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LEIDOS HOLDINGS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) The following combined discussion and analysis of Leidos Holdings, Inc.'s ("Leidos'") and Leidos, Inc.'s financial condition and results of operations and quantitative and qualitative disclosures about market risk should be read in conjunction with our condensed consolidated financial statements and related combined notes. As Leidos is a holding company and consolidates Leidos, Inc. for financial statement purposes, disclosures that relate to activities of Leidos, Inc. also apply to Leidos, unless otherwise noted. Leidos, Inc.'s revenues and operating expenses comprise 100% of Leidos' revenues and operating expenses. In addition, Leidos, Inc. comprises approximately the entire balance of Leidos' assets, liabilities and operating cash flows. Therefore, the following discussion is applicable to both Leidos and Leidos, Inc., unless otherwise noted. The following discussion contains forward-looking statements, 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, the impact of competition, and the performance and carrying values of our assets, including Plainfield. 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. Some of these factors include, but are not limited to, the risk factors set forth in our Annual Report on Form 10-K for the fiscal year ended January 31, 2014, as updated periodically through our subsequent quarterly reports on Form 10-Q. 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 events or developments. All amounts in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" are presented for our continuing operations. We use the terms "Company," "we," "us," and "our" to refer to Leidos, Leidos, Inc., and its consolidated subsidiaries. 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 fiscal quarters typically consisting of 13 weeks. For example, we refer to the fiscal year ending January 30, 2015 as "fiscal 2015." Unless otherwise noted, references to fiscal years are to fiscal years ended the Friday closest to January 31. Overview We are an applied technology company delivering solutions and services that leverage the power of data analytics, systems integration, and cyber security across our three markets of national security, health, and engineering to agencies of the U.S. Department of Defense ("DoD"), the intelligence community, the U.S. Department of Homeland Security, and other U.S. Government civil agencies, state and local government agencies, foreign governments, and customers across a variety of commercial markets. We operate in the following segments: National Security Solutions, Health and Engineering, and Corporate and Other. Our National Security Solutions segment provides solutions and systems for air, land, sea, space, and cyberspace for the U.S. intelligence community, the DoD, the military services, and the U.S. Department of Homeland Security. Our solutions deliver technology, large-scale intelligence systems, data analytics, cyber solutions, logistics and intelligence analysis, and operations support to critical missions around the world. Our Health and Engineering segment provides health systems integration services to implement and optimize the use of electronic health records, apply data analytics, and conduct behavioral health research to help enable customers to improve healthcare quality and patient outcomes, detect and prevent diseases, enhance scientific discovery, and reduce costs to the healthcare system. We also provide engineering services and solutions focused on solving energy, environmental, and infrastructure challenges. These include products and solutions in energy generation, efficiency and management, environmental services, securing critical infrastructure, and designing and building construction projects. 39 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. Our significant management initiatives include the following: • Achieving internal, or non-acquisition related, revenue growth through internal collaboration and better leveraging of key differentiators across our company and the deployment of resources and investments into higher growth markets; • Increasing the growth of our operating profits through improving the quality of our revenues and contract profitability, continued improvement in our information technology (IT) systems infrastructure, and related business processes for greater effectiveness and efficiency across all business functions; and • Disciplined deployment of our cash resources and use of our capital structure to enhance shareholder value while retaining an appropriate amount of financial leverage, through internal growth initiatives, stock repurchases, dividends, strategic acquisitions, debt level management, and other uses to achieve our goals. Key financial results during the three months ended August 1, 2014 include: • Revenues for the three months ended August 1, 2014 decreased 10% from the corresponding period in the prior year. The revenue contraction for the quarter was due to a decrease in National Security Solutions segment revenues of 9% and a decrease in Health and Engineering segment revenues of 14%. • Operating loss from continuing operations was $410 million for the three months ended August 1, 2014 as compared to operating income from continuing operations of $10 million for the corresponding period in the prior year. Operating loss from continuing operations for the three months ended August 1, 2014 includes $486 million of goodwill impairment charges and a $24 million intangible asset impairment charge in our Health and Engineering segment. The prior year's operating income from continuing operations includes a $30 million intangible asset impairment charge, $27 million for unfavorable changes in contract estimates, $19 million in separation and restructuring expenses associated with the spin-off which was completed in fiscal 2014, and $14 million of costs to establish infrastructures for two separate companies. • Diluted loss per share from continuing operations for the three months ended August 1, 2014 was $(5.93) as compared to diluted earnings per share from continuing operations of $0.05 in the corresponding period in the prior year, primarily due to the aforementioned operating loss from continuing operations increase of $420 million and a decrease in the diluted weighted average number of shares outstanding of 10 million shares, or 12%, primarily due to shares repurchased under our accelerated stock repurchase programs. • Cash and cash equivalents increased $175 million during the three months ended August 1, 2014 primarily due to cash provided by operations of $124 million and $80 million of proceeds from the U.S. Treasury cash grant, partially offset by dividend payments of $24 million. • Net bookings (as defined in "Key Performance Measures-Bookings and Backlog") were approximately $889 million for the three months ended August 1, 2014. Total backlog was $8.4 billion at August 1, 2014 as compared to $8.8 billion at May 2, 2014. Spin-off Transaction In accordance with a distribution agreement, on September 27, 2013 (the "Distribution Date"), Leidos completed a spin-off of its technical services and enterprise information technology services business into an independent, publicly traded company named Science Application International Corporation ("New SAIC"). The spin-off was effected through a tax-free distribution to Leidos' stockholders of 100% of the shares of New SAIC's common stock. On the Distribution Date, New SAIC's common stock was distributed, on a pro rata basis, to Leidos' stockholders of record as of the close of business on September 19, 2013, the record date. Each holder of Leidos common stock received one share of New SAIC common stock for every seven shares of Leidos common stock held on the record 40 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. date. As a result of the spin-off, the assets, liabilities, results of operations, and cash flows of New SAIC have been classified as discontinued operations for all periods presented. References to financial information are to our continuing operations, unless otherwise noted. In fiscal 2014, in connection with the spin-off transaction and in order to align our cost structure for post-separation, we incurred approximately $46 million in expenses related to lease termination costs, facility consolidation costs and other costs in connection with vacating facilities that were not necessary for our future requirements as well as $10 million of severance costs and $9 million of other separation transaction and restructuring expenses. For the three and six months ended August 2, 2013, we incurred approximately $14 million and $23 million of lease termination and facility consolidation expenses, respectively, and $5 million and $8 million of severance costs, respectively. For the six months ended August 2, 2013, we incurred $2 million of other separation transaction and restructuring expenses. There were no separation transaction and restructuring expenses for the three months ended August 1, 2014. For the six months ended August 1, 2014, we incurred approximately $1 million of lease termination and facility consolidation expenses related to an adjustment to the prior year reserve established for loss on leases in connection with revised sublease income assumptions. We do not expect to incur significant additional separation transaction and restructuring expenses in fiscal 2015 related to the spin-off transaction. Dispositions Fiscal 2015 Discontinued Operations In July 2014, we committed to plans to dispose of a business primarily focused on full service emergency management consulting for disaster preparedness, response, recovery, and mitigation historically included in our Health and Engineering segment. The sale transaction was completed on August 22, 2014 with cash proceeds received of $19 million. Fiscal 2014 Discontinued Operations In addition to the spin-off of New SAIC discussed above, in order to better align our business portfolio with our strategy, we sold or committed to plans to dispose of certain other components of our business that were historically included in our National Security Solutions segment. In August 2013, we committed to plans to dispose of a business primarily focused on technology used to detect if an individual is concealing explosive devices or other hidden weapons. In the first quarter of fiscal 2015, we adjusted the carrying values of the business's assets to their fair value based on the estimated selling price of the business (Level 1 fair value measurement). The carrying value exceeded the fair value which resulted in approximately $12 million of impairment charges recorded in discontinued operations. The sale transaction was completed in the second quarter of fiscal 2015 with insignificant cash proceeds received, resulting in an immaterial loss on sale. In November 2013, we sold a certain component of our business focused on machine language translation with insignificant cash proceeds received, resulting in an immaterial gain on sale. In January 2014, we committed to plans to dispose of Cloudshield Technologies, Inc., previously acquired in fiscal 2011, which is focused on producing a suite of cybersecurity hardware and associated software and services. 41 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. The operating results of our discontinued operations discussed above for the periods presented were as follows: Three Months Ended Six Months Ended August 2, August 1, August 2, August 1, 2014 2013 2014 2013 (in millions) Revenues $ 20 $ 1,018 $ 46 $ 2,132 Costs and expenses: Cost of revenues 21 927 43 1,932 Selling, general and administrative expenses (including impairment charges of $9 million for the six months months ended August 1, 2014) 5 15 19 38 Intangible asset impairment charges - - 3 2 Separation transaction and restructuring expenses - 15 - 34 Operating (loss) income $ (6 ) $ 61 $ (19 ) $ 126 Non-operating income (expense) $ 8 $ (1 ) $ 8 $ (1 ) Total income (loss) from discontinued operations before income taxes $ 2 $ 60 $ (11 ) $ 125 Business Environment and Trends U.S. Government Markets In fiscal 2014, we generated approximately 78% of our total revenues from contracts with the U.S. Government, either as a prime contractor or a subcontractor to other contractors engaged in work for the U.S. Government. Revenues under contracts with the DoD, including subcontracts under which the DoD is the ultimate purchaser, represented approximately 68% of our total revenues in fiscal 2014. Accordingly, our business performance is affected by the overall level of U.S. Government spending, especially national security, homeland security, and intelligence spending, and the alignment of our service and product offerings and capabilities with current and future budget priorities of the U.S. Government. Contributing to long term fiscal uncertainty is the continuing uncertainty over the debt ceiling extension, which will expire in March 2015. We believe that U.S. Government budget deficits and the national debt have created increasing pressure to examine and reduce spending across all federal agencies. The Budget Control Act of 2011 raised the U.S. Government's debt ceiling and imposed 10-year discretionary spending sequestration caps expected to generate over $1 trillion in savings for the U.S. Government. According to the Office of Management and Budget, these savings include nearly $500 billion in DoD baseline spending reductions over 10 years, which began to be implemented in the U.S. Government fiscal year ended September 30, 2013. In December 2013, the President signed into law the Bipartisan Budget Act of 2013, which reduced the effects of sequestration in FY 2014 and FY 2015 for national security, but did not make the same concessions for the cuts in medical reimbursements. Roughly 60% of all healthcare in the United States is reimbursed by a government program. These reimbursements are tied to the government spending level and were significantly reduced as part of the Budget Control Act. We believe this has had a direct effect in the amount of available discretionary spending on IT modernization in U.S. hospitals and has therefore slowed the growth we had previously experienced in our commercial health IT practice. 42 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. The implementation of sequestration spending cuts and associated government guidance and planning activities has impacted existing contracts, caused program delays and cancellations and caused delays in other government contracting actions. In addition, future implementation of spending cuts as we return to Sequestration in Government FY 2016 could cause further delays in contract awards and continued uncertainty. We continue to evaluate the impact of spending reductions on our businesses. The amount and nature of these federal budget spending reductions could adversely impact our operations, future revenues, and growth prospects. Trends in the U.S. Government contracting process, including a shift towards multiple-awards contracts (in which certain contractors are preapproved using indefinite-delivery/indefinite-quantity ("IDIQ") and U.S. General Services Administration ("GSA") contract vehicles) and awarding contracts on a low price, technically acceptable basis, have increased competition for U.S. Government contracts, reduced backlogs by shortening periods of performance on contracts, 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 more information on these risks and uncertainties, see "Risk Factors" in Part I of our Annual Report on Form 10-K for the fiscal year ended January 31, 2014. Commercial and International Markets Sales to customers in commercial and international markets serve to diversify us from reliance upon U.S. Government business. In addition, the timing of sales to customers in our commercial health business is partially dependent upon legislation which impacts implementation time lines for Meaningful Use of certified electronic health record ("EHR") technology and International Statistical Classification of Diseases and Related Health Problems ("ICD-10"). Implementation requirements for both of these catalysts have been delayed, which we believe has adverse impacts to the near-term performance of our commercial health business. Key Performance Measures The primary financial performance measures we use to manage our business and monitor results of operations are revenue, operating income, cash flows from operations, and diluted EPS. 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 measures to management and investors evaluating our operating income and margin performance. We previously reported in our fiscal 2014 Quarterly Reports on Form 10-Q internal revenue growth (contraction), which is a non-GAAP financial measure due to acquisitions occurring in prior periods. In this quarterly report, there were no acquisitions for the current and comparable periods presented, therefore we are not presenting this non-GAAP measure in this quarterly report. Bookings and Backlog. We received net bookings worth an estimated $889 million and $1,736 million during the three and six months ended August 1, 2014, respectively. Net bookings represent the estimated amount of revenues to be earned in the future from funded and unfunded contract awards that were received during the period, net of any adjustments to previously awarded backlog amounts. We calculate net bookings as the period's ending backlog plus the period's revenues less the prior period's ending backlog and less the backlog obtained in acquisitions during the period. Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts as work is performed. We segregate our backlog into two categories as follows: 43-------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. • Funded Backlog. Funded backlog for contracts with government agencies primarily represents contracts for which funding is appropriated less revenues previously recognized 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 and commercial customers 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 revenues 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 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, with the prior period recast for consistency with the current period's presentation, was as follows: August 1, May 2, January 31, 2014 2014 2014 (in millions) National Security Solutions: Funded backlog $ 1,837 $ 1,986 $ 1,854 Negotiated unfunded backlog 4,778 5,005 5,604 Total National Security Solutions backlog $ 6,615 $ 6,991 $ 7,458 Health and Engineering: Funded backlog $ 1,048 $ 1,112 $ 1,144 Negotiated unfunded backlog 750 728 694 Total Health and Engineering backlog $ 1,798 $ 1,840 $ 1,838 Total: Funded backlog $ 2,885 $ 3,098 $ 2,998 Negotiated unfunded backlog 5,528 5,733 6,298 Total backlog $ 8,413 $ 8,831 $ 9,296 Bookings and backlog fluctuate from period to period depending on our success rate in winning contracts and the timing of contract awards, renewals, modifications, and cancellations. Contract awards continue to be negatively impacted by ongoing industry-wide delays in procurement decisions, and budget cuts, including sequestration, by the U.S. Government as discussed in "Business Environment and Trends" in this Quarterly Report on Form 10-Q. We expect to recognize a substantial portion of our funded backlog as revenues within the next 12 months. However, the U.S. Government may cancel any contract at any time through a termination for the convenience of the U.S. Government. In addition, certain contracts with commercial customers include provisions that allow the customer to cancel at any time. 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. 44 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. 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 additional information regarding the types of contracts under which we generate revenues, see "Business-Contract Types" in Part I of our Annual Report on Form 10-K for the fiscal year ended January 31, 2014. The following table summarizes revenues by contract type as a percentage of total revenues for the periods presented: Six Months Ended August 2, August 1, 2014 2013 Cost-reimbursement 48 % 46 % Time and materials (T&M) and fixed-price-level-of-effort (FP-LOE) 26 27 Firm-fixed price (FFP) 26 27 Total 100 % 100 % Revenue Mix. We generate revenues under our contracts from (1) the efforts of our technical staff, which we refer to as labor-related revenues, and (2) the materials provided on a contract and efforts of our subcontractors, which we refer to as M&S revenues. M&S revenues are generated primarily from large, multi-year systems integration contracts and contracts in our logistics, readiness, and sustainment business area, as well as through sales of our proprietary products, such as our border, port, and mobile security products and our checked baggage explosive detection systems. The following table presents changes in labor-related revenues and M&S revenues for the periods presented: Three Months Ended Six Months Ended August 2, August 1, August 2, August 1, 2014 Percent change 2013 2014 Percent change 2013 (dollars in millions) Labor-related revenues $ 789 (11)% $ 890 $ 1,605 (14)% $ 1,876 As a percentage of revenues 60 % 61 % 61 % 62 % M&S revenues 517 (9)% 567 1,013 (14)% 1,174 As a percentage of revenues 40 % 39 % 39 % 38 % Geographic Location. Substantially all of our revenues and tangible long-lived assets are generated by or owned by entities located in the United States. 45 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. Results of Operations The following table summarizes our results of operations for the periods presented: Three Months Ended Six Months Ended August 1, 2014 Dollar change Percent change August 2, 2013 August 1, 2014 Dollar change Percent change August 2, 2013 (dollars in millions) Revenues $1,306 $ (151 ) (10 )% $1,457 $2,618 $ (432 ) (14 )% $3,050 Cost of revenues 1,119 (174 ) (13 )% 1,293 2,260 (406 ) (15 )% 2,666 Selling, general and administrative expenses: General and administrative 57 (16 ) (22 )% 73 112 (58 ) (34 )% 170 Bid and proposal 19 (2 ) (10 )% 21 38 (3 ) (7 )% 41 Internal research and development 11 - - % 11 20 (1 ) (5 )% 21 Goodwill impairment charges 486 486 100 % - 486 486 100 % - Intangible asset impairment charges 24 (6 ) (20 )% 30 24 (8 ) (25 )% 32 Separation transaction and restructuring expenses - (19 ) (100 )% 19 1 (32 ) (97 )% 33 Operating (loss) income (410 ) (420 ) NM 10 (323 ) (410 ) NM 87 Operating (loss) income margin (31.4 )% 0.7 % (12.3 )% 3 % Non-operating expense, net (20 ) (8 ) (67 )% (12 ) (38 ) (11 ) (41 )% (27 ) (Loss) income from continuing operations before income taxes (430 ) (428 ) NM (2 ) (361 ) (421 ) NM 60 Income tax (expense) benefit (9 ) (15 ) NM 6 (33 ) (18 ) (120 )% (15 ) (Loss) income from continuing operations (439 ) (443 ) NM 4 (394 ) (439 ) NM 45 Income (loss) from discontinued operations, net of tax 1 (37 ) (97 )% 38 (7 ) (85 ) (109 )% 78 Net (loss) income $ (438 ) (480 ) NM $ 42 $ (401 ) (524 ) NM $ 123 NM - Not meaningful We classify indirect costs incurred within or allocated to our government customers as overhead (included in cost of revenues) and general and administrative expenses in the same manner as such costs are defined in our disclosure statements under U.S. Government Cost Accounting Standards. General and administrative expenses decreased in fiscal 2015 as compared to fiscal 2014 in part due to the aforementioned restructuring plan in fiscal 2014 to align our cost structure for post-separation. 46 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. Changes in Estimates on Contracts. Changes in estimates related to certain types of contracts accounted for using the 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 resulted in an increase to operating income of $6 million and an increase of $0.06 per diluted share for the three months ended August 1, 2014, and an increase to operating income of $18 million and an increase of $0.15 per diluted share for the six months ended August 1, 2014. Aggregate changes in contract estimates resulted in a decrease to operating income of $27 million and a decrease of $0.19 per diluted share for the three months ended August 2, 2013, and a decrease to operating income of $28 million and a decrease of $0.21 per diluted share for the six months ended August 2, 2013. Long-Lived Asset Impairment Evaluations Goodwill Interim Impairment Evaluation. In the second quarter of fiscal 2015, our Health Solutions and Engineering reporting units within the Health and Engineering reportable segment were adversely impacted by certain unexpected events that caused us to reassess current year and future year performance expectations for both reporting units. Based on significant declines in revenue volumes and delayed award decisions, we conducted an interim goodwill impairment test using the two-step quantitative approach. Based on the first step of the two-step quantitative goodwill impairment test, we determined that the carrying value of the both the Health Solutions and Engineering reporting units were greater than the respective estimated fair values of the reporting units, and the second step of the two-step quantitative goodwill impairment test was performed in order to determine the amount of the impairment of the respective reporting units. As a result of the second step evaluation, we recorded goodwill impairment charges in the Health Solutions and Engineering reporting units of $369 million and $117 million, respectively for the three and six months ended August 1, 2014. There were no other goodwill impairment charges recorded for the remaining reporting units. See Note 4 within our combined notes to condensed consolidated financial statements for further information. Property, Plant & Equipment Evaluation. During the three months ended August 1, 2014, our 37.5 megawatt Plainfield biomass-powered generating facility ("Plainfield") experienced an over-pressurization of its combustor, resulting in damage to the combustor and adjacent equipment which accelerated and extended a planned outage to make capital improvements . During the outage we initiated a number of optimizations designed to improve fuel management, quality, and distribution to enhance the plant's availability and power generation. We expect these optimizations to be completed during the remainder of the current fiscal year, improving Plainfield's performance and remediating a number of notices of violation. To the extent that these optimizations do not yield the intended performance improvements, or are not otherwise correctable, the carrying value of Plainfield would likely be negatively impacted. For the current fiscal year, the plant has operated with 30% availability with generation during available periods averaging 28.2 megawatts of net generation. Once the plant is fully optimized, we believe the plant should operate at approximately 90% availability, resulting in 37.5 megawatts of average power generation during operation. The current carrying value of Plainfield at August 1, 2014 was $158 million. For the three month periods ended May 2, 2014 and August 1, 2014, the operating loss of the plant was $7 million and $9 million, respectively. 47 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. Reportable Segment Results. The following table summarizes changes in National Security Solutions revenues and operating income for the periods presented: Three Months Ended Six Months Ended National Security August 2, August 1, August 2, Solutions August 1, 2014 Dollar change Percent change 2013 2014 Dollar change Percent change 2013 (dollars in millions) Revenues $ 925 $ (94 ) (9 )% $ 1,019 $ 1,869 $ (227 ) (11 )% $ 2,096 Operating income 78 6 8 % 72 155 12 8 % 143 Operating income margin 8 % 7 % 8 % 7 % National Security Solutions revenues decreased $94 million, or 9% for the three months ended August 1, 2014 as compared to the corresponding period in the prior year. Revenue contraction was primarily attributable to contract activities tied to the drawdown of overseas U.S. military forces ($73 million) including the ramp down of the Joint Logistics Integration (JLI) program for tactical mine resistant ambush protected vehicles ($29 million of the $73 million). The remainder of the decline was primarily driven by overall reductions in defense and U.S. government spending resulting from sequestration and budget cuts. National Security Solutions revenues decreased $227 million, or 11% for the six months ended August 1, 2014 as compared to the corresponding period in the prior year. Revenue contraction was primarily attributable to contract activities tied to the drawdown of overseas U.S. military forces ($153 million) including the ramp down of the JLI program ($61 million of the $153 million). The remainder of the decline was primarily driven by overall reductions in defense and U.S. government spending resulting from sequestration and budget cuts. National Security Solutions operating income increased $6 million, or 8%, for the three months ended August 1, 2014 as compared to the corresponding period in the prior year. The increase in operating income margin was primarily due to net favorable changes in contract estimates for the three months ended August 1, 2014 ($4 million), as compared to net unfavorable changes in contract estimates the prior year which was negatively impacted by two international fixed price development programs ($16 million). This increase was partially offset by a decrease in revenues ($6 million) and higher indirect costs. National Security Solutions operating income increased $12 million, or 8%, for the six months ended August 1, 2014 as compared to the corresponding period in the prior year. The increase in operating income margin was primarily due to net favorable changes in contract estimates for the six months ended August 1, 2014 ($14 million), as compared to net unfavorable changes in contract estimates the prior year which was negatively impacted by two international fixed price development programs ($16 million). This increase was partially offset by a decrease in revenues ($16 million). 48-------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. The following table summarizes changes in Health and Engineering revenues and operating (loss) income for the periods presented: Three Months Ended Six Months Ended Health and August 2, August 1, August 2, Engineering August 1, 2014 Dollar change Percent change 2013 2014 Dollar change Percent change 2013 (dollars in millions) Revenues $ 381 $ (64 ) (14 )% $ 445 $ 753 $ (209 ) (22 )% $ 962 Operating (loss) income (482 ) (479 ) NM (3 ) $ (459 ) (491 ) NM $ 32 Operating (loss) income margin (127 )% (1 )% (61 )% 3 % NM - Not meaningful Health and Engineering revenues decreased $64 million, or 14%, for the three months ended August 1, 2014 as compared to the corresponding period in the prior year. The revenue contraction reflects a decline in engineering services ($38 million) primarily due to the completion of two energy design-build construction projects in the fourth quarter of fiscal 2014 ($34 million of the $38 million), lower sales in our health business ($20 million) primarily related to commercial sales, and lower sales volume in our security products business due to the timing of product shipments ($6 million). Health and Engineering revenues decreased $209 million, or 22%, for the six months ended August 1, 2014 as compared to the corresponding period of the prior year. The revenue contraction reflects a decline in engineering services ($126 million) primarily due to the completion of two energy design-build construction projects in the fourth quarter of fiscal year 2014 ($97 million of the $126 million), timing of product shipments and related maintenance of our security products business ($48 million), and lower sales in our health business ($35 million) primarily related to commercial sales. Health and Engineering operating loss was $482 million for the three months ended August 1, 2014 as compared to $3 million for the corresponding period in the prior year. Operating loss for the three months ended August 1, 2014 included non-cash impairment charges of goodwill for our health business ($369 million) and engineering business ($117 million), and non-cash impairments charges for customer related intangibles for our health business ($24 million). In addition, there was an operating loss due to production shortfalls and outages at the Plainfield biomass power plant ($9 million) and there were lower revenues, including our business areas that typically generate higher margins. Operating loss for the three months ended August 2, 2013 included an impairment charge of intangible assets acquired from the fiscal year 2011 acquisition of Reveal Imaging Technologies ($30 million) and an unfavorable change in contract estimates on the Plainfield construction project ($14 million). Health and Engineering operating loss was $459 million for the six months ended August 1, 2014 as compared to operating income of $32 million for the corresponding period in the prior year. Operating loss for the six months ended August 1, 2014 included non-cash impairment charges of goodwill for our health business ($369 million) and engineering business ($117 million), and non-cash impairment charges for customer related intangibles for our health business ($24 million). In addition, there was an operating loss due to production short falls and outages at the Plainfield biomass power plant ($16 million) and there were lower revenues, including our business areas that typically generate higher margins. Operating income for the six months ended August 2, 2013 included an impairment charge of intangible assets acquired from the fiscal year 2011 acquisition of Reveal Imaging Technologies ($30 million) and, an unfavorable change in contract estimates on the Plainfield construction project ($17 million). 49 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. The following table summarizes changes in Corporate and Other revenues and operating loss for the periods presented: Three Months Ended Six Months Ended August 2, August 1, August 2, Corporate and Other August 1, 2014 Dollar change Percent change 2013 2014 Dollar change Percent change 2013 (in millions) Operating loss $ (6 ) $ 53 90 % $ (59 ) $ (19 ) $ 69 78 % $ (88 ) Corporate and Other operating loss for the three and six months ended August 1, 2014 represents corporate costs that are unallowable under U.S. Government Cost Accounting Standards and the net effect of various items that are not directly related to the operating performance of the reportable segments. Corporate and Other operating loss for the three and six months ended August 1, 2014 was $6 million and $19 million down from $59 million and $88 million for the corresponding prior year periods, respectively. This decrease was primarily due to a decrease in separation transaction and restructuring expenses ($19 million and $32 million, respectively) associated with the spin-off which was completed in fiscal 2014 and costs to establish infrastructures for two separate companies ($14 million and $21 million, respectively). Non-Operating Expense. Non-operating expense for the three and six months ended August 1, 2014 increased $8 million and $11 million, respectively, as compared to the corresponding period of the prior year. The increase is primarily attributable to a decrease in interest income for the three and six months ended August 1, 2014 when compared to the corresponding period of the prior year due to the collection or forgiveness of deferred receivables for commercial customers related to certain construction contracts. Interest expense for Leidos, Inc. increased $2 million for the three and six months ended August 1, 2014 as compared to the corresponding period of the prior year. Interest expense on Leidos Inc.'s note with Leidos decreased $3 million and $5 million, respectively, compared to the corresponding period of the prior year. This note may fluctuate significantly from year to year based on changes in the underlying note balance and interest rates throughout the fiscal year. Provision for Income Taxes. We recorded an income tax expense of $9 million for the three months ended August 1, 2014, compared to an income tax benefit of $6 million for the corresponding period in the prior year. During the three months ended August 1, 2014, we recorded a $486 million goodwill impairment charge which was mostly not deductible for tax purposes. The increase in income tax expense was also impacted by the expiration of the federal research and development credit on December 31, 2013 and a decrease in the domestic manufacturer's deduction. In addition, the income tax benefit recorded for the three months ended August 2, 2013 included the tax benefit from the special dividend, which was declared and paid in fiscal 2014, on shares held by the Leidos Retirement Plan. We recorded an income tax expense of $33 million for the six months ended August 1, 2014, resulting in a negative effective tax rate, compared to an income tax expense of $15 million resulting in an effective tax rate of 25.0% for the corresponding period in prior year. The goodwill impairment charge had a significant impact on the effective tax rate for the six months ended August 1, 2014. The effective tax rate was also impacted by the expiration of the federal research and development credit on December 31, 2013 and a decrease in the domestic manufacturer's deduction, partially offset by the tax benefit from state income tax refunds recorded in the first quarter. The effective tax rate for the six months ended August 2, 2013 included the estimated non-deductible portion of settlements of legal and regulatory matters and the tax benefit from the special dividend, which was declared and paid in fiscal 2014, on shares held by the Leidos Retirement Plan. We file income tax returns in the United States and various state and foreign jurisdictions and have effectively settled with the IRS for all fiscal years prior to fiscal 2014, except fiscal 2010. 50 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. As of August 1, 2014, we had liabilities for uncertain tax positions of $15 million, $11 million of which were classified as other long-term liabilities in the condensed consolidated balance sheet. The resolution of certain of these tax matters could result in an $8 million reduction in our uncertain tax positions and a $4 million reduction in income tax expense from continuing operations during the second half of fiscal 2015. Liquidity and Capital Resources Overview of Liquidity We had $358 million in cash and cash equivalents at August 1, 2014, which were primarily comprised of cash held in investments in several large institutional money market funds and bank deposits. We anticipate our principal sources of liquidity for the next 12 months and beyond will be our existing cash and cash equivalents and cash flows from operations. We may also borrow under our $750 million revolving credit facility. The available borrowing capacity under the revolving credit facility decreased to approximately $450 million as of August 1, 2014, primarily due to the lower EBITDA for Leidos over the past four quarters and the reduction of EBITDA attributable to New SAIC, which was spun off in September 2013. Based on our planned performance, the borrowing capacity under the revolving credit facility is anticipated to be further reduced to a range of $200 million to $300 million. The reduction in available borrowing capacity reflects a restrictive covenant in connection with the maximum leverage permitted under the facility which is based, in part, on the results of our trailing four quarters of EBITDA (see Outstanding Indebtedness below for further information). Our revolving credit facility is backed by a number of financial institutions, matures in March 2017 and, by its terms, can be accessed on a same-day basis. We anticipate our principal uses of cash for the next 12 months and beyond will be for operating expenses, capital expenditures, stock repurchases, dividends, and acquisitions of businesses. We may from time to time seek to retire or purchase our outstanding debt through cash purchases in the open market, privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions, and other factors. The amounts involved may be material. In December 2013, we entered into an Accelerated Share Repurchase ("ASR") agreement with a financial institution to repurchase shares of our outstanding common stock for an aggregate purchase price of $300 million. The delivery of all shares under the December 2013 ASR agreement was completed during the first quarter of fiscal 2015. In March 2014, we entered into a second ASR agreement with a different financial institution to repurchase shares of our outstanding common stock for an aggregate purchase price of $200 million. The delivery of all shares under the March 2014 ASR agreement was completed during the second quarter of fiscal 2015. We anticipate that our operating cash flows, existing cash and cash equivalents, which have no restrictions on withdrawal, and borrowing capacity under our revolving credit facility will be sufficient to meet our anticipated cash requirements for at least the next 12 months. 51 -------------------------------------------------------------------------------- LEIDOS HOLDINGS, INC. LEIDOS, INC. |