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DRCO > SEC Filings for DRCO > Form 10-K on 18-Mar-2013All Recent SEC Filings

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Form 10-K for DYNAMICS RESEARCH CORP


18-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read together with the consolidated financial statements and the notes to those statements that appear elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks, uncertainties, and assumptions, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those anticipated in the forward-looking statements. Factors that could cause or contribute to our actual results differing materially from those anticipated include, but are not limited to, those discussed in "Risk Factors" in Part 1, Item 1A and elsewhere in this Form 10-K.

OVERVIEW

Business

Dynamics Research Corporation is a leading technology and management consulting company focused on driving performance, process, and results for government clients. We have large company capabilities, small company agility, and a track record providing innovative solutions and rock solid results. Our go-to-market strategy has several dimensions:

Well Positioned in the Best Funded Federal Markets. We believe these markets - healthcare, research and development, homeland security, intelligence, surveillance and reconnaissance, and financial/regulatory reform - will receive sustained priority funding for years to come, based on long-term market force drivers such as (i) the need to curb the growth of healthcare costs and improve quality of care, (ii) the continued emergence of cyber threats, (iii) the on-going war on terrorism, (iv) immigration reform, (v) increased financial regulation, (vi) tax reform, (vii) the need for greater efficiency, (viii) technologically driven change, and (ix) changing federal workforce demographics.

Relevant, Differentiated Capabilities. We solve our clients' most complex problems, applying cost effective and emerging technologies. Our solutions - in the science and technology, IT and management services areas - are differentiated capabilities such as high performance computing, cloud computing, big data, health informatics, mobile, cyber-security, technology strategy and governance, and systems and software engineering. We believe our capabilities align well with the needs of today's government clients that require improved efficiencies and effectiveness, and face procurement reform, transformational and technology based changes, and ongoing, changing security threats.

Highly Talented Workforce. We have a highly credentialed and degreed staff - smart, talented experts in their field. Our staff has a record of success solving difficult technical problems, providing the most cost effective solutions, and using a process driven approach. We have hard-working, vibrant breakthrough thinkers, who are focused on client needs and results driven.

Extensive Prime Contract Portfolio. Our contracts enable direct client access. We hold a broad, outstanding portfolio of government and agency-wide multiple award schedule indefinite delivery/indefinite quantity ("ID/IQ") task order contracts and single award base purchase agreements. Today, these types of contracts are the federal government's preferred means of procurement for services.

Strong Growth Platform. Rapidly adaptable to change, our integrated financial, contracts, human resources, and technology infrastructure provides consistent, reliable results to our clients. As a highly scalable capability, we can commit to support our clients' most stringent and complex needs.


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Market

In each of 2012 and 2011, 95% of our total revenues were derived from contracts with the United States government, either as a prime contractor or as a subcontractor. As a result, we are significantly impacted by trends and changes in federal expenditures and procurement policies. The U.S. government deficit, budgetary challenges, and efforts to curtail expenditures are on-going and reflected in (i) the Budget Control Act of 2011, which increased the debt ceiling and enacted 10-year discretionary spending caps and automatic spending cuts, referred to as sequestration, which will enact $1.2 trillion of spending cuts over 10 years, (ii) the Defense Strategic Guidance, issued on January 5, 2012 which outlines fundamental changes in strategy- a force, which is smaller, leaner but agile, flexible and technologically advanced, and (iii) the ongoing inability of the federal government to legislate spending priorities through the timely approval of an annual budget.

We have seen and anticipate continued impacts from government budget management initiatives, the specific timing and effects of which may not be predictable, such as:

Reduced professional services spending;
program delays, cuts, and terminations;
fewer new program starts;
intensified price competition for new business and re-competes of current business; and
pressure to reduce dependency on service contractors and set more work aside for small and socially disadvantaged businesses.

These events may result in (i) new business contract wins being lower than expected or needed to sustain growth, (ii) ending of or reductions to current programs and contracts, and (iii) lower profit margins as a result of pricing pressure and the need to invest in winning new and retaining existing business, all of which may adversely affect our results of operations and financial condition.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

There are specific business risks to the industries in which we operate. These risks include: estimates of costs to complete contract obligations, changes in government policies and procedures, government contracting issues, and risks associated with technological development. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. We continually evaluate our estimates, judgments and assumptions based on available information.
Estimates and assumptions also affect the amount of revenue and expenses during the reported period. Actual results could differ from those estimates.

We base our estimates on historical experience and various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities. The use of alternative estimates and assumptions and changes in business strategy or market conditions may significantly impact our assets or liabilities, and potentially result in a different impact to our results of operations. We believe the following critical accounting policies affect the more significant accounting areas particularly those that involve judgments, estimates, and assumptions used in the preparation of our consolidated financial statements.


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Revenue Recognition

Our revenues consist primarily of services provided by our employees and the pass through of costs for materials and subcontract efforts under contracts with government customers. These contracts have different terms based on the scope and complexity of the engagement, the terms of which frequently require us to make judgments and estimates in recognizing revenue. Costs of services consist mainly of compensation expenses for program personnel, the fringe benefits associated with the compensation, and other direct expenses to complete programs including the cost of materials and subcontract efforts. The labor based services provided to our customers are delivered under time and materials, cost reimbursable, and fixed-price contracts including service-type contracts. These services are delivered to government customers primarily through single element arrangements under time and material and cost reimbursable contracts.

We recognize revenue under ASC 605-35, Revenue Recognition: Construction-Type and Production-Type Contracts, which provides revenue recognition guidance for contracts where services are performed to customer specifications. ASC 605-35-15-4 covers arrangements that include fixed-price contracts, time and materials contracts, as well as the cost type contracts which represent the type of arrangements that we enter into with our customers.

For time and materials contracts, revenue reflects the number of direct labor hours expended in the performance of a contract multiplied by the contract billing rate, as well as reimbursement of other billable direct costs. The risk inherent in time and materials contracts is that actual costs may differ materially from negotiated billing rates in the contract, which would directly affect operating income.

For cost reimbursable contracts, revenue is recognized as costs are incurred and includes a proportionate amount of the fee earned. Cost reimbursable contracts specify the contract fee in dollars or as a percentage of estimated costs. Expected award fees are accrued over the period of performance based on historical experience and trued up at the time of award. The primary risk on a cost reimbursable contract is that a government audit of direct and indirect costs could result in the disallowance of some costs, which would directly impact revenue and margin on the contract. Historically, such audits have not had a material impact on our revenue and operating income.

Revenue from service-type fixed-price contracts is recognized ratably over the contract period or by other appropriate output methods to measure service provided, and contract costs are expensed as incurred. Under fixed-price contracts, other than service-type contracts, revenue is recognized primarily under the percentage of completion method. Under this method, we recognize estimated contract revenue and resulting income based on costs incurred to date as a percentage of total estimated costs as we consider this model best reflects the economics of these contracts. The risk on fixed-price contracts is that actual costs may exceed estimated costs to complete.

From time to time, we may proceed with work based on client direction prior to the completion and signing of formal contract documents. We have a formal review process for approving any such work. Revenue associated with such work is recognized only when it can reliably be estimated and realization is probable. We base our estimates on a variety of factors, including previous experiences with the client, communications with the client regarding funding status, and our knowledge of available funding for the contract.

For all types of contracts, we recognize anticipated contract losses as soon as they become known and estimable. Out-of-pocket expenses that are reimbursable by the customer are included in revenue and cost of revenue.

Unbilled receivables are the amounts of recoverable revenue that have not been billed at the balance sheet date. Unbilled receivables relate principally to revenue that is billed in the month after services are performed. In certain instances, billing is deferred in compliance with the contract terms, such as milestone billing arrangements and withholdings, indirect rate approvals or other reasons. Costs related to certain U.S. Government contracts, including applicable indirect costs, are subject to audit by the government. Revenue from such contracts has been recorded at amounts we expect to realize upon final settlement.


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Goodwill and Other Intangible Assets

With the acquisitions of HPTi, Kadix, and other businesses, we acquired goodwill and other intangible assets which totaled $177.8 million and $230.5 million at December 31, 2012 and 2011, respectively. The identification and valuation of these intangible assets and the determination of the estimated useful lives at the time of acquisition, as well as the completion of annual impairment tests, require significant management judgments and estimates. These estimates are based on, among other things, consultations with an accredited independent valuation firm and reviews of projected cash flows.

We test goodwill for impairment on an annual basis or if an event occurs or circumstances change that would more likely than not reduce the fair value of our goodwill below its carrying value. We estimate fair value for our goodwill impairment test by employing three different methodologies to calculate a fair value and then weighting the outputs to arrive at an estimated fair value. The valuation methods utilized include a comparison to comparable industry companies, market value, application of a control premium and discounted cash flows. The determination of relevant comparable industry companies impacts our assessment of fair value. Should our operating performance change in comparison to these companies or should the valuation of these companies change, this could impact our assessment of the fair value of the reporting unit. Our discounted cash flow analysis factors in assumptions on revenue and expense growth rates. These estimates are based upon our historical experience and projections of future activity, factoring in customer demand, changes in technology and a cost structure necessary to achieve the related revenues. Additionally, the discounted cash flow analysis factors in expected amounts of working capital and weighted average cost of capital. The market value factor is primarily driven by the underlying value of our common stock, which can vary significantly depending upon a number of factors, such as overall market conditions and our estimated future profitability. The control premium is based on the premium paid in transactions occurring in the past three years by acquirers of publicly traded companies who provide management and information technology services to the federal government, which are similar to the services provided by the Company.
The control premium may vary based upon business, industry and other market conditions. Changes in judgments on any of these factors could materially impact the fair value of our goodwill thereby increasing the risk of impairment of recorded goodwill.

We operate in the government IT consulting marketplace which has historically been characterized by high visibility of future revenue streams, profitability and generally consistent positive cash flows. Long-term industry trends and other business considerations, such as those outlined in the Risk Factors section of our Form 10-K can have a favorable or unfavorable effect on future cash flows. These trends and business considerations include our concentration of business with the federal government, competitive bidding for contracts, and the mix of contract types into which we enter.

During 2012, due to a decline in the market price of the Company's stock, the market capitalization of the Company was below the carrying value of equity, which we considered a triggering event and therefore performed an interim impairment test. As a result of the impairment test, we recorded goodwill impairment charges totaling $48.6 million.

As a result of the annual impairment test performed as of November 30, 2012, we determined that the carrying amount of the reporting unit did not exceed its fair value and, accordingly, did not record an additional charge for impairment. The fair value of the reporting unit exceeded carrying value by approximately 6%. At December 31, 2012 and December 30, 2011, the price of our common stock was $5.85 per share and $11.34 per share, respectively. We experienced no impairment indicators from November 30, 2012 through year end that would warrant updating its calculation.

The determination of valuation for goodwill impairment testing is sensitive to
(i) changes in the market price of DRC's stock, (ii) changes in premiums paid in excess of market price for public companies in our industry sector which are acquired, (iii) estimated future cash flows, (iv) weighted average cost of capital, and (v) market multiples. A significant decrease in any of these assumptions would cause a decline in valuation and increase the risk of impairment. Future deterioration in operating performance, peer group multiples and/or share price could result in impairment of goodwill. As a result, we are unable to assure that goodwill will not be impaired in subsequent periods.


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Income Taxes and Deferred Taxes

Tax provisions are completed based on the asset and liability method. As part of our process of preparing consolidated financial statements, management is required to estimate the provision for income taxes, deferred tax assets and liabilities, and future taxable income for purposes of assessing our ability to realize any future benefits from deferred taxes. This process involves estimating the current tax liability and assessing temporary and permanent differences resulting from differing treatment of items for tax and accounting purposes, which result in deferred tax assets and liabilities. At December 31, 2012 we had a net deferred asset of $11.7 million compared to a net deferred tax liability of $2.9 million at December 31, 2011.

We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from these positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. We review our tax positions on a quarterly basis and more frequently as facts surrounding tax positions change. Based on these future events, we may recognize uncertain tax positions or reverse current uncertain tax positions which would affect the statement of operations and/or the balance sheet.

We must also assess the likelihood that our deferred tax asset will be recovered from future taxable income and, to the extent a recovery is not likely, a valuation allowance must be established. On both December 31, 2012 and 2011, we determined that a valuation allowance was not required. However, we are unable to assure that a valuation allowance will not be required in subsequent periods.

Pension Obligations

Accounting and reporting for our pension plan requires the use of assumptions, including the discount rate and expected rate of return on assets. These assumptions are used by our independent actuary to determine the value of our pension obligations and allocate this cost to the service periods. The actuarial assumptions used to calculate pension costs are determined and reviewed annually by management after consulting with outside investment advisors and actuaries.

The discount rate represents the estimated rate at which we could effectively settle our pension benefit obligations. In order to estimate this rate for 2012, future expected cash flows of the plan were matched against the Towers Watson RATE:Link yield curve to produce a single discount rate. As of December 31, 2012, the pension plan's measurement date, the weighted average discount rate used to determine the benefit obligations and the net periodic benefit costs was 3.86% and 4.75%, respectively. A decrease of 50 basis points in the discount rate would have resulted in an immaterial increase in annual pension expense.

The assumed expected rate of return on plan assets, which is the average return expected on the funds invested or to be invested to provide future benefits to pension plan participants, is determined by an annual review of historical long-term asset returns and consultation with outside investment advisors. The weighted average expected rate of return for 2012 was 8.15%. A decrease of 50 basis points in the expected rate of return would have resulted in an increase in annual pension expense by approximately $0.3 million.

If assumptions differ materially from actual results in the future, our obligations under the pension plan could also differ materially, potentially requiring us to record an additional pension liability and record additional pension costs. An actuarial valuation of the pension plan is performed each year. The results of this actuarial valuation are reflected in the accounting for the pension plan upon determination. On December 31, 2012 and 2011, we recorded a pension liability of $28.9 million and $27.1 million, respectively, which represented the underfunded benefit obligation.


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Litigation, Commitments and Contingencies

We are subject to a range of claims, lawsuits, and administrative proceedings that arise in the ordinary course of business. Estimating liabilities and costs associated with these matters requires judgment and assessment based upon professional knowledge and experience of management and its internal and external legal counsel. Amounts are recorded as charges to earnings when management, after taking into consideration the facts and circumstances of each matter, including any settlement offers, has determined that it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The ultimate resolution of any such exposure to us may vary from earlier estimates as further facts and circumstances become known.

RESULTS OF OPERATIONS

Operating results and results expressed as a percentage of total revenues are as follows:

                                                                               Year Ended December 31,
(in millions)                                                      2012                  2011                  2010
 Revenue                                                     $ 317.0               $ 322.6               $ 272.1

 Gross profit                                                $  49.9     15.7 %    $  56.6     17.6 %    $  43.9     16.1 %
 Selling, general and administrative                            24.9      7.8 %       26.5      8.2 %       21.5      7.9 %
 Amortization of intangible assets                               4.1      1.3 %        3.8      1.2 %        1.5      0.6 %
 Impairment of goodwill                                         48.6     15.3 %          -      0.0 %          -      0.0 %
 Operating income (loss)(1)                                    (27.7 )   (8.7 )%      26.4      8.2 %       20.8      7.7 %
 Interest expense, net                                         (12.7 )   (4.0 )%      (6.9 )   (2.1 )%      (1.1 )   (0.4 )%
 Other income, net                                               2.6      0.8 %        0.1      0.0 %        0.5      0.2 %
 Provision (benefit) for income taxes(2)                       (13.5 )   35.8 %        8.1     41.4 %        7.9     39.0 %
 Gain on discontinued operations                                   -      0.0 %          -      0.0 %        0.4      0.1 %
 Net income (loss) (1)                                       $ (24.2 )   (7.6 )%   $  11.5      3.6 %    $  12.7      4.7 %

(1) Totals may not add due to rounding.

(2) The percentage for provision (benefit) for income taxes relate to a percentage of income before provision for income taxes.

Revenue

Revenues were earned from the following sectors:

                                                                                 Year Ended December 31,
(in millions)                                                       2012                  2011                  2010
National defense and intelligence agencies                    $ 183.2      57.8 %   $ 205.7      63.8 %   $ 179.7      66.1 %
Homeland security                                                47.4      15.0        48.7      15.1        50.5      18.5
Federal civilian agencies                                        70.0      22.1        53.4      16.6        23.9       8.8
Total revenue from federal agencies (1)                         300.6      94.8       307.8      95.4       254.1      93.4
State and local government agencies and other                    16.4       5.2        14.8       4.6        18.0       6.6
Total revenue (1)                                             $ 317.0     100.0 %   $ 322.6     100.0 %   $ 272.1     100.0 %

(1) Totals may not add due to rounding.


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Revenue decreased from $322.6 million in 2011 to $317.0 million in 2012, or 1.7%. 2011 reported results did not include $53.6 million of HPTi revenue for the first half of 2011, as the merger with HPTi closed on June 30, 2011. On a pro-forma comparative basis, adding the first-half of 2011 HPTi revenue to total 2011 revenue, 2012 revenue was down $59.2 million, or 15.7%, as compared with 2011. More than half the pro-forma decline in revenue resulted from several contracts, which ended in the fourth quarter of 2011. In this period we saw evidence of aggressive government cost-cutting initiatives that impacted several very successful programs, which completed in the fourth quarter of 2011, where clients deferred or cancelled follow-on awards due to cost-cutting efforts.
Over the course of 2012 we also saw an additional $5 million of scope reductions or contract ends in our Air Force advisory and assistance services and logistics businesses

For 2011, revenue increased from $272.1 million in 2010 to $322.6 million, or 18.6%. Revenue growth on a pro forma basis was 3.8% in 2011 compared to 2010.
Pro forma revenue growth for 2011, calculated by including HPTi's 2010 revenue of $90.5 million in the 2010 period and including HPTi's first half of 2011 revenue of $53.6 million in the 2011 period.

Due to on-going federal budget challenges, we anticipate continued turbulence in 2013 in the federal market, including unanticipated scope reductions on existing contracts, delays in award decisions and new program initiatives, and an increase in set asides under SBA programs for which we will be ineligible to compete as a prime contractor. Along these lines, we anticipate two events occurring in 2013. First, a DoD research program, which generated $7.2 million of mostly pass-through revenue in 2012, is ending in April 2013, and second, we are anticipating scope reductions on DHS headquarters IT programs as a result of budget cuts in the range of $4 to $6 million in 2013 as compared with 2012.

The DHS EAGLE contract is currently under re-competition. We have been one of the leading providers of services under the management services function category of EAGLE. We believe we are well positioned to win the successor contract. However, the outcome from the competition remains uncertain and there can be no assurance that a successor contract will be awarded to DRC.

The total contract value of our new business wins in 2012 totaled $155.6 million, an increase of 30% compared with 2011, but short of the level needed to generate overall revenue growth for the Company. Regarding competitions to re-win existing business we won 85% of the award decisions made in 2012, down from a re-win rate of 98% during 2011.

Revenues by contract type as a percentage of revenues were as follows:

                                                      Year Ended December 31,
                                                   2012           2011       2010
 Fixed-price, including service type contracts         45 %           48 %      47 %
. . .
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