.8 million to $7.9 million for the 2005 Nine Month Period from $7.1 million for the 2004 Nine Month Period, due to higher net income for Aviation Communications and Surveillance Systems LLC, partially offset by lower net income for Army Fleet Support LLC.
The income tax provision of 35.4% was based on an effective income tax rate of 36.5% for the 2005 Nine Month Period compared to an effective income tax rate of 36.5% for the 2004 Nine Month Period. The provision for the 2005 Nine Month Period was impacted by the favorable disposition of certain tax contingencies in the 2005 Third Quarter, partially offset by an increase to our effective tax rate as a result of the acquisition of Titan.
Basic EPS increased by $0.54 to $3.02 for the 2005 Nine Month Period from $2.48 for the 2004 Nine Month Period. Diluted EPS increased by $0.63, or 27.2%, to $2.95 for the 2005 Nine Month Period from $2.32 for the 2004 Nine Month Period. Diluted weighted-average common shares outstanding increased by 3.4% to 120.9 million for the 2005 Nine Month Period from 116.9 million for the 2004 Nine Month Period. In accordance with EITF Issue No. 04-8, diluted EPS and weighted-average diluted common shares outstanding for the 2004 Nine Month Period have been restated, resulting in a non-cash reduction to diluted EPS of $0.09.
C3ISR
Sales within our C3ISR segment increased by $224.6 million, or 18.1%, to $1,464.9 million for the 2005 Nine Month Period from $1,240.3 million for the 2004 Nine Month Period. The increase in sales from acquired businesses was $162.0 million, including $154.9 million as a result of the Titan acquired businesses. The acquired businesses also included BAI Aerosystems business, which was acquired in the fourth quarter of 2004. Organic sales growth was $62.6 million, or 5.0%, driven by an increase in secure network communications and upgrades of airborne mission and ISR systems for allied foreign governments, which was partially offset by volume declines for secure telephone equipment.
Operating income increased by $21.9 million to $178.5 million for the 2005 Nine Month Period from $156.6 million for the 2004 Nine Month Period. Operating margin decreased by 40 basis points to 12.2% for the 2005 Nine Month Period from 12.6% for the 2004 Nine Month Period, primarily due to lower margins on the acquired Titan businesses.
GOVERNMENT SERVICES
Sales within our Government Services segment increased by $375.9 million, or 49.1%, to $1,141.3 million for the 2005 Nine Month Period from $765.4 million for the 2004 Nine Month Period. The increase in sales from acquired businesses was $280.1 million, including $233.6 million as a result of the Titan acquired businesses. The acquired businesses also included Joseph Sheairs Associates, which was acquired in 2005, and Beamhit LLC, D.P. Associates Inc., the GEDD business and Sarnoff Video
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Security Systems, which were acquired in 2004. Organic sales growth was $95.8 million, or 12.5%, driven primarily by increased volume in international training services and logistics, communication systems and software engineering services for the U.S. Army and increased support services for the U.S. Missile Defense Agency.
Operating income increased by $18.0 million to $103.1 million for the 2005 Nine Month Period from $85.1 million for the 2004 Nine Month Period. Operating margin decreased by 210 basis points to 9.0% for the 2005 Nine Month Period from 11.1% for the 2004 Nine Month Period. Operating margins decreased by 160 basis points because of cost overruns on certain fixed price contracts, and lower absorption of indirect costs due primarily to timing of indirect cost recognition, which are expensed as incurred. The remaining decrease is primarily due to the Titan acquired businesses, which had lower margins than the other businesses in the segment.
AIRCRAFT MODERNIZATION AND MAINTENANCE
Sales within our Aircraft Modernization and Maintenance segment increased by $336.2 million, or 24.6%, to $1,704.9 million for the 2005 Nine Month Period from $1,368.7 million for the 2004 Nine Month Period. Organic sales growth was $269.0 million, or 19.7%, driven by higher sales for aircraft base operations, support and maintenance, aircraft modernization and maintenance, and the recently awarded competitive Canadian Maritime Helicopter Program (MHP). The increase in sales from acquired businesses was $67.2 million. The acquired businesses include AVISYS, Inc. and Electronics Systems, both of which were acquired in 2004.
Operating income increased by $28.4 million to $169.7 million for the 2005 Nine Month Period from $141.3 million for the 2004 Nine Month Period. Operating margin decreased by 30 basis points to 10.0% for the 2005 Nine Month Period from 10.3% for the 2004 Nine Month Period, primarily due to higher sales volume of lower margin aircraft base operations and support and maintenance, which are primarily performed under cost-reimbursable type and time-and-material type contracts.
SPECIALIZED PRODUCTS
Sales within our Specialized Products segment increased by $622.0 million, or 38.6%, to $2,233.4 million for the 2005 Nine Month Period from $1,611.4 million for the 2004 Nine Month Period. The increase in sales from acquired businesses was $450.7 million, including $55.1 million as a result of the Titan acquired businesses. The acquired businesses also included MAPPS, Boeing Electron Technologies, Combat Propulsion Systems, ITC, Mobile-Vision, SDG, Inc., and ALST, all of which were acquired in the 2005, and Bay Metals, Brashear LP, Infrared Products and Cincinnati Electronics, Inc., all of which were acquired in 2004. Organic sales growth was $171.3 million, or 10.6%, primarily due to higher sales volume for acoustic undersea anti-submarine warfare products, simulation devices and airport security systems. Organic growth was also due to higher volume for commercial aviation products during the 2005 First Quarter, primarily due to Federal Aviation Administration (FAA) mandates for Terrain Awareness Warning Systems (TAWS), which became effective in March 2005.
Operating income increased by $93.2 million to $239.3 million for the 2005 Nine Month Period from $146.1 million for the 2004 Nine Month Period. Operating margin increased by 160 basis points to 10.7% for the 2005 Nine Month Period from 9.1% for the 2004 Nine Month Period. Operating margin decreased by 90 basis points due to lower margins on airport security systems, and 10 basis points from the Titan acquired businesses. These decreases were offset by an increase of 120 basis points due to higher volume and cost reductions for aviation products and power & control systems, and 70 basis points due to higher sales volume and contract profit improvements for simulation devices. The remaining increase is primarily due to acquired businesses, which have higher margins than the other businesses in the segment.
LIQUIDITY AND CAPITAL RESOURCES
Balance Sheet
Contracts in process increased by $847.7 million to $2,826.7 million at September 30, 2005 from $1,979.0 million at December 31, 2004. The increase included (i) $689.0 million related to business acquisitions and (ii) $158.7 million principally from:
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| • | increases of $80.7 million in unbilled contract receivables due to sales exceeding deliveries and billings for ISR systems and products, aircraft modernization and maintenance and international training services and logistics. These increases were partially offset by decreases for simulation devices and aircraft base operations and maintenance due to deliveries and billings exceeding sales; |
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| • | increases of $46.4 million in billed receivables for aircraft base operations and maintenance, secure communication products and international training services. These increases were partially offset by collections for support services for the U.S. Missile Defense Agency; |
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| • | increases of $4.5 million in inventoried contract costs, primarily for simulation devices, naval power and propulsion products and fuzing products. These increases were partially offset by a decrease for ISR systems and products and aircraft operations and maintenance due to deliveries during the period; and |
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| • | increases of $27.1 million in inventories at lower of cost or market due to increases for airport security products and satellite communications products. |
L-3's days sales outstanding (DSO) was 74.0 at September 30, 2005 compared with 71.8 at December 31, 2004. The increase in DSO was primarily due to the timing items discussed above. We calculate our DSO 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 business acquisitions that we completed as of the end of the period (which amounted to $10,604.5 million for the twelve-month period ended September 30, 2005), multiplied by 365.
The increase in property, plant and equipment (PP&E) during the 2005 Nine Month Period was principally related to the Titan, Electron Technologies and Combat Propulsion Systems acquired businesses. The percentage of depreciation expense to average gross PP&E decreased slightly to 9.3% for the 2005 Nine Month Period from 9.5% for the 2004 Nine Month Period. 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 $2,860.4 million to $6,915.2 million at September 30, 2005 from $4,054.8 million at December 31, 2004. The increase was comprised of (i) $2,818.3 million for business acquisitions completed during the 2005 Nine Month Period, (ii) $21.7 million for additional purchase price payments for certain business acquisitions completed prior to January 1, 2005, related to final closing date net assets, and contingent purchase price adjustments or earnouts, which were resolved during the period, and (iii) net increases of $20.4 million primarily related to changes in estimates of fair value for acquired assets and liabilities assumed in connection with business acquisitions completed prior to January 1, 2005.
The increases in other current assets, accrued expenses, billings in excess of costs and estimated profits and other non-current liabilities were primarily due to balances from business acquisitions completed during the 2005 Nine Month Period. The increase in deferred debt issue costs was due to the debt issued to finance the Titan acquisition. See "Statement of Cash Flows — Financing Activities" below. The increase in other assets was primarily due to capitalized software development costs for new products, investments in equipment for training devices, as well as balances from business acquisitions. The increase in accounts payable was primarily due to balances from business acquisitions completed during the 2005 Nine Month Period, partially offset by a decrease in accounts payable due to the timing of payments for purchases from third-party vendors and subcontractors. The increase in accrued employment costs was primarily due to balances from business acquisitions completed during the 2005 Nine Month Period and to the timing of payments of salaries and wages to employees. Customer advances increased due to cash payments received for an aircraft modernization contract and an EDS contract with the Transportation Security Administration (TSA) and partially due to the business acquisitions completed during the 2005 Nine Month Period. The increase in other current liabilities was primarily due to balances from business acquisitions, as well as higher accrued interest balances due to the debt issued to finance the Titan acquisition. The increase in pension and
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postretirement benefit liabilities was primarily due to balances from business acquisitions, as well as pension expenses exceeding related cash contributions.
Statement of Cash Flows
Nine Months Ended September 30, 2005 Compared with Nine Months Ended September 30, 2004
Cash decreased by $427.1 million to $226.3 million at September 30, 2005 from $653.4 million at December 31, 2004. The table below provides a summary of our cash flows for the periods indicated.
| | | | | | | | | | |
| | | Nine Months Ended
September 30, |
| | | 2005 | | 2004 |
| | | (in millions) |
| Net cash from operating activities | | $ | 579.6 | | | $ | 408.0 | |
| Net cash used in investing activities | | | (3,445.9 | ) | | | (183.9 | ) |
| Net cash from financing activities | | | 2,439.2 | | | | 8.4 | |
| Net (decrease) increase in cash | | $ | (427.1 | ) | | $ | 232.5 | |
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Operating Activities
We generated $579.6 million of cash from operating activities during the 2005 Nine Month Period, an increase of $171.6 million from the $408.0 million generated during the 2004 Nine Month Period. Net income increased by $94.5 million. Non-cash expenses increased by $40.7 million to $260.0 million for the 2005 Nine Month Period from $219.3 million for the 2004 Nine Month Period, primarily for higher contributions to employee savings plans in L-3 Holdings' common stock of $8.9 million, higher depreciation expense of $12.6 million, higher amortization expense for identifiable intangible assets of $5.8 million, and higher deferred income tax expense of $11.3 million. During the 2005 Nine Month Period, cash used for changes in operating assets and liabilities decreased by $36.4 million to $37.5 million, from $73.9 million for the 2004 Nine Month Period. The use of cash for contracts in process was primarily driven by increases in billed and unbilled contract receivables for our defense businesses, as discussed above under "Liquidity and Capital Resources—Balance Sheet". The use of cash for other assets was primarily due to capitalized software development costs for new products and investments in equipment for simulation devices. The use of cash for accounts payable was due to the timing of payments for purchases from third-party vendors and subcontractors. The timing of payments to employees for salaries and wages was a source of cash because cost and expenses for salaries and wages exceeded the cash payments. The source of cash for customer advances was due to the receipt on certain foreign contracts and to orders received from the TSA for EDS. The source of cash from the change in pension and postretirement benefit liabilities was due to pension expenses exceeding related cash contributions. We made approximately $52.4 million of pension contributions during the 2005 Nine Month Period and we expect to contribute a total of approximately $90.0 million to our pension plans for all of 2005. The source of cash from other liabilities was primarily due to an increase in our workers compensation and deferred compensation obligations.
The source of cash from income taxes was due to our provision for income taxes exceeding our income tax payments, primarily because of income tax deductions for compensation expense arising from the exercise of employee stock options.
Investing Activities
During the 2005 Nine Month Period, we used $3,380.6 million of cash for business acquisitions. We paid $3,351.6 million in connection with our 2005 business acquisitions discussed above. We also paid $29.0 million primarily for the contractual purchase price adjustments relating to businesses acquired prior to 2005. During the 2004 Nine Month Period, we used $134.6 million of cash for business acquisitions, contractual purchase price adjustments relating to businesses acquired prior to 2004, and for the final contractual purchase price adjustment for the Vertex business acquisition.
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On July 29, 2005, we acquired all of the outstanding shares of The Titan Corporation for $23.10 per share in cash. The total transaction value was approximately $2,759.3 million, including the assumption of approximately $626.0 million of Titan's debt. The acquisition was financed using $357.4 million of cash on hand (approximately $25.2 million of which was acquired from Titan), $750.0 million of term loan borrowings under our senior credit facility, net proceeds from the issuances of $700.0 million of contingent convertible debt securities by L-3 Holdings and $1.0 billion of senior subordinated notes by L-3 Communications.
Financing Activities
Debt
Senior Credit Facility. On July 29, 2005, in connection with the Titan acquisition discussed above, we amended and restated our senior credit facility. The amended and restated credit facility provides for a term loan facility in an aggregate amount equal to $750.0 million in addition to the existing $1.0 billion revolving credit facility, both maturing on March 9, 2010. The cash received from the term loan borrowings was used to pay a portion of the aggregate consideration required for the acquisition of Titan. The loans under the term loan facility and revolving credit facility bear interest in the manner, and at the rates set forth in the previous senior credit facility. In addition, the consolidated leverage ratio covenant in the previous credit facility was amended to require that our consolidated leverage ratio be less than or equal to (1) 4.5 to 1.0 for each fiscal quarter ending on or prior to December 31, 2005, (2) 4.25 to 1 for the fiscal quarter ending on March 31, 2006 and (3) 4.0 to 1.0 for each fiscal quarter ending on or after June 30, 2006. Available borrowings under the senior credit facility at September 30, 2005 were $886.7 million, after reductions for outstanding letters of credit of $113.3 million. There were no outstanding revolving credit borrowings under our senior credit facility at September 30, 2005.
Debt Issuances. On July 29, 2005, L-3 Communications sold $1.0 billion of 6 3/8% Senior Subordinated Notes due October 15, 2015 (2005 Notes) at a discount of $9,100. Interest is payable semi-annually on April 15 and October 15 of each year. The net cash proceeds from this offering amounted to $973.4 million after deducting the discounts and commissions and were used to pay a portion of the aggregate consideration required for the acquisition of Titan.
On July 29, 2005, L-3 Holdings sold $600.0 million of 3% Convertible Contingent Debt Securities (CODES) due August 1, 2035. Interest is payable semi-annually on February 1 and August 1 of each year, commencing February 1, 2006. The net cash proceeds from this offering amounted to $585.0 million after deducting the commissions and were used to pay a portion of the aggregate consideration required for the acquisition of Titan. On August 4, 2005, L-3 Holdings sold an additional $100.0 million of CODES, pursuant to an over-allotment option exercised by the initial purchasers of the CODES.
The 2005 Notes and the CODES are general unsecured obligations and are subordinated in right of payment to all existing and future senior debt of L-3.
See Note 8 to the unaudited condensed consolidated financial statements for a detailed description of our debt.
Interest Rate Swap Agreements. Depending on current and expectations for future 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 paid by us is equal to (i) the variable rate basis, plus (ii) the variable rate spread. There are no interest rate swap agreements currently outstanding. See Note 8 to the Unaudited Condensed Consolidated Financial Statements for a table that presents the activity for our terminated interest rate swap agreements during 2005.
Including the amortization of net deferred gains, our previously outstanding interest rate swap agreements reduced interest expense by $0.8 million during the 2005 Third Quarter, compared to $3.1 million during the 2004 Third Quarter and by $2.8 million during the 2005 Nine Month Period, compared to $7.3 million during the 2004 Nine Month Period.
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Debt Covenants. The senior credit facility and indentures governing the senior subordinated notes contain financial covenants and other restrictive covenants. We are in compliance with those covenants in all material respects. See Note 8 to our consolidated financial statements for the fiscal year ended December 31, 2004, included in our Annual Report on Form 10-K filed on March 15, 2005, for a description of our debt and related financial covenants at December 31, 2004, as modified by the amendment and restatement discussed above. The borrowings under the senior credit facility are guaranteed by L-3 Holdings and by substantially all of the material wholly-owned 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 rank pari passu with one another and with the guarantees of the CODES and are junior to the guarantees of the senior credit facility. The CODES are unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally, by the existing and future domestic subsidiaries of L-3 that guarantee any other indebtedness of L-3 or any of its domestic subsidiaries. The guarantees of the CODES rank pari passu with all of the guarantees of the senior subordinated notes and are junior to the guarantees of the senior credit facility.
Equity
During 2005, L-3 Holdings' Board of Directors authorized the following quarterly cash dividends:
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Date
Declared | | Record
Date | | Cash
Dividends
Per Share | | Date
Paid | | Total
Dividends
Paid
(in millions) |
| February 10, 2005 | | February 22, 2005 | | $0.125 | | March 15, 2005 | | $14.5 |
| April 26, 2005 | | May 17, 2005 | | $0.125 | | June 15, 2005 | | $14.8 |
| July 12, 2005 | | August 17, 2005 | | $0.125 | | September 15, 2005 | | $15.0 |
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On October 11, 2005, L-3 Holdings' Board of Directors declared a regular quarterly dividend of $0.125 per share, payable on December 15, 2005 to shareholders of record at the close of business on November 17, 2005.
Anticipated Sources of Cash Flow
Our primary source of liquidity is cash flow generated from operations. We also have availability under our senior credit facility, subject to certain conditions. As of September 30, 2005, we had available borrowings of $886.7 million under our senior credit facility (excluding $113.3 million of outstanding letters of credit). Based upon our current level of operations, we believe that our cash from operating activities, together with available borrowings under the senior credit facility, will be adequate to meet our anticipated requirements for working capital, capital expenditures, commitments, contingencies, research and development expenditures, contingent purchase prices, assumed liabilities and pre-acquisition contingencies from acquired businesses, program and other discretionary investments, L-3 Holdings' 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, 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, to make necessary capital expenditures and to make discretionary investments.
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Contingencies and other uncertainties
For a discussion of risks and uncertainties that could impact our results of operation, financial condition, or cash flows, see Note 12 to the unaudited condensed consolidated financial statements.
RECENTLY ISSUED ACCOUNTING STANDARDS
In December of 2004, the FASB revised its FASB Statement No. 123, Accounting for Stock Based Compensation (SFAS 123) and renamed it FASB Statement No. 123, Share-Based Payment (SFAS 123R). SFAS 123R requires that compensation expense relating to share-based payment transactions be recognized in financial statements at estimated fair value. The scope of SFAS 123R includes a wide range of share-based compensation arrangements, including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. This standard replaces SFAS 123 and supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees. We are currently assessing the provisions of SFAS 123R. We previously elected not to adopt the fair value based method of accounting for stock-based employee compensation as permitted by SFAS 123. The adoption of SFAS 123R will result in the recording of non-cash compensation expenses, which we do not currently recognize in our financial statements. In accordance with SFAS 123, we disclose pro forma net income and earnings per share adjusted for non-cash compensation expense arising from the estimated fair value of share-based payment transactions. For a further discussion of our accounting for stock-based employee compensation and disclosure of our pro forma historical net income and earnings per share, see Note 3 to the unaudited condensed consolidated financial statements. On April 15, 2005, the SEC issued Release No. 33-8568, Amendment to Rule 4-01a of Regulation S-X Regarding the Compliance Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment. The SEC Release amends the effective date for compliance with SFAS 123R from July 1, 2005 to January 1, 2006.
In March of 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment (SAB 107). SAB 107 provides guidance to assist registrants in the initial implementation of SFAS 123R. SAB 107 includes, but is not limited to, interpretive guidance related to share-based payment transactions with nonemployees, valuation methods and underlying expected volatility and expected term assumptions, the classification of compensation expenses and accounting for the income tax effects of share-based arrangements upon adopting the SFAS 123R. We are currently assessing the guidance provided in SAB 107 in connection with the implementation of SFAS 123R. We expect that the impact of adopting SFAS 123R may result in a non-cash reduction to our diluted EPS in 2006 of approximately between $0.17 and $0.20.
The U.S. enacted the American Jobs Creation Act of 2004 (the American Jobs Creation Act) in October 2004 which contains many provisions affecting corporate taxation. The American Jobs Creation Act phases out the extraterritorial income (ETI) exclusion benefit for export sales and phases in a new tax deduction for income from qualified domestic production activities (QPA) over a transition period beginning in 2005. In December 2004, the FASB issued FASB Staff Position 109-1 (FSP 109-1), which provides guidance that the QPA deduction should be treated as a special income tax deduction as described in SFAS 109. As such, QPA has no impact on our deferred tax assets or liabilities existing as of the enactment date. Rather, the QPA deduction will be reported in the period that the deductions are claimed on the our income tax returns. We have completed our evaluation of the net impact of the American Jobs Creation Act, and have determined that the benefit from phase-in of the QPA deduction will be substantially equivalent to the lost benefit from the phase-out of the ETI exclusion in 2005. We also determined that the other provisions included in the American Jobs Creation Act will not have a significant impact on our financial position, results of operations or cash flows.
In May of 2005, the FASB issued SFAS Statement No. 154, Accounting Changes and Error Corrections, which requires retrospective application of all voluntary changes in accounting principles to all periods presented, rather than using a cumulative catch-up adjustment as currently required for most accounting changes under APB Opinion 20. This Statement replaces APB Opinion No. 20,
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Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and will be effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005.
In June of 2005, the FASB approved Emerging Issues Task Force (EITF) issued No. 05-06, Determining the Amortization Period for Leasehold Improvements (EITF 05-06). EITF 05-06 provides guidance on determining the amortization period for leasehold improvements acquired in a business combination or acquired subsequent to lease inception. The guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the lesser of the useful life of the assets or a term that includes renewals that are reasonably assured at the date of the business combination or purchase. The guidance is effective for periods beginning after June 29, 2005. EITF 05-06 is not expected to have a material impact on our financial position, results of operation or cash flows.
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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| • | the extensive legal and regulatory requirements surrounding our contracts with the U.S. Government and the results of any investigation of our contracts undertaken by the U.S. Government; |
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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, as well as our ability to retain and hire employees with U.S. Government security clearances that are required to perform work on classified contracts for the U.S. Government; |
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| • | actual future interest rates, volatility and other assumptions used in the determination of pension, benefits and stock options amounts; |
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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 we operate in, 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; |
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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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| • | the outcomes of litigations material to us to which we currently are, or to which we may become in the future, a party; |
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| • | the outcomes of current and future governmental investigations of our businesses, including acquired businesses; |
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| • | costs or difficulties related to the integration of the businesses of us and Titan may be greater than expected; |
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| • | anticipated cost savings from the Titan acquisition may not be fully realized or realized within the expected time frame; |
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| • | operating results following the Titan acquisition may be lower than expected; |
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| • | ultimate resolution of contingent matters, claims and investigations relating to Titan, including the impact on the final purchase price allocations; |
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| • | Titan's compliance with its plea agreement and consent to entry of judgment with the U.S. Government relating to the Foreign Corrupt Practices Act; |
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| • | competitive pressure among companies in our industry may increase significantly; |
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| • | pension, environmental or legal matters or proceedings, including the Kalitta and OSI Systems 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 the 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 our Annual Report on Form 10-K for the fiscal year ended December 31, 2004 for a discussion of our exposure to market risks. There were no substantial changes in those risks during the nine months ended September 30, 2005.
Derivative Financial Instruments
Interest Rate Risk. Our financial instruments that are sensitive to changes in interest rates include borrowings under an amended and restated credit facility that includes a revolving credit facility and a term loan facility, and interest rate swap agreements, if outstanding. All of our financial instruments that are sensitive to changes in interest rates 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 June of 2005, we terminated our interest rate swap agreement which was outstanding at December 31, 2004. At September 30, 2005, we did not have any interest rate swap agreements in place. We had outstanding term loan borrowings of $750.0 million under our amended and restated senior credit facility at September 30, 2005.
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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 Chief Executive Officer and our 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 Chief Executive Officer and our Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2005. Based upon that evaluation and subject to the foregoing, our Chief Executive Officer and our Chief Financial Officer concluded that the design and operation of L-3's disclosure controls and procedures provided reasonable assurance that L-3's disclosure controls and procedures are effective to accomplish their objectives.
In addition, as a result of our acquisition of The Titan Corporation in the third quarter of 2005, L-3 has expanded its internal controls over financial reporting to include Titan, and the internal controls over financial reporting pertaining to Titan will be considered as part of our consolidated evaluation of L-3's internal control over financial reporting for the year ending December 31, 2005. There was no change in L-3's internal control over financial reporting that occurred during the three months ended September 30, 2005, that has materially affected, or is reasonably likely to materially affect, L-3's 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 or assumed in connection with business acquisitions. In particular, at the time of the Titan acquisition, Titan had a number of pending legal matters and governmental investigations as further discussed in Note 12 to the Unaudited Condensed Consolidated Financial Statements. 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, we are a party to a number of material litigations, including the matters described below, for which an adverse determination could have a material adverse effect on our consolidated financial position, results of operations or cash flows.
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 subsequently 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. In preparation for retrial, Kalitta Air 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 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 we believe 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. The retrial began on January 18, 2005 and ended on March 2, 2005 with a deadlocked jury and mistrial. At trial, Kalitta Air claimed damages of $235 million. Although no date has been set for any further proceedings, a second retrial may be necessary in this matter. By order dated July 22, 2005, the Trial Court granted our motion for judgment as a matter of law as to negligence dismissing that claim, denied our motion for judgment as a matter of law as to negligent misrepresentation, and certified the decision for interlocutory appeal to the Ninth Circuit Court of Appeals. The Ninth Circuit has accepted the appeals and all proceedings at the District Court will be stayed pending resolution of the appeals. We believe that 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
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"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, breached obligations of fiduciary duty to OSI and breached our obligations under the OSI Letter of Intent. OSI has provided an expert report that calculated OSI's damages in the case at approximately $49.0 million, not including punitive damages and interest. 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. A trial has been set for February 2006. We believe that the claims asserted by OSI in its suit are without merit and intend to defend against the OSI claims vigorously. 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 and cash flows.
On July 1, 2004, lawsuits were filed on behalf of the estates of 31 Russian children in state courts of Washington, Arizona, California, Florida, New York and New Jersey against us, Honeywell, Honeywell TCAS, ACSS, Thales USA and Thales France. The suits are based on facts arising out of the crash over southern Germany of a Bashkirian Airways Tupelov TU 154M aircraft and a DHL Boeing 757 cargo aircraft. On-board the Tupelov aircraft were 12 crew members and 57 passengers, including 45 children. The Boeing aircraft carried a crew of three. Both aircraft were equipped with Honeywell/ACSS Model 2000, Change 7 Traffic Collision and Avoidance Systems. Sensing the other aircraft, the on-board DHL TCAS instructed the DHL pilot to climb, and the Tupelov on-board TCAS instructed the Tupelov pilot to descend. However, the Swiss air traffic controller ordered the Tupelov pilot to climb. The Tupelov pilot disregarded the on-board TCAS and put the Tupelov aircraft into climb striking the DHL aircraft in midair at approximately 35,000 feet. All crew and passengers of both planes were lost. Investigations by the NTSB after the crash revealed that both TCAS units were performing as designed. The suits allege negligence and strict product liability based upon the design of the units and the training provided to resolve conflicting commands and seek compensatory damages. Our insurers have accepted defense of the matter and retained counsel. The matters were consolidated in the Federal Court of New Jersey, which has dismissed the actions on the basis of forum non conveniens.
On April 4, 2005, Lockheed Martin Corporation (Lockheed) filed a lawsuit against L-3 Integrated Systems in the Federal District Court for the Northern District of Georgia alleging misappropriation of proprietary information and breach of a license agreement. The lawsuit arises out of L-3 Integrated Systems' pursuit of the Republic of Korea's P-3 Lot II Maritime Patrol Aircraft Program as a subcontractor to Korean Airspace Industries. Lockheed claims that in connection with this subcontracting effort, L-3 Integrated Systems will use certain Lockheed proprietary information in violation of both a prior settlement agreement between Lockheed and the U.S. Government, and a license agreement between Lockheed and L-3 Integrated Systems because L-3 Integrated Systems is acting as a subcontractor (as opposed to a prime contractor) to the Republic of Korea. Lockheed is seeking an injunction prohibiting L-3 Integrated Systems from using the proprietary P-3 data in violation of the existing agreements and unspecified money damages. We believe that the claims asserted by Lockheed in its suit are without merit and intend to defend against the Lockheed claims vigorously.
Legal Matters Pertaining to the Titan Acquired Businesses
Foreign Corrupt Practices Act Investigation
During the first quarter of 2004, Titan learned of allegations that improper payments under the Foreign Corrupt Practices Act (FCPA) had been made, or items of value had been provided, involving international consultants for Titan or its subsidiaries to foreign officials. The allegations, which were identified as part of internal reviews conducted by Titan and Lockheed in connection with their failed merger, were reported at that time to the government. Titan's Board of Directors established a committee of the Board to oversee Titan's internal review of these matters. In connection with the
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internal review, the SEC commenced an investigation into whether payments involving Titan's international consultants were made in violation of applicable law, particularly the FCPA. In addition, the Department of Justice (DoJ) initiated a criminal inquiry into this matter, and also initiated an investigation into whether these same alleged practices violated provisions of the United States Internal Revenue Code of 1986, as amended.
On March 1, 2005, Titan announced that it had entered into a consent to entry of a final judgment with the SEC without admitting or denying the SEC's allegations, and reached a plea agreement with the DoJ, under which Titan pled guilty to three FCPA counts related to its overseas operations. These counts consist of violations of the anti-bribery and the books and records provisions of the FCPA and aiding and assisting in the preparation of a false tax return.
In connection with the FCPA settlement, Titan made total payments of $28.5 million, including a DoJ-recommended fine of $13.0 million and payments to the SEC of $15.5 million. A federal judge also imposed a three-year term of supervised probation. As part of these agreements, Titan agreed to: (1) implement a best-practices compliance program designed to detect and deter future violations of the FCPA; and (2) retain an independent consultant to review its policies and procedures with respect to FCPA compliance and to adopt the consultant's recommendations. If Titan fails to comply with its sentence or the consent to entry of a final judgment, it could be subject to additional criminal and civil fines or penalties and limitations on its ability to enter into or perform under U.S. government contracts, which would have a material adverse effect on our financial position, results of operations or cash flows.
Titan has made voluntary disclosures to the U.S. Department of State of suspected violations of law discovered in the course of Titan's internal FCPA investigation. The voluntary disclosures have not yet been resolved and may result in the assessment of fines or penalties against Titan. Further, as a result of Titan's plea agreement, Titan is currently unable to obtain new export licenses for items regulated by the U.S. Department of State. Titan has been working with the U.S. Department of State to obtain relief from this licensing ineligibility rule, but there is no assurance that Titan will be able to obtain new export licenses or amendments to existing ones or to utilize licensing exemptions in the foreseeable future. In addition, Titan's privilege to export products or services under existing export licenses may also be suspended. If Titan were prevented from obtaining new licenses and/or exporting products or services under existing licenses for a significant period of time, this could breach its obligations under certain contracts and could cause Titan to suffer adverse consequences, including termination of contracts and/or claims for damages. Titan does not know when, or if, it will be able to obtain relief from the licensing ineligibility rule, or for any further export license suspensions. Certain of Titan's revenues are generated by contracts with international customers which require export licenses. For the year ended December 31, 2004, Titan had revenues of approximately $27.0 million that required it to have export licenses.
On March 2, 2005, the Navy, acting on behalf of the DoD, and Titan executed an administrative settlement agreement that would allow Titan to continue to receive U.S. government contracts. The agreement imposes certain duties and limitations on Titan and provides that the Navy will monitor for three years Titan's compliance with, among other things, the FCPA and federal procurement laws and regulations. Under the agreement, the Navy agreed not to undertake any administrative action to propose Titan for debarment, but reserved the right to undertake appropriate administrative action, in its discretion, in the event of the indictment or conviction of any then-current (as of the date of execution of the agreement) officer or director of Titan or any of its wholly-owned subsidiaries arising out of continuing investigations into the underlying matters that were the subject of the Titan plea agreement or the final judgment entered by the SEC. The Justice Department is continuing its investigation of individuals involved in these matters. The Navy agreement defines "Titan" to include, among other things, Titan's "affiliates." There is no assurance that we will not be construed as Titan's affiliate under the agreement. We are working with the Navy to make appropriate modifications to the Navy agreement to reflect our acquisition of Titan.
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Titan has an ongoing obligation under its by-laws and under indemnity agreements with current and former employees to advance their costs of defense relating to the FCPA investigations and related class action and derivative litigation, subject to each individual undertaking to repay the costs of defense if it is ultimately determined that such individual is not entitled to be indemnified by Titan.
Stockholder and Derivative Actions
Titan and its officers and directors are subject to several lawsuits arising out of the FCPA settlement and the failed merger with Lockheed Martin Corporation.
In re Titan Inc. Securities Litigation, No. 04-CV-0701-K(NLS), is a consolidated putative class action filed before the U.S. District Court for the Southern District of California (the Federal Securities Action). The complaint alleges, among other things, that Titan and its officers and directors violated Section 10(b) of the Securities Exchange Act of 1934, as amended (the Exchange Act), and Securities and Exchange Commission (SEC) Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act, by issuing a series of press releases, public statements and filings disclosing significant historical and future revenue growth, but omitting to mention certain allegedly improper payments involving international consultants in connection with Titan's international operations, thereby artificially inflating the trading price of Titan's common stock. On July 18, 2005, an amended complaint in the securities action was filed that, among other things, added the claims that were previously pled in the "Holder Actions" described in the next paragraph. The Federal Securities Action and the Holder Actions are referred to collectively as the "Securities Action."
Certain Titan officers are also parties to putative class action complaints filed in the Superior Court for the State of California in and for San Diego County (the Holder Actions). These cases include Paul Berger v. Gene W. Ray, et al., No. GIC 828346, and Robert Garfield v. Mark W. Sopp, et. al, No. GIC 828345. These actions purport to be brought on behalf of all holders of Titan common stock as of April 7, 2004. The Holder Actions allege, among other things, that the defendants breached their fiduciary duties by acquiescing in or condoning Titan's alleged violations of the FCPA by failing to establish adequate procedures to prevent the alleged FCPA violations, and by failing, in bad faith, to voluntarily report the alleged FCPA violations to government officials.
Titan's directors and certain Titan officers, with Titan as a nominal defendant, are also party to Theodore Weisgerber v. Gene Ray, et al., No. 832018, which was filed in the Superior Court for the State of California, San Diego; Robert Ridgeway v. Gene Ray, et al., No. 542-N, which was filed in Delaware Court of Chancery, New Castle County; Bernd Bildstein v. Gene Ray, et al., No. 833701, which was filed in the Superior Court for the State of California, San Diego County; and Madnick v. Gene Ray, et al., No. 1215-N, which was filed in the Delaware Court of Chancery, New Castle County (the Derivative Actions). The Derivative Actions purport to be brought for the benefit of the nominal defendant, Titan, and allege that the defendants breached their fiduciary duties by failing to monitor and supervise management in a way that would have either prevented the alleged FCPA violations or would have detected the alleged FCPA violations. The Weisgerber complaint was subsequently amended to include allegations that the defendants breached their fiduciary duties by failing to monitor and supervise management in a way that would have prevented the alleged mistreatment of prisoners at the Abu Ghraib prison in Iraq, alleged billing errors relating to the work performed by foreign nationals, and the loss of contracts with the government. On June 3, 2005, an amended complaint was filed in the Ridgeway action which added, among other things, a claim alleging that Titan's directors breached their fiduciary duty in connection with their approval of the merger with us. We were named as a defendant in the Ridgeway action for allegedly aiding and abetting this alleged breach of fiduciary duty.
On June 6, 2005, a putative class action, Gentsch v. Titan Corp. et al., No. GIC 848598, was filed in Superior Court for the State of California against Titan and its board of directors challenging the merger between Titan and us.
Concurrently with entering into the merger agreement relating to the Titan acquisition, two memoranda of understanding were executed. First, the defendants in the Securities Action, including Titan and certain of its directors and officers, entered into a memorandum of understanding (the
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Securities MOU) with plaintiffs in the Federal Securities and Holder actions. Pursuant to the Securities MOU, plaintiffs and their counsel will receive $61.5 million. Second, the defendants in the Derivative Actions, including Titan and certain of its directors and officers and L-3, entered into a separate memorandum of understanding (the Derivative MOU) with plaintiffs in the Derivative Actions. As a result of negotiations by the plaintiffs in the Derivative Actions, we agreed to, among other things, increase the purchase price for Titan's common stock to $23.10 per share and reduced the termination fee potentially payable by Titan. Pursuant to the Derivative MOU, we agreed to pay any plaintiff attorneys' fees awarded by the Delaware Court of Chancery up to $5.9 million.
After the completion of confirmatory discovery, including the review by plaintiffs' counsel of certain documents of Titan and L-3 and the taking of several depositions, the parties executed stipulations of settlement (i.e., the Securities Settlement and the Derivative Settlement) on July 22, 2005. The Derivative Settlement that was executed included the settlement of the Gentsch matter. The Securities Settlement was preliminarily approved on September 26, 2005 and a Final Settlement Hearing is scheduled for December 19, 2005. The Derivative Settlement was preliminarily approved on August 8, 2005 and a Final Settlement Hearing is scheduled for November 2, 2005. Both settlements remain subject to court approval.
SureBeam Related Litigation
In August 2002, Titan completed the spin-off of its former subsidiary, SureBeam Corporation. On January 19, 2004, SureBeam voluntarily filed for bankruptcy relief to be liquidated under Chapter 7 of the United States Bankruptcy Court. Various lawsuits have been filed against Titan and/or certain directors and executive officers of Titan in connection with SureBeam.
Titan, certain corporate officers of SureBeam, Dr. Gene Ray and Susan Golding, as SureBeam directors, and certain investment banks that served as lead underwriters for SureBeam's March 2001 initial public offering, have been named as defendants in several purported class action lawsuits filed by holders of common stock of SureBeam in the U.S. District Court. On October 6, 2003, these lawsuits were consolidated into In re SureBeam Corporation Securities Litigation, No. 03-CV-001721-JM (POR) in the U.S. District Court for the Southern District of California. The consolidated action seeks an unspecified amount of damages and alleges that each of the defendants, including Titan, as a "control person" of SureBeam within the meaning of Section 15 of the Securities Act, should be held liable under Section 11 of the Securities Act because the prospectus for SureBeam's initial public offering was allegedly inaccurate and misleading, contained untrue statements of material facts, and omitted to state other facts necessary to make the statements made therein not misleading. The consolidated action further alleges that the defendants, including Titan, as a control person of SureBeam within the meaning of Section 20(a) of the Exchange Act, should be held liable under Section 10(b) of the Exchange Act for false and misleading statements made during the period from March 16, 2001 to August 27, 2003. On January 3, 2005, the court granted in part and denied in part motions to dismiss the operative complaint. An amended complaint was filed on March 1, 2005. We intend to defend the claims vigorously.
On September 17, 2004, the bankruptcy trustee in the SureBeam Corporation bankruptcy pending in the United States Bankruptcy Court for the Southern District of California brought an action in San Diego Superior Court, on behalf of the bankruptcy estate, against certain directors and current and former executive officers of Titan who served at one time as directors or officers of SureBeam. The bankruptcy trustee's complaint raises claims of breach of fiduciary duties, gross mismanagement, abuse of corporate control, waste of corporate assets, breach of the duty of loyalty, unjust enrichment, breach of fiduciary duties for insider trading and violation of the California Corporation Code. Because the defendants were named by reason of the fact that they were serving as directors or officers of SureBeam at the request of Titan, Titan is covering the costs of defense of these claims, subject to indemnification agreements and bylaw provisions. We agreed to settle the trustee claims for $5.0 million and are working to finalize the settlement.
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Government Investigations
In October 2002, Titan received a grand jury subpoena from the Antitrust Division of the DoJ requesting the production of documents relating to information technology services performed for the Air Force at Hanscom Air Force Base in Massachusetts and Wright-Patterson Air Force Base in Ohio. Titan has been informed that other companies who have performed similar services have received subpoenas as well. A senior Titan employee has provided a handwriting exemplar in connection with this matter and three Titan employees have previously testified before the grand jury in exchange for receiving immunity. Titan is not aware of any illegal or inappropriate conduct and has been cooperating and will continue to cooperate fully with the investigation.
In March 2003, Titan received a subpoena from the Office of Inspector General for the National Aeronautics and Space Administration (NASA) seeking certain records relating to billing for labor services in connection with its contracts with NASA. Titan also received a subpoena from the Office of Inspector General for the General Services Administration (GSA) seeking similar records relating to billing for labor categories in connection with contracts with GSA. In response to these subpoenas, Titan has provided documents relating to billing for labor services in connection with government contracts. Titan has been informed by NASA that the NASA investigation is closed. Titan is not aware of any illegal or inappropriate conduct and has been cooperating and will continue to cooperate fully with the GSA investigation.
These investigations are ongoing, and we are unable to predict their outcome at this time. Any penalties imposed by the U.S. Government in these matters could have a material adverse effect on our financial position, results of operations or cash flows.
Other Legal Proceedings
Since June 9, 2004, two lawsuits have been filed alleging that Titan and other defendants either participated in, approved of, or condoned the mistreatment of prisoners by United States military officials in certain prison facilities in Iraq in violation of federal, state and international law. The first of these cases, Saleh v. Titan Corporation, No. 04-CV-1143 R, was filed in the United States District Court for the Southern District of California against The Titan Corporation, CACI International, Inc. (CACI), and its affiliates, and three individuals (one formally employed by Titan and one by a Titan subcontractor). Plaintiffs in Saleh seek class certification. The second case, Ibrahim v. Titan Corporation, No. 04-CV-1248, was filed on July 27, 2004, on behalf of five individual plaintiffs against Titan, CACI and CACI affiliates, and contains allegations similar to those in Saleh. Class certification has not been requested in Ibrahim. We intend to defend these lawsuits vigorously.
On January 23, 2004, Titan, together with its wholly-owned subsidiary, Titan Wireless, Inc., and Titan Wireless's wholly-owned subsidiary, Titan Africa, Inc., were named as defendants in Gonzales Communications, Inc. v. Titan Wireless, Inc., Titan Africa, Inc., The Titan Corporation, Geolution International Inc., and Mundi Development, Inc., a lawsuit filed in the U.S. District Court for the Southern District of California, No. 04-CV-00147 WQH (JMA). The complaint relates to the purchase by Gonzales Communications of equipment and related services under an equipment purchase agreement entered into with Titan Wireless in June 2001. Gonzales Communications contends that the equipment and services delivered were unsatisfactory. In the complaint, Gonzales Communications seeks direct damages in the amount of $0.9 million plus interest, representing the amount Gonzales Communications alleges to have previously paid under the agreement, and consequential damages of approximately $16.3 million. To date, Titan and its subsidiaries have not received payment in full under the agreement for the equipment and services that were delivered to Gonzales Communications. Titan has filed a counterclaim against Gonzales Communications for in excess of $1.2 million. On July 11, 2005, the court granted in part and denied in part Titan's motion for summary judgment. We intend to defend our position vigorously.
On March 14, 2005, Makram Majid Chams, a former consultant of Titan filed a claim with the Preliminary Committee on Labor Disputes Settlement in Saudi Arabia. Mr. Chams alleges that Titan wrongfully terminated his consulting agreement and that he was defamed by Titan's publication in a local newspaper of a mandatory notice that he is no longer representing Titan. The plaintiff is seeking approximately $21.9 million in damages. We intend to defend our position vigorously.
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In December 2001, the current occupants of a property formerly owned by Titan commenced an environmental action, Lefcourt Associates, Ltd. et al. v. The Thor Corporation, et al., against Titan and others in New Jersey state court. Plaintiffs contend that Titan is liable for the damages caused by hazardous waste materials originating from adjacent land to the extent that Titan purportedly provided indemnification to plaintiffs when it sold the property to them in 1986. Discovery is in progress, and we cannot predict the outcome of this litigation at this time.
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ITEM 6.
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)). |
| 4.1 | | Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to L-3 Communications Holdings' Registration Statement on Form S-1 No. 333-46975). |
| 10.40 | | Amended and Restated Credit Agreement, dated as of July 29, 2005, among L-3 Communications Corporation, L-3 Communications Holdings, Inc. and certain subsidiaries of the Registrants from time to time party thereto as guarantors, the lenders from time to time party thereto, and Bank of America, N.A., as administrative agent (incorporated by reference to Exhibit 10.40 to the Registrants' Quarterly Report on Form 10-Q for the quarter ended June 30, 2005). |
| **10.55 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of June 28, 2002 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.63 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of May 21, 2003 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.65 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of December 22, 2003 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.68 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of November 12, 2004 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| 10.69 | | Indenture dated as of July 29, 2005 (Notes Indenture) among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as Trustee (incorporated by reference to Exhibit 10.69 to the Registrants' Quarterly Report on Form 10-Q for the quarter ended June 30, 2005). |
|
69
| | | | | | |
Exhibit
Number | | Description of Exhibit |
| 10.70 | | Indenture dated as of July 29, 2005 (CODES Indenture) among L-3 Communications Holdings, Inc., the guarantors named therein and The Bank of New York, as Trustee (incorporated by reference to Exhibit 10.70 to the Registrants' Quarterly Report on Form 10-Q for the quarter ended June 30, 2005). |
| **10.71 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of July 29, 2005 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.72 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Holdings, Inc., The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of July 29, 2005 among L-3 Communications Holdings, Inc., the guarantors named therein and The Bank of New York, as trustee. |
| *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 September 30, 2005 in accordance with the provisions of SFAS No. 128, Earnings Per Share. |
| |
| ** | Filed herewith. |
70
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: November 1, 2005 | | |
| | | /s/ Michael T. Strianese |
| | | Name: Michael T. Strianese
Title: Senior Vice President and Chief
Financial Officer
(Principal Financial Officer) |
|
71
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)). |
| 4.1 | | Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to L-3 Communications Holdings' Registration Statement on Form S-1 No. 333-46975). |
| 10.40 | | Amended and Restated Credit Agreement, dated as of July 29, 2005, among L-3 Communications Corporation, L-3 Communications Holdings, Inc. and certain subsidiaries of the Registrants from time to time party thereto as guarantors, the lenders from time to time party thereto, and Bank of America, N.A., as administrative agent (incorporated by reference to Exhibit 10.40 to the Registrants' Quarterly Report on Form 10-Q for the quarter ended June 30, 2005). |
| **10.55 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of June 28, 2002 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.63 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of May 21, 2003 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.65 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of December 22, 2003 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.68 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of November 12, 2004 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| 10.69 | | Indenture dated as of July 29, 2005 (Notes Indenture) among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as Trustee (incorporated by reference to Exhibit 10.69 to the Registrants' Quarterly Report on Form 10-Q for the quarter ended June 30, 2005). |
| 10.70 | | Indenture dated as of July 29, 2005 (CODES Indenture) among L-3 Communications Holdings, Inc., the guarantors named therein and The Bank of New York, as Trustee (incorporated by reference to Exhibit 10.70 to the Registrants' Quarterly Report on Form 10-Q for the quarter ended June 30, 2005). |
|
| | | | | | |
Exhibit
Number | | Description of Exhibit |
| **10.71 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Corporation, The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of July 29, 2005 among L-3 Communications Corporation, the guarantors named therein and The Bank of New York, as trustee. |
| **10.72 | | Supplemental Indenture dated as of November 1, 2005 among L-3 Communications Holdings, Inc., The Bank of New York, as trustee, and the guarantors named therein to the Indenture dated as of July 29, 2005 among L-3 Communications Holdings, Inc., the guarantors named therein and The Bank of New York, as trustee. |
| *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 September 30, 2005 in accordance with the provisions of SFAS No. 128, Earnings Per Share. |
| |
| ** | Filed herewith. |
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Yes