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GENCORP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Unless otherwise indicated or required by the context, as used in this Quarterly Report on Form 10-Q, the terms "the Company," "we," "our" and "us" refer to GenCorp Inc. and all of its subsidiaries that are consolidated in conformity with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of the consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. In addition, our operating results for interim periods may not be indicative of the results of operations for a full year. This section contains a number of forward-looking statements, all of which are based on current expectations and are subject to risks and uncertainties including those described in this Quarterly Report under the heading "Forward-Looking Statements." Actual results may differ materially. This section should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended November 30, 2013, and periodic reports subsequently filed with the Securities and Exchange Commission ("SEC"). Overview We are a manufacturer of aerospace and defense products and systems with a real estate segment that includes activities related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. We develop and manufacture propulsion systems for defense and space applications, and armaments for precision tactical and long range weapon systems applications. Our continuing operations are organized into two segments: Aerospace and Defense - includes the operations of our wholly-owned subsidiary Aerojet Rocketdyne, Inc. ("Aerojet Rocketdyne"), a leading technology-based designer, developer and manufacturer of aerospace and defense products and systems for the United States ("U.S.") government, including the Department of Defense ("DoD"), the National Aeronautics and Space Administration ("NASA"), major aerospace and defense prime contractors as well as portions of the commercial sector. Aerojet Rocketdyne is a world-recognized engineering and manufacturing company that specializes in the development and production of propulsion systems for defense and space applications, armament systems for precision tactical systems and munitions, and is considered a domestic market leader in launch propulsion, in-space propulsion, missile defense propulsion, tactical missile propulsion and hypersonic propulsion systems. Real Estate - includes the activities of our wholly-owned subsidiary Easton Development Company, LLC related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. We own approximately 11,900 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento ("Sacramento Land"). We are currently in the process of seeking zoning changes and other governmental approvals on a portion of the Sacramento Land to optimize its value. In addition, we are currently in the process of performing several upgrade activities to the Sacramento Land to reduce the time a developer would have to hold the Sacramento Land before development could start. A summary of the significant financial highlights for the second quarter of fiscal 2014 which management uses to evaluate our operating performance and financial condition is presented below. • Net sales for the second quarter of fiscal 2014 totaled $403.1 million compared to $286.6 million for the second quarter of fiscal 2013. • Net loss for the second quarter of fiscal 2014 was $50.2 million, or $0.87 loss per share, compared to a net loss of $11.8 million, or $0.20 loss per share, for the second quarter of fiscal 2013. • Adjusted EBITDAP (Non-GAAP measure) for the second quarter of fiscal 2014 was $33.5 million, or 8.3% of net sales, compared to $30.6 million or 10.7% of net sales, for the second quarter of fiscal 2013. • Segment performance (Non-GAAP measure) before environmental remediation provision adjustments, retirement benefit plan expense, and unusual items was $24.5 million for the second quarter of fiscal 2014, compared to $37.4 million for the second quarter of fiscal 2013. • Cash provided by operating activities in the second quarter of fiscal 2014 totaled $3.0 million, compared to $12.0 million in the second quarter of fiscal 2013. • Free cash flow (Non-GAAP measure) in the second quarter of fiscal 2014 totaled ($6.2) million, compared to ($0.6) million in the second quarter of fiscal 2013. • Repurchased 3.0 million of our common shares at a cost of $55.9 million during the second quarter of fiscal 2014. • Repurchased $45.7 million principal of our 4.0625% Convertible Subordinated Debentures ("4 1/16% Debentures") up to 206% of par resulting in a charge of $45.9 million during the second quarter of fiscal 2014. • As of May 31, 2014, we had $2.0 billion of funded backlog. 32 -------------------------------------------------------------------------------- Table of Contents • As of May 31, 2014, we had $662.3 million in net debt (Non-GAAP measure) compared to $501.6 million and $102.8 million as of November 30, 2013 and May 31, 2013, respectively. Our fiscal year ends on November 30 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday of November. As a result of the 2013 calendar, Aerojet Rocketdyne had 14 weeks of operations in the first quarter of fiscal 2013 compared to 13 weeks of operations in the first quarter of fiscal 2014. The additional week of operations in the first quarter of fiscal 2013 accounted for $27.8 million in additional net sales. In July 2012, we signed a stock and asset purchase agreement (the "Original Purchase Agreement") with United Technologies Corporation ("UTC") to acquire the Pratt & Whitney Rocketdyne division (the "Rocketdyne Business") from UTC for $550 million (the "Acquisition"). On June 10, 2013, the Federal Trade Commission ("FTC") announced that it closed its investigation into the Acquisition under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. On June 12, 2013, we entered into an amended and restated stock and asset purchase agreement, (the "Amended and Restated Purchase Agreement") with UTC, which amended and restated the Original Purchase Agreement, as amended. On June 14, 2013, we completed the acquisition of substantially all of the Rocketdyne Business pursuant to the Amended and Restated Purchase Agreement. The aggregate consideration to UTC was $411 million which represents the initial purchase price of $550 million reduced by $55 million relating to the pending future acquisition of UTC's 50% ownership interest of RD Amross, LLC ("RD Amross" a joint venture with NPO Energomash of Khimki, Russia which sells RD-180 engines to RD Amross), and the portion of the UTC business that markets and supports the sale of RD-180 engines (the "RDA Acquisition"). The acquisition of UTC's 50% ownership interest of RD Amross and UTC's related business is contingent upon certain conditions including receipt of certain Russian governmental regulatory approvals, which may not be obtained. Pursuant to the terms of the Amended and Restated Purchase Agreement, either party to such agreement may terminate the obligations to consummate the RDA Acquisition on or after June 12, 2014; provided, however, that such termination date may be extended for up to four additional three-month periods (with the final termination date extended until June 12, 2015). On May 30, 2014, we elected the first option to extend the terms of the Amended and Restated Purchase Agreement for three months. Subject to the terms of Amended and Restated Purchase Agreement, in order to extend the termination date, either party may request the extension by providing written notice to the other party at least five business days prior to the termination date, provided that the requesting party must have a reasonable belief at the time such notice is given that a certain authorization from the Russian government will be forthcoming for completion of the RDA Acquisition. The final purchase price was further adjusted for advance payments on contracts and capital expenditures. The Rocketdyne Business integration costs incurred and capitalized through May 31, 2014, all of which we believe will be allocated to our U.S. government contracts, totaled $22.2 million. Such costs are reimbursable costs and will be allocated to our U.S. government contracts based on our planned integration savings exceeding the restructuring costs by a factor of at least two to one. We believe that the anticipated restructuring savings will exceed restructuring costs by a factor of at least two to one; therefore, the costs were deferred as we believe that subsequent recovery of said costs through the pricing of our products and services to the U.S. government is probable. We review on a quarterly basis the probability of recovery of these costs. The unaudited pro forma information for the periods set forth below gives effect to the Acquisition as if it had occurred at the beginning of each respective fiscal year. These amounts have been calculated after applying our accounting policies and adjusting the results of the Rocketdyne Business to reflect depreciation and amortization that would have been charged assuming the fair value adjustments to property, plant and equipment and intangible assets had been applied as at the beginning of each respective year, together with the tax effects, as applicable. The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the Acquisition been consummated as of that time or that may result in the future. The pro forma information for the second quarter and first half of fiscal 2013 is presented below: Three months ended Six months ended May 31, 2013 May 31,2013 (In millions, except per share amounts) Net sales: As reported $ 286.6 $ 530.3 Pro forma $ 489.0 $ 909.9 Net (loss) income: As reported $ (11.8 ) $ (25.8 ) Pro forma $ 1.4 $ 13.5 Basic (loss) income per share As reported $ (0.20 ) $ (0.43 ) Pro forma $ 0.02 $ 0.22 Diluted (loss) income per share As reported $ (0.20 ) $ (0.43 ) Pro forma $ 0.02 $ 0.21 33 -------------------------------------------------------------------------------- Table of Contents We provide Non-GAAP measures as a supplement to financial results based on GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management's Discussion and Analysis under the heading "Operating Segment Information" and "Use of Non-GAAP Financial Measures." We are operating in an environment that is characterized by both increasing complexity in the global security environment, as well as continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our industry, integration of the Rocketdyne Business (including integration into our enterprise resource planning ("ERP") system), environmental matters, capital structure and an underfunded pension plan. Some of these matters are discussed in more detail below. Major Customers The principal end user customers of our products and technology are agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within "budget top-line" limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. Customers that represented more than 10% of net sales for the periods presented are as follows: Three months ended May 31, Six months ended May 31, 2014 2013 2014 2013 Lockheed Martin 30 % 31 % 25 % 31 % United Launch Alliance 25 % 12 % 26 % * Raytheon 18 % 42 % 18 % 43 % NASA 12 % * 13 % * * Less than 10%. Sales to the U.S. government and its agencies, including sales to our significant customers discussed above, were as follows (dollars in millions): U.S. Government Percentage of Net Sales Sales Three months ended May 31, 2014 $ 385.1 96 % Three months ended May 31, 2013 273.5 95 Six months ended May 31, 2014 694.2 95 Six months ended May 31, 2013 506.6 96 The Standard Missile program, which is included in the U.S. government sales, represented 12% and 31% of net sales for the second quarter of fiscal 2014 and 2013, respectively. The Standard Missile program represented 12% and 32% of net sales for the first half fiscal 2014 and 2013, respectively. Industry Update Our primary aerospace and defense customers include the DoD and its agencies, NASA, and the prime contractors that supply products to these customers. We are seeing more opportunities for commercial launch and in-space business. In addition, sales to our aerospace and defense customers that provide products to international customers continue to grow. However, we rely on particular levels of U.S. government spending on propulsion systems for defense, space and armament systems for precision tactical weapon systems and munitions applications, and our backlog depends, in large part, on continued funding by the U.S. government for the programs in which we are involved. These funding levels are not generally correlated with any specific economic cycle, but rather follow the cycle of general public policy and political support for this type of funding. Moreover, although our contracts often contemplate that our services will be performed over a period of several years, the U.S. President must propose and Congress must appropriate funds for a given program each government fiscal year ("GFY") and may significantly increase, decrease or eliminate, funding for a program. A decrease in DoD and/or NASA expenditures, the elimination or curtailment of a material program in which we are or hope to be involved, or changes in payment patterns of our customers as a result of changes in U.S. government outlays, could have a material adverse effect on our operating results, financial condition, and/or cash flows. 34-------------------------------------------------------------------------------- Table of Contents The Bipartisan Budget Act of 2013 set overall discretionary spending levels for GFY 2014 and 2015 and eased sequestration cuts to the DoD and other federal agencies (e.g., NASA) for GFY 2014 and 2015, paving the way for an eventual agreement on GFY 2014 Appropriations for all federal agencies. Despite a delay in the delivery of the President's budget request for GFY 2015, House and Senate Appropriators will seek to quickly move the GFY 2015 Defense and NASA Appropriations bills, ahead of the November 2014 midterm elections. It is not yet clear what impact global unrest, particularly in the Ukraine and Middle East, will have on overall defense spending or specific Aerojet Rocketdyne programs. Despite overall U.S. government budget pressures, we believe we are well-positioned to benefit from funding in DoD and NASA priority areas. This view reflects the DoD's strategic guidance report released in January 2012, and the recently released 2014 Quadrennial Defense Review ("QDR") which affirms support for many of our core programs and points toward continued DoD investment in: access to space - in order to ensure access to this highly congested and contested "global commons"; missile defense - in order to protect the homeland, counter weapons of mass destruction and enhance space-based capabilities; and power projection by tactical missile systems. The QDR explicitly states Missile Defense, Space, Nuclear Deterrence, and Precision Strike as key capabilities for the DoD to preserve. During 2013, Congress began consideration of a new NASA Authorization Act, authorizing NASA funding for the next several years, starting with GFY 2014. Ultimately, Congress did not complete action on a new NASA Authorization Act in 2013, but has resumed consideration in 2014. In 2010, the NASA Authorization Act, which remains in effect, impacted GFYs 2011-2013. NASA has again identified the Space Launch System ("SLS") program as one of its top priorities in the NASA portion of the GFY 2015 President's Budget Request. The SLS program also enjoys wide bipartisan support in both chambers of Congress. We maintain a strong relationship with NASA and our propulsion systems have been powering NASA launch vehicles and spacecraft since the inception of the U.S. space program. Our booster and upper stage propulsion systems are currently baselined on the new SLS vehicle and both upper stage and booster engines are in development for future SLS variants. Due to the retirement of the space shuttle fleet, U.S. astronauts are now dependent on Russian Soyuz flights for access to and from the International Space Station ("ISS") for the better part of this decade. NASA has indicated that it is working to re-establish U.S. manned space capability as soon as possible through development of the commercial cargo and crew ISS resupply capability and the heavy lift SLS designed for manned deep space exploration. In both instances, we have significant propulsion content. Environmental Matters Our current and former business operations are subject to, and affected by, federal, state, local, and foreign environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. Our policy is to conduct our business with due regard for the preservation and protection of the environment. We continually assess compliance with these regulations and we believe our current operations are materially in compliance with all applicable environmental laws and regulations. We review on a quarterly basis estimated future remediation costs that could be incurred over the contractual term or the next fifteen years of the expected remediation. These liabilities have not been discounted to their present value as the timing of cash payments is not fixed or reliably determinable. We have an established practice of estimating environmental remediation costs over a fifteen year period, except for those environmental remediation costs with a specific contractual term. With respect to the Baldwin Park Operable Unit ("BPOU") site, our estimates of anticipated environmental remediation costs only extend through the term of the project agreement for such site, which expires in 2017, since we are unable to reasonably estimate the related costs after the expiration of such agreement. Therefore no reserve has been accrued for this site for the period after the expiration of the project agreement and we will reevaluate the environmental reserves related to the BPOU site once the terms of a new agreement related to the site are available and we are able to reasonably estimate the related environmental remediation costs. At that time, the amount of reserves accrued following such reevaluation may be significant. As the period for which estimated environmental remediation costs increase, the reliability of such estimates decrease. These estimates consider the investigative work and analysis of engineers, outside environmental consultants, and the advice of legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum amount is used when no single amount in the range is more probable. Accordingly, such estimates can change as we periodically evaluate and revise such estimates as new information becomes available. We cannot predict whether new information gained as projects progress will affect the estimated liability accrued. The timing of payment for estimated future environmental costs is influenced by a number of factors such as the regulatory approval process and the time required to design, construct, and implement the remedy. 35-------------------------------------------------------------------------------- Table of Contents A summary of our recoverable amounts, environmental reserves, and range of liability, as of May 31, 2014 is presented below: Recoverable Estimated Range Amount(1) Reserve of Liability (In millions) Sacramento $ 83.5 $ 124.6 $ 124.6 -$197.4 BPOU 15.9 23.7 23.7 - 36.6 Other Aerojet Rocketdyne sites 8.2 8.7 8.7 - 23.7 Other sites 0.9 6.7 6.7 - 8.3 Total $ 108.5 $ 163.7 $ 163.7 - $266.0 (1) Excludes the long-term receivable from Northrop Grumman Corporation ("Northrop") of $73.2 million as of May 31, 2014 related to environmental costs already paid (and therefore not reserved) by the Company in prior years that are expected to be reimbursed by Northrop. Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowable to be included in our contracts with the U.S. government and allocable to Northrop until the cumulative expenditure limitation is reached (discussed below). On January 12, 1999, Aerojet Rocketdyne and the U.S. government implemented the October 1997 Agreement in Principle ("Global Settlement") resolving certain prior environmental and facility disagreements, with retroactive effect to December 1, 1998. Under the Global Settlement, Aerojet Rocketdyne and the U.S. government resolved disagreements about an appropriate cost-sharing ratio with respect to the cleanup costs of the environmental contamination at the Sacramento and Azusa sites. The Global Settlement cost-sharing ratio does not have a defined term over which costs will be recovered. Additionally, in conjunction with the sale of the EIS business in 2001, Aerojet Rocketdyne entered into an agreement with Northrop (the "Northrop Agreement") whereby Aerojet Rocketdyne is reimbursed by Northrop for a portion of environmental expenditures eligible for recovery under the Global Settlement, subject to annual and cumulative limitations. Pursuant to the Global Settlement, prior to the third quarter of fiscal 2010, approximately 12% of environmental costs related to Aerojet Rocketdyne's Sacramento site and its former Azusa site were charged to the consolidated statements of operations. Subsequent to the third quarter of fiscal 2010, because our estimated environmental costs have reached the reimbursement ceiling under the Northrop Agreement, approximately 37% of such costs will not be reimbursable and were therefore directly charged to the consolidated statements of operations. However, we are seeking to amend our agreement with the U.S. government to increase the amount allocable to U.S. government contracts. There can be no assurances as to when or if we will be successful in this pursuit. Allowable environmental costs are charged to our contracts as the costs are incurred. Aerojet Rocketdyne's mix of contracts can affect the actual reimbursement made by the U.S. government. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet Rocketdyne to continue recovering these costs from the U.S. government depends on Aerojet Rocketdyne's sustained business volume under U.S. government contracts and programs. Additionally, we are reviewing the percentage of Global Settlement environmental costs allocable to our Aerojet Rocketdyne business and Northrop. Any change in the percentage allocable will require approval from the U.S. government and if received, this change may materially and favorably affect our results of operations and cash flows in the period received along with future periods. The inclusion of such environmental costs in our contracts with the U.S. government impacts our competitive pricing and earnings; however, we believe that this impact is mitigated by driving improvements and efficiencies across our operations as well as our ability to deliver innovative and quality products to our customers. Capital Structure We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of May 31, 2014, we had $783.0 million of debt principal outstanding. The fair value of the debt outstanding at May 31, 2014 was $979.3 million. Retirement Benefits We do not expect to make any significant cash contributions to our U.S. government contractor business segment, Aerojet Rocketdyne, tax-qualified defined benefit pension plan until fiscal 2015, which will be recoverable through our U.S government contracts. Additionally, we do not expect to make any significant cash contributions to the GenCorp tax-qualified defined benefit pension plan until fiscal 2018 or later, which will not be recoverable through our U.S. government contracts. We estimate that approximately 91% of our unfunded pension obligation as of November 30, 2013 is related to Aerojet Rocketdyne which will be recoverable through our U.S. government contracts. 36-------------------------------------------------------------------------------- Table of Contents The funded status of our pension plans may be adversely affected by the investment experience of the plans' assets, by any changes in U.S. law and by changes in the statutory interest rates used by tax-qualified pension plans in the U.S. to calculate funding requirements. Accordingly, if the performance of our plans' assets does not meet our assumptions, if there are changes to the Internal Revenue Service regulations or other applicable law or if other actuarial assumptions are modified, our future contributions to our underfunded pension plans could be higher than we expect. Rocketdyne Business ERP Integration The integration of the Rocketdyne Business into our ERP system is scheduled to be complete by the first half of 2015. Any extension beyond January 1, 2015 will result in additional implementation costs and fees paid to UTC for additional transitional services costs. Results of Operations Net Sales: Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change** (In millions) Net sales $ 403.1 $ 286.6 $ 116.5 $ 732.8 $ 530.3 $ 202.5 * Primary reason for change. The increase in net sales was primarily due to sales from the Rocketdyne Business which was acquired on June 14, 2013 and contributed $173.3 million of net sales in the second quarter of fiscal 2014. The increase in net sales was partially offset by the following (i) a decrease of $39.0 million in the various Standard Missile contracts primarily from the transitioning of the Standard Missile-3 Block IB contract from development activities to production, decreased development activities for the Throttling Divert and Attitude Control System for the Standard Missile-3 Block IIA contract, and lower deliveries on the Standard Missile-1 Regrain contract as a result of completion of the contract; (ii) a decrease of $10.8 million from lower deliveries on the Antares program; (iii) a decrease of $11.4 million as a result of the completion of the Triple Target Terminator ("T3") IIA and IIB contracts; and (iv) decreased deliveries on the Atlas V program reducing sales by $5.8 million. See additional discussion of changes to net sales in "Aerospace and Defense Segment" below. ** Primary reason for change. The increase in net sales was primarily due to sales from the Rocketdyne Business which was acquired on June 14, 2013 and contributed $334.7 million of net sales in the first half of fiscal 2014. The increase in net sales was partially offset by the following (i) a decrease of $77.5 million in the various Standard Missile contracts primarily from the transitioning of the Standard Missile-3 Block IB contract from development activities to production, decreased development activities for the Throttling Divert and Attitude Control System for the Standard Missile-3 Block IIA contract, and lower deliveries on the Standard Missile-1 Regrain contract as a result of completion of the contract; (ii) an additional week of operations in the first quarter of fiscal 2013 resulting in $27.8 million in net sales (see discussion below); (iii) a decrease of $18.5 million as a result of the completion of the T3 IIA and IIB contracts; and (iv) a decrease of $11.8 million from lower deliveries on the Antares program. See additional discussion of changes to net sales in "Aerospace and Defense Segment" below. The Standard Missile program represented 12% and 32% of net sales, respectively, for the first half of fiscal 2014 and 2013. The Standard Missile-3 Block IB program transitioned from a research and development contract into a low rate production contract during the first quarter of fiscal 2014. Standard Missile-3 Block IB low rate production will continue for a period of up to 18 months before it transitions to full rate production. Appropriations bills for both DoD and NASA have become increasingly difficult for Congress to pass by the start of the GFY resulting in funding delays to many of our customers and, in turn, delays in contract awards received by us. This generally leads to delays in the number of new and follow-on awards in the first half of the fiscal year and an increase during the second half, which results in varying levels of uncertainty in the timing of contract awards received and sales generated by Aerojet Rocketdyne. Our fiscal year ends on November 30 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday of November. As a result of the 2013 calendar, Aerojet Rocketdyne had 14 weeks of operations in the first quarter of fiscal 2013 compared to 13 weeks of operations in the first quarter of fiscal 2014. The additional week of operations in the first quarter of fiscal 2013 accounted for $27.8 million in additional net sales. 37-------------------------------------------------------------------------------- Table of Contents Cost of Sales (exclusive of items shown separately below): Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change** (In millions, except percentage amounts) Cost of sales: $ 367.0 $ 254.4 $ 112.6 $ 653.0 $ 471.9 $ 181.1 Percentage of net sales 91.0 % 88.8 % 89.1 % 89.0 % Percentage of net sales excluding retirement benefit expense and step-up in fair value of inventory 89.3 % 85.0 % 87.2 % 84.9 % Components of cost of sales: Cost of sales excluding retirement benefit expense and step-up in fair value of inventory $ 360.0 $ 243.6 $ 116.4 $ 638.9 $ 450.4 $ 188.5 Cost of sales associated with the Acquisition step-up in fair value of inventory not allocable to our U.S. government contracts 0.9 - 0.9 1.9 - 1.9 Retirement benefit expense 6.1 10.8 (4.7 ) 12.2 21.5 (9.3 ) Cost of sales $ 367.0 $ 254.4 $ 112.6 $ 653.0 $ 471.9 $ 181.1 * Primary reason for change. The increase in cost of sales excluding retirement benefit expense and step-up in fair value of inventory as a percentage of net sales was primarily due to (i) cost growth and an engine test anomaly on the Antares AJ-26 program which resulted in a $13.5 million, 3.3% of net sales, impact and (ii) cost growth of $5.6 million, 1.4% of net sales, on the Standard Missile program primarily associated with increased investment in the early production phase of the Standard Missile 3 Block IB contract and Standard Missile 3 Block IIA development contract as we complete qualification. ** Primary reason for change. The increase in cost of sales excluding retirement benefit expense and step-up in fair value of inventory as a percentage of net sales was primarily due to (i) cost growth and an engine test anomaly on the Antares AJ-26 program which resulted in a $13.5 million, 1.8% of net sales, impact and (ii) cost growth of $10.3 million, 1.4% of net sales, on the Standard Missile program primarily associated with increased investment in the early production phase of the Standard Missile 3 Block IB contract and Standard Missile 3 Block IIA development contract as we complete qualification. Selling, General and Administrative ("SG&A"): Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change** (In millions, except percentage amounts) SG&A: $ 9.2 $ 13.5 $ (4.3 ) $ 18.4 $ 25.8 $ (7.4 ) Percentage of net sales 2.3 % 4.7 % 2.5 % 4.9 % Components of SG&A: SG&A excluding retirement benefit expense and stock- based compensation $ 4.8 $ 5.1 $ (0.3 ) $ 9.8 $ 9.0 $ 0.8 Stock-based compensation 1.6 3.1 (1.5 ) 3.0 6.3 (3.3 ) Retirement benefit expense 2.8 5.3 (2.5 ) 5.6 10.5 (4.9 ) SG&A $ 9.2 $ 13.5 $ (4.3 ) $ 18.4 $ 25.8 $ (7.4 ) * Primary reason for change. The decrease in SG&A expense was primarily driven by the following (i) lower non-cash retirement benefit plan expense (see discussion of "Retirement Benefit Plans" below) and (ii) a decrease of $1.5 million in stock-based compensation primarily as a result of increases in the fair value of the stock appreciation rights in the second quarter of fiscal 2013. ** Primary reason for change. The decrease in SG&A expense was primarily driven by the following (i) lower non-cash retirement benefit plan expense (see discussion of "Retirement Benefit Plans" below) and (ii) a decrease of $3.3 million in stock-based compensation primarily as a result of increases in the fair value of the stock appreciation rights in the first half of fiscal 2013. 38 -------------------------------------------------------------------------------- Table of Contents Depreciation and Amortization: Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change** (In millions) Depreciation and amortization: $ 15.4 $ 5.3 $ 10.1 $ 30.2 $ 11.4 $ 18.8 Components of depreciation and amortization: Depreciation $ 12.1 $ 5.0 $ 7.1 $ 23.5 $ 10.7 $ 12.8 Amortization 3.3 0.3 3.0 6.7 0.7 6.0 * Primary reason for change. The increase in depreciation and amortization is primarily related to the following: (i) $5.8 million of depreciation expense related to the Rocketdyne Business, of which $3.0 million was associated with the step-up in fair value of the tangible assets not allocable to our U.S. government contracts; (ii) $3.0 million of amortization of intangible assets associated with the Rocketdyne Business which is not allocable to our U.S. government contracts; and (iii) $1.4 million of depreciation expense associated with the ERP system which was placed into service in June 2013. ** Primary reason for change. The increase in depreciation and amortization is primarily related to the following: (i) $11.3 million of depreciation expense related to the Rocketdyne Business, of which $5.7 million was associated with the step-up in fair value of the tangible assets not allocable to our U.S. government contracts; (ii) $6.0 million of amortization of intangible assets associated with the Rocketdyne Business which is not allocable to our U.S. government contracts; and (iii) $2.8 million of depreciation expense associated with the ERP system which was placed into service in June 2013. Other Expense, net: Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change** (In millions) Other expense, net: $ 48.5 $ 10.5 $ 38.0 $ 55.9 $ 16.4 $ 39.5 * Primary reason for change. The increase in other expense, net was primarily due to an increase of $39.9 million in unusual item charges partially offset by a decrease of $3.5 million in environmental remediation expenses. See Notes 8(b) and 8(c) in Notes to Unaudited Condensed Consolidated Financial Statements for additional discussion of environmental remediation matters. See discussion of unusual items below. ** Primary reason for change. The increase in other expense, net was primarily due to an increase of $38.9 million in unusual item charges partially offset by a decrease of $0.9 million in environmental remediation expenses. See Notes 8(b) and 8(c) in Notes to Unaudited Condensed Consolidated Financial Statements for additional discussion of environmental remediation matters. See discussion of unusual items below. Total unusual items expense, a component of other expense, net in the unaudited condensed consolidated statements of operations, for the second quarter and first half of fiscal 2014 and 2013 was as follows: Three months ended May 31, Six months ended May 31, 2014 2013 2014 2013 (In millions) Unusual items Legal related matters $ 0.1 $ (0.1 ) $ 0.1 $ 0.4 Loss on debt repurchased 45.9 - 50.8 - Loss on bank amendment 0.2 - 0.2 - Rocketdyne Business acquisition related costs(1) - 6.4 - 11.8 $ 46.2 $ 6.3 $ 51.1 $ 12.2 (1) Includes a benefit of $4.0 million and $3.6 million for the three and six months ended May 31, 2013, respectively, related to the Company not being required to divest the Liquid Divert and Attitude Control Systems program. 39 -------------------------------------------------------------------------------- Table of Contents First half of fiscal 2014 Activity: A summary of our loss on the 4 1/16% Debentures repurchased during the first half of fiscal 2014 is as follows (in millions): Principal amount repurchased $ 50.2 Cash repurchase price (100.8 ) Write-off of deferred financing costs (0.2 ) Loss on 4 1/16% Debentures repurchased $ (50.8 ) During the second quarter of fiscal 2014, we recorded $0.2 million of losses related to an amendment to the Senior Credit Facility. During the first half of fiscal 2014, we recorded $0.1 million for realized losses and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. First half of fiscal 2013 Activity: During the first half of fiscal 2013, we recorded ($0.1) million for realized gains and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. During the first quarter of fiscal 2013, we recorded a charge of $0.5 million related to a legal settlement. We incurred expenses of $11.8 million, including internal labor costs of $1.1 million, related to the Rocketdyne Business acquisition in the first half of fiscal 2013. Interest Income: Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change* (In millions) Interest income: $ - $ 0.1 $ (0.1 ) $ - $ 0.2 $ (0.2 ) * Primary reason for change. Interest income was essentially unchanged for the periods presented. Interest Expense: Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change 2014 2013 Change* (In millions) Interest expense: $ 12.6 $ 12.6 $ - $ 25.0 $ 23.8 $ 1.2 Components of interest expense: Contractual interest and other 11.7 11.7 - 23.2 21.1 2.1 Amortization of deferred financing costs 0.9 0.9 - 1.8 2.7 (0.9 ) Interest expense $ 12.6 $ 12.6 $ - $ 25.0 $ 23.8 $ 1.2 * Primary reason for change. The increase in interest expense was primarily due to the issuance of the 7.125% Second-Priority Senior Secured Notes due 2021 (the "7 1/8% Notes") in January 2013 related to the acquisition of the Rocketdyne Business partially offset by the amortization in the first quarter of fiscal 2013 of the commitment fee for the $510 million of debt financing with Morgan Stanley Senior Funding, Inc. and Citigroup Global Markets Inc. entered into in July 2012. 40 -------------------------------------------------------------------------------- Table of Contents Income Tax Provision: The income tax provision for the first half of fiscal 2014 and 2013 was as follows: Six months ended May 31, May 31, 2014 2013 (In millions) Federal and state current income tax expense $ 4.8 $ 7.4 Net deferred (benefit) expense (4.1 ) 1.6 Impact of change in research credit estimates 1.1 (2.0 ) Income tax provision $ 1.8 $ 7.0 Cash paid for income taxes $ 1.7 $ 4.9 The effective tax rate for the first half of fiscal 2014 is (3.6%) and differs from the federal statutory rate of 35% primarily due to the significant non-deductible premium on the 4 1/16% Debentures repurchased during the first half of fiscal 2014, which we have treated for tax purposes as a non-recurring, discrete event due to the inability to accurately estimate an annualized total, as well as the impacts from state income taxes, changes in estimates related to the fiscal 2012 research and development credits, and certain expenditures which are permanently not deductible for tax purposes. The effective tax rate for the first half of fiscal 2013 was (37.2%) and differs from the federal statutory tax rate of 35% primarily due to the impact of the change in the valuation allowance, certain permanently non-deductible items (principally interest) and state income taxes, offset by the benefit from the federal re-enactment of the research and development credit retroactive to fiscal 2012. As of May 31, 2014, the total liability for uncertain income tax positions, including accrued interest and penalties was $6.7 million. Due to the high degree of uncertainty regarding the timing of potential future cash flows associated with the respective liabilities, we have been unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. It is reasonably possible that a reduction of up to $0.3 million of unrecognized tax benefits and related interest may occur within the next 12 months as a result of the expiration of certain statute of limitations. Discontinued Operations: On August 31, 2004, we completed the sale of our GDX Automotive ("GDX") business. On November 30, 2005, we completed the sale of the Fine Chemicals business. Summarized financial information for discontinued operations is set forth below: Three months ended May 31, Six months ended May 31, 2014 2013 2014 2013 (In millions) Net sales $ - $ - $ - $ - Loss before income taxes (1.4 ) - (1.4 ) (0.1 ) Income tax benefit (provision) 0.6 (0.1 ) 0.6 0.1 Net loss from discontinued operations (0.8 ) (0.1 ) (0.8 ) - Retirement Benefit Plans: Components of retirement benefit expense are: Three months ended May 31, Six months ended May 31, 2014 2013 2014 2013 (In millions) Service cost $ 2.2 $ 1.5 $ 4.4 $ 2.8 Interest cost on benefit obligation 17.4 15.8 34.8 31.6 Assumed return on plan assets (23.2 ) (24.1 ) (46.4 ) (48.2 ) Amortization of prior service credits (0.2 ) (0.2 ) (0.4 ) (0.4 ) Recognized net actuarial losses 12.7 23.1 25.4 46.2 Retirement benefit expense $ 8.9 $ 16.1 $ 17.8 $ 32.0 Market conditions and interest rates significantly affect the assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This "smoothing" results in the creation of other accumulated income or losses which will be amortized to retirement benefit expense or benefit in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses associated with the market-related value of pension assets and all other gains and losses, including changes in the discount rate used to calculate benefit costs each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual retirement benefit expense, future expenses are impacted by changes in the market value of pension plan assets and changes in interest rates. 41-------------------------------------------------------------------------------- Table of Contents Additionally, we sponsor a defined contribution 401(k) plan and participation in the plan is available to all employees. The cost of the 401(k) plan was $10.3 million and $6.0 million, respectively, in the first half of fiscal 2014 and 2013. The cost is recoverable through our U.S. government contracts. Operating Segment Information: We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance, which is a non-GAAP financial measure, represents net sales from continuing operations less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, legacy income or expenses, and provisions for unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our underlying operational performance. In addition, we provide the Non-GAAP financial measure of our operational performance called segment performance before environmental remediation provision adjustments, retirement benefit plan expense, Rocketdyne purchase accounting adjustments, and unusual items. We believe the exclusion of the items listed above permits an evaluation and a comparison of results for ongoing business operations, and it is on this basis that management internally assesses operational performance. Aerospace and Defense Segment Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change* (In millions, except percentage amounts) Net sales $ 401.5 $ 285.4 $ 116.1 $ 729.7 $ 527.7 $ 202.0 Segment performance 17.1 22.7 (5.6 ) 42.8 41.9 0.9 Segment margin 4.3 % 8.0 % 5.9 % 7.9 % Segment margin before environmental remediation provision adjustments, retirement benefit plan expense, Rocketdyne purchase accounting adjustments, and unusual items (Non-GAAP measure) 7.6 % 12.8 % 9.7 % 12.4 % Components of segment performance: Aerospace and Defense $ 30.5 $ 36.4 $ (5.9 ) $ 70.6 $ 65.6 $ 5.0 Environmental remediation provision adjustments (0.3 ) (1.2 ) 0.9 (1.9 ) (0.6 ) (1.3 ) Retirement benefit plan expense (6.1 ) (10.8 ) 4.7 (12.2 ) (21.5 ) 9.3 Unusual items (0.1 ) (1.7 ) 1.6 (0.1 ) (1.6 ) 1.5 Rocketdyne purchase accounting adjustments not allocable to the our U.S. government contracts: Amortization of the Rocketdyne Business' intangible assets (3.0 ) - (3.0 ) (6.0 ) - (6.0 ) Depreciation associated with the step-up in the fair value of the Rocketdyne Business' tangible assets (3.0 ) - (3.0 ) (5.7 ) - (5.7 ) Cost of sales associated with the step-up in the fair value of the Rocketdyne Business' inventory (0.9 ) - (0.9 ) (1.9 ) - (1.9 ) Aerospace and Defense total $ 17.1 $ 22.7 $ (5.6 ) $ 42.8 $ 41.9 $ 0.9 * Primary reason for change. The increase in net sales in the second quarter and first half of fiscal 2014 was primarily related to activity from the Rocketdyne Business which was acquired on June 14, 2013. The Rocketdyne Business contributed $173.3 million and $334.7 million of net sales during the second quarter and first half of fiscal 2014, respectively. However, business in the second quarter of fiscal 2014 continued to see sales fluctuations which began in first quarter of fiscal 2014 driven by the transition of the Standard Missile 3 Block IB contract from a cost reimbursable development type contract to a fixed price contract as a result of a favorable acquisition decision. 42 -------------------------------------------------------------------------------- Table of Contents Sales on the Standard Missile 3 Block IIA contract, the Missile Defense Agency's (the "MDA") newest member of the Standard Missile family, were also lower for the second quarter and first half of fiscal 2014 when compared to the same periods in fiscal 2013, reflecting work entering the latter stages of planned development activity in preparation for an expected U.S. government acquisition decision to enter low-rate initial production. This contract is being conducted by the MDA jointly with Japan and supports a critical need to provide regional missile defense capability supporting U.S. and Japanese interests in Asia and around the world. In addition, the second quarter and first half of fiscal 2014 sales recorded on the Standard Missile 1 contract were significantly lower as compared to second quarter and first half of fiscal 2013 as re-grain motor deliveries have largely been completed on the latest Foreign Military Sales ("FMS") order from international customers. This kind of FMS contract intermittency is typical of our recent history on the Standard Missile 1 contract. While, in aggregate, the Standard Missile family of contracts recorded a sales reduction totaling $39.0 million in the second quarter of fiscal 2014 and $77.5 million for the first half of fiscal 2014, as compared to the same prior year periods, considerable progress has been made in advancing the maturity of the Missile Defense product line. In the space launch program area, the Atlas V solid rocket booster production program saw a decrease in sales of $5.8 million when compared to the second quarter of last year and a decrease of $4.8 million for the first half of fiscal 2014, attributable to a difference in timing of booster deliveries during the same prior year periods. Antares AJ-26 engine sales were impacted during the second quarter of fiscal 2014 by the failure of an engine during an evaluation test in support of the Antares booster engine program. This action resulted in a decrease of $10.8 million of sales during the second quarter of fiscal 2014 and a decrease of $11.8 million for the first half of fiscal 2014 as compared to the same periods last year. Eight more engine deliveries are required to complete the current contract. In the tactical propulsion product area, a decrease of $11.4 million in sales during the second quarter of fiscal 2014 and a decrease in sales of $18.5 million for the first half of fiscal 2014 as compared to the same periods last year were recorded as development work on the T-3 IIA and IIB contracts was completed and this contract is now transitioning to the next phase. Our fiscal year ends on November 30 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday of November. As a result of the 2013 calendar, Aerojet Rocketdyne had 14 weeks of operations in the first quarter of fiscal 2013 compared to 13 weeks of operations in the first quarter of fiscal 2014. The additional week of operations in the first quarter of fiscal 2013 accounted for $27.8 million in additional net sales. A table summarizing these impacts on net sales is provided below: Three months ended May 31, Six months ended May 31, 2014 2013 2014 2013 (In millions) Net Sales Aerojet Standard Missile $ 49.7 $ 88.7 $ 90.3 $ 167.8 Atlas V 27.3 33.1 41.1 45.9 Antares (1.7 ) 9.1 5.9 17.7 T-3 IIA and IIB 0.2 11.6 3.1 21.6 All other programs 152.7 142.9 254.6 246.9 Extra week of sales in fiscal 2013 - - - 27.8 Rocketdyne 173.3 - 334.7 - $ 401.5 $ 285.4 $ 729.7 $ 527.7 The decrease in the segment margin before environmental remediation provision adjustments, retirement benefit plan expense, Rocketdyne purchase accounting adjustments, and unusual items in the second quarter of fiscal 2014 compared to the second quarter of fiscal 2013, was primarily due to (i) cost growth and an engine test anomaly on the Antares AJ-26 program which resulted in a $13.5 million, 3.4% of net sales, impact and (ii) cost growth of $5.6 million, 1.4% of net sales, on the Standard Missile program primarily associated with increased investment in the early production phase of the Standard Missile 3 Block IB contract and Standard Missile 3 Block IIA development contract as we complete qualification . 43 -------------------------------------------------------------------------------- Table of Contents The decrease in the segment margin before environmental remediation provision adjustments, retirement benefit plan expense, Rocketdyne purchase accounting adjustments, and unusual items in the first half of fiscal 2014 compared to the first half of fiscal 2013, was primarily due to (i) cost growth and an engine test anomaly on the Antares AJ-26 program which resulted in a $13.5 million, 1.9% of net sales, impact and (ii) cost growth of $10.3 million, 1.4% of net sales, on the Standard Missile program primarily associated with increased investment in the early production phase of the Standard Missile 3 Block IB contract and Standard Missile 3 Block IIA development contract as we complete qualification. A summary of our backlog is as follows: May 31, November 30, 2014 2013 (In billions) Funded backlog $ 2.0 $ 1.7 Unfunded backlog 1.1 0.8 Total contract backlog $ 3.1 $ 2.5 The increase in backlog from November 30, 2013 is primarily due to receipt of large multi-year awards on the Atlas V and Terminal High Altitude Area Defense programs, increasing our confidence in the strength of future sales. Total backlog includes both funded backlog (unfilled orders for which funding is authorized, appropriated and contractually obligated by the customer) and unfunded backlog (firm orders for which funding has not been appropriated). Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. Backlog is subject to funding delays or program restructurings/cancellations which are beyond our control. Appropriations bills for both DoD and NASA have become increasingly difficult for Congress to pass by the start of the GFY resulting in funding delays to many of our customers and, in turn, delays in contract awards received by us. This generally leads to delays in the number of new and follow-on awards in the first half of the fiscal year and an increase during the second half, which result in varying levels of uncertainty in the timing of contract awards received and sales generated by Aerojet Rocketdyne. Real Estate Segment Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 Change* 2014 2013 Change* (In millions) Net sales $ 1.6 $ 1.2 $ 0.4 $ 3.1 $ 2.6 $ 0.5 Segment performance 0.9 1.0 (0.1 ) 1.8 2.0 (0.2 ) * Primary reason for change. Net sales and segment performance consist primarily of rental property operations, and were essentially unchanged for the periods presented. The City of Folsom gave final approval to a Development Agreement ("DA") for our Hillsborough at Easton Project which vests the approved entitlements and grants development rights for 30 years. The DA is a formal contract between the landowner and the City and vests the rights, development specifications, zoning, and other granted entitlements for the approved development plan and protects against potentially undesirable, unilateral changes by the City within the 30-year period while also delineating other details including development impact fees, bond districts and development financing mechanisms over the life of the agreement. With the completion of this important DA for the Hillsborough at Easton Project, a total of three projects within the Easton Master Plan areas are now entitled with completed long-term DAs. They include Easton Place, Glenborough at Easton and Hillsborough at Easton. Because the terms of the DA are integral to the execution of development work, potential buyers/developers now have improved profit visibility and decreased financial risk for subsequent development of the affected property. Use of Non-GAAP Financial Measures In addition to segment performance (discussed above), we provide the Non-GAAP financial measure of our operational performance called Adjusted EBITDAP. We use this metric to further our understanding of the historical and prospective consolidated core operating performance of our segments, net of expenses resulting from our corporate activities in the ordinary, on-going and customary course of our operations. Further, we believe that to effectively compare the core operating performance metric from period to period on a historical and prospective basis, the metric should exclude items relating to retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the 44 -------------------------------------------------------------------------------- Table of Contents ordinary, on-going and customary course of our operations. Accordingly, we define Adjusted EBITDAP as GAAP loss from continuing operations before income taxes adjusted by interest expense, interest income, depreciation and amortization, retirement benefit expense, and unusual items which we do not believe are reflective of such ordinary, on-going and customary course activities. Adjusted EBITDAP does not represent, and should not be considered an alternative to, net loss, as determined in accordance with GAAP. Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 2014 2013 (In millions, except percentage amounts) Loss from continuing operations before income taxes $ (49.6 ) $ (9.6 ) $ (49.7 ) $ (18.8 ) Interest expense 12.6 12.6 25.0 23.8 Interest income - (0.1 ) - (0.2 ) Depreciation and amortization 15.4 5.3 30.2 11.4 Retirement benefit expense 8.9 16.1 17.8 32.0 Unusual items 46.2 6.3 51.1 12.2 Adjusted EBITDAP $ 33.5 $ 30.6 $ 74.4 $ 60.4 Adjusted EBITDAP as a percentage of net sales 8.3 % 10.7 % 10.2 % 11.4 % In addition to segment performance and Adjusted EBITDAP, we provide the Non-GAAP financial measures of free cash flow and net debt. We use these financial measures, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that these financial measures are useful because it presents our business using the same tools that management uses to gauge progress in achieving our goals. Three months ended Six months ended May 31, May 31, May 31, May 31, 2014 2013 2014 2013 (In millions)Cash provided by (used in) operating activities $ 3.0 $ 12.0 $ (22.3 ) $ 18.9 Capital expenditures (9.2 ) (12.6 ) (18.5 ) (21.7 ) Free cash flow(1) $ (6.2 ) $ (0.6 ) $ (40.8 ) $ (2.8 ) (1) Free Cash Flow, a Non-GAAP financial measure, is defined as cash flow from operating activities less capital expenditures. Free Cash Flow excludes any mandatory debt service requirements and other non-discretionary expenditures. Free Cash Flow should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to cash flows from operations presented in accordance with GAAP. The Company believes Free Cash Flow is useful as it provides supplemental information to assist investors in viewing the business using the same tools that management uses to gauge progress in achieving the Company's goals. May 31, May 31, 2014 2013 (In millions) Debt principal $ 783.0 $ 707.4 Cash and cash equivalents (120.7 ) (134.6 ) Restricted cash - (470.0 ) Net debt $ 662.3 $ 102.8 Because our method for calculating the Non-GAAP measures may differ from other companies' methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures. Other Information Recently Adopted Accounting Pronouncement In July 2013, the Financial Accounting Standards Board ("FASB") issued an amendment to the accounting guidance related to the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carryforward exists. The guidance requires an unrecognized tax benefit to be presented as a decrease in a deferred tax asset where a net operating loss, a similar tax loss, or a tax credit carryforward exists and certain criteria are met. We adopted this guidance beginning in the first quarter of fiscal 2014. As the accounting standard only impacted presentation, the new standard did not have an impact on our financial position, results of operations, or cash flows. 45-------------------------------------------------------------------------------- Table of Contents Recently Issued Accounting Pronouncement In April 2014, the FASB issued authoritative guidance which specifies that only disposals, such as a disposal of a major line of business, representing a strategic shift in operations should be presented as discontinued operations. In addition, the new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. This guidance is effective for us prospectively in the first quarter of fiscal 2016. An entity should not apply the amendments in this new guidance to a component of an entity that is classified as held for sale before the effective date even if the component of an entity is disposed of after the effective date. As the accounting standard will only impact presentation, the new standard will not have an impact on our financial position, results of operations, or cash flows. In May 2014, the FASB amended the existing accounting standards for revenue recognition. The amendments are based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. We are required to adopt the amendments in the first quarter of fiscal 2018. Early adoption is not permitted. The amendments may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of initial application. We are currently evaluating the impact of these amendments and the transition alternatives on our consolidated financial statements. Critical Accounting Policies and Estimates Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America that offer acceptable alternative methods for accounting for certain items affecting our financial results, such as determining inventory cost, deferring certain costs, depreciating long-lived assets, recognizing pension benefits, and recognizing revenues. The preparation of financial statements requires the use of estimates, assumptions, judgments, and interpretations that can affect the reported amounts of assets, liabilities, revenues, and expenses, the disclosure of contingent assets and liabilities and other supplemental disclosures. The development of accounting estimates is the responsibility of our management. Management discusses those areas that require significant judgment with the audit committee of our board of directors. The audit committee has reviewed all financial disclosures in our filings with the SEC. Although we believe the positions we have taken with regard to uncertainties are reasonable, others might reach different conclusions and our positions can change over time as more information becomes available. If an accounting estimate changes, its effects are accounted for prospectively and, if significant, disclosed in the Notes to Unaudited Condensed Consolidated Financial Statements. The areas that are most affected by our accounting policies and estimates are revenue recognition for long-term contracts, other contract considerations, goodwill, retirement benefit plans, litigation reserves, environmental remediation costs and recoveries, and income taxes. Except for income taxes, which are not allocated to our operating segments, these areas affect the financial results of our business segments. 46-------------------------------------------------------------------------------- Table of Contents In our Aerospace and Defense segment, recognition of profit on long-term contracts requires the use of assumptions and estimates related to the contract value or total contract revenue, the total cost at completion and the measurement of progress towards completion. Due to the nature of the programs, developing the estimated total cost at completion requires the use of significant judgment. Estimates are continually evaluated as work progresses and are revised as necessary. Factors that must be considered in estimating the work to be completed include labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements and inflationary trends, schedule and performance delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. We review contract performance and cost estimates for some contracts at least monthly and for others at least quarterly and more frequently when circumstances significantly change. When a change in estimate is determined to have an impact on contract profit, we will record a positive or negative adjustment to the statement of operations. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact from changes in estimates and assumptions on the statement of operations on contracts, representing 89% of our net sales over the first half of fiscal 2014 and 2013, accounted for under the percentage-of-completion method of accounting: Three months ended May 31, Six months ended May 31, 2014 2013 2014 2013 (In millions, except per share amounts) (Unfavorable) favorable effect of the changes in contract estimates on loss from continuing operations before income taxes $ (5.2 ) $ 3.2 $ (2.9 ) $ 9.4 (Unfavorable) favorable effect of the changes in contract estimates on net loss (3.1 ) 1.3 (1.6 ) 4.9 (Unfavorable) favorable effect of the changes in contract estimates on basic and diluted loss per share (0.05 ) 0.02 (0.03 ) 0.08 A detailed description of our significant accounting policies can be found in our most recent Annual Report on Form 10-K for the fiscal year ended November 30, 2013. Arrangements with Off-Balance Sheet Risk As of May 31, 2014, arrangements with off-balance sheet risk consisted of: • $58.1 million in outstanding commercial letters of credit expiring through January 2015, the majority of which may be renewed, primarily to collateralize obligations for environmental remediation and insurance coverage. • $43.7 million in outstanding surety bonds to primarily satisfy indemnification obligations for environmental remediation coverage. • Up to $120.0 million aggregate in guarantees by GenCorp of Aerojet Rocketdyne's obligations to U.S. government agencies for environmental remediation activities. • $55.0 million related to the pending future acquisition of UTC's 50% ownership interest of RD Amross. • Guarantees, jointly and severally, by our material domestic subsidiaries of their obligations under our Senior Credit Facility and 7 1/8% Notes. In addition to the items discussed above, we have and will from time to time enter into certain types of contracts that require us to indemnify parties against potential third-party and other claims. These contracts primarily relate to: (i) divestiture agreements, under which we may provide customary indemnification to purchasers of our businesses or assets including, for example, claims arising from the operation of the businesses prior to disposition, liability to investigate and remediate environmental contamination existing prior to disposition; (ii) certain real estate leases, under which we may be required to indemnify property owners for claims arising from the use of the applicable premises; and (iii) certain agreements with officers and directors, under which we may be required to indemnify such persons for liabilities arising out of their relationship with us. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Additionally, we issue purchase orders and make other commitments to suppliers for equipment, materials, and supplies in the normal course of business. These purchase commitments are generally for volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers and would be subject to reimbursement if contract is terminated. We provide product warranties in conjunction with certain product sales. The majority of our warranties are one-year standard warranties for parts, workmanship, and compliance with specifications. On occasion, we have made commitments beyond the standard warranty obligation. While we have contracts with warranty provisions, there is not a history of any significant warranty claims experience. A reserve for warranty exposure is made on a product by product basis when it is both estimable and probable. These costs are included in the program's estimate at completion and are expensed in accordance with our revenue recognition methodology. 47-------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Net Cash (Used in) Provided by Operating, Investing, and Financing Activities The change in cash and cash equivalents was as follows: Six months ended May 31, May 31, 2014 2013 (In millions) Net Cash (Used in) Provided by Operating Activities $ (22.3 ) $ 18.9 Net Cash Used in Investing Activities (18.5 ) (492.2 ) Net Cash (Used in) Provided by Financing Activities (36.1 ) 445.8 Net Decrease in Cash and Cash Equivalents $ (76.9 ) $ (27.5 ) Net Cash (Used in) Provided by Operating Activities The $22.3 million of cash used by operating activities in the first half of fiscal 2014 was primarily the result of cash used to fund working capital (defined as accounts receivables, inventories, accounts payable, contract advances, and other current assets and liabilities) including our real estate activities. The cash used in operating activities in fiscal 2014 compared to the first half of fiscal 2013 was impacted by the following: (i) cash expenditures to fund contract losses on the Antares and Standard Missile programs; (ii) increased overhead expenditures including the $13.7 million related to future recoverable restructuring costs and $4.8 million related to the cost reduction plan for ongoing business volume in fiscal 2014; and (iii) delays in the rate negotiations and approvals with the U.S. government for certain billing matters. The $18.9 million of cash provided by operating activities in the first half of fiscal 2013 was primarily the result of loss from continuing operations before income taxes adjusted for non-cash adjustments which generated $33.5 million, including expenses of $11.8 million related to the acquisition of the Rocketdyne Business. This amount was partially offset by cash used to fund working capital of $6.2 million. The funding of working capital is due to the following (i) an increase in accounts receivables due to timing of sales during the quarter and (ii) an increase in inventories due to growth in capitalized overhead and the timing of deliveries under the Atlas V program. These factors were partially offset by (i) an increase in accounts payable related to the increase in cost-reimbursable contract sales and timing of payments and (ii) an increase in other current liabilities primarily related to the timing of payments. Net Cash Used In Investing Activities During the first half of fiscal 2014 and 2013, we had capital expenditures of $18.5 million and $21.7 million, respectively. As of May 31, 2013, we designated $470.0 million as restricted cash related to the cash collateralization of the 7 1/8% Notes issued in January 2013 and related interest costs. See Note 7 of the Notes to Unaudited Condensed Consolidated Financial Statements for additional information. Net Cash (Used in) Provided by Financing Activities During the first half of fiscal 2014, we repurchased 3.5 million of our common shares at a cost of $64.5 million. We also issued $179.0 million of debt and had $145.8 million in debt cash payments (see below). In addition, we incurred $4.1 million of debt issuance costs. During the first half of fiscal 2013, we issued $460.0 million of debt and had $1.3 million in debt repayments. In addition, we incurred $13.1 million of debt issuance costs. Debt Activity and Covenants Our debt activity during the first half of fiscal 2014 was as follows: November 30, Cash Non-cash May 31, 2013 Additions Payments Activity 2014 (In millions) Term loan $ 45.0 $ 100.0 $ (45.0 ) $ - $ 100.0 7 1/8% Notes 460.0 - - - 460.0 4 1/16% Debentures 193.2 - (100.8 ) 50.6 143.0 2 1/4% Convertible Subordinated Debentures 0.2 - - - 0.2 Delayed draw term loan - 79.0 - - 79.0 Other debt 0.8 - - - 0.8 Total Debt and Borrowing Activity $ 699.2 $ 179.0 $ (145.8 ) $ 50.6 $ 783.0 48 -------------------------------------------------------------------------------- Table of Contents We are subject to certain limitations including the ability to incur additional debt, make certain investments and acquisitions, and make certain restricted payments, including stock repurchases and dividends. The Senior Credit Facility includes events of default usual and customary for facilities of this nature, the occurrence of which could lead to an acceleration of our obligations thereunder. Additionally, the Senior Credit Facility includes certain financial covenants, including that we maintain (i) a maximum total leverage ratio, calculated net of cash up to a maximum of $150.0 million, of 4.50 to 1.00 through fiscal periods ending November 30, 2015, 4.25 to 1.00 through fiscal periods ending November 30, 2017, and 4.00 to 1.00 thereafter; and (ii) a minimum interest coverage ratio of 2.40 to 1.00. Actual Ratios as of Financial Covenant May 31, 2014 Required Ratios Interest coverage ratio, as defined under the Senior Credit Facility 3.67 to 1.00 Not less than: 2.4 to 1.00 Leverage ratio, as defined under the Senior Credit Facility 3.85 to 1.00 Not greater than: 4.50 to 1.00 We were in compliance with our financial and non-financial covenants as of May 31, 2014. Outlook Short-term liquidity requirements consist primarily of recurring operating expenses, including but not limited to costs related to our capital and environmental expenditures, integration costs of the Rocketdyne Business, debt service requirements, and retirement benefit plans. We believe that our existing cash and cash equivalents and existing credit facilities will provide sufficient funds to meet our operating plan for the next twelve months. The operating plan for this period provides for full operation of our businesses, and interest and principal payments on our debt. As of May 31, 2014, we had $162.9 million of available borrowings under our Senior Credit Facility and Subordinated Credit Facility. Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of May 31, 2014. Our failure to comply with these covenants could result in an event of default that, if not cured or waived, could result in the acceleration of the Senior Credit Facility, the Subordinated Credit Facility, the 7 1/8% Notes, and the 4 1/16% Debentures. In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility, and in certain cases, would cause cross defaults on the 7 1/8% Notes and 4 1/16% Debentures. We may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. As disclosed in Note 9 of the Notes to Unaudited Condensed Consolidated Financial Statements, we have a $55.0 million commitment associated with the pending future acquisition of UTC's 50% ownership interest of RD Amross. As disclosed in Notes 8(a) and 8(b) of the Notes to Unaudited Condensed Consolidated Financial Statements, we have exposure for certain legal and environmental matters. We believe that it is currently not possible to estimate the impact, if any, that the ultimate resolution of certain of these matters will have on our financial position, results of operations, or cash flows. Major factors that could adversely impact our forecasted operating cash and our financial condition are described in the section "Risk Factors" in Item 1A of our Annual Report to the SEC on Form 10-K for the fiscal year ended November 30, 2013. In addition, our liquidity and financial condition will continue to be affected by changes in prevailing interest rates on the portion of debt that bears interest at variable interest rates. Forward-Looking Statements Certain information contained in this report should be considered "forward-looking statements" as defined by Section 21E of the Private Securities Litigation Reform Act of 1995. All statements in this report other than historical information may be deemed forward-looking statements. These statements present (without limitation) the expectations, beliefs, plans and objectives of management and future financial performance and assumptions underlying, or judgments concerning, the matters discussed in the statements. The words "believe," "estimate," "anticipate," "project" and "expect," and similar expressions, are intended to identify forward-looking statements. Forward-looking statements involve certain risks, estimates, assumptions and uncertainties, including with respect to future sales and activity levels, cash flows, contract performance, the outcome of litigation and contingencies, environmental remediation and anticipated costs of capital. A variety of factors could cause actual results or outcomes to differ materially from those expected and expressed in our forward-looking statements. Important risk factors that could cause actual results or outcomes to differ from those expressed in the forward-looking statements are described in the section "Risk Factors" in Item 1A of our Annual Report to the SEC on Form 10-K for the fiscal year ended November 30, 2013 include the following: • future reductions or changes in U.S. government spending; • cancellation or material modification of one or more significant contracts; • negative audit of the Company's business by the U.S. government; 49 -------------------------------------------------------------------------------- Table of Contents • the integration difficulties or inability to integrate the Rocketdyne Business into the Company's existing operations successfully or to realize the anticipated benefits of the acquisition; • ability to manage effectively the Company's expanded operations following the acquisition of the Rocketdyne Business; • the increase in the Company's leverage and debt service obligations as a result of the acquisition of the Rocketdyne Business and the Company's recent capital transactions; • the Rocketdyne Business's international sales are subject to applicable laws relating to export controls, the violation of which could adversely affect its operations; • the acquisition of RD Amross is subject to a number of conditions which could delay or materially adversely affect the timing of its completion, or prevent it from occurring; • cost overruns on the Company's contracts that require the Company to absorb excess costs; • failure of the Company's subcontractors or suppliers to perform their contractual obligations; • failure to secure contracts; • failure to comply with regulations applicable to contracts with the U.S. government; • failure to comply with applicable laws, including laws relating to export controls and anti-corruption or bribery laws; • costs and time commitment related to potential acquisition activities; • the Company's inability to adapt to rapid technological changes; • failure of the Company's information technology infrastructure; • failure to effectively integrate the Rocketdyne Business into the Company's ERP system; • product failures, schedule delays or other problems with existing or new products and systems; • the release, or explosion, or unplanned ignition of dangerous materials used in the Company's businesses; • loss of key qualified suppliers of technologies, components, and materials; • the funded status of the Company's defined benefit pension plan and the Company's obligation to make cash contributions in excess of the amount that the Company can recover in its current period overhead rates; • effects of changes in discount rates, actual returns on plan assets, and government regulations of defined benefit pension plans; • the possibility that environmental and other government regulations that impact the Company become more stringent or subject the Company to material liability in excess of its established reserves; • environmental claims related to the Company's current and former businesses and operations including the inability to protect or enforce previously executed environmental agreements; • reductions in the amount recoverable from environmental claims; • the results of significant litigation; • occurrence of liabilities that are inadequately covered by indemnity or insurance; • inability to protect the Company's patents and proprietary rights; • business disruptions; • the earnings and cash flow of the Company's subsidiaries and the distribution of those earnings to the Company; • the substantial amount of debt which places significant demands on the Company's cash resources and could limit the Company's ability to borrow additional funds or expand its operations; • the Company's ability to comply with the financial and other covenants contained in the Company's debt agreements; • risks inherent to the real estate market; • changes in economic and other conditions in the Sacramento, California metropolitan area real estate market or changes in interest rates affecting real estate values in that market; • additional costs related to the Company's discontinued operations; • the loss of key employees and shortage of available skilled employees to achieve anticipated growth; • a strike or other work stoppage or the Company's inability to renew collective bargaining agreements on favorable terms; • fluctuations in sales levels causing the Company's quarterly operating results and cash flows to fluctuate; • failure to maintain effective internal controls in accordance with the Sarbanes-Oxley Act; and • those risks detailed in the Company's reports filed with the SEC. Additional risk factors may be described from time to time in our future filings with the SEC. Accordingly, all forward-looking statements should be evaluated with the understanding of their inherent uncertainty. All such risk factors are difficult to predict, contain material uncertainties that may affect actual results and may be beyond our control. |