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LLL > SEC Filings for LLL > Form 10-Q on 5-Nov-2012All Recent SEC Filings

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Form 10-Q for L 3 COMMUNICATIONS HOLDINGS INC


5-Nov-2012

Quarterly Report


MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Overview and Outlook

Spin-off of Engility

On July 17, 2012, L-3 completed the spin-off of its subsidiary, Engility Holdings, Inc. (Engility) to L-3's shareholders. The spin-off was a tax-free distribution to L-3 shareholders for U.S. federal tax purposes, except for cash received in lieu of fractional shares. L-3 shareholders of record on July 16, 2012 (the record date) received one share of Engility common stock for every six shares of L-3 common stock held on the record date. Engility began trading as an independent publicly traded company on the New York Stock Exchange on July 18, 2012.

Engility included the systems engineering and technical assistance (SETA), training and operational support services businesses that were part of L-3's Government Services segment. L-3 retained the cyber security, intelligence, enterprise information technology (IT) and security solutions businesses that were also part of L-3's Government Services segment, which was renamed National Security Solutions (NSS). The NSS businesses develop unique solutions to address growing challenges for the United States (U.S.) Department of Defense (DoD), U.S. Government intelligence agencies, and global security customers.

In connection with the spin-off, Engility made a cash distribution of $335 million to L-3. We used a portion of the proceeds to redeem $250 million of our 63/8% Senior Subordinated Notes due 2015 (2015 Notes) on July 26, 2012 and we intend to use the remaining proceeds primarily to repurchase outstanding shares of our common stock. There was no gain or loss recognized by us as a result of the spin-off transaction.

Prior to the completion of the spin-off, L-3 and Engility entered into a Distribution Agreement dated July 16, 2012 and several other agreements that govern certain aspects of our relationship with Engility following the spin-off. These agreements generally provide that each party will be responsible for its respective assets, liabilities and obligations, including employee benefits, insurance and tax-related assets and liabilities, following the spin-off, whether accrued or contingent. The agreements also describe our future commitments to provide Engility with certain services for a period of two to eighteen months in most circumstances.

As a result of the spin-off, the assets, liabilities and non-controlling interests, results of operations and cash flows of the Engility businesses have been classified as discontinued operations for all periods presented. We incurred transaction expenses in connection with the spin-off of $19 million ($14 million after income tax) for the for the year-to-date period ended September 28, 2012 and $4 million ($3 million after income tax) year-to-date period ended September 30, 2011, which have been included in discontinued operations. In addition, we allocated interest expense for debt not directly attributable or related to L-3's other operations of $14 million for the year-to-date period ended September 28, 2012 and $24 million for the year-to-date period ended September 30, 2011. Interest expense was allocated in accordance with the accounting standards for discontinued operations and was based on the ratio of Engility net assets to the sum of: (1) total L-3 consolidated net assets and (2) L-3 consolidated total debt.


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Statement of operations data classified as discontinued operations related to Engility is provided in the table below:

                                           Third Quarter Ended                              Year-to-Date Ended
                                 September 28,             September 30,          September 28,           September 30,
                                     2012                      2011                   2012                     2011
                                                                      (in millions)
Product and service
revenues                        $            68           $           486        $           911         $          1,539

Operating income from
discontinued operations
before income taxes                           2                        47                     68                      155
Interest expense allocated
to discontinued operations                    1                         7                     14                       24

Income from discontinued
operations before income
taxes                           $             1           $            40        $            54         $            131
Income tax expense                            2                        16                     22                       50

Income (loss) from
discontinued operations,
net of income tax               $            (1 )         $            24        $            32         $             81
Net income from
discontinued operations
attributable to
noncontrolling interests                      -                         1                      4                        3

Net income (loss) from
discontinued operations
attributable to L-3             $            (1 )         $            23        $            28         $             78

In connection with the spin-off of Engility, L-3 was required to allocate the goodwill of the former Government Services reporting unit between Engility and NSS based on the relative fair values of each business at the spin-off date in accordance with the accounting standards for goodwill. As a result, based on the relative fair value, L-3 allocated $1,225 million being allocated to Engility.

The major classes of assets and liabilities included as discontinued operations related to Engility are presented in the table below:

                                                          December 31,
                                                              2011
                                                         (in millions)
          Assets
          Current assets                                 $          386
          Property, plant and equipment, net                         13
          Goodwill                                                1,225
          Other assets                                              105

          Total assets of discontinued operations        $        1,729
          Liabilities
          Accounts payable, trade                        $           37
          Other current liabilities                                 187

          Current liabilities                                       224
          Long-term liabilities                                     127

          Total liabilities of discontinued operations   $          351

L-3's Business

L-3 is a prime contractor in Command, Control, Communications, Intelligence, Surveillance and Reconnaissance (C3ISR) systems, aircraft modernization and maintenance, and national security solutions. L-3 is also a leading provider of a broad range of electronic systems used on military and commercial platforms. Our


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customers include the DoD and its prime contractors, U.S. Government intelligence agencies, the U.S. Department of Homeland Security (DHS), U.S. Department of State (DoS), allied foreign governments, and domestic and foreign commercial customers.

For the year ended December 31, 2011, we generated sales of $13.2 billion. Our primary customer was the DoD. The table below presents a summary of our 2011 sales by end customer and the percent contributed by each to our total 2011 sales. We currently expect sales to the DoD, as a percentage of total 2012 sales, to decline by a few percentage points as compared to sales to the DoD as a percentage of total 2011 sales.

                                                              % of
                                        2011 Sales         2011 Sales
                                       (in millions)
              DoD                     $         9,711               74 %
              Other U.S. Government               728                5

              Total U.S. Government            10,439               79 %
              Foreign governments               1,192                9
              Commercial - foreign                898                7
              Commercial - domestic               629                5

              Total sales             $        13,158              100 %

We have the following four reportable segments: (1) Electronic Systems,
(2) C3ISR, (3) Aircraft Modernization and Maintenance (AM&M), and (4) NSS. Financial information with respect to each of the Company's segments is included in Note 20. Electronic Systems provides a broad range of products and services, including components, products, subsystems and systems and related services to military and commercial customers in several niche markets across several business areas, including microwave, power & control systems, integrated sensor systems, aviation products, simulation & training, warrior systems, precision engagement, security & detection, space & propulsion, undersea warfare and marine services. C3ISR provides products and services for the global ISR (intelligence, surveillance and reconnaissance) market, C3 systems, networked communications systems and secure communications products. The Company believes that these products and services are critical elements for a substantial number of major command, control and communication, intelligence gathering and space systems. These products and services are used to connect a variety of airborne, space, ground and sea-based communication systems and are used in the transmission, processing, recording, monitoring, and dissemination functions of these communication systems. AM&M provides modernization, upgrades and sustainment, maintenance and logistics support services for military and various government aircraft and other platforms. The Company sells these services primarily to the DoD, the Canadian Department of Defense and other allied foreign governments. NSS provides a full range of cyber security, intelligence, enterprise information technology (IT) and security solutions services to the DoD, DoS, U.S. Government intelligence agencies and global security customers.

Industry Considerations

As described above, sales to the DoD represented approximately 74% of our total 2011 sales. The U.S. Government fiscal year ends on September 30th. From fiscal year (FY) 2000 to FY 2010, the DoD budget, including wartime funding for Overseas Contingency Operations (OCO) grew at a compound annual rate of approximately 9%. The total DoD budget (base and OCO) for FY 2011 was approximately flat compared to fiscal year 2010. During the year ended December 31, 2011, the U.S. Government completed its drawdown of U.S. military troops from Iraq, and began to drawdown troops from Afghanistan, in accordance with the Obama Administration's (the "Administration") plan to complete the drawdown from Afghanistan by the end of 2014. While the U.S. is expected to maintain a presence in the Middle East to deter aggression and prevent the emergence of new threats, we expect that there will be a rebalance toward other regions of the world such as the Asia-Pacific theatre. In addition, the U.S. Government has been under increasing pressure to reduce the U.S. fiscal budget deficit and national spending.

In August 2011, Congress enacted the Budget Control Act of 2011 (the BCA). The BCA immediately imposes spending caps that contain approximately $487 billion in reductions to the DoD base budgets over the next ten years (FY 2012 to FY 2021), compared to previously proposed DoD base budgets for the same fiscal years. An


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automatic sequestration process was also triggered and becomes effective on January 3, 2013, unless modified by the enactment of new law. The sequestration process imposes additional cuts of approximately $50 billion per year to the currently proposed DoD budgets for each fiscal year beginning with FY 2013 through FY 2021, for which FY 2013 to FY 2017 proposed DoD budgets are presented below. If the sequestration cuts to the DoD budgets occur, we expect that they will have a negative impact on our results of operations and cash flows, and could cause goodwill impairment charges.

On February 13, 2012, the Administration submitted its FY 2013 proposed budget (FY 2013 DoD Plan) to Congress, which complies with the first phase of the BCA imposed spending cuts. The FY 2013 DoD Plan reduces proposed DoD base budgets by $259 billion for FY 2013 to FY 2017, compared to the previously proposed DoD base budgets. The FY 2013 DoD Plan does not address or provision for the automatic sequestration process. The FY 2013 DoD Plan reflects a revised national security strategy that includes a more disciplined use of resources from: (1) various efficiency initiatives, (2) military force structure reductions, (3) equipment modernization savings, including program terminations, restructuring and deferrals, and (4) military personnel compensation changes. The table below presents the enacted DoD budget (base and OCO) for FY 2012 and the proposed DoD budgets for FY 2013 to FY 2017, as provided in the FY 2013 DoD Plan.

                                                                    Annual
                                                                     Total
                                                                    Budget
                  Fiscal Year    Base         OCO        Total      Change
                                               (in billions)
                  2012          $ 530.6     $ 115.1     $ 645.7          -6 %
                  2013          $ 525.4     $  88.5     $ 613.9          -5 %
                  2014          $ 533.6     $  44.2     $ 577.8          -6 %
                  2015          $ 545.9     $  44.2     $ 590.1           2 %
                  2016          $ 555.9     $  44.2     $ 600.1           2 %
                  2017          $ 567.3     $  44.2     $ 611.5           2 %

The FY 2013 DoD Plan continues to focus on advanced ISR, communications, strike aircraft, precision-guided weapons, unmanned systems, networked information technologies, cyber security, special operations forces, missile defense and space programs, and generally, systems and capabilities that are critical to both conventional and irregular warfare, and the ability to project power in denied environments. We believe L-3 is well positioned to benefit from the DoD's focus in several of these areas. The declining DoD budgets, however, will reduce funding for some of our revenue arrangements and generally will have a negative impact on our sales, results of operations and cash flows. Additionally, the planned withdrawal of U.S. military forces from Afghanistan by the end of 2014 is expected to negatively impact our sales related to supporting U.S. military operations in Afghanistan.

In September 2012, Congress passed and the President signed a six-month continuing resolution on appropriations which funds the DoD at the BCA cap level until March 27, 2013.

Key Performance Measures

The primary financial performance measures that L-3 uses to manage its businesses and monitor results of operations are sales and operating income trends. The two main determinants of our operating income are sales and operating margin. We define operating margin as operating income as a percentage of sales. Management believes that these financial performance measures (sales growth and operating margin improvements) are the primary growth drivers for L-3's earnings per common share and net cash from operating activities. Generally, in evaluating our businesses and contract performance, we focus on net sales, operating income and operating margin, and not by type or amount of operating costs. As a result of this approach and the general nature of our operations, the discussion of results of operations focuses on changes in net sales and operating margin.

One of L-3's primary business objectives is to increase sales from organic growth and select business acquisitions. We define organic sales growth as the increase or decrease in sales for the current period compared to the prior period, excluding sales in the: (1) current period from business acquisitions that are included in L-3's actual results of operations for less than twelve months, and (2) prior period from business divestitures that are


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included in L-3's actual results of operations for the twelve-month period prior to the divestiture date. We expect to supplement our organic sales growth by selectively acquiring businesses that: (1) add important new technologies and products, (2) provide access to select customers, programs and contracts, (3) expand our market share and strengthen our businesses and (4) provide attractive returns on investment.

Sales Trend. For the year ended December 31, 2011, consolidated net sales of $13,158 million declined by 2%, due to a decline in organic sales of 3%, partially offset by net sales from business acquisitions of 1%. For the quarter ended September 28, 2012 (2012 Third Quarter), consolidated net sales of $3,283 million declined by $18 million, or 0.5%, due to a decline in organic sales of $81 million, or 2.4%, partially offset by net sales from acquisitions of $63 million, or 1.9%, compared to the quarter ended September 30, 2011 (2011 Third Quarter). For the year-to-date period ended September 28, 2012 (2012 Year-to-Date Period), consolidated net sales of $9,586 million declined by $29 million, or 0.3%, due to a decline in organic sales of $159 million, or 1.7%, partially offset by net sales from acquisitions of $130 million, or 1.4%, compared to the year-to-date period ended September 30, 2011 (2011 Year-to-Date Period).

For the year ended December 31, 2011, our largest contract (revenue arrangement) in terms of annual sales was the Fort Rucker Maintenance Support contract with the U.S. Army Aviation and Missile Life Cycle Management Command (AMCOM), which is included in our AM&M segment. Under this contract, which generated approximately 4% of our 2011 sales, we provide maintenance, logistics and other related sustainment support services for rotary-wing aircraft assigned to Fort Rucker and satellite units in Alabama. On July 24, 2012, we won the AMCOM contract re-competition, which includes a one-year base period through September 30, 2013, and four one-year options, with an estimated total contract value of $1.98 billion. However, the award has been protested. We expect a decision on the award in the fourth quarter of 2012. We cannot provide any reassurance that we will prevail in the protest.

Operating Income Trend. Operating income for the 2012 Third Quarter was $331 million, a decrease of 8% from $359 million for the 2011 Third Quarter. Our operating margin was 10.1% for the 2012 Third Quarter, a decrease of 80 basis points from 10.9% for the 2011 Third Quarter.

Operating income for the 2012 Year-to-Date Period was $987 million, a decrease of 6% from $1,045 million for the 2011 Year-to-Date Period. Our operating margin was 10.3% for the 2012 Year-to-Date Period, a decrease of 60 basis points from 10.9% for the 2011 Year-to-Date Period. See Results of Operations, including segment results below for a discussion of operating margin.

We are focused on increasing operating margin, to the extent possible, by reducing our indirect costs and improving our overall contract performance. Our 2012 Third Quarter and Year-to-Date Period operating margin was lower than our prior year comparative period operating margin and we expect our 2012 annual operating margin to decline as compared to 2011. While we are taking actions to increase operating margin, these actions may not be successful. Furthermore, in the future, select business acquisitions and select new business, including contract renewals and new contracts, could have lower operating margins than L-3's operating margin on existing business and contracts. Changes in the competitive environment and DoD procurement practices and reductions in our consolidated sales levels could also result in lower operating margin.

Other Events

2012 Amended and Restated Revolving Credit Facility. On February 3, 2012, we amended and restated our $1 billion Revolving Credit Facility, which extended the expiration date to February 3, 2017. The terms of the Amended and Restated Revolving Credit Facility are substantially consistent with the terms of this facility prior to its amendment and restatement except that: (1) provisions that previously limited the ability of L-3 Communications to pay dividends, repurchase L-3 Holdings' common stock and make other distributions with respect to any capital stock were eliminated, (2) a provision that previously limited the ability of L-3 Communications to make investments in L-3 Holdings was made less restrictive and (3) the cost of borrowings, loan commitment fees and letter of credit fees were reduced. In addition, the Amended and Restated Revolving Credit Facility provides for uncommitted incremental revolving facilities and additional term loan facilities in an aggregate principal amount of up to $500 million. See Note 9 of our unaudited condensed consolidated financial statements contained in this quarterly report for additional information regarding the amendment of our $1 billion Amended and Restated Revolving Credit Facility.


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Debt Redemptions. On July 26, 2012 (the redemption date), L-3 Communications used a portion of the proceeds from the spin-off of Engility to redeem $250 million of its 63/8% Senior Subordinated Notes due 2015 (2015 Notes) at a redemption price of 102.125%, plus accrued and unpaid interest, up to but not including the redemption date. In connection with the redemption of the 2015 Notes, we recorded a debt retirement charge of $8 million ($5 million after income tax, or $0.05 per diluted share).

On October 15, 2012 (the redemption date), L-3 Communications redeemed the remaining outstanding $250 million of its 2015 Notes at a redemption price of 101.063%, plus accrued and unpaid interest up to but not including the redemption date. In connection with the redemption we will record a debt retirement charge of approximately $5 million ($3 million after income tax, or $0.03 per diluted share) in the quarter ending December 31, 2012.

Business Acquisitions and Dispositions

Our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 summarizes the business acquisitions and business dispositions that we completed during the three years ended December 31, 2011. During the 2012 Year-to-Date Period, we used $349 million of cash to acquire the Kollmorgen Electro-Optical (KEO) business, MAVCO, Inc. (MAVCO) and the commercial aircraft simulation business from Thales Group (named Link Simulation & Training U.K., Limited (Link U.K.)). All of our business acquisitions are included in our consolidated results of operations from their dates of acquisition. Also, see Note 4 to our unaudited condensed consolidated financial statements contained in this quarterly report for further discussion of the business acquisitions completed during the 2012 Year-to-Date Period.

On July 17, 2012, we completed the previously announced spin-off of our subsidiary, Engility Holdings, Inc. See "Overview and Outlook" for further discussion of the distribution of proceeds and impact on our financial results and financial position.

Results of Operations

The following information should be read in conjunction with our unaudited condensed consolidated financial statements contained in this quarterly report. Our results of operations for the periods presented are affected by our business acquisitions. See Note 4 to our unaudited condensed consolidated financial statements contained in this quarterly report for a discussion of our 2012 business acquisitions and Note 4 to our audited consolidated financial statements for the year ended December 31, 2011, included in our Annual Report on Form 10-K, for a discussion of our 2011 business acquisitions.

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