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TSYS > SEC Filings for TSYS > Form 10-K on 4-Mar-2014All Recent SEC Filings

Show all filings for TELECOMMUNICATION SYSTEMS INC /FA/

Form 10-K for TELECOMMUNICATION SYSTEMS INC /FA/


4-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Critical Accounting Policies and Estimates

Management's Discussion and Analysis of Financial Condition and Results of Operations addresses our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We have identified our most critical accounting policies and estimates to be those related to the following:

Revenue Recognition. We recognize revenue according to the guidance in the Accounting Standards Update ("ASU") 2009-14 (ASC topic 985) "Certain Revenue Arrangements That Include Software Elements" and the ASU 2009-13 (ASC topic 605) "Revenue Recognition - Multiple Deliverable Revenue Arrangements". We recognize revenue when all of the following criteria are met: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred, (iii) the fee is fixed or determinable, and (iv) the fee is probable of collection.

Revenue is reported as described below:

Services Revenue. Revenue from hosted and subscriber services consists of monthly recurring service fees and is recognized in the month earned. Maintenance fees are generally collected in advance and recognized ratably over the maintenance period. Services revenue for consulting, training and the design, development, deployment, field support and maintenance of communication systems is generated under time and materials contracts, cost plus fee contracts, or fixed price contracts. Revenue is recognized under time and materials contracts and cost plus fee contracts as billable costs are incurred. Fixed-price service contracts are accounted for using the proportional performance method. These contracts generally allow for monthly billing or billing upon achieving certain specified milestones.

Systems Revenue. We design, develop, and deploy custom communications products, components, and systems. Custom systems typically contain multiple elements, which may include hardware, installation, integration, and product licenses, which are either incidental or provide essential functionality.

We allocate the fees in a multi-element arrangement to each element based on the relative fair value of each element, using vendor-specific objective evidence ("VSOE") of the fair value of each of the elements, if available. VSOE is generally determined based on the price charged when an element is sold separately. In the absence of VSOE of fair value, the fee is allocated among each element based on third-party evidence ("TPE") of fair value, which is determined based on competitor pricing for similar deliverables when sold separately. When the Company is unable to establish fair value using VSOE or TPE, the Company uses estimated selling price ("ESP") to allocate value to each element. The objective of ESP is to determine the price at which the Company would transact a sale if the product or service were sold separately. The Company determines ESP for deliverables by considering multiple factors including, but not limited to, prices it charges for similar offerings, market conditions, competitive landscape, and pricing practices.

Fees from the development and implementation of custom systems are generally performed under time and materials and fixed fee contracts. Revenue is recognized under time and materials contracts and cost plus fee contracts as billable costs are incurred. Fixed-price product delivery contracts are accounted for using the percentage-of-completion or proportional performance method, measured either by total costs incurred as a percentage of total estimated costs at the completion of the contract, or direct labor costs incurred compared to estimated total direct labor costs for projects for which third-party hardware represents a significant portion of the total estimated costs. These contracts generally allow for monthly billing or billing upon achieving certain specified milestones. Any estimated losses under long-term contracts are recognized in their entirety at the date that it becomes probable of occurring. Revenue from hardware sales to monthly subscriber customers is recognized as systems revenue. The Company has contracts and purchase orders where revenue is recognized at the time products or services are delivered, or when the product is shipped and the risk of the loss is transferred to the buyer, net of discounts.

Software licenses are generally perpetual licenses for a specified number of users that allow for the purchase of annual maintenance at a specified rate. All fees are recognized as revenue when the four criteria described above are met. For multiple element arrangements that contain only software and software-related elements, we allocate the fees to each element based on the VSOE of fair value of each element. Systems containing software licenses include a 90-day warranty for defects. We have not incurred significant warranty costs on any software product to date, and no costs are currently accrued upon recording the related revenue.


Revenue generated from our intellectual property consists of patent infringement liabilities, upfront and non-refundable license fees, royalty fees, and sales of our patents. Revenue from upfront and non-refundable payments is recognized when the arrangement is executed. When patent licensing arrangements include royalties for future sales of products using our licensed patented technology, revenue is recognized when earned during the applicable period. Due to the nature of some of the agreements it may be difficult to establish VSOE of separate elements of an agreement, in these circumstances the appropriate recognition of revenue may require the use of judgment based on the particular facts and circumstances. In all cases, revenue from the licensing of our intellectual property is recognized when all of four of the revenue recognition criteria are met, and included in Commercial systems revenue.

When a customer is billed or we receive payment and we have not met all of the criteria for revenue recognition, the billed or paid amount is recorded as deferred revenue on the Company's consolidated balance sheet. As the revenue recognition criteria are met, the deferred amounts are recognized as revenue. We defer direct project costs incurred in certain situations as dictated by authoritative accounting literature. The Company classifies deferred revenue and deferred project costs on the consolidated balance sheet as either current or long-term depending on the expected product delivery dates or service coverage periods. Long-term deferred revenue is included in other liabilities and long-term deferred project costs are included in other assets on the Company's consolidated balance sheet.

Under our contracts with the U.S. government for both systems and services, contract costs, including the allocated indirect expenses, are subject to audit and adjustment by the Defense Contract Audit Agency. We record revenue under these contracts at estimated net realizable amounts.

Business Combinations. Pursuant to ASC 805 for Business Combinations, we account for each business combination under the "acquisition method." Accordingly, the total estimated purchase prices were allocated to the net tangible and intangible assets acquired in connection with each acquisition, based on their estimated fair values as of the effective date of the acquisition. The preliminary allocation of the purchase prices on each of the acquisitions were based upon management's preliminary valuation of the fair value of tangible and intangible assets acquired and liabilities assumed and such estimates and assumptions are subject to change (generally one year from their acquisition date). The purchase price allocation process requires management to make significant estimates and assumptions, especially at acquisition date with respect to intangible assets and deferred revenue obligations assumed.

Although we believe the assumptions and estimates we have made are reasonable, they are based in part on historical experience and information obtained from the managements of the acquired companies and are inherently uncertain. Examples of critical estimates in valuing certain of the intangible assets we have acquired or may acquire in the future include but are not limited to:

future expected cash flows from application subscriptions, software license sales, support agreements, consulting contracts and acquired developed technologies and patents;

expected costs to develop the in-process research and development into commercially viable products and estimated cash flows from the projects when completed;

the acquired company's trade name and trademarks as well as assumptions about the period of time the acquired trade name and trademarks will continue to be used in the combined company's product portfolio;

variable seller consideration arrangements; and

discount rates

Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.

Acquired Intangible Assets. The acquired intangible assets are amortized over their useful lives of between four and nineteen years, based on the straight-line method. We evaluate acquired intangible assets when events or changes in circumstances indicate that the carrying values of such assets might not be recoverable. Our review of factors present and the resulting appropriate carrying value of our acquired intangible assets are subject to judgments and estimates by management. Future events such as a significant underperformance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets, and significant negative industry or economic trends could cause us to conclude that impairment indicators exist and that our acquired intangible assets might be impaired.

In the fourth quarter of 2013, after adjusting projections for uncertainty at a significant customer, we recorded an impairment charge of $0.6 million to acquired intangible assets. In the second quarter of 2012, after adjusting projections for the impact of a customer contract renegotiation, we recorded an impairment charge of $14.0 million to acquired intangible assets.

Goodwill. Goodwill represents the excess of cost over the fair value of assets of acquired businesses. Goodwill is not amortized, but instead is evaluated for impairment in the fourth quarter of each fiscal year, or sooner should there be an indicator of impairment. We may assess qualitative factors to determine whether it is more likely than not an event or circumstance might indicate the fair


value of the reporting unit is less than its carrying value. Such indicators include a sustained, significant decline in the Company's stock price and market capitalization, a decline in the Company's expected future cash flows, a significant adverse change in legal factors or in the business climate, unanticipated competition, and/or slower expected growth, among others. After completing our assessment of such qualitative factors, and if it is determined that it is more likely than not that the fair value of a reporting unit is less than its carrying value we perform a two-step process. The first step requires a comparison of the book value of net assets to the fair value of the reporting units that have goodwill assigned to them. If the fair value is determined to be less than the book value, a second step is performed to compute the amount of the impairment. In the second step, a fair value for goodwill is estimated, based in part on the fair value of the reporting unit used in the first step, and is compared to its carrying value. The shortfall of the fair value below carrying value, if any, would represent the amount of goodwill impairment.

For goodwill impairment testing, we have four reporting units. In 2013, we reorganized the Commercial Segment in order to better conform and integrate the product lines and create efficiencies, so that one management team is now responsible for all Commercial Platforms & Applications other than the 9-1-1 Safety and Security part of the Commercial Segment. Previously, our Commercial Segment was comprised of Navigation and Other Commercial reporting units. Our two Government Segment reporting units, the Government Solutions Group ("GSG") unit and the Cyber Intelligence unit, remain the same.

Our year-end goodwill balances by reporting unit were:

                                                    2013
                      Platforms and Applications   $  27.9
                      Safety and Security Group       22.0
                      Government Solutions Group      26.1
                      Cyber Intelligence              28.2
                      Total goodwill               $ 104.2


                                                    2012
                      Navigation                   $  22.1
                      Other Commercial                36.1
                      Government Solutions Group      26.1
                      Cyber Intelligence              28.2
                      Total goodwill               $ 112.5

Following our fourth quarter 2013 testing, we wrote down the values of our Platforms and Applications reporting unit's goodwill and long-lived assets from a carrying value of $65.4 million to their estimated fair value of $33.4 million at December 31, 2013, resulting in an impairment charge of $32.0 million. We valued the existing technology using a discounted cash flow method to determine whether a write-down was necessary, and after concluding that a write-down was necessary, used a relief from royalty method to value the licensable technology. We then used a discounted cash flow method to determine the fair value of our Platforms and Applications reporting unit. We consulted with a third party valuation firm to assist in the work.

In performing our 2013 testing for our Safety and Security and Cyber Intelligence reporting units, we used a discounted cash flow method as well as a market approach based on observable public comparable company multiples of revenue and earnings before interest, taxes, depreciation, and amortization ("EBITDA") and weighted the results from the two methods to estimate the reporting units' fair values. For our Government Solutions Group we used only a discounted cash flow method. Determining fair value requires the exercise of significant judgment, including judgment about appropriate discount rates, the amount and timing of expected future cash flows, as well as relevant comparable company multiples for the market comparable approach and the relevant weighting of the methods utilized.

For the market comparable approaches, we evaluated comparable company public trading values and valued our reporting units using multiples of EBITDA ranging from approximately 6 to 8 times. Comparable company public trading values are based on the market's view of future industry conditions and the comparable companies' future financial results. Adverse changes in any of these variables would negatively influence the valuation of our reporting units. It is not possible to determine the impact of such potential adverse changes on the valuation of our reporting units.

Our discounted cash flow models are based on our most recent long-range forecast and, for years beyond the forecast, we estimated terminal values based on estimated exit multiples ranging from approximately 6 to 7 times the final forecasted year EBITDA. They reflect management's expectation of future market conditions and expected levels of financial performance for our reporting units, as well as discount rates and estimated terminal values that would be used by market participants in an arms-length transaction. Business operational risks which could impact profits are detailed in our "Risk Factors" disclosures. Discount rates used were intended to reflect the risks inherent in the future cash flows of the respective reporting units and were between 13% and 15%.


A summary of the impairment charge recorded in 2013 is as follows:

                                               Carrying                      Impairment
                                                Value        Fair Value        Charge
  Goodwill - Platforms and Applications       $     36.1     $      27.9     $       8.2
  Property and equipment, including
  capitalized software for internal use             18.1             5.5            12.6
  Software development costs                         9.3               -             9.3
  Other assets                                       1.3               -             1.3
  Acquired intangible assets                         0.6               -             0.6
                                              $     65.4     $      33.4     $      32.0

In the second quarter of 2012, we received notice from a significant navigation application customer that it intended to adjust pricing for TCS services. Management considered this to be an indicator that we should evaluate the long-lived assets (including goodwill and other intangible assets) related to the Company's 2009 acquisition of Networks In Motion, operating as the Company's Navigation reporting unit, for potential impairment. No triggering events occurred with regard to other reporting units, so an interim analysis of other units was not completed.

We completed Step 1 of the goodwill impairment testing for the Navigation reporting unit using a discounted cash flow ("DCF") method supported by a market comparable approach. The DCF model was based on our updated long-range forecast for the Navigation reporting unit. For years beyond the forecast, our estimated terminal value was based on a discount rate of approximately 12% and a perpetual cash flow growth rate of 3%. For the market comparable approach, we evaluated comparable company public trading values, using sales and EBITDA multiples. The estimated fair value of the Navigation reporting unit was compared to the carrying amount including goodwill, and the results of the Step 1 goodwill testing indicated a potential impairment.

Accordingly, we proceeded with Step 2 of the impairment test to measure the amount of potential impairment. We allocated the fair value of the Navigation reporting unit to its assets and liabilities as of the date of the impairment analysis. As a result of our analysis as described above, an impairment charge of $86.3 million was recorded in 2012 for the excess of the carrying value of goodwill over the estimated fair value.

Our Navigation reporting unit's goodwill, acquired intangibles, capitalized software development costs, and long-lived assets with a carrying value of $164.5 million were written down to estimated fair value of $38.8 million, resulting in a total impairment charge of $125.7 million. We engaged a third party valuation firm to assist in the determination of the fair value of goodwill, acquired intangibles, capitalized software, and long-lived assets.

A summary of the impairment charge recorded in the second quarter of 2012 is as follows:

                                              Carrying
                                                Value        Fair Value         Total
                                              March 31,       June 30,        Impairment
                                                2012            2012            Charge

 Property and Equipment, including
 capitalized software for internal use       $      23.3     $      10.3     $       13.0
 Software development costs                         18.8             6.4             12.4
 Acquired intangible assets                         14.0               -             14.0
 Goodwill - Navigation                             108.4            22.1             86.3
                                             $     164.5     $      38.8     $      125.7

We performed our annual fourth quarter 2012 goodwill Step 1 testing and there was no indication of any further impairment in any of our reporting units, so the second step of the goodwill impairment analysis was not performed. For all reporting units, we used a market approached based on observable public comparable company multiples. For our Navigation and Cyber Intelligence reporting units, we also used a DCF analysis. Where multiple approaches were used, we weight the results from different methods to estimate the reporting unit's fair value. The cash flows employed in 2012 DCF analyses were based on our most recent long-range forecast and, for years beyond the forecast, we estimated terminal value based on estimated exit multiples ranging from 6 to 7 times the final forecasted year earnings before interest, taxes, depreciation and amortization. The discount rates used in the DCF analyses were intended to reflect the risks inherent in the future cash flows of the respective reporting units and were approximately 12%. For the market comparable approaches, we evaluated comparable company public trading values, using multiples of earnings before interest, taxes, depreciation and amortization ranging from 6 to 12 times and multiples of revenue ranging from 1 to 2 times.

For 2011, all of our reporting units passed the first step of the goodwill impairment testing, indicating no impairments.


Software Development Costs. Acquired technology, representing the estimated value of the proprietary technology acquired, has been recorded as capitalized software development costs. We also capitalize software development costs after we establish technological feasibility, and amortize those costs over the estimated useful lives of the software beginning on the date when the software is available for general release. We believe that these capitalized costs will be recoverable from gross profits generated by these products.

For new products, technological feasibility is established when an operative version of the computer software product is completed in the same software language as the product to be ultimately marketed, performs all the major functions planned for the product, and has successfully completed initial customer testing. Technological feasibility for enhancements to an existing product is established when a detail program design is completed. Costs that are capitalized include direct labor and other direct costs. In 2013, 2012, and 2011, we capitalized $2.0 million, $1.9 million, and $2.4 million, respectively, of software development costs for software developed for resale.

These costs are amortized on a product-by-product basis using the straight-line method over the product's estimated useful life, between three and five years. Amortization is also computed using the ratio that current revenue for the product bears to the total of current and anticipated future revenue for that product (the revenue curve method). If this revenue curve method results in amortization greater than the amount computed using the straight-line method, amortization is recorded at that greater amount. Our policies to determine when to capitalize software development costs and how much to amortize in a given period require us to make subjective estimates and judgments. If our software products do not achieve the level of market acceptance that we expect and our future revenue estimates for these products change, the amount of amortization that we record may increase compared to prior periods. The amortization of capitalized software development costs is recorded as a cost of revenue.

We capitalize all costs related to software developed or obtained for internal use when management commits to funding the project and the project completes the preliminary project stage. Capitalization of such costs ceases when the project is substantially complete and ready for its intended use. Capitalized software development costs for internal use are included in Property and Equipment on the Consolidated Balance Sheets.

In 2013, we recorded an impairment charge of $9.3 million related to our Platforms and Applications reporting unit. In 2012, we recorded an impairment charge of $12.4 million after determining the capitalized software development costs related to our Navigation reporting unit were not recoverable based on decreased projected revenues and sales pipeline.

Marketable Securities. Our marketable securities are classified as available-for-sale. Our primary objectives when investing are to preserve principal, maintain liquidity, and obtain higher returns than from cash equivalents. Our intent is not specifically to invest and hold securities with longer term maturities. We have the ability and intent, if necessary, to liquidate any of these investments in order to meet our operating needs within the next twelve months. The securities are carried at fair market value based on quoted market price with net unrealized gains and losses in stockholders' equity as a component of accumulated other comprehensive income. If we determine that a decline in fair value of the marketable securities is other than temporary, a realized loss would be recognized in earnings. Gains or losses on securities sold are based on the specific identification method and are recognized in earnings.

Stock Compensation Expense. We estimate the fair value of our employee stock awards at the date of grant using the Black-Scholes option pricing model, which requires the use of certain subjective assumptions. The most significant of these assumptions are our estimates of expected volatility of the market price of our stock and the expected term of the stock award. We have determined that historical volatility is the best predictor of expected volatility and the expected term of our awards was determined taking into consideration the vesting period of the award, the contractual term and our historical experience of employee stock option exercise behavior. We review our valuation assumptions at each grant date and, as a result, we could change our assumptions used to value employee stock-based awards granted in future periods. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those awards expected to vest. If our actual forfeiture rate were materially different from our estimate, the stock-based compensation expense would be different from what we have recorded in the current period. Our employee stock-based compensation costs are recognized over the vesting period of the award and are recorded using the straight-line method.

Income Taxes. We use the asset and liability method of accounting for deferred income taxes. Under this method, deferred tax assets and liabilities are determined based on temporary differences between financial reporting basis and the tax basis of assets and liabilities. We also recognize deferred tax assets for tax net operating loss carryforwards. The deferred tax assets and liabilities are measured using the enacted tax rates and laws expected to be in effect when such amounts are projected to reverse or be utilized. The realization of total deferred tax assets is contingent upon the generation of future taxable income in the tax jurisdictions in which the deferred tax assets are located. When appropriate, we recognize a valuation allowance to reduce such . . .

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