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XLS > SEC Filings for XLS > Form 10-Q on 2-Nov-2012All Recent SEC Filings

Show all filings for EXELIS INC.

Form 10-Q for EXELIS INC.


2-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(In millions, except per share amounts, unless otherwise stated)

You should read the following discussion of our results of operations and financial condition together with the unaudited Condensed Consolidated and Combined Financial Statements and notes thereto included in this quarterly report on Form 10-Q, as well as the audited Consolidated and Combined Financial Statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011, which provides additional information regarding the Company, our products and services, industry outlook and forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward looking statements.

OVERVIEW

Exelis is a leader in Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance (C4ISR) related products and systems and information and technical services, which it supplies to military, government and commercial customers in the United States and globally. Exelis provides mission-critical systems in the areas of integrated electronic warfare, sensing and surveillance, air traffic management, information and cyber-security, and networked communications. Exelis also has growing positions in composite aerostructures, logistics and technical services. The Company's customers include the United States (U.S.) Department of Defense (DoD), including the U.S. Army, Navy, Marines and Air Force, and its prime contractors, U.S. Government intelligence agencies, National Aeronautics and Space Administration (NASA), Federal Aviation Administration (FAA), allied foreign governments and domestic and foreign commercial customers. As a prime contractor, subcontractor, or preferred supplier, Exelis participates in many high priority defense and non-defense programs in the United States. Exelis conducts most of its business with the U.S. Government, principally the DoD.

Our business is reported in two segments: C4ISR Electronics and Systems and Information and Technical Services. Our C4ISR Electronics and Systems segment provides engineered electronic systems and equipment, including force protection, electronic warfare systems, reconnaissance and surveillance systems, and integrated structures. Our Information and Technical Services segment is a provider of logistics, infrastructure, and sustainment support, while also providing a diverse set of technical services.

On October 31, 2011, ITT Corporation ("ITT") completed the spin-off (the "Spin-off") of Exelis and Exelis began operating as a stand-alone publicly traded corporation. Prior to the Spin-off, Exelis operated as the Defense and Information Solutions Segment of ITT.

Prior to the Spin-off, the financial information included herein may not necessarily reflect our financial position, results of operations and cash flows in the future or what our financial position, result of operations and cash flows would have been had we been an independent, publicly traded company during the periods presented prior to October 31, 2011. We are incurring additional costs as an independent, publicly traded company, including additional costs related to corporate finance, governance and public reporting. We believe cash flows from operations will be sufficient to fund these additional costs going forward.

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Unless the context otherwise requires, references in these notes to "Exelis," "we," "us," "our," "the Company" and "our Company" refer to Exelis Inc. and its subsidiaries. References in these notes to "ITT" or "parent" refer to ITT Corporation, an Indiana corporation, and its subsidiaries (other than Exelis), unless the context otherwise requires.

Economic Opportunities, Challenges, and Risks

The United States continues to face significant economic and fiscal challenges, including slow GDP growth, high unemployment, and persistent U.S. federal government budget deficits. Concerns over fiscal deficits and the national debt continue to drive the political debate and no national consensus exists on the appropriate level of defense and other federal spending, making long-term funding targets and priorities unclear.

This uncertainty is not likely to abate prior to the U.S. presidential election in November 2012, and we expect that fiscal uncertainty is likely to prevail through mid-December 2012. We believe the prospects for finalizing fiscal year 2013 spending levels remain low because Congress has failed to pass either a fiscal year 2013 budget resolution or the individual appropriations bills that serve to allocate discretionary spending among the federal government's cabinet agencies, commissions, boards and independent agencies. For the near term, Congress has enacted a six month continuing resolution (CR), which will keep the government operating through March 27, 2013.

The CR assumes a top line discretionary spending amount of $1.05 trillion for fiscal year 2013, consistent with the Comprehensive Budget Agreement (CBA) of August 2011, which translates into an expected spending level of $608 billion for the DoD, down from $634 billion in fiscal year 2012, driven in large part by declining Overseas Contingency Operation (OCO) funding of $89 billion, down from about $115 billion in fiscal year 2012. The CBA also includes a provision known as "Sequestration," scheduled to be implemented in January 2013, which would impose significantly greater cuts to DoD budgets over the next ten years, unless a compromise solution to reduce budget deficits is reached by Congress and the President. If Sequestration were implemented it would significantly reduce most defense and domestic discretionary spending by fixed percentages of approximately 9% and 8%, respectively.

We believe potential solutions to this budgetary uncertainty include the following: a yearlong CR with no enacted fiscal year 2013 appropriations bills or budget resolutions; a short term one year spending reduction bill which temporarily delays the first year of Sequestration; or a comprehensive multi-year budget agreement which combines spending cuts, tax reform, and entitlement or mandatory spending formula changes. Companies which derive substantial revenues from federal contracting will benefit the most from a comprehensive agreement which implements fundamental multi-year changes that would prevent Sequestration from actually occurring. The debate over how and when a solution may be reached over the as-yet unresolved Sequestration issue remains a significant issue for the defense industry.

We believe that spending on recapitalization, modernization and maintenance of defense and security assets will continue despite possible reductions to some defense programs in which we participate or for which we expect to compete. We expect ongoing DoD emphasis to be placed on our areas of strength, such as electronic warfare, intelligence, surveillance and reconnaissance (ISR), precision navigation instruments, cyber, and information processing, exploitation and dissemination. However, uncertainty related to potential changes in appropriations and priorities could materially impact our business.

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The information provided above does not represent a complete list of known trends and uncertainties that could impact our business in either the near or long-term. It should, however, be considered along with the risk factors identified in Part 1, Item 1A under the caption "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2011 and our disclosure under the caption "Forward-Looking and Cautionary Statements" at the end of this section.

Executive Summary

Exelis reported revenue of $1.4 billion for the quarter ended September 30, 2012, a decrease of 11% compared to the corresponding period in 2011. The decrease in revenue was driven by revenue declines of 18% in our C4ISR Electronics and Systems segment primarily due to lower demand for surge-related products, including our Night Vision products and Single Channel Ground and Airborne Radio Systems (SINCGARS). Revenue also declined 5% within our Information and Technical Services segment primarily due to the completion of an Advanced Information Systems contract.

Operating income for the three months ended September 30, 2012 was $143, reflecting a decrease of $13 or 8% compared to the corresponding prior year period primarily due to lower revenue. Overall, operating margin increased quarter-over-quarter to 10.5% from 10.2% primarily due to lower selling, general and administrative expenses.

Further details related to the quarter are contained in the Discussion of Financial Results section.

Key Performance Indicators and Non-GAAP Measures

Management reviews key performance indicators including revenue, segment operating income and margins, orders growth, and backlog, among others metrics on a regular basis. In addition, we consider certain additional measures to be useful to management and investors evaluating our operating performance for the periods presented, and provide a tool for evaluating our ongoing operations, liquidity and management of assets. This information can assist investors in assessing our financial performance and measures our ability to generate capital for deployment among competing strategic alternatives and initiatives, including, but not limited to, acquisitions and debt repayment. These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (GAAP) and should not be considered a substitute for revenue, operating income, income from continuing operations, or net cash from continuing operations as determined in accordance with GAAP. We consider the following non-GAAP measure, which may not be comparable to similarly titled measures reported by other companies, to be a key performance indicator:

"Adjusted net income" defined as net income, adjusted to exclude items that include, but are not limited to significant charges or credits that impact current results, but are not related to our ongoing operations, unusual and infrequent non-operating items and non-operating tax settlements or adjustments. A reconciliation of adjusted net income is provided below.

                                   Three Months Ended September 30,                  Nine Months Ended September 30,
                                   2012                       2011                   2012                       2011
Net income                    $           88            $            101        $           244            $           262
Separation costs, net of
tax                                        4                           6                     19                         15
Reversal of separation
related tax receivable
write-down                                (4 )                         -                     (4 )                        -
Reversal of separation
related tax items                         (4 )                         -                      -                          -
Adjusted net income           $           84            $            107        $           259            $           277

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DISCUSSION OF FINANCIAL RESULTS

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2012 COMPARED TO THREE AND NINE MONTHS
ENDED SEPTEMBER 30, 2011

Selected financial highlights are presented in the table below:



                                    Three Months Ended September 30,                     Nine Months Ended September 30,
                                 2012              2011            Change             2012              2011           Change
Product and service
revenue                       $     1,361        $   1,529            (11.0 )%     $     4,161        $   4,359            (4.5 )%
Cost of product and
service revenue                     1,083            1,198             (9.6 )%           3,305            3,461            (4.5 )%
Operating expense                     135              175            (22.9 )%             430              506           (15.0 )%
Operating income                      143              156             (8.3 )%             426              392             8.7 %
Operating margin                     10.5 %           10.2 %                              10.2 %            9.0 %
Interest expense                        9                1              800 %               29                1           2,800 %
Other expense (income),
net                                    (4 )              1             (500 )%               3              (13 )           123 %
Income tax expense                     50               53             (5.7 )%             150              142             5.6 %
Effective tax rate                   36.2 %           34.4 %                              38.1 %           35.1 %
Net income                    $        88        $     101            (12.9 )%     $       244        $     262            (6.9 )%

Revenue

Revenue for the three and nine months ended September 30, 2012 decreased $168 or
11.0% and $198 or 4.5%, respectively, as compared to the same prior year
periods. The following table illustrates revenue for our segments:



                                          Three Months Ended September 30,                    Nine Months Ended September 30,
                                        2012             2011            Change             2012            2011           Change
C4ISR Electronics & Systems         $        611       $     746            (18.1 )%     $     1,884      $   2,114         (10.9)%
Information & Technical Services             750             786             (4.6 )%           2,277          2,250           1.2%
Eliminations                                   -              (3 )                                 -             (5 )
Total Revenue                       $      1,361       $   1,529            (11.0 )%     $     4,161      $   4,359          (4.5)%

Revenue from our C4ISR Electronics and Systems segment decreased $135 and $230 for the three and nine months ended September 30, 2012, respectively, as compared with the same periods in 2011. The decrease in revenue for the three and nine months ended September 30, 2012 was primarily due to volume declines in surge-related products, including Night Vision products of approximately $87 and $135, respectively, SINCGARS products of approximately $63 and $124, respectively, and Counter RCIED Electronic Warfare (CREW) 2.1 and special purpose jammers products of approximately $10 and $35, respectively. The decrease in revenue for the three and nine months ended September 30, 2012 as compared with the same prior year periods was partially offset by higher revenue from the sales of our Band C Upgrade kits for legacy CREW products of approximately $45 and $75, respectively. Additionally, for the nine months ended September 30, 2012, sales of other counter-IED systems increased by approximately $31 as compared to the same period in 2011.

Revenue from our Information and Technical Services segment decreased $36 for the three months ended September 30, 2012 as compared with the same period in 2011. The decrease in revenue was

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primarily due to lower revenue on our Technology and Systems Engineering Bridge (TSE Bridge) program of approximately $19 and lower activity on our Kuwait Based Operations and Security Support Services (K-BOSSS) contract of approximately $15 and our Total Army Communications for Southwest Asia, Central Asia and Africa (TACSWACAA) program of approximately $14. The TSE Bridge program, performed in our Advanced Information Systems area, ended in late 2011. The decrease in revenue for the three months ended September 30, 2012 as compared with the same prior year period was partially offset by higher revenue from Afghan National Security Forces (ANSF) Facilities Support programs of approximately $14.

Revenue from our Information and Technical Services segment increased $27 for the nine months ended September 30, 2012 as compared with the same period in 2011. The increase in revenue was primarily due to efforts to support NASA under our Space Communication and Networks Services (SCNS) contract, which had a revenue increase of approximately $52, and efforts to support the U.S. Armed Services on our Afghanistan Programs, including the ANSF Facilities Support programs and the Logistics Civilian Augmentation Program (LOGCAP), which had revenue increases of approximately $51 and $30, respectively. The SCNS contract provides most of the communications and tracking services for a wide range of Earth-orbiting spacecraft, including the International Space Station. The increase in revenue for the nine months ended September 30, 2012 was partially offset by lower revenue on the TSE Bridge program of approximately $56, and lower net revenue on our Middle East Programs, including a decrease on the Kuwait based Army Preposition Stock-5 (APS-5 Kuwait) contract of approximately $54.

Cost of Revenue and Operating Expenses

Cost of product and service revenue and other operating expenses are comprised
of the following:



                                        Three Months Ended September 30,                           Nine Months Ended September 30,
                                   2012               2011              Change               2012               2011              Change
Cost of product revenue         $      434         $      510               (14.9 )%      $     1,328         $   1,465                (9.4 )%
% of product revenue                  71.0 %             68.5 %                                  70.5 %            69.4 %
Cost of service revenue                649                688                (5.7 )%            1,977             1,996                (1.0 )%
% of service revenue                  86.5 %             87.6 %                                  86.8 %            88.8 %
Selling, general and
administrative expenses                114                150               (24.0 )%              377               429               (12.1 )%
% of total revenue                     8.4 %              9.8 %                                   9.1 %             9.8 %
Research and development
expenses                                18                 24               (25.0 )%               48                72               (33.3 )%
% of total revenue                     1.3 %              1.6 %                                   1.2 %             1.7 %
Restructuring and asset
impairment charges, net                  3                  1                 200 %                 5                 5                   -

Cost of Product and Service Revenue

The decrease in cost of product revenue of $76 or 14.9% and $137 or 9.4% for the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011 was primarily due to lower revenue in our C4ISR Electronics and Systems segment. The cost of product revenue as a percentage of product revenue increased for the three and nine months ended September 30, 2012 as compared to the corresponding periods in 2011 due to a net sales mix of lower margin products.

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The decrease in cost of service revenue of $39 or 5.7% for the three months ended September 30, 2012 as compared to the same period in 2011 was primarily due to lower revenue in our Information and Technical Services segment. The cost of service revenue as a percentage of service revenue decreased for the three months ended September 30, 2012 as compared to the corresponding period in 2011 primarily due to productivity improvements and contract pricing adjustments on several contracts in our Air Traffic Management and Afghanistan Programs areas.

The decrease in cost of service revenue of $19 or 1.0% for the nine months ended September 30, 2012 as compared to the same period in 2011 was primarily due to productivity improvements in our Information and Technical Services segment. The cost of service revenue as a percentage of service revenue decreased for the nine months ended September 30, 2012 as compared to the corresponding period in 2011 primarily due to productivity improvements and contract pricing adjustments on several contracts in our Air Traffic Management and Afghanistan Programs areas.

Selling, General & Administrative Expenses (SG&A)

SG&A expenses as a percent of total revenue were 8.4% and 9.1% for the three and nine months ended September 30, 2012, respectively, compared to 9.8% in both of the same periods in 2011. The decrease in SG&A expenses as a percent of total revenue as compared to the same periods in 2011 was due to lower SG&A expenses, partially offset by lower revenue in both periods. For the three and nine months ended September 30, 2012, SG&A expenses decreased as compared to the same periods in 2011 primarily due to the absence of general corporate expense allocations from ITT of $31 and $90, respectively, and cost reductions partially resulting from prior year restructuring in our C4ISR Electronics and Systems segment, partially offset by higher net periodic benefit costs of $10 and $29, respectively, and higher general corporate expenses necessary to operate as a stand-alone company. The Corporate expense allocations received from ITT during the three and nine months ended September 30, 2011 included allocations for pension and other defined benefit postretirement plan costs of $27 and $67, respectively.

Research and Development Expenses (R&D)

The decrease in R&D expenses of $6 or 25.0% and $24 or 33.3% for the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011 primarily reflects the completion of certain R&D projects for integrated electronic warfare systems, other communication technologies and night vision technologies primarily within our C4ISR Electronics and Systems segment.

Restructuring and Asset Impairment Charges, Net

During the three and nine months ended September 30, 2012, we recognized net restructuring and asset impairment charges of $3 and $5, respectively. Restructuring and asset impairment charges, net, for the three and nine months ended September 30, 2011 were $1 and $5, respectively. The period-over-period changes in restructuring and asset impairment charges, net, were not significant.

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Operating Income

The following table illustrates the operating income results of our business
segments, including operating margin results.



                                         Three Months Ended September 30,                          Nine Months Ended September 30,
                                    2012               2011              Change               2012               2011             Change
C4ISR Electronics & Systems      $       84         $      107               (21.5 )%      $      261         $      278               (6.1 )%
Operating margin                       13.7 %             14.3 %                                 13.9 %             13.2 %
Information and Technical
Services                                 59                 49                20.4 %              165                114               44.7 %
Operating margin                        7.9 %              6.2 %                                  7.2 %              5.1 %
Total operating income           $      143         $      156                (8.3 )%      $      426         $      392                8.7 %
Total operating margin                 10.5 %             10.2 %                                 10.2 %              9.0 %

During the performance of long-term sale contracts, estimated final contract prices and costs are reviewed periodically and revisions are made as required and recorded in income in the period in which they are determined. Changes in estimated revenues, cost of revenue and the related effect to operating income are recognized using a cumulative catch-up adjustment which recognizes in the current period the cumulative effect of the changes on current and prior periods based on a contract's percent complete. Net favorable cumulative catch-up adjustments related to prior periods increased operating income by approximately $26 and $79 for the three and nine months ended September 30, 2012, respectively, and by approximately $52 and $127 for the three and nine months ended September 30, 2011, respectively. Productivity improvements and contract pricing adjustments primarily contributed to the net favorable cumulative catch-up adjustments in the current three and nine month periods.

Operating income at our C4ISR Electronics and Systems segment for the three months ended September 30, 2012 decreased $23 or 21.5% as compared to the same period in 2011. Operating income as a percentage of revenue was 13.7% for the three months ended September 30, 2012 as compared to 14.3% for the same period in 2011. The decrease in operating margin was primarily due to higher cost of product revenue as a percentage of product revenue for the three months ended September 30, 2012 as compared to the same period in 2011.

Operating income at our C4ISR Electronics and Systems segment for the nine months ended September 30, 2012 decreased $17 or 6.1% as compared to the same period in 2011. Operating income as a percentage of revenue was 13.9% for the nine months ended September 30, 2012 as compared to 13.2% for the same period in 2011. The increase in operating margin was primarily due to lower SG&A expenses as a percentage of product revenue for the nine months ended September 30, 2012 as compared to the same period in 2011.

Operating income at our Information and Technical Services segment for the three and nine months ended September 30, 2012 increased $10 or 20.4% and $51 or 44.7%, respectively, as compared to the same periods in 2011. Operating income as a percentage of revenue for the three and nine months ended September 30, 2012 was 7.9% and 7.2%, respectively, as compared to 6.2% and 5.1% for the same periods in 2011. The increase in operating margin was primarily due to lower cost of service revenue as a percentage of service revenue for both the three and nine months ended September 30, 2012 as compared to the same periods in 2011.

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Impact to Operating Income from Postretirement Expense

We recorded net periodic benefit costs of $12 and $36 for the three and nine . . .

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