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BOOZ ALLEN HAMILTON HOLDING CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis is intended to help the reader understand our business, financial condition, results of operations, and liquidity and capital resources. You should read this discussion in conjunction with our condensed consolidated financial statements and the related notes contained elsewhere in this Quarterly Report on Form 10-Q, or Quarterly Report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity and capital resources, and other non-historical statements in this discussion are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in our Annual Report on Form 10-K for the fiscal year ended March 31, 2014 filed with the Securities and Exchange Commission on May 22, 2014, or Annual Report, and under Part II, "Item 1A. Risk Factors," and "- Special Note Regarding Forward Looking Statements" of this Quarterly Report. Our actual results may differ materially from those contained in or implied by any forward-looking statements. Our fiscal year ends March 31 and, unless otherwise noted, references to years or fiscal are for fiscal years ended March 31. See "-Results of Operations." Overview We are a leading provider of management consulting, technology, and engineering services to the U.S. government in the defense, intelligence, and civil markets. Additionally, we provide our management and technology consulting services to major corporations, institutions, and not-for-profit organizations. We are a well-known, trusted and long-term partner to our clients, who seek our expertise and objective advice to address their most important and complex problems. Leveraging our 100-year consulting heritage and a talent base of approximately 22,100 people, we deploy our deep domain knowledge, functional expertise, and experience to help our clients achieve their objectives. We have a collaborative culture, supported by our operating model, which helps our professionals identify and respond to emerging trends across the markets we serve and deliver enduring results for our clients. Today, we serve substantially all of the cabinet-level departments of the U.S. government. Our major clients include the Department of Defense, all branches of the U.S. military, the U.S. Intelligence Community, and civil agencies such as the Department of Homeland Security, the Department of Energy, the Department of Health and Human Services, the Department of the Treasury, and the Environmental Protection Agency. We support these clients in addressing complex and pressing challenges such as combating global terrorism, improving cyber capabilities, transforming the healthcare system, improving efficiency and managing change within the government, and protecting the environment. In the commercial sector, we serve U.S. clients primarily in the financial services, healthcare, and energy markets, and international clients, primarily in the Middle East. Financial and Other Highlights During the second quarter of fiscal 2015 we continued to see positive signals in the federal contracting environment, despite revenue declines. Proposal volume continued at levels higher than seen in the previous comparable period and award activity was seasonally strong to include growth in funded and unfunded backlog at the close of the federal government's fiscal year. The Company continued to effectively manage indirect costs during the six months ended September 30, 2014, including a continuing focus on management of our capacity to balance the supply of consulting staff with market demand. This effective management of indirect costs supports the Company's continued investment in growth areas including the expansion of our commercial and international markets. Revenue decreased 5.3% from the three months ended September 30, 2013 to the three months ended September 30, 2014, and decreased 6.4% from the six months ended September 30, 2013 to the six months ended September 30, 2014 as a result of lower demand primarily driven by continuing macro challenges in the federal government spending environment and the residual impact of the slower award pace in the months immediately following last October's government shutdown, which resulted in reductions in consulting staff headcount over the past twelve months. The decline in consulting staff headcount led to fewer billable hours in total. While our headcount has decreased, the Company has maintained a high level of productivity of consulting staff. The revenue decline period over period was also attributable to a reduction in billable expenses due to a decline in our use of subcontractors and other direct expenses incurred to perform on contracts. Operating income decreased 10.1% to $122.0 million in the three months ended September 30, 2014 from $135.7 million in the three months ended September 30, 2013, which reflects a 50 basis point decrease in operating margin to 9.3% from 9.8% in the comparable period. Operating income decreased 4.9% to $261.0 million in the six months ended September 30, 2014 from $274.3 million in the six months ended September 30, 2013. Although operating income decreased, there was a 10 basis point increase in operating margin to 9.9% from 9.8% in the comparable period, which is consistent with the Company's focus on continued margin improvement. The decline in operating margin period over period was primarily due to lower demand and reductions in headcount which led to reduced revenue as discussed above. The impact of revenue declines on operating income 16 -------------------------------------------------------------------------------- were mitigated by a decline in certain provisions for the potential recovery of allowable expenses recorded during the six months ended September 30, 2014 in comparison to the prior year. In addition, to a lesser extent, decreases in salaries and salary related benefits, including employer retirement plan contributions, and depreciation and amortization expense contributed to the change in operating margin. As discussed above, while the Company continues to focus on disciplined cost management of indirect spending, there was an increase in the level of bid and proposal volume and associated spending as compared to the prior year period which supported our pursuit of new contract opportunities that were expected as we approached the end of the government fiscal year on September 30, 2014. These actions and an improved award environment resulted in an increase in funded and unfunded backlog at the close of the government's fiscal year. Non-GAAP Measures We publicly disclose certain non-GAAP financial measurements, including Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, and Adjusted Diluted Earnings Per Share, or Adjusted Diluted EPS, because management uses these measures for business planning purposes, including to manage our business against internal projected results of operations and measure our performance. We view Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, and Adjusted Diluted EPS as measures of our core operating business, which exclude the impact of the items detailed below, as these items are generally not operational in nature. These non-GAAP measures also provide another basis for comparing period to period results by excluding potential differences caused by non-operational and unusual or non-recurring items. We also utilize and discuss Free Cash Flow, because management uses this measure for business planning purposes, measuring the cash generating ability of the operating business, and measuring liquidity generally. We present these supplemental measures because we believe that these measures provide investors with important supplemental information with which to evaluate our performance, long term earnings potential, or liquidity, as applicable, and to enable them to assess our performance on the same basis as management. These supplemental performance measurements may vary from and may not be comparable to similarly titled measures by other companies in our industry. Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, Adjusted Diluted EPS, and Free Cash Flow are not recognized measurements under accounting principles generally accepted in the United States, or GAAP, and when analyzing our performance or liquidity, as applicable, investors should (i) evaluate each adjustment in our reconciliation of operating and net income to Adjusted Operating Income, Adjusted EBITDA and Adjusted Net Income, and net cash provided by operating activities to Free Cash Flows, and the explanatory footnotes regarding those adjustments, (ii) use Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, and Adjusted Diluted EPS in addition to, and not as an alternative to, operating income, net income or diluted EPS, as a measure of operating results, and (iii) use Free Cash Flows in addition to, and not as an alternative to, net cash provided by operating activities as a measure of liquidity, each as defined under GAAP. We have defined the aforementioned non-GAAP measures as follows: • "Adjusted Operating Income" represents operating income before (i) certain stock option-based and other equity-basedcompensation expenses, (ii) adjustments related to the amortization of intangible assets, and (iii) any extraordinary, unusual, or non-recurring items. We prepare Adjusted Operating Income to eliminate the impact of items we do not consider indicative of ongoing operating performance due to their inherent unusual, extraordinary, or non-recurring nature or because they result from an event of a similar nature. • "Adjusted EBITDA" represents net income before income taxes, net interest and other expense, and depreciation and amortization and before certain other items, including: (i) certain stock option-based and other equity-based compensation expenses, (ii) transaction costs, fees, losses, and expenses, including fees associated with debt prepayments, and (iii) any extraordinary, unusual, or non-recurring items. We prepare Adjusted EBITDA to eliminate the impact of items we do not consider indicative of ongoing operating performance due to their inherent unusual, extraordinary, or non-recurring nature or because they result from an event of a similar nature. • "Adjusted Net Income" represents net income before: (i) certain stock option-based and other equity-based compensation expenses, (ii) transaction costs, fees, losses, and expenses, including fees associated with debt prepayments, (iii) adjustments related to the amortization of intangible assets, (iv) amortization orwrite-off of debt issuance costs and write-off of original issue discount, and (v) any extraordinary, unusual, or non-recurring items, in each case net of the tax effect calculated using an assumed effective tax rate. We prepare Adjusted Net Income to eliminate the impact of items, net of tax, we do not consider indicative of ongoing operating performance due to their inherent unusual,extraordinary, or non-recurring nature or because they result from an event of a similar nature. • "Adjusted Diluted EPS" represents diluted EPS calculated using Adjusted Net Income as opposed to net income. Additionally, Adjusted Diluted EPS does not contemplate any adjustments to net income as required under the two-class method as disclosed in thefootnotes to the financial statements. 17-------------------------------------------------------------------------------- • "Free Cash Flow" represents the net cash generated from operating activities less the impact of purchases of property and equipment. Below is a reconciliation of Adjusted Operating Income, Adjusted EBITDA, Adjusted Net Income, Adjusted Diluted EPS, and Free Cash Flow to the most directly comparable financial measure calculated and presented in accordance with GAAP. Three Months Ended Six Months Ended September 30, September 30, (Amounts in thousands, except share and per share data) 2014 2013 2014 2013 (Unaudited) (Unaudited) Adjusted Operating Income Operating Income $ 121,983 $ 135,667 $ 261,006 $ 274,340 Certain stock-based compensation expense (a) - - - 1,094 Amortization of intangible assets (b) 1,056 2,112 2,112 4,225 Transaction expenses (c) - - 2,039 - Adjusted Operating Income $ 123,039 $ 137,779 $ 265,157 $ 279,659 EBITDA & Adjusted EBITDA Net income $ 65,284 $ 67,813 $ 136,399 $ 138,126 Income tax expense 39,689 45,985 87,623 93,687 Interest and other, net 17,010 21,869 36,984 42,527 Depreciation and amortization 15,810 18,102 32,042 36,432 EBITDA 137,793 153,769 293,048 310,772 Certain stock-based compensation expense (a) - - - 1,094 Transaction expenses (c) - - 2,039 - Adjusted EBITDA $ 137,793 $ 153,769 $ 295,087 $ 311,866 Adjusted Net Income Net income $ 65,284 $ 67,813 $ 136,399 $ 138,126 Certain stock-based compensation expense (a) - - - 1,094 Amortization of intangible assets (b) 1,056 2,112 2,112 4,225 Transaction expenses (c) - - 2,039 - Amortization or write-off of debt issuance costs and write-off of original issue discount 1,301 1,705 3,961 3,355 Adjustments for tax effect (d) (943 ) (1,527 ) (3,245 ) (3,470 ) Adjusted Net Income $ 66,698 $ 70,103 $ 141,266 $ 143,330 Adjusted Diluted Earnings Per Share Weighted-average number of diluted shares outstanding 150,403,896 148,505,826 149,537,560 147,257,574 Adjusted Net Income Per Diluted Share (e) $ 0.44 $ 0.47 $ 0.94 $ 0.97 Free Cash Flow Net cash provided by operating activities $ 108,803 $ 65,762 $ 200,529 $ 139,609 Less: Purchases of property and equipment (6,279 ) (4,288 ) (8,931 ) (6,718 ) Free Cash Flow $ 102,524 $ 61,474 $ 191,598 $ 132,891 (a) Reflects stock-based compensation expense for options for Class A Common Stock and restricted shares, in each case, issued in connection with the Acquisition of our Company by The Carlyle Group (the Acquisition) under the Officers' Rollover Stock Plan. Also reflects stock-based compensation expense for Equity Incentive Plan Class A Common Stock options issued in connection with the Acquisition under the Equity Incentive Plan. (b) Reflects amortization of intangible assets resulting from the Acquisition. (c) Reflects debt refinancing costs incurred in connection with the refinancing transaction consummated on May 7, 2014. (d) Reflects tax effect of adjustments at an assumed marginal tax rate of 40%. (e) Excludes an adjustment of approximately $2.5 million and $2.7 million of net earnings for the three and six months ended September 30, 2014, and excludes an adjustment of approximately $642,000 and $1.2 million of net earnings for the three and six months ended September 30, 2013 respectively, associated with the application of the two-class method for computing diluted earnings per share. 18-------------------------------------------------------------------------------- Recent Developments The following recent development occurred after September 30, 2014, which may cause our future results of operations to differ from our historical results of operations discussed under "- Results of Operations." During October 2014, we entered into a stock purchase agreement to acquire an informatics company that provides early insights, continuous monitoring and consumer engagement for a wide range of population health domain. In addition, we also entered into an asset purchase agreement to acquire the assets of a unit of a company that provides IT solutions and strategy for the U.S. government's Centers for Medicare and Medicaid Services and other health institutions. Neither acquisition is material under Accounting Standard Codification 805, Business Combinations, nor is either acquisition considered significant under the Securities and Exchange Commission's Rule 3-05 of Regulation S-X. Pursuant to the terms of the agreements, the acquisitions will be accounted for using the purchase method of accounting which requires the total purchase price consideration to be allocated to the assets acquired and liabilities assumed based on estimates of fair value. The excess of purchase consideration over the amounts assigned to tangible and intangible assets acquired and liabilities assumed will be recognized as goodwill. Factors and Trends Affecting Our Results of Operations Our results of operations have been, and we expect them to continue to be, affected by the following factors, which may cause our future results of operations to differ from our historical results of operations discussed under "- Results of Operations." Business Environment and Key Trends in Our Markets We believe that the following trends and developments in the U.S. government services industry and our markets may influence our future results of operations: • budget deficits and the growing U.S. national debt increasing pressure on the U.S. government to reduce federal spending across all federal agencies together with associated uncertainty about the size and timing of those reductions; • changes in the relative mix of overall U.S. government spending and areas of spending growth, with lower spending on homeland security, intelligence and defense-related programs as overseasoperations end, and continued increased spending on cyber-security, advanced analytics, technology integration and healthcare; • cost cutting and efficiency initiatives, current and future budget reductions, continued implementation of Congressionally mandated automatic spending cuts, and other efforts to reduce U.S.government spending, which could cause clients to reduce or delay funding for orders for services or invest appropriated funds on a less consistent or rapid basis or not at all, particularly when considering long-term initiatives and in light of uncertainty around Congressional efforts to craft a long-term agreement on the U.S. government's ability to incur indebtedness in excess of its current limits and generally in the current political environment, not issue task orders in sufficient volume to reach current contractceilings, alter historical patterns of contract awards, including the typical increase in the award of task orders or completion of other contract actions by the U.S. government in the period before the end of the U.S. government's fiscal year on September 30, delay requests for new proposals and contract awards, rely on short-termextensions and funding of current contracts, or reduce staffing levels and hours of operation; • current and continued uncertainty around the timing, extent, nature and effect of Congressional and other U.S. government action to address budgetary constraints, the outcome of Congressional efforts to craft a long-term agreement on the U.S. government's ability to incur indebtedness in excess of its current limits and the U.S. deficit, including, the required reductions under the Budget Control Act of 2011 (as amended by the American Taxpayer Relief Act of 2012 and the Consolidated Appropriations Act, 2014), which provides for automatic spending cuts totaling approximately $1.2 trillion between 2013 and 2021, and the extension of the Temporary Debt Limit Extension Act, which is currently scheduled to expire on March 15, 2015; • delays in the completion of future U.S. government's budget processes, which have in the past and could in the future delay procurement of the products, services, and solutions we provide; • increased audit, review, investigation and general scrutiny by U.S. government agencies of government contractors' performance under U.S. government contracts and compliance with the terms of those contracts and applicable laws; 19-------------------------------------------------------------------------------- • the implementation by U.S. government agencies of approximately $64 billion and $90 billion in mandated 2014 and 2015 sequestration spending cuts, respectively, including an estimated $30billion and $45 billion in cuts to the Department of Defense, respectively; • the federal focus on refining the definition of "inherently governmental" work, including proposals to limit contractor access to sensitive or classified information and work assignments, which will continue to drive pockets of insourcing in various agencies, particularly in the intelligence market; • negative publicity and increased scrutiny of governmentcontractors in general, including us, relating to U.S. governmentexpenditures for contractor services and incidents involving the mishandling of sensitive or classified information; • cost cutting and efficiency and effectiveness efforts by U.S. civilian agencies with a focus on increased use of performance measurement, "program integrity" efforts to reduce waste, fraud and abuse in entitlement programs, and renewed focus on improving procurement practices for and interagency use of IT services, including through the use of cloud based options and data center consolidation; • U.S. government agencies awarding contracts on a technically acceptable/lowest cost basis, which could have a negative impact on our ability to win certain contracts; • as a result of the U.S. government's efforts to reduceoutlays for contractor costs, we may see a continuing shift towardplacement of our consulting staff at client site locations instead of our facilities, which generally results in lower billing rates and could have a negative impact on our revenue; • restrictions by the U.S. government on the ability of federal agencies to use lead system integrators, in response to cost, schedule and performance problems with large defenseacquisition programs where contractors were performing the lead system integrator role; • increasingly complex requirements of the Department ofDefense and the U.S. Intelligence Community, including cyber-security, managing federal health care cost growth and focus on reformingexisting government regulation of various sectors of the economy, such as financial regulation and healthcare; • increased competition from other government contractors andmarket entrants seeking to take advantage of certain of the trends identified above; • legislative and regulatory changes to limitations on theamount of allowable executive compensation permitted under flexibly priced contracts following implementation of interim rules adopted by federal agencies pursuant to the Bipartisan Budget Act of 2013 published on June 24, 2014, which substantially further reduce the amount of allowable executive compensation under thesecontracts and extend these limitations to a larger segment of our executives and our entire contract base; and • efforts by the U.S. government to address organizational conflicts of interest and related issues and the impact of those efforts on us and our competitors. Sources of Revenue Substantially all of our revenue is derived from services provided under contracts and task orders with the U.S. government, primarily by our consulting staff and, to a lesser extent, our subcontractors. Funding for our contracts and task orders is generally linked to trends in budgets and spending across various U.S. government agencies and departments. We provide services under a large portfolio of contracts and contract vehicles to a broad client base, and we believe that our diversified contract and client base lessens potential volatility in our business; however, a reduction in the amount of services that we are contracted to provide to the U.S. government or any of our significant U.S. government clients could have a material adverse effect on our business and results of operations. In particular, the Department of Defense is one of our significant clients, and the Budget Control Act of 2011 (as amended by the American Taxpayer Relief Act of 2012 and the Consolidated Appropriations Act, 2014), provides for automatic spending cuts totaling approximately $1.2 trillion between 2013 and 2021, and requires an estimated $500 billion in federal defense spending cuts over this time period. Under the Budget Control Act, as amended, approximately $64 billion and $90 billion in spending cuts are mandated for fiscal 2014 and 2015, respectively, and the Department of Defense has estimated its share of these cuts at $30 billion and $45 billion, respectively. A reduction in the amount of services that we are contracted to provide to the Department of Defense could have a material adverse effect on our business and results of operations, and given the uncertainty of when and how these automatic reductions may be applied, we are unable to predict the nature or magnitude of the potential adverse effect. 20 -------------------------------------------------------------------------------- Contract Types We generate revenue under the following three basic types of contracts: • Cost-Reimbursable Contracts. Cost-reimbursable contracts provide for the payment of allowable costs incurred during performance of the contract, up to a ceiling based on the amount that has been funded, plus a fee. As we increase or decrease our spending on allowable costs, our revenue generated on cost-reimbursable contracts will increase, up to the ceiling and funded amounts, or decreaserespectively. We generate revenue under two general types ofcost-reimbursable contracts: cost-plus-fixed-fee and cost-plus-award-fee, both of which reimburse allowable costs and provide for a fee. The fee under each type of cost-reimbursable contract is generally payable upon completion of services in accordance with the terms of the contract. Cost-plus-fixed-fee contracts offer no opportunity for payment beyond the fixed fee. Cost-plus-award-fee contracts also provide for an award fee that varies within specified limits based upon the client's assessment of our performance against a predetermined set of criteria, such as targets for factors like cost, quality, schedule, and performance. • Time-and-Materials Contracts. Under atime-and-materials contract, we are paid a fixed hourly rate for each direct labor hour expended, and we are reimbursed for billable material costs and billable out-of-pocket expenses inclusive of allocable indirect costs. To the extent our actual direct labor including allocated indirect costs, and associated billable expenses decrease or increase in relation to the fixed hourly billing rates provided in the contract, we will generate more or less profit, respectively, or could incur a loss. • Fixed-Price Contracts. Under a fixed-price contract, we agree to perform the specified work for a pre-determined price. To the extent our actual direct and allocated indirect costs decrease or increase from the estimates upon which the price was negotiated, we will generate more or less profit, respectively, or could incur a loss. Some fixed-price contracts have a performance-based component, pursuant to which we can earn incentive payments or incur financial penalties based on our performance. Fixed-price level of effort contracts require us to provide a specified level of effort (i.e., labor hours), over a stated period of time, for a fixed price. The amount of risk and potential reward varies under each type of contract. Under cost-reimbursable contracts, there is limited financial risk, because we are reimbursed for all allowable costs up to a ceiling. However, profit margins on this type of contract tend to be lower than on time-and-materials and fixed-price contracts. Under time-and-materials contracts, we are reimbursed for the hours worked using the predetermined hourly rates for each labor category. In addition, we are typically reimbursed for other contract direct costs and expenses at cost. We assume financial risk on time-and-materials contracts because our labor costs may exceed the negotiated billing rates. Profit margins on well-managed time-and-materials contracts tend to be higher than profit margins on cost-reimbursable contracts as long as we are able to staff those contracts with people who have an appropriate skill set. Under fixed-price contracts, we are required to deliver the objectives under the contract for a pre-determined price. Compared to time-and-materials and cost-reimbursable contracts, fixed-price contracts generally offer higher profit margin opportunities because we receive the full benefit of any cost savings but generally involve greater financial risk because we bear the impact of any cost overruns. In the aggregate, the contract type mix in our revenue for any given period will affect that period's profitability. The table below presents the percentage of total revenue for each type of contract: Three Months Ended Six Months Ended September 30, September 30, 2014 2013 2014 2013 Cost-reimbursable (1) 55% 55% 56% 55% Time-and-materials 26% 29% 26% 30% Fixed-price (2) 19% 16% 18% 15% (1) Includes both cost-plus-fixed-fee and cost-plus-award-fee contracts. (2) Includes fixed-price level of effort contracts. 21 -------------------------------------------------------------------------------- Contract Diversity and Revenue Mix We provide services to our clients through a large number of single award contracts and contract vehicles and multiple award contract vehicles. Most of our revenue is generated under indefinite delivery/indefinite quantity, or ID/IQ, contract vehicles, which include multiple award government wide acquisition contract vehicles, or GWACs, and General Services Administration Multiple Award Schedule Contracts, or GSA schedules, and certain single award contracts. GWACs and GSA schedules are available to all U.S. government agencies. Any number of contractors typically compete under multiple award ID/IQ contract vehicles for task orders to provide particular services, and we earn revenue under these contract vehicles only to the extent that we are successful in the bidding process for task orders. We generate revenue under our contracts and task orders through our provision of services as both a prime contractor and subcontractor, as well as from the provision of services by subcontractors under contracts and task orders for which we act as the prime contractor. The mix of these types of revenue affects our operating margin. Substantially all of our operating margin is derived from direct consulting staff labor, as the portion of our operating margin derived from fees we earn on services provided by our subcontractors is not significant. We view growth in direct consulting staff labor as the primary driver of earnings growth. Direct consulting staff labor growth is driven by consulting staff headcount growth, after attrition, and total backlog growth. Our People Revenue from our contracts is derived from services delivered by consulting staff and, to a lesser extent, from our subcontractors. Our ability to hire, retain, and deploy talent with skills appropriately aligned with client needs is critical to our ability to grow our revenue. We continuously evaluate whether our talent base is properly sized and appropriately compensated, and contains an optimal mix of skills to be cost competitive and meet the rapidly evolving needs of our clients.We seek to achieve that result through recruitment and management of capacity and compensation. As of September 30, 2014 and 2013, we employed approximately 22,100 and 23,200 people, respectively, of which approximately 20,100 and 21,000, respectively, were consulting staff. Contract Backlog We define backlog to include the following three components: • Funded Backlog. Funded backlog represents the revenue value of orders for services under existing contracts for which funding is appropriated or otherwise authorized less revenue previously recognized on these contracts. • Unfunded Backlog. Unfunded backlog represents the revenue value of orders for services under existing contracts for which funding has not been appropriated or otherwise authorized. • Priced Options. Priced contract options represent 100% of the undiscounted revenue value of all future contract option periods under existing contracts that may be exercised at our clients' option and for which funding has not been appropriated or otherwise authorized. Backlog does not include any task orders under ID/IQ contracts, including GWACs and GSA schedules, except to the extent that task orders have been awarded to us under those contracts. The following table summarizes the value of our contract backlog at the respective dates presented: As of September 30, 2014 2013 (In millions) Backlog: Funded $ 3,337 $ 3,220 Unfunded (1) 2,844 2,758 Priced options 4,711 5,673 Total backlog $ 10,892 $ 11,651 22-------------------------------------------------------------------------------- (1) Reflects a reduction by management to the revenue value of orders for services under one existing single award ID/IQ contract the Company has had for several years, based on an established pattern of funding under these contracts by the U.S. government. Our backlog includes orders under contracts that in some cases extend for several years. The U.S. Congress generally appropriates funds for our clients on a yearly basis, even though their contracts with us may call for performance that is expected to take a number of years. As a result, contracts typically are only partially funded at any point during their term and all or some of the work to be performed under the contracts may remain unfunded unless and until the U.S. Congress makes subsequent appropriations and the procuring agency allocates funding to the contract. We view growth in total backlog and consulting staff headcount as the two key measures of our potential business growth. Growing and deploying consulting staff is the primary means by which we are able to achieve profitable revenue growth. To the extent that we are able to hire additional consulting staff and deploy them against funded backlog, we generally recognize increased revenue. Total backlog decreased by 6.5% from September 30, 2013 to September 30, 2014. Additions to funded backlog during the twelve months ended September 30, 2014 remained consistent, totaling $5.4 billion in comparison to $5.4 billion for the comparable period, as a result of the conversion of unfunded backlog to funded backlog, the award of new contracts and task orders under which funding was appropriated, and the exercise and subsequent funding of priced options. We report internally on our backlog on a monthly basis and review backlog upon occurrence of certain events to determine if any adjustments are necessary. We cannot predict with any certainty the portion of our backlog that we expect to recognize as revenue in any future period and we cannot guarantee that we will recognize any revenue from our backlog. The primary risks that could affect our ability to recognize such revenue on a timely basis or at all are: program schedule changes, contract modifications, and our ability to assimilate and deploy new consulting staff against funded backlog; cost cutting initiatives and other efforts to reduce U.S. government spending, which could reduce or delay funding for orders for services; and delayed funding of our contracts due to delays in the completion of the U.S. government's budgeting process and the use of continuing resolutions by the U.S. government to fund its operations. Funded backlog includes orders under contracts for which the period of performance has expired, and we may not recognize revenue on the funded backlog that includes such orders due to, among other reasons, the tardy submission of invoices by our subcontractors and the expiration of the relevant appropriated funding in accordance with a pre-determined expiration date such as the end of the U.S. government's fiscal year. The revenue value of orders included in funded backlog that has not been recognized as revenue due to period of performance expirations has not exceeded approximately 6.7% of funded backlog as of the end of any of the four fiscal quarters preceding the fiscal quarter ended September 30, 2014. In our recent experience, none of the following additional risks have had a material negative effect on our ability to realize revenue from our funded backlog: the unilateral right of the U.S. government to cancel multi-year contracts and related orders or to terminate existing contracts for convenience or default; in the case of unfunded backlog, the potential that funding will not be made available; and, in the case of priced options, the risk that our clients will not exercise their options. Operating Costs and Expenses Costs associated with compensation and related expenses for our people are the most significant component of our operating costs and expenses. The principal factors that affect our costs are additional people as we grow our business and are awarded new contracts, task orders, and additional work under our existing contracts, and the hiring of people with specific skill sets and security clearances as required by our additional work. Our most significant operating costs and expenses are described below. • Cost of Revenue. Cost of revenue includes direct labor, related employee benefits, and overhead. Overhead consists of indirect costs, including indirect labor relating to infrastructure, management and administration, and other expenses. • Billable Expenses. Billable expenses include directsubcontractor expenses, travel expenses, and other expenses incurred to perform on contracts. • General and Administrative Expenses. General andadministrative expenses include indirect labor of executive management and corporate administrative functions, marketing and bid and proposal costs, and other discretionary spending. 23-------------------------------------------------------------------------------- • Depreciation and Amortization. Depreciation and amortization includes the depreciation of computers, leasehold improvements, furniture and other equipment, and the amortization of internally developed software, as well as third-party software that we use internally, and of identifiable long-lived intangible assets over their estimated useful lives. Seasonality The U.S. government's fiscal year ends on September 30 of each year. While not certain, it is not uncommon for U.S. government agencies to award extra tasks or complete other contract actions in the weeks before the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. In addition, we also have historically experienced higher bid and proposal costs in the months leading up to the U.S. government's fiscal year end as we pursue new contract opportunities being awarded shortly after the U.S. government fiscal year end as new opportunities are expected to have funding appropriated in the U.S. government's subsequent fiscal year. We may continue to experience this seasonality in future periods, and our future periods may be affected by it. While not certain, changes in the government's funding and spending patterns have altered historical seasonality trends, supporting our approach to managing the business on an annual basis. Critical Accounting Estimates and Policies There have been no material changes during the period covered by this Quarterly Report to the information disclosed in the Critical Accounting Estimates and Policies section in Part II, "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board issued a new standard that will replace existing revenue recognition standards and significantly expand the disclosure requirements for revenue arrangements. The new standard will be effective for the Company beginning on April 1, 2017 (i.e., beginning with the first quarter fiscal 2018 interim financial statements). The new standard may be adopted retrospectively for all periods presented, or adopted using a modified retrospective approach. Under the retrospective approach, the fiscal 2017 and 2016 financial statements would be adjusted to reflect the effects of applying the new standard on those periods. Under the modified retrospective approach, the new standard would only be applied for the period beginning April 1, 2017 to new contracts and those contracts that are not yet complete at April 1, 2017, with a cumulative catch-up adjustment recorded to beginning retained earnings for existing contracts that still require performance. We are still in the process of determining which transition method to utilize in order to apply the new standard and still assessing what effect the application of this standard may have on the timing of our revenue recognition and our financial statements. 24-------------------------------------------------------------------------------- Results of Operations The following table sets forth items from our condensed consolidated statements of operations for the periods indicated: Three Months Ended Six Months Ended September 30, Percent September 30, Percent 2014 2013 Change 2014 2013 Change (Unaudited) (Unaudited) (Unaudited) (Unaudited) (In thousands) (In thousands) Revenue $ 1,304,841 $ 1,378,020 (5.3 )% $ 2,627,138 $ 2,805,711 (6.4 )% Operating costs and expenses: Cost of revenue 642,425 685,138 (6.2 )% 1,287,426 1,386,610 (7.2 )% Billable expenses 347,651 365,632 (4.9 )% 698,623 763,520 (8.5 )% General and administrative expenses 176,972 173,481 2.0 % 348,041 344,809 0.9 % Depreciation and amortization 15,810 18,102 (12.7 )% 32,042 36,432 (12.0 )% Total operating costs and expenses 1,182,858 1,242,353 (4.8 )% 2,366,132 2,531,371 (6.5 )% Operating income 121,983 135,667 (10.1 )% 261,006 274,340 (4.9 )% Interest expense (17,817 ) (20,175 ) (11.7 )% (36,681 ) (40,887 ) (10.3 )% Other, net 807 (1,694 ) (147.6 )% (303 ) (1,640 ) (81.5 )% Income before income taxes 104,973 113,798 (7.8 )% 224,022 231,813 (3.4 )% Income tax expense 39,689 45,985 (13.7 )% 87,623 93,687 (6.5 )% Net income $ 65,284 $ 67,813 (3.7 )% $ 136,399 $ 138,126 (1.3 )% Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 Revenue Revenue decreased to $1,304.8 million from $1,378.0 million, or a 5.3% decrease as a result of lower demand primarily driven by continuing macro challenges in the federal government spending environment and the residual impact of the slower award pace in the months immediately following last October's government shutdown, which resulted in reductions in consulting staff headcount. While the decline in consulting staff headcount led to fewer billable hours in total, the Company maintained a high level of productivity of consulting staff, which continues to help offset the headcount reductions and reduces the ratio of indirect costs to direct labor. The revenue decline period over period was also attributable to a reduction in billable expenses due to a decline in our use of subcontractors and other direct expenses incurred to perform on contracts. Conversions to funded backlog during the twelve months ended September 30, 2014 and the twelve months ended September 30, 2013 totaled $5.4 billion for both periods. The revenue conversion was a result of the conversion of unfunded backlog to funded backlog, the award of new contracts and task orders under which funding was appropriated, and the exercise and subsequent funding of priced options. Cost of Revenue Cost of revenue decreased to $642.4 million from $685.1 million, or a 6.2% decrease. This decrease was primarily due to a decrease in salaries and salary-related benefits of $32.3 million and a decrease in employer retirement plan contributions of $13.1 million. The decrease in salaries and salary-related benefits was primarily due to reduced headcount in direct consulting staff. The decrease in employer retirement plan contributions was due to a decrease in the Company's expected discretionary employer contribution percentage due to a change to the matching program effective April 1, 2014, as well as the reduced headcount noted above. Cost of revenue as a percentage of revenue was 49.2% and 49.7% for the three months ended September 30, 2014 and 2013, respectively. Billable Expenses Billable expenses decreased to $347.7 million from $365.6 million, or a 4.9% decrease. The overall decrease was primarily due to decreases in subcontractor-related expenses and other direct expenses of $21.5 million incurred to perform on contracts. Direct subcontractor related expenses decreased due to lower demand. Billable expenses as a percentage of revenue were 26.6% and 26.5% for the three months ended September 30, 2014 and 2013, respectively. 25 -------------------------------------------------------------------------------- General and Administrative Expenses General and administrative expenses increased to $177.0 million from $173.5 million, or a 2.0% increase. This increase was primarily due to increases in incentive compensation of $2.0 million, offset by decreases in salaries and salary-related benefits of $3.3 million and employer retirement plan contributions of $1.2 million. In addition, the prior year period included a release of a provision of approximately $3.8 million for a contingency that was settled, for which a similar event was not present in the current period. The decrease in salaries and salary-related benefits was primarily driven by the net reduction in our headcount. The decrease in employer retirement plan contributions was due to a decrease in the Company's expected discretionary employer contribution percentage due to a change to the matching program effective April 1, 2014, as well as the reduced headcount noted above. General and administrative expenses as a percentage of revenue were 13.6% and 12.6% for the three months ended September 30, 2014 and 2013, respectively. Depreciation and Amortization Depreciation and amortization decreased to $15.8 million from $18.1 million, or an 12.7% decrease primarily due to a reduction in amortization of intangible assets. Interest Expense Interest expense decreased to $17.8 million from $20.2 million, or an 11.7% decrease, primarily as a result of the First Amendment to the Credit Agreement consummated in August 2013 that repriced the outstanding Term Loan B indebtedness which generated a reduction in interest expense for the three months ended September 30, 2014 as compared to September 30, 2013. Income Tax Expense Income tax expense decreased to $39.7 million from $46.0 million, or a 13.7% decrease, primarily due to a decrease in both pre-tax income and the effective tax rate from 40.4% to 37.8%. The decrease in the effective tax rate primarily relates to state income tax credits recognized during the three months ended September 30, 2014, which reduced the effective tax rate by approximately 2.7% Six Months Ended September 30, 2014 Compared to Six Months Ended September 30, 2013 Revenue Revenue decreased to $2,627.1 million from $2,805.7 million, or a 6.4% decrease as a result of lower demand primarily driven by continuing macro challenges in the federal government spending environment and the residual impact of the slower award pace in the months immediately following last October's government shutdown which resulted in reductions in consulting staff headcount. While the decline in consulting staff headcount led to fewer billable hours in total, the Company maintained a high level of productivity of consulting staff, which continues to help offset the headcount reductions and reduces the ratio of indirect costs to direct labor. The revenue decline period over period was also attributable to a reduction in billable expenses due to a decline in our use of subcontractors and other direct expenses incurred to perform on contracts. Conversions to funded backlog during the twelve months ended September 30, 2014 and the twelve months ended September 30, 2013 both totaled $5.4 billion. The revenue conversion was a result of the conversion of unfunded backlog to funded backlog, the award of new contracts and task orders under which funding was appropriated, and the exercise and subsequent funding of priced options. Cost of Revenue Cost of revenue decreased to $1,287.4 million from $1,386.6 million, or a 7.2% decrease. This decrease was primarily due to a decrease in salaries and salary-related benefits of $73.4 million and a decrease in employer retirement plan contributions of $26.1 million. The decrease in salaries and salary-related benefits was primarily due to reduced headcount in direct consulting staff. The decrease in employer retirement plan contributions was due to a decrease in the Company's expected discretionary employer contribution percentage due to a change to the matching program effective April 1, 2014, as well as the reduced headcount noted above. Cost of revenue as a percentage of revenue was 49.0% and 49.4% for the six months ended September 30, 2014 and 2013, respectively. Billable Expenses Billable expenses decreased to $698.6 million from $763.5 million, or an 8.5% decrease. The overall decrease was primarily due to decreases in subcontractor-related expenses and other direct expenses of $70.0 million incurred to perform on contracts. Direct subcontractor related expenses decreased due to lower demand. Billable expenses as a percentage of revenue were 26.6% and 27.2% for the six months ended September 30, 2014 and 2013, respectively. 26 -------------------------------------------------------------------------------- General and Administrative Expenses General and administrative expenses increased to $348.0 million from $344.8 million, or a 0.9% increase. This increase was primarily due to the release of a provision of approximately $3.8 million in the prior year period for a contingency that was settled, for which a similar event was not present in the current period. This was partially offset by decreases in employer retirement plan contributions of $2.6 million and salary and salary related benefits of $1.8 million. The decrease in employer retirement plan contributions was due to a decrease in the Company's expected discretionary employer contribution percentage due to a change to a matching program effective April 1, 2014, as well as reduced headcount. The decrease in salaries and salary-related benefits was primarily driven by the net reduction in our headcount. General and administrative expenses as a percentage of revenue were 13.2% and 12.3% for the six months ended September 30, 2014 and 2013, respectively. Depreciation and Amortization Depreciation and amortization decreased to $32.0 million from $36.4 million, or a 12.0% decrease primarily due to a reduction in amortization of intangible assets. Interest Expense Interest expense decreased to $36.7 million from $40.9 million, or a 10.3% decrease, primarily as a result of the First Amendment to the Credit Agreement consummated in August 2013 that repriced the outstanding Term Loan B indebtedness which generated a reduction in interest expense for the six months ended September 30, 2014 as compared to September 30, 2013. Income Tax Expense Income tax expense decreased to $87.6 million from $93.7 million, or a 6.5% decrease, primarily due to a decrease in both pre-tax income and the effective tax rate from 40.4% to 39.1% . The decrease in the effective tax rate primarily relates to state income tax credits recognized during the six months ended September 30, 2014, which reduced the effective tax rate by approximately 1.2% Liquidity and Capital Resources We have historically been able to generate sufficient cash to fund our operations, debt payments, capital expenditures, and discretionary funding needs. We had $241.8 million and $260.0 million in cash and cash equivalents as of September 30, 2014 and March 31, 2014, respectively. However, due to fluctuations in cash flows, including as a result of the trends and developments described above under "-Factors and Trends Affecting Our Results of Operations" relating to U.S. government cost-cutting, reductions or delays in the U.S. government appropriations and spending process and other budgetary matters, it may be necessary from time-to-time in the future to borrow under our senior secured loan facilities to meet cash demands. We anticipate that cash provided by operating activities, existing cash and cash equivalents, and borrowing capacity under our revolving credit facility will be sufficient to meet our anticipated cash requirements for the next twelve months, which primarily include: • operating expenses, including salaries; • working capital requirements to fund the growth of our business; • capital expenditures which primarily relate to the purchase of computers, business systems, furniture and leasehold improvements to support our operations; • debt service requirements for borrowings under our senior secured loan facilities; and • cash taxes to be paid. From time to time we evaluate alternative uses for excess cash resources once our operating cash flow needs and required debt amortization have been met. Some of the possible uses of our remaining excess cash at any point in time may include funding acquisitions, further investment in our business and voluntary debt prepayments, as well as initiatives intended to return value to stockholders in the form of payment of special dividends and share repurchases. The Company is currently authorized by the Board of Directors to repurchase up to $30.0 million of our shares, of which no shares have been repurchased as of September 30, 2014. Any determination to pursue one or more of the above alternative uses for excess cash is subject to 27 -------------------------------------------------------------------------------- the discretion of our Board of Directors, and will depend upon various factors, including our results of operations, financial condition, liquidity requirements, restrictions that may be imposed by applicable law, our contracts, and our senior secured credit agreement, as amended, and other factors deemed relevant by our Board of Directors. The following table summarizes the cash distributions recognized in the condensed consolidated statement of cash flows: Three Months Ended Six Months Ended September 30, September 30, 2014 2013 2014 2013 Recurring dividends (1) $ 16,196 $ 14,273 $ 32,244 $ 28,188 Special dividends (2) 147,248 - 147,248 - Dividend equivalents (3) 42,325 34,044 46,797 47,908 Total distributions $ 205,769 $ 48,317 $ 226,289 $ 76,096 (1) Amounts represent recurring dividends of $0.11 per share and $0.10 per share that were declared and paid during fiscal 2015 and fiscal 2014, respectively. (2) Amounts represent a special dividend of $1.00 per share that was declared and paid for during fiscal 2015. (3) Dividend equivalents are distributions made to option holders equal to the special dividends declared and paid. On October 29, 2014, we announced a regular quarterly cash dividend in the amount of $0.11 per share, payable on November 28, 2014 to stockholders of record on November 10, 2014. For each special dividend declared, the Board of Directors, acting as the Administrator of the Officers' Rollover Stock Plan and the Equity Incentive Plan, as amended, is required to make a determination under the respective plan's antidilution provision to adjust the outstanding options. In the event the Board of Directors elects to grant option holders a cash payment equal to the amount of the special dividend, the Company accrues a stock-based compensation liability as the respective option's stock compensation expense is recorded in the statement of operations. This obligation will be settled on the options' mandatory exercise date for Rollover options and on the later of the date the dividend is paid or vesting for the EIP options. The stock-based compensation liability as of September 30, 2014 includes all special dividends declared through September 30, 2014. As of September 30, 2014 and March 31, 2014, the Company calculated a total recorded and unrecorded stock-based compensation liability of $36.4 million and $73.1 million, respectively, related to the special dividends paid in July and December 2009, June and August 2012, November 2013, and February and August 2014. Cash Flows Cash received from clients, either from the payment of invoices for work performed or for advances in excess of costs incurred, is our primary source of cash. We generally do not begin work on contracts until funding is appropriated by the client. Billing timetables and payment terms on our contracts vary based on a number of factors, including whether the contract type is cost-reimbursable, time-and-materials, or fixed-price. We generally bill and collect cash more frequently under cost-reimbursable and time-and-materials contracts, as we are authorized to bill as the costs are incurred or work is performed. In contrast, we may be limited to bill certain fixed-price contracts only when specified milestones, including deliveries, are achieved. In addition, a number of our contracts may provide for performance-based payments, which allow us to bill and collect cash prior to completing the work. Accounts receivable is the principal component of our working capital and is generally driven by revenue growth with other short-term fluctuations related to the payment practices of our clients. Our accounts receivable reflect amounts billed to our clients as of each balance sheet date. Our clients generally pay our invoices within 30 days of the invoice date. At any month-end, we also include in accounts receivable the revenue that was recognized in the preceding month, which is generally billed early in the following month. Finally, we include in accounts receivable amounts related to revenue accrued in excess of amounts billed, primarily on our fixed-price and cost-plus-award-fee contracts. The total amount of our accounts receivable can vary significantly over time, but is generally sensitive to revenue levels. Total accounts receivable (billed and unbilled combined, net of allowance for doubtful accounts) days sales outstanding or DSO, which we calculate by dividing total accounts receivable by revenue per day during the relevant fiscal quarter, was 59 as of September 30, 2014 and 60 as of March 31, 2014. 28 --------------------------------------------------------------------------------The table below sets forth our net cash flows for the periods presented: Six Months Ended September 30, 2014 2013 (Unaudited) (Unaudited) (In thousands) Net cash provided by operating activities $ 200,529 $ 139,609 Net cash used in investing activities (8,931 ) (3,155 ) Net cash used in financing activities (209,768 ) (59,615 ) Total (decrease) increase in cash and cash equivalents $ (18,170 ) $ 76,839 Net Cash from Operating Activities Net cash from operations is primarily affected by the overall profitability of our contracts, our ability to invoice and collect from clients in a timely manner, and our ability to manage our vendor payments. Net cash provided by operations was $200.5 million in the six months ended September 30, 2014 compared to $139.6 million in the same prior year period, or a 43.6% increase. The increase in net cash provided by operations was primarily due to the following: • Higher cash collections in fiscal 2015 as compared to fiscal 2014. In the prior year, our cash collections were lower due to less timely payments by our customers due in part to the government sequestration and staff furloughs, as the government agency payment offices did not have full staff to process and approve payments. The current year showed a return to a typical volume of cash collections during the U.S. government's fiscal year end. • A reduction in accrued compensation for bonuses in fiscal 2015 as compared to fiscal 2014 primarily due to the decline in headcount. • An increase in the change in income taxes payable compared to the prior year period due to the timing of the estimated tax payments. • A reduction in the volume of outstanding invoices as compared to the prior year which partially offset the increases noted above. Net Cash from Investing Activities Net cash used in investing activities was $8.9 million in the six months ended September 30, 2014 compared to $3.2 million in the same prior year period, or a 183.1% increase. The increase in net cash used in investing activities was due to an increase in capital expenditures. In addition the Company received a purchase price adjustment from a business acquisition, which offset the cash used in investing activities during the six months ended September 30, 2013. Net Cash from Financing Activities Net cash used in financing activities was $209.8 million in the six months ended September 30, 2014 compared to $59.6 million in the same prior year period, or a 251.9% increase. The increase in net cash used in financing activities was primarily due to an increase in regular and special cash dividends paid in fiscal 2015 as compared to fiscal 2014. Indebtedness On May 7, 2014 the Company entered into the Second Amendment to the Credit Agreement, dated as of July 31, 2012 (as previously amended by the First Amendment to the Credit Agreement, dated as of August 16, 2013). As of September 30, 2014, the Credit Agreement provided the Company with an $830.0 million Term Loan A and an $841.2 million Term Loan B, and a $500.0 million revolving credit facility, with a sublimit for letters of credit of $100.0 million. Our debt totaled $1,645.5 million and $1,658.9 million as of September 30, 2014 and March 31, 2014, respectively. The interest rate in effect for Term Loan A was 2.65% and for Term Loan B was 3.75% as of September 30, 2014 and March 31, 2014. As of September 30, 2014 and March 31, 2014, there were no amounts outstanding under our revolving credit facility of $500.0 million. As of September 30, 2014 and March 31, 2014, the Company was in compliance with all of the Credit Agreement's debt covenants. 29 --------------------------------------------------------------------------------Absent any prepayment accelerations of Debt Issuance Costs, or DIC, or the effect of changes in interest rates, the following table summarizes the estimated annual amortization expense of DIC using the effective interest rate method: DIC Amortization Expense Total 2015 2016 2017 2018 2019 Thereafter (in thousands) Term Loan A $ 6,896 $ 883 $ 1,733 $ 1,622 $ 1,463 $ 1,108 $ 87 Term Loan B 8,275 775 1,610 1,678 1,752 1,830 630 Revolver 8,652 925 1,858 1,853 1,853 1,853 310 Total $ 23,823 $ 2,583 $ 5,201 $ 5,153 $ 5,068 $ 4,791 $ 1,027 The Credit Agreement, as amended, requires quarterly principal payments of 1.25% of the stated principal amount of Term Loan A, with annual incremental increases to 1.875%, 2.50%, 3.125%, and 13.0%, prior to Term Loan A's maturity date of May 31, 2019. As a result of paying approximately $168.4 million of Term Loan B principal during the May 7, 2014 Second Amendment, no additional principal payments are required until the remaining balance is due on Term Loan B's maturity date of July 31, 2019. The revolving credit facility matures on May 31, 2019, at which time any outstanding principal balance is due in full. The interest rate on borrowings under Term Loan A is LIBOR plus a 2.50% spread. The spread ranges from 2.00% to 2.75% based on the Company's total leverage ratio. The interest rate on borrowings under Term Loan B is LIBOR plus a 3.0% spread with a 0.75% floor. The spread ranges from 2.00% to 3.00% based upon either an ABR or LIBOR borrowing. The revolving credit facility margin and commitment fee are subject to the leveraged based pricing grid, as set forth in the Credit Agreement, as amended. The loans under the Credit Agreement, as amended, are secured by substantially all of our assets and none of such assets will be available to satisfy the claims of our general creditors. The Credit Agreement, as amended, contains customary representations and warranties and customary affirmative and negative covenants. The negative covenants are limited to the following, in each case subject to certain exceptions: a maximum net total leverage ratio; a minimum net interest coverage ratio; limitations on indebtedness and liens; mergers, consolidations or amalgamations, or liquidations, wind-ups or dissolutions; dispositions of property; restricted payments; investments; transactions with affiliates; sale and lease back transactions; change in fiscal periods; negative pledges; restrictive agreements; limitations on line of business; limitations on speculative hedging and limitations on changes of names and jurisdictions. In addition, we are required to meet certain financial covenants at each quarter end, namely Consolidated Net Total Leverage and Consolidated Net Interest Coverage Ratios. As of September 30, 2014, we were compliant with these covenants. On September 26, 2014, we accessed $30 million of our $500 million revolving credit facility to support month-end transactions. On September 30, 2014, we repaid the $30 million borrowed from the revolving credit facility. Capital Structure and Resources At the annual meeting of stockholders held on July 31, 2014, the stockholders approved a proposal to amend and restate the Company's certificate of incorporation, which had the effect of converting all issued and outstanding shares of Class B Non-Voting Common Stock and Class C Restricted Common Stock into shares of Class A Common Stock on a one-for-one basis. The conversion was effected on August 13, 2014 when the Company filed its third amended and restated certificate of incorporation with the Secretary of State of the State of Delaware. As a result of the conversion, there were no more shares of Class B Non-Voting Common Stock and Class C Restricted Common Stock as of September 30, 2014. Our stockholders' equity amounted to $164.3 million as of September 30, 2014, a decrease of $7.3 million compared to stockholders' equity of $171.6 million as of March 31, 2014. The decrease is primarily due to $179.5 million in recurring and special dividend payments and an $8.3 million increase in treasury stock, partially offset by net income of $136.4 million in the six months ended September 30, 2014, $37.3 million in excess tax benefits for the exercise of stock options, and stock-based compensation expense. Off-Balance Sheet Arrangements As of September 30, 2014, we did not have any off-balance sheet arrangements. 30 -------------------------------------------------------------------------------- Capital Expenditures Since we do not own any of our facilities, our capital expenditure requirements primarily relate to the purchase of computers, business systems, furniture, and leasehold improvements to support our operations. Direct facility and equipment costs billed to clients are not treated as capital expenses. Our capital expenditures for the six months ended September 30, 2014 and 2013 were $8.9 million and $6.7 million, respectively, and the majority of such capital expenditures related to facilities infrastructure, equipment, and information technology. Expenditures for facilities infrastructure and equipment are generally incurred to support new and existing programs across our business. We also incur capital expenditures for information technology to support programs and general enterprise information technology infrastructure. Commitments and Contingencies We are subject to a number of reviews, investigations, claims, lawsuits, and other uncertainties related to our business. For a discussion of these items, refer to Note 16 to our condensed consolidated financial statements. Special Note Regarding Forward Looking Statements This Quarterly Report on Form 10-Q, or Quarterly Report, including information incorporated by reference into this Quarterly Report, contains forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "could," "should," "forecasts," "expects," "intends," "plans," "anticipates," "projects," "outlook," "believes," "estimates," "predicts," "potential," "continue," "preliminary," or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we can give you no assurance these expectations will prove to have been correct. These forward-looking statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These risks and other factors include: cost cutting and efficiency initiatives, budget reductions, Congressionally mandated automatic spending cuts, and other efforts to reduce U.S. government spending, including automatic sequestration required by the Budget Control Act of 2011 (as amended by the American Taxpayer Relief Act of 2012 and the Consolidated Appropriations Act, 2014), which have reduced and delayed contract awards and funding for orders for services especially in the current political environment or otherwise negatively affect our ability to generate revenue under contract awards, including as a result of reduced staffing and hours of operation at U.S. government clients; delayed funding of our contracts due to uncertainty relating to and a possible failure of Congressional efforts to craft a long-term agreement on the U.S. government's ability to incur indebtedness in excess of its current limits, or changes in the pattern or timing of government funding and spending (including those resulting from or related to cuts associated with sequestration or other budgetary cuts made in lieu of sequestration); current and continued uncertainty around the timing, extent, nature, and effect of ongoing Congressional and other U.S. government action to address budgetary constraints, including, but not limited to, uncertainty around the outcome of Congressional efforts to craft a long-term agreement on the U.S. government's ability to incur indebtedness in excess of its current limits, and the U.S. deficit; any issue that compromises our relationships with the U.S. government or damages our professional reputation, including negative publicity concerning government contractors in general or us in particular; changes in U.S. government spending, including a continuation of efforts by the U.S. government to decrease spending for management support service contracts, and mission priorities that shift expenditures away from agencies or programs that we support; the size of our addressable markets and the amount of U.S. government spending on private contractors; failure to comply with numerous laws and regulations; our ability to compete effectively in the competitive bidding process and delays or losses of contract awards caused by competitors' protests of major contract awards received by us; the loss of General Services Administration Multiple Award schedule contracts, or GSA schedules, or our position as prime contractor on government-wide acquisition contract vehicles, or GWACs; changes in the mix of our contracts and our ability to accurately estimate or otherwise recover expenses, time, and resources for our contracts; our ability to generate revenue under certain of our contracts; our ability to realize the full value of and replenish our backlog and the timing of our receipt of revenue under contracts included in backlog; changes in estimates used in recognizing revenue; an inability to attract, train, or retain employees with the requisite skills, experience, and security clearances; an inability to hire, assimilate, and deploy enough employees to serve our clients under existing contracts; an inability to timely and effectively utilize our employees; failure by us or our employees to obtain and maintain necessary security clearances; the loss of members of senior management or failure to develop new leaders; misconduct or other improper activities from our employees or subcontractors, including the improper use or release of our clients' sensitive or classified information; increased insourcing by various U.S. government agencies due to changes in the definition of "inherently governmental" work, including proposals to limit contractor access to sensitive or classified information and work assignments; increased competition from other companies in our industry; failure to maintain strong relationships with other contractors; inherent uncertainties and potential adverse developments in legal or regulatory proceedings, including litigation, audits, reviews, and investigations, which may result in materially adverse judgments, 31-------------------------------------------------------------------------------- settlements, withheld payments, penalties, or other unfavorable outcomes including debarment, as well as disputes over the availability of insurance or indemnification; continued efforts to change how the U.S. government reimburses compensation related and other expenses or otherwise limit such reimbursements, including recent rules that expand the scope of existing reimbursement limitations, such as a reduction in allowable annual employee compensation to certain contractors as a result of the Bipartisan Budget Act of 2013, and an increased risk of compensation being deemed unallowable or payments being withheld as a result of U.S. government audit, review or investigation; internal system or service failures and security breaches, including, but not limited to, those resulting from external cyber attacks on our network and internal systems; risks related to changes to our operating structure, capabilities, or strategy intended to address client needs, grow our business or respond to market developments; risks associated with new relationships, clients, capabilities, and service offerings in our U.S. and international businesses; failure to comply with special U.S. government laws and regulations relating to our international operations; risks related to our indebtedness and credit facilities which contain financial and operating covenants; the adoption by the U.S. government of new laws, rules, and regulations, such as those relating to organizational conflicts of interest issues or limits; risks related to completed and future acquisitions, including our ability to realize the expected benefits from such acquisitions; an inability to utilize existing or future tax benefits, including those related to our stock-based compensation expense, for any reason, including a change in law; variable purchasing patterns under U.S. government GSA schedules, blanket purchase agreements and indefinite delivery, indefinite quantity, or ID/IQ, contracts; and other risks and factors described in Part II, "Item 1A. Risk Factors" and elsewhere in this Quarterly Report. In light of these risks, uncertainties and other factors, the forward-looking statements contained in this Quarterly Report might not prove to be accurate and you should not place undue reliance upon them. All forward-looking statements speak only as of the date made and we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. |