[May 23, 2013] BOOZ ALLEN HAMILTON HOLDING CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations Tweet (Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis is intended to help the reader understand our business, financial condition, results of operations, and liquidity and capital resources. You should read this discussion in conjunction with "Item 6. Selected Financial Data," and our consolidated financial statements and the related notes contained elsewhere in this Annual Report. 41 -------------------------------------------------------------------------------- The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity and capital resources, and other non-historical statements in this discussion are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in "Item 1A. Risk Factors" and "Introductory Note - Cautionary Note Regarding Forward-Looking Statements". Our actual results may differ materially from those contained in or implied by any forward-looking statements. Our fiscal year ends March 31 and, unless otherwise noted, references to years or fiscal are for fiscal years ended March 31. See "- Results of Operations." Overview We are a leading provider of management and technology consulting services to the U.S. government in the defense, intelligence, and civil markets. We are further developing the scope and scale of our engineering service capabilities that we provide to our U.S. government clients. Additionally, we provide our management and technology consulting services to major corporations, institutions, and not-for-profit organizations. As the needs of our clients have grown more complex, we have expanded beyond our management consulting foundation to develop deep expertise in technology, engineering, and analytics. Our acquisition of the Defense Systems Engineering and Support, or DSES, division of ARINC Incorporated, effective November 30, 2012, will further enhance our existing engineering capabilities and defense market position. Subsequent to the acquisition, we changed the name of the acquired company to Booz Allen Hamilton Engineering Services, or BES. Leveraging our 99-year consulting heritage and a talent base of approximately 24,500 people, we deploy our deep domain knowledge, functional expertise, and experience to help our clients achieve their objectives. Today, we serve substantially all of the cabinet-level departments of the U.S. government. Our major clients include the Department of Defense, all branches of the U.S. military, the U.S. Intelligence Community, and civil agencies such as the Department of Homeland Security, the Department of Energy, the Department of Health and Human Services, the Department of the Treasury, and the General Services Administration. We support these clients in addressing complex and pressing challenges such as combating global terrorism, improving cyber capabilities, transforming the healthcare system, improving efficiency and managing change within the government, and protecting the environment. In the commercial sector, we serve U.S. clients primarily in the financial services, healthcare, and energy markets, and international clients, primarily in the Middle East. We have a collaborative culture, supported by our operating model, which helps our professionals identify and respond to emerging trends across the markets we serve and deliver enduring results for our clients. Financial and Other Highlights Revenue decreased 1.7% from fiscal 2012 to fiscal 2013. We continue to focus on cost reduction efforts and efficiency initiatives which includes effective management of our capacity and efficient management of our costs. Capacity management and other cost reduction activities continued throughout the current period, and may influence future periods, due to the continuing trends of fiscal uncertainty and cost cutting in our principal markets. These efforts in fiscal 2013 have resulted in a net decline in our headcount, which has led to declines in billable hours and therefore a decline in our direct labor. Each of these factors directly results in revenue declines. In this environment, we have also continued to focus on the effective deployment of our consulting staff to minimize the amount of time our staff spend on non-revenue producing activities, which has helped minimize the decline in revenue. This reduction in unbillable time along with efficient use of our indirect costs, contributes to lower indirect costs, and most importantly a lower ratio of indirect costs to direct labor. Reductions in indirect costs have a direct correlation to a reduction of revenue recognized on our large portfolio of cost-reimbursable contracts. Substantially all of our revenue and backlog continues to be derived from services and solutions provided to client organizations across the U.S. government, primarily by our consulting staff and, to a lesser extent, our subcontractors. The mix of revenue generated by our consulting staff and subcontractors affects our operating margin, as the portion of our operating income derived from fees we earn on services provided by our subcontractors is significantly less than the operating income derived from direct consulting staff labor. The decline in our revenue described above was partially offset by an increase in revenue of $100.1 million from our acquisition of DSES that closed on November 30, 2012. Operating income grew 15.2% to $446.2 million in fiscal 2013 from $387.4 million in fiscal 2012, which reflects a 120 basis point increase in operating margin to 7.8% from 6.6% in the comparable periods. The improvement in operating margin was due to increased contract profitability due to disciplined cost management of indirect spending, as described above, as well as decreases in compensation related costs primarily due to the net decline in our headcount. Our effective management of other indirect costs and lower ratio of indirect costs to direct labor produces higher margins on our time-and-material contracts and ultimately produces higher margins on our fixed-price contracts. The factors contributing to the increased operating margin were partially offset by increases in depreciation expense due to facility expansion in previous years, causing a higher increase in depreciation for fiscal 2013, and transaction costs incurred in connection with the acquisition of DSES. In fiscal 2012 the 42 --------------------------------------------------------------------------------Company recognized approximately $11.2 million (net of revenue) of charges associated with a restructuring plan to reduce certain personal and infrastructure cost; there were no such costs in fiscal 2013. During the fourth quarter of fiscal 2013, the Company recovered additional allowable indirect expenses in conjunction with a reevaluation of its estimate of the recoverability of incentive compensation and other allowable indirect expenses. This resulted in an increase to revenue and operating income of approximately $29.5 million. However, this positive effect to operating income was more than offset by an increase in discretionary incentive compensation expense of approximately $38.6 million recorded in the fourth quarter of fiscal 2013. Cash provided by operations increased $104.7 million to $464.7 million for fiscal 2013 from $360.0 million for fiscal 2012. The increase in cash provided by operations was a result of overall profitability of our contracts, our ability to invoice and collect from clients in a timely manner, and our effective management of vendor payments. Non-GAAP Measures We publicly disclose certain non-GAAP financial measurements, including Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, and Adjusted Diluted Earnings Per Share, or EPS, because management uses these measures for business planning purposes, including to manage our business against internal projected results of operations and measure our performance. We view Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, and Adjusted Diluted EPS as measures of our core operating business, which exclude the impact of the items detailed below, as these items are generally not operational in nature. These non-GAAP measures also provide another basis for comparing period to period results by excluding potential differences caused by non-operational and unusual or non-recurring items. We also utilize and discuss Free Cash Flow, because management uses this measure for business planning purposes, measuring the cash generating ability of the operating business, and measuring liquidity generally. We present these supplemental measures because we believe that these measures provide investors with important supplemental information with which to evaluate our performance, long term earnings potential, or liquidity, as applicable, and to enable them to assess our performance on the same basis as management. These supplemental performance measurements may vary from and may not be comparable to similarly titled measures by other companies in our industry. Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, Adjusted Diluted EPS, and Free Cash Flow are not recognized measurements under accounting principles generally accepted in the United States, or GAAP, and when analyzing our performance or liquidity, as applicable, investors should (i) evaluate each adjustment in our reconciliation of operating and net income to Adjusted Operating Income, Adjusted EBITDA and Adjusted Net Income, and net cash provided by operating activities to Free Cash Flows, and the explanatory footnotes regarding those adjustments, each as defined under GAAP, (ii) use Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, and Adjusted Diluted EPS in addition to, and not as an alternative to, operating income, net income or diluted EPS, as measures of operating results, and (iii) use Free Cash Flows in addition to, and not as an alternative to, net cash provided by operating activities as a measure of liquidity, each as defined under GAAP. We have defined the aforementioned non-GAAP measures as follows: • "Adjusted Operating Income" represents operating income before (i) certain stock option-based and other equity-basedcompensation expenses, (ii) adjustments related to the amortization of intangible assets, and (iii) any extraordinary, unusual, or non-recurring items. We prepare Adjusted Operating Income to eliminate the impact of items we do not consider indicative of ongoing operating performance due to their inherent unusual, extraordinary, or non-recurring nature or because they result from an event of a similar nature. • "Adjusted EBITDA" represents net income before income taxes, net interest and other expense, and depreciation and amortization and before certain other items, including: (i) certain stock option-based and other equity-based compensation expenses, (ii) transaction costs, fees, losses, and expenses, including fees associated with debt prepayments, and (iii) any extraordinary, unusual, or non-recurring items. We prepare Adjusted EBITDA to eliminate the impact of items we do not consider indicative of ongoing operating performance due to their inherent unusual, extraordinary, or non-recurring nature or because they result from an event of a similar nature. • "Adjusted Net Income" represents net income before: (i) certain stock option-based and other equity-based compensation expenses, (ii) transaction costs, fees, losses, and expenses, including fees associated with debt prepayments, (iii) adjustments related to the amortization of intangible assets, (iv) amortization orwrite-off of debt issuance costs and write-off of original issue discount, and (v) any extraordinary, unusual, or non-recurring items, in each case net of the tax effect calculated using an assumed effective tax rate. We prepare Adjusted Net Income to eliminate the impact of items, net of tax, we do not consider indicative of ongoing operating performance due to their inherent unusual,extraordinary, or non-recurring nature or because they result from an event of a similar nature. 43-------------------------------------------------------------------------------- • "Adjusted Diluted EPS" represents diluted EPS calculated using Adjusted Net Income as opposed to net income. Additionally, Adjusted Diluted EPS does not contemplate any adjustments to net income as required under the two-class method as disclosed in thefootnotes to the financial statements. • "Free Cash Flow" represents the net cash generated from operating activities less the impact of purchases of property andequipment. Below is a reconciliation of Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, Adjusted Diluted EPS, and Free Cash Flow to the most directly comparable financial measure calculated and presented in accordance with GAAP. 44 -------------------------------------------------------------------------------- Fiscal Year Ended March 31, (Amounts in thousands, except share and per share data) 2013 2012 2011 (Unaudited) Adjusted Operating Income Operating Income $ 446,234 $ 387,432 $ 319,444 Certain stock-based compensation expense (a) 5,868 14,241 39,947 Amortization of intangible assets (b) 12,510 16,364 28,641 Net restructuring charge (c) - 11,182 - Transaction expenses (d) 2,725 - 4,448 Adjusted Operating Income $ 467,337 $ 429,219 $ 392,480 EBITDA & Adjusted EBITDA Net income $ 219,058 $ 239,955 $ 84,694 Income tax expense 149,253 103,919 43,370 Interest and other, net 77,923 43,558 191,380 Depreciation and amortization 74,009 75,205 80,603 EBITDA 520,243 462,637 400,047 Certain stock-based compensation expense (a) 5,868 14,241 39,947 Net restructuring charge (c) - 11,182 - Transaction expenses (d) 2,725 - 4,448 Adjusted EBITDA $ 528,836 $ 488,060 $ 444,442 Adjusted Net Income Net income $ 219,058 $ 239,955 $ 84,694 Certain stock-based compensation expense (a) 5,868 14,241 39,947 Net restructuring charge (c) - 11,182 - Transaction expenses (d) 2,725 - 20,948 Amortization of intangible assets (b) 12,510 16,364 28,641 Amortization or write-off of debt issuance costs and write-off of original issue discount 13,018 4,783 50,102 Net gain on sale of state and local transportation business (e) - (5,681 ) - Release of income tax reserves (f) - (35,022 ) (10,966 ) Adjustments for tax effect (g) (13,649 ) (18,628 ) (55,855 ) Adjusted Net Income $ 239,530 $ 227,194 $ 157,511 Adjusted Diluted Earnings Per Share Weighted-average number of diluted shares outstanding 144,854,724 140,812,012 127,448,700 Adjusted Net Income Per Diluted Share (h) $ 1.65 $ 1.61 $ 1.24 Free Cash Flow Net cash provided by operating activities $ 464,654 $ 360,046 $ 296,339 Less: Purchases of property and equipment (33,113 ) (76,925 ) (88,784 ) Free Cash Flow $ 431,541 $ 283,121 $ 207,555 (a) Reflects stock-based compensation expense for options for Class A Common Stock and restricted shares, in each case, issued in connection with the Acquisition of our Company by The Carlyle Group (the Acquisition) under the Officers' Rollover Stock Plan. Also reflects stock-based compensation expense for Equity Incentive Plan Class A Common Stock options issued in connection with the Acquisition under the Equity Incentive Plan. (b) Reflects amortization of intangible assets resulting from the Acquisition. (c) Reflects restructuring charges of approximately $15.7 million incurred during the three months ended March 31, 2012, net of approximately $4.5 million of revenue recognized on recoverable expenses, associated with the cost of a restructuring plan to reduce certain personnel and infrastructure costs. (d) Fiscal 2013 reflects debt refinancing costs incurred in connection with the Recapitalization Transaction consummated on July 31, 2012. Fiscal 2011 reflects debt refinancing costs and prepayment fees incurred in connection with the 45--------------------------------------------------------------------------------Refinancing Transaction as well as certain external administrative and other expenses incurred in connection with the initial public offering. (e) Fiscal 2012 reflects the gain on sale of our state and local transportation business, net of the associated tax benefit of $1.6 million. (f) Reflects the release of income tax reserves. (g) Reflects tax effect of adjustments at an assumed marginal tax rate of 40%. (h) Excludes an adjustment of approximately $9.1 million of net earnings for fiscal 2013 associated with the application of the two-class method for computing diluted earnings per share. Factors and Trends Affecting Our Results of Operations Our results of operations have been, and we expect them to continue to be, affected by the following factors, which may cause our future results of operations to differ from our historical results of operations discussed under "- Results of Operations." Business Environment and Key Trends in Our Markets We believe that the following trends and developments in the U.S. government services industry and our markets may influence our future results of operations: • budget deficits and the growing U.S. national debt increasing pressure on the U.S. government to reduce federal spending across all federal agencies together with associated uncertainty about the size and timing of those reductions; • changes in the relative mix of overall U.S. government spending and areas of spending growth, with lower spending on homeland security, intelligence and defense-related programs as overseas operations end, and continued increased spending on cyber-security, advanced analytics, technology integration and healthcare; • cost cutting and efficiency initiatives, budget reductions, Congressionally mandated automatic spending cuts, and other efforts to reduce U.S. government spending, which could reduce or delay funding for orders for services especially in the current political environment; • continued uncertainty around the timing, extent and nature of Congressional and other U.S. government action to address budgeting constraints and the U.S. government's ability to incurindebtedness in excess of its current limit and the U.S. deficit, including, the required reductions under the Budget Control Act of 2011 (as amended by the American Taxpayer Relief Act of 2012), which provides for automatic spending cuts totaling approximately $1.2 trillion between 2013 and 2021; • delays in the completion of the U.S. government's budget process, which has in the past and could in the future delayprocurement of the products, services, and solutions we provide; • existing and proposed fiscal constraints by the U.S. government and uncertainty about the size of future budget reductions may cause clients to invest appropriated funds on a less consistent or rapid basis, or not at all, particularly when considering long-term initiatives, not issue task orders in sufficient volume to reach current contract ceilings, and delay requests for newproposals and contract awards, relying on short-term extensions of current contracts instead; • the federal focus on refining the definition of "inherently governmental" work will continue to drive pockets ofinsourcing in various agencies, particularly in the intelligence market; • cost cutting and efficiency and effectiveness efforts by U.S. civilian agencies with a focus on increased use of performance measurement, "program integrity" efforts to reduce waste,fraud and abuse in entitlement programs, and renewed focus on improving procurement practices for and interagency use of IT services, including through the use of cloud based options and data center consolidation; • U.S. government agencies awarding contracts on a technically acceptable/lowest cost basis, which could have a negativeimpact on our ability to win certain contracts; • As a result of the U.S. governments efforts to reduce outlays for contractor costs, we may see a continuing shift towardplacement of our consulting staff at client site locations instead of our facilities, which generally results in lower billing rates and could have a negative impact on our revenue. 46-------------------------------------------------------------------------------- • restrictions by the U.S. government on the ability of federal agencies to use lead system integrators, in response to cost, schedule and performance problems with large defense acquisition programs where contractors were performing the lead system integrator role; • increasingly complex requirements of the Department of Defense and the U.S. Intelligence Community, including cyber-security, managing federal health care cost growth and focus on reforming existing government regulation of various sectors of the economy, such as financial regulation and healthcare; • increased competition from other government contractors and market entrants seeking to take advantage of the trends identified above; and • efforts by the U.S. government to address organizational conflicts of interest and related issues and the impact of those efforts on us and our competitors. Sources of Revenue Substantially all of our revenue is derived from services provided under contracts and task orders with the U.S. government, primarily by our consulting staff and, to a lesser extent, our subcontractors. Funding for our contracts and task orders is generally linked to trends in budgets and spending across various U.S. government agencies and departments. We provide services under a large portfolio of contracts and contract vehicles to a broad client base, and we believe that our diversified contract and client base lessens potential volatility in our business; however, a reduction in the amount of services that we are contracted to provide to the U.S. government or any of our significant U.S. government clients could have a material adverse effect on our business and results of operations. In particular, the Department of Defense is one of our significant clients, and the Budget Control Act of 2011 (as amended by the American Taxpayer Relief Act of 2012), which provides for automatic spending cuts totaling approximately $1.2 trillion between 2013 and 2021, requires an estimated $500 billion in federal defense spending cuts over this time period. A reduction in the amount of services that we are contracted to provide to the Department of Defense could have a material adverse effect on our business and results of operations, and given the uncertainty of how these automatic reductions may be applied, we are unable to predict the nature or magnitude of the potential adverse effect. Contract Types We generate revenue under the following three basic types of contracts: • Cost-Reimbursable Contracts. Cost-reimbursable contracts provide for the payment of allowable costs incurred during performance of the contract, up to a ceiling based on the amount that has been funded, plus a fee. We generate revenue under two general types of cost-reimbursable contracts: cost-plus-fixed-fee and cost-plus-award-fee, both of which reimburse allowable costs and provide for a fee. The fee under each type of cost-reimbursable contract is generally payable upon completion of services in accordance with the terms of the contract. Cost-plus-fixed-fee contracts offer no opportunity for payment beyond the fixed fee. Cost-plus-award-fee contracts also provide for an award fee that varies within specified limits based upon the client's assessment of our performance against a predetermined set of criteria, such as targets for factors like cost, quality, schedule, and performance. • Time-and-Materials Contracts. Under atime-and-materials contract, we are paid a fixed hourly rate for each direct labor hour expended, and we are reimbursed for allowable material costs and allowable out-of-pocket expenses. To the extent our actual direct labor and associated costs vary in relation to the fixed hourly billing rates provided in the contract, we will generate more or less profit, or could incur a loss. • Fixed-Price Contracts. Under a fixed-price contract, we agree to perform the specified work for a pre-determined price. To the extent our actual costs vary from the estimates upon which the price was negotiated, we will generate more or less profit, or could incur a loss. Some fixed-price contracts have a performance-based component, pursuant to which we can earn incentive payments or incur financial penalties based on our performance. Fixed-price level of effort contracts require us to provide a specified level of effort (i.e., labor hours), over a stated period of time, for a fixed price. The amount of risk and potential reward varies under each type of contract. Under cost-reimbursable contracts, there is limited financial risk, because we are reimbursed for all allowable costs up to a ceiling. However, profit margins on this type of contract tend to be lower than on time-and-materials and fixed-price contracts. Under time-and-materials contracts, we are reimbursed for the hours worked using the predetermined hourly rates for each labor category. In addition, we are typically reimbursed for other contract direct costs and expenses at cost. We assume financial risk on time-and-materials contracts 47 -------------------------------------------------------------------------------- because our labor costs may exceed the negotiated billing rates. Profit margins on well-managed time-and-materials contracts tend to be higher than profit margins on cost-reimbursable contracts as long as we are able to staff those contracts with people who have an appropriate skill set. Under fixed-price contracts, we are required to deliver the objectives under the contract for a pre-determined price. Compared to time-and-materials and cost-reimbursable contracts, fixed-price contracts generally offer higher profit margin opportunities because we receive the full benefit of any cost savings but generally involve greater financial risk because we bear the impact of any cost overruns. In the aggregate, the contract type mix in our revenue for any given period will affect that period's profitability. Over time we have experienced a relatively stable contract mix. However, over the last twelve months we have experienced a shift from time-and-materials contracts to cost-reimbursable contracts. The table below presents the percentage of total revenue for each type of contract: Fiscal Year Ended March 31, 2013 2012 2011 Cost-reimbursable (1) 57% 54% 51% Time-and-materials 28% 31% 35% Fixed-price (2) 15% 15% 14% (1) Includes both cost-plus-fixed-fee and cost-plus-award-fee contracts. (2) Includes fixed-price level of effort contracts. Contract Diversity and Revenue Mix We provide services to our clients through a large number of single award contracts and contract vehicles and multiple award contract vehicles. Most of our revenue is generated under indefinite delivery/indefinite quantity, or ID/IQ, contract vehicles, which include multiple award government wide acquisition contract vehicles, or GWACs, and General Services Administration Multiple Award Schedule Contracts, or GSA schedules, and certain single award contracts. GWACs and GSA schedules are available to all U.S. government agencies. Any number of contractors typically compete under multiple award ID/IQ contract vehicles for task orders to provide particular services, and we earn revenue under these contract vehicles only to the extent that we are successful in the bidding process for task orders. In fiscal 2013, 2012 , and 2011, our revenue under GWACs and GSA schedules collectively represented 19%, 20%, and 20% of our total revenue, respectively. No single task order under any contract represented more than 2.1% of our revenue in fiscal 2013, 2012, and 2011. No single contract accounted for more than 10% of our revenue in fiscal 2013, 2012, and 2011. We generate revenue under our contracts and task orders through our provision of services as both a prime contractor and subcontractor, as well as from the provision of services by subcontractors under contracts and task orders for which we act as the prime contractor. For fiscal 2013, 2012, and 2011, 91%, 90%, and 89%, respectively, of our revenue was generated by contracts and task orders for which we served as a prime contractor; 9%, 10%, and 11%, respectively, of our revenue was generated by contracts and task orders for which we served as a subcontractor; and 21%, 21%, and 23%, respectively, of our revenue was generated by services provided by our subcontractors. The mix of these types of revenue affects our operating margin. Substantially all of our operating margin is derived from direct consulting staff labor and the portion of our operating margin derived from fees we earn on services provided by our subcontractors is not significant. We view growth in direct consulting staff labor as the primary measure of earnings growth. Direct consulting staff labor growth is driven by consulting staff headcount growth, after attrition, and total backlog growth. Our People Revenue from our contracts is derived from services delivered by consulting staff and, to a lesser extent, from our subcontractors. Our ability to hire, retain, and deploy talent with skills appropriately aligned with client needs is critical to our ability to grow our revenue. We continuously evaluate whether our talent base is properly sized and appropriately compensated, and contains an optimal mix of skills to be cost competitive and meet the rapidly evolving needs of our clients.We seek to achieve that result through recruitment and management of capacity and compensation. As of March 31, 2013, 2012, and 2011 we employed approximately 24,500, 25,000 and 25,000 people, respectively, of which approximately 22,000 , 22,500 and 22,600, respectively, were consulting staff. Our headcount as of March 31, 2013 is inclusive of the approximately 1,000 employees that joined us as a result of the DSES acquisition. Contract Backlog We define backlog to include the following three components: 48 -------------------------------------------------------------------------------- • Funded Backlog. Funded backlog represents the revenue value of orders for services under existing contracts for which funding is appropriated or otherwise authorized less revenue previously recognized on these contracts. • Unfunded Backlog. Unfunded backlog represents the revenue value of orders for services under existing contracts for which funding has not been appropriated or otherwise authorized. • Priced Options. Priced contract options represent 100% of the revenue value of all future contract option periods under existing contracts that may be exercised at our clients' option and for which funding has not been appropriated or otherwise authorized. Backlog does not include any task orders under ID/IQ contracts, including GWACs and GSA schedules, except to the extent that task orders have been awarded to us under those contracts. The following table summarizes the value of our contract backlog at the respective dates presented: Fiscal Year Ended March 31, 2013 2012 2011 (In millions) Backlog: Funded $ 2,509 $ 2,898 $ 2,392 Unfunded (1) 3,056 2,681 2,979 Priced options 6,265 5,225 5,553 Total backlog $ 11,830 $ 10,804 $ 10,924 (1) Reflects a reduction by management to the revenue value of orders for services under two existing single award ID/IQ contracts the Company has had for several years, based on an established pattern of funding under these contracts by the U.S. government. Our backlog includes orders under contracts that in some cases extend for several years. The U.S. Congress generally appropriates funds for our clients on a yearly basis, even though their contracts with us may call for performance that is expected to take a number of years. As a result, contracts typically are only partially funded at any point during their term and all or some of the work to be performed under the contracts may remain unfunded unless and until the U.S. Congress makes subsequent appropriations and the procuring agency allocates funding to the contract. We view growth in total backlog and consulting staff headcount as the two key measures of our potential business growth. Growing and deploying consulting staff is the primary means by which we are able to recognize profitable revenue growth. To the extent that we are able to hire additional consulting staff and deploy them against funded backlog, we generally recognize increased revenue. Total backlog, including backlog from BES of $1.4 billion, increased by 9.5% from March 31, 2012 to March 31, 2013 and decreased 1.1% from March 31, 2011 to March 31, 2012. Additions to funded backlog, including funded backlog from BES in fiscal 2013 of $222.7 million, during fiscal 2013 and 2012 totaled $5.4 billion and $6.4 billion, respectively, as a result of the conversion of unfunded backlog to funded backlog, the award of new contracts and task orders under which funding was appropriated, and the exercise and subsequent funding of priced options. We report internally on our backlog on a monthly basis and review backlog upon occurrence of certain events to determine if any adjustments are necessary. We cannot predict with any certainty the portion of our backlog that we expect to recognize as revenue in any future period and we cannot guarantee that we will recognize any revenue from our backlog. The primary risks that could affect our ability to recognize such revenue on a timely basis or at all are: program schedule changes, contract modifications, and our ability to assimilate and deploy new consulting staff against funded backlog; cost cutting initiatives and other efforts to reduce U.S. government spending, which could reduce or delay funding for orders for services; and delayed funding of our contracts due to delays in the completion of the U.S. government's budgeting process and the use of continuing resolutions by the U.S. government to fund its operations. Funded backlog includes orders under contracts for which the period of performance has expired, and we may not recognize revenue on the funded backlog that includes such orders due to, among other reasons, the tardy submission of invoices by our subcontractors and the expiration of the relevant appropriated funding in accordance with a pre-determined expiration date such as the end of the U.S. government's fiscal year. The revenue value of orders included in funded backlog that has not been recognized as revenue due to period of performance expirations has not exceeded 49 -------------------------------------------------------------------------------- approximately 5.8% of funded backlog as of the end of any of the eight fiscal quarters preceding the fiscal quarter ended March 31, 2013. In our recent experience, none of the following additional risks have had a material negative effect on our ability to realize revenue from our funded backlog: the unilateral right of the U.S. government to cancel multi-year contracts and related orders or to terminate existing contracts for convenience or default; in the case of unfunded backlog, the potential that funding will not be made available; and, in the case of priced options, the risk that our clients will not exercise their options. Operating Costs and Expenses Costs associated with compensation and related expenses for our people are the most significant component of our operating costs and expenses. The principal factors that affect our costs are additional people as we grow our business and are awarded new contracts, task orders, and additional work under our existing contracts, and the hiring of people with specific skill sets and security clearances as required by our additional work. In conjunction with our initial public offering, our Board of Directors adopted a new equity compensation plan. The equity compensation component of the new plan has reduced officer-related compensation expense included in cost of revenue and general and administrative expenses over the near term with such expense reduction to reverse over time. Our most significant operating costs and expenses are described below. • Cost of Revenue. Cost of revenue includes direct labor, related employee benefits, and overhead. Overhead consists of indirect costs, including indirect labor relating to infrastructure, management and administration, and other expenses. • Billable Expenses. Billable expenses include directsubcontractor expenses, travel expenses, and other expenses incurred to perform on contracts. • General and Administrative Expenses. General andadministrative expenses include indirect labor of executive management and corporate administrative functions, marketing and bid and proposal costs, and other discretionary spending. • Depreciation and Amortization. Depreciation and amortization includes the depreciation of computers, leaseholdimprovements, furniture and other equipment, and the amortization of internally developed software, as well as third-party software that we use internally, and of identifiable long-lived intangible assets over their estimated useful lives. Seasonality The U.S. government's fiscal year ends on September 30 of each year. It is not uncommon for U.S. government agencies to award extra tasks or complete other contract actions in the weeks before the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. In addition, we also have generally experienced higher bid and proposal costs in the months leading up to the U.S. government's fiscal year end as we pursue new contract opportunities being awarded shortly after the U.S. government fiscal year end as new opportunities are expected to have funding appropriated in the U.S. government's subsequent fiscal year. We may continue to experience this seasonality in future periods, and our future periods may be affected by it. Seasonality is just one of a number of factors, many of which are outside of our control, which may affect our results in any period. See "Item 1A. Risk Factors." Critical Accounting Estimates and Policies Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingencies at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Management evaluates these estimates and assumptions on an ongoing basis. Our estimates and assumptions have been prepared on the basis of the most current reasonably available information. Actual results may differ from these estimates under different assumptions or conditions. 50 -------------------------------------------------------------------------------- Our significant accounting policies, including the critical policies and practices listed below, are more fully described and discussed in the notes to the consolidated financial statements. We consider the following accounting policies to be critical to an understanding of our financial condition and results of operations because these policies require the most difficult, subjective or complex judgments on the part of our management in their application, often as a result of the need to make estimates about the effect of matters that are inherently uncertain, and are the most important to our financial condition and operating results. Revenue Recognition and Cost Estimation Substantially all of our revenue is derived from contracts to provide professional services to the U.S. government and its agencies. In most cases, we recognize revenue as work is performed. We recognize revenue for cost-plus-fixed-fee contracts with the U.S. government as hours are worked based on reimbursable and allowable costs, recoverable indirect costs and an accrual for the fixed fee component of these contracts. We recognize as revenue, net of reserves, executive compensation that we determine, based on management's estimates, to be allowable; management's estimates in this regard are based on a number of factors that may change over time, including executive compensation survey data, our and other government contractors' experiences with the DCAA audit practices in our industry and relevant decisions of courts and boards of contract appeals. Many of our U.S. government contracts include award fees, which are earned based on the client's evaluation of our performance. We have significant history with the client for the majority of contracts on which we earn award fees. That history and management's evaluation and monitoring of performance form the basis for our ability to estimate such fees over the life of the contract. Based on these estimates, we recognize award fees as work on the contracts is performed. Revisions to these estimates may result in increases or decreases to revenue and income, and are reflected in the financial statements in periods in which they are identified. Revenue earned under time-and-materials contracts is recognized as hours are worked based on contractually billable rates to the client. Costs on time-and-materials contracts are expensed as incurred. For fixed-price contracts, we recognize revenue on the percentage-of-completion basis with progress toward completion of a particular contract based on actual costs incurred relative to total estimated costs to be incurred over the life of the contract. Profits on fixed-price contracts result from the difference between the incurred costs and the revenue earned. This method is followed where reasonably dependable estimates of revenue and costs under the contract can be made. Estimates of total contract revenue and costs are regularly reviewed and recorded revenue and costs are subject to revision as the contract progresses. Such revisions may result in increases or decreases to revenue and income, and are reflected in the financial statements in the periods in which they are first identified. If our estimates indicate that a contract loss will occur, a loss provision is recorded in the period in which the loss first becomes probable and reasonably estimable. Estimating costs under our long-term contracts is complex and involves significant judgment. Factors that must be considered in making estimates include labor productivity and availability, the nature and technical complexity of the work to be performed, potential performance delays, warranty obligations, availability and timing of funding from the client, progress toward completion, and recoverability of claims. Adjustments to original estimates are often required as work progresses and additional information becomes known, even though the scope of the work required under the contract may not change. Any adjustment as a result of a change in estimates is made when facts develop, events become known, or an adjustment is otherwise warranted, such as in the case of a contract modification. We have procedures and processes in place to monitor the actual progress of a project against estimates and our estimates are updated if circumstances are warranted. Business Combinations The Company has engaged in business combination activity. The accounting for business combinations requires management to make judgments and estimates of the fair value of assets acquired, including the identification and valuation of intangible assets, as well as liabilities and contingencies assumed. Such judgments and estimates directly impact the amount of goodwill recognized in connection with each acquisition, as goodwill presents the excess of the purchase price of an acquired business over the fair value of its net tangible and identifiable intangible assets. In our recent acquisitions the valuation of the customer relationships required significant judgments related to the cash flows of the contract backlog that are expected to recognized by the Company. Goodwill and Intangible Assets Impairment We test goodwill for impairment at the reporting unit level on an annual basis or if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. As the consolidated entity represents the only component that constitutes a business whereby discrete financial information is available, we concluded that we have one reporting unit, which is the same as our single operating segment. We test the trade name for impairment using the royalty relief method. We perform our annual testing for impairment of goodwill and the trade name as of January 1 of each year. 51 -------------------------------------------------------------------------------- We performed an annual impairment test of goodwill and the trade name as of January 1, 2013 and 2012. On December 31, 2011, we adopted new Goodwill impairment guidance whereby we performed a qualitative assessment of whether it was more likely than not the fair value of the reporting unit was less than the carrying value of equity. In making this assessment we considered all relevant events and circumstances. These include, but are not limited to, macroeconomic conditions, industry and market considerations, and the reporting unit's overall financial performance. Based on our qualitative assessment at January 1, 2013, we believe that it was not more likely than not (i.e., a likelihood of more than 50 percent) that the fair value of our reporting unit was less than the carrying amount. During the fiscal years ended March 31, 2013 and 2012, we did not record any goodwill impairment or any impairment of our trade name or amortizable intangible assets. Further, we do not consider any of the goodwill, trade name or amortizable intangible assets at risk of impairment. Share-Based Payments We use the Black-Scholes option-pricing model to determine the estimated fair value for stock options. Critical inputs into the Black-Scholes option-pricing model include the following: option exercise price; fair value of the stock price; expected life of the option; annualized volatility of the stock; annual rate of quarterly dividends on the stock; and risk-free interest rate. On February 1, 2012, the Company's Board of Directors authorized and declared a cash dividend in the amount of $0.09 per share to holders of Booz Allen Holding's Class A Common Stock, Class B Non-Voting Common Stock and Class C Restricted Common Stock. Therefore, an annualized dividend yield of approximately 2% was used in the Black-Scholes option-pricing model for all grants issued after February 1, 2012. Prior to this, the company did not issue recurring dividends and a dividend yield of zero was used in the Black-Scholes option-pricing model. Implied volatility is calculated as of each grant date based on our historical volatility along with an assessment of a peer group for future option grants. Other than the expected life of the option, volatility is the most sensitive input to our option grants. To be consistent with all other implied calculations, the same peer group used to calculate other implied metrics is also used to calculate implied volatility. While we are not aware of any news or disclosures by our peers that may impact their respective volatility, there is a risk that peer group volatility may increase, potentially increasing any prospective future compensation expense that will result from future option grants. The risk-free interest rate used in the Black-Scholes option-pricing model is determined by referencing the U.S. Treasury yield curve rates with the remaining term equal to the expected life assumed at the date of grant. Forfeitures are estimated based on our historical analysis of attrition levels. Forfeiture estimates will be updated quarterly for actual forfeitures. We do not expect this assumption to change materially, as attrition levels associated with new option grants have not materially changed. As our Class A Common Stock was not publicly traded until November 16, 2010, we previously obtained contemporaneous valuations by an independent valuation specialist for our fair value determinations. The valuations were based on several generally accepted valuation techniques: a discounted cash flow analysis, a comparable public company analysis, and for the most recent valuation, a comparative transaction analysis. Estimates used in connection with the discounted cash flow analysis were consistent with the plans and estimates that we use to manage the business although there is inherent uncertainty in these estimates. The valuation analysis resulted in a range of derived values with the final value selected and approved by our Compensation Committee. The completion of the initial public offering has added value to the shares due to, among other things, increased liquidity and marketability; however, the extent (if any) of such additional value cannot be measured with precision or certainty and the shares could suffer a decrease in value. As a public company, we now use the closing price of our Class A Common Stock on the grant date for valuation purposes. Accounting for Income Taxes Provisions for federal and state income taxes are calculated from the income reported on our financial statements based on current tax law and also include the cumulative effect of any changes in tax rates from those previously used in determining deferred tax assets and liabilities. Such provisions differ from the amounts currently receivable or payable because certain items of income and expense are recognized in different time periods for purposes of preparing financial statements than for income tax purposes. Significant judgment is required in determining income tax provisions and evaluating tax positions. We establish reserves for uncertain tax positions when, despite the belief that our tax positions are supportable, there remains uncertainty in a tax position taken in our previously filed income tax returns. For tax positions where it is more likely than not that a tax benefit will be sustained, we record the largest amount of tax benefit with a greater than 50% likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. To the extent we prevail in matters for which accruals have been established or are required to pay amounts in excess of reserves, our effective tax rate in a given financial statement period may be materially impacted. 52 -------------------------------------------------------------------------------- The carrying value of our net deferred tax assets assumes that we will be able to generate sufficient future taxable income in certain tax jurisdictions to realize the value of these assets. If we are unable to generate sufficient future taxable income in these jurisdictions, a valuation allowance is recorded when it is more likely than not that the value of the deferred tax assets is not realizable. Recent Accounting Pronouncements During the fiscal year ended March 31, 2013, the Company adopted the following accounting pronouncement which did not have a material impact on the Company's consolidated financial statements: In February 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, which amends Topic 220, Comprehensive Income. ASU 2013-02 requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required to be reclassified in its entirety to net income. For other amounts that are not required to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures that provide additional detail about those amounts. The amendments do not change the current requirements for reporting net income or other comprehensive income in financial statements. The guidance is effective prospectively for interim and annual periods beginning after December 15, 2012, with early adoption permitted. The Company elected early adoption effective March 31, 2013. Refer to Note 15. Other recent accounting pronouncements issued by the FASB during fiscal 2013 and through the filing date did not and are not believed by management to have a material impact on the Company's consolidated financial statements. Segment Reporting We report operating results and financial data in one operating and reportable segment. We manage our business as a single profit center in order to promote collaboration, provide comprehensive functional service offerings across our entire client base, and provide incentives to employees based on the success of the organization as a whole. Although certain information regarding served markets and functional capabilities is discussed for purposes of promoting an understanding of our complex business, we manage our business and allocate resources at the consolidated level of a single operating segment. Basis of Presentation The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, and have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. All intercompany balances and transactions have been eliminated in consolidation. The Company's fiscal year ends on March 31 and unless otherwise noted, references to fiscal year or fiscal are for fiscal years ended March 31. The accompanying consolidated financial statements present the financial position of the Company as of March 31, 2013 and 2012 and the Company's results of operations for fiscal 2013, fiscal 2012, and fiscal 2011. Certain prior year amounts have been reclassified to conform to the current year presentation. 53-------------------------------------------------------------------------------- Results of Operations We completed our acquisition of DSES on November 30, 2012. The operating results of DSES were included in our consolidated statements of operations from the date of closing through March 31, 2013. The following table sets forth items from our consolidated statements of operations for the periods indicated: Fiscal Year Ended March 31, Fiscal 2013 Fiscal 2012 Versus Versus 2013 2012 2011 Fiscal 2012 Fiscal 2011 (In thousands) Revenue $ 5,758,059 $ 5,859,218 $ 5,591,296 (1.7 )% 4.8 % Operating costs and expenses: Cost of revenue 2,871,240 2,934,378 2,836,955 (2.2 )% 3.4 % Billable expenses 1,532,590 1,542,822 1,473,266 (0.7 )% 4.7 % General and administrative expenses 833,986 903,721 881,028 (7.7 )% 2.6 % Depreciation and amortization 74,009 75,205 80,603 (1.6 )% (6.7 )% Restructuring charge - 15,660 - - - Total operating costs and expenses 5,311,825 5,471,786 5,271,852 (2.9 )% 3.8 % Operating income 446,234 387,432 319,444 15.2 % 21.3 % Interest expense (70,284 ) (48,078 ) (131,892 ) 46.2 % (63.5 )% Other, net (7,639 ) 4,520 (59,488 ) (269.0 )% (107.6 )% Income from operations and before income taxes 368,311 343,874 128,064 7.1 % 168.5 % Income tax expense 149,253 103,919 43,370 43.6 % 139.6 % Net income $ 219,058 $ 239,955 $ 84,694 (8.7 )% 183.3 % Fiscal 2013 Compared to Fiscal 2012 Revenue Revenue decreased to $5,758.1 million from $5,859.2 million, or a 1.7% decrease. The decrease was primarily driven by a decrease in revenue attributable to billable expenses and a net decline in our headcount, which has led to declines in billable hours and therefore a decline in our direct labor. Each of these factors directly results in revenue declines. We also had a lower rate of indirect expenses period over period which has a direct correlation to the reduction of revenue on our large portfolio of cost reimbursable contracts. The decline in headcount and the lower rate of indirect expenses is primarily attributable to the cost reduction actions the Company implemented in late fiscal 2012 and continued focus on effective capacity and cost management. The decrease in revenue was also due to the sale of our state and local transportation business in July 2011; however this was more than offset by an increase in revenue of $100.1 million from the Company's acquisition of DSES. Conversions to funded backlog during fiscal 2013, totaled $5.4 billion in comparison to $6.4 billion for the comparable period, with the decrease due to challenging and uncertain market conditions which is contributing to a lower conversion of unfunded backlog to funded backlog, the reduced award of new contracts and task orders under which funding was appropriated, and the decline in exercise and subsequent funding of priced options. Cost of Revenue Cost of revenue decreased to $2,871.2 million from $2,934.4 million, or a 2.2% decrease. This decrease was primarily due to a decrease in salaries and salary related benefits of $77.5 million, a decrease of $8.7 million in incentive compensation costs, and a decrease of $1.9 million in stock-based compensation expense, offset by an increase in other direct consulting staff expenses of $24.4 million. The decrease in salaries and salary related benefits and incentive compensation costs was primarily due to reduced headcount in the direct consulting staff senior ranks associated with the cost restructuring plan that was implemented during fiscal 2012. The decrease in stock-based compensation expense was primarily due to a decrease in expense recognition compared to the prior fiscal year due to the application of the accounting method for recognizing stock-based compensation, which requires higher expenses initially and declining expenses in subsequent years. Cost of revenue as a percentage of revenue was 49.9% and 50.1% in in fiscal 2013 and fiscal 2012, respectively. Billable Expenses Billable expenses decreased to $1,532.6 million from $1,542.8 million, or a 0.7% decrease. This decrease was primarily due to decreases in travel and material expenses of $54.6 million offset by increases in other billable expenses of $36.1 million incurred to perform on contracts and an increase in subcontractor-related expenses of $8.3 million. The increase in direct 54 -------------------------------------------------------------------------------- subcontractor expenses was in support of growth on existing and new contracts and task orders during fiscal 2013. Billable expenses as a percentage of revenue was 26.6% and 26.3% in fiscal 2013 and fiscal 2012, respectively. General and Administrative Expenses General and administrative expenses decreased to $834.0 million from $903.7 million, or a 7.7% decrease. This decrease was primarily due to a decrease of $59.5 million in other business-related expenses and professional fees attributable to the Company's disciplined management of corporate-related expenditures, a decrease of $17.2 million in salaries and salary-related benefits, and a decrease in stock-based compensation of $4.7 million. The decrease in salaries and salary related expenses was primarily due to the net reduction in our headcount. The decrease in stock-based compensation expense was primarily due to a decrease in expense recognition compared to the prior fiscal year due to the application of the accounting method for recognizing stock-based compensation, which requires higher expenses initially and declining expenses in subsequent years. The decrease in general and administrative expenses was partially offset by increases of $8.6 million in incentive compensation costs and $3.1 million in employer retirement plan contributions. The increase in incentive compensation costs was due to increased compensation under our annual performance bonus program for senior personnel. The increase in employer retirement plan contributions was due to the number of employees who completed one year of service and became eligible to participate in our defined contribution plan, the ECAP. General and administrative expenses as a percentage of revenue were 14.5% and 15.4% for fiscal 2013 and fiscal 2012, respectively. Depreciation and Amortization Depreciation and amortization decreased to $74.0 million from $75.2 million, or a 1.6% decrease. This decrease was primarily due to a decrease of $1.6 million in the amortization of our intangible assets, which includes below market rate leases and contract backlog that were recorded in connection with the acquisition and are amortized based on contractual lease terms and projected future cash flows, respectively, thereby reflecting higher amortization expense initially and declining expense in subsequent periods. Intangible asset amortization expense decreased to $14.8 million in fiscal 2013 compared to $16.4 million in fiscal 2012. Interest Expense Interest expense increased to $70.3 million from $48.1 million, or a 46.2% increase. This increase was primarily due to debt incurred in connection with the Recapitalization Transaction consummated on July 31, 2012. Interest is accrued on our $1,726.8 million outstanding debt principal balance as of March 31, 2013 at contractually specified rates ranging from 2.7% to 4.5%, and is generally required to be paid to our syndicate of lenders on a monthly or quarterly basis. Income Tax Expense Income tax expense increased to $149.3 million from $103.9 million, or a $45.3 million increase. The effective tax rate increased to 40.5% from 30.2% primarily due to the release of uncertain tax position reserves in the prior year. Fiscal 2012 Compared to Fiscal 2011 Revenue Revenue increased to $5,859.2 million from $5,591.3 million, or a 4.8% increase. The increase in revenue was primarily driven by improved deployment of direct consulting staff against funded backlog and increased other direct costs. We deployed during fiscal year 2012 approximately 300 net additional consulting staff, before taking into consideration the decrease in consulting staff due to the cost restructuring plan at the end of fiscal year 2012. The increase in net consulting staff during fiscal 2012 was offset by a reduction of personnel as a result of a cost restructuring plan finalized in the fourth quarter of fiscal year 2012 that was intended to reduce personnel and infrastructure costs. We implemented this in response to continued budget constraints and uncertainty in our industry and to provide funds to increase our resources dedicated to growth areas across our markets. As part of this cost restructuring plan, we reduced overall headcount by approximately 2%. Additions to funded backlog during fiscal 2012 totaled $6.4 billion, as a result of the conversion of unfunded backlog to funded backlog, the award of new contracts and task orders under which funding was appropriated, and the exercise and subsequent funding of priced options. Cost of Revenue Cost of revenue increased to $2,934.4 million from $2,837.0 million, or a 3.4% increase. This increase was primarily due to increases in salaries and salary-related benefits of $110.3 million and employer retirement plan contributions of $12.7 55 -------------------------------------------------------------------------------- million. The increase in salaries and salary-related benefits was driven by an increase in headcount growth prior to the impact of the cost restructuring plan finalized during the fourth quarter of fiscal 2012 and annual base salary increases. The increase in employer retirement plan contributions was due to an increase in the number of employees who completed one year of service and became eligible to participate in our defined contribution plan, the Employees' Capital Accumulation Plan, or ECAP. The cost of revenue increase was partially offset by decreases of $25.2 million in incentive compensation and $5.1 million in stock-based compensation expense. The decrease in incentive compensation was due to an amendment to the Officers' compensation plan effective October 1, 2010, such that a portion of incentive compensation is now paid via grants of restricted stock on July 1 of each year, rather than cash, and will vest over a three year period, and management's determination to reduce incentive compensation accrual rates for fiscal year 2012 in response to higher than expected business development costs and marketing and bid and proposal activity as well as administrative costs associated with delays in deploying certain direct consulting staff labor. The decrease in stock-based compensation expense was primarily due to a decrease in expense recognition compared to the prior fiscal year due to the application of the accounting method for recognizing stock-based compensation, which requires higher expenses initially and declining expenses in subsequent years. Cost of revenue as a percentage of revenue was 50.1% and 50.7% in fiscal 2012 and fiscal 2011, respectively. Billable Expenses Billable expenses increased to $1,542.8 million from $1,473.3 million, or a 4.7% increase. This increase was primarily due to increased subcontractor-related expenses of $80.7 million and increased travel and material expenses of $7.3 million. The increase in direct subcontractor expenses was in support of growth on existing and new contracts and task orders during fiscal 2012. Billable expenses as a percentage of revenue was 26.3% in fiscal 2012 and fiscal 2011, respectively. General and Administrative Expenses General and administrative expenses increased to $903.7 million from $881.0 million, or a 2.6% increase. This increase was primarily due to increases in salaries and salary-related benefits of $56.6 million associated with an increase in average headcount and an increase of $15.8 million in other business-related expenses and professional fees to support the increased scale of our business. The increase in general and administrative expenses was partially offset by decreases of $31.3 million in incentive compensation, $12.5 million in stock-based compensation expenses and $5.9 million in employer retirement plan contributions. The decrease in incentive compensation was due to lower incentive compensation accrual rates for fiscal year 2012, and an amendment to the Officers' compensation plan that was effective October 1, 2010, such that a portion of incentive compensation is now paid via grants of restricted stock on July 1 of each year, rather than cash, and will vest over a three year period. The decrease in stock-based compensation expense was primarily due to a decrease in expense recognition compared to the same prior year period due to the application of the accounting method for recognizing stock-based compensation, which requires higher expenses initially and declining expenses in subsequent years. The decrease in employer retirement plan contributions was due to the associated decrease in incentive compensation. General and administrative expenses as a percentage of revenue were 15.4% and 15.8% for fiscal 2012 and fiscal 2011, respectively. Depreciation and Amortization Depreciation and amortization decreased to $75.2 million from $80.6 million, or a 6.7% decrease. This decrease was primarily due to a decrease of $12.3 million in the amortization of our intangible assets, which includes below market rate leases and contract backlog that were recorded in connection with the acquisition and are amortized based on contractual lease terms and projected future cash flows, respectively, thereby reflecting higher amortization expense initially and declining expense in subsequent periods. Intangible asset amortization expense decreased to $16.4 million in fiscal 2012 compared to $28.6 million in fiscal 2011. The decrease in amortization expense was partially offset by an increase in depreciation expense associated with capital expenditures purchased during fiscal 2012 attributable to investments in facility expansion and computer equipment. Interest Expense Interest expense decreased to $48.1 million from $131.9 million, or a 63.5% decrease. This decrease was primarily due to the refinancing of our senior secured loan facilities in February 2011 to lower interest rates during fiscal 2012. Interest is accrued on our $970.0 million outstanding debt principal balance as of March 31, 2012 at contractually specified rates ranging from 2.49% to 3.75%, and is generally required to be paid to our syndicate of lenders on a monthly or quarterly basis. 56 -------------------------------------------------------------------------------- Income Tax Expense Income tax expense increased to $103.9 million from $43.4 million, or a 139.6% increase. The increase was primarily due to an increase in fiscal 2012 pre-tax income as compared to fiscal 2011 partially offset by a lower effective tax rate. The effective tax rate decreased to 30.2% from 33.9% primarily due to the increase in the release of uncertain tax position reserves in fiscal 2012 as compared to fiscal 2011. Liquidity and Capital Resources We have historically been able to generate sufficient cash to fund our operations, debt payments, capital expenditures, and discretionary funding needs. We had $350.4 million and $484.4 million in cash and cash equivalents as of March 31, 2013 and 2012, respectively. However, due to fluctuations in cash flows and the growth in operations, it may be necessary from time-to-time in the future to borrow under our senior secured loan facilities to meet cash demands. We anticipate that cash provided by operating activities, existing cash and cash equivalents, and borrowing capacity under our revolving credit facility will be sufficient to meet our anticipated cash requirements for the next twelve months, which primarily include: • operating expenses, including salaries; • working capital requirements to fund the growth of our business; • capital expenditures which primarily relate to the purchase of computers, business systems, furniture and leasehold improvements to support our operations; • debt service requirements for borrowings under our senior secured loan facilities; and • cash taxes to be paid. Our debt totaled $1,715.2 million and $965.4 million as of March 31, 2013 and 2012, respectively. Our debt bears interest at specified rates and is held by a syndicate of lenders (see Note 11 in our consolidated financial statements). Our senior secured loan facilities consist of a $725.0 million Tranche A term facility, or Tranche A Loans, and a $1,025.0 million Tranche B term facility, or Tranche B Loans. As of March 31, 2013 we had $706.9 million and $1,019.9 million principal outstanding under the Tranche A term facility and Tranche B term facility, respectively. As of March 31, 2012 we had $475.0 million and $495.0 million principal outstanding under the Tranche A term facility and Tranche B term facility, respectively of our prior credit facility. We periodically consider opportunities to optimize our capital structure. In light of the current strength of the credit markets, there is a likelihood that we will engage in a process intended to effectuate a repricing of the outstanding term loan indebtedness under our senior secured facilities, possibly including an extension of the maturities of such indebtedness, and to amend certain terms of such facilities to provide us with more operating flexibility. While the timing of a potential repricing transaction has not been determined and any decision to ultimately launch or consummate such a transaction will be subject to market conditions and remain within the sole discretion of our Board of Directors, we currently view it as reasonably likely that we would launch such a transaction sometime during calendar year 2013. As an additional consideration, there is a 1% pre-payment premium payable if we refinance our outstanding Tranche B Loans with debt with a lower average yield before August 1, 2013. On November 30, 2012, the Company acquired DSES for approximately $155.1 million in cash. Additionally, on December 31, 2012 the Company acquired an engineering services company for an immaterial amount. Effective July 31, 2012, the Company consummated the Recapitalization Transaction whereby our debt under the new senior credit facilities total $1.75 billion ($725.0 million Tranche A and $1,025.0 million Tranche B) and includes a $500.0 million revolving credit facility. See "-- Indebtedness." On December 12, 2011, our Board of Directors approved a $30.0 million share repurchase program, to be funded from cash on hand. A special committee of the Board of Directors was appointed to evaluate market conditions and other relevant factors and initiate repurchases under the program from time to time. The share repurchase program may be suspended, modified or discontinued at any time at the Company's discretion without prior notice. As of March 31, 2013, no shares have been repurchased under the program. On May 21, 2013, we declared a regular quarterly cash dividend in the amount of $0.10 per share. The quarterly dividend is payable on June 28, 2013 to shareholders of record on June 10, 2013. During fiscal 2013, we declared recurring cash dividends 57 -------------------------------------------------------------------------------- totaling $48.7 million ($0.36 per share). Additionally, during fiscal 2013, we declared special cash dividends totaling $1,112.1 million (in May 2012 we declared a $1.50 per share special dividend and in August 2012 we declared a $6.50 per share special dividend). During fiscal 2012, we declared cash dividends totaling $11.9 million ($0.09 per share). No special cash dividends were declared in fiscal 2012. For each special dividend declared, the Compensation Committee, as Administrator of the Officers' Rollover Stock Plan and the Equity Incentive Plan, as amended, is required to make a determination under the respective plan's antidilution provision to adjust the outstanding options. For both the $1.50 and $6.50 special dividends, holders of the Rollover Options received a cash payment equal to the amount of the special dividend on the options' mandatory exercise date. For the $1.50 special dividend, holders of EIP options were granted a dividend equivalent equal to the special dividend payable on June 29, 2012 or the vesting of the EIP option, whichever is later. For the $6.50 special dividend, holders of EIP options with a pre-dividend exercise price less than $11.00 per share received a dividend equivalent equal to the amount of the special dividend payable on August 31, 2012 or the vesting of the EIP option, whichever is later. All other EIP options were adjusted by reducing the exercise price by $6.36 which is equal to the difference between the pre-dividend closing fair market value of our Class A Common Stock and the post-dividend opening fair market value of our Class A Common Stock as noted on the New York Stock Exchange. Associated with the payment of the dividends, and in connection with the authorization of the special dividends, the Company paid accrued interest on the DPO of $7.4 million during fiscal 2013. No such payments were made for the same periods in fiscal 2012. From time to time we evaluate alternative uses for excess cash resources including debt prepayments, payment of recurring and special dividends, share repurchases or funding acquisitions. Any determination to pursue one or more of the above alternative uses for excess cash is subject to the discretion of our Board of Directors, and will depend upon various factors, including our results of operations, financial condition, liquidity requirements, restrictions that may be imposed by applicable law, our contracts, and our senior secured credit agreement, as amended, and other factors deemed relevant by our Board of Directors. Cash Flows Cash received from clients, either from the payment of invoices for work performed or for advances in excess of costs incurred, is our primary source of cash. We generally do not begin work on contracts until funding is appropriated by the client. Billing timetables and payment terms on our contracts vary based on a number of factors, including whether the contract type is cost-reimbursable, time-and-materials, or fixed-price. We generally bill and collect cash more frequently under cost-reimbursable and time-and-materials contracts, as we are authorized to bill as the costs are incurred or work is performed. In contrast, we may be limited to bill certain fixed-price contracts only when specified milestones, including deliveries, are achieved. We experienced a slight shift to fixed-price contracts year over year resulting in no material impact to operating cash flow. In addition, a number of our contracts may provide for performance-based payments, which allow us to bill and collect cash prior to completing the work. Accounts receivable is the principal component of our working capital and is generally driven by revenue growth with other short-term fluctuations related to the payment practices of our clients. Our accounts receivable reflect amounts billed to our clients as of each balance sheet date. Our clients generally pay our invoices within 30 days of the invoice date. At any month-end, we also include in accounts receivable the revenue that was recognized in the preceding month, which is generally billed early in the following month. Finally, we include in accounts receivable amounts related to revenue accrued in excess of amounts billed, primarily on our fixed-price and cost- plus-award-fee contracts. The total amount of our accounts receivable can vary significantly over time, but is generally sensitive to revenue levels. Total accounts receivable (billed and unbilled combined, net of allowance for doubtful accounts) days sales outstanding, which we calculate by dividing total accounts receivable by revenue per day during the relevant fiscal quarter, was 61 and 65 as of March 31, 2013 and 2012, respectively. The table below sets forth our net cash flows for the periods presented: 58 -------------------------------------------------------------------------------- Fiscal Year Ended March 31, 2013 2012 2011 (In thousands)Net cash provided by operating activities $ 464,654 $ 360,046 $ 296,339 Net cash used in investing activities (190,452 ) (53,593 ) (87,400 ) Net cash used in financing activities (408,186 ) (14,716 ) (324,143 ) Total increase / (decrease) in cash and cash equivalents $ (133,984 ) $ 291,737 $ (115,204 ) Net Cash from Operating Activities Net cash from operations is primarily affected by the overall profitability of our contracts, our ability to invoice and collect from clients in a timely manner, and our ability to manage our vendor payments. Net cash provided by operations was $464.7 million in fiscal 2013 compared to $360.0 million in the same prior year period, or a 29.1% increase. The increase in net cash provided by operations was primarily the result of overall profitability of our contracts, our ability to invoice and collect from clients in a timely manner, and our effective management of vendor payments. Net Cash from Investing Activities Net cash used in investing activities was $190.5 million in fiscal 2013 compared to $53.6 million in the same prior year period, or a 255.4% increase. The increase in net cash used in investing activities was primarily due to the $155.1 million in cash paid to ARINC for the acquisition of DSES on November 30, 2012. Net Cash from Financing Activities Net cash used in financing activities was $408.2 million in fiscal 2013 compared to net cash used in financing activities of $14.7 million in the same prior year period. The increase in net cash used in financing activities was primarily due to the payment of regular and special dividends and associated dividend equivalents, partially offset by the net proceeds of the Recapitalization Transaction. Indebtedness On July 31, 2012, the Company consummated the Recapitalization Transaction, which included the refinancing and termination of the Company's existing senior secured credit agreement with the proceeds of the borrowings under the Company's new senior secured credit agreement. Additionally the net proceeds of the recapitalization were used to pay a special dividend on August 31, 2012, as described above under Liquidity and Capital Resources. The new senior secured credit agreement, or the Credit Agreement, provided the Company with a $725.0 million Term Loan A tranche and a $1,025.0 million Term Loan B tranche, and a $500.0 million revolving credit facility with a $100.0 million sublimit for letters of credit. In connection with the recapitalization, the Company accelerated the amortization of ratable portions of the Debt Issuance Costs, or DIC, and Original Issuance Discount, or OID, associated with the prior senior secured term loan facilities and portions of the DIC and OID of the Credit Agreement that do not qualify for deferral of $7.2 million. These amounts are reflected in other expense, net in fiscal 2013. Furthermore, the Company expensed third party debt issuance costs of $2.7 million that did not qualify for deferral, which are reflected in general and administrative costs in fiscal 2013. The Credit Agreement requires quarterly principal payments of 1.25% of the stated principal amount of Tranche A Loans, with annual incremental increases to 1.875%, 2.50%, 3.125%, and 13%, prior to the Tranche A Loans maturity date of December 31, 2017, and 0.25% of the stated principal amount of Tranche B Loans, with the remaining balance payable on the Tranche B Loans maturity date of July 31, 2019. The revolving credit facility matures on December 31, 2017, at which time any outstanding principal balance is due in full. The interest rate on borrowings under Tranche A is LIBOR plus 2.50%, and will range from 2.00% to 2.75% based on the Company's total leverage ratio. The interest rate on borrowings under Tranche B is LIBOR plus 3.5% with a 1% floor. The revolving credit facility margin and commitment fee are subject to the leveraged based pricing grid, as set forth in the Credit Agreement. As of March 31, 2013, we were contingently liable under open standby letters of credit and bank guarantees issued by our banks in favor of third parties that total $2.8 million. These letters of credit and bank guarantees primarily relate to leases and support of insurance obligations. These instruments reduce our available borrowings under the revolving credit facility. As of March 31, 2013, we had $497.2 million of capacity available for additional borrowings under the revolving credit facility. 59-------------------------------------------------------------------------------- The loans under the Credit Agreement are secured by substantially all of our assets and none of such assets will be available to satisfy the claims of our general creditors. The Credit Agreement contains customary representations and warranties and customary affirmative and negative covenants. The negative covenants are limited to the following, in each case subject to certain exceptions: a maximum net total leverage ratio; a minimum net interest coverage ratio; limitations on indebtedness and liens; mergers, consolidations or amalgamations, or liquidations, wind-ups or dissolutions; dispositions of property; restricted payments; investments; transactions with affiliates; sale and lease back transactions; change in fiscal periods; negative pledges; restrictive agreements; limitations on line of business; limitations on speculative hedging and limitations on changes of names and jurisdictions. In addition, we are required to meet certain financial covenants at each quarter end, namely Consolidated Net Total Leverage and Consolidated Net Interest Coverage Ratios. As of March 31, 2013 we were compliant with these covenants. Prior to the July 31, 2012 Recapitalization Transaction, our then existing senior secured credit agreement provided for $1.0 billion in term loans ($500.0 million Tranche A Loans and $500.0 million Tranche B Loans), and a $275.0 million revolving credit facility. During fiscal 2013, interest payments of $18.8 million and $40.0 million were made for Tranche A term loans and Tranche B term loans, respectively. During fiscal 2012, interest payments of $14.4 million and $20.2 million were made for Tranche A term loans and Tranche B term loans, respectively, under our prior facility. As of March 31, 2013, no amounts were drawn on the revolving credit facility. The total outstanding debt balance is recorded in the accompanying consolidated balance sheets net of unamortized discount of $11.6 million and $4.6 million as of March 31, 2013 and 2012, respectively. Capital Structure and Resources Our stockholders' equity amounted to $226.8 million as of March 31, 2013, a decrease of $958.4 million compared to stockholders' equity of $1,185.2 million as of March 31, 2012, primarily due to the payment of special dividends on June 29, 2012 and August 31, 2012, offset by the net increase in fiscal 2013 from common stock issuances, stock option exercises, net income of $219.1 million, and stock-based compensation expense of $24.8 million. Off-Balance Sheet Arrangements As of March 31, 2013, we did not have any off-balance sheet arrangements. Contractual Obligations The following table summarizes our contractual obligations that require us to make future cash payments as of March 31, 2013. For contractual obligations, we included payments that we have an unconditional obligation to make. Payments Due by Period Less Than 1 to 3 3 to 5 More Than Total 1 Year Years Years 5 years (In thousands) Long-term debt (a) $ 1,726,750 $ 55,562 $ 165,501 $ 537,062 $ 968,625 Operating lease obligations 314,896 91,236 134,292 46,679 42,689 Interest on indebtedness 355,227 65,874 124,655 106,074 58,624 Deferred payment obligation (b) 99,670 - - 99,670 - Liability to option holders (c) 106,360 48,468 55,927 1,965 - Tax liabilities for uncertain tax positions (d) 57,018 23 56,508 484 3 Other 26,443 - 26,443 - - Total contractual obligations $ 2,686,364 $ 261,163 563,326 791,934 1,069,941 (a) See Note 11 to our consolidated financial statements for additional information regarding debt and related matters. (b) Includes $61.5 million deferred payment obligation balance, plus current and future interest accruals. (c) Reflects liabilities to holders of stock options issued under our Officers' Rollover Stock Plan and Equity Incentive Plan related to the reduction in the exercise price of such options as a result of special dividends issued in July 2009, December 2009, May 2012 and July 2012. (d) Includes $18.5 million of tax liabilities offset by amounts owed under the deferred payment obligation. The remainder is related to other tax liabilities. 60-------------------------------------------------------------------------------- In the normal course of business, we enter into agreements with subcontractors and vendors to provide products and services that we consume in our operations or that are delivered to our clients. These products and services are not considered unconditional obligations until the products and services are actually delivered, at which time we record a liability for our obligation. Capital Expenditures Since we do not own any of our facilities, our capital expenditure requirements primarily relate to the purchase of computers, business systems, furniture, and leasehold improvements to support our operations. Direct facility and equipment costs billed to clients are not treated as capital expenses. Our capital expenditures for fiscal 2013 and 2012 were $33.1 million and $76.9 million, respectively, and the majority of such capital expenditures related to facilities infrastructure, equipment, and information technology. Expenditures for facilities infrastructure and equipment are generally incurred to support new and existing programs across our business. We also incur capital expenditures for information technology to support programs and general enterprise information technology infrastructure. Commitments and Contingencies We are subject to a number of reviews, investigations, claims, lawsuits, and other uncertainties related to our business. For a discussion of these items, refer to Note 20 to our consolidated financial statements. [ Back To TMCnet.com's Homepage ]