SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
Quarterly Report under Section 13 or 15 (d)
of the Securities Exchange Act of 1934
For the three months ended January 31, 2005 Commission file number 0-13880
ENGINEERED SUPPORT SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
Missouri 43-1313242
(State of Incorporation) (IRS Employer Identification Number)
201 Evans Lane, St. Louis, Missouri 63121
(Address of principal executive offices) (Zip Code)
Registrant's telephone number including area code: (314) 553-4000
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. Yes X No
--- ---
Indicate by check mark whether the Registrant is an accelerated
filer (as defined by Rule 12b-2 of the Exchange Act). Yes X No
--- ---
The number of shares of the Registrant's common stock, $.01 par
value, outstanding at February 28, 2005 was 27,615,411.
1
ENGINEERED SUPPORT SYSTEMS, INC.
INDEX
Page
----
Part I - Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of January 31, 2005 and
October 31, 2004................................................... 3
Condensed Consolidated Statements of Income for the three
months ended January 31, 2005 and 2004............................. 4
Condensed Consolidated Statements of Cash Flows for the three
months ended January 31, 2005 and 2004............................. 5
Notes to Condensed Consolidated Financial Statements .............. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ............................. 15
Item 3. Quantitative and Qualitative Disclosures About Market Risk... 21
Item 4. Controls and Procedures...................................... 21
Part II - Other Information
Items 1-6 ............................................................ 22
Signatures ................................................................. 24
Exhibits
2
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
ENGINEERED SUPPORT SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
January 31 October 31
2005 2004
----------- ----------
(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents $ 10,334 $ 33,153
Accounts receivable 128,885 139,191
Contracts in process and inventories 73,107 61,009
Deferred income taxes 6,921 6,921
Other current assets 11,098 2,846
-------- --------
Total Current Assets 230,345 243,120
Property, plant and equipment, less accumulated
depreciation of $30,712 and $29,177 48,379 46,946
Goodwill 191,422 167,358
Acquired customer-related intangibles 43,304 38,314
Deferred income taxes 2,097 1,876
Other assets 13,905 13,520
-------- --------
Total Assets $529,452 $511,134
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt $ 371 $ 340
Accounts payable 63,044 71,796
Other current liabilities 44,241 58,936
-------- --------
Total Current Liabilities 107,656 131,072
Long-term debt 1,005 781
Additional minimum pension liability 28,237 28,237
Other liabilities 14,126 14,088
Shareholders' Equity
Common stock, par value $.01 per share; 85,000
shares authorized; 27,283 and 26,642 shares issued 273 266
Additional paid-in capital 173,273 151,805
Retained earnings 222,857 202,730
Accumulated other comprehensive loss (17,975) (17,845)
-------- --------
378,428 336,956
-------- --------
Total Liabilities and Shareholders' Equity $529,452 $511,134
======== ========
See notes to condensed consolidated financial statements.
3
ENGINEERED SUPPORT SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(UNAUDITED)
Three Months Ended
January 31
-------------------------
2005 2004
-------- --------
Net revenues:
Products $141,732 $124,976
Services 91,801 70,154
-------- --------
233,533 195,130
-------- --------
Cost of revenues:
Products 93,988 87,230
Services 82,001 61,629
-------- --------
175,989 148,859
-------- --------
Gross profit 57,544 46,271
Selling, general and administrative expense 24,553 19,997
Restructuring expense 27
Loss on sale of assets 1 4
-------- --------
Income from operations 32,990 26,243
Interest expense (7) (698)
Interest income 261 54
-------- --------
Income before income taxes 33,244 25,599
Income tax provision 12,633 9,856
-------- --------
Net income $ 20,611 $ 15,743
======== ========
Earnings per share:
Basic $ 0.77 $ 0.63
======== ========
Diluted $ 0.73 $ 0.57
======== ========
See notes to condensed consolidated financial statements.
4
ENGINEERED SUPPORT SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(UNAUDITED)
Three Months Ended
January 31
-------------------------
2005 2004
-------- --------
From operating activities:
Net income $ 20,611 $ 15,743
Depreciation and amortization 3,189 2,269
Loss on sale of assets 1 4
-------- --------
Cash provided before changes in operating
assets and liabilities 23,801 18,016
Net increase in non-cash current assets (3,053) (37,197)
Net decrease in non-cash current liabilities (23,650) (5,900)
Net changes in other assets and liabilities (621) 1,393
-------- --------
Net cash used in operating activities (3,523) (23,688)
-------- --------
From investing activities:
Purchase of PCA, net of cash acquired (37,635)
Purchase of TAMSCO, net of cash acquired (7,436)
Purchase of Pivotal, net of cash acquired (9,967)
Purchase of UPSI, net of cash acquired (2,026)
Additions to property, plant and equipment (2,583) (1,578)
Proceeds from sale of property, plant and equipment 127
-------- --------
Net cash used in investing activities (40,218) (20,880)
-------- --------
From financing activities:
Net borrowings under line-of-credit agreement 6,500
Payments of long-term debt (88) (24)
Proceeds of long-term debt 370 346
Exercise of stock options 18,889 36,379
Issuance of common stock to employee stock purchase plan 2,238 1,279
Cash dividends (484) (453)
-------- --------
Net cash provided by financing activities 20,925 44,027
-------- --------
Effect of exchange rate changes on cash (3) (63)
-------- --------
Net decrease in cash and cash equivalents (22,819) (604)
Cash and cash equivalents at beginning of period 33,153 2,880
-------- --------
Cash and cash equivalents at end of period $ 10,334 $ 2,276
======== ========
See notes to condensed consolidated financial statements.
5
ENGINEERED SUPPORT SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED)
(in thousands, except per share amounts)
JANUARY 31, 2005
NOTE A - BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements have
been prepared by Engineered Support Systems, Inc. (the Company) without
audit and include the accounts of the Company and its wholly-owned
subsidiaries. These subsidiaries are organized within the Company's two
business segments: Support Systems and Support Services. The Support Systems
segment includes the operations of Systems & Electronics Inc. (SEI), Keco
Industries, Inc. (Keco), Engineered Air Systems, Inc. (Engineered Air),
Engineered Coil Company, d/b/a Marlo Coil (Marlo Coil), Engineered Electric
Company, d/b/a Fermont (Fermont), Universal Power Systems, Inc. (UPSI),
Engineered Environments, Inc. (EEI), Pivotal Power Inc. (Pivotal Power) and
Prospective Computer Analysts Incorporated (PCA). The Support Services
segment includes the operations of Technical and Management Services
Corporation (TAMSCO), Radian, Inc. (Radian) and ESSIbuy.com, Inc. (ESSIbuy).
In the opinion of management, all adjustments (including normal recurring
accruals) considered necessary for a fair presentation have been included.
Operating results for the three months ended January 31, 2005 are not
necessarily indicative of the results to be expected for the entire fiscal
year.
The accompanying unaudited condensed consolidated financial
statements have been prepared in accordance with generally accepted
accounting principles for interim financial statements and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by
generally accepted accounting principles for complete financial statements.
For further information, refer to the consolidated financial statements and
footnotes thereto included in the Company's annual report to shareholders
for the year ended October 31, 2004.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In October 2004, Congress passed the American Jobs Creation Act of
2004 (the Jobs Creation Act). The Jobs Creation Act includes numerous
provisions that may materially affect business practices and accounting for
income taxes. For companies that pay U.S. income taxes on manufacturing
activities in the U.S., the Jobs Creation Act provides a phased-in deduction
from taxable income equal to a stipulated percentage of qualified income
from domestic production activities. In December 2004, the FASB issued two
FASB Staff Positions (FSP) regarding the accounting implications of the Act
related to (1) the deduction for qualified domestic production activities
(FSP 109-1) and (2) the one-time tax benefit for the repatriation of foreign
earnings (FSP 109-2). This guidance applies to financial statements for
periods ending after the date the Act was enacted. The Jobs Creation Act
also provides for a change in the period of application
6
for foreign tax credits, elimination of the 90-percent limitation of foreign
tax credits against Alternative Minimum Tax, expanded disallowance of
interest on convertible debt, and tax shelter disclosure penalties. The
Company adopted FSP 109-1 and FSP 109-2 in the first quarter of 2005. The
Jobs Creation Act and related FASB pronouncements will have a material
impact on the Company's financial statements in future periods. However, the
Company has determined that this impact is not material for the quarter
ended January 31, 2005 and will not be material for the year ending October
31, 2005.
In November 2004, the FASB issued SFAS 151, "Inventory Costs - an
amendment of ARB No. 43, Chapter 4." SFAS 151 seeks to clarify the
accounting for abnormal amounts of idle facility expense, freight, handling
costs and wasted material (spoilage) in the determination of inventory
carrying costs. The statement requires such costs to be treated as a current
period expense. This statement is effective November 1, 2005 for the
Company. The Company does not believe that the adoption of SFAS 151 will
have a significant impact on the consolidated financial statements.
In December 2004, the FASB issued SFAS 123 (revised 2004),
"Share-Based Payment", (SFAS 123R). SFAS 123R requires companies to expense
the value of employee stock options and similar awards. SFAS 123R is
effective for public entities that do not file as small business issuers as
of the first interim or annual reporting period that begins after June 15,
2005 and thus will be adopted by the Company for the quarter ending October
31, 2005. The Company is currently evaluating its compensation policies and
practices, along with the impact of SFAS 123R on its results of operations.
NOTE B - EARNINGS PER SHARE
Average diluted common shares outstanding include common stock
equivalents, which represent common stock options as computed based on the
treasury stock method.
Basic earnings per share for the three months ended January 31,
2005 and 2004 is based on average basic common shares outstanding of 26,827
and 25,066, respectively. Diluted earnings per share for the three months
ended January 31, 2005 and 2004 is based on average diluted common shares
outstanding of 28,348 and 27,552, respectively.
NOTE C - STOCK-BASED COMPENSATION
The Company applies Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations in
accounting for all stock option plans. Accordingly, no compensation expense
has been recognized for stock option awards. The following table illustrates
the effect on net income from continuing operations and earnings per share
had the Company applied the fair value recognition provisions of Statement
of Financial Accounting Standards (SFAS) No. 123, "Accounting for
Stock-Based Compensation," to stock option awards.
7
Three Months Ended
January 31
--------------------
2005 2004
------- -------
Reported net income $20,611 $15,743
Total stock-based employee compensation expense
determined under the fair value method for all stock
option awards, net of income tax 2 49
------- -------
Pro forma net income $20,609 $15,694
======= =======
Earnings per share:
Basic - as reported $ 0.77 $ 0.63
======= =======
Basic - pro forma $ 0.77 $ 0.63
======= =======
Diluted - as reported $ 0.73 $ 0.57
======= =======
Diluted - pro forma $ 0.73 $ 0.57
======= =======
Historically, options granted have been fully vested at grant date.
The fair value of options at the grant date was estimated using the
Black-Scholes model with the following weighted average assumptions for the
three months ended January 31, 2005 and 2004: an expected life of 1.5 years,
volatility of 26% and 36%, a dividend yield of 0.07% and 0.12% and a
risk-free interest rate of 3.52% and 3.25%, respectively. The weighted
average fair value of options granted in the three months ended January 31,
2005 and 2004 was $8.06 and $7.55 per share, respectively.
NOTE D - ACQUISITIONS
On January 7, 2005, the Company acquired all of the outstanding
stock of PCA, which develops and manufactures electronic test and
measurement equipment provided for electronic warfare and avionics systems
primarily to military customers. The purchase price, including transaction
costs, was $37.6 million and is subject to a working capital adjustment. The
purchase price was financed with the Company's existing cash balances. The
fair value of assets acquired, including goodwill of $24.1 million and
acquired customer-related intangibles of $6.4 million, was $38.1 million and
liabilities assumed totaled $0.5 million.
On December 5, 2003, the Company acquired all of the outstanding
stock of Pivotal Power, a supplier of high-performance static power
conversion equipment primarily to military customers. The purchase price,
including transaction costs, was approximately $10.1 million, net of cash
acquired. The purchase price was financed with short-term borrowings under
the Company's revolving credit facility. The fair value of assets acquired,
including goodwill of $4.4 million and acquired customer-related intangibles
of $1.2 million, was $11.6 million and liabilities assumed totaled $1.5
million.
On May 1, 2003, the Company acquired all of the outstanding stock
of TAMSCO, a provider of information technology logistics and digitization
services and a designer and integrator of telecommunication systems
primarily for the U.S. Department of Defense (DoD). The purchase price,
including transaction costs, was approximately $71.1 million, which is net
of $0.1 million of cash acquired. Approximately $1.1 million of the purchase
price has not yet been paid subject to final collection of accounts
receivable. In connection with this transaction, the Company also assumed
and paid $14.9 million of TAMSCO indebtedness. The purchase of TAMSCO, net
of cash acquired, totals $84.9 million, which represents the
8
$71.1 million purchase price plus assumed indebtedness of $14.9 million less
$1.1 million of purchase price not yet paid.
The initial purchase price allocation for TAMSCO was based on
preliminary information, which was subject to adjustment upon obtaining
complete valuation information. During the second quarter of 2004, the
Company obtained the final valuation report from an independent third party
valuation firm of the assets acquired and liabilities assumed. As a result,
the Company reclassified $29.9 million from goodwill, as recorded in the
preliminary allocation, to acquired customer-related intangibles and
recorded a $2.2 million non-cash charge in the quarter ended April 30, 2004
to reflect the related amortization expense from acquisition date. The fair
value of assets acquired, including goodwill of $35.9 million and acquired
customer-related intangibles of $29.9 million, was $103.9 million and
liabilities assumed totaled $32.8 million.
PCA and Pivotal Power are included in the Support Systems segment.
TAMSCO is included in the Support Services segment. The operating results of
each are included in consolidated operations since their respective dates of
acquisition.
NOTE E - OTHER COMPREHENSIVE INCOME
A reconciliation of net income to other comprehensive income for
the three months ended January 31, 2005 and 2004 is as follows:
Three Months Ended
January 31
------------------
2005 2004
---- ----
Net income $20,611 $15,743
Other components of
Comprehensive
income, net of tax:
Currency translation adjustments (130) (63)
------- -------
Total comprehensive income $20,481 $15,680
======= =======
NOTE F - GOODWILL AND INTANGIBLE ASSETS
The following table presents changes in the Company's goodwill for
the Support Systems segment and for the Support Services segment for the
three months ended January 31, 2005:
9
Support Support
Systems Services Total
-------- -------- --------
October 31, 2004 $ 99,774 $67,584 $167,358
Acquisitions 24,064 24,064
-------- ------- --------
January 31, 2005 $123,838 $67,584 $191,422
======== ======= ========
The following table presents certain information on the Company's
acquired intangible assets. All acquired intangible assets are being
amortized over their estimated useful lives with no estimated residual
values.
Weighted Average
Amortization Gross Accumulated Net
Period Amount Amortization Amount
------ ------ ------------ ------
Customer-related intangibles:
January 31, 2005 10.9 years $55,683 $12,379 $43,304
October 31, 2004 11.6 years 49,263 10,949 38,314
The amortization expense related to acquired intangible assets was
$1,430 for the three months ended January 31, 2005 and $710 for the three
months ended January 31, 2004. Related estimated amortization expense is
$6,475 for the year ending October 31, 2005, $6,669 for the year ending
October 31, 2006, $6,301 for the year ending October 31, 2007, $3,714 for
the year ending October 31, 2008 and $3,674 for the year ending October 31,
2009.
NOTE G - NOTES PAYABLE
On January 27, 2005, the Company entered into an Amended and Restated
Credit Agreement (Amended Credit Agreement) with its banks. The Amended
Credit Agreement replaced the Company's previous credit agreement dated
April 23, 2003. The Amended Credit Agreement, which expires January 27,
2010, provides for a $200 million unsecured revolving credit facility. The
Company can request, subject to certain conditions, an increase of up to
$100 million in the amount of the aggregate commitment under the Amended
Credit Agreement.
Borrowings under the Amended Credit Agreement bear interest, at the
Company's option, at either the Eurodollar rate plus an applicable margin,
or at the higher of the prime rate or the federal funds rate plus one-half
of one percent. The margin applicable to the Eurodollar rate varies from
0.625% to 1.375% depending upon the Company's ratio of total indebtedness to
earnings before interest, taxes, depreciation and amortization (leverage
ratio). The Amended Credit Agreement contains certain covenants, including
maintaining net worth of at least $265 million, plus 50% of the sum, to
extent positive, of the Company's consolidated net income and other
comprehensive income (loss) reported after October 31, 2004, plus the net
proceeds of all subsequent
10
equity offerings. The Company must also comply with certain financial
covenants, including maintenance of a leverage ratio of no greater than 2.75
to 1. The Company is also subject to various other financial and operating
covenants and maintenance criteria, including restrictions on the Company's
ability to incur additional indebtedness, make investments, create liens,
dispose of material assets and enter into merger transactions and
acquisitions. As of January 31, 2005, the Company had no borrowings against
the Amended Credit Facility.
NOTE H - CONTRACTS IN PROCESS AND INVENTORIES
Contracts in process and inventories of certain of the Company's
operating subsidiaries (SEI, Engineered Air, Keco, Fermont, Radian, TAMSCO,
Pivotal Power and PCA) represent accumulated contract costs, estimated
earnings thereon based upon the percentage of completion method and contract
inventories reduced by the contract value of delivered items. Inventories of
Marlo Coil, UPSI and EEI are valued at the lower of cost or market using the
first-in, first-out method. Contracts in process and inventories are
comprised of the following:
January 31, 2005 October 31, 2004
---------------- ----------------
Raw materials $ 2,212 $ 1,874
Work-in-process 5,158 5,246
Finished goods 519 493
Inventories substantially applicable to
government contracts in process, less
progress payments of $33,349 and
$54,629 65,218 53,396
------- -------
$73,107 $61,009
======= =======
NOTE I - SEGMENT INFORMATION
Based on its organizational structure, the Company operates in two
business segments: Support Systems and Support Services. The Support Systems
segment designs, engineers and manufactures integrated military electronics
and other military support equipment primarily for the DoD, as well as
related heat transfer and air handling equipment for domestic commercial and
industrial users. Segment products include environmental control systems,
load management and transport systems, power generation, distribution and
conditioning systems, airborne radar systems, reconnaissance, surveillance
and target acquisition systems, chemical and biological protection systems,
petroleum and water distribution systems and other multipurpose military
support equipment. The Support Services group provides engineering services,
logistics and training services, advanced technology services, asset
protection systems and services, telecommunication systems integration and
information technology services primarily for the DoD. The Support Services
segment also provides certain power generation and distribution equipment
and vehicle armor installation to the DoD.
Total assets at January 31, 2005, by segment were $295,764 for
Support Systems and $233,688 for Support Services. Goodwill by segment as of
January 31, 2005 totaled $123,838 for Support Systems and $67,584 for
Support Services.
11
The differences in net revenues between the accompanying condensed
consolidated statements of income and the reporting segment information as
presented below are due to certain reclassifications made to categorize net
revenues by their functional nature, as required, on the face of the
financial statements.
Three Months Ended
January 31
---------------------
2005 2004
---- ----
Net Revenues:
Support Systems $119,885 $111,794
Support Services 122,972 89,142
Intersegment Revenues (9,324) (5,806)
-------- --------
Total $233,533 $195,130
======== ========
Operating Income from Continuing Operations:
Support Systems $ 21,432 $ 18,978
Support Services 11,558 7,265
-------- --------
32,990 26,243
Interest expense, net 254 (644)
-------- --------
Income from continuing operations
before income taxes $ 33,244 $ 25,599
======== ========
NOTE J - SHAREHOLDERS' EQUITY
The following summary presents a reconciliation of total
shareholders' equity from October 31, 2004 to January 31, 2005:
Balance at October 31, 2004 $336,956
Comprehensive income:
Net income 20,611
Currency translation adjustments (130)
--------
Total comprehensive income 20,481
--------
Cash dividends (484)
Exercise of stock options 18,889
Issuance of common stock 2,586
--------
Balance at January 31, 2005 $378,428
========
NOTE K - PENSION AND OTHER POSTRETIREMENT BENEFITS
The following tables detail the amount of net periodic benefit cost
recognized related to the Company's pension and other postretirement
benefits for the three months ended January 31, 2005 and 2004.
12
Three Months Ended
January 31
-----------------------------------------------------
Other
Pension Benefits Postretirement Benefits
---------------------- -----------------------
2005 2004 2005 2004
---- ---- ---- ----
Service cost $ 814 $ 706 $ 66 $ 71
Interest cost 1,889 1,743 156 169
Expected return on plan assets (1,863) (1,823)
Amortization of prior service cost 158 149
Actuarial loss 1,046 641 103 110
------- ------- ---- ----
$ 2,044 $ 1,416 $325 $350
======= ======= ==== ====
During the quarter ended January 31, 2005, $2,000 of contributions
have been made to pension and other postretirement benefit plans. The
Company anticipates contributing an additional $6,000 to fund the pension
and other postretirement benefit plans in 2005 for a total of $8,000.
NOTE L - CONTINGENCIES
The Company completed the sale of Engineered Specialty Plastics,
Inc. (ESP), a wholly-owned subsidiary, in the quarter ended April 30, 2003
to a private equity group (the Buyers). The Buyers subsequently alleged that
the Company breached certain representations made under the related Stock
Purchase Agreement (the Agreement) and are seeking $6.0 million in damages
from the Company. Under the terms of the Agreement, this claim is subject to
binding arbitration which the Company believes will be completed by April
30, 2005. The Company has denied liability and is defending the claim
vigorously. The Company also believes that this claim is without merit and
that awarded damages, if any, will not have a material effect on the
consolidated financial position, results of operations or cash flows of the
Company.
NOTE M - SUBSEQUENT EVENTS
Effective February 1, 2005, the Company acquired all of the
membership interests of Spacelink International, LLC (Spacelink), which
designs, integrates, operates and maintains deployed satellite and wireless
networks for the DoD, the U.S. intelligence community and other federal
agencies, and for multinational organizations worldwide. The purchase price,
including transaction costs, was $152.6 million, which is subject to a final
working capital adjustment, plus certain contingent cash consideration based
upon Spacelink's levels of earnings before interest, taxes, depreciation and
amortization (EBITDA) through two measurement dates, January 31, 2006 and
January 31, 2007. The purchase price was financed with $139.4 million in
cash and short-term borrowings under the Company's revolving credit facility
and with the issuance of 228 shares of common stock valued at $13.2 million.
13
On March 1, 2005, the Company announced a three-for-two stock split
to be effected in the form of a 50% stock dividend payable on April 15, 2005
to shareholders of record as of the close of business on March 15, 2005.
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
CRITICAL ACCOUNTING POLICIES
Refer to Management's Discussion and Analysis of Financial Condition
and Results of Operations from the Company's 2004 Annual Report to
Shareholders into the Company's Annual Report on Form 10-K for the period
ended October 31, 2004 for a discussion of the critical accounting policies
which we believe are most difficult, subjective or complex.
The following analysis should be read in this context.
RESULTS OF OPERATIONS
Consolidated net revenues increased $38.4 million, or 19.7%, to
$233.5 million in the first quarter of 2005 compared to $195.1 million in
the first quarter of 2004. The increase was primarily due to additional
revenues from refurbishment of M1000 Heavy Equipment Transporters,
production of generator sets, satellite telecommunications support
activities for deployed troops abroad, U.S. Army depot support efforts and
the installation of vehicle uparmor kits. Revenue increases from these
programs were partially offset by reduced work on the 60-K Tunner Aircraft
Cargo Loader as production on this contract winds down in the second quarter
of 2005, and on the Manportable Surveillance and Target Acquisition Radar
(MSTAR) perimeter security program for which a large base security
subcontract for Northrup Grumman was completed in the fourth quarter of
2004. In addition, more recently acquired subsidiaries, Pivotal Power
(acquired December 5, 2003) and PCA (acquired January 7, 2005), added a
combined $1.5 million of incremental revenues in the first quarter of 2005.
Gross profit for the
15
three months ended January 31, 2005 increased $11.3 million, or 24.4%, to
$57.5 million (24.6% of consolidated net revenues) from $46.2 million (23.7%
of consolidated net revenues) in the comparable 2004 period. Revenue growth
of $38.4 million, coupled with improved gross margins within both the
Support Systems segment and Support Services segment, resulted in the
increase in gross profit. Selling, general and administrative expense
increased $4.6 million, or 22.8%, in the first quarter of 2005 to $24.6
million (10.5% of consolidated net revenues) from $20.0 million (10.2% of
consolidated net revenues) in the first quarter of 2004. Selling, general
and administrative expense for Pivotal Power and PCA accounted for $0.8
million of the $4.6 million increase, with the remaining increase required
to support higher operating levels. As a result of the above, operating
income increased $6.8 million, or 25.7%, in the quarter ended January 31,
2005 to $33.0 million from $26.2 million in the first quarter of 2004.
SUPPORT SYSTEMS. Net revenues in the first quarter of 2005 for the
Support Systems segment totaled $119.9 million compared to $111.8 million
(prior to the elimination of intersegment revenues in each period) for the
same period in the prior year, a 7.2% increase. The improved results reflect
the inclusion of a combined $1.5 million in net revenues from Pivotal Power
and PCA during the first quarter. The programs with the largest revenue
gains during the quarter include $6.1 million from refurbishment of M1000
Heavy Equipment Transporters, $5.4 million from production of generator sets
and $4.0 million for intersegment work performed for the Support Systems
segment. Revenue increases from these and other Support Systems programs
were partially offset by reduced revenues of $6.1 million on the 60-K Tunner
Aircraft Cargo Loader as production on the contract winds down in the second
quarter 2005, and
16
by reduced revenues of $12.4 million on the MSTAR program for which a large
base security subcontract for Northrup Grumman was completed in the fourth
quarter of 2004. Gross profit for the segment increased by $4.0 million, or
12.5%, in the three months ended January 31, 2005 to $36.1 million (30.1% of
segment revenues) from $32.1 million (28.7% of segment revenues) in the
prior year quarter primarily on the strength of the above revenue increases,
as well as overall product mix improvements. Quarterly operating income for
the segment climbed to $21.4 million (17.9% of segment revenues) compared to
$19.0 million (17.0% of segment revenues) last year. Incremental revenues
and related gross profit contributions led to the overall improved results
for the Support Systems segment.
SUPPORT SERVICES. Net revenues for the Support Services segment
increased to $123.0 million, an increase of $33.8 million, or 38.0%,
compared to $89.2 million (prior to the elimination of intersegment revenues
in each period) for the first quarter of 2005. The most significant
year-over-year revenue increases were generated by satellite
telecommunications support for deployed forces ($28.3 million) and the
vehicle uparmor kit program ($11.6 million). Gross profit for the segment
increased by $7.3 million, or 51.1% in the three months ended January 31,
2005 to $21.4 million (17.4% of segment revenues) from $14.1 million (15.9%
of segment revenues) in the prior year quarter as a result of increased
revenues and a more profitable mix of contracts. Segment operating income
for the first quarter of 2005 totaled $11.6 million (9.4% of segment
revenues) compared to $7.3 million (8.1% of segment revenues) in the same
period last year. Incremental revenues and related gross profit
contributions led to the overall improved results for the Support Services
segment.
17
CONSOLIDATED RESULTS OF OPERATIONS. Net interest expense (income)
totaled $0.6 million in the first quarter of 2004 compared to $(0.3) million
in the first quarter of 2005 as a result of significantly reduced borrowing
levels. The effective income tax rate was 38.0% for the three months ended
January 31, 2005 compared to 38.5% for the three months ended January 31,
2004. This reduction is primarily a result of the Company's ongoing state
income tax reduction initiatives. As a result of the foregoing, net income
increased 30.9% to $20.6 million (8.8% of consolidated net revenues) in the
quarter ended January 31, 2005 as compared to $15.7 million (8.1% of
consolidated net revenues) in the first quarter of 2004.
Based on first quarter results, existing backlog and anticipated
orders, the Company anticipates that 2005 revenues will approximate $990
million to $1 billion, and that earnings per share will approximate between
$3.13 and $3.18. These estimates include the operations of Spacelink
International, LLC (Spacelink), which was acquired effective February 1,
2005.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In October 2004, Congress passed the American Jobs Creation Act of
2004 (the Jobs Creation Act). The Jobs Creation Act includes numerous
provisions that may materially affect business practices and accounting for
income taxes. For companies that pay U.S. income taxes on manufacturing
activities in the U.S., the Jobs Creation Act provides a phased-in deduction
from taxable income equal to a stipulated percentage of qualified income
from domestic production activities. In December 2004, the FASB issued two
FASB Staff Positions (FSP) regarding the accounting implications of the Act
related to (1) the deduction for qualified domestic production activities
(FSP 109-1) and (2) the one-time tax benefit for the repatriation of foreign
earnings (FSP 109-2). This guidance applies to financial statements for
periods ending after the date the Act was enacted. The Jobs Creation Act
also provides for a change in the period of application for foreign tax
credits, elimination of the 90-percent limitation of foreign tax credits
against Alternative Minimum Tax, expanded disallowance of interest on
convertible debt, and tax shelter disclosure penalties. The Company adopted
FSP 109-1 and FSP 109-2 in the first quarter of 2005. The Jobs Creation Act
and related FASB pronouncements
18
will have a material impact on the Company's financial statements in future
periods. However, the Company has determined that this impact is not
material for the quarter ended January 31, 2005 and will not be material for
the year ending October 31, 2005.
In November 2004, the FASB issued SFAS 151, "Inventory Costs - an
amendment of ARB No. 43, Chapter 4." SFAS 151 seeks to clarify the
accounting for abnormal amounts of idle facility expense, freight, handling
costs and wasted material (spoilage) in the determination of inventory
carrying costs. The statement requires such costs to be treated as a current
period expense. This statement is effective November 1, 2005 for the
Company. The Company does not believe that the adoption of SFAS 151 will
have a significant impact on the consolidated financial statements.
In December 2004, the FASB issued SFAS 123 (revised 2004),
"Share-Based Payment", (SFAS 123R). SFAS 123R requires companies to expense
the value of employee stock options and similar awards. SFAS 123R is
effective for public entities that do not file as small business issuers as
of the first interim or annual reporting period that begins after June 15,
2005 and thus will be adopted by the Company for the quarter ending October
31, 2005. The Company is currently evaluating its compensation policies and
practices, along with the impact of SFAS 123R on its results of operations.
LIQUIDITY AND CAPITAL RESOURCES
On January 27, 2005, the Company entered into an Amended and
Restated Credit Agreement (Amended Credit Agreement) with its banks. The
Amended Credit Agreement replaced the Company's previous credit agreement
dated April 23, 2003. The Amended Credit Agreement, which expires January
27, 2010, provides for a $200 million unsecured revolving credit facility.
The Company can request, subject to certain conditions, an increase of up to
$100 million in the amount of the aggregate commitment under the Amended
Credit Agreement.
Borrowings under the Amended Credit Agreement bear interest, at the
Company's option, at either the Eurodollar rate plus an applicable margin,
or at the higher of the prime rate or the federal funds rate plus one-half
of one percent. The margin applicable to the Eurodollar rate varies from
0.625% to 1.375% depending upon the Company's ratio of total indebtedness to
earnings before interest, taxes, depreciation and amortization (leverage
ratio). The Amended Credit Agreement contains certain covenants, including
maintaining net worth of at least $265 million, plus 50% of the sum, to
extent positive, of the Company's consolidated net income and other
comprehensive income (loss) reported after October 31, 2004, plus the net
proceeds of all subsequent equity offerings. The Company must also comply
with certain financial covenants, including maintenance of a leverage ratio
of no greater than 2.75 to 1. The Company is also subject to various other
financial and operating covenants and maintenance criteria, including
restrictions on the Company's ability to incur additional indebtedness, make
investments, create liens, dispose of material assets and enter into merger
transactions and acquisitions. As of January 31, 2005, the Company had no
borrowings against the Amended Credit Facility.
On January 7, 2005, the Company acquired all of the outstanding
stock of PCA, which develops and manufactures electronic test and
measurement equipment provided for electronic warfare and avionics systems
primarily to military customers. The purchase price was $37.6 million and is
subject to a working capital adjustment. The purchase price was financed
with the Company's existing cash balances. The fair value of assets
acquired, including goodwill of $24.1 million and acquired customer-related
intangibles of $6.4 million, was $38.1 million and liabilities assumed
totaled $0.5 million.
19
Effective February 1, 2005, the Company acquired all of the
membership interests of Spacelink International, LLC (Spacelink), which
designs, integrates, operates and maintains deployed satellite and wireless
networks for the DoD, the U.S. intelligence community and other federal
agencies, and for multinational organizations worldwide. The purchase price
was $152.6 million, which is subject to a final working capital adjustment,
plus certain contingent cash consideration based upon Spacelink's levels of
earnings before interest, taxes, depreciation and amortization (EBITDA)
through two measurement dates, January 31, 2006 and January 31, 2007. The
purchase price was financed with $139.4 million in short-term borrowings
under the Company's revolving credit facility and with the issuance of 228
shares of common stock valued at $13.2 million.
At January 31, 2005, the Company's working capital and ratio of
current assets to current liabilities were $122.7 million and 2.14 to 1 as
compared with $112.0 million and 1.85 to 1 at October 31, 2004. Net cash
used in operations totaled $3.5 million in the first quarter of 2005
compared to net cash used in operations of $23.7 million in the first
quarter of 2004. The negative operating cash flow generated in the quarter
ended January 31, 2005 reflects a temporary increase in working capital of
$26.7 million related to the timing of contractual deliveries, which the
Company anticipates will be substantially liquidated in the quarter ending
April 30, 2005. Investment in property, plant and equipment totaled $2.6
million and $1.6 million for the first three months of 2005 and 2004,
respectively. The Company anticipates that capital expenditures in 2005
should not exceed $20.0 million. Management believes that cash flow
generated from operations, together with the available line of credit, will
provide the necessary resources to meet the needs of the Company in the
foreseeable future.
During the three months ended January 31, 2005 and 2004, the
Company received proceeds of $18.9 million and $36.4 million related to the
exercise of stock options.
BUSINESS AND MARKET CONSIDERATIONS
Approximately 92% of consolidated net revenues for the three months
ended January 31, 2005 were directly or indirectly derived from defense
orders by the U.S. government and its agencies. As of January 31, 2005, the
Company's funded backlog of orders totaled $582.1 million, with related
customer options of an additional $825.3 million. These amounts compare to
funded backlog of $588.1 million and related customer options of an
additional $849.1 million as of October 31, 2004.
Management continues to pursue potential acquisitions, primarily of
those companies providing strategic consolidation within the defense
industry.
FORWARD-LOOKING STATEMENTS
In addition to historical information, this report includes certain
forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended, which
20
are intended to be covered by the safe harbors created thereby. The
forward-looking statements involve certain risks and uncertainties, which
could cause the Company's actual results to differ materially from those
projected in, or inferred by, the forward-looking statements, including, but
not limited to acquisitions, additional financing requirements, the decision
of any of the Company's key customers (including the U.S. government) to
reduce or terminate orders with the Company, cutbacks in defense spending by
the U.S. government and increased competition in the Company's markets and
other risks discussed in the Company's reports filed with the Securities and
Exchange Commission from time to time.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risks relating to the Company's operations result primarily
from changes in interest rates. Given existing debt levels, significant cash
flows and anticipated expenditures, Company management has not utilized
interest rate swaps or other derivative contracts to hedge this risk since
November 2002. Management does not believe its exposure to interest rate
fluctuations has had, or will have, a significant impact on the Company's
operations.
ITEM 4. CONTROLS AND PROCEDURES.
As of January 31, 2005, the Company carried out an evaluation,
under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures as defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the
"Exchange Act"). Based upon the evaluation, the Company's Chief Executive
Officer and Chief Financial Officer concluded that the Company's disclosure
controls and procedures are effective.
There have been no changes in the Company's internal control over
financial reporting during the period covered by this report that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
21
PART II
OTHER INFORMATION
Item 1 Not Applicable
Item 2 Unregistered Sales of Equity Securities
Effective February 1, 2005, the Company acquired all of the membership
interests of Spacelink International, LLC ("Spacelink"). A portion of the
purchase price paid by the Company at closing consisted of the issuance by
the Company of 228,292 shares of its restricted common stock valued at
approximately $13.2 million. The Company issued these shares of common stock
to the sellers of Spacelink's membership interests, Spacelink International
LTD., a Delaware corporation and SatComSolutions LLC, a Delaware limited
liability company. The common stock was issued as a private placement of
securities under Section 4(2) of the Securities Act of 1933.
Item 3 - 5 Not Applicable
Item 6 Exhibits
See Exhibit Index.
22
SIGNATURES
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 thereunto duly authorized.
ENGINEERED SUPPORT SYSTEMS, INC.
Date: March 14, 2005
--------------
By: /s/ Gerald A. Potthoff
--------------------------------
Gerald A. Potthoff
Vice Chairman, Chief Executive
Officer and President
Date: March 14, 2005
--------------
By: /s/ Gary C. Gerhardt
-------------------------------
Gary C. Gerhardt
Vice Chairman and Chief
Financial Officer
23
EXHIBIT INDEX
10.1 Form of Employment Agreement with Michael F. Shanahan, Sr.
dated November 1, 2005 filed as Exhibit 10.1 to the
Company's Annual Report on Form 10-K filed January 14,
2005, as amended, and incorporated herein by reference.
10.2 Form of Employment Agreement with Gerald A. Potthoff dated
November 1, 2005 filed as Exhibit 10.2 to the Company's
Annual Report on Form 10-K filed January 14, 2005, as
amended, and incorporated herein by reference.
10.3 Form of Employment Agreement with Gary C. Gerhardt, dated
November 1, 2005 filed as Exhibit 10.3 to the Company's
Annual Report on Form 10-K filed January 14, 2005, as
amended, and incorporated herein by reference.
10.4 Form of Employment Agreement with Ronald W. Davis, dated
November 1, 2005 filed as Exhibit 10.4 to the Company's
Annual Report on Form 10-K filed January 14, 2005, as
amended, and incorporated herein by reference.
10.5 Purchase Agreement by and between Engineered Support
Systems, Inc. and Spacelink International LLC, Spacelink
International LTD and SatComSolutions LLC dated December
9, 2004 filed as Exhibit 10.7 to the Company's Annual
Report on Form 10-K filed January 14, 2005, as amended,
and incorporated herein by reference.
10.6 Closing Letter amending the Purchase Agreement by and
between Engineered Support Systems, Inc. and Spacelink
International LLC, Spacelink International LTD and
SatComSolutions LLC dated February 7, 2005.
10.7 Stock Purchase Agreement by and between Prospective
Computer Analysts Incorporated, Edward Wenger, The Lauren
Wenger 2004 GRAT, The Eric Wenger 2004 GRAT, the Mitchell
Wenger 2004 GRAT and Engineered Support Systems, Inc.
dated January 7, 2005 filed as Exhibit 10.8 to the
Company's Annual Report on Form 10-K filed January 14,
2005, as amended, and incorporated herein by reference.
10.8 Amended and Restated Credit Agreement dated as of January
27, 2005 among Engineered Support Systems, Inc., as the
Borrower, Bank of America, N.A. and the Other Lenders
Party Hereto filed as Exhibit 99 to the Company's Current
Report on Form 10-Q filed February 2, 2005 and
incorporated herein by reference.
11 Statement Re: Computation of Earnings Per Share
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to
Section 906 of the Section 906 of the Sarbanes-Oxley Act
of 2002
24