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EGL > SEC Filings for EGL > Form 10-K on 21-Mar-2013All Recent SEC Filings

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Form 10-K for ENGILITY HOLDINGS, INC.


21-Mar-2013

Annual Report


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

You should read the following discussion of our results of operations and financial condition together with the audited historical consolidated and combined financial statements, and the notes thereto included in this Annual Report as well as the discussion in the section of this Annual Report titled "Business." This discussion contains 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 due to a number of factors, including those discussed in the sections of this Annual Report titled "Risk Factors" and "Cautionary Statement Regarding Forward-Looking Statements." The financial information discussed below and included in this Annual Report may not necessarily reflect what our financial condition, results of operations or cash flow would have been had we been a stand-alone company during the periods presented or what our financial condition, results of operations and cash flows may be in the future.

Except as otherwise indicated or unless the context otherwise requires, the information included in this discussion and analysis assumes the completion of all the transactions referred to in this Annual Report in connection with the separation and distribution.

Separation from L-3

On July 12, 2011, the Board of Directors of L-3 approved the Spin-Off, pursuant to which part of L-3's Government Services segment was transferred into a new company named Engility Holdings, Inc., following which Engility became an independent, publicly traded company. Before the Spin-Off, we entered into a Distribution Agreement and several other agreements with L-3 related to the Spin-Off. These agreements govern the relationship between us and L-3 after completion of the Spin-Off and provide for the allocation between us and L-3 of various assets, liabilities, rights and obligations (including employee benefits, insurance and tax-related assets and liabilities). These agreements also include arrangements for transition services to be provided between L-3 and Engility. On July 17, 2012, L-3 completed the Spin-Off of Engility Holdings through the distribution of 100% of the common stock of Engility Holdings to stockholders of L-3. Following the Spin-Off, Engility Holdings retained the SETA, training and operational support services businesses, that were previously part of L-3's Government Services segment, with L-3 retaining the cyber security, intelligence, enterprise information technology, and security solutions businesses of its Government Services segment.

For periods prior to the Spin-Off, the combined financial statements presented herein, and discussed below, are derived from the accounting records of L-3 as if we operated on a stand-alone basis for all the periods presented. The combined financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) and reflect the financial position, results of operations and cash flows of our SETA, training and operational support services businesses.

Prior to the Spin-Off, the combined statements of operations include expense allocations for corporate functions provided to us by L-3. These expenses were allocated to us on the basis of direct usage when identifiable, with the remainder allocated on the basis of revenue or headcount. While we believe these allocations have been made on a consistent basis and are reasonable, such expenses may not be indicative of the actual expenses that would have been incurred if Engility had been operating as a separate and independent business.

Overview and Outlook

Engility's Business

We are a leading provider of systems engineering services, training, program management, and operational support for the U.S. government worldwide. Our business is focused on supporting the mission success of our customers by providing a full range of engineering, technical, analytical, advisory, training, logistics and support services. Our revenue is spread over a diverse mix of activities and services with no single program accounting for more than 10% of our revenue in 2012. For the year ended December 31, 2012, we had revenue of $1.66 billion, 99% of which was derived from our U.S. government customers.

Engility, through its predecessor companies, has provided mission critical services to several U.S. government departments and agencies for over four decades. Our customers include the U.S. Department of Defense (DoD), U.S. Department of Justice (DoJ), U.S. Agency for International Development (USAID), U.S. Department of State (DoS), Federal Aviation Administration (FAA), Department of Homeland Security (DHS), and foreign governments.

As of December 31, 2012, we operated in two segments: Professional Support Services (PSS) and Mission Support Services (MSS). The Professional Support Services segment provided SETA services, program management support and software engineering lifecycle sustainment and support services. The Professional Support Services segment had 2012 revenue of $905 million. Through


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our Mission Support Services segment, we provided capabilities such as defense related training, education and support services, law enforcement training, national security infrastructure and institutional development. The Mission Support Services segment had 2012 revenue of $773 million.

Effective upon our strategic realignment, which was completed in the first quarter of 2013, we realigned our business with core competencies in six key areas: (i) specialized technical consulting including international capacity development; (ii) program and business support services; (iii) engineering and technology lifecycle support; (iv) information technology modernization and sustainment; (v) supply chain services and logistics management; and
(vi) training and education.

Industry Trends

The U.S. government is the largest consumer of services in the United States and our largest customer. The demand for outsourced services and contracted labor within the U.S. government experienced dramatic growth over the last decade. That demand was driven by government initiatives aimed at improving efficiency, increased requirements in response to global military operations, the ever-increasing complexity of combat and non-combat missions, business requirements, technological innovation, and the loss of personnel and competencies within the U.S. government caused by manpower reductions and retirements.

Despite the opportunities in this sector, the U.S. government services market is presently facing significant uncertainty in terms of budgets, funding, changing mission priorities, and political and legislative challenges. Given the overarching economic and fiscal constraints that may continue to adversely affect the U.S government's non-discretionary and discretionary budgets, we expect that several federal agencies, including our largest customer, the DoD, may significantly reduce their use of government services. In addition, if sequestration were to be enacted in 2013 as mandated by the Budget Control Act of 2011, substantial cuts to the U.S. defense budget would occur, which could adversely affect our results of operations and financial condition.

Currently, the U.S. government is operating under a continuing resolution enacted by the U.S. Congress in September 2012. The continuing resolution restricts the ability of the U.S. government to initiate new contracts and provides for discretionary spending levels that represent a slight increase over the U.S. government's fiscal year end (GFY) 2012 budget. It is unclear whether annual appropriations bills will be passed during GFY 13. The U.S. government may operate under a continuing resolution for all of GFY 2013, restricting new contract or program starts for the entire fiscal year and reducing the overall GFY 13 budget to GFY 12 levels.

Given the high certainty of budget reductions, we expect the government services market will contract from historic annual levels. While this will create significant challenges for government services providers like Engility, we expect that the following trends will result in enduring demand for our services, though at potential lower levels than the historic highs of the past decade:

Global security and threats to U.S. national interests are not abating, and the DoD and those departments and agencies that focus on law enforcement and capacity development likely will maintain high levels of readiness and engagement for the foreseeable future.

In 2012, the DoD set forth a new strategy intended to outline its priorities and budgeting decisions. The guidance calls for the U.S. military to operate globally and effectively in all domains, and it places particular emphasis on Asia Pacific as an area of strategic focus.

We expect the DoD's procurement and research budgets to decline. These declines, however, could result in increased opportunities for government service providers, as the DoD seeks to extend, reset and modernize its existing platforms and products.

The pace of technological change continues unabated, and we expect that the U.S. government will continue to rely on the private sector for expertise, innovation, and affordable solutions in both the IT and C4ISR domains.

The percentage and number of U.S. government employees who are eligible for retirement is expected to increase over the next several years, potentially creating additional demand for government contractor services in the areas of mission sustainment and underlying business process operations and continuity.

While we expect enduring demand for our services, the current U.S. political and fiscal environments pose significant risks for our company, including:

Budget and funding pressures in our market continue to drive competition for fewer contract dollars, resulting in pricing pressure and difficulty in retaining talent and incumbent positions.


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Overseas contingency operations will likely decline over the next several years, reducing our revenue from support to the U.S. government in certain international theaters, notably Afghanistan.

The U.S. government has provided guidance regarding changes to the procurement process that is intended to control cost growth throughout its acquisition cycle for products and services by developing a competitive process for each outsourced program. Thus, many of our DoD customers are focused on awarding contracts on a lowest price/technically acceptable basis, which further increases competitive dynamics and adversely impacts revenue and profit margins for those who win under such circumstances.

In certain service markets, the U.S. government is promoting the use of government personnel to perform activities traditionally provided by private contractors, known as "in sourcing." Similarly, the U.S. government has been shifting certain out-sourced projects to federally-funded research and development centers, which could reduce our future revenue related to program office support.

Acquisitions have played an important role in the U.S. government services industry over the last decade, allowing companies to grow into new markets, provide more integrated offerings to their customers, and leverage fixed costs and economies of scale to enhance competitiveness. Going forward, companies in our industry will likely continue to use acquisitions for similar reasons, but the dynamics associated with the inevitable decline in U.S. government budgets and funding for services could lead to a more dramatic restructuring of the competitive marketplace. Long-term competitiveness will likely require companies to offer highly specialized, enduring capabilities in niche markets and/or have sufficient breadth and size to weather future volatility while continuing to provide cost-effective services.

Key Performance Measures

For 2012, the primary financial performance measures we used to manage our businesses and monitor results of operations were revenue and operating income. Management believes that these financial performance measures are the primary drivers for our earnings and net cash from operating activities.

Operating income represents revenue less cost of revenue, selling, general and administrative expenses, and goodwill impairment. We define operating margin as operating income as a percentage of revenue. Cost of revenue consists of labor, subcontracting costs, materials, and an allocation of indirect costs (i.e., recoverable overhead). Selling, general and administrative expenses consists of indirect labor costs, including wages and salaries for executives and administrative personnel, bid and proposal expenses, and other general and administrative expenses not allocated to cost of revenue.

For each of our contracts, we manage the nature and amount of costs at the contract level, which forms the basis for estimating our total costs and profitability for a specific contract. Management evaluates its contracts and business performance by focusing on revenue, operating income and operating margin, and not by type or amount of operating expense. As a result, our discussion of results of operations focuses on revenue, operating income and operating margin. This is consistent with our approach for managing our business, which begins with management's approach for assessing the bidding opportunity for each contract and then managing contract profitability throughout the performance period.


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Results of Operations - Years ended December 31, 2012, 2011 and 2010

The following information should be read in conjunction with our audited consolidated and combined financial statements included herein.

2012 Compared with 2011

The table below provides selected financial data for Engility for the years ended December 31, 2012 compared with 2011.

                                                     Year Ended December 31,             Increase/
                                                    2012                2011            (decrease)
                                                         (in thousands)
Total revenue                                    $ 1,655,344         $ 2,070,781        $  (415,437 )
Cost and expenses:
Total cost of revenue                              1,415,386           1,785,832           (370,446 )
Selling, general and administrative expenses         142,440             115,908             26,532
Goodwill impairment                                  426,436              76,600            349,836

Total costs and expenses                           1,984,262           1,978,340              5,922

Operating income (loss)                             (328,918 )            92,441           (421,359 )

Operating margin                                       (19.9 )%              4.5 %               NM (1)
Effective income tax rate                               (1.5 )%             71.9 %               NM (1)
Net income (loss) attributable to Engility       $  (350,373 )       $    25,859        $  (376,232 )

(1) NM - Not meaningful

Revenue: For the year ended December 31, 2012, total revenue of $1,655 million decreased by 20.1% compared to the year ended December 31, 2011. Revenue declined in both of our segments. The decrease in total revenue was primarily due to: (1) $172 million in reduced demand for services on certain of our major contracts supporting military efforts in Afghanistan and Iraq, which resulted from the drawdown of U.S. military forces in these countries; (2) $296 million from revenue reductions from contracts and task orders that ended after 2011 and includes $63 million of reduced revenue tied to OCI constraints related to period prior to the Spin-Off. These revenue reductions were offset in part by $53 million in new contract revenue during 2012 for which there was no corresponding revenue in 2011. See the segment results below for additional discussion of our revenue.

Cost of revenue: Cost of revenue as a percentage of revenue decreased to 86.0% for the year ended December 31, 2012 compared to 86.2% for the year ended December 31, 2011. Total costs of revenue declined by 20.7% in 2012, which was relatively consistent with the 20.1% decline in our revenue over the same period.

Selling, general, and administrative expenses: For the year ended December 31, 2012, selling, general and administrative expenses of $142 million increased by $27 million, or 22.9%, compared to the year ended December 31, 2011. The increase in selling, general and administrative expenses was primarily due to an $8 million increase in Spin-Off-related transaction costs, $8 million of realignment costs, and $5 million for a legal settlement recorded in 2012. Selling, general and administrative expenses as a percentage of revenue increased to 8.6% for the year ended December 31, 2012 as compared to 5.6% for the year ended December 31, 2011, primarily due to Spin-Off-related expenses, realignment costs, and a legal settlement.

Goodwill impairment: For the year ended December 31, 2012, we recorded a goodwill impairment charge of $426 million due to a decline in the estimated fair value of each reporting unit. The decline in fair value was primarily due to a change in our cost of capital as a stand-alone company. For the year ended December 31, 2011, we recorded a goodwill impairment charge of $77 million. The goodwill impairment charge in 2011 was due to a decline in the estimated fair value in the Linguist Operations & Technical Support (LOTS) reporting unit, as a result of a decline in their projected future cash flows. For additional information on these goodwill impairments, see "-Critical Accounting Policies-Goodwill and Identifiable Intangible Assets" and Note 4 to our Consolidated and Combined Financial Statements included herein.


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Operating income (loss) and operating margin: Total operating income for the year ended December 31, 2012 decreased by $421 million compared to the year ended December 31, 2011. Operating income declined primarily due to: (1) a goodwill charge of $426 million; (2) an overall reduction in revenue,
(3) reductions in higher profit revenue for overseas contingency operations; and
(4) various charges including an $8 million increase in Spin-Off-related transaction costs, $8 million of realignment costs, and $5 million of legal and settlement costs recorded in 2012. These increase were offset by $26 million in reduced other selling, general, and administrative expenses. See the reportable segment results below for additional discussion of operating margin.

Interest expense: On July 17, 2012, we entered into a senior secured credit agreement (the Credit Facility) that provides for total aggregate borrowings of $400 million under a $335 million senior secured term loan and a $65 million senior secured revolving credit facility with Bank of America, N.A., as administrative agent, and the other lenders party thereto. On this same date, we borrowed $335 million under this Credit Facility, which we paid as a cash dividend to L-3. During the year ended December 31, 2012, we incurred $10.9 million in interest expense, principally related to the term loan. Our average revolver balance from July 17, 2012 to December 31, 2012 was $0.9 million.

Effective income tax rate: The effective tax rate for the year ended December 31, 2012 decreased to (1.5) % from 71.9% for the year ended December 31, 2011. For the years ended December 31 2012 and 2011, the effective tax rate includes (38.9)% and 31.8%, respectively, for the goodwill impairment charges, portions of which were not deductible for U.S. federal or state tax purposes.

Net income (loss) attributable to Engility: Net loss attributable to Engility decreased by $376 million to a net loss of $350 million for the year ended December 31, 2012, compared to net income of $26 million for the year ended December 31, 2011, primarily due to increased goodwill impairment charges in 2012 compared to 2011 and reduced revenue.

2011 Compared with 2010

The table below provides selected financial data for Engility for the years ended December 31, 2011 compared with 2010.

                                                    Year Ended December 31,             Increase/
                                                    2011               2010            (decrease)
                                                         (in thousands)
Total revenue                                    $ 2,070,781        $ 2,374,296        $  (303,515 )
Cost and expenses:
Total cost of revenue                              1,785,832          1,999,736           (213,904 )
Selling, general and administrative expenses         115,908            135,053            (19,145 )
Goodwill impairment                                   76,600            172,000            (95,400 )

Total costs and expenses                           1,978,340          2,306,789           (328,449 )

Operating income                                      92,441             67,507             24,934

Operating margin                                         4.5 %              2.8 %               NM (1)
Effective income tax rate                               71.9 %            112.0 %               NM (1)
Net income (loss) attributable to Engility       $    25,859        $    (8,866 )           34,725

(1) NM - Not meaningful

Revenue: For the year ended December 31, 2011, total revenue of $2,071 million decreased by 13% compared to the year ended December 31, 2010. Revenue declined in both of our segments. The decrease in total revenue was primarily due to:
(1) $90 million related to the loss of an Afghanistan Ministry of Defense (MoD) support contract in October 2010; (2) $90 million in lower linguist, training and logistics support services for the U.S. Army due to the drawdown of military forces from Iraq; (3) $75 million in reduced SSES services; and (4) $48 million of lower revenue related to the SBInet program for the U.S. Department of Homeland Security and an international maritime security enhancement program. See the segment results below for additional discussion of our revenue.

Cost of revenue: Cost of revenue as a percentage of revenue increased to 86.2% for the year ended December 31, 2011 compared to 84.2% for the year ended December 31, 2010. Total costs of revenue declined by 11% in 2011, which was consistent with the 13% decline in our revenue.


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Selling, general, and administrative expenses: For the year ended December 31, 2011, selling, general and administrative expenses of $116 million decreased by 14% compared to the year ended December 31, 2010. The decline in selling, general and administrative expenses was primarily due to lower corporate expense allocations and cost reduction efforts due to lower revenue, partially offset by $9 million of transaction expenses for the Spin-Off and $3 million of severance charges recorded in 2011. Selling, general and administrative expenses as a percentage of revenue decreased to 5.6% for the year ended December 31, 2011 as compared to 5.7% for the year ended December 31, 2010. The decrease in selling, general and administrative expenses as a percentage of revenue, after excluding the Spin-Off transaction expenses and severance charges, was due primarily to selling, general and administrative expenses declining at a greater rate than revenue.

Goodwill impairment: We recorded non-cash charges of $77 million and $172 million for the years ended December 31, 2011 and 2010, respectively, for the impairment of goodwill. The goodwill impairment charges were due to a decline in the estimated fair value of the LOTS reporting unit in 2011 and 2010 and the Global Security & Engineering Solutions (GS&ES) reporting unit in 2010, which are part of the Mission Support Services and Professional Support Services segments, respectively, as a result of a decline in their projected future cash flows. The 2010 goodwill impairment charges were comprised of $161 million for the GS&ES reporting unit and $11 million for the LOTS reporting unit. For additional information on these goodwill impairments, see "-Critical Accounting Policies-Goodwill and Identifiable Intangible Assets" and Note 4 to our Consolidated and Combined Financial Statements included herein.

Operating income and operating margin: Total operating income for the year ended December 31, 2011, increased by $25 million, or 37%, compared to the year ended December 31, 2010. Operating income declined in our MSS segment and increased in our PSS segment. The increase in operating income was primarily due to: a reduced goodwill impairment charge of $95 million for the year ended December 31, 2011 as compared to the prior year. This increase was offset by
(1) lower contract profit rates on select new business and re-competitions of existing business primarily within our Mission Support Services segment due to competitive price pressures, (2) a reduction in higher margin revenue for an Afghanistan MoD support contract and training and logistics support services for the U.S. Army, also within our Mission Support Services segment and
(3) severance charges of $4 million recorded in 2011. See the reportable segment results below for additional discussion of operating margin.

Effective income tax rate: The effective tax rate for the year ended December 31, 2011 decreased to 71.9% from 112.0% for the year ended December 31, 2010. For the years ended December 31 2011 and 2010, the effective tax rate includes 31.8% and 72.0%, respectively, for the goodwill impairment charges, portions of which were not deductible for U.S. federal or state tax purposes.

Net income (loss) attributable to Engility: Net income attributable to Engility increased by $35 million to $26 million for the year ended December 31, 2011, compared to a loss of $9 million for the year ended December 31, 2010, primarily due to lower goodwill impairment charges in 2011 compared to 2010, which is discussed above.


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Reportable Segment Results of Operations

The table below presents selected data by reportable segment reconciled to the
combined totals. See Note 11 to the Consolidated and Combined Financial
Statements for additional reportable segment data.

2012 Compared with 2011



                                        Year Ended December 31,          Increase/
                                         2012             2011          (decrease)
                                             (in thousands)
      Revenue:
      Professional Support Services   $   905,320      $ 1,102,430      $  (197,110 )
      Mission Support Services            772,928          978,106         (205,178 )
      Adjustments and Eliminations        (22,904 )         (9,755 )        (13,149 )

      Total revenue                   $ 1,655,344      $ 2,070,781      $  (415,437 )

      Operating income:
      Professional Support Services   $  (331,550 )    $    90,461      $  (422,011 )
      Mission Support Services             26,837           11,081           15,756
      Adjustments and Eliminations        (24,205 )         (9,101 )        (15,104 )
. . .
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