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SCIENCE APPLICATIONS INTERNATIONAL CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations and quantitative and qualitative disclosures about market risk should be read in conjunction with our consolidated and combined financial statements and the related notes. It contains forward-looking statements, (which may be identified by words such as those described in "Risk Factors-Forward-Looking Statement Risks" in Part I of this Annual Report) including statements regarding our intent, belief, or current expectations with respect to, among other things, trends affecting our financial condition or results of operations, backlog, our industry, government budgets and spending and the impact of competition. Such statements are not guarantees of future performance and involve risks and uncertainties and actual results may differ materially from those in the forward-looking statements as a result of various factors. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report, particularly in "Risk Factors" in Part I of this Annual Report. Due to such uncertainties and risks, you are cautioned not to place undue reliance on such forward-looking statements, which speak only as of the date hereof. We do not undertake any obligation to update these factors or to publicly announce the results of any changes to our forward-looking statements due to future results or developments. We use the terms "Company," "we," "us" and "our" to refer to both (1) Science Applications International Corporation and its consolidated subsidiaries for time periods after the separation and (2) the technical, engineering and enterprise information technology (IT) services businesses of former Parent, which were contributed to Science Applications International Corporation as part of the separation, for time periods prior to the separation. The financial information discussed below and included elsewhere in this Annual Report may not necessarily reflect what our financial condition, results of operations or cash flow would have been had we been a stand-alone company during the periods presented prior to separation or what our financial condition, results of operations and cash flows may be in the future. Subsequent to separation, we are incurring additional costs to be able to function as an independent, publicly traded company, including additional costs related to IT. Unless otherwise noted, references to fiscal years are to fiscal years ended January 31 (for fiscal 2013 and earlier periods) or fiscal years ending the Friday closest to January 31 (for fiscal 2014 and later periods). For example, we refer to the fiscal year ended January 31, 2014 as "fiscal 2014." Effective in fiscal 2014, we changed our fiscal year to a 52/53 week fiscal year ending on the Friday closest to January 31, with interim fiscal quarters typically consisting of thirteen weeks and ending on the Friday closest to April 30, July 31, and October 31. Overview We are a leading provider of technical, engineering, and enterprise IT services primarily to the U.S. government, including the Department of Defense (DoD) and federal civilian agencies. Despite recently becoming a separate company following a separation from our former parent in September 2013, our well-known and prestigious heritage was developed over more than 45 years of addressing our client's mission critical needs and solving their problems. The SAIC brand carries tremendous value with our customers and the markets that we serve and we have proudly retained the SAIC name following the separation. We serve markets of significant scale and opportunity, with our primary customer being the U.S. government. We serve our customers through more than 1,500 active contracts and task orders and employ approximately 13,000 individuals with an experienced executive team of proven industry leaders. Serving our country's defense and civilian markets, along with many commercial and state/local governments, has afforded us the ability to develop strong and longstanding relationships with some of the largest customers in the markets we serve. We provide engineering and integration offerings for large, complex government projects and offer a broad range of services with a targeted emphasis on higher-end, differentiated technology services. We operate in two operating segments that provide comprehensive service offerings across our customer base. Our technical and engineering offerings include engineering and maintenance of ground and maritime systems, logistics, training and simulation, as well as operation and program support services. Our enterprise IT offerings include end-to-end enterprise IT services, which span the design, development, integration, deployment, management and operation, sustainment and security of our customers' entire IT infrastructure. Our segments have been aggregated into one reporting segment for financial reporting purposes. Substantially all of our revenues and tangible long-lived assets are generated by or are owned by entities located in the United States. Leveraging our customer relationships and the new operating model and cost efficiency afforded through the separation, we believe we are poised to protect our existing business base, expand our offerings to current customers and grow into adjacent markets. We believe that SAIC's value proposition is found in the proven ability to serve as a trusted adviser to our customers. In doing so, we leverage our expertise and scale to help them execute their mission. We succeed as a business based on the solutions we deliver, our past performance and our ability to compete on price. Our solutions are based on best practices, technology transfer and inspired through innovation. Our past performance was achieved by employee dedication and customer focus. Our ability to be competitive in the future will continue to be driven by our cost structure and efficiencies in assigning the right people, at the right time, on our contract work and functional services. SAIC Annual Report 23 -------------------------------------------------------------------------------- Table of Contents PART II --------------------------------------------------------------------------------Economic Opportunities, Challenges, and Risks In fiscal 2014, we generated greater than 90% of our total revenues from contracts with the U.S. government and greater than 70% of our total revenues from contracts with the DoD, including subcontracts on which we perform. Our business performance is affected by the overall level of U.S. government spending (especially defense spending) and the alignment of our offerings and capabilities with the budget priorities of the U.S. government. While we believe that national security, including defense, will continue to be a priority, the U.S. government budget deficit and the national U.S. debt has created pressure to examine and reduce spending across all federal agencies. Baseline spending for the DoD for the next 10 years has been reduced and there may be further reductions. Adverse changes in fiscal and economic conditions, such as the manner in which spending reductions are implemented, including sequestration, future government shutdowns, and issues related to the nation's debt ceiling, could materially impact our business. The U.S. government has increasingly relied on contracts that are subject to a competitive bidding process, including Indefinite Delivery/Indefinite Quantity (IDIQ), U.S. General Services Administration (GSA) Schedule and other multi-award contracts, which has resulted in greater competition and increased pricing pressure. We expect that a majority of the business that we seek in the foreseeable future will be awarded through a competitive bidding process. For example, during fiscal 2013 we were not awarded the successor contract to the DISN Global Solutions (DGS) program with the Defense Information System Agency. Additionally, since 2011, organizational conflict of interest (OCI) rules have become more restrictive, leading to greater fragmentation of the industry. Despite the budget and competitive pressures impacting the industry, we believe we are well-positioned to expand customer penetration and benefit from opportunities that we have not previously pursued. Our scale, size and prime contractor leadership position are expected to help differentiate us from our competitors, especially on large contracts. We believe our long-term, trusted customer relationships and deep technical expertise provide us with the sophistication to handle mission-critical contracts. Our current competitive cost structure, as well as our ongoing efforts to maintain or reduce costs by centralizing strategic sourcing and developing repeatable offerings, are expected to allow us to compete effectively on price in the evolving environment. Additionally, due to the separation and the resulting removal of many OCI restrictions, we believe we have enhanced our ability to expand market share with our existing customers and pursue new growth opportunities. Results of Operations The primary financial performance measures we use to manage our business and monitor results of operations are revenue, operating income, and cash flows from operating activities. The following table summarizes our results of operations for the periods presented: Year ended January 31 Percent Percent 2014 change 2013 change 2012 (dollars in millions) Revenues $ 4,017 $ 4,690 $ 4,637 Revenues performed by former Parent 104 91 96 Total revenues 4,121 (14 %) 4,781 1 % 4,733 Cost of revenues 3,684 4,282 4,211 Cost of revenues performed by former Parent 104 91 96 Total cost of revenues 3,788 (13 %) 4,373 2 % 4,307 Selling, general, and administrative expenses 92 (7 %) 99 (22 %) 127 Separation transaction and restructuring expenses 58 107 % 28 100 % - Operating income 183 (35 %) 281 (6 %) 299 As a percentage of total revenues 4.4 % 5.9 % 6.3 % As a percentage of revenues, excluding separation transaction and restructuring expenses 6.0 % 6.6 % 6.4 % Cash flows from operating activities $ 183 (35 %) $ 280 (8 %) $ 303 Management believes that the presentation of operating income excluding separation transaction and restructuring expenses, as a percentage of revenues, which is a non-GAAP financial measure, provides useful information to investors regarding the registrant's financial condition and results of operations. We classify overhead costs as cost of revenues and general and administrative expenses as defined in our disclosure statements in accordance with U.S. government cost accounting standards (CAS). 24 SAIC Annual Report -------------------------------------------------------------------------------- Table of Contents PART II --------------------------------------------------------------------------------Fiscal 2014 Compared to Fiscal 2013 Revenues. Total revenues decreased $660 million, or 14%, for fiscal 2014 as compared to fiscal 2013. Revenue contraction was primarily due to the loss of the DGS program ($293 million), decrease in activity on logistics programs primarily related to the drawdown in theater ($156 million), lower material and subcontract revenues on Navy contract vehicles ($123 million) and completion of a program to supply technical support to the Army ($52 million). The remainder of the decline was driven by the slower U.S. government contract ordering environment resulting from budget pressures. Operating Income. Operating income decreased $98 million to 4.4% of total revenues for fiscal 2014 from 5.9% of total revenues for fiscal 2013 primarily driven by decreased operating income on lower revenue volume ($41 million), increased separation transaction and restructuring costs ($30 million), lower revenues on relatively higher profit margin contracts such as DGS ($12 million), non-recurring costs for external consulting services related to IT system replication in preparation for the separation ($5 million), and an increase in unfavorable changes in estimates on contracts accounted for under the percentage of completion revenue recognition method ($2 million). Cash Flows from Operating Activities. Cash flows provided by operating activities were $183 million for fiscal 2014, which was a decrease of $97 million as compared to the comparable prior year period. The decrease was primarily due to lower net income and a reduction in accrued vacation in fiscal 2014. We changed our vacation accrual policy in the fourth quarter of fiscal 2014. Under the revised policy the maximum vacation accrual was reduced and employees will no longer earn vacation once the maximum has been reached. This change resulted in a payment to employees of approximately $14 million for previously accrued vacation above the revised maximum level. Fiscal 2013 Compared to Fiscal 2012 Revenues. Total revenues increased $48 million, or 1%, in fiscal 2013 as compared to fiscal 2012. The increase in total revenues was attributable to increased activity on a number of contracts, including on a program to operate and maintain the enterprise network information technology infrastructure for the Department of State ($145 million), a prime contract with the Defense Logistics Agency to provide supply chain management and delivery of military land and aircraft tires ($136 million), and a systems and software maintenance/upgrade program for the U.S. Army ($114 million). These increases were partially offset by reduced revenues from the U.S. Army Brigade Combat Team Modernization contract as a result of the program's termination during fiscal 2012 ($154 million), declines in various federal civilian programs ($139 million) and reduced activity on a program to provide systems engineering and management support for the U.S. Navy ($54 million). Operating Income. Operating income decreased $18 million to 5.9% of total revenues in fiscal 2013 from 6.3% of total revenues in fiscal 2012. Fiscal 2013 operating income was negatively impacted by separation transaction expenses associated with the planned separation ($28 million), a net unfavorable change in contract estimates ($2 million) as compared to a net favorable change in the prior year ($9 million) and a gain in the prior year on the sale of certain assets previously used in developing guidance and navigation control systems for precision munitions ($5 million). These decreases were partially offset by a prior year settlement charge for a litigation matter involving work performed for the National Center for Critical Information Processing ($22 million) in fiscal 2012. Cash Flows from Operating Activities. Cash flows provided by operating activities decreased $23 million for fiscal 2013 as compared to fiscal 2012, primarily due to a decrease in the relative amount of accounts payable and accrued liabilities. The decrease was partially offset by a reduction in the average time to collect accounts receivable, which benefited from the U.S. government's accelerated payment initiative that encouraged agencies to more timely pay contractors. Other Key Performance Measures In addition to the primary financial performance measures discussed above, we also believe that bookings and backlog are useful measures for management and investors to evaluate our potential future revenues. In addition, we consider measures such as contract types and revenue mix to be useful for management and investors to evaluate our operating income and performance. Bookings and Backlog. We had net bookings worth an estimated $3.0 billion and $3.8 billion during fiscal 2014 and fiscal 2013, respectively. Net bookings represent the estimated amount of revenue to be earned in the future from funded and unfunded contract awards that were received during the period, net of any adjustments to estimates on previously awarded contracts. We calculate net bookings as the period's ending backlog plus the period's revenues less the prior period's ending backlog. Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts as work is performed. Backlog related to future revenues to be performed by former Parent is included in the values presented below. We segregate our backlog into two categories as follows: • Funded Backlog. Funded backlog for contracts with government agencies primarily represents estimated amounts of revenue to be earned in the future from contracts for which funding is appropriated less revenues previously recognized SAIC Annual Report 25 -------------------------------------------------------------------------------- Table of Contents PART II -------------------------------------------------------------------------------- on these contracts, and does not include the unfunded portion of contracts where funding is incrementally appropriated or authorized on a quarterly or annual basis by the U.S. government and other customers, even though the contract may call for performance over a number of years. Funded backlog for contracts with non-government agencies represents the estimated value on contracts, which may cover multiple future years, under which we are obligated to perform, less revenues previously recognized on these contracts. • Negotiated Unfunded Backlog. Negotiated unfunded backlog represents estimated amounts of revenue to be earned in the future from (1) negotiated contracts for which funding has not been appropriated or otherwise authorized and (2) unexercised priced contract options. Negotiated unfunded backlog does not include any estimate of future potential task orders expected to be awarded under IDIQ, GSA Schedule or other master agreement contract vehicles. The estimated value of our total backlog as of the dates presented was as follows: January 31 2014 2013 (in millions) Funded backlog $ 1,639 $ 1,953 Negotiated unfunded backlog 5,012 5,811 Total backlog $ 6,651 $ 7,764 The year over year decline in backlog was driven primarily by a decrease in contract awards largely as a result of aggressive competition driven by U.S. government spending reductions and changing priorities in addition to revenues recognized by us in fiscal 2014. We currently have approximately $250 million in contract awards that are under protest and will not be included in backlog unless and until the protest is resolved in our favor. Bookings and backlog fluctuate from period to period depending on the timing of contract awards, renewals, modifications and cancellations. We expect to recognize revenue from a substantial portion of our funded backlog within the next 12 months (from the end of the reporting period). However, the U.S. government can adjust the scope of services of or cancel contracts at any time. Similarly, certain contracts with commercial customers include provisions that allow the customer to cancel prior to contract completion. Most of our contracts have cancellation terms that would permit us to recover all or a portion of our incurred costs and fees for work performed. Contract Types. Our earnings and profitability may vary materially depending on changes in the proportionate amount of revenues derived from each type of contract. For a discussion of the types of contracts under which we generate revenue, see "Business-Contract Types" in Part I of this Annual Report. The following table summarizes revenues by contract type as a percentage of total revenues for the periods presented: Year ended January 31 2014 2013 2012 Cost reimbursement 37 % 38 % 44 % Time and materials (T&M) and fixed-price level of effort (FP-LOE) 31 % 29 % 27 % Firm-fixed price (FFP) 32 % 33 % 29 % Total 100 % 100 % 100 % 26 SAIC Annual Report -------------------------------------------------------------------------------- Table of Contents PART II -------------------------------------------------------------------------------- Revenue Mix. We generate revenues under our contracts from the efforts of our employees, which we refer to as labor-related revenues, the efforts of our subcontractors and the materials provided on a contract. Our subcontractor-related revenues and materials-related revenues generally have lower margins than our labor-related revenues. The following table presents changes in labor-related, subcontractor-related and materials-related revenues for the periods presented: Year ended January 31 Percent Percent 2014 change 2013 change 2012 (dollars in millions) Labor-related revenues $ 1,785 (10 %) $ 1,983 (5 %) $ 2,083 As a % of revenues 43 % 42 % 44 % Subcontractor-related revenues 1,507 (17 %) 1,821 (1 %) 1,837 As a % of revenues 37 % 38 % 39 % Supply chain materials-related revenues 573 (15 %) 671 32 % 508 As a % of revenues 14 % 14 % 11 % Other materials-related revenues 256 (16 %) 306 0 % 305 As a % of revenues 6 % 6 % 6 % Subcontractor-related revenues decreased for fiscal 2014 relative to the respective prior periods primarily due to the ramp down of the DGS program. Materials-related revenues decreased for fiscal 2014 relative to the respective prior periods primarily on IT and logistics contracts affected by the in-theater force drawdown and due to the completion of a program to supply IT infrastructure support for the Army. For fiscal 2013, the increase in materials-related revenues as compared to labor-related revenues from fiscal 2012 was primarily due to increased activity as a prime contractor on large programs involving significant material deliveries. This included a contract to provide supply chain management and delivery of military land and aircraft tires. Labor-related revenues declined during fiscal 2013, largely due to the ending of the U.S. Army Brigade Combat Team Modernization program in the third quarter of fiscal 2012. Liquidity and Capital Resources Our business requires minimal infrastructure investment because we are primarily a services provider. We expect to fund our ongoing working capital, capital expenditures, commitments and other discretionary investments with existing cash and cash equivalents, future cash flows from operations and, if needed, borrowings under our $200 million Revolving Credit Facility. In connection with the separation, we raised $500 million from advances under our Term Loan Facility, of which $295 million was used to pay a cash distribution to former Parent. Our $500 million borrowing under the Term Loan Facility and, if used in the future, the Revolving Credit Facility will incur interest at a variable rate. In September 2013, in accordance with our risk management objectives, we entered into fixed rate swap agreements for the same notional amount and tenor as the Term Loan Facility. These instruments are used to hedge the variability in interest payment cash flows and are accounted for as a cash flow hedge. Under the swap agreements, we pay the fixed rate and the counterparties to the agreement pay a floating interest rate, for which settlement occurs monthly. We anticipate that our future cash needs will be for working capital, capital expenditures, commitments and strategic investments. Our ability to fund these needs will depend, in part, on our ability to generate cash in the future, which depends on our future financial results, which are subject to general economic, financial, competitive, legislative and regulatory factors. Furthermore, our ability to forecast future cash flows is more limited because we do not have a recent operating history as a stand-alone company. Although we believe that the arrangements in place will permit us to finance our operations on acceptable terms and conditions, our access to, and the availability of, financing on acceptable terms and conditions in the future will be impacted by many factors, including: our credit ratings, the liquidity of the overall capital markets and overall economic conditions. We cannot assure that such financing will be available to us on acceptable terms or that such financing will be available at all. We believe that our future cash from operations together with our existing cash and cash equivalents, as well as access to bank financing and capital markets will provide adequate resources to fund our short-term and long-term liquidity and capital needs. SAIC Annual Report 27 -------------------------------------------------------------------------------- Table of Contents PART II --------------------------------------------------------------------------------Historical Cash Flow Trends The following table summarizes cash flow information for the periods presented: Year ended January 31 2014 2013 2012 (in millions) Total cash flows provided by operating activities $ 183 $ 280 $ 303 Total cash flows used in investing activities (16 ) (6 ) (1 ) Total cash flows provided by (used in) financing activities 86 (274 ) (302 ) Total increase in cash and cash equivalents $ 253 $ - $ - Cash Provided by Operating Activities. Refer to "Results of Operations" above for a discussion of the changes in cash provided by operating activities between fiscal 2014 and fiscal 2013 and between fiscal 2013 and fiscal 2012. Cash Used in Investing Activities. Cash used in investing activities for fiscal 2014 increased by $10 million over the prior year due primarily to investments in facility leasehold improvements and furniture and fixtures related to the renovation of our corporate headquarters as a result of our separation from former Parent. The increase from fiscal 2012 to fiscal 2013 was also as a result of increased investments in plant, property, and equipment. Cash Provided by (Used in) Financing Activities. For fiscal 2014 and prior to separation, financing activities primarily consisted of borrowings under the Term Loan Facility of $495 million (net of $5 million in debt issuance costs), payment of a dividend to former Parent of $295 million, and net transfers to former Parent using a centralized cash management approach for the periods prior to separation whereby the cash generated from our operations was received by former Parent to settle its obligations, including those related to our operations. Subsequent to separation, we paid two quarterly cash dividends to our stockholders totaling $27 million. Outstanding Indebtedness Long-term Debt and Capital Leases. Our long-term debt and capital lease obligations for the periods presented consisted of the following: January 31 Stated & effective interest rate 2014 2013 (in millions) Term loan facility 1.94 % $ 500 $ - Capital leases and other notes payable due on various dates through fiscal 2016 2 3 Total long-term debt and capital lease obligations 502 3 Less current portion 13 2 Total long-term debt, net of current portion $ 489 $ 1 The Term Loan Facility contains financial covenants and customary restrictive covenants, including limitations on the ability to merge or consolidate with other entities, property sale and lease back transactions, and dividend and stock repurchases under certain leverage ratios. We were in compliance with all covenants as of January 31, 2014. Revolving Credit Facility. We have a revolving credit facility providing for up to $200 million in unsecured borrowing capacity bearing interest at variable rates through September 2018. For additional information on our notes payable and long-term debt see Note 9 of the notes to the consolidated and combined financial statements contained within this Annual Report. Off-Balance Sheet Arrangements We have obligations relating to letters of credit outstanding principally related to guarantees on contracts with foreign government customers and obligations relating to surety bonds outstanding principally related to performance and payment bonds as described in Note 15 of the notes to consolidated and combined financial statements contained within this Annual Report. The letters of credit and surety bonds initially were obtained by former Parent and we are required to satisfy these obligations under the terms of the distribution agreement between former Parent and us. These arrangements have not had, 28 SAIC Annual Report -------------------------------------------------------------------------------- Table of Contents PART II -------------------------------------------------------------------------------- and management does not believe it is likely that they will in the future have, a material effect on our liquidity, capital resources, operations or financial condition. Contractual Obligations The following table summarizes, as of January 31, 2014, our obligations to make future payments pursuant to certain contracts or arrangements and provides an estimate of the fiscal years in which these obligations are expected to be satisfied: Payments Due by Fiscal Year 2016- 2018- 2020 and Total 2015 2017 2019 Thereafter (in millions) Contractual obligations: Long-term debt and capital lease obligations, including current portion (1) $ 502 $ 13 $ 76 $ 413 $ - Interest payments on long-term debt (2) 62 10 26 26 - Operating lease obligations 98 24 37 23 14 Estimated purchase obligations (3) 71 49 20 2 - Other long-term liabilities (4) 17 4 5 4 4 Total contractual obligations $ 750 $ 100 $ 164 $ 468 $ 18 (1) The amounts presented are based on an anticipated loan repayment schedule however we have the option to prepay loan principal amounts at any time. (2) Amounts represent an estimate of future variable interest payments on the Term Credit Facility based on scheduled outstanding principal amounts and projected 1-month LIBOR as of January 31, 2014. We have the option to prepay loan principal amounts, in which case interest would not be due and we would not have a contractual obligation. The above table excludes the effects of interest rate swaps used to hedge against changes in 1-month LIBOR. (3) Includes estimated obligations to transfer funds under legally enforceable agreements for fixed or minimum amounts or quantities of goods or services at fixed or minimum prices. Excludes purchase orders for services or products to be delivered pursuant to U.S. government contracts in which we have full recourse under normal contract termination clauses. (4) Other long-term liabilities primarily consist of liabilities associated with deferred compensation plan obligations and deferred rent and excludes the liabilities associated with tax liabilities for uncertain tax positions. Deferred compensation plan obligations have been allocated to fiscal years based upon participants' payment elections upon retirement and estimated retirement ages but is subject to acceleration upon participants' termination of employment prior to retirement. Deferred rent has been allocated to fiscal years on a straight-line basis over the remaining contractual lease term but actual expense may be accelerated upon early termination of the lease arrangement (or vacating a leased facility prior to the end of the lease). 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, see Note 15 of the notes to the consolidated and combined financial statements contained within this Annual Report. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our combined financial statements, which are prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of these financial statements 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 revenues and expenses during the reporting periods. 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. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates under different assumptions and conditions. We have several significant accounting policies that are both important to the presentation of our financial condition and results of operations and require management's most difficult, subjective and complex judgments. Typically, the circumstances that make these judgments difficult, subjective and complex have to do with making estimates about the effect of matters that are inherently uncertain. Our significant accounting policies are described below. Revenue Recognition. We generate our revenues from various types of contracts, which include FFP, T&M, FP-LOE, cost-plus-fixed-fee, cost-plus-award-fee and cost-plus-incentive-fee contracts. SAIC Annual Report 29 -------------------------------------------------------------------------------- Table of Contents PART II --------------------------------------------------------------------------------FFP contracts-Revenues and fees on these contracts that are system integration or engineering in nature are primarily recognized using the percentage-of-completion method of accounting utilizing the cost-to-cost method. T&M contracts-Revenue is recognized on T&M contracts with the U.S. government using the percentage-of-completion method of accounting utilizing an output measure of progress. Revenue is recognized on T&M contracts with non-U.S. government customers using a proportional performance method. Under both of these methods, revenue is recognized based on the hours provided in performance under the contract multiplied by the negotiated contract billing rates, plus the negotiated contract billing rate of any allowable material and subcontract costs and out-of-pocket expenses. FP-LOE contracts-These contracts are substantially similar to T&M contracts except they require a specified level of effort over a stated period of time. Accordingly, we recognize revenue on FP-LOE contracts with the U.S. government in a manner similar to T&M contracts in which we measure progress toward completion based on the hours provided in performance of the contract multiplied by the negotiated contract billing rates, plus the negotiated contract billing rate of any allowable material costs and out-of-pocket expenses. Cost-plus-fixed-fee contracts-Revenue is recognized on cost-plus-fixed-fee contracts with the U.S. government on the basis of partial performance equal to costs incurred, plus an estimate of applicable fees earned as we become contractually entitled to reimbursement of costs and the applicable fees. Cost-plus-award-fee/cost-plus-incentive fee contracts-Revenues and fees on these contracts with the U.S. government are primarily recognized using the percentage-of-completion method of accounting, most often based on the cost-to-cost method. We include an estimate of the ultimate incentive or award fee to be received on the contract in the estimate of contract revenues for purposes of applying the percentage-of-completion method of accounting. Revenues from services and maintenance contracts, notwithstanding contract type, are recognized over the term of the respective contracts as the services are performed and revenue is earned. Revenues from unit-priced contracts are recognized as transactions are processed based on objective measures of output. We also use the efforts-expended method of percentage-of-completion accounting using measures such as labor dollars for measuring progress toward completion in situations in which this approach is more representative of the progress on the contract. For example, the efforts-expended method is utilized when there are significant amounts of materials or hardware procured for the contract that is not representative of progress on the contract. We also evaluate contracts for multiple elements, and when appropriate, separate the contracts into separate units of accounting for revenue recognition. We provide for anticipated losses on all types of contracts by recording an expense during the period in which the losses are determined. Amounts billed and collected but not yet earned as revenues under certain types of contracts are deferred. Contract costs incurred for U.S. government contracts, including indirect costs, are subject to audit and adjustment through negotiations with government representatives. Revenues on U.S. government contracts have been recorded in amounts that are expected to be realized upon final settlement. Contract claims are unanticipated additional costs incurred but not provided for in the executed contract price that the Company seeks to recover from the customer. Such costs are expensed as incurred. Additional revenue related to contract claims is recognized when the amounts are awarded by the customer. In certain situations, primarily where the Company is not the primary obligor on certain elements of a contract the Company recognizes as revenue the net management fee associated with the services and excludes from its income statement the gross sales and costs associated with the facility or other vendors' products. Changes in Estimates on Contracts. Changes in estimates related to contracts accounted for using the cost-to-cost percentage-of-completion method of accounting are recognized in the period in which such changes are made for the inception-to-date effect of the changes. Changes in these estimates can routinely occur over the contract performance period for a variety of reasons, including changes in contract scope, changes in contract cost estimates due to unanticipated cost growth or retirements of risk for amounts different than estimated, and changes in estimated incentive or award fees. Aggregate changes in contract estimates reduced operating income by $4 million for fiscal 2014, reduced operating income by $2 million for fiscal 2013, and increased operating income by $9 million for fiscal 2012. For additional information related to changes in estimates on contracts, including gross favorable and unfavorable adjustments as well as the impact to earnings per share, see Note 1 of the notes to the consolidated and combined financial statements contained within this Annual Report. Receivables. Our accounts receivable include both receivables billed to customers and unbilled receivables, which consist of costs and fees billable upon contract completion or the occurrence of a specified event, the majority of which is expected to be billed and collected within one year. Unbilled receivables are stated at estimated realizable value. Since our receivables 30 SAIC Annual Report -------------------------------------------------------------------------------- Table of Contents PART II -------------------------------------------------------------------------------- are primarily with the U.S. government, we do not have a material credit risk exposure. Contract retentions are billed when we have negotiated final indirect rates with the U.S. government and, once billed, are subject to audit and approval by government representatives. Consequently, the timing of collection of retention balances is outside our control. Based on our historical experience, the majority of retention balances are expected to be collected beyond one year and write-offs of retention balances have not been significant. Contract claims are unanticipated additional costs incurred but not provided for in the executed contract price that we seek to recover from the customer. Such costs are expensed as incurred. Revenue related to contract claims is recognized when the contract price is adjusted by the customer. Goodwill and Intangible Assets Impairment. We evaluate goodwill for potential impairment annually at the beginning of the fourth quarter, or whenever events or circumstances indicate that the carrying value of goodwill may not be recoverable. The goodwill impairment test is a two-step process performed at the reporting unit level. The first step consists of estimating the fair values of each of the reporting units based on a market approach. Fair value computed using this method is determined using a number of factors, including projected future operating results and business plans, economic projections, anticipated future cash flows, comparable market data based on industry grouping, and the cost of capital. The estimated fair values are compared with the carrying values of the reporting units. If the fair value is less than the carrying value of a reporting unit, which includes the allocated goodwill, a second step is performed to compute the amount of the impairment by determining an implied fair value of goodwill. The implied fair value of goodwill is the residual fair value derived by deducting the fair value of a reporting unit's identifiable assets and liabilities from its estimated fair value calculated in the first step. The impairment expense represents the excess of the carrying amount of the reporting unit's goodwill over the implied fair value of the reporting unit's goodwill. We face uncertainty in our business environment due to the substantial fiscal and economic challenges facing the U.S. government, its primary customer. Adverse changes, such as the manner in which budget cuts are implemented, including sequestration, and issues related to the nation's debt ceiling, could negatively impact our expected future operating results and potentially result in an impairment of goodwill. Intangible assets with finite lives are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We did not recognize any impairment losses on intangible assets during the last three fiscal years. Income Taxes. Prior to the separation our operations were historically included in former Parent's U.S. federal and state income tax returns and all income taxes were paid by former Parent. Income taxes are presented in the consolidated and combined financial statements as if we filed our own tax returns on a separate tax return basis. Income tax liabilities were assumed to be immediately settled with former Parent against the parent company investment account. Following the separation, we account for income taxes under the asset and liability method of accounting, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Under this method, changes in tax rates and laws are recognized in income in the period such changes are enacted. The provision for federal, state, foreign and local income taxes is calculated on income before income taxes based on current tax law and includes the cumulative effect of any changes in tax rates from those used previously in determining deferred tax assets and liabilities. Such provision differs from the amounts currently payable because certain items of income and expense are recognized in different reporting periods for financial reporting purposes than for income tax purposes. Recording our provision for income taxes requires management to make significant judgments and estimates for matters whose ultimate resolution may not become known until the final resolution of an examination by the IRS or state agencies. Additionally, recording liabilities for uncertain tax positions involves significant judgment in evaluating our tax positions and developing our best estimate of the taxes ultimately expected to be paid. We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent results of operations. If we were to determine that we would be able to realize our deferred income tax assets in the future in excess of their net recorded amount or would no longer be able to realize our deferred income tax assets in the future as currently recorded, we would make an adjustment to the valuation allowance which would decrease or increase the provision for income taxes. We have also recognized liabilities for uncertain tax positions when it is more likely than not that a tax position will not be sustained upon examination and settlement with various taxing authorities. Liabilities for uncertain tax positions are measured based upon the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Stock-Based Compensation. We issue stock-based awards, including stock options and vesting stock awards, as compensation to employees and directors. These awards are accounted for as equity awards. We recognize stock-based SAIC Annual Report 31 -------------------------------------------------------------------------------- Table of Contents PART II -------------------------------------------------------------------------------- compensation expense net of estimated forfeitures on a straight-line basis over the underlying award's requisite service period, as measured using the award's grant-date fair value. We estimate forfeitures using former Parent's historical experience. At separation all former Parent stock-based awards held by our employees were converted into awards of the stock-based compensation plans sponsored by us, as discussed in Note 6 of the notes to the consolidated and combined financial statements contained within this Annual Report. We use the Black-Scholes option-pricing model to calculate the grant date fair value of stock options awarded. The model calculates the fair value of stock options based on input assumptions about, among other things, employee exercise behavior and the expected volatility of our common stock. The assumptions used in the model represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those awards expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. For further discussion on the assumptions used, see Note 6 of the notes to the consolidated and combined financial statements contained within this Annual Report. Recently Issued But Not Yet Adopted Accounting Pronouncements New pronouncements issued but not effective until after January 31, 2014 are not expected to have a material impact on our financial position, results of operations or cash flows. Effects of Inflation Approximately 40% of our revenues for fiscal 2014 were derived from cost-reimbursement type contracts, which are generally completed within one year. Bids for longer-term FFP, T&M and FP-LOE contracts typically include sufficient provisions for labor and other cost escalations to cover anticipated cost increases over the period of performance. As a result, our revenues and costs have generally both increased commensurate with inflation and operating income as a percentage of total revenues has not been significantly affected. |