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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED MARCH 31, 2007 |
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
Commission File Number
000-51579
NCI, Inc.
(Exact name of registrant as specified in its charter)
| Delaware | 20-3211574 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
11730 Plaza America Drive Reston, Virginia | 20190-4764 | |
| (Address of principal executive offices) | (Zip Code) | |
Registrant’s telephone number, including area code: (703) 707-6900
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one:)
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). ¨ Yes x No
As of May 1, 2007, there were 7,027,760 shares outstanding of the registrant’s Class A common stock. In addition, there are 6,300,000 shares outstanding of the registrant’s Class B common stock, which are convertible on a one-for-one basis into Class A common stock.
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FINANCIAL INFORMATION
| Item 1. | Financial Statements |
NCI, INC.
(amounts in thousands, except per share data)
March 31, 2007 | December 31, 2006 | |||||||
| (unaudited | ) | |||||||
Assets | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 8,383 | $ | 13,930 | ||||
Accounts receivable, net | 66,980 | 65,841 | ||||||
Deferred tax assets | 1,753 | 1,678 | ||||||
Prepaid expenses and other current assets | 1,251 | 1,280 | ||||||
Total current assets | 78,367 | 82,729 | ||||||
Property and equipment, net | 4,775 | 4,925 | ||||||
Other assets | 869 | 785 | ||||||
Deferred tax assets, net | 528 | 552 | ||||||
Intangible assets, net | 1,930 | 381 | ||||||
Goodwill | 22,361 | 17,427 | ||||||
Total assets | $ | 108,830 | $ | 106,799 | ||||
Liabilities and stockholders’ equity | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 19,720 | $ | 22,712 | ||||
Accrued salaries and benefits | 9,257 | 9,036 | ||||||
Other accrued expenses/liabilities | 5,100 | 3,402 | ||||||
Deferred revenue | 1,595 | 1,259 | ||||||
Total current liabilities | 35,672 | 36,409 | ||||||
Other liabilities | 137 | 168 | ||||||
Deferred rent | 3,507 | 3,636 | ||||||
Total liabilities | 39,316 | 40,213 | ||||||
Stockholders’ equity: | ||||||||
Class A common stock, $0.019 par value—37,500,000 shares authorized; 7,027,760 shares issued and outstanding, | 134 | 134 | ||||||
Class B common stock, $0.019 par value—12,500,000 shares authorized; 6,300,000 shares issued and outstanding | 120 | 120 | ||||||
Additional paid-in capital | 57,553 | 57,580 | ||||||
Deferred compensation | (437 | ) | (507 | ) | ||||
Retained earnings | 12,144 | 9,259 | ||||||
Total stockholders’ equity | 69,514 | 66,586 | ||||||
Total liabilities and stockholders’ equity | $ | 108,830 | $ | 106,799 | ||||
See accompanying notes
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CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(amounts in thousands, except per share data)
| Three months ended March 31, | ||||||||
| 2007 | 2006 | |||||||
Revenue | $ | 64,291 | $ | 46,035 | ||||
Operating costs and expenses: | ||||||||
Cost of revenue (exclusive of depreciation and amortization, shown separately below) | 55,509 | 39,470 | ||||||
General and administrative expense | 3,580 | 3,255 | ||||||
Depreciation and amortization | 370 | 410 | ||||||
Amortization of intangible assets | 183 | 246 | ||||||
Total operating costs and expenses | 59,642 | 43,381 | ||||||
Operating income | 4,649 | 2,654 | ||||||
Interest income | 142 | 117 | ||||||
Interest expense | (24 | ) | (26 | ) | ||||
Income before taxes | 4,767 | 2,745 | ||||||
Income tax expense | 1,882 | 1,074 | ||||||
Net income | $ | 2,885 | $ | 1,671 | ||||
Earnings per common and common equivalent share: | ||||||||
Basic: | ||||||||
Weighted average shares outstanding | 13,328 | 13,328 | ||||||
Net income per share | $ | 0.22 | $ | 0.13 | ||||
Diluted: | ||||||||
Weighted average shares and equivalent shares outstanding | 13,508 | 13,502 | ||||||
Net income per share | $ | 0.21 | $ | 0.12 | ||||
See accompanying notes
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(amounts in thousands)
| Three months ended March 31, | ||||||||
| 2007 | 2006 | |||||||
Cash flows from operating activities | ||||||||
Net income | $ | 2,885 | $ | 1,671 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization | 553 | 655 | ||||||
Non-cash stock compensation expense | 42 | 9 | ||||||
Deferred income taxes | (51 | ) | 699 | |||||
Changes in operating assets and liabilities, net of effects of business combination: | ||||||||
Accounts receivable, net | 190 | 9,001 | ||||||
Prepaid expenses and other assets | 158 | (944 | ) | |||||
Accounts payable | (3,307 | ) | (572 | ) | ||||
Accrued expenses/other current liabilities | 1,667 | (1,322 | ) | |||||
Deferred rent | (116 | ) | (103 | ) | ||||
Net cash provided by operating activities | 2,021 | 9,094 | ||||||
Cash flows from investing activities | ||||||||
Purchase of property and equipment | (209 | ) | (53 | ) | ||||
Proceeds from sale of property and equipment | — | 3 | ||||||
Cash paid for acquisition, net of cash acquired | (7,298 | ) | — | |||||
Net cash used in investing activities | (7,507 | ) | (50 | ) | ||||
Cash flows from financing activities | ||||||||
Principal payments under capital lease obligations | (61 | ) | (71 | ) | ||||
Distributions to stockholders | — | (5,866 | ) | |||||
Net cash used in financing activities | (61 | ) | (5,937 | ) | ||||
Net change in cash and cash equivalents | (5,547 | ) | 3,107 | |||||
Cash and cash equivalents, beginning of year | 13,930 | 12,323 | ||||||
Cash and cash equivalents, end of period | $ | 8,383 | $ | 15,430 | ||||
Supplemental disclosure of cash flow information | ||||||||
Cash paid during the period for: | ||||||||
Interest | $ | 24 | $ | 26 | ||||
Income taxes | $ | 58 | $ | 24 | ||||
Supplemental disclosure of non-cash activities: | ||||||||
Equipment acquired under capital leases | $ | 2 | $ | 30 | ||||
See accompanying notes
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. Basis of Presentation
The accompanying unaudited consolidated financial statements for NCI, Inc. and its wholly-owned subsidiaries (the Company or NCI) as of and for the three months ended March 31, 2007 and 2006, have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. As a result, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all necessary adjustments and reclassifications (all of which are of a normal, recurring nature) that are necessary to a fair presentation of the results for such periods. The information disclosed in the notes to the financial statements for these periods is unaudited. For further information, refer to the financial statements and footnotes included in NCI’s Form 10-K for the year ended December 31, 2006, as filed with the Securities and Exchange Commission. The current period’s results of operations are not necessarily indicative of results that may be achieved for any future period.
2. Business Overview
NCI is a provider of information technology services and solutions to federal government agencies. The Company’s focus is on designing, implementing, maintaining and upgrading secure information technology (IT) systems and networks by leveraging the Company’s skills across four core service offerings: network engineering; information assurance; systems development and integration; and enterprise systems management. The Company provides these services to defense, intelligence and federal civilian agencies. Substantially all of the Company’s revenue was derived from contracts with the federal government, directly as a prime contractor or as a subcontractor. The Company conducts business throughout the United States. In addition, the Company may conduct business internationally in support of federal government contracts.
The Company’s operations are subject to certain risks and uncertainties including, among others, dependence on contracts with federal government agencies, dependence on significant clients, existence of contracts with fixed pricing, dependence on subcontractors to fulfill contractual obligations, current and potential competitors with greater resources, dependence on key management personnel, ability to recruit and retain qualified employees, and uncertainty of future profitability and possible fluctuations in financial results.
3. Summary of Significant Accounting Policies
Income Taxes
In June 2006, FASB issued FIN 48,Accounting for Uncertainty in Income Taxes (FIN 48) —an interpretation of SFAS No. 109,Accounting for Income Taxes (SFAS No. 109). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This guidance is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 effective January 1, 2007. The Company’s analysis of uncertain tax positions as required under FIN 48 determined that the Company had no material unrecorded liabilities and there was no cumulative effect on retained earnings of applying the provisions of the interpretation. Interest and penalties accrued under FIN 48 will be classified as Interest Expense and General and Administrative Expense, respectively.
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NCI, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
3. Summary of Significant Accounting Policies (continued)
Earnings Per Share
SFAS No. 128, Earnings Per Share, requires presentation of basic and diluted earnings per share. Basic earnings per share exclude dilution and are computed by dividing net income by the weighted average number of common shares outstanding for the period. The computation of earnings per share presented is for both Class A and Class B common stock.
Diluted earnings per share reflect potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Diluted earnings per share include the incremental effect of stock options calculated using the treasury stock method.
The following details the historical computation of basic and diluted earnings per common share (Class A and Class B) for the three months ended March 31, 2007 and 2006, respectively.
| Three months ended March 31, | ||||||
| 2007 | 2006 | |||||
| (in thousands, except per share data) | ||||||
Net Income | $ | 2,885 | $ | 1,671 | ||
Weighted average number of basic shares outstanding during the period | 13,328 | 13,328 | ||||
Dilutive effect of stock options after application of treasury stock method | 180 | 174 | ||||
Weighted average number of diluted shares outstanding during the period | 13,508 | 13,502 | ||||
Basic earnings per share | $ | 0.22 | $ | 0.13 | ||
Diluted earnings per share | $ | 0.21 | $ | 0.12 | ||
4. Accounts Receivable
Accounts receivable consist of billed and unbilled amounts at March 31, 2007 and December 31, 2006 as follows:
As of March 31, 2007 | As of December 31, 2006 | |||||
| (in thousands) | ||||||
Billed receivables: | ||||||
Billed receivables | $ | 37,307 | $ | 37,394 | ||
Billable receivables at end of period | 28,509 | 26,510 | ||||
Total billed receivables | 65,816 | 63,904 | ||||
Total unbilled receivables | 1,954 | 2,727 | ||||
Total accounts receivable | 67,770 | 66,631 | ||||
Less: Allowance for doubtful accounts | 790 | 790 | ||||
Total accounts receivable, net | $ | 66,980 | $ | 65,841 | ||
Unbilled receivables primarily consist of fees withheld by the client in accordance with the contract terms, items waiting on customer acceptance, and conditions that will be billed upon contract completion and approval of indirect rates. We expect to bill substantially all the unbilled costs and accrued profits within one year.
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NCI, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
5. Stock Compensation
Effective January 1, 2006, the Company adopted SFAS No. 123(R),Share-Based Payment(SFAS No. 123(R)), using the prospective method. Under this method, compensation costs for all awards granted after the date of adoption and modifications of any previously granted awards outstanding at the date of adoption are measured at estimated fair value and included in operating expenses over the vesting period during which an employee provides service in exchange for the award. Prior to the adoption of SFAS No. 123(R), the Company accounted for stock compensation in accordance with APB No. 25,Accounting for Stock Issued to Employees (APB No. 25), using the intrinsic-value method. Under the prospective method, we will continue to apply APB No. 25 in future periods to awards outstanding at the date of adoption. The Company uses the Black-Scholes-Merton option pricing model and straight-line amortization of compensation expense over the requisite service period of the grant.
Assumptions Used in Fair Value determination
The following weighted-average assumptions were used for option grants made during the three months ended March 31, 2007 and 2006:
| 2007 | 2006 | |||||
Expected Volatility | 39 | % | 35 | % | ||
Expected Term (in years) | 5.5 | 7.5 | ||||
Risk-free Interest Rate | 4.62 | % | 4.66 | % | ||
Dividend Yield | 0 | % | 0 | % |
| • | Expected Volatility. The expected volatility of the Company’s shares was estimated based upon the historical volatility of the Company’s share price. |
| • | Expected Term. Because the Company does not have significant historical data on employee exercise behavior, we have calculated the expected term by averaging the vesting period and term of the option. |
| • | Risk-free Interest Rate. The Company bases the risk-free interest rate used in the Black-Scholes-Merton valuation method on the implied yield available on a U.S. Treasury note with a term equal to the expected term of the underlying grants. |
| • | Dividend Yield. The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company has not paid dividends in the past nor does it expect to pay dividends in the future. |
Stock Options Activity
The following table summarizes stock option activity for the period January 1, 2007 through March 31, 2007:
| Options | Weighted Average Exercise Price per Share | |||||
| (in thousands) | ||||||
Outstanding at December 31, 2006 | 644 | $ | 8.35 | |||
Granted | 150 | 15.37 | ||||
Forfeited/cancelled | (21 | ) | 6.65 | |||
Exercised | — | — | ||||
Outstanding at March 31, 2007 | 773 | $ | 9.76 | |||
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NCI, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
5. Stock Compensation (continued)
The following table summarizes stock option vesting and unvested options for the period January 1, 2007 through March 31, 2007:
| Options (in thousands) | Weighted Average Fair Value | Aggregate (in thousands) | ||||||
Unvested December 31, 2006 | 567 | $ | 3.49 | $ | 1,124 | |||
Granted | 150 | 15.37 | — | |||||
Vested | — | — | — | |||||
Forfeited | 21 | 6.65 | 65 | |||||
Unvested March 31, 2007 | 696 | $ | 9.76 | $ | 1,059 | |||
Vested March 31, 2007 | 77 | $ | 9.10 | $ | 63 | |||
The following table summarizes stock options outstanding at March 31, 2007:
Range of exercise prices | Number of options | Weighted average exercise price | Weighted average remaining contractual life | Options exercisable | |||||
| (in thousands) | (in years) | (in thousands) | |||||||
$1.00 – $2.00 | 5 | $ | 1.90 | 6.6 | 5 | ||||
$6.00 – $7.00 | 336 | 6.65 | 5.9 | 8 | |||||
$10.00 – $11.00 | 228 | 10.02 | 7.6 | 64 | |||||
$12.00 – $16.00 | 204 | 14.79 | 7.0 | — | |||||
Stock options granted in 2003 and 2004 will fully vest over a period of zero to seven years from the date of grant in accordance with the individual stock option agreement. The achievement of specified performance criteria, or a change in control as defined by the option agreements may accelerate the vesting period on certain option agreements. Stock options granted since 2005 will fully vest over a period of three to five years from the date of grant in accordance with the individual stock option agreement.
Stock Compensation
The following table summarizes stock compensation for the three months ending March 31, 2007 and 2006:
| 2007 | 2006 | ||||||
| (in thousands) | |||||||
Cost of Revenue | $ | 27 | $ | (19 | ) | ||
General and Administrative | 15 | 28 | |||||
| $ | 42 | 9 | |||||
As of March 31, 2007, there was approximately $1.5 million of total unrecognized compensation cost related to unvested stock compensation agreements. Of this amount, approximately $437,000 is related to options accounted for under APB No. 25, and approximately $1.1 million related to options accounted for under SFAS No. 123(R). This cost is expected to be fully amortized over the next five years, with approximately $335,000 during the remainder of 2007, and approximately $442,000 during 2008, $435,000 during 2009, $286,000 during 2010, and $39,000 during 2011. The Company issued options during 2003 where vesting will accelerate when the company reaches certain performance benchmarks. SFAS No. 123(R) requires that the cost of the options be included in the Company’s Statement of Operations before or in conjunction with the vesting of options. The future amortized cost stated above does not take into account any accelerated vesting of options.
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NCI, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
6. Loan and Security Agreement
On March 14, 2006, the Company entered into a Loan and Security Agreement (the Agreement). Contemporaneously with the execution of the Agreement, the Company terminated the prior Loan and Security Agreement. The borrowing capacity under the Agreement consists of a revolving credit facility with an original principal amount of up to $60.0 million, which includes a swingline facility with an original principal amount of up to $5.0 million. The Agreement also has a $30.0 million accordion feature allowing the Company to increase its borrowing capacity to up to $90.0 million, subject to obtaining commitments for the incremental capacity from existing or new lenders. The outstanding balance of the facility accrues interest based on LIBOR plus an applicable margin, ranging from 100 to 175 basis points, based on a ratio of funded debt to earnings. The credit facility expires on March 14, 2011.
The outstanding borrowings are collateralized by a security interest in substantially all of the Company’s assets. The lenders also require a direct assignment of all contracts at the lenders’ discretion.
The Agreement contains various restrictive covenants that, among other things, restrict the Company’s ability to: incur or guarantee additional debt; make certain distributions, investments and other restricted payments, including cash dividends on the Company’s outstanding common stock; enter into transactions with certain affiliates; create or permit certain liens; and consolidate, merge or sell assets. In addition, the Agreement contains certain financial covenants that require the Company to: maintain a minimum tangible net worth; maintain a minimum fixed charge coverage ratio and a ratio of funded debt to earnings; and limit capital expenditures below certain thresholds.
Funds borrowed under the revolving credit facility will be used to finance possible future acquisitions, to provide for working capital expenditures and for general corporate uses. As of March 31, 2007, there were no amounts outstanding under the credit facility.
7. Related Party Transactions
The Company purchased services from Net Commerce Corporation, which is a government contractor wholly-owned by Rajiv Narang, the son of Charles K. Narang, the Chairman and Chief Executive Officer of the Company, under a subcontract and a blanket purchase order. For the three months ended March 31, 2006, the payments for services and expenses incurred under these agreements were approximately $101,000, of which $33,000 was included in accounts payable at March 31, 2006. No amounts were paid during the three months ended March 31, 2007 as these agreements expired during May 2006.
Management believes that all transactions with related parties have been conducted based on then current market conditions.
8. Acquisition of Operational Technologies Services, Inc.
Effective January 31, 2007, the Company completed the acquisition of Operational Technologies Services, Inc. (OTS). OTS generated revenues for calendar year 2006 of approximately $10 million (unaudited), all derived from contracts with the Federal Aviation Administration. OTS has approximately 70 employees located primarily within the Greater Washington, DC area. NCI paid approximately $7.7 million in cash at closing including approximately $0.4 million of transaction costs.
On January 31, 2007, OTS had net assets including identifiable intangibles with a fair market value of $2.8 million. The OTS assets and liabilities were recorded at fair value under the purchase method of accounting. As the cost of the acquisition exceeded the fair value of the assets acquired, goodwill was recorded in the amount of $4.9 million.
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NCI, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
8. Acquisition of Operational Technologies Services, Inc. (continued)
The following table represents the purchase price allocation of OTS’ assets and liabilities at fair market value:
| January 31, 2007 | ||||
| (in thousands) | ||||
Cash | $ | 412 | ||
Accounts receivable | 1,330 | |||
Other current assets | 166 | |||
Property and equipment | 8 | |||
Others assets | 47 | |||
Intangible assets | 1,732 | |||
Goodwill | 4,934 | |||
Liabilities | (919 | ) | ||
Net assets acquired | $ | 7,710 | ||
The table includes the final value of intangibles. The value was determined by an unrelated third party valuation expert.
In addition, the definitive agreement for the acquisition of OTS provided for various contingent consideration. NCI will pay up to an additional $2.5 million over the next 18 months following closing based on achievement of certain milestones. As of March 31, 2007, no events have occurred that have triggered the obligation to pay any of the contingent consideration. Pursuant to the provisions of SFAS No. 141,Business Combinations, the Company believes the payment of any contingent consideration will be treated as additional cost of the acquisition and added to goodwill as the contingencies are resolved.
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| Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
Forward Looking Statements
This Quarterly Report on Form 10-Q, including the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements regarding our business, financial condition, results of operations and prospects. There are statements made herein which may not address historical facts and, therefore, could be interpreted to be forward looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Such statements are subject to factors that could cause actual results to differ materially from anticipated results. The factors that could cause actual results to differ materially from those anticipated include, but are not limited to, the following: our dependence on our contracts with federal government agencies, particularly within the U.S. Department of Defense, for substantially all of our revenue; continued funding of our contracts by the U.S. Government, based on a change in spending patterns, or in the event of a priority need for funds, such as homeland security, the war on terrorism or rebuilding Iraq; risk of contract performance or termination; failure to achieve contract awards in connection with recompetes for present business and/or competition for new business; government contract procurement (such as bid protest, small business set asides, etc.) and termination risks; competitive factors such as pricing pressures and competition to hire and retain employees (particularly those with security clearances); failure to successfully integrate Operational Technologies Services, Inc. and future acquired companies or businesses into our operations or to realize any accretive or synergistic effects from such acquisitions; failure to identify, execute and effectively integrate acquisitions appropriate to the achievement of our strategic plans; economic conditions in the United States, including conditions that result from terrorist activities or war; material changes in laws or regulations applicable to our businesses, particularly legislation affecting (i) government contracts for services, (ii) outsourcing of activities that have been performed by the government, (iii) delays related to agency specific funding freezes, and (iv) competition for task orders under Government Wide Acquisition Contracts (GWACs) and/or schedule contracts with the General Services Administration; and our own ability to achieve the objectives of near term or long range business plans. Some of these important factors are outlined under Item 1A. Risk Factors and elsewhere in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee our future results, level of activity or performance. We undertake no obligation to update publicly or revise any forward-looking statements. You should not place undue reliance on the forward-looking statements.
In this document, unless the context indicates otherwise, the terms “Company,” “NCI,” “we,” “us” and “our” refer to NCI, Inc., a Delaware corporation, and, where appropriate, its subsidiaries.
Overview
We are a provider of information technology services and solutions to federal government agencies. We focus on designing, implementing, maintaining and upgrading secure IT systems and networks. Our technology and industry expertise enables us to provide a full spectrum of services and solutions that assist our clients in achieving their program goals. We deliver a wide range of complex services and solutions by leveraging our skills across four core service offerings:
| • | network engineering; |
| • | information assurance; |
| • | systems development and integrations; and |
| • | enterprise systems management. |
We generate substantially all of our revenue from federal government contracts. We report operating results and financial data as one operating segment. Funding for our contracts and task orders is generally linked to trends in federal government spending by defense, intelligence and federal civilian agencies. The following table shows our revenue from the client groups listed as a percentage of total revenue for the periods shown.
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| Three months ended March 31, | ||||||
| 2007 | 2006 | |||||
Department of Defense and intelligence agencies (1) | 80.3 | % | 77.8 | % | ||
Federal civilian agencies (1) | 19.7 | % | 22.0 | % | ||
Commercial and state & local entities | — | 0.2 | % | |||
| (1) | Percentages may not reflect disclosure in prior filings as a result of the reclassification during the second quarter of 2006 of a contract awarded during third quarter 2005, that was initially classified as a federal civilian agency contract, as a Department of Defense and intelligence agency contract. |
Revenue
Substantially all of our revenue is derived from services and solutions provided to the federal government, primarily by our employees and, to a lesser extent, our subcontractors. In some cases, our revenue includes third-party hardware and software that we purchase on behalf of our clients. The level of hardware and software purchases we make for clients may vary from period to period depending on specific contract and client requirements.
Contract Types
Our services and solutions are provided under three types of contracts: time-and-materials; cost-plus; and fixed-price. Our contract mix varies from year to year due to numerous factors including our business strategies and federal government procurement objectives.
The following table shows our revenue from each of these types of contracts as a percentage of our total revenue for the periods shown.
| Three months ended March 31, | ||||||
| 2007 | 2006 | |||||
Time-and-materials | 38.5 | % | 46.9 | % | ||
Cost-plus | 27.6 | % | 31.9 | % | ||
Fixed-price | 33.9 | % | 21.2 | % | ||
We have been experiencing an increase in the percentage of fixed price revenue we receive, and a decrease in the percentage of time and materials revenue. This is due to the increased use of our government wide acquisition contracts (GWACs), where the majority of the tasks are fixed price or fixed price level of effort instead of on a time-and-materials or cost-plus basis. Additionally, we have seen an increase in product sales under our NETCENTS contract, which are typically on a fixed-unit price basis.
The amount of risk and potential reward varies under each type of contract. Under time-and-materials contracts, where we are paid a fixed hourly rate by labor category, to the extent that our actual labor costs vary significantly from the negotiated hourly rates, we may generate more or less than the targeted amount of profit. We are typically reimbursed for other contract direct costs and expenses at our cost, and typically receive no fee on those costs. Under cost-plus type contracts, there is very little risk, since we are reimbursed all of our allowable costs, and therefore, the profit margins tend to be lower on cost-plus type contracts. Under fixed-price contracts, we perform specific tasks or provide specified goods for a predetermined price. Compared to time-and-materials and cost-plus contracts, fixed-price services contracts generally offer higher profit margin opportunities but involve greater financial risk because we bear the impact of potential cost overruns in return for the full benefit of any cost savings. The majority of our services work under fixed-price contracts is fixed-price level-of-effort work, which has a lower risk than fixed-price completion contracts, such as software development. Some of our GWACs include provisions for both services as well as product (hardware and software) purchases. Fixed price product sales, such as under our NETCENTS contract, tend to carry lower margins, but with lower risk as well, since our prices from our vendors are fixed.
See “Critical Accounting Polices - Revenue Recognition” for a more detailed discussion of the various contract types.
Operating Expenses
Cost of Revenue
Cost of revenue primarily includes direct costs incurred to provide our services and solutions to clients. The most significant portion of these costs is salaries and wages, plus associated fringe benefits including stock compensation,
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of our employees directly serving clients, in addition to the related management, facilities and infrastructure costs. Cost of revenue also includes the costs of subcontractors and outside consultants, third-party materials, such as hardware or software that we purchase on behalf of our clients, and any other related direct costs, such as travel expenses. These other direct costs are incurred in response to specific client tasks, and vary from period to period. Changes in the mix of services and equipment provided under our contracts can result in variability in our contract margins.
General and Administrative Expenses
General and administrative expenses include the salaries and wages, plus associated fringe benefits including stock compensation, of our employees not performing work directly for clients. Among the functions covered by these costs are corporate business development, bid and proposal, contracts administration, finance and accounting, legal, corporate governance, and executive and senior management.
Depreciation and Amortization
Depreciation and amortization includes the depreciation of computers, furniture and other equipment, the amortization of third party software we use internally, and leasehold improvements.
Amortization of Intangible Assets
Amortization of intangible assets includes the amortization of identifiable intangible assets over their estimated useful lives. Non-compete agreements are generally amortized straight-line over the term of the agreement, while contracts and related client relationships are amortized proportionately against the acquired backlog.
Results of Operations
The following table sets forth certain items from our consolidated statements of operations and expresses each item in dollars and as a percentage of revenue for the periods indicated.
| Three months ended March 31, | As a percentage of revenue Three months ended March 31, | |||||||||||||
| 2007 | 2006 | 2007 | 2006 | |||||||||||
| (unaudited) | ||||||||||||||
Revenue | $ | 64,291 | $ | 46,035 | 100.0 | % | 100.0 | % | ||||||
Operating costs and expenses: | ||||||||||||||
Cost of revenue | 55,509 | 39,470 | 86.3 | 85.7 | ||||||||||
General and administrative expenses | 3,580 | 3,255 | 5.6 | 7.1 | ||||||||||
Depreciation and amortization | 370 | 410 | 0.6 | 0.9 | ||||||||||
Amortization of intangible assets | 183 | 246 | 0.3 | 0.5 | ||||||||||
Total operating costs and expenses | 59,642 | 43,381 | 92.8 | 94.2 | ||||||||||
Operating income | 4,649 | 2,654 | 7.2 | 5.8 | ||||||||||
Interest income | 142 | 117 | 0.2 | 0.3 | ||||||||||
Interest expense | (24 | ) | (26 | ) | — | (0.1 | ) | |||||||
Income before taxes | 4,767 | 2,745 | 7.4 | 6.0 | ||||||||||
Provision for income taxes | 1,882 | 1,074 | 2.9 | 2.4 | ||||||||||
Net income | $ | 2,885 | $ | 1,671 | 4.5 | % | 3.6 | % | ||||||
Three Months Ended March 31, 2007 Compared to Three Months Ended March 31, 2006
Revenue
For the three months ended March 31, 2007, total revenue increased by 39.7% or $18.3 million, over the same period a year ago. This increase was primarily due to new task orders under our GWAC contract vehicles, primarily NETCENTS, ITES, TEIS and VA GITTS, as well as growth on existing programs and the acquisition of Operational Technologies, Inc (OTS). OTS revenue for the quarter since the date of acquisition was $1.6 million. These increases were slightly offset by revenue reductions due to tasks that ended.
Cost of revenue
Cost of revenue increased 40.6%, or $16.0 million, for the three months ended March 31, 2007, as compared to the same period a year ago. The increase was attributable to an increase in subcontractor costs, direct labor and associated indirect costs and other direct costs due to the increase in revenue. As a percentage of revenue, cost of
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revenue was 86.3% and 85.7% for the quarters ended March 31, 2007 and 2006, respectively. The 0.6% increase in cost of revenue as a percentage of revenue for the quarter ended March 31, 2007 compared to the quarter ended March 31, 2006 resulted primarily from an increase in subcontractor and other direct costs, including the hardware and software purchases under NETCENTS, as a percentage of cost of revenue.
General and Administrative Expenses
General and administrative expense increased 10.0%, or $0.3 million, for the three months ended March 31, 2007, as compared to the same period a year ago. The increase is due mainly to increased accounting and audit fees along with higher business development and bid and proposal costs. These cost increases were partially offset by reduced legal expenses. As a percentage of revenue, general and administrative expenses decreased to 5.6% from 7.1% for the quarters ended March 31, 2007 and 2006, respectively.
Depreciation and Amortization
Depreciation and amortization expense was approximately $0.4 million for each of the quarters ended March 31, 2007 and 2006.
Amortization of Intangible Assets
Amortization of intangible assets was approximately $0.2 million for the quarters ended March 31, 2007 and 2006.
Operating income
For the three months ended March 31, 2007, operating income was $4.6 million, or 7.2% of revenue, compared to $2.7 million, or 5.8% of revenue, for the three months ended March 31, 2006. Operating income was higher for the three months ended March 31, 2007 due to the higher revenue volume as compared to the same period in the prior year. Operating income, as a percent of revenue, was higher for the three months ended March 31, 2007 compared to the same period in the prior year due to the leveraging of our infrastructure costs, primarily general and administrative expenses, over a larger revenue base. This leveraging is a result of the high percentage of our revenue that comes from time-and-materials and fixed-price contracts.
Interest Income/Expense
Net interest income was approximately $0.1 million for each of the quarters ended March 31, 2007 and 2006.
Income Taxes
The increase in income taxes of $0.8 million is the result the increase in operating income and a 0.4% rate increase. The effective income tax rate for the quarter ended March 31, 2007 is approximately 39.5% as compared to an effective income tax rate of 39.1% for the quarter ended March 31, 2006.
Contract Backlog
At March 31, 2007 and December 31, 2006, our estimated backlog was $622.0 million and $611.8 million, respectively, of which $120.4 million and, $123.1 million, respectively, was funded. We define backlog as our estimate of the remaining future revenue from existing signed contracts over the remaining base contract performance period and from the option periods of those contracts, assuming the exercise of all related options. We define funded backlog as the portion of backlog for which funding currently is appropriated and obligated to us under a contract or other authorization for payment signed by an authorized purchasing agency, less the amount of revenue we have previously recognized. Our backlog does not include any estimate of future potential delivery orders that might be awarded under our GWAC or other multiple award contract vehicles. Additional information on how we determine backlog is included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 as previously filed with the SEC.
Liquidity and Capital Resources
Our primary liquidity needs are for financing working capital, investing in capital expenditures and making selective strategic acquisitions. Historically, we have relied primarily on our cash flow from operations, borrowings under our credit facility and proceeds from our initial public offering to provide the capital for our liquidity needs. We expect the combination of our current cash and cash equivalent balances, cash flow from operations and the available borrowing capacity on our credit facility to continue to meet our normal working capital and capital expenditure requirements. As part of our growth strategy, we may pursue acquisitions that could require us to raise additional external capital or increase our borrowings.
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During the first quarter of 2007, we used approximately $7.7 million of cash on hand for the acquisition of OTS including approximately $0.4 million of transaction costs. Generally, our most significant use of working capital is for accounts receivables. During the first quarter of 2007, the balance of accounts receivable increased by $1.1 million to $67 million at the end of the quarter. Days sales outstanding of accounts receivable (DSO) stood at 93 days as of March 31, 2007 and December 31, 2006. This is an increase of 18 days as compared to March 31, 2006. The increase in DSO is primarily attributable to billing issues related to some of the larger NETCENTS product orders and we are presently working with our customers to resolve these issues and to reduce our DSO. Our March 31, 2007 DSO calculation includes OTS’ January 2007 revenues.
Funds borrowed under the revolving credit facility will be used to finance possible future acquisitions, to provide for working capital expenditures and for general corporate uses. As of March 31, 2007, there were no amounts outstanding under the credit facility.
Credit Agreement: The borrowing capacity under our Loan and Security Agreement (the Agreement) consists of a revolving credit facility with an original principal amount of up to $60.0 million, which includes a swingline facility with an original principal amount of up to $5.0 million. The Agreement also has a $30.0 million accordion feature allowing us to increase our borrowing capacity to up to $90.0 million, subject to obtaining commitments for the incremental capacity from existing or new lenders. The outstanding balance of the facility accrues interest based on LIBOR plus an applicable margin, ranging from 100 to 175 basis points, based on a ratio of funded debt to earnings. The credit facility expires on March 14, 2011. As of March 31, 2007, the balance of the credit facility was $0.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements.
Critical Accounting Policies
Our significant accounting policies are described in Note 3 to our accompanying consolidated financial statements. We consider the accounting policies related to revenue recognition to be critical to the understanding of our results of operations. We prepare our financial statements in conformity with U.S. generally accepted accounting principles. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. If any of these estimates or judgments proves to be incorrect, our reported results could be materially affected.
Revenue Recognition
Our revenue recognition policy addresses our three different types of contractual arrangements: time-and-materials contracts; cost-plus contracts; and fixed-price contracts.
Time-and-Materials Contracts: Revenue on time-and-materials contracts is recognized based on negotiated billable rates multiplied by the number of hours delivered plus allowable expenses incurred during the period.
Cost-Plus Contracts: Revenue on cost-plus contracts is recognized based on the allowable costs incurred during the period, plus any recognizable earned fee. Revenue associated with fixed fees under cost-plus contracts is considered earned in proportion to the allowable expenses incurred in performance of the contract.
Fixed-Price Contracts: Revenue on fixed unit price contracts, where specified units are delivered under service arrangements, is recognized as units are delivered based on the specified price per unit. Revenue for fixed-price level-of-effort contracts is recognized based upon the number of units of labor actually delivered multiplied by the negotiated rate for each unit of labor. Revenue for fixed price contracts in which the Company is paid a specific amount to provide services for a stated period of time is recognized ratably over the service period. Revenue on certain fixed-price completion contracts that are within the scope of Statement of Position 81-1 Accounting for Performance of Construction Type and Certain Production-Type Contracts (SOP 81-1) is recognized on the percentage-of-completion method using costs incurred in relation to total estimated costs.
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Contract accounting requires judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Due to the size and nature of many of the Company’s contracts, the estimation of total revenue and cost at completion is complicated and subject to many variables. Contract costs include material, labor and subcontracting costs, as well as an allocation of allowable indirect costs. Assumptions have to be made regarding the length of time to complete the contract because costs also include expected increases in wages and prices for materials. For contract change orders, claims or similar items, the Company applies judgment in estimating the amounts and assessing the potential for realization. These amounts are only included in contract value when they can be reliably estimated and realization is considered probable. Estimates of award fees for certain contracts are also a significant factor in estimating revenue and profit rates based on actual and anticipated awards. Anticipated losses on contracts accounted for under SOP 81-1 are recognized in the period they are deemed probable and can be reasonably estimated. Anticipated losses on other contracts are recognized as the services and materials are provided.
Contracts that use the percentage-of-completion method of accounting as described above are subject to the most management judgments. Historically, these projects account for less than 5% of our revenue annually.
Estimates of award fees related to performance on certain contracts, which are generally awarded at the discretion of the client, as well as penalties related to contract performance, are considered in estimating sales and profit rates. Incentives and penalties are recorded when there is sufficient information for us to assess anticipated performance.
| Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Our exposure to market risk relates to changes in interest rates for borrowings under our Loan and Security Agreement. Since we had no outstanding bank debt during the three months ended March 31, 2007, a change in interest rates would have had no impact on our interest expense or cash flow.
Additionally, we are subject to credit risks associated with our cash and cash equivalents, short-term investments and accounts receivable. We believe that the concentration of credit risks with respect to cash equivalents and investments are limited due to the high credit quality of these investments. Our investment policy that requires we invest excess cash in high quality investments which preserve principal, provide liquidity, and minimize investment risk. We also believe that our credit risk associated with accounts receivable is limited as they are primarily with the federal government or prime contractors working for the federal government.
| Item 4. | Controls and Procedures |
Evaluation of the Effectiveness of Disclosure Controls and Procedures
Management carried out an evaluation as of March 31, 2007 of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. This evaluation was done under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based upon the evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of March 31, 2007, the Company’s disclosure controls and procedures were effective.
Changes in Internal Control Over Financial Reporting
The Company made no change to its internal control over financial reporting during the three months ended March 31, 2007 that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.
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OTHER INFORMATION
| Item 1. | Legal Proceedings |
The Company is party to various legal actions, claims, government inquiries, and audits resulting from the normal course of business. The Company believes that the probability is remote that any resulting liability will have a material effect on the Company’s financial position, results of operations or liquidity.
| Item 1A. | Risk Factors |
No significant changes from those discussed in “Risk Factors” included in NCI, Inc.’s Form 10-K, filed with the Securities and Exchange Commission.
| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
None.
| Item 3. | Defaults Upon Senior Securities |
None.
| Item 4. | Submission of Matters to a Vote of Security Holders |
None.
| Item 5. | Other Information |
None.
| Item 6. | Exhibits |
Exhibits
31.1 | Section 302 Certification of the Chief Executive Officer | |||
31.2 | Section 302 Certification of the Chief Financial Officer | |||
32.1 | Section 906 Certification of the Chief Executive Officer | |||
32.2 | Section 906 Certification of the Chief Financial Officer |
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Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
| NCI, Inc. | ||||
| Registrant | ||||
| Date: May 4, 2007 | By: | /s/ Charles K. Narang | ||
| Charles K. Narang | ||||
| Chairman of the Board, | ||||
| Chief Executive Officer and Director | ||||
| (Principal Executive Officer) | ||||
| Date: May 4, 2007 | By: | /s/ Judith L. Bjornaas | ||
| Judith L. Bjornaas | ||||
| Senior Vice President | ||||
| Chief Financial Officer | ||||
| (Principal Financial and Accounting Officer) | ||||
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